SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                                    ---------
                                   FORM 10-KSB
  (Mark One)

  |X|    ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT
         OF 1934: For the fiscal year ended February 28, 1998
                                            -----------------

  | |    TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE
         ACT OF 1934: For the transition period from _________ to ______________

                         Commission file number 0-24426
                                                -------

                               C-PHONE CORPORATION
                 ----------------------------------------------
                 (Name of small business issuer in its charter)

                    NEW YORK                                  06-1170506
         -------------------------------                 -------------------
         (State or other jurisdiction of                 (I.R.S. employer
         incorporation or organization)                  identification No.)

         6714 NETHERLANDS DRIVE, WILMINGTON, NORTH CAROLINA            28405
         --------------------------------------------------           --------
               (Address of principal executive offices)              (Zip Code)

                    Issuer's telephone number: (910) 395-6100
                                               --------------

       Securities registered under Section 12(b) of the Exchange Act: None
                                                                      ----

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

                          Common Stock, $.01 par value
                          ----------------------------
                                (Title of class)

         Check  whether  the issuer:  (1) has filed all  reports  required to be
filed by Section 13 or 15(d) of the Exchange Act 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 [ ]

         Check if there is no  disclosure  of  delinquent  filers in response to
Item 405 of  Regulation  S-B contained in this form,  and no disclosure  will be
contained,  to the  best of  registrant's  knowledge,  in  definitive  proxy  or
information statements incorporated by reference in Part III of this Form 10-KSB
or any amendment to this Form 10-KSB. [ ]

         State issuer's revenues for its most recent fiscal year: $1,890,666

         State the aggregate  market value of the voting and  non-voting  common
equity held by  non-affiliates  computed by  reference to the price at which the
common  equity  was sold,  or the  average  bid and asked  price of such  common
equity, as of a specified date within the past 60 days:

         Approximately  $31,643,000  based  on the  last  published  sale  price
($5-11/32) on The Nasdaq National Market on May 26, 1998.

         State the number of shares  outstanding of each of the issuer's classes
of common equity, as of the latest practicable date:

         As of May 26, 1998 - 7,058,200 shares.

         Documents   Incorporated   by  Reference:   Portions  of  the  issuer's
definitive  proxy  statement to be mailed to shareholders in connection with the
issuer's 1998 Annual Meeting are incorporated by reference into Part III of this
Annual Report on Form 10-KSB.

         Transitional  Small Business  Disclosure  Format (check one) Yes [ ] No
[X]
<PAGE>

                                TABLE OF CONTENTS

Item No.                                                                    Page
--------                                                                    ----


Glossary ...................................................................  ii

1.       Description of Business ...........................................   2

2.       Description of Property ...........................................  13

3.       Legal Proceedings .................................................  13

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

5.       Market for Common Equity and Related Stockholder Matters ..........  14

6.       Management's Discussion and Analysis or Plan of Operations ........  14

7.       Financial Statements ..............................................  23

8.       Changes In and Disagreements With Accountants
         on Accounting and Financial Disclosure ............................  24

9.       Directors, Executive Officers, Promoters and Control Persons;
         Compliance with Section 16(a) of the Exchange Act. ................  24

10.      Executive Compensation. ...........................................  24

11.      Security Ownership of Certain Beneficial Owners and Management. ...  24

12.      Certain Relationships and Related Transactions. ...................  24

13.      Exhibits and Reports on Form 8-K. .................................  24

Signatures .................................................................  28

                                        i

<PAGE>

                                    GLOSSARY

Algorithm:                    A step-by-step problem solving procedure.

Analog telephone lines:       Standard telephone lines in use in most home (also
                              known  as  POTS  (plain  old  telephone   service)
                              lines).

Bandwidth:                    The  amount  of data a medium  can  transmit  in a
                              given amount of time.  The greater the  bandwidth,
                              the faster the rate of data transmission.

bps:                          Bits  per  second - A unit of  measurement  of the
                              speed of data transmission.

Codec:                        Compression/decompression    hardware    providing
                              digital  compression and  decompression  of analog
                              video  signals  so that  they  can be  efficiently
                              transmitted.

Compression:                  Reducing  the size of a data  file by  eliminating
                              unnecessary   information,   such  as  blanks  and
                              repeating or redundant  characters or information.
                              Compressing   video   information   also   can  be
                              accomplished by sending fewer frames per second or
                              reducing   the   quality   (by    displaying   the
                              information in a smaller window).

Digital telephone lines:      Telephone lines,  such as ISDN, T-1,  Switched 56,
                              Frame Relay and Sonet,  which  transmit  data in a
                              digital  format  through  the  use of  codecs  and
                              compression  algorithms.  Use of digital telephone
                              service may require  the  installation  of special
                              wiring.

DVC:                          Desktop video conferencing,  also sometimes called
                              PC-based video conferencing.

fps:                          Frames per second.

Frame Relay:                  Packet data protocol with less error correction to
                              speed   up   communication   over   high   quality
                              connections.

H.320                         The industry standard for video  conferencing over
                              digital telephone lines.

H.323                         The industry standard for video  conferencing on a
                              LAN.

H.324                         The industry standard for video  conferencing over
                              analog telephone lines using a modem.

Internet:                     A  network  of  computer   networks  using  TCP/IP
                              protocol.

ISDN:                         Integrated  services  digital  network  - A set of
                              protocol and interface  standards that effectively
                              provide  3  separate,   integrated,   transmission
                              channels.  ISDN  service  is  expected  to replace
                              certain current telephone lines.

LAN:                          Local area  network - A private  computer  network
                              connecting  work-stations,  file servers, printers
                              and other devices in a local area,  such as within
                              an office, building or campus using coaxial cable,
                              twisted pair or multimode

                                       ii
<PAGE>

                              fiber.  A LAN permits the sharing of resources and
                              the exchange of information between work-stations.

Modem:                        A device for converting  digital signals to analog
                              signals, and vice versa, typically used to connect
                              digital devices with analog telephone lines.

Network:                      A  group  of  devices   (such  as   work-stations,
                              telephones,  file  servers,  etc.)  connected by a
                              communications facility.

Packet:                       A  sequence  of  digitized   information  that  is
                              transmitted as a unit.

PC:                           Personal computer.

POTS:                         Plain old telephone service - Conventional  analog
                              telephone lines using twisted-pair copper wire.

Protocol:                     A set of rules for data  communications;  a set of
                              rules  and   procedures   for   establishing   and
                              controlling   the   exchange   of   data   between
                              computers.

Roll-About System:            A mobile  video  conferencing  system which allows
                              the  video  conferencing  equipment  to  be  moved
                              between rooms.

Sonet:                        Synchronous   optical   network  -  An   interface
                              standard  for  transmitting  data over fiber optic
                              lines.

Switched 56:                  A switched digital telephone service which permits
                              users to  transmit  up to 56,000  bits of  digital
                              information per second.

T-1:                          A  point-to-point   high-speed  digital  telephone
                              transmission service.

TCP/IP:                       Transmission control protocol/Internet  protocol -
                              The    protocol    used   for   packet    oriented
                              communication between networked computers.

Unshielded twisted pair:      Standard   building   wiring   currently  used  to
                              transmit voice  (telephone) and data throughout an
                              office or building.

World Wide Web:               A very large collection of linked Internet servers
                              using a standard linking and display language.

                                       iii
<PAGE>

                                     PART I

Item 1.  Description of Business
         -----------------------

GENERAL

         C-Phone Corporation (the "Company") has been, and is, primarily engaged
in the  engineering,  manufacturing  and  marketing of a line of TV-based  video
phones and PC-based  desktop video  conferencing  systems.  The Company's  stand
alone TV-based video conferencing  system or "video phone",  which operates over
regular  analog  telephone  lines using a standard  television  set, is marketed
under the name C-Phone Home(TM).  In addition,  in March 1998, the Company began
limited  shipments of its C-Phone DS 324 TV-based  video phone,  which  operates
over both analog and ISDN  digital  telephone  lines.  In May 1998,  the Company
introduced  C-Phone  ITV(TM),  a TV-based set top device that provides  Internet
access  using a  standard  television  set and an  analog  telephone  line.  The
Company's  PC-based video  conferencing  systems,  which operate over local area
networks ("LANs"), are marketed under the name C-Phone(R).

         The Company was  incorporated in New York in 1986 under the name Target
Tuning,  Inc., as a  manufacturer  of promotional  radios.  In 1990, the Company
developed  data/fax  modems  under the name  "TWINCOM"  and  changed its name to
Target  Technologies,  Inc. In early 1993, because of continued price pressures,
shrinking margins and for competitive  reasons,  the Company shifted its primary
focus from modems to the development of video conferencing products; and, during
the fiscal  year ended  February  28,  1995,  the  Company  phased out its modem
product  line as it was no  longer  profitable.  In  August  1994,  the  Company
completed an initial public offering  pursuant to which the Company received net
proceeds of approximately  $12,288,000.  In March 1997, the Company  completed a
private  placement  pursuant to which it received net proceeds of  approximately
$4,370,000.  In December 1997, the Company  completed a second private placement
pursuant to which it received net proceeds of approximately  $4,110,000.  In May
1998, the Company  received net proceeds of  approximately  $4,600,000  from the
exercise  of  outstanding  warrants  and  options.  See  Item 6 -  "Management's
Discussion  and Analysis or Plan of  Operation - Recent  Equity  Offerings"  and
Notes 6 and 14 of Notes to  Financial  Statements  included in Item 7 "Financial
Statements."

         Since 1993, the Company has invested  significant  resources in product
development,  engineering  and marketing  activities for its video  conferencing
systems and related products. As a result of these activities and the low volume
of sales during the initial  commercialization of its video conferencing systems
and video phones  (which  initial  commercialization  is  ongoing),  the Company
incurred  significant  losses  during the three fiscal years ended  February 28,
1998 and expects that it will incur significant losses during its current fiscal
year ending February 28, 1999 ("Fiscal 1999").  The Company  anticipates that it
will  continue to make  significant  expenditures  for product  development  and
marketing of its TV-based products during the foreseeable  future.  See Item 6 -
"Management's  Discussion  and Analysis or Plan of  Operation -  Overview."  The
Company  believes  that its TV-based  products  currently  have  greater  market
potential  than its PC-based  products and, in light of the lack of  significant
industry  acceptance for PC-based desktop video conferencing  products operating
over a LAN, and the Company's limited financial and other resources, the Company
has  decided to shift its  resources  to its  TV-based  products,  although  the
Company will continue to support and provide  equipment to its existing customer
base  for  its  PC-based  products  and  to new  customers  in  connection  with
specialized  applications relating to its PC-based products, if any, that may be
presented to the Company. See "Marketing and Sales - PC-BASED PRODUCTS."

         In August 1996, in order to more closely  identify the Company with its
C-Phone product line, and to eliminate  confusion among  investors,  the Company
changed its name to "C-Phone Corporation."

                                       2
<PAGE>

INDUSTRY BACKGROUND

         Video  conferencing  was  introduced  in  the  late  1970s  with  video
conferencing rooms located in office parks or office buildings. These rooms were
outfitted  with  expensive  video  conferencing   equipment   requiring  trained
operators.  Using special leased digital  telephone  lines,  these systems could
only conference with other compatible facilities. While early video conferencing
rooms  cost  between  $200,000  and  $400,000,  technological  improvements  and
increased production volumes have lowered the present total cost of a room-based
corporate video conferencing system to between $50,000 and $90,000, with certain
lower-cost,  lesser-function  systems selling below $20,000.  Video conferencing
rooms are  typically  used by large  corporations  primarily  for  intra-company
communications  between  distant  locations,  although  within the past  several
years,  telecommunication  companies,  as an  adjunct to their  other  services,
hotels offering business conference  facilities and other third parties in major
metropolitan   areas  have  made  video  conference  room  facilities   publicly
available,  at an hourly fee of several hundred  dollars.  The Company  believes
that there are in excess of 25,000  installed video  conference rooms worldwide,
but that the high costs of video conferencing rooms, the logistical difficulties
in scheduling their simultaneous availability and the need for trained operators
have limited their growth.

         During the last several years, mobile video conferencing systems, known
as "roll-about"  systems, have become available at prices generally ranging from
$15,000 to $30,000,  which allow the video  conferencing  equipment  to be moved
between locations. In addition, desktop video conferencing ("DVC") systems using
a personal  computer ("PC") have been developed,  some of which offer advantages
over video  conferencing  rooms and "roll-about"  systems. A DVC system improves
productivity by offering the ease of operation of a telephone, avoiding the need
for special  scheduling,  and allowing the video  conferencing  participants  to
share software  applications.  In addition,  a DVC system is substantially  less
expensive than a video conferencing room or "roll-about"  system,  with a system
price,  excluding the cost of the PC, of typically less than $5,000, with prices
of certain  available systems as low as $1,200 to $2,000.  However,  neither the
DVC market in general nor the Company's  PC-based product line in particular has
achieved  substantial  market  acceptance.  See  "Marketing and Sales - PC-BASED
PRODUCTS."  and  Item 6 -  "Management's  Discussion  and  Analysis  or  Plan of
Operation - Overview."

         Historically,  video  conferencing  systems have used digital telephone
lines to interconnect users. In order to transmit a real-time video image over a
digital  telephone  line, the  electronic  video and  accompanying  audio signal
(which,  in its  original  form,  may contain  over 130 million bits of data per
second) must first be "digitized"  and then reduced or  "compressed"  to fit the
capacity  of the digital  telephone  line.  The video  signal is  compressed  by
eliminating  data,  which  typically  causes the  quality of the video  image to
degrade.   After  transmission,   the  video  image  is  then  reconstructed  or
"decompressed."  The quality of the reconstructed image is a function of (i) the
sophistication of the compression algorithm (which determines the information to
be  eliminated),  (ii) the  amount  (expressed  as bits per second  ("bps"))  of
real-time data which can be transmitted  over the digital  telephone line, (iii)
the power,  speed and  sophistication  of the codec (which  ranges in price from
$1,000 to $25,000, unless a lower quality codec is built into the PC processor),
and (iv) the relative amount of audio accompanying the video signal.

         With  the   widespread   availability   of  modems   which  permit  the
transmission  of data over analog  telephone lines at rates of up to 33,600 bits
of data per second,  as well as the recent  adoption of the H.324  standard  for
video conferencing over analog telephone lines, several companies, including the
Company, have announced or introduced products to allow video conferencing using
modems  over  analog  telephone   lines.   While  these  systems  operate  at  a
significantly  lower  video  frame  rates  (ranging  up to 16  fps  under  ideal
conditions,  as compared to television which delivers a higher  resolution video
image at 30 fps) and often without fully  synchronized  audio, such products are
designed to appeal to non-commercial  home users and small  businesses,  and are
less expensive to own and operate than video  conferencing  products requiring a
digital  telephone  line.  During the past two years, a number of companies have
introduced  products which,  when connected to a PC, allow video telephone calls
to be made through analog telephone lines over the

                                       3
<PAGE>

Internet.  Although  video  conferencing  over the Internet may  eliminate  long
distance  telephone  charges,  the fps rate is less than with a direct telephone
connection,  the lack of industry  standards  requires the use by the parties of
comparable  equipment,   portions  of  the  conference  may  be  "lost"  in  the
transmission  and delays in the  receipt  of the  transmission  may occur.  As a
result,  the  Company  does not expect that  Internet  video  conferencing  will
materially affect the market for direct video conferencing over analog telephone
lines.

         In 1997, several companies,  including the Company, introduced TV-based
"set-top"  video  phones  which  allow  users to make video  calls  using  their
television sets and an analog  telephone line without the need for a PC. As with
PC-based  systems,  these TV-based systems operate at significantly  lower video
frame  rates  (ranging up to 16 fps under ideal  conditions)  and often  without
fully synchronized audio. Also in 1997, several other companies introduced video
phones  containing  their own screen which allow users to make video calls using
an ISDN  telephone  line  utilizing  the H.320  standard.  In 1998,  the Company
introduced  its TV-based  video phone which also  operates  over an ISDN digital
telephone line utilizing the H.324 standard and is capable of delivering  higher
video  frame  rates  (ranging  up to 30 fps under  ideal  conditions).  See "The
Company's Products - TV-BASED PRODUCTS."

INDUSTRY STANDARDS

         Historically,  a factor that  limited the growth of video  conferencing
was the lack of uniform protocols so that proprietary video conferencing systems
could only  communicate  with similar  systems of the same  manufacturer.  Video
conferencing  has  become  more  widespread  as a  result  of the  emergence  of
international  industry standards  designed to allow video conferencing  systems
manufactured by different vendors to be compatible.

         In  1990,   the   Telecommunication   Standardization   Sector  of  the
International  Telecommunication  Union  ("ITU"),  a United Nations agency which
develops  international  standards for  telecommunications  equipment,  formally
adopted the H.320 standard for video conferencing,  which includes standards for
video and audio  transmission  and data transfers.  While other protocols exist,
H.320 has achieved the most widespread  acceptance,  and has been adopted by the
Company and substantially all of its competitors.

         The ITU  formally  adopted  the H.324  standard in March 1996 for video
conferencing  over analog telephone lines. The Company believes that adoption of
the H.324  standard  will permit a broad  acceptance of analog  telephone  video
conferencing using products such as C-Phone Home. C-Phone Home has been designed
to be compatible with other H.324 compatible equipment.

         The ITU formally  adopted the H.323 standard in November 1996 for video
conferencing  over a LAN.  Although the Company  believes  that  adoption of the
H.323  standard  may lead to wider  use of video  conferencing  over a LAN,  the
quality of such video  conferencing  will not be as high as with  direct  dialed
video calls and it is uncertain as to whether  managers of LAN systems will find
the increased amount of LAN traffic acceptable to their systems.

THE COMPANY'S PRODUCTS

TV-BASED PRODUCTS

         The  Company's  TV-based  "set-top",  video  phones allow users to make
video phone calls using their  television set and their analog or ISDN telephone
line. The Company believes that a market for its TV-based products exist for (i)
business   applications,   such  as   videoconferencing,   video   surveillance,
recruiting,  distance learning and training,  tele-maintenance  and tele-health,
and (ii) personal  use, such as signing by the hearing  impaired and video phone
calls between family members,  including  grandparents and

                                       4
<PAGE>

their grandchildren,  parents and their children away at school, and divorced or
separated parents and their young children.

         The  Company  introduced  C-Phone  Home at the  January  1997  Consumer
Electronics  Show and began  commercial  shipments  in March  1997.  The Company
introduced  C-Phone DS 324 at the January  1998  Consumer  Electronics  Show and
began limited commercial  shipments in March 1998. The Company believes that its
DS 324 video phone is the only product  currently on the market which is capable
of  using  either  an  analog  or ISDN  telephone  line  and is  designed  to be
compatible with both H.324 and H.320 standards.

         C-PHONE   HOME.   C-Phone  Home  allows  a  user  to  engage  in  video
    conferencing  over an analog telephone line using a standard  television set
    or  monitor  and is  capable  of  delivering  data at rates of up to 16 fps.
    C-Phone Home consists of a "set-top" box, a hand-held  remote control and an
    AC power  adapter.  The set-top  box,  which  weighs less than five  pounds,
    connects to the  television's  RF or audio and video  inputs and  includes a
    color  camera,  built-in  full-duplex  microphone,  modem (to connect to the
    telephone line), codec and proprietary  software.  The remote control allows
    the users to dial,  answer or end a call by pushing one or two  buttons.  In
    addition,  C-Phone Home offers easy-to-use  on-screen  instructions and text
    menus to operate and configure  the system.  C-Phone Home utilizes the H.324
    standard  and is designed to be  compatible  with other  systems  using such
    standard. See "Industry Standards."

         C-PHONE DS 324. In addition to having all the features of C-Phone Home,
    the DS 324 also  operates  over ISDN  digital  networks,  and is  capable of
    delivering  video  data at  rates  of up to 30 fps  when  used  with an ISDN
    digital  telephone  line.  The DS 324 video  phone can be used to make video
    telephone  calls to any other video  conferencing  device that  supports the
    H.324  standard  (and will support the H.320  standard in the near  future),
    including  PC-based  systems,  video  conferencing  rooms and TV-based video
    phone using either analog  telephone lines or ISDN digital  telephone lines.
    In addition to the basic  C-Phone DS 324,  the Company  also offers  several
    enhanced  models.  The  C-Phone  DS 324 Pro  features  an  external,  higher
    quality,  pan,  tilt and zoom camera with far end control and the C-Phone AV
    324 contains multiple jacks for connecting video surveillance equipment.

         The  Company  has no  reliable  data  to  assure  that  there  will  be
significant  market  acceptance  of TV-based  video  phones in  general,  or the
Company's  products  in  particular,  and  there  can be no  assurance  that the
Company's  TV-based  video  phones will gain  sufficient  market  acceptance  to
generate  significant  commercial  sales. In addition,  previous efforts to sell
video  phones by larger,  better  known,  companies  than the Company  have been
unsuccessful  due, in part,  to the  inability of such systems to deliver  video
data  at the  rate  of  greater  than  between  one-half  to ten  fps and to the
inability of such systems to emulate a normal  telephone call,  primarily as the
result of lower audio quality  associated  with the analog phone line's  limited
bandwidth  which  must be shared  with  video  data.  Currently,  the  Company's
TV-based video phone,  when operating over an analog  telephone line, is capable
of  delivering  video data at rates of up to 16 fps under  ideal  circumstances.
Many factors,  taken either  singularly or together,  will lower the frame rate.
These include  non-optimal  conditions on the phone line to the user's premises,
the  presence of noise on the phone line and  substantial  movement in the video
being  transmitted,  especially when  transmitting in a high resolution mode. In
the instance  when any or all of these  factors are  present,  frame rate may be
reduced  to as low as one fps.  The  Company  believes  that  most  users of the
Company's TV-based video phone will prefer full screen, highest resolution mode,
when frame rates are  typically  four to eight fps. At these lower frame  rates,
there is not  enough  motion  in the  lips of the  users  for  video  and  audio
synchronization  to  be  necessary,  and  the  Company's  TV-based  video  phone
transmits the audio with as little processing delay as possible in an attempt to
make the users feel as if they are  participating  in a regular  phone call.  In
other   conditions,   where  over  ten  to  twelve  fps  are  transmitted,   lip
synchronization  may be more  desirable  and may result in as much as a one-half
second delay in the audio  transmission.  Such a delay may not be  acceptable by
most consumers and, as a result, there can be no assurance that the Company will
be able to achieve a satisfactory level of consumer  acceptance of the Company's
TV-based video phone within a reasonable  period of time, if at all. 

                                       5
<PAGE>

The Company began limited  shipments of its DS 324 TV-based video phone in March
1998,  which is capable of  delivering  video data at rates of up to 30 fps when
used  with an ISDN  digital  telephone  line.  While  many of the  same  factors
mentioned  above also  impact the audio and video of the  Company's  video phone
when used with an ISDN digital telephone line, the increased  bandwidth afforded
by a digital telephone line significantly increases the quality of the audio and
video as compared to operation over an analog  telephone line.  However,  due to
(i) the  higher  price  of the  Company's  DS 324  video  phone,  and  (ii)  the
installation  cost and higher  monthly  service fee of an ISDN telephone line as
compared  to an  analog  telephone  line,  there  can be no  assurance  that the
Company's DS 324 video phone will receive market acceptance.  See "Marketing and
Sales -TV-BASED PRODUCTS."

         The Company recently  introduced  C-Phone ITV, a self contained set-top
device that provides Internet access,  without a PC, using a standard television
and a regular  analog phone line.  C-Phone ITV consists of a "set-top" box and a
wireless,  infrared unit,  which also functions as a universal  remote  control.
C-Phone  ITV is capable of  connecting  to any  Internet  Service  Provider by a
dial-up  connection and allows the user complete  Internet access,  including to
the World  Wide Web and for  e-mail.  The  device's  hardware  key  allows  easy
configuration,  stores the Internet account information for each individual user
and serves as a lock-out device to prevent  unauthorized  or  unsupervised  use.
C-Phone ITV,  which  includes an embedded  web browser,  offers many of the same
features  commonly  available on PC web browsers,  including Secure Socket Layer
("SSL") protocol for Internet purchases via credit card, and the ability to view
and play a wide range of sound, animation, and graphic file formats which may be
retrieved  from the  Internet.  C-Phone  ITV has a printer  port  with  built in
drivers to directly support over 150 different  commercially available printers.
The device also features  stereo audio outputs.  Higher  resolution VGA computer
monitors can be connected as well,  and a mouse or wired keyboard can be used in
place of the wireless keyboard. A variety of additional capabilities,  including
network computer functionality and Java(TM) support, can be added to C-Phone ITV
through  ROM card  upgrades.  To date,  the Company has  supplied  only  limited
quantities of the device to certain of its business and institutional  partners.
Retail  distribution  plans  still  are  being  formulated,  and there can be no
assurance that the device will receive market acceptance or that the Company can
successfully negotiate acceptable distribution arrangements.  See "Marketing and
Sales - PC-Based Products."

PC-BASED PRODUCTS

         The Company's C-Phone video conferencing products primarily are used as
PC-based DVC systems  operating  over a LAN. The C-Phone  system  permits two or
more  persons  using PCs  linked by a LAN to  engage in  real-time,  full-color,
television-quality video calls with fully synchronized audio. The video image of
the participants appears on the computer monitor, and the audio is produced from
the  camera/speaker/microphone   unit  mounted  on  the  monitor  or  through  a
conventional  telephone  handset.  Within  the  LAN,  C-Phone's  video  image is
displayed at a rate of 30 fps  regardless of image size.  C-Phone users also can
call  outside  of  their  LAN to  other  C-Phones,  PC-based  systems  or  video
conferencing  rooms,  with  picture  quality  equal to that of  other  presently
available video conferencing systems, which typically offer less than television
quality  picture,  depending  on the type of codec  and the type and  number  of
digital  telephone  lines used.  The C-Phone system is designed to be compatible
with  all  PC-based  codecs,   whether  they  contain  standard  or  proprietary
protocols,   provided  that  the  codec  manufacturer   provides  the  requisite
developmental  software.  As a result, a C-Phone user calling outside the LAN is
able to connect to any other video  conferencing  system,  provided  the systems
have  compatible  codecs.  See  "Industry  Standards."  In  addition  to its LAN
systems,  the Company's video  conferencing  products can be used in traditional
video conferencing room systems and in small group "roll-about" units.

                                       6
<PAGE>

MARKETING AND SALES

TV-BASED PRODUCTS

         The Company  introduced its first TV-based  product  C-Phone Home, as a
production prototype, at the January 1997 Consumer Electronics Show. At the time
of such introduction,  the Company had engaged in only preliminary marketing for
C-Phone Home and had not obtained  any orders for  consumer  resale.  Based upon
perceived  enthusiasm  from the trade for C-Phone Home,  the Company  determined
that a viable market for the product  existed,  and that its marketing  strategy
should be to make  initial  sales of  C-Phone  Home  through  one or more  large
consumer  electronics  retail  chains,  assuming that the Company could convince
such chains that  C-Phone  Home was a credible  product  deserving  retail store
display  space.  The  Company's  net  revenues  from  TV-based   products  since
commercial   introduction  in  March  1997,  through  February  28,  1998,  have
aggregated approximately $1,027,000.

         The   Company   uses    independent    manufacturer's    representative
organizations  to act as the  Company's  national  field  sales  force  for  the
Company's  TV-based  video  phones.  In  addition,  the Company has  established
relationships with companies operating in 15 countries,  including South Africa,
India, Malaysia, Mexico, Canada, Korea and Japan for the foreign distribution of
its TV-based video phones. The Company's  international partners are responsible
for  establishing a local presence for the product,  creating market  awareness,
handling local government import and certification requirements, arranging local
technical  support and  distribution,  demonstrating the product at trade shows,
implementing  local  advertising  and  marketing  programs and  translating  the
operating system and manual and related materials.

         As  part  of  the  Company's  plan  to  develop  market  awareness  and
acceptance  for its  TV-based  video  phone,  the Company  has  entered  into an
agreement  (the "Sprint  Agreement")  with an  affiliate  of Sprint  Corporation
("Sprint") to supply Sprint with its TV-based  video phone  co-branded  with the
C-Phone and Sprint  names.  However,  Sprint is not  obligated  to purchase  any
minimum number of units and, through May 26, 1998, had purchased for resale only
a limited number of units to test market the product in five stores. Pursuant to
the Sprint  Agreement,  Sprint is  entitled  to return to the Company any unsold
units  (excluding  those  units  that it has  already  purchased  for  its  test
marketing)  that are held in its inventory  for more than four months,  provided
that no more than  one-third  of the total  number of units  purchased by Sprint
during the term of the Sprint Agreement may be returned,  and to receive, at its
option,  either a cash refund or a credit against future purchase,  in an amount
equal to 80% of the original  invoice price for such units.  At such time, if at
all, as Sprint purchases a significant amount of products from the Company,  the
exercise  by Sprint of its right to return for cash of a  significant  number of
units could have a material adverse effect on the Company and its available cash
resources.  In addition,  pursuant to the Sprint  Agreement,  in order to permit
Sprint to continue to sell the  co-branded  TV-based  video phone,  in the event
that,  among other  things,  (i) the Company is  unwilling  or unable to provide
upgrades or  modifications  to the  software  for the unit,  or (ii) the Company
liquidates  or becomes  insolvent or the subject of a bankruptcy  petition,  the
Company has agreed,  if requested by Sprint, to place in escrow the source codes
(the "Source  Codes") for the software  related to the unit. Upon the occurrence
of such events,  the Source Codes would be released to Sprint on a nonexclusive,
non-transferable  basis (and subject to  establishment  of a reasonable  royalty
payment) for so long as any such event is continuing.  The Company believes that
a  release  of  the  Source  Codes,   which  include   non-public,   proprietary
information, could have a material adverse effect on the Company.

         In addition to the sale of its video phones through  telecommunications
companies,   through  international   distributors  and  special  projects,  the
Company's  marketing strategy includes sales to consumer  electronic  retailers,
including catalog  companies.  The Company has had only limited prior experience
in marketing and selling its products to consumer electronic retailers,  some of
whom have special problems, such as inadequate working capital, which may affect
their ability to timely pay for their purchases from the Company and may require
the Company to grant extended  credit terms.  Such retailers  typically  require
that their vendors pay advertising  expense prior to consumer resale and payment
to the vendor.  Furthermore,  and  irrespective of the contracted  payment terms
negotiated  with such retailers,  such retailers  generally do not pay for their
merchandise  unless and until such merchandise  "sells through" to the consumer,
thereby creating higher payment risks.

                                       7
<PAGE>

         The Company has limited sales,  marketing and  distribution  experience
relating  to retail  consumer  goods.  The  commercialization  of the  Company's
TV-based  video  phones  require  certain  sales,   marketing  and  distribution
capabilities,  some of which the Company does not currently  possess,  and there
can be no  assurance  that the Company  will be able to  establish  and retain a
sales and marketing  capability which would be successful in gaining  commercial
market  acceptance  for the  Company's  TV-based  video  phones.  The Company is
devoting a material portion of its available resources for the commercialization
of the Company's  TV-based video phone,  and failure of the Company to establish
the necessary sales,  marketing and  distribution  network for this product will
have a material adverse effect on the Company's financial condition.

PC-BASED PRODUCTS

         The Company  developed its initial PC-based product in 1993 for desktop
video  conferencing over a LAN, and has developed a number of enhancements since
such time. However,  the market for this type of PC-based video conferencing has
not  matured  as  rapidly  as  expected.  In order to  expedite  the  commercial
introduction of its video conferencing products, the Company's initial sales and
marketing  strategy was to attempt to form alliances  with  strategic  partners,
primarily nationally recognized system integrators, resellers, telecommunication
service companies and original equipment manufacturers, to assist the Company in
identifying,  developing and exploiting specific high-volume market applications
which would  incorporate the Company's video  conferencing  products into larger
information  management  and  communication  systems.  Although  the Company has
entered  into  several  such  alliances,  none of  such  alliances  resulted  in
significant  commercial sales.  During 1996, the Company reoriented the emphasis
of its sales and marketing strategy and focused on sales to regional  resellers,
including  systems  integrators,   telephone  system  dealers  and  audio/visual
specialists,  and selected large  potential  customers with needs for customized
video conferencing  capabilities.  The Company's revenues from PC-based products
during  the  year  ended   February  28,  1998   ("Fiscal   1998"),   aggregated
approximately $863,000. In light of the Company's shift in focus to its TV-based
products, the lack of significant industry acceptance for PC-based desktop video
conferencing  products operating over a LAN, and the Company's limited financial
and other  resources,  the  Company has  decided to shift its  resources  to its
TV-based  products,  although the Company  will  continue to support and provide
equipment to its  existing  customer  base for its PC-based  products and to new
customers in connection with specialized  applications  relating to its PC-based
products, if any, that may be presented to the Company.

GENERAL

         The Company's success will depend, in part, upon its ability to provide
its customers, either directly or through others, technical support and customer
service  for its  products.  The Company  presently  provides  support  services
directly for its U.S. customers, but relies on its foreign strategic partners to
supply support services outside of the United States. If the Company's  business
expands, of which there can be no certainty,  there can be no assurance that the
Company can continue to directly provide such services to its U.S. customers, in
which event it would be required to negotiate  third-party  support  services on
acceptable  terms,  of which there can be no assurance.  Failure to provide such
support services would have a material adverse effect on the Company.

         A  significant  portion  of  the  Company's  past  revenues  have  been
dependent on sales to a limited  number of customers.  During  Fiscal 1998,  net
revenues  from Comtrad  Industries  and Nobody  Beats the Wiz (the "Wiz"),  were
11.0% and 10.4%,  respectively,  of the  Company's  net revenues  from  TV-based
products (and 6.0% and 5.6%, respectively,  of the Company's total net revenues)
and the Company's  ten largest  customers  for TV-based  products  accounted for
approximately  73.1% of the Company's  net revenues from TV-based  products (and
39.7% of the Company's  total net revenues).  During the year ended February 28,
1997 ("Fiscal 1997"), net revenues from Mirage Resorts,  Inc. and C-Phone Europe
NV/SA (the Company's former European  distributor)  constituted 14.3% and 10.3%,
respectively,  of the  Company's  net revenues  (all 

                                       8
<PAGE>

of which was related to the Company's  PC-based  product).  Although the Company
requires its non-North American distributors to purchase a minimum annual amount
of products to maintain their exclusive  distributorships,  the Company does not
have written  agreements with any of its customers which require the purchase of
any minimum quantities of products and,  therefore,  such customers could reduce
or curtail their purchases at any time. As a result, a substantial  reduction in
orders from existing customers (which has occurred from time to time) would have
a material  adverse  effect on the Company unless the Company is able to attract
orders from new customers,  of which there can be no assurance.  On December 16,
1997, the Wiz filed for protection  under the United States  bankruptcy laws and
there can be no  assurance  as to the  amount,  if any,  that the  Company  will
receive as payment on its  outstanding  accounts  receivable from the Wiz (which
constitutes  all sales to the Wiz  during  Fiscal  1998),  and the  Company  has
established an allowance for doubtful accounts equal to substantially all of its
Wiz receivables.

         During  Fiscal  1998,  the  Company's  non-U.S.  net  sales  aggregated
approximately  17.1%  of  total  net  sales,  and were  derived  from  resellers
primarily located in South Africa, India,  Malaysia,  Mexico,  Canada, Korea and
Japan,  55.6% of which were from TV-based  product sales and 44.4% of which were
from PC-based  product  sales.  During Fiscal 1997, the Company's  non-U.S.  net
sales, all of which were from PC-based products,  aggregated approximately 15.0%
of  total  net  sales,  and were  derived  from the  Company's  former  European
distributor and resellers in Canada,  Europe and southeastern  Asia. A reduction
in the volume of non-U.S. trade or any material restrictions on such trade could
have a material adverse impact on the Company's revenues from its PC-based video
conferencing  products.  The Company  sells to its  Canadian  reseller on credit
terms and usually  makes its other  foreign  sales on a prepaid basis due to the
difficulty in collecting  foreign  accounts  receivable;  and any change in such
policy which may be  occasioned  by the  potential of larger  orders from one or
more  foreign  customers  could expose the Company to  increased  credit  risks.
Foreign sales are denominated in U.S. dollars and the Company does not incur any
foreign currency risks;  however,  fluctuations in currency exchange rates could
cause the  Company's  products to become  relatively  more  expensive to foreign
customers,  which could result in a reduction in foreign sales or  profitability
of foreign sales.

MANUFACTURING

         The   Company's   products  are   comprised   primarily  of  components
manufactured  on  a  batch  basis  by  the  Company,  sub-assemblies  and  parts
manufactured to the Company's  specifications by third parties and certain other
"off the shelf" electronic  components  purchased from third parties. To date, a
substantial  portion  of the  Company's  manufacturing,  as  well  as the  final
assembly, testing and packaging of all of its products has been performed at the
Company's facility in Wilmington, North Carolina.

         The Company  relies on a number of small and large  manufacturers  that
supply a wide variety of off-the-shelf  semiconductor  integrated  circuit chips
and specialized  electronic  components,  several of which manufacturers are the
sole source of supply. The Company also relies on third party  manufacturers and
assemblers to manufacture  and/or assemble certain components and sub-assemblies
for the Company's  products that are built to the Company's  specifications  and
which require  fabrication  equipment  the Company does not  presently  possess.
Further,  the  Company  relies  on third  party  manufacturers  for  specialized
sub-assemblies, including the charged coupled device color camera presently used
by the  Company  which,  although  not  built  to  Company  specifications,  are
manufactured   outside  of  the  United  States  and  are   inventoried  by  the
manufacturers in limited  quantities.  While the Company believes that all these
components could be obtained elsewhere if needed and that the Company's products
could be redesigned  to use  alternative  components,  no assurance can be given
that other  sources of supply would be available  without  significant  delay or
increased cost, and the use of alternative  available  components  could require
re-engineering  by the Company of portions of its  products,  which could impose
additional cost and significant delay on the Company. In addition, the Company's
reliance on third parties to manufacture  and  sub-assemble  certain  components
involve  significant risks,  including reduced control over delivery  schedules,
the  inability to ship product  under  "just-in-time"  arrangements  and quality
assurance. Furthermore, certain of the

                                       9
<PAGE>

Company's  manufacturers,  sub-assemblers and suppliers,  including suppliers of
components made outside the United States,  may require the Company to make firm
scheduling and delivery  commitments and deliver secure financing  arrangements,
such as letters of credit,  as a condition to fulfillment  of their  contractual
obligations to the Company.  Failure to obtain an adequate  supply of components
and  required  sub-assembler  services  on a timely  basis would have a material
adverse effect on the Company.  As a result, the Company anticipates that, if it
is  successful  in  the  commercialization  of  its  products,  so  that  larger
quantities  of its  products  can be sold,  the  Company  will  become even more
dependent  on a timely  supply of purchased  inventory,  and will be required to
devote significant capital to inventory. The Company currently does not have the
significant   financial   resources  necessary  to  fully  fund  such  level  of
commercialization. See Item 6 - "Management's Discussion and Analysis or Plan of
Operations - Liquidity and Capital Resources."

         While the Company has been  manufacturing  certain  video  conferencing
components  since 1994,  sales volume to date has kept  production at relatively
low and inefficient levels. In order to be profitable,  the Company must be able
to  manufacture  its products at acceptable  costs and there can be no assurance
that the Company will be able to make the transition to higher production volume
successfully  or within  acceptable  profit  margins.  As the  Company  only has
limited experience in manufacturing  commercial quantities of its products,  and
anticipates heavy reliance on contract  manufacturers if demand for its products
increase,  the  Company is in the  process of  evaluating  a third party for the
purpose of providing  final assembly of its products.  However,  there can be no
assurance that such third party will be acceptable or that the parties can agree
on terms  that are  acceptable  to the  Company.  Furthermore,  there  can be no
assurance that unforeseen  technical or other  difficulties will not arise which
could interfere with the development or manufacture of its products, or prevent,
or create delays in, marketing of its products.

COMPETITION

GENERAL

         The technology  underlying  video  conferencing  products is subject to
rapid change,  including potential introduction of new products and technologies
which may have a material adverse impact on the Company's products.  The Company
needs to maintain an on-going research,  development and engineering program and
its success,  if any,  will depend in part on its ability to respond  quickly to
technological  advances by developing and  introducing new products or features.
There can be no assurance  that the Company will have the  financial  ability to
maintain an appropriate  on-going research,  development and engineering program
and, if it has such  ability,  whether  the Company  will be able to foresee and
respond to  technological  advances in a timely manner,  if at all. In addition,
even though the open architecture of the Company's  products allow components to
be replaced as new  technologies  develop,  there can be no  assurance  that the
development  of  technologies  and products by  competitors  will not render the
Company's products non-competitive or obsolete.

TV-BASED PRODUCTS

         To date,  TV-based video  conferencing  over analog telephone lines has
received very limited  market  acceptance  and TV-based  video phones using ISDN
telephone lines has been confined to more expensive products designed to support
limited business applications.  As a result of recent technological advances and
the adoption of the H.324  standard for video  telephony  over analog  telephone
lines, consumer video phones are being developed by a number of companies,  some
of which are more established,  benefit from greater market recognition and have
significantly  greater  financial,  technological,  manufacturing  and marketing
resources  than the Company.  The Company  expects that the  Company's  TV-based
video phones may face substantial  competition from many well-known  established
suppliers   of  consumer   electronic   products,   which  may  include   Lucent
Technologies,  PictureTel  Corporation,  Philips  Electronics  N.V.,  Sony Corp,
Tandberg  and VTEL  Corporation;  and if any of such  companies,  among  others,
determine to market a competitive  product,  the Company  could have  difficulty
obtaining necessary retail display space for its video

                                       10
<PAGE>

phones.  Many of these  potential  competitors  sell  television  and  telephone
products into which they may integrate video phone systems,  thereby eliminating
the need to purchase a separate video phone system. 8x8, Inc., a manufacturer of
integrated video compression  semiconductors and associated software,  from whom
the Company  previously  had  purchased  integrated  circuits for the  Company's
products,  sells TV-based video phones which directly compete with the Company's
TV-based  video phones.  Additionally,  8x8, Inc.  sells private label  TV-based
video  phones  to  several  third  parties  and has  licensed  its  video  phone
technology to other companies,  including 3COM  Corporation,  Kyushu  Matsushita
Electric Co.,  Ltd.,  Leadtek and Truedox,  which  companies  also are producing
competing products. As a result, there can be no assurance that the Company will
be able to compete successfully in the video phone market.

         The Company  believes  that the  principal  competitive  factors in the
TV-based video phone market are quality of video and audio, price, compatibility
with standard  communication  protocols,  ease of use,  strength of distribution
channels,   ability  to  timely  fulfill  order  requests,   customer   support,
reliability and brand-name recognition.  The Company's marketing efforts for its
TV-based  products have emphasized the Company being one of the first to offer a
product for home use which is easy to use and has acceptable picture quality.

PATENTS AND OTHER INTELLECTUAL PROPERTY

         The Company has four United  States  patents  (one of which is a design
patent) and has pending five United States patent  applications  and one foreign
patent application,  all of which relate to technology incorporated in its video
conferencing  products  and  the  design  of  various  related  components.  The
inventions  which are the subject of these patent and patent  applications  were
created  jointly by Daniel Flohr and certain other  employees of, or consultants
to, the  Company  and,  in each case,  all rights to such  inventions  have been
assigned to the Company. The Company has licensed, on a non-exclusive basis, its
utility  patent  relating to the camera  display  configuration  of its PC-based
desktop video conferencing product.

         Patents  and patent  applications  involve  complex  legal and  factual
issues.  Moreover,  the  technology  applicable  to the  Company's  products  is
developing  rapidly.  A number of companies have filed applications for, or have
been issued, patents relating to products or technology that are similar to some
of the products or technology being developed or used by the Company.  The scope
and validity of these  patents,  the extent to which the Company may be required
to obtain licenses thereunder or under other proprietary rights and the cost and
availability  of  licenses,  are  unknown.  There can be no  assurance  that the
Company's  patent  applications  will result in patents being issued or that, if
issued,  the  patents  will afford  protection  against  competitors  developing
similar or related  technologies.  Although  the  earliest  patent  owned by the
Company was granted in 1995,  and patents  generally have a seventeen year life,
due to rapidly developing technology,  the Company contemplates that alternative
technological  solutions  will be  devised to  accomplish  the  purposes  of its
patents substantially before the Company's patents expire, but that such patents
may offer  short-term  protection from third parties.  There can be no assurance
that other parties have not applied for, or will not obtain, patents under which
the Company would need to be granted a license or around which the Company would
be  forced  to  redesign  its  products.   The  Company  seeks  to  protect  its
intellectual   property   rights   through  a   combination   of  trade  secret,
nondisclosure  and other  contractual  arrangements,  and patent,  copyright and
trademark laws. The Company  generally  enters into  confidentiality  agreements
with its employees,  consultants,  sales  representatives  and certain potential
customers and limits access to and distribution of its proprietary  information.
However,  there can be no assurance that these actions will be adequate to deter
misappropriation of the Company's proprietary information, that the Company will
be able to detect unauthorized use of its intellectual  property rights, or that
the Company can afford the high cost  required to enforce,  through  litigation,
its intellectual property rights.  Moreover, any such litigation could result in
substantial  diversion of managerial  time and resources,  which could be better
and more fruitfully utilized on other activities. Furthermore, since the Company
does not have the  resources  to maintain a staff whose  primary  function is to
investigate  the level of protection  afforded to third parties on devices which
the Company  uses in its products or  sub-assemblies,  there can be no assurance
that a claim that the Company's  

                                       11
<PAGE>

products  infringe  on the  intellectual  property  rights of others will not be
asserted successfully against the Company in the future.

         In 1995, the U.S.  Patent and Trademark  Office (the "PTO")  registered
the  "C-Phone"  trademark  to the  Company.  In 1996,  in order to more  closely
identify the Company with its  products,  all of which utilize the C-Phone name,
and in an attempt to eliminate  confusion among  investors,  the Company changed
its name to C-Phone Corporation.  In August 1996, the Company was advised by the
PTO that a former  registered  owner of the  C-Phone  trademark  (which  the PTO
canceled  in 1993 for  failure  to  submit a  required  affidavit),  had filed a
petition  to  cancel  the  Company's  registration,  alleging  that  there was a
likelihood  of  confusion  between  the  marks,  and that its  failure to file a
required affidavit was inadvertent.  The former owner had used, and continues to
use,  the  C-Phone  name for marine  telephone  products,  and may have  certain
"common  law"  rights to  continued  use of the name and to prevent  others from
using the name.  A proceeding  with respect to the matter is pending  before the
PTO's  Trademark  Trial  and  Appeal  Board,  who  will  determine  whether  the
conflicting  use by the Company is so  confusingly  similar that a  registration
should not have been  granted  to the  Company.  If the  matter is not  resolved
between  the  parties  and the  Company is not  successful  in the  current  PTO
proceedings,  the  Company  may  need  to  change  the  identifying  name on its
products,  may determine that it is appropriate to change its corporate name and
may be subject to damages if it could be shown that the  Company  had  infringed
the former  owner's  common law rights.  Any change in the use by the Company of
the C-Phone  name would result in a loss of good will and  identification  which
the Company has been promoting  since 1993,  and could have a temporary  adverse
impact on the Company's marketing plans.

IMPACT OF YEAR 2000 ISSUE

         Computer systems may experience problems handling dates beyond the year
1999 because many computer  programs use only two digits to identify a year in a
date field.  As the Company's  products do not include  date/time  mechanisms in
their operating software, compliance with the Year 2000 issue is not a concern.

         During  Fiscal 1998,  for  operational  purposes,  the Company made the
decision to upgrade its internal financial  software system,  which is Year 2000
compliant.  The Company has substantially  completed the identification of other
internal  computer-based  systems it uses which may require  upgrading to insure
operational  continuity  beyond December 31, 1999, and anticipates that the cost
of bringing these internal minor systems into  compliance  will not be material.
The Company is assessing  the possible  effects on the  Company's  operations of
Year 2000 compliance related to key suppliers, subcontractors and customers. The
Company's  reliance on suppliers  and  subcontractors  means that the failure to
address compliance issues by these parties could have an impact on the Company's
business,  although the Company believes that such impact,  if any, would not be
material.

GOVERNMENT REGULATION

         The  Company's  products  must comply  with  certain  requirements  and
specifications   set  forth  in  regulations   adopted  by  the  FCC  regulating
electromagnetic radiation and the connection of terminal equipment to the public
switched telephone network. These regulations,  among other things, require that
the Company's  products be in compliance with such regulations as a prerequisite
to marketing them.  Although the Company's  products are currently in compliance
with such  regulations,  if the Company  redesigns  or  otherwise  modifies  its
products, or if current regulations or industry standards are revised, there can
be no  assurance  as to when,  if ever,  the  Company's  redesigned  or modified
products will be in compliance  with  applicable  governmental  regulations  and
evolving industry standards.  In addition,  the Company must comply with certain
similar  requirements  of  various  foreign  government  agencies  to effect its
foreign  sales.  The Company's  foreign  distributors,  as part of the Company's
distribution  agreements,  are  responsible  for ensuring  compliance  with, and
obtaining any necessary permits from, such foreign government agencies.

                                       12
<PAGE>

EMPLOYEES

         As of May 26, 1998, the Company  employed 50 persons (all but 3 of whom
were  full-time   employees),   including  19  manufacturing   and  distribution
employees,  13 product  development  and engineering  employees,  four sales and
marketing  employees,  nine  management  and  administrative  employees and five
customer  support  employees,  as compared to 66 persons at May 15, 1997 (all of
whom were  full-time  employees).  The  decrease in the number of the  Company's
employees  was  primarily  a result of the  Company's  shift in focus  away from
PC-based  products.  The  Company  considers  that  its  relationships  with its
employees are good.  The  continued  development  of the Company's  business and
operations  is dependent  upon the efforts and talents of three of its executive
officers, Daniel Flohr, Tina Jacobs and Stuart Ross, and the services of certain
key technical  personnel.  The loss of the services of any of these persons,  as
well as the  inability  of the  Company to attract  and then  retain  additional
required  qualified  personnel in connection with the  commercialization  of the
Company's  TV-based  video phone,  would have a material  adverse  effect on the
Company.

Item 2.  Description of Property
         -----------------------

         The Company  conducts all of its operations from its 14,420 square foot
Wilmington,  North  Carolina  facility,  approximately  17% of which is used for
engineering,  approximately  23% of  which is used  for  administration  and the
balance of which is used for production, inventory, shipping and receiving.

         The  Company  leases  its  facility,  which  was  built  in 1993 to the
Company's  specifications,  from its two principal  executive  officers,  Daniel
Flohr and Tina Jacobs, under a triple net lease pursuant to which the Company is
responsible for all costs and expenses,  including applicable taxes, relating to
the facility.  The current lease for the facility expires April 30, 1999 and has
a  three-year  renewal  option at a renewal rent no greater than the fair market
value of the rented space at the beginning of the renewal term. The current base
annual  rent for the  facility is  $75,360,  which was no greater  than the fair
market  rental for the facility at the  commencement  of the current  term.  Mr.
Flohr and Ms. Jacobs allow the Company to use approximately 9,000 square feet of
a 1.4 acre  adjacent  tract of land  owned by them (the  "Adjacent  Tract") as a
parking area for the Company's  employees and customers,  in  consideration  for
which the Company  provides  minimal  maintenance  of the parking  area and pays
approximately  $345 per year of real  estate  taxes  on the  tract of land.  The
Company  believes  that  the  terms  and  conditions  of the  lease  are no less
favorable to the Company than those available from unaffiliated third parties.

         The Company's  present  facility is being fully utilized.  In the event
that the Company needs  additional  space, Mr. Flohr and Ms. Jacobs have offered
to  construct an  additional  building on the  Adjacent  Tract to the  Company's
specifications and to lease such building,  when constructed,  to the Company on
terms  similar to the lease for the present  facility,  including at a rental no
greater than fair market value at the commencement of the lease term.

         See Note 10 of  Notes  to  Financial  Statements  included  in Item 7 -
"Financial Statements."

Item 3.  Legal Proceedings
         -----------------

         The  Company  is  involved  in  various  legal  proceedings  which  are
incidental to the conduct of its business. None of such proceedings are expected
to have a material adverse effect on the Company's financial position or results
of operations;  however,  see Item 1. -  "Description  of Business - Patents and
Other Intellectual Property."

                                       13
<PAGE>

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

         No matter was submitted to a vote of securities  holders of the Company
during the fiscal quarter ended February 28, 1998.


                                     PART II

Item 5.  Market for Common Equity and Related Stockholder Matters
         --------------------------------------------------------

         The Common  Stock is traded on The  Nasdaq  National  Market  under the
symbol  "CFON." The following  table sets forth the high and low sales price for
each quarterly  period since March 1, 1996 for the Common Stock,  as reported by
The Nasdaq Stock Market, Inc.

         Fiscal 1997                                      High      Low
         -----------                                      ----      ---

         1st Quarter (quarter ended May 31, 1996)          8-3/8    6
         2nd Quarter (quarter ended August 31, 1996)       6-5/8    2-1/4
         3rd Quarter (quarter ended November 30, 1996)     6-5/8    2-3/8
         4th Quarter (quarter ended February 28, 1997)    19-3/8    3-1/8


         Fiscal 1998                                      High      Low
         -----------                                      ----      ---

         1st Quarter (quarter ended May 31, 1997)         11-1/2    5-7/8
         2nd Quarter (quarter ended August 31, 1997)      10        5
         3rd Quarter (quarter ended November 30, 1997)    10-1/2    5
         4th Quarter (quarter ended February 28, 1998)     8-3/4    3-13/16

         On May 26,  1998,  the closing  sale price was  5-11/32.  As of May 26,
1998, there were 327 holders of record of the Common Stock,  including CEDE & Co
and three other institutional  holders who held an aggregate of 5,253,859 shares
of Common Stock as nominees for an undisclosed number of beneficial holders. The
Company  estimates  that it has in  excess  of  2,000  beneficial  holders.  For
information concerning issuances of securities by the Company during Fiscal 1998
and Fiscal 1999, see Item 6 -  "Management's  Discussion and Analysis or Plan of
Operations - Recent Equity Offerings."

         The  Company  has never paid any  dividends  and,  for the  foreseeable
future, the Company expects to retain earnings, if any, to finance the expansion
and development of its business.  Any future payment of dividends will be within
the  discretion of the Company's  Board of Directors,  which may be deemed to be
controlled by the Company's principal shareholders, and will depend, among other
factors,  on the  earnings,  capital  requirements  and  operating and financial
condition of the Company.

Item 6.  Management's Discussion and Analysis or Plan of Operations
         ----------------------------------------------------------

       THIS ANNUAL  REPORT ON FORM 10-KSB  CONTAINS,  IN ADDITION TO  HISTORICAL
       INFORMATION,  CERTAIN FORWARD-LOOKING STATEMENTS THAT INVOLVE SIGNIFICANT
       RISKS AND  UNCERTAINTIES.  SUCH  FORWARD-LOOKING  STATEMENTS ARE BASED ON
       MANAGEMENT'S  BELIEF  AS WELL AS  ASSUMPTIONS  MADE BY,  AND  INFORMATION
       CURRENTLY   AVAILABLE  TO,  MANAGEMENT  PURSUANT  TO  THE  "SAFE  HARBOR"
       PROVISIONS  OF THE  PRIVATE  SECURITIES  LITIGATION  REFORM  ACT OF 1995.
       FORWARD-LOOKING  STATEMENTS  CAN  GENERALLY BE IDENTIFIED AS SUCH BECAUSE
       THE  CONTEXT OF THE  STATEMENT  USUALLY  WILL  INCLUDE  WORDS SUCH AS THE
       COMPANY  "BELIEVES" OR "EXPECTS" OR WORDS OF SIMILAR  IMPORT.  SIMILARLY,
       STATEMENTS  THAT  DESCRIBE  THE  COMPANY'S   FUTURE  PLANS,   OBJECTIVES,
       ESTIMATES OR GOALS ARE ALSO

                                       14
<PAGE>

       FORWARD-LOOKING  STATEMENTS.  SUCH  STATEMENTS  ADDRESS FUTURE EVENTS AND
       CONDITIONS CONCERNING CAPITAL EXPENDITURES,  EARNINGS,  SALES,  LIQUIDITY
       AND CAPITAL  RESOURCES,  AND  ACCOUNTING  MATTERS.  THE COMPANY'S  ACTUAL
       RESULTS COULD DIFFER  MATERIALLY  FROM THOSE EXPRESSED IN, OR IMPLIED BY,
       THE FORWARD-LOOKING STATEMENTS CONTAINED HEREIN. FACTORS THAT COULD CAUSE
       OR CONTRIBUTE TO SUCH DIFFERENCES  INCLUDE, BUT ARE NOT LIMITED TO, THOSE
       DISCUSSED  BELOW AND IN ITEM 1 - "DESCRIPTION  OF BUSINESS" AND ELSEWHERE
       IN THIS ANNUAL  REPORT ON FORM 10-KSB,  AS WELL AS FACTORS SUCH AS FUTURE
       ECONOMIC  CONDITIONS,  ACCEPTANCE BY CUSTOMERS OF THE COMPANY'S PRODUCTS,
       CHANGES IN  CUSTOMER  DEMAND,  LEGISLATIVE,  REGULATORY  AND  COMPETITIVE
       DEVELOPMENTS  IN  MARKETS  IN  WHICH  THE  COMPANY   OPERATES  AND  OTHER
       CIRCUMSTANCES  AFFECTING  ANTICIPATED  REVENUES  AND COSTS.  THE  COMPANY
       UNDERTAKES NO OBLIGATION TO RELEASE  PUBLICLY THE RESULT OF ANY REVISIONS
       TO THESE FORWARD LOOKING STATEMENTS THAT MAY BE MADE TO REFLECT EVENTS OR
       CIRCUMSTANCES  AFTER THE DATE OF THIS ANNUAL  REPORT ON FORM 10-KSB OR TO
       REFLECT THE OCCURRENCE OF OTHER UNANTICIPATED EVENTS.

OVERVIEW

         The Company has been,  and is,  primarily  engaged in the  engineering,
manufacturing   and  marketing  of  a  line  of  TV-based  and  PC-based   video
conferencing  systems.  The Company's  stand alone TV-based  video  conferencing
system or "video  phone",  which operates over regular  analog  telephone  lines
using a standard  television  set, is marketed  under the name C-Phone  Home. In
addition,  in March 1998,  the Company  began  limited  shipments  of its DS 324
TV-based video phone, which operates over both analog and ISDN digital telephone
lines.  In May 1998,  the Company  introduced  C-Phone  ITV, a TV-based  set top
device that  provides  Internet  access using a standard  television  set and an
analog telephone line. The Company's PC-based video conferencing systems,  which
operate over digital networks, are marketed under the name C-Phone. From time to
time, the Company also has engaged in contractual  software  development related
to its products.

         The  Company  commenced   operations  in  1986  as  a  manufacturer  of
promotional  radios  and,  in 1990,  developed  data/fax  modems  under the name
"TWINCOM".  In early  1993,  because of  continued  price  pressures,  shrinking
margins and for competitive  reasons, the Company shifted its primary focus from
modems to the  development of C-Phone and, during the fiscal year ended February
28,  1995,  the Company  phased out its modem  product  line as it was no longer
profitable.  Since 1993,  the  Company has  invested  significant  resources  in
product  development,   engineering  and  marketing  activities  for  its  video
conferencing  products,  and expects that such  investments will continue in the
foreseeable future.

         The  Company's  products  are  marketed  through a variety of  channels
depending  upon the product.  The Company's  TV-based video phone is marketed to
end users,  distributors,  and resellers and to original equipment manufacturers
("OEMs") which integrate the product with other equipment for resale to specific
industries such as health care and security  services.  During Fiscal 1998, many
retail  distributors  offered the end user the option to purchase the  Company's
TV-based  video phone on a stand-alone  basis or, similar to the method by which
most  cellular  telephones  are  sold,  at a lower  price  when  purchased  with
telecommunications  services offered by the Company. The proceeds to the Company
from units sold under the latter option were less than the Company's cost of the
product and, as 36% of C-Phone Home sales were made under such  purchase  option
in Fiscal 1998,  such sales and the required  mark-down of related  inventory to
reflect  such sale price  contributed  significantly  to the gross loss for that
period.  However, the percentage of sales under this option has decreased to the
point that the Company no longer offers a telecommunications option. The Company
is currently  exploring the market  opportunities for C-Phone ITV and has not at
this time developed a marketing strategy for this product.  The Company believes
that its TV-based  products  currently  have greater  market  potential than its
PC-based products and, in light of the lack of significant  industry  acceptance
for PC-based desktop video  conferencing  products operating over a LAN, and the
Company's  limited  financial  and other  resources,  the Company has decided to
shift its resources to its TV-based products, although the Company will continue
to support and provide equipment to its existing customer

                                       15
<PAGE>

base  for  its  PC-based  products  and  to new  customers  in  connection  with
specialized  applications relating to its PC-based products, if any, that may be
presented to the Company.  See  "Marketing  and Sales - PC-BASED  PRODUCTS." See
Item 1 - "Description of Business - Marketing and Sales."

         As a result of the foregoing  and the low volume of sales,  the Company
has incurred significant losses during the three fiscal years ended February 28,
1998.  The  Company  expects  to  continue  to incur  significant  losses in the
foreseeable future due to its significant  expenditures for product  development
and the commercialization of its TV-based products.

RECENT EQUITY OFFERINGS

         MARCH 1997 PRIVATE  PLACEMENT.  During the week of March 31, 1997,  the
Company completed a private placement (the "March Placement")  pursuant to which
the Company issued an aggregate of 833,667 shares (the "Original Shares") of the
Company's common stock,  par value $0.1 per share (the "Common  Stock"),  to the
participants in the March  Placement and received net proceeds of  approximately
$4,370,000 (after payment of fees and expenses of approximately $632,000).

         Accompanying  each of the Original Shares was the right,  under certain
circumstances,  to receive  additional shares of Common Stock in accordance with
the terms of a "contingent value right" (the "Rights"). The Rights, which expire
June 25, 1998,  are  automatically  exercised at the time, and from time to time
as, the Original  Shares are first  publicly sold through a  broker-dealer.  The
terms of the  Rights  provide  that,  upon the first  such sale of any  Original
Shares  at a price of less than  $8.00 per  share,  the  seller of the  Original
Shares will receive,  for each such Original Share sold, and without the payment
of any  additional  consideration,  such  additional  number of shares of Common
Stock as equals (i) $8.00 divided by the Adjusted  Price,  minus (ii) one; where
the Adjusted  Price equals the greater of (x) the average  closing bid price per
share of Common Stock on The Nasdaq  National Market ("NNM") for the ten trading
days  immediately  preceding  the date of sale of the  Original  Shares,  or (y)
$2.00.

         As of  February  28,  1998,  all the  Original  Shares  had  been  sold
(although  the holder of 30,000  Original  Shares has not yet  submitted  to the
Company  the  necessary  documentation  to  determine  the  number,  if any,  of
additional  shares to which he is  entitled)  and,  pursuant to the terms of the
Rights, 136,863 additional shares were issued as a result thereof.

         In  connection  with the  March  Placement,  the  Company  issued to an
affiliate  of the  placement  agent  warrants to acquire an aggregate of 150,000
shares of Common Stock at an exercise  price of $9.60 per share,  which warrants
have since expired unexercised.

         The securities issued in the March Placement were offered for sale, and
were sold,  without  registration  thereof under the Securities Act of 1933 (the
"1933 Act"),  pursuant to the exemption from registration provided by Regulation
D under the 1933 Act.

         DECEMBER  1997 PRIVATE  PLACEMENT.  On December  19, 1997,  the Company
completed a private placement (the "December  Placement")  pursuant to which the
Company  issued to several  participants  an  aggregate of (i) 4,500 shares (the
"Series A Preferred  Shares") of the Company's  Series A  Convertible  Preferred
Stock, par value $.01 per share (the "Series A Preferred Stock") with an initial
stated value of $1,000 per share  (which  increases at the rate of 5% per annum)
(such amount, as increased from time to time, the "Stated Value"), (ii) warrants
(the "One-Year  Warrants") to acquire up to 315,000 shares of Common Stock,  and
(iii)  warrants  (the  "Three-Year  Warrants"  and with the  One-Year  Warrants,
collectively,  the "1997  Warrants")  to acquire up to 135,000  shares of Common
Stock,  to the  participants  in the December  Placement and received  aggregate
proceeds of  approximately  $4,110,000  (after  payment of fees and  expenses of
approximately $390,000).

                                       16
<PAGE>

         The  Company  has agreed  that,  without  the consent of the holders of
two-thirds of the then outstanding  Series A Preferred  Shares,  it will not (i)
issue any other class or series of preferred stock that would rank senior to the
Series A Preferred  Stock,  and (ii) on or before  December 19, 1998,  issue any
other  class or series of  preferred  stock  that would rank pari passu with the
Series A Preferred  Stock,  in either case,  as to  distribution  of assets upon
liquidation.

         Each Series A Preferred Share is convertible, from time to time, at the
option  of the  holder,  into  such  number  of  shares  of  Common  Stock as is
determined  by dividing the Stated Value by the lesser of (i) $7.3575,  and (ii)
85% of the  average of the  closing  bid price  during  such  three  consecutive
trading day period as may be  selected  by the holder  during the 25 trading day
period preceding the date of conversion.  The Series A Preferred Shares cease to
be convertible  (the "19.99%  Limitation") if, at any time, the aggregate number
of shares of Common Stock then issued upon  conversion of the Series A Preferred
Shares would equal  1,068,513  shares of Common Stock (the  remaining  shares of
Common Stock then  issuable  upon  conversion  of the Series A Preferred  Shares
being the "Excess  Shares"),  unless, in accordance with the rules of The Nasdaq
Stock Market, Inc. ("Nasdaq") (on which the Common Stock is traded), the Company
has obtained approval for the issuance of the Excess Shares by a majority of the
total votes cast on such proposal by the holders of the then outstanding  Common
Stock  (not  including  any  shares of Common  Stock  held by  present or former
holders of the Series A Preferred Shares that were issued upon conversion of the
Series A Preferred Shares),  or it has otherwise obtained permission from Nasdaq
to allow such issuances.  Any outstanding  Series A Preferred Shares on December
19, 1999  automatically  will be converted  into Common Stock at the  conversion
price then in effect. As of May 26, 1998, 2,576 of the Series A Preferred Shares
had been  converted into  1,067,217  shares of Common Stock.  As a result of the
19.99%  Limitation,  the remaining  Series A Preferred  Shares are not presently
convertible. However, if the Series A Preferred Shares remaining outstanding had
not ceased to be convertible and all such remaining shares had been converted as
of May 26,  1998,  the  Company  would  have  been  required  to  issue  837,743
additional  shares of Common  Stock (or,  with the shares of Common Stock issued
upon the shares of Preferred Stock  previously  converted,  36% of the number of
shares  outstanding  on December  19, 1997 (the date of issuance of the Series A
Preferred Stock)).

         The One-Year  Warrants expire on December 19, 1998 and have an exercise
price of $8.05 per share (115% of the closing  price of the Common  Stock on the
NNM on the trading day  immediately  preceding  the closing date of the December
Placement),  subject to adjustment under certain  circumstances,  including upon
the  issuance  of  shares  of  Common  Stock  (or   securities   convertible  or
exchangeable  into  shares of Common  Stock) at less than 80% of the then market
price on the NNM for the Common Stock.  The One-Year  Warrants are redeemable at
the option of the Company at a price of $.01 per warrant if the closing price of
the Common Stock on the NNM is greater  than 130% of the  exercise  price of the
One-Year Warrants then in effect for 10 consecutive trading days. The Three-Year
Warrants  expire on December  19,  2000 and have an exercise  price of $9.10 per
share (130% of the closing  price of the Common  Stock on the NNM on the trading
day immediately  preceding the closing date of the December Placement),  subject
to adjustment under certain circumstances, including upon the issuance of shares
of Common Stock (or securities convertible or exchangeable into shares of Common
Stock)  at less  than 80% of the  then  market  price on the NNM for the  Common
Stock. The Three-Year  Warrants are not redeemable.  As of May 26, 1998, 325,000
shares of Common  Stock had been  issued  upon  exercise  of  One-Year  Warrants
including  the  warrants  issued to the finder in the  December  Placement)  and
60,000  shares had been issued  upon  exercise of  Three-Year  Warrants  and the
Company has received proceeds of $3,162,250 from the exercise thereof.

         Pursuant to certain registration rights granted to the investors in the
December  Placement,  the  Company  has  registered  on a Form S-3  registration
statement (the  "Registration  Statement") such number of shares of Common Stock
as equals the sum of (i) 30% of the number of outstanding shares of Common Stock
as of the close of business on the third business day immediately  preceding the
date of filing of the Registration Statement,  plus (ii) the number of shares of
Common  Stock  issuable  upon  exercise  of  the  1997  Warrants  issued  to the
investors. The Company also has agreed that if the Registration Statement is

                                       17
<PAGE>

insufficient to cover all of the shares of Common Stock issuable upon conversion
of the Series A  Preferred  Shares  (based  upon the market  price of the Common
Stock and other relevant  factors),  it will register such additional  number of
shares of  Common  Stock as may be  required  (collectively,  the  "Registerable
Securities").  The Company has also agreed use its best  efforts to maintain the
effectiveness  of the  Registration  Statement until the earlier of (i) December
19, 2001, or (ii) the time that all the  Registerable  Securities have been sold
pursuant to the  Registration  Statement or may be sold under Rule 144 under the
1933 Act without regard to the volume limitations thereof.

         The Series A Preferred  Shares are subject to  redemption at the option
of a holder if, among other things,  (i) the  effectiveness  of the Registration
Statement  lapses for more than 30 consecutive  days or more than 60 days in any
12 month  period,  (ii) the Company  fails to maintain the listing of the Common
Stock on the NNM or another principal securities exchange or automated quotation
system and such failure  continues  for more that 30 days, or (iii) the Series A
Preferred  Shares cease to be convertible  as a result of the 19.99%  Limitation
and the  Company has not,  prior  thereto,  or within 75 days after  notice from
holders of two-thirds of the Series A Preferred Shares (which notice has not yet
been received),  obtained  approval to issue additional  shares of Common Stock.
The Company  intends to seek approval to issue the  additional  shares of Common
Stock at its 1998  Annual  Meeting  of  Shareholders.  If the  Company  does not
receive approval to issue the additional  shares of Common Stock and the holders
of the Series A Preferred Shares elect to exercise their redemption  rights, the
Company will be required to redeem the remaining  outstanding Series A Preferred
Shares at an amount  equal to the greater of (a) 118% of the Stated Value of the
Series A Preferred  Shares on the date of redemption and (b) the market value of
the  Common  Stock  into which the  Series A  Preferred  Shares  would have been
converted on the date of  redemption.  If the  redemption had occurred as of May
26, 1998, the Company would have be required to pay approximately  $4,650,000 to
redeem the remaining  outstanding  Series A Preferred  Shares.  However,  as the
actual  redemption  amount will be based on the Stated Value or the price of the
Common Stock in effect at the time of redemption,  the actual  redemption amount
could be higher or lower.  There can be no assurance  that the Company will have
the financial ability to redeem the Series A Preferred Shares, if required, and,
even if the Company has such ability,  such payment could  materially  adversely
effect the Company's financial condition and deplete its cash resources.

         The Company has agreed to pay certain  penalties  to the holders of the
Series A  Preferred  Shares in the  event  that the  Company  (i) fails to cause
timely  delivery of the Common Stock  issuable  upon  conversion of the Series A
Preferred  Shares,  (ii) is unable to convert  Series A  Preferred  Shares  into
Common Stock because the Company does not have a sufficient number of authorized
but  unissued  shares  available  for  issuance  therefor,   (iii)  permits  the
effectiveness  of  the  Registration   Statement  to  lapse  for  more  than  15
consecutive  days or more than 30 days in any 12 month period,  or (iv) fails to
maintain  the  listing  of the  Common  Stock  on the  NNM  or  other  principal
securities  exchange or automated  quotation system on which the Common Stock is
then trading, and such failure continues for more than 10 days.

         In connection with the December  Placement,  the Company paid a finders
fee of $295,000 and issued to an affiliate of the finder warrants (upon the same
terms as the One-Year  Warrants)  to acquire an  aggregate of 185,000  shares of
Common Stock, which warrants have been exercised.

         The securities issued in the December  Placement were offered for sale,
and were sold, without  registration thereof under the 1933 Act, pursuant to the
exemption from registration provided by regulation D under the 1933 Act.

         1994 WARRANT  EXERCISES.  In connection with the Company's 1994 initial
public  offering,   the  Company  had  issued  to  the   representative  of  the
underwriters,  warrants  (the  "1994  Warrants")  expiring  August  19,  1999 to
purchase 200,000 shares of Common Stock at an exercise price of $8.40 per share.
On May 13, 1998, the Company  reduced the exercise price of the 1994 Warrants to
$6.00 per share,  in  consideration  for changing the expiration date thereof to
May 21, 1998. On May 13, 1998, the holders of the 1994 Warrants

                                       18
<PAGE>

irrevocably  agreed to exercise all of the 1994  Warrants on or before the close
of business on May 15, 1998.  Pursuant thereto,  all the 1994 Warrants have been
exercised and the Company received aggregate proceeds of $1,200,000.  The shares
of Common Stock issued to the holders upon  exercise of the 1994  Warrants  (the
"Warrant  Shares")  were issued  pursuant  to the  exemption  from  registration
provided by Section 4(2) under the 1933 Act; however,  a registration  statement
under the 1933 Act is in effect with respect to the resale of the Warrant Shares
by the warrant holders.

RESULTS OF OPERATIONS

FISCAL 1998 AS COMPARED TO FISCAL 1997

         REVENUES.  Net sales  decreased  4% to  $1,818,663  in Fiscal 1998 from
$1,890,213 in Fiscal 1997 reflecting an industry-wide  slowdown in the continued
acceptance  of  PC-based  desktop  video  conferencing,  partially  offset by an
increase in net sales of  TV-based  products.  Other  revenue  decreased  53% to
$72,003 in Fiscal 1998 from  $152,665  in Fiscal  1997 as a result of  decreased
revenue  from  software  development.  As a  result,  revenues  decreased  7% to
$1,890,666 in Fiscal 1998 from $2,042,878 in Fiscal 1997.

         COST OF  REVENUE.  Cost of revenue  consists  of cost of goods sold and
cost of other revenue.  Cost of goods sold includes  labor,  materials and other
manufacturing  costs (such as salaries,  supplies,  leasing costs,  depreciation
related  to  production  operations  and  the  write-down  of  inventory  to net
realizable value). Cost of other revenue consists primarily of the allocation of
salaries  and benefits of personnel  and the cost of outside  services  directly
related to such revenue. Cost of goods sold increased 97% to $3,209,875 (176% of
net sales) in Fiscal 1998 from $1,629,287 (86% of net sales) in Fiscal 1997. The
increase  in cost of goods sold and the  increase in the  percentage  of cost of
goods sold to net sales  reflected the high cost of manufacture of the Company's
TV-based  products in its initial  production stage, low production runs and the
write-down of related  inventory to its current net realizable  value based upon
the historical  percentage of sales of TV-based video phones below  manufactured
cost when sold in conjunction with  telecommunications  services.  Cost of goods
sold also included a $475,824  provision for inventory  obsolescence  related to
the Company's PC-based desktop video  conferencing  equipment as a result of the
slowdown  in the rate of  acceptance  of this  product  line  and the  Company's
decision to redeploy  most of its  available  resources to other  products.  See
"Overview."  The cost of other  revenues  ($22,506)  in  Fiscal  1998 was 31% of
related revenue, while similar costs ($81,079) in Fiscal 1997 was 53% of related
revenue.

         GROSS PROFIT  (LOSS).  The gross loss was $1,341,715 in Fiscal 1998, as
compared to a gross profit of $332,512  (16% of  revenues)  in Fiscal 1997.  The
gross  loss in Fiscal  1998 was  primarily  the result of the high cost of goods
sold due to low volume  production,  the  Company's  marketing  strategy for its
TV-based products and the provision for inventory obsolescence for the Company's
PC-based inventory. See "Overview."

         SELLING,    GENERAL   AND   ADMINISTRATIVE.    Selling,   general   and
administrative expenses increased 56% to $3,816,806 (202% of revenues) in Fiscal
1998 from  $2,454,337  (120% of revenues) in Fiscal 1997. The primary reason for
the  increase  was  an  73%  increase  in  selling  and  marketing  expenses  to
approximately  $1,943,000 in Fiscal 1998 from approximately $1,125,000 in Fiscal
1997,  substantially all of which increase was directly related to the marketing
launch of C-Phone  Home.  Other  increases in expenses  directly  related to the
Company's  TV-based  product  were  increased  personnel  costs  resulting  from
additional  customer  support  and  administrative  personnel  and an  increased
reserve for bad debt  expenses  based upon the Company's  historical  experience
with the  retail  industry.  In  addition,  other  increases  in  administrative
expenses were increased legal and accounting expenses,  primarily as a result of
the  complexities  related to the addition of the  TV-based  product  line,  the
reallocation  of duties of certain  personnel  from  research,  development  and
engineering,  and increased  investor  relations and other shareholder  expenses
resulting from a significant  increase in the number of holders of record of the
Common Stock. The Company expects that it will continue

                                       19
<PAGE>

to incur substantial  selling,  general and  administrative  expenses during the
Fiscal  1999 as a result of the  continued  commercialization  of the  Company's
TV-based products.

         RESEARCH,  DEVELOPMENT  AND  ENGINEERING.   Research,  development  and
engineering  expenses  decreased 4% to $973,210 (51% of revenues) in Fiscal 1998
from $1,016,293 (50% of revenues) in Fiscal 1997. The decrease was primarily the
result of a decrease  in  personnel  costs  resulting  from a partial  change in
duties of certain personnel to selling,  general and  administrative,  partially
offset by development  and  engineering  expenses  related to the development of
enhancements to the Company's TV-based products. All of these costs were charged
to operations as incurred and were funded by the Company's  cash  reserves.  The
Company  expects  to  continue  to  invest  significant   resources  during  the
foreseeable future in new product development and engineering.

         OPERATING  LOSS.  As a  result  of the  factors  discussed  above,  the
Company's  operating  loss  increased  95% to  $6,131,731  in  Fiscal  1998 from
$3,138,118 in Fiscal 1997.

         INTEREST. Interest income increased 19% to $157,350 in Fiscal 1998 from
$132,405 in Fiscal  1997 as a result of the  receipt of proceeds  from the March
Placement and the December  Placement,  partially offset by the continued use of
the Company's cash and cash equivalents to fund operations.

         INCOME TAXES.  The Company's losses for Fiscal 1998 and Fiscal 1997 may
be utilized as an offset against future earnings, although there is no assurance
that future operations will produce taxable earnings.

FISCAL 1997 AS COMPARED TO FISCAL 1996

         REVENUES.  Revenues  increased  14% to  $2,042,878  in Fiscal 1997 from
$1,786,115 in the year ended February 28, 1996 ("Fiscal 1996"). The revenues for
Fiscal 1997 included $150,000 of other revenue related to software  developed by
the  Company at two  customers'  requests  for use with  PC-based  products  and
$1,890,213  of sales of PC-based  products,  while the  revenues for Fiscal 1996
consisted only of sales of PC-based products. As a result, net sales of PC-based
products  increased  6% in Fiscal 1997 as compared to Fiscal  1996.  The Company
believes that such minimal  increase was primarily  related to a change in sales
and marketing personnel.

         COST OF  REVENUE.  Cost of revenue  consists  of cost of goods sold and
cost of other revenue.  Cost of goods sold includes  labor,  materials and other
manufacturing  costs (such as salaries,  supplies,  leasing costs,  depreciation
related to production  operations and write-off of obsolete inventory).  Cost of
other revenue  includes the allocation of salaries and benefits of personnel and
the cost of outside  services  directly  related to such revenue.  Cost of goods
sold  increased  5% to  $1,629,287  (86%  of net  sales)  in  Fiscal  1997  from
$1,556,353 (87% of net sales) in Fiscal 1996. The increase in cost of goods sold
and the decrease in the  percentage of cost of goods sold to net sales were both
primarily  related to the moderate  increase in sales. The cost of other revenue
($81,079) was 53% of the related revenue;  the Company had no similar revenue in
Fiscal 1996.

         GROSS PROFIT.  Gross profit  increased to $332,512 (16% of revenues) in
Fiscal 1997 from  $229,762  (13% of revenues)  in Fiscal 1996.  The gross profit
produced  from sales of goods was $260,926 (14% of net sales) in Fiscal 1997, as
compared  to  $229,762  (13% of net  sales) in  Fiscal  1996.  The gross  profit
percentage  related to other revenue was $71,586 (47% of such revenue) in Fiscal
1997;  the Company did not have any such revenue in Fiscal 1996. The increase in
gross profit and gross profit  percentage  related to sales was directly related
to the increase in sales.

         SELLING,    GENERAL   AND   ADMINISTRATIVE.    Selling,   general   and
administrative  expenses  decreased 33% to  $2,454,337  (or 120% of revenues) in
Fiscal 1997 from $3,662,679 (or 205% of revenues) in Fiscal

                                       20
<PAGE>

1996.  The primary  reason for the decrease  was a 50%  reduction in selling and
marketing expenses to approximately $1,125,000 in Fiscal 1997 from approximately
$2,230,000  in Fiscal  1996,  of which  approximately  $1,200,000  was  directly
related to a nationwide advertising and marketing campaign which ran for most of
the first  quarter of Fiscal  1996.  While the  Company's  trade  show  expenses
decreased to approximately  $230,000 in Fiscal 1997 from approximately  $425,000
in Fiscal 1996 as a result of the Company's  decision not to  participate in the
1996 Las Vegas Comdex trade show,  this decrease was mostly offset by additional
marketing  expenses  related to the initial  marketing  launch of the  Company's
TV-based products. In additional,  general and administrative expenses increased
as a result of increased  personnel  costs  resulting from  additional  customer
support  personnel  and a  reallocation  of duties  of  certain  personnel  from
research, development and engineering.

         RESEARCH,  DEVELOPMENT  AND  ENGINEERING.   Research,  development  and
engineering  expenses decreased 8% to $1,016,293 (50% of revenue) in Fiscal 1997
from  $1,102,737 (62% of revenue) in Fiscal 1996. The decrease was primarily the
result of the  reallocation of  approximately  $76,000 of certain  personnel and
benefit  costs to the cost of other  revenue and a decrease in  personnel  costs
resulting  from a partial  change in duties of  certain  personnel  to  selling,
general and administrative.  Without the reallocation of personnel costs to cost
of software  development,  research,  development and  engineering  expenses for
Fiscal 1997 would be  approximately  the same amount as such expenses for Fiscal
1996, as the majority of these allocated costs were for permanent personnel. All
of these costs were  charged to  operations  as incurred  and were funded by the
Company's cash reserves.

         OPERATING  LOSS.  As a  result  of the  factors  discussed  above,  the
Company's  operating  loss  decreased  31% to  $3,138,118  in  Fiscal  1997 from
$4,535,654 in Fiscal 1996.

         INTEREST. Interest income decreased 65% to $132,405 in Fiscal 1997 from
$378,932 in Fiscal  1996 as a result of  decreased  investments,  as the Company
utilized  the net  proceeds  of the  1994  Public  Offering  for the  continuing
development and commercialization of PC-based products.

         INCOME TAXES.  The Company's  losses for Fiscal 1996 may be utilized as
an offset  against future  earnings,  although there is no assurance that future
operations will produce taxable earnings.

LIQUIDITY AND CAPITAL RESOURCES

         The Company  has  financed  its recent  operations  primarily  from the
proceeds of the 1994 Public Offering, which raised net proceeds of approximately
$12,288,000,  the March  Placement,  which raised net proceeds of  approximately
$4,370,000,   and  the  December   Placement,   which  raised  net  proceeds  of
approximately  $4,110,000.  In addition,  during May 1998, the Company  received
approximately  $4,600,000  from the exercise of previously  issued  warrants and
options. See "Recent Equity Offerings."

         At February 28, 1998, the Company had working capital of $5,170,505 (an
increase of $2,851,739  from  $2,318,766 at February 28, 1997) and cash and cash
equivalents of $4,200,231 (as compared to $1,398,049 at February 28, 1997).  The
Company's invested funds consisted primarily of overnight repurchase  agreements
for  discount  notes  issued by the  United  States  Treasury  or United  States
government agencies. During Fiscal 1998, operating activities used $5,681,467 of
net cash,  primarily to fund operating  activities,  investing  activities  used
$43,492 of net cash for equipment  purchases,  and financing activities provided
$8,527,141  of net cash  primarily  from the March  Placement  and the  December
Placement.  Due to the  technical  nature  of the  Company's  business  and  the
anticipated   expansion   of  its  video   conferencing   technology   into  new
applications, management expects to continue to expend significant resources for
continued development and engineering as well as selling and marketing expenses.

         The Company believes that its current working  capital,  which includes
the net  proceeds  from the March  Placement,  the  December  Placement  and the
exercise, in May 1998, of previously issued warrants and options,

                                       21
<PAGE>

together with anticipated funds from operations,  will be sufficient to meet the
Company's  projected  operating  needs and capital  expenditures,  including the
continued  development and  commercialization of its TV-based products, at least
through the end of fiscal year 1999.  However,  if any of the Company's TV-based
products gain significant market acceptance, of which there can be no assurance,
the very substantial  investment which would then be required by the Company for
manufacturing,  inventory  and marketing  expenditures  and carrying of accounts
receivable related to the  commercialization  of such TV-based  products,  would
require the Company to obtain even more working capital. The Company anticipates
that such  additional  funds  should be available  through one or more  possible
sources,  including  through (i) a private placement of (a) its debt securities,
including debt securities  convertible into Common Stock,  and/or (b) its Common
Stock  or  preferred  stock,  (ii)  the  exercise  of  the  Company's  remaining
outstanding  1997  Warrants,  if the market  price of the  Common  Stock were to
exceed the exercise price of such warrants,  of which there can be no assurance,
and/or (iii) a public offering of Common Stock.  Unless adequate income relating
to sales of TV-based products is attained, the timing or receipt of which cannot
be  predicted,  the  Company  may  require  additional  cash  resources  for the
development of alternative  products.  There can be no assurance that additional
funds needed by the Company will be available when needed or, if available, that
the terms of such fundings will be favorable or acceptable to the Company.

         The  development  and recent  introduction,  of TV-based  products  has
placed a significant strain on the Company's limited  personnel,  management and
other resources.  The Company's ability to manage any future growth  effectively
will require it to continue to attract, train, motivate and manage its employees
successfully  and  to  continue  to  improve  its  operational,   financial  and
management systems. The Company's failure to effectively manage its growth could
have a material adverse effect on the Company's business and operating results.

         The Company  leases its facility and owns its  manufacturing  equipment
free from  encumbrances.  As of February 28,  1998,  the Company had no material
commitments for capital expenditures.

         At February 28, 1998,  the Company  estimates that it had available net
operating loss  carryforwards of approximately  $15,125,000 for Federal purposes
and net economic  loss  carryforwards  of  approximately  $15,337,000  for state
purposes, which may be used to reduce future taxable income, if any. The Federal
carryforwards  will  expire  starting in 2009 and the state  carryforwards  will
expire starting in 1999.

         The Company believes that,  during the past three years,  inflation has
not had a  significant  impact  on the  Company's  sales or  operating  results.
Certain of the Company's products, and components and sub-assemblies used by the
Company in its  products,  are  manufactured  outside  of the United  States and
represents a material  portion of the unit cost of the Company's basic products.
Although the Company has not experienced any significant price increases to date
as a result of changes  in foreign  currency  rates,  there can be no  assurance
that, in the future,  changes in foreign currency rates will not affect the cost
of its foreign purchased components and sub-assemblies.

         The Company's  foreign sales are  denominated  in U.S.  dollars and the
Company does not incur any foreign  currency  risks;  however,  fluctuations  in
currency exchange rates could cause the Company's  products to become relatively
more  expensive  to foreign  customers,  which would  result in a  reduction  in
foreign sales or the profitability of any of such sales.

NEW ACCOUNTING PRONOUNCEMENTS

         In June 1997, the Financial Accounting Standards Board issued Statement
of  Financial  Accounting  Standards  No.  130  ("SFAS  No.  130"),   "Reporting
Comprehensive  Income". SFAS No. 130 establishes standards for the reporting and
displaying of comprehensive income and its components (revenues, expenses, gains
and losses) in a full set of general purpose financial statements. SFAS No. 130

                                       22
<PAGE>

requires the disclosure of an amount that represents total comprehensive  income
and the  components  of  comprehensive  income  in a  financial  statement.  The
pronouncement  is effective for fiscal years  beginning after December 15, 1997,
and is not  expected  to  have a  material  impact  on the  Company's  financial
statements.

         In June 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting  Standards No. 131 ("SFAS No. 131"),  "Disclosures about
Segments of an Enterprise  and Related  Information".  SFAS No. 131  establishes
standards for determining an entity's  operating segments and the type and level
of financial  information  to be disclosed in both annual and interim  financial
statements.  SFAS No. 131 also  establishes  standards  for related  disclosures
about  products  and  services,   geographic  areas  and  major  customers.  The
pronouncement is effective for periods beginning after December 15, 1997, and is
not expected to have a material impact on the Company's financial statements.

         In February  1998,  the  Financial  Accounting  Standards  Board issued
Statement  of  Financial   Accounting   Standards  No.  132  ("SFAS  No.  132"),
"Employers' Disclosures about Pensions and Other Postretirement  Benefits". SFAS
No. 132 revises  employers'  disclosures about pension and other  postretirement
benefit  plans.  The  pronouncement  is effective  for periods  beginning  after
December 15, 1997 and, as the Company does not presently have a pension or other
postretirement  benefit plan,  is not expected to have a material  impact on the
Company's financial statements.

Item 7.  Financial Statements                                               Page
         --------------------                                               ----

Table of Contents
-----------------

Report of Independent Accountants                                            F-1

Balance Sheets as of February 28, 1998 and February 28, 1997                 F-2

Statements of Operations for the years ended
  February 28, 1998, February 28, 1997 and February 29, 1996                 F-3

Statements of Shareholders'  Equity for the years ended
  February  28,  1998, February 28, 1997 and February 29, 1996               F-4

Statements of Cash Flows for the years ended
  February 28, 1998, February 28, 1997 and February 29, 1996                 F-5

Notes to Financial Statements                                                F-6

                                       23
<PAGE>

                        REPORT OF INDEPENDENT ACCOUNTANTS



To the Board of Directors and 
Shareholders of C-Phone Corporation:


We have audited the  accompanying  balance  sheets of C-Phone  Corporation as of
February  28,  1998  and  1997,  and  the  related   statements  of  operations,
shareholders'  equity and cash  flows for each of the three  years in the period
ended February 28, 1998. These financial  statements are the  responsibility  of
the Company's  management.  Our responsibility is to express an opinion on these
financial statements based on our audits.

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

In our opinion,  the financial  statements  referred to above present fairly, in
all material  respects,  the  financial  position of C-Phone  Corporation  as of
February 28, 1998 and 1997, and the results of its operations and its cash flows
for each of the three years in the period ended February 28, 1998, in conformity
with generally accepted accounting principles.




Coopers & Lybrand L.L.P.

Raleigh, North Carolina
May 8, 1998, except as to the information
   presented in Note 14, for which the date
   is May 15, 1998


                                      F-1

<PAGE>
                                         C-PHONE CORPORATION

                                            BALANCE SHEETS

                                      FEBRUARY 28, 1998 AND 1997
<TABLE>
<CAPTION>

          ASSETS                                                            1998            1997
                                                                        ------------    ------------
<S>                                                                     <C>             <C>
Current assets:
  Cash and cash equivalents                                             $  4,200,231    $  1,398,049
  Accounts receivable, net of allowance for doubtful
    accounts of $173,227 and $120,000 at February
    28, 1998 and 1997, respectively                                          346,684         422,042
  Inventories                                                              1,641,528       1,341,931
  Prepaid expenses and other current assets                                   73,728          82,066
                                                                        ------------    ------------
          Total current assets                                             6,262,171       3,244,088

Property and equipment, net                                                  164,174         251,913

Other assets                                                                  42,686         154,246
                                                                        ------------    ------------

          Total assets                                                  $  6,469,031    $  3,650,247
                                                                        ============    ============

          LIABILITIES, PREFERRED STOCK AND
          SHAREHOLDERS' EQUITY

Current liabilities:
  Accounts payable, trade                                               $    796,019    $    587,877
  Accrued expenses                                                           295,647         325,938
  Current obligations under capital leases                                        --          11,507
                                                                        ------------    ------------
          Total current liabilities                                        1,091,666         925,322

Commitments and Contingencies (Notes 10 and 12)

Series A Convertible Preferred Stock, $1,000 stated amount;
  5,000 shares designated; 4,500 shares issued and outstanding
  at February 28, 1998 (Note 6)                                            4,543,767              --

Shareholders' equity:
  Common stock, $.01 par value; 20,000,000 and 10,000,000 shares
   authorized at February 28, 1998 and 1997, respectively;
   5,348,234 and 4,355,393 shares issued and outstanding at
   February 28, 1998 and 1997, respectively                                   53,482          43,554
  Paid-in capital - common stock                                          18,038,006      13,530,208
  Paid-in capital - preferred stock                                        1,318,350              --
  Accumulated deficit                                                    (18,576,240)    (10,848,837)
                                                                        ------------    ------------
          Total shareholders' equity                                         833,598       2,724,925
                                                                        ------------    ------------

          Total liabilities, preferred stock and shareholders' equity   $  6,469,031    $  3,650,247
                                                                        ============    ============

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

                                                 F-2
</TABLE>
<PAGE>
                                     C-PHONE CORPORATION

                                   STATEMENTS OF OPERATIONS

                            FOR THE YEARS ENDED FEBRUARY 28, 1998,
                           FEBRUARY 28, 1997 AND FEBRUARY 29, 1996

<TABLE>
<CAPTION>

                                                      1998            1997           1996
                                                   -----------    -----------    -----------

<S>                                                <C>            <C>            <C>
Net sales                                          $ 1,818,663    $ 1,890,213    $ 1,786,115
Other revenue                                           72,003        152,665             --
                                                   -----------    -----------    -----------

     Total revenue                                   1,890,666      2,042,878      1,786,115
                                                   -----------    -----------    -----------

Cost of goods sold                                   3,209,875      1,629,287      1,556,353
Cost of other revenue                                   22,506         81,079             --
                                                   -----------    -----------    -----------

     Total cost of revenue                           3,232,381      1,710,366      1,556,353
                                                   -----------    -----------    -----------

     Gross profit (loss)                            (1,341,715)       332,512        229,762
                                                   -----------    -----------    -----------

Operating expenses:
  Selling, general and administrative                3,816,806      2,454,337      3,662,679
  Research, development and engineering                973,210      1,016,293      1,102,737
                                                   -----------    -----------    -----------

     Total operating expenses                        4,790,016      3,470,630      4,765,416
                                                   -----------    -----------    -----------

     Operating loss                                 (6,131,731)    (3,138,118)    (4,535,654)

Interest expense                                          (447)        (2,511)        (4,614)
Interest income                                        157,350        132,405        378,932
                                                   -----------    -----------    -----------

     Net loss                                      $(5,974,828)   $(3,008,224)   $(4,161,336)
                                                   ===========    ===========    ===========

Per-share data:
     Basic and diluted net loss per common share   $     (1.49)   $     (0.69)   $     (0.96)
                                                   ===========    ===========    ===========

Weighted average number of common
  shares and common share
  equivalents outstanding                            5,202,608      4,347,968      4,347,293
                                                   ===========    ===========    ===========

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

                                             F-3
</TABLE>
<PAGE>
<TABLE>
<CAPTION>

                                                        C-PHONE CORPORATION

                                                 STATEMENTS OF SHAREHOLDERS' EQUITY

                                               FOR THE YEARS ENDED FEBRUARY 28, 1998,
                                              FEBRUARY 28, 1997 AND FEBRUARY 29, 1996



                                             Common Stock                         Paid-in Capital                          Total
                                             ------------         Paid-in Capital    Preferred      Accumulated        Shareholders'
                                         Shares        Amount      Common Stock        Stock          Deficit             Equity
                                      ----------      --------    --------------- ---------------  ------------       --------------
<S>                                    <C>            <C>          <C>             <C>             <C>                 <C>
Balance, February 28, 1995             4,347,293      $ 43,473     $ 13,495,376                    $ (3,679,277)       $ 9,859,572

Net loss                                                                                             (4,161,336)        (4,161,336)
                                      ----------      --------     ------------    ------------    ------------        -----------
Balance, February 29, 1996             4,347,293        43,473       13,495,376                      (7,840,613)         5,698,236

Exercise of employee stock                 8,100            81           25,232                                             25,313
  options

Expense of stock options
  granted to consultant                                                   9,600                                              9,600

Net loss                                                                                             (3,008,224)        (3,008,224)
                                      ----------      --------     ------------    ------------    ------------        -----------

Balance, February 28, 1997             4,355,393        43,554       13,530,208                     (10,848,837)         2,724,925

Exercise of employee stock
  options                                 17,571           176           59,412                                             59,588

Expense of stock options
  granted to consultant                                                  74,400                                             74,400

Stock issued to consultant                 4,740            47           14,173                                             14,220

Issuance of common stock in
  March 1997 private placement           833,667         8,336        4,361,182                                          4,369,518

Issuance of common stock
  pursuant to contingent value
  rights issued in March 1997
  private placement                      136,863         1,369           (1,369)

Issuance of preferred stock
 in December 1997 private
 placement                                                                         $   (390,458)                          (390,458)

To reflect beneficial conversion
  feature of preferred stock                                                          1,708,808      (1,708,808)                 0

Accretion of preferred stock                                                                            (43,767)           (43,767)

Net loss                                                                                             (5,974,828)        (5,974,828)
                                      ----------      --------     ------------    ------------    ------------        -----------

Balance, February 28, 1998             5,348,234      $ 53,482     $ 18,038,006     $ 1,318,350    $(18,576,240)       $   833,598
                                      ==========      ========     ============     ===========    ============        ===========


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

                                                                F-4
<PAGE>
                                            C-PHONE CORPORATION

                                          STATEMENTS OF CASH FLOWS

                                   FOR THE YEARS ENDED FEBRUARY 28, 1998,
                                  FEBRUARY 28, 1997 AND FEBRUARY 29, 1996
<TABLE>
<CAPTION>

                                                                     1998          1997            1996
                                                                 -----------    -----------    -----------
<S>                                                              <C>            <C>            <C>
Cash flows from operating activities:
  Net loss                                                       $(5,974,828)   $(3,008,224)   $(4,161,336)
  Adjustments to reconcile net loss to net
   cash used in operating activities:
      Depreciation and amortization                                  131,231        134,202        182,803
      Provision for inventory obsolescence                           515,431             --         70,227
      Bad debt expense                                               178,773         90,831        164,554
      Compensation expense of stock options                           74,400          9,600             --
      Compensation expense of stock issued                            14,220             --             --
      Changes in operating assets and liabilities:
        Accounts receivable                                         (103,415)      (114,869)      (391,124)
        Inventories                                                 (815,028)      (280,435)      (535,997)
        Prepaid expenses and other current assets                      8,338         41,849        145,740
        Other assets                                                 111,560        (86,926)       (64,318)
        Accounts payable                                             208,142        298,515       (191,229)
        Accrued expenses                                             (30,291)       102,940         42,249
                                                                 -----------    -----------    -----------
          Net cash used in operating activities                   (5,681,467)    (2,812,517)    (4,738,431)
                                                                 -----------    -----------    -----------

Cash flows from investing activities:
  Equipment purchases                                                (43,492)       (77,867)       (92,334)
  Purchases of short-term investments                                     --     (1,647,371)    (8,319,464)
  Maturities of short-term investments                                    --      4,073,774      9,763,943
                                                                 -----------    -----------    -----------
          Net cash (used in) provided by investing activities        (43,492)     2,348,536      1,352,145
                                                                 -----------    -----------    -----------

Cash flows from financing activities:
  Proceeds from exercise of stock options                             59,588         25,313             --
  Proceeds from private placement of common stock                  4,369,518             --             --
  Proceeds from private placement of preferred stock               4,109,542             --             --
  Payment of capital lease obligations                               (11,507)       (16,103)       (21,999)
                                                                 -----------    -----------    -----------
          Net cash provided by (used in) financing activities      8,527,141          9,210        (21,999)
                                                                 -----------    -----------    -----------

          Net increase (decrease) in cash and cash equivalents     2,802,182       (454,771)    (3,408,285)

Cash and cash equivalents, beginning of year                       1,398,049      1,852,820      5,261,105
                                                                 -----------    -----------    -----------

Cash and cash equivalents, end of year                           $ 4,200,231    $ 1,398,049    $ 1,852,820
                                                                 ===========    ===========    ===========

Supplemental disclosure of cash flow information:

  Interest paid                                                  $       447    $     2,511    $     4,614
                                                                 ===========    ===========    ===========



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

                                                    F-5

<PAGE>
                               C-PHONE CORPORATION

                          NOTES TO FINANCIAL STATEMENTS

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

1.   NATURE OF BUSINESS

     C-Phone  Corporation  (the "Company") was  incorporated in the State of New
     York on March 28, 1986. The Company has been, and is, primarily  engaged in
     the  engineering,  manufacturing  and  marketing  of a line of TV-based and
     PC-based video  conferencing  systems.  The Company's  stand alone TV-based
     video  conferencing  system or "video  phone",  which operates over regular
     analog  telephone lines using a standard  television set, is marketed under
     the name C-Phone  Home(TM).  In January 1998,  the Company  introduced  its
     C-Phone DS 324 TV-based  video phone,  which  operates over both analog and
     ISDN  digital   telephone  lines.  In  May  1998,  the  Company   announced
     development  of C-Phone  ITV(TM),  a TV-based  set-top device that provides
     Internet access using a standard  television set and analog telephone line.
     The  Company's  PC-based  video  conferencing  systems,  which operate over
     digital  networks,  are marketed  under the name  C-Phone(R).  From time to
     time,  the Company  also has engaged in  contractual  software  development
     related to its products.

2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

     Use of Estimates in the Preparation of Financial Statements
     -----------------------------------------------------------

     The  preparation  of financial  statements  in  conformity  with  generally
     accepted  accounting  principles  requires management to make estimates and
     assumptions  that affect the reported  amount of assets and liabilities and
     disclosure  of  contingent  assets  and  liabilities  at  the  date  of the
     financial  statements  and the  reported  amount of revenues  and  expenses
     during  the  reporting  period.  Actual  results  could  differ  from those
     estimates.

     Cash and Cash Equivalents
     -------------------------

     Cash and cash  equivalents  includes all cash  balances  and highly  liquid
     investments  with a  maturity  of  three  months  or less  from the date of
     purchase.

     Short-term Investments
     ----------------------

     Short-term investments include highly liquid investments with a maturity of
     more  than  three  months  and not  more  than  one  year  from the date of
     purchase.

     Concentration of Credit Risk
     ----------------------------

     Concentrations  of credit risk that arise from financial  instruments exist
     for   groups   of   counterparties   when  they   have   similar   economic
     characteristics   that  would  cause  their  ability  to  meet  contractual
     obligations  to be  similarly  affected  by  changes in  economic  or other
     conditions.

     Significant  customers and  concentrations  of credit risk are discussed in
     Note 11. As  discussed  in Note 3, the Company  maintains  its cash in bank
     deposit accounts which, at times, may exceed federally insured limits.

     Fair Value of Financial Instruments
     -----------------------------------

     The carrying value of the Company's financial instruments, which consist of
     cash and cash  equivalents  at February  28, 1998,  February 28, 1997,  and
     February  29,  1996,  approximates  the fair  value  because  of the  short
     maturities of these instruments.

                                      F-6

<PAGE>
                               C-PHONE CORPORATION

                          NOTES TO FINANCIAL STATEMENTS

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

2.    SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

     Inventories
     -----------

     Inventories  are stated at the lower of cost  (first-in,  first-out "FIFO "
     basis) or market.  Inventories  reflect valuation  allowances  necessary to
     reduce inventories to their net realizable value.

     Property and Equipment
     ----------------------

     Property  and  equipment  is stated at cost and is  depreciated,  including
     equipment under capital leases, by the double-declining-balance method over
     the  estimated  useful life of the assets,  which range from three to seven
     years.  Leasehold improvements are amortized over the remaining term of the
     lease or the useful life, if shorter.  Major tooling costs are  capitalized
     and amortized over the expected life of the tooling or the expected life of
     the related  product,  whichever is less.  Expenditures  for minor tooling,
     maintenance and repairs are charged to expense as incurred.

     Significant expenditures for betterments and renewals are capitalized.  The
     cost and related  accumulated  depreciation  of property and  equipment are
     removed from the accounts  upon  retirement or other  disposition,  and any
     gain or loss is reflected in operations.

     The Company  assesses the  impairment of its long-lived  assets,  including
     property,  plant and  equipment,  whenever  economic  events or  changes in
     circumstances  indicate  that the  carrying  value of the assets may not be
     recoverable.  Long-lived  assets are considered to be impaired when the sum
     of the  expected  future  operating  cash flows,  undiscounted  and without
     interest charges, is less than the carrying values of the related assets.

     Income Taxes
     ------------

     The Company  provides  for income  taxes in  accordance  with  Statement of
     Financial  Accounting  Standards No. 109 ("SFAS No. 109"),  "Accounting for
     Income  Taxes".  SFAS No.  109  requires  that all  deferred  tax asset and
     liability balances be determined by application to temporary differences of
     the tax rate  expected to be in effect  when taxes will  become  payable or
     receivable.  Temporary differences are differences between the tax basis of
     assets  and  liabilities  and  their  reported  amounts  in  the  financial
     statements  that will  result in  taxable or  deductible  amounts in future
     years.   The  Company's   temporary   differences   consist   primarily  of
     depreciation,  allowance  for doubtful  accounts  receivable  and inventory
     valuation reserves.

     Revenue Recognition
     -------------------

     Product revenues are recognized when the product is shipped,  collection of
     the purchase price is probable and the Company has no  significant  further
     obligation  to the  customer.  Software  development  revenue is recognized
     under the  completed  contract  method  when the  software  development  is
     completed or  substantially  completed.  Costs of  remaining  insignificant
     Company obligations, if any, are accrued as costs of revenue at the time of
     revenue recognition.

     Warranty
     --------

     The  Company  generally  provides  a  one-year  warranty  on its  products.
     Estimated  warranty  expenses are accrued and charged to cost of goods sold
     when the related revenues are recognized.

                                      F-7

<PAGE>

                               C-PHONE CORPORATION

                          NOTES TO FINANCIAL STATEMENTS

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

2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

     Research and Development Costs
     ------------------------------

     Research and  development  expenditures  are charged to expense in the year
     incurred.

     Preferred Stock
     ---------------

     In December 1997, the Company issued 4,500 shares (the "Preferred  Shares")
     of its Series A Preferred  Stock (the  "Preferred  Stock")  with an initial
     stated  value of $1,000 per share,  which  increases  at the rate of 5% per
     annum (such amount,  as increased from time to time,  the "Stated  Value").
     Each  Preferred  Share is convertible  into shares of the Company's  common
     stock, par value $.01 per share (the "Common Stock"),  from time to time at
     the option of the holder,  into such number of shares of Common Stock as is
     determined  by dividing  the Stated  Value by the lesser of (a) $7.3575 and
     (b)  85%  of the  average  of the  closing  bid  price  during  such  three
     consecutive  trading day period as may be selected by the holder during the
     25 day trading  period  preceding the date of conversion.  Any  outstanding
     Preferred Shares on December 19, 1999  automatically will be converted into
     Common Stock at the conversion  price then in effect.  The Preferred Shares
     cease to be convertible  if the aggregate  number of shares of Common Stock
     then issued upon  conversion of the Preferred  Shares would equal 1,068,513
     shares of Common  Stock  (the  "19.99%  Limitation")  unless  and until the
     Company  receives  approval  from its  shareholders  or  otherwise to issue
     additional shares of Common Stock. See Note 6.

     In  its  November  7,1997  Current  Issues  and  Rulemaking  Projects,  the
     Securities  and Exchange  Commission  (the "SEC")  addressed the issue of a
     "beneficial  conversion feature",  where securities may be convertible into
     common stock at the lower of a  conversion  rate fixed at the date of issue
     or a fixed  discount  to the  common  stock's  market  price at the date of
     conversion.  The beneficial  conversion  feature of the Preferred  Stock is
     recognized  and measured by  allocating a portion of the proceeds  equal to
     the  intrinsic  value of the  feature to  additional  paid-in-capital.  The
     beneficial  conversion  feature of $1,708,808 was calculated at the date of
     issue as the difference  between the conversion price and the fair value of
     the Common  Stock.  This amount is  recognized as a return to the preferred
     shareholders  over the minimum period in which the shareholders can realize
     the return.  As there are no time  restraints on the  conversion,  the full
     amount of the feature was amortized on the date of issuance.

     SEC regulations require that all issues of mandatorily  redeemable stock be
     excluded from the shareholders'  equity section of the balance sheet and be
     presented   separately.   One  of  the  characteristics  of  a  mandatorily
     redeemable  stock is that it contains  conditions for redemption  which are
     not solely within the control of the issuer. The Preferred Stock is subject
     to  redemption  at the  option of the  holder if (a) the  Company  fails to
     maintain an effective  registration statement with respect to the shares of
     Common  Stock  issuable  upon  exercise of the  Preferred  Shares,  (b) the
     Preferred  Shares cease to be convertible due to the 19.99%  Limitation and
     the  Company  does not  obtain  shareholder  approval  within 75 days after
     requested by the holders,  or (c) the Company fails to maintain  listing of
     the  Common  Stock  on  the  Nasdaq  National  Market  or  other  principal
     securities exchange.  Since there is the possibility that the occurrence of
     an event  outside the control of the Company  could cause  redemption,  the
     Preferred Stock has been classified separately from shareholders' equity on
     the balance sheet. See Notes 6 and 14.

                                      F-8

<PAGE>
                               C-PHONE CORPORATION

                          NOTES TO FINANCIAL STATEMENTS

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

2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

     Net Loss per Share
     ------------------

     In February 1997, the Financial Accounting Standards Board issued Statement
     of Financial Accounting  Standards No. 128 ("SFAS No. 128"),  "Earnings Per
     Share",  which  established  new standards for  computation of earnings per
     share.  SFAS No. 128  requires the  presentation  on the face of the income
     statement of "basic"  earnings per share and "diluted"  earnings per share.
     Basic  earnings  per share is computed by  dividing  the net income  (loss)
     available  to  common  shareholders  by  the  weighted  average  number  of
     outstanding common shares. The calculation of diluted earnings per share is
     similar  to basic  earnings  per  share  except  the  denominator  includes
     dilutive  common  stock  equivalents  such as stock  options and  warrants.
     Common  stock  options and  warrants  are not  included for the years ended
     February 28, 1998 ("Fiscal  1998"),  February 28, 1997 ("Fiscal  1997") and
     February  29,  1996  ('Fiscal  1996') as they would be  anti-dilutive.  The
     amortization of the beneficial  conversion feature and the accretion of the
     5%  annual  increase  in  stated  value of the  Preferred  Stock  totalling
     $1,752,575  increased the net loss attributable to common  shareholders for
     the purposes of the calculation of net loss per share in Fiscal 1998.

     Accounting for Stock Options
     ----------------------------

     As permitted by Statement of Financial  Accounting Standards No. 123 ("SFAS
     No. 123"),  "Accounting for Stock Based Compensation",  the Company applies
     Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to
     Employees"  and  related  interpretations  in  accounting  for the  C-Phone
     Corporation  Amended and Restated 1994 Stock Option Plan (the "Stock Option
     Plan").  Accordingly,  no compensation cost has been recognized for options
     granted  under the Stock Option Plan except for $74,400 for Fiscal 1998 and
     $9,600 for Fiscal 1997  related to the fair value of  services  rendered in
     exchange  for  options  granted to  consultants.  However,  the Company has
     disclosed  in Note 7 the pro  forma  effects  had  compensation  cost  been
     determined based on the fair value of the options at the grant date.

     New Accounting Pronouncements
     -----------------------------

     In June 1997, the Financial  Accounting Standards Board issued Statement of
     Financial  Accounting  Standards  No.  130  ("SFAS  No.  130"),  "Reporting
     Comprehensive Income". SFAS No. 130 establishes standards for the reporting
     and  displaying  of  comprehensive  income  and its  components  (revenues,
     expenses,  gains and  losses)  in a full set of general  purpose  financial
     statements.  SFAS  No.  130  requires  the  disclosure  of an  amount  that
     represents total  comprehensive  income and the components of comprehensive
     income in a financial statement.  The pronouncement is effective for fiscal
     years  beginning  after  December 15,  1997,  and is not expected to have a
     material impact on the Company's financial statements.

     In June 1997, the Financial  Accounting Standards Board issued Statement of
     Financial Accounting Standards No. 131 ("SFAS No. 131"), "Disclosures about
     Segments  of  an  Enterprise  and  Related   Information".   SFAS  No.  131
     establishes  standards for determining an entity's  operating  segments and
     the type and level of financial  information to be disclosed in both annual
     and interim financial  statements.  SFAS No. 131 also establishes standards
     for related  disclosures about products and services,  geographic areas and
     major customers. The pronouncement is effective for periods beginning after
     December  15, 1997,  and is not  expected to have a material  impact on the
     Company's financial statements.

                                      F-9

<PAGE>

                               C-PHONE CORPORATION

                          NOTES TO FINANCIAL STATEMENTS

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

2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

     In February 1998, the Financial Accounting Standards Board issued Statement
     of Financial  Accounting  Standards No. 132 ("SFAS No.  132"),  "Employers'
     Disclosures about Pensions and Other Postretirement Benefits". SFAS No. 132
     revises  employers'  disclosures  about  pension  and other  postretirement
     benefit plans. The  pronouncement is effective for periods  beginning after
     December 15, 1997 and, as the Company does not presently  have a pension or
     other  postretirement  benefit  plan,  is not  expected  to have a material
     impact on the Company's financial statements.

3.   CASH AND SHORT-TERM INVESTMENTS

     The Company places a portion of its cash and cash  equivalents with various
     financial institutions.  At times, such cash and cash equivalents may be in
     excess of the FDIC  insurance  limits.  At February 28, 1998, the Company's
     cash equivalents consisted primarily of overnight repurchase agreements for
     discount  notes  issued by the  United  States  Treasury  or United  States
     government  agencies.   The  aggregate  fair  value  of  these  investments
     approximated the amortized cost at February 28, 1998.

4.   INVENTORIES

     Inventories consist of the following at February 28, 1998 and 1997:
<TABLE>
<CAPTION>

                                                                            1998           1997
                                                                         ----------     ----------
<S>                                                                      <C>            <C>
     Raw materials                                                       $  881,095     $  985,914
     Work in process                                                        486,335        304,839
     Finished goods                                                         274,098         51,178
                                                                         ----------     ----------

                                                                         $1,641,528     $1,341,931
                                                                         ==========     ==========

</TABLE>

5.   PROPERTY AND EQUIPMENT

     Property and  equipment  consist of the  following at February 28, 1998 and
     1997:
<TABLE>
<CAPTION>

                                                                            1998           1997
                                                                         ----------     ----------
<S>                                                                      <C>            <C>
     Machinery and equipment                                             $  997,210     $  965,711
     Furniture and fixtures                                                  50,940         49,084
     Leasehold improvements                                                  82,032         71,895
                                                                         ----------     ----------

                                                                          1,130,182      1,086,690
     Less accumulated depreciation
       and amortization                                                     966,008        834,777
                                                                         ----------     ----------

                                                                         $  164,174     $  251,913
                                                                         ==========     ==========
</TABLE>

                                      F-10

<PAGE>

                               C-PHONE CORPORATION

                          NOTES TO FINANCIAL STATEMENTS

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

6.   SHAREHOLDERS' EQUITY

     In connection  with the Company's  initial public  offering in August 1994,
     the  Company  granted  to the  managing  underwriter  warrants  (the  "1994
     Warrants") to purchase  200,000  shares of Common Stock at $8.40 per share.
     The 1994  Warrants may be exercised at any time until  expiration on August
     18, 1999. See Note 14.

     During Fiscal 1997, in conjunction  with a one-year  consulting  agreement,
     the Company  granted to a consultant a five-year  option to purchase 25,000
     shares of Common  Stock at a price of $3.375 per share (the market price of
     the Common Stock on the date of grant).  The agreement was extended  during
     Fiscal 1998 for another year and the Company granted the consultant another
     five-year  option to purchase  24,000 shares at a price of $5.95 per share.
     The  agreement was  terminated  in May 1998 and options to purchase  10,000
     shares of  Common  Stock  under  the  option  granted  in Fiscal  1998 were
     forfeited  pursuant to the terms of the option. The options were granted in
     partial  payment for  services to be rendered by the  consultant  under the
     agreement, which services the Company valued at $38,400 for Fiscal 1998 and
     $9,600 for Fiscal 1997.  Also during  Fiscal 1998,  the Company  granted to
     another  consultant a five-year  option to purchase 18,000 shares of Common
     Stock at $7.8125  per share (the  market  price of the Common  Stock on the
     date of grant).  The relationship with this other consultant was terminated
     prior to the end of its six-months term and the right to exercise one-third
     of the option was forfeited pursuant to the terms of the option. The option
     was  granted  in  partial  payment  for  services  to be  rendered  by  the
     consultant,  which  services the Company valued at $36,000 for Fiscal 1998.
     All of these amounts were expensed  and, as a result,  paid-in  capital was
     increased by such amounts.

     During  the week of  March  31,  1997,  the  Company  completed  a  private
     placement (the "March Placement"),  through a placement agent,  pursuant to
     which the Company  issued an  aggregate  of 833,667  shares of Common Stock
     (the "Original  Shares") to the participants (the "Investors") in the March
     Placement  and  received net proceeds of  approximately  $4,370,000  (after
     payment,  or  accrual,  of fees and  expenses of  approximately  $632,000).
     Accompanying  each of the  Original  Shares  was the right,  under  certain
     circumstances,  to receive  additional shares of Common Stock in accordance
     with the terms of a "contingent  value right" (the  "Rights").  The Rights,
     which expire June 25, 1998,  are  automatically  exercised at the time, and
     from time to time as, the Original Shares are first publicly sold through a
     broker-dealer.  The terms of the Rights  provide that,  upon the first such
     sale of any  Original  Shares at a price of less than $8.00 per share,  the
     seller of the Original  Shares will receive,  for each such Original  Share
     sold,  and  without  the  payment  of any  additional  consideration,  such
     additional  number of shares of Common Stock as equals (i) $8.00 divided by
     the Adjusted  Price,  minus (ii) one;  where the Adjusted  Price equals the
     greater of (x) the average  closing bid price per share of Common  Stock on
     The Nasdaq National Market for the ten trading days  immediately  preceding
     the date of sale of the Original  Shares,  or (y) $2.00. As of February 28,
     1998, all the Original  Shares had been sold (although the holder of 30,000
     Original  Shares  has  not  yet  submitted  to the  Company  the  necessary
     documentation  to determine  the number,  if any, of  additional  shares to
     which he is  entitled)  and,  pursuant to the terms of the Rights,  136,863
     additional  shares were issued as a result thereof.  In connection with the
     March Placement,  the Company issued to an affiliate of the placement agent
     warrants to acquire an  aggregate  of 150,000  shares of Common Stock at an
     exercise price of $9.60 per share, which warrants have expired.

                                      F-11

<PAGE>

                               C-PHONE CORPORATION

                          NOTES TO FINANCIAL STATEMENTS

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

6.   SHAREHOLDERS' EQUITY (Continued)

     On December  19,  1997,  the Company  completed  a private  placement  (the
     "December  Placement")  pursuant to which the Company issued to the several
     participants an aggregate of (a) 4,500 Preferred Shares,  (b) warrants (the
     "One-Year  Warrants") to acquire up to 315,000 shares of Common Stock,  and
     (c) warrants (the "Three-Year Warrants") to acquire up to 135,000 shares of
     Common Stock. The Company received net proceeds of approximately $4,110,000
     (after payment,  or accrual,  of fees (including  finders fees) and related
     expenses of approximately  $390,000).  Each Preferred Share is convertible,
     from time to time, at the option of the holder,  into such number of shares
     of Common Stock as is determined by dividing the Stated Value by the lesser
     of (a) $7.3575,  and (b) 85% of the average of the closing bid price during
     such three consecutive  trading day period as may be selected by the holder
     during the 25 day trading  period  preceding  the date of  conversion.  Any
     outstanding  Preferred  Shares on December 19, 1999  automatically  will be
     converted  into Common Stock at the  conversion  price then in effect.  The
     Preferred  Shares are subject to redemption at the option of the holder if,
     among  other  things,  (a) the  Company  fails  to  maintain  an  effective
     registration  statement with respect to the shares of Common Stock issuable
     upon exercise of the Preferred  Shares for more than 30 consecutive days or
     more than 60 days in any 12 month period, (b) the Company fails to maintain
     the listing of the Common  Stock on the Nasdaq  National  Market or another
     principal  securities  exchange or automated  quotation  system, or (c) the
     Preferred Shares cease to be convertible due to the 19.99%  Limitation (see
     Note 2) and the  Company  has not,  prior  thereto  or within 75 days after
     notice from holders of two-thirds of the Preferred Shares (which notice has
     not yet been received),  obtained  approval to issue  additional  shares of
     Common  Stock.  If the  Company  does not  receive  approval  to issue  the
     additional  shares of Common Stock and the holders of the Preferred  Shares
     elect to exercise their redemption  rights, the Company will be required to
     redeem the remaining outstanding Preferred Shares at an amount equal to the
     greater of (a) 118% of the Stated Value of the Preferred Shares and (b) the
     market value of the Common Stock into which the Preferred Shares would have
     been converted on the date of redemption.  The One-Year  Warrants expire on
     December  19,  1998,  have an  exercise  price of $8.05  per  share and are
     redeemable  at the option of the  Company at a price of $.01 per warrant if
     the closing  price of the Common Stock is greater than 130% of the exercise
     price  of the  One-Year  Warrants  for 10  consecutive  trading  days.  The
     Three-Year  Warrants expire on December 19, 2000, have an exercise price of
     $9.10 per share and are not  redeemable.  In  connection  with the December
     Placement,  the Company  paid a finders  fee of  $295,000  and issued to an
     affiliate  of the  finder  warrants  (upon the same  terms as the  One-Year
     Warrants) to acquire an aggregate of 185,000  shares of Common  Stock.  See
     Notes 2 and 14.

7.   STOCK OPTION PLAN

     The Stock  Option  Plan  provides  for the grant of  options  to  officers,
     directors, employees and consultants. Options may be either incentive stock
     options or non-qualified  stock options,  except that only employees may be
     granted  incentive  stock  options.  The maximum number of shares of Common
     Stock with respect to which  options may be granted  under the Stock Option
     Plan is  500,000  shares.  Options  generally  vest  over a period of three
     years.  The maximum  term of an option is ten years.  The Stock Option Plan
     will terminate in August 2004,  though options granted prior to termination
     may expire after that date.

     Had  compensation  cost for the Stock Option Plan been determined  based on
     the fair value at the grant dates for awards  under the Stock  Option Plan,
     excluding the grants to consultants  discussed in Note 6,  consistent  with
     the  method of SFAS No. 123 (see Note 2),  the  Company's  net loss and net
     loss per share  would have  increased  to the pro forma  amounts  indicated
     below:

                                      F-12
<PAGE>

                               C-PHONE CORPORATION

                          NOTES TO FINANCIAL STATEMENTS

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

7.   STOCK OPTION PLAN (Continued)

<TABLE>
<CAPTION>
                                Fiscal 1998            Fiscal 1997            Fiscal 1996
                          ---------------------   ---------------------   ---------------------
                              As         Pro          As         Pro          As         Pro
                           Reported     Forma      Reported     Forma      Reported     Forma
                          ---------   ---------   ---------   ---------   ---------   ---------

<S>                       <C>         <C>         <C>         <C>         <C>         <C>      
Net loss (in thousands)   $   5,975   $   6,247   $   3,008   $   3,108   $   4,161   $   4,191
Net loss per share        $    1.49   $    1.54   $    0.69   $    0.71   $    0.96   $    0.96
</TABLE>

     The fair value of each option grant is estimated on the date of grant using
     the Black Scholes option-pricing method with the following weighted average
     assumptions used for grants.

                                   1998      1997     1996
                                   ----      ----     ----
     Dividend yield                   0%        0%       0%
     Expected volatility           81.4%    138.8%    43.3%
     Risk-free interest rate       6.25%     6.25%    6.25%
     Expected lives, in years         5         5        5

     The weighted  average  fair value of options  granted  during  Fiscal 1998,
     Fiscal  1997  and  Fiscal  1996 was  $4.16,  $2.85  and  $3.51  per  share,
     respectively.

     A summary of the status of the Stock  Option  Plan at  February  28,  1998,
     February 28, 1997 and  February  29, 1996 and the changes  during the years
     then ended is presented below:

<TABLE>
<CAPTION>

                                                1998                  1997                   1996
                                       ---------------------  --------------------  ---------------------
                                                    Weighted              Weighted               Weighted
                                         Shares     Average    Shares     Average    Shares      Average
                                        Underlying  Exercise  Underlying  Exercise  Underlying   Exercise
                                         Options      Price     Options    Price      Options     Price
                                       -----------  --------  ----------  --------  ----------   --------
     <S>                                  <C>        <C>        <C>       <C>         <C>        <C>     
     Outstanding at beginning of year     275,200    $ 4.66     116,500   $ 7.34      106,950    $ 7.13
     Granted                              134,650    $ 8.11     189,150   $ 3.18       47,050    $ 7.45
     Exercised                            (17,571)   $ 3.39      (8,100)  $ 3.13            0        --
     Forfeited                            (54,552)   $ 4.86     (22,350)  $ 6.39      (37,500)   $ 7.03
                                          -------               -------                ------
     Outstanding at end of year           337,727    $ 6.07     275,200   $ 4.66      116,500    $ 7.34
                                          =======               =======               =======
     Exercisable at end of year           188,401    $ 5.47      85,967   $ 6.01       30,583    $ 7.21
                                          =======               =======               =======
</TABLE>

                                                  F-13

<PAGE>

                               C-PHONE CORPORATION

                          NOTES TO FINANCIAL STATEMENTS

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

7.   STOCK OPTION PLAN (Continued)

     The following table  summarizes  information  about stock options under the
     Stock Option Plan at February 28, 1998:

<TABLE>
<CAPTION>
                                        Options Outstanding                         Options Exercisable
                            ----------------------------------------------      -----------------------------
                                            Weighted
                                             Average           Weighted                           Weighted
                                            Remaining           Average                            Average
         Range of             Number       Contractual          Exercise          Number          Exercisable
     Exercise Price         Outstanding       Life               Price          Exercisable         Price
     ---------------        -----------    -----------         ----------       -----------       -----------
     <S>                    <C>                 <C>             <C>             <C>                  <C>    
     $ 2.38 - $ 3.38           117,850          3.5             $   3.21           81,342            $  3.13
     $ 5.95 - $ 6.99            46,617          4.6             $   6.21            8,334            $  6.14
     $ 7.00 - $ 7.99           110,060          2.2             $   7.35           98,725            $  7.34
     $ 8.00 - $ 8.99            41.200          4.7             $   8.38                0                 --
     $10.00 - $10.99            22,000          4.2             $  10.38                0                 --
                            ----------                                          ---------
                               337,727                                            188,401
                            ==========                                          =========
</TABLE>

8.   RELATED PARTY TRANSACTIONS

     The Company leases its office,  manufacturing  and warehouse space from two
     of its executive officers who also are directors of the Company (Note 10).

9.   OBLIGATIONS UNDER CAPITAL LEASES

     The Company leased certain manufacturing equipment,  with an aggregate cost
     of $68,674 and accumulated  depreciation of $66,413,  at February 28, 1997.
     Obligations under the capital leases totalled $11,507 at February 28, 1997.
     These  capital  leases were payable in monthly  installments  of $1,506 for
     Fiscal 1997,  including interest,  and were collateralized by manufacturing
     equipment having a net book value of $2,261 at February 28, 1997.

10.  COMMITMENTS

     The Company  leases  office,  manufacturing  and warehouse  space  totaling
     approximately  14,420  square feet from two of its  executive  officers who
     also are directors of the Company. The lease currently expires on April 30,
     1999 with monthly rental payments of $6,280.  Under the lease,  the Company
     is  required  to pay all real  estate  taxes  and  maintenance  costs,  and
     maintain property and liability insurance on the leased property.

     The  Company,  at its  option,  may  extend the lease term to April 2002 by
     exercising the remaining  three-year renewal option and, in that event, the
     monthly  rental  payment would be adjusted to the then current market rate,
     as defined, of similar space at the time of renewal.

                                      F-14

<PAGE>

                               C-PHONE CORPORATION

                          NOTES TO FINANCIAL STATEMENTS

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

10.  COMMITMENTS (Continued)

     The future minimum aggregate lease payments under  noncancelable  operating
     leases are as follows at February 28, 1998:

     Fiscal year ending February 28,
     -------------------------------
     1999                                                            $75,360
     2000                                                             12,560
                                                                     -------
                                                                     $87,920
                                                                     =======


     Rent expense was $75,360, $72,800, and $60,000 in Fiscal 1998, Fiscal 1997,
     and Fiscal 1996, respectively.

11.  SIGNIFICANT CUSTOMERS AND CONCENTRATION OF CREDIT RISK

     At February 28, 1998 and 1997, the Company had  outstanding  trade accounts
     receivable from 64 and 33 customers, respectively. The Company monitors the
     granting of credit to all its customers  and,  generally,  no collateral is
     required.

     For Fiscal  1998,  the  Company did not have any  revenues  from any single
     customer that  exceeded 10% of total net  revenues.  In each of Fiscal 1997
     and Fiscal 1996,  there were net  revenues  from two major  customers  that
     exceeded 10% of total net revenues.  Net revenues from these customers were
     as follows:

                          1998           1997           1996
                        --------       --------       --------

     Customer A         $ 52,518       $ 31,678       $187,119
     Customer B               --        291,710             --
     Customer C               --          5,864        184,063
     Customer D               --        211,224         58,325
                        --------       --------       --------
                        $ 52,518       $540,476       $429,507
                        ========       ========       ========

     Accounts  receivable  from these  customers were as follows at February 28,
     1998 and 1997:

                                        1998           1997
                                       -------        -------

     Customer A                        $    --        $17,417
     Customer B                             --         30,066
     Customer C                             --             --
     Customer D                             --         51,938
                                       -------        -------

                                       $    --        $99,421
                                       =======        =======


     The Company had net revenues from customers  located  outside of the United
     States of $314,000,  $308,000 and $299,000 during Fiscal 1998,  Fiscal 1997
     and Fiscal 1996, respectively.

                                      F-15
<PAGE>

                               C-PHONE CORPORATION

                          NOTES TO FINANCIAL STATEMENTS

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

12.  CONTINGENCIES

     The Company is involved in various legal  proceedings  which are incidental
     to the conduct of its  business.  Although  the final  resolution  of these
     matters cannot be  determined,  it is  management's  opinion that the final
     outcome of these  matters  will not have a material  adverse  effect on the
     Company's financial position or results of operations.

13.  INCOME TAXES

     The  components  of the net  deferred tax asset were as follows at February
     28, 1998 and 1997:

                                     1998           1997
                                   -----------    -----------

     Net operating loss
       carryforwards               $ 5,926,262    $ 4,034,541
     Alternative minimum tax
       credit carryforwards              5,924          5,924
     Allowance for doubtful
       accounts                        164,782         46,938
     Research and development
       tax credit                      135,529        118,550
     Inventory reserve                 404,663             --
     Other                              83,469        164,302
     Valuation allowance            (6,720,629)    (4,370,255)
                                   -----------    -----------

     Net deferred tax asset        $        --    $        --
                                   ===========    ===========

     The Company provides a valuation allowance for deferred tax assets that are
     not expected to be realized.  Due to the recent net losses  incurred by the
     Company,  a valuation  allowance has been  established for all deferred tax
     assets.  

                                      F-16

<PAGE>

                               C-PHONE CORPORATION

                          NOTES TO FINANCIAL STATEMENTS

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

13.  INCOME TAXES (Continued)

     Reconciliation of differences between the statutory U.S. Federal income tax
     rate and the Company's effective tax rate are as follows:

                                      1998       1997        1996
                                    --------   ---------   --------
     Federal statutory income 
       tax rate                          (34)%       (34)%      (34)%
     State income taxes, net 
       of federal benefit                 (5)         (5)        (7)
     Valuation allowance 
       increase                           39          39         41
     Research and development 
       tax credit                         --          --         --
                                    --------   ---------   --------

                                           0%          0%         0%
                                    ========   =========   ========

     The net  operating  loss  carryforwards  for  Federal  tax  purposes  as of
     February 28, 1998 are  estimated to be  $15,125,000.  The net economic loss
     carryforwards  for state tax purposes as of February 28, 1998 are estimated
     to be $15,337,000.  The Federal net operating loss carryforwards  expire in
     2009 through 2013 and the state net economic loss  carryforwards  expire in
     1999 through 2003.

14.  SUBSEQUENT EVENT

     On May 13,  1998,  the  Company  reduced  the  exercise  price  of the 1994
     Warrants from $8.40 to $6.00 per share, in  consideration  for changing the
     expiration  date thereof from August 18, 1999 to May 21, 1998.  The holders
     of the 1994 Warrants  then  exercised all of the 1994 Warrants on or before
     the close of business on May 15,  1998.  In  addition,  as of May 15, 1998,
     One-Year Warrants (including the warrants issued to the finder) to purchase
     325,000 shares of Common Stock and Three-Year  Warrants to purchase  60,000
     shares of Common Stock also had been  exercised.  As a result,  the Company
     received aggregate  proceeds of $4,362,250  subsequent to the end of Fiscal
     1998. As of May 15, 1998,  2,576  Preferred  Shares had been converted into
     1,067,217 shares of Common Stock. See Note 6.

     The pro forma  balances as of February 28,  1998,  assuming the exercise of
     the above  warrants and  conversion  of the  Preferred  Shares,  would have
     reflected  cash and cash  equivalents  of  $8,562,481,  Preferred  Stock of
     $1,942,713 and total shareholders' equity of $7,796,902.

                                      F-17
<PAGE>

Item 8.  Changes in and Disagreements With Accountants
         on Accounting and Financial Disclosure
         --------------------------------------

         Coopers & Lybrand L.L.P.,  independent  accountants,  currently is, and
for more than the  Company's  last two  fiscal  years has  been,  the  Company's
independent  auditors.  Since the beginning of such two fiscal year period,  (i)
Coopers & Lybrand L.L.P. has not expressed reliance, in its audit report, on the
audit  services  of any  other  accounting  firm,  and (ii)  there  have been no
reported  disagreements  between the Company and Coopers & Lybrand L.L.P. on any
matter of accounting principles or practices,  financial statement disclosure or
auditing scope or procedure.

                                    PART III

Item 9.  Directors, Executive Officers, Promoters and Control Persons;
         Compliance with Section 16(a) of the Exchange Act.
         --------------------------------------------------

         The  information  required for this Item 9 is incorporated by reference
from the Company's  definitive  proxy  statement to be filed with the Securities
and Exchange Commission (the "Commission")  pursuant to Regulation 14A under the
Securities Exchange Act of 1934 ("Regulation 14A") within 120 days after the end
of the Company's fiscal year covered by this Annual Report on Form 10-KSB.

Item 10. Executive Compensation.
         -----------------------

         The information  required for this Item 10 is incorporated by reference
from the Company's  definitive  proxy  statement to be filed with the Commission
pursuant to Regulation 14A within 120 days after the end of the Company's fiscal
year covered by this Annual Report on Form 10-KSB.

Item 11. Security Ownership of Certain Beneficial Owners and Management.
         ---------------------------------------------------------------

         The information  required for this Item 11 is incorporated by reference
from the Company's  definitive  proxy  statement to be filed with the Commission
pursuant to Regulation 14A within 120 days after the end of the Company's fiscal
year covered by this Annual Report on Form 10-KSB.

Item 12. Certain Relationships and Related Transactions.
         -----------------------------------------------

         The information  required for this Item 12 is incorporated by reference
from the Company's  definitive  proxy  statement to be filed with the Commission
pursuant to Regulation 14A within 120 days after the end of the Company's fiscal
year covered by this Annual Report on Form 10-KSB.

Item 13. Exhibits and Reports on Form 8-K.
         ---------------------------------

(a) Exhibits.

 3.     Articles of incorporation and by-laws.

        3(i)     (a)     Restated  Certificate of  Incorporation of the Company,
                         as filed  with the  Secretary  of State of the State of
                         New York on February 24, 1994(1)

                 (b)     Certificate    of   Amendment   to    Certificate    of
                         Incorporation,  as filed with the Secretary of State of
                         the State of New York on August 9, 1996(5)

                 (c)     Certificate    of   Amendment   to    Certificate    of
                         Incorporation,  as filed with the Secretary of State of
                         the State of New York on August 12, 1997(7)

                                       24
<PAGE>

                 (d)     Certificate   of  Amendment  of  the   Certificate   of
                         Incorporation, as filed with the Department of State of
                         the State of New York on December 18, 1997(8)

        3(ii)    By-laws of the Company, as currently in effect(1)

 4.     Instruments   defining  the  rights  of  security   holders,   including
        indentures.

        4.1      Form of certificate representing shares of the Common Stock(2)

        4.2      Form  of  certificate  representing  shares  of  the  Series  A
                 Preferred Stock

        4.3      Warrant  Agreement,  dated August 20, 1994, between the Company
                 and  Josephthal  Lyon & Ross  Incorporated  and form of Warrant
                 Certificate(2)

        4.4      Placement  Agent  Warrant  Agreement,  dated  March  31,  1997,
                 between the Company and Josephthal Lyon & Ross Incorporated and
                 form of Warrant Certificate(6)

        4.5      Form of One-Year  Warrant,  dated December 19, 1997, of C-Phone
                 Corporation(8)

        4.6      Form of Three-Year Warrant, dated December 19, 1997, of C-Phone
                 Corporation(8)

 9.     Voting trust agreement and amendments - None.

 10.    Material contracts.

        10.1     (a)     Lease,  dated May 1,  1993,  between  the  Company  and
                         Daniel Flohr and Tina Jacobs(1)

                 (b)     Addendum,  dated as of May 1,  1996,  to  Indenture  of
                         Lease,  between the  Company and Daniel  Flohr and Tina
                         Jacobs(4)

        10.2     (a)     Employment  Agreement,  dated  as  of  March  1,  1994,
                         between the Company and Daniel Flohr, as amended(3)

                 (b)     Amendment  No. 2 to Employment  Agreement,  dated as of
                         March 1, 1996, between the Company and Daniel Flohr(4)

        10.3     (a)     Employment  Agreement,  dated  as  of  March  1,  1994,
                         between the Company and Tina Jacobs, as amended(3)

                 (b)     Amendment  No. 2 to Employment  Agreement,  dated as of
                         March 1, 1996, between the Company and Tina Jacobs(4)

        10.4     Employment  Agreement,  dated as of December 30, 1993,  between
                 the Company and Stuart Ross(1)

        10.5     C-Phone Corporation Amended and Restated 1994 Stock Option Plan
                 and form of Option Agreement(4)

        10.6     (a)     Placement  Agent  Agreement,   dated  March  31,  1997,
                         between  the  Company  and   Josephthal   Lyon  &  Ross
                         Incorporated(6)

                                       25
<PAGE>

                 (b)     Form of Securities Purchase Agreement,  dated March 31,
                         1997,  between the Company  and each  subscriber  party
                         thereto,  with terms of Contingent Value Rights granted
                         thereby attached thereto(6)

                 (c)     Form of Registration Rights Agreement,  dated March 31,
                         1997,  between the Company  and each  subscriber  party
                         thereto(6)

                 (d)     Stock Pledge Agreement,  dated March 31, 1997,  between
                         Daniel Flohr and Josephthal  Lyon & Ross  Incorporated,
                         as agent(6)

        10.7     (a)     Form of  Securities  Purchase  Agreement,  dated  as of
                         December 17, 1997, between C-Phone Corporation and each
                         purchaser party thereto(8)

                 (b)     Form of Registration  Rights Agreement,  dated December
                         19,  1997,   between   C-Phone   Corporation  and  each
                         purchaser party thereto(8)

 11.    Statement re computation of per share earnings - Not required since such
        computation  can be clearly  determined  from the material  contained in
        this report on Form 10-KSB.

 13.    Annual report to security holders for the last fiscal year, Form 10-Q or
        10-QSB or  quarterly  report to security  holders,  if  incorporated  by
        reference in the filing - Not applicable.

 16.    Letter on change in certifying accountant - Not applicable.

 18.    Letter on change in accounting principles - Not applicable.

 21.    Subsidiaries of the small business issuer - None.

 22.    Published report regarding matters submitted to vote of security holders
        - Not applicable.

 23.    Consent of experts and counsel

        23.1    Consent of Coopers & Lybrand L.L.P.

 24.    Power of attorney - Not applicable.

 27.    Financial Data Schedule

 28.    Information from reports furnished to state regulatory authorities - Not
        applicable.

 99.    Additional Exhibits -  Not applicable.
--------------------

 (1)    Incorporated  by reference to an Exhibit  filed as part of the Company's
        Registration  Statement on Form S-1 (the "S-1  Registration  Statement")
        (Registration No. 33-80280), filed on June 14, 1994.

 (2)    Incorporated by reference to an Exhibit filed as part of Amendment No. 2
        to the S-1 Registration Statement, filed on August 11, 1994.

 (3)    Incorporated by reference to an Exhibit filed as part of Amendment No. 1
        to the S-1 Registration Statement, filed on July 21, 1994.

                                       26
<PAGE>

 (4)    Incorporated  by reference to an Exhibit  filed as part of the Company's
        Annual  Report on Form  10-KSB for the fiscal  year ended  February  29,
        1996.

 (5)    Incorporated  by reference to an Exhibit  filed as part of the Company's
        Quarterly  Report on Form 10-QSB for the fiscal quarter ended August 30,
        1996.

 (6)    Incorporated  by reference to an Exhibit  filed as part of the Company's
        Current Report on Form 8-K, dated April 1, 1997.

 (7)    Incorporated  by reference to an Exhibit  filed as part of the Company's
        Quarterly  Report on Form 10-QSB for the fiscal quarter ended August 30,
        1997.

 (8)    Incorporated  by reference to an Exhibit  filed as part of the Company's
        Current Report on Form 8-K, dated December 31, 1997.

(b) Reports on Form 8-K. A Current  Report on Form 8-K  (responding  to Item 5 -
"Other  Events")  was filed by the  Company on  December  31, 1997 and a Current
Report  on Form 8-K  (responding  to Item 5 - "Other  Events")  was filed by the
Company on May 14, 1998.

                                       27
<PAGE>

                                   SIGNATURES

         In  accordance  with  Section  13 or 15(d)  of the  Exchange  Act,  the
registrant  caused  this  report to be signed on its behalf by the  undersigned,
thereunto duly authorized.

Dated: May 28, 1998

                         C-PHONE CORPORATION


                         By: /s/ Daniel P. Flohr
                             ---------------------------------------------------
                                 Daniel P. Flohr, President and
                                 Chief Executive Officer


         In accordance  with the Exchange Act, this report has been signed below
by the following  persons on behalf of the  registrant and in the capacities and
on the dates indicated:

Dated:
May 28, 1998                 /s/ Daniel P. Flohr
                             ---------------------------------------------------
                                 Daniel P. Flohr
                                 President, Chief Executive Officer and Director
                                 (Principal Executive Officer)

May 28, 1998                 /s/ Tina L. Jacobs
                             ---------------------------------------------------
                                 Tina L. Jacobs
                                 Director

May 28, 1998                 /s/ Seymour L. Gartenberg
                             ---------------------------------------------------
                                 Seymour L. Gartenberg
                                 Director

May 28, 1998                 /s/ E. Henry Mize
                             ---------------------------------------------------
                                 E. Henry Mize
                                 Director

May 28, 1998                 /s/ Donald S. McCoy
                             ---------------------------------------------------
                                 Donald S. McCoy
                                 Director

May 28, 1998                 /s/ Stuart E. Ross
                             ---------------------------------------------------
                                 Stuart E. Ross
                                 Director

May 28, 1998                 /s/ Paul H. Albritton
                             ---------------------------------------------------
                                 Paul H. Albritton
                                 Vice President and Chief Financial Officer
                                 (Principal Financial and Accounting Officer)

                                       28