<PAGE>   1
 
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
 
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                            ------------------------
 
                                   FORM 10-K
 
(MARK ONE)
[X]   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
      ACT OF 1934
 
      FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
 
                                       OR
 
[ ]   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
      EXCHANGE ACT OF 1934
 
                          COMMISSION FILE NO.: 0-21669
 
                            DIGITAL LIGHTWAVE, INC.
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
<TABLE>
<S>                                              <C>
                    DELAWARE                                        95-4313013
        (STATE OR OTHER JURISDICTION OF                           (IRS EMPLOYER
         INCORPORATION OR ORGANIZATION)                        IDENTIFICATION NO.)
</TABLE>
 
                             15550 LIGHTWAVE DRIVE
                           CLEARWATER, FLORIDA 33760
                                 (727) 442-6677
 (ADDRESS, INCLUDING ZIP CODE, OF PRINCIPAL EXECUTIVE OFFICES AND REGISTRANT'S
                     TELEPHONE NUMBER, INCLUDING AREA CODE)
 
        Securities registered pursuant to Section 12(b) of the Act: NONE
 
   Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK,
                          $0.0001 PAR VALUE PER SHARE
 
     Indicate by check mark whether Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter periods that Registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.  YES [X]  NO [ ]
 
     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Report or any amendment to this
Report.  [ ]
 
     The aggregate market value of Registrant's voting stock, held by
non-affiliates, computed by reference to the average of the closing bid and
asked prices of the Common Stock as reported by Nasdaq on March 26,
1999: $19,821,560.
 
     The number of shares of Registrant's Common Stock issued and outstanding as
of March 26, 1999: 26,558,766.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
                                     None.
 
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
<PAGE>   2
 
                                     PART I
 
     Certain statements contained in this report on Form 10-K including, without
limitation, statements containing the words "believes," "anticipates,"
"estimates," "expects" and words of similar import, constitute "forward-looking
statements." Such forward-looking statements involve known and unknown risks,
uncertainties and other factors that may cause the actual results, performance
or achievements of the Company, or industry results, to be materially different
from any future results, performance or achievements expressed or implied by
such forward-looking statements. Factors that could cause or contribute to such
differences include, but are not limited to, those discussed in Item 1 under the
heading "Factors That May Affect Operating Results." Given these risks and
uncertainties, readers are cautioned not to place undue reliance on such
forward-looking statements.
 
     A glossary of terms used in this Report appears at the end of this Item 1.
 
ITEM 1.  BUSINESS
 
GENERAL
 
     Digital Lightwave designs, develops, markets and supports diagnostic
products that monitor, maintain and manage fiber optic-based networks.
Telecommunications networks increasingly rely on optical fiber to provide
sufficient network bandwidth to transmit Internet, data, voice and multimedia
video traffic. The Company's products provide telecommunications service
providers and equipment manufacturers with capabilities to cost-effectively
deploy and manage fiber optic networks to address the rapidly increasing demand
for bandwidth. The Company's current customers include telecommunications
service providers, such as AT&T, MCI WorldCom, Qwest Communications and Sprint
Corporation, and telecommunications equipment manufacturers, such as Alcatel
Network Systems, Northern Telecom Limited and Tellabs.
 
     The Company's products are used to qualify and verify service during
network installation and to provide ongoing real-time quality assurance for
deployed networks. In contrast to other existing telecommunications test
equipment, the Company's products are based on modular and scaleable hardware
and software platforms with a flexible architecture that allows customers to
readily upgrade existing systems to accommodate new technologies.
 
     The Company's ASA 312 Network Information Computer provides engineers and
technicians with a truly portable, easy-to-use diagnostic product that offers
increased functionality for the installation and maintenance testing of
advanced, high speed networks and transmission equipment. In 1998, the Company
introduced its initial Network Access Agent, which incorporates the technology
developed for the Network Information Computer and is an unattended,
software-controlled performance monitoring and diagnostic product permanently
installed within optical-based networks for management from a central location.
 
     The Company was incorporated in California on October 12, 1990 under the
name Digital Lightwave, Inc., and reincorporated in Delaware on March 18, 1996
through its merger into a newly formed Delaware corporation. Unless the context
otherwise requires, as used in this Report the "Company" and "Digital Lightwave"
refer to Digital Lightwave, Inc., a Delaware corporation, and its predecessor
entity. The Company's principal executive offices are located at 15550 Lightwave
Drive, Clearwater, Florida, 33760, and the telephone number at that address is
(727) 442-6677.
 
INDUSTRY
 
     Over the past several years, the telecommunications industry has undergone
fundamental changes. The volume of traffic carried over telecommunications
networks has increased significantly, principally as the result of the rapidly
growing amount of data traffic as well as steady growth of voice traffic. Data
traffic has increased due to a proliferation of bandwidth intensive
applications, including the Internet, online commerce and other multi-media
applications. As of January 1999, there were an estimated 150 million Internet
users worldwide, up more than 200% from 1996, according to NUA Internet Surveys,
a market research company specializing in on-line Internet demographics and
trends. Global Internet bandwidth demand is projected to increase at a
 
                                        1
<PAGE>   3
 
compound annual growth rate of 109% from 1998 through 2003, according to KMI
Corporation, a market research company specializing in fiber optics.
 
     This rising demand, together with worldwide deregulation of the
telecommunications industry, has led to an increase in the number of service
providers entering the industry. The growing number of industry participants has
heightened competition in an environment characterized by downward price
pressure and near zero tolerance of communication network failures. These
competitive pressures are causing service providers to seek solutions to improve
operational efficiency and network performance, including the deployment of
easy-to-use test equipment with self-diagnosing features and the implementation
of centralized network management with remote monitoring capabilities.
 
     The telecommunications industry has addressed the demand for increased
network capacity by installing new optical fiber, transmission lines, increasing
transmission rates and employing new technologies such as Dense Wave Division
Multiplexing (DWDM), which increases the carrying capacity of existing fiber.
The continuing deployment of optical fiber and the implementation of new
technologies are significantly increasing the demand for optical networking
equipment, including diagnostic equipment. Optical diagnostic equipment enables
telecommunications service providers to more effectively and efficiently deploy,
maintain and manage telecommunications networks. The global high-speed fiber
optic transmission equipment market generated estimated revenues of $11.2
billion in 1997 and is expected to grow at a compound annual growth rate of 20%
to approximately $23.1 billion by the year 2001, according to KMI Corporation.
 
     Faster transmission speeds and new technologies magnify the complexity of
telecommunications networks while continuing demands for greater bandwidth
stress their capacity, requiring sophisticated diagnostic equipment to prevent
network interruptions or failures. In addition, new fiber optic networks must be
compatible with existing legacy networks, as well as with wireless networks used
in cellular technologies. Various standards, or "protocols," have been developed
for encoding and transmitting information across these networks, including the
T-Carrier protocol, SONET and ATM. Service providers must be able to efficiently
transport signals carrying multiple protocols. To effectively manage the
performance and reduce the possibility of network downtime, real-time,
simultaneous and independent monitoring of protocols is required at multiple
access points throughout networks.
 
     To meet the challenge of managing increasingly complex networks,
telecommunications service providers require increasingly sophisticated optical
diagnostic equipment. The lightwave diagnostic products historically available
have been primarily hardware-based and typically have worked with one
transmission speed or protocol at a time. Many of these products do not have the
technology required to permit users to simultaneously switch and multiplex
different signals to derive information concerning embedded signals. In
addition, many of these products, which are designed to be used by technicians
in the field, are large and heavy, and do not provide intuitive user interfaces.
 
THE DIGITAL LIGHTWAVE SOLUTION
 
     Digital Lightwave provides the optical networking industry with products
for monitoring, maintaining and managing fiber optic-based networks. The
Company's products enable telecommunications service providers and equipment
manufacturers with capabilities to cost-effectively deploy and manage fiber
optic networks to address the rapidly increasing demand for bandwidth.
Characterized by their ease of use, Digital Lightwave's products qualify and
verify service during optical network installation and provide ongoing quality
assurance after new equipment is deployed.
 
     The Company believes that its Network Information Computers and Network
Access Agents offer a broad range of features and capabilities that provide
distinct competitive advantages over the optical network diagnostic equipment
offered by its competitors. The Company's Network Information Computers were
designed to provide technicians with a more compact, easy-to-use, lightweight
product with increased functionality compared to other products currently
available. The Network Information Computer: (i) is an integrated product that
is capable of independently and simultaneously testing multiple protocols; (ii)
utilizes an intuitive windows-based graphical user interface with a touch sensor
display to create an easy-to-use diagnostic tool; and (iii) is a software-based
solution which can be easily upgraded and customized.
                                        2
<PAGE>   4
 
     Utilizing the technology of the Network Information Computer, the Company
has recently introduced optical diagnostic equipment that is permanently
installed within the network. In 1998, the Company introduced the Network Access
Agent product line, which is comprised of software-controlled performance
monitoring and diagnostic equipment, permanently installed at multiple access
points within optical networks to provide real-time analysis and network
management from a centralized location.
 
     The Company's products are based on advanced technologies, including
modular and scaleable hardware and software platforms and a flexible
architecture that allows customers to easily upgrade existing systems to
accommodate new technologies. The Company plans to utilize the core technology
of its Network Information Computer and its Network Access Agents to continue to
develop products that address the evolving needs of the optical networking
industry.
 
THE DIGITAL LIGHTWAVE STRATEGY
 
     Digital Lightwave has developed a growth strategy to increase its market
share and expand distribution across a wide range of customers, the key elements
of which are:
 
     Continue to Penetrate New and Existing Markets and Broaden Customer
Base.  The Company believes that its family of products offer superior
performance over competing products. The Company intends to continue to market
its Network Information Computers and Network Access Agents to new and
established telecommunications equipment manufacturers and service providers,
including the RBOCs, IXCs, CLECs and other recent entrants to the
telecommunications industry that require lightwave management products. The
Company intends to leverage its customer relationships and its reputation for
high quality products to attract new key accounts.
 
     Develop New Products and Enhancements by Leveraging Technology and Product
Design Expertise. Digital Lightwave believes that there is significant
opportunity for the development of a family of lightwave management products
that address the evolving and emerging markets within the telecommunications
industry. The Company plans to continue to build upon the core technologies and
architecture developed for its Network Information Computers and Network Access
Agents to offer advanced, easy-to-use products based on a flexible platform that
can be easily upgraded to include advanced features and functionality. In the
third quarter of 1998, the Company released its latest enhancement to the
Network Information Computer, adding OC-48 analysis capabilities, which enable
customers to monitor higher speed networks. Future products are expected to
include enhanced Network Access Agents and other lightwave management products.
 
     Establish Strategic Relationships.  The Company is seeking to supplement
its direct sales network by entering into strategic relationships for certain of
its lightwave management products. The Company believes such relationships will
enable it to more effectively develop and market additional lightwave management
products. The Company believes that strategic relationships will be critical to
its continued growth and to future development of new products and technologies.
 
     Develop and Market International Products.  The Company believes that
significant opportunities exist outside the United States for its lightwave
management products, and is currently developing versions of the Network
Information Computer for international markets.
 
PRODUCTS
 
     The Company's current family of products is organized into two product
lines: Network Information Computers and Network Access Agents.
 
     Network Information Computers.  The Company manufactures, sells and
supports portable Network Information Computers, which enable users to verify,
qualify and monitor the performance of telecommunications networks and
transmission equipment. The Network Information Computer was designed to replace
existing network test instruments by incorporating their functions into a
software-based information processing system, adding additional functions and
improving performance with competitive pricing. With the Network Information
Computer, telecommunications service providers and equipment manufacturers are
able to plan
                                        3
<PAGE>   5
 
for and implement fiber optic network expansion more cost-effectively and verify
and manage information concerning the transmission of voice, data, image and
video traffic. Telecommunications equipment manufacturers also use the Network
Information Computer in designing, engineering and manufacturing their products,
installing their products in the networks of their customers and providing
ongoing customer support.
 
     The Network Information Computer generates, transmits, receives,
multiplexes and processes legacy and lightwave signals and provides network
analysis. The Network Information Computer's easy-to-use graphical user
interface is a touch sensor over a large color display which provides simple and
intuitive windowed graphics and menus. The Network Information Computer may be
accessed and operated remotely by modem or through direct connection to an
Ethernet Local Area Network ("LAN").
 
     The Network Information Computer competes against the optical network
diagnostic instruments currently available, which are primarily hardware-based,
work with one transmission speed or protocol at a time, do not provide an
easy-to-use graphical user interface which permits users to simultaneously
switch and multiplex different signals to derive information concerning embedded
signals, cannot store a significant amount of data and which the Company
believes are generally more difficult to use than the Network Information
Computer.
 
     The following core technologies are used in the Network Information
Computer and provide a basis for certain of the Company's products in
development: (1) a software operating environment which runs over a windows or a
MS-DOS platform; (2) programs which operate the Company's firmware and hardware;
(3) graphical user interface programs, written in object-oriented code, running
in a windowed environment; (4) "Network Protocol Translators," which logically
process discrete network information from signals at specific bandwidths and
specific protocols; and (5) "Network Protocol Processors," which process
information encoded in a specific protocol over a range of bandwidth.
 
     To allow its customers to work simultaneously with different bandwidths and
protocols, the Company has developed a non-blocking switch matrix and
applications software that allow the Company's customers to "frame up" on a
given signal, multiplex the signal into different transmission speeds and map
the signal into different protocols. These functions allow customers to derive
information concerning the performance of the network under various existing or
potential conditions.
 
     Network Access Agents.  Network Access Agents are unattended, software
controlled performance monitoring and diagnostic equipment installed within
optical networks for analysis and management of a telecommunications network
from a centralized location. The Company recently commenced sales of its Network
Access Agents which is a modular hardware/software platform designed to provide
network operators with real-time information concerning performance of the
network segments where a Network Access Agent has been installed. Installation
of Network Access Agents at multiple access points throughout networks provides
the capability for end-to-end monitoring, maintenance and management of fiber
optic networks. Network Access Agents provide performance and quality data to
the network operator through a standard operations interface to allow
centralized monitoring and administration. Network Access Agents incorporate
technology developed by the Company for the Network Information Computer, which
includes advanced hardware and software technology that accesses bits in
lightwave and legacy telecommunications transmissions, a non-blocking switch
matrix that maps signals into different transmission speeds and protocols, and
object-oriented software that controls selectable features accessible through
Windows operating system or other user environments.
 
     Future Products and Enhancements.  The Company plans to leverage the core
technologies of its Network Information Computer and Network Access Agents to
continue to develop a family of advanced products and enhancements that address
the evolving needs of the optical networking industry.
 
                                        4
<PAGE>   6
 
CUSTOMERS
 
     Through December 31, 1998, the Company has sold over 1,100 units of the
Network Information Computer to over 80 customers. Set forth below is a
representative list of purchasers of the Company's products:
 
<TABLE>
<S>                                             <C>
INTEREXCHANGE CARRIERS                          EQUIPMENT MANUFACTURERS
--------------------------------------------    --------------------------------------------
AT&T Corp.                                      ADC Telecommunications
IXC Communications, Inc.                        Alcatel Network Systems, Inc.
Level 3 Communications, Inc.                    Ascend Communications Inc.
MCI WorldCom, Inc.                              Cisco Systems, Inc.
Qwest Communications                            FORE Systems
Sprint Corporation                              Fujitsu
                                                Hitachi Telecom Technologies Co., Ltd. (USA)
                                                Lucent Technologies, Inc.
                                                NEC America, Inc.
                                                Northern Telecom Limited Systems
                                                QUALCOMM
                                                Tellabs Operations, Inc.
                                                CIENA
REGIONAL BELL OPERATING COMPANIES               COMPETITIVE LOCAL EXCHANGE CARRIERS
--------------------------------------------    --------------------------------------------
Ameritech Corporation                           GST Corporation
Bell Atlantic Communications, Inc.              ICG Communications
Pacific Telesis Group                           MFS WorldCom
SBC Communications Inc.                         Electric Lightwave
US West Communications, Inc.                    WorldxChange Communications
                                                AT&T Local Service (TCG)
                                                Hyperion Communications
INDEPENDENT TELEPHONE COMPANIES                 WIRELESS SERVICE PROVIDERS
--------------------------------------------    --------------------------------------------
Frontier Communications                         GTE Mobilnet
GTE Corp.                                       Pacific Bell Mobile Services
Sprint Centel                                   AT&T Wireless
EQUIPMENT LEASING COMPANIES                     PRIVATE NETWORK OPERATORS
--------------------------------------------    --------------------------------------------
AT&T Capital Corporation                        Bear Stearns & Co., Inc.
GE Capital                                      IBM Global Services
McGrath Rentelco                                Time Warner
Telogy                                          U.S. Department of Defense
</TABLE>
 
     The Company involves key customers in the evaluation of products in
development and continually solicits suggestions from customers regarding
additional desirable features of products that it has introduced or plans to
develop. Because the Company's products are software-based, the Company has
generally been able to satisfy requests for additional feature sets by providing
software upgrades for loading into its products in the field.
 
     For the year ended December 31, 1998, the Company's four largest customers
accounted for approximately 57% of total revenues, with Qwest, MCI Worldcom,
Tellabs, and GTE accounting for approximately 17%, 16%, 13% and 11% of total
sales, respectively. For the year ended December 31, 1997, sales to the
Company's five largest customers comprised 69% of its total revenues, with
WorldCom, Inc. (prior to its acquisition of MCI Communications Corporation) and
its subsidiaries accounting for 42% of total sales. For the year ended December
31, 1996, the Company's five largest customers accounted for approximately 62%
of total revenues, with MCI Communications Corporation (prior to its acquisition
by WorldCom, Inc.), Ameritech Corporation and Pacific Telesis Group accounting
for 23%, 19% and 15% of total sales, respectively. No other customers accounted
for sales of 10% or more during such periods. There can be no
 
                                        5
<PAGE>   7
 
assurance regarding the amount or timing of purchases by any customer in any
future period. See "Factors That May Affect Operating Results -- We are
dependent on a limited number of major customers."
 
SALES, MARKETING AND CUSTOMER SUPPORT
 
     Sales.  The Company sells its products to telecommunications service
providers and network equipment manufacturers through a sales organization of 29
employees, including managers, sales engineers and sales administrative staff
based at the Company's principal executive offices. The primary functions of the
Company's direct sales force are (i) to ensure that existing and potential
customers in each territory are being regularly contacted, (ii) to differentiate
the features and capabilities of the Company's products from competitive
offerings, (iii) to assist customers with the implementation of the Company's
products and (iv) to serve as a direct link to assure quality and timely
customer support. In addition, the Company believes that its direct sales staff
helps the Company to monitor changing customer requirements, as well as the
development of industry standards.
 
     Marketing.  In marketing the Network Information Computer, the Company
focuses on the divisions of telecommunications service providers that are
responsible for planning and installing extensions of the network, as well as
the quality assurance divisions of telecommunications equipment manufacturers.
In marketing the Network Access Agents, the Company has directed its preliminary
efforts towards the strategic planning divisions of telecommunications service
providers and private network operators in order to define customer
requirements. The Company seeks to build awareness of its products through a
variety of marketing channels and methodologies, including industry trade shows
and conferences and direct mailings to targeted potential customers.
 
     Customer Support.  The Company offers technical support to its customers 24
hours a day, seven days a week, via a toll-free hotline to reach on-site or
on-call personnel. The Company's customer support organization is comprised of
19 employees. All service, repair and technical support are performed at the
Company's facilities. The Company's technical support engineers are trained in
the hardware and software incorporated in its products, as well as the networks
and transmission equipment operated by its customers. The Company offers a
three-year limited warranty on all components of its products, other than the
laser transmitter unit, which has a one-year limited warranty, and software and
firmware, which have a 90-day limited warranty.
 
PRODUCTION
 
     The Company's production operations consist primarily of material planning
and procurement, final assembly, software loading, testing and quality
assurance. The Company's operational strategy relies on outsourcing of
manufacturing to reduce fixed costs and to provide flexibility in meeting market
demand. The Company subcontracts the manufacture of computer system boards,
plastic molds and metal chassis, and certain subassemblies and components for
the Network Information Computer and the Network Access Agent. The Company
performs final assembly and programs the products with the Company's software.
The Company has implemented strict quality control procedures throughout each
stage of the manufacturing process, and tests the boards and subassemblies at
various stages in the process, including final test and qualification of the
product. The Company is ISO 9001 certified. To further enhance quality and
efficiency, the Company is in the process of centralizing all of its production
in one location by transferring all operations to its new Clearwater
headquarters facility.
 
     Although the Company generally uses standard parts and components for its
products, several key components used in the manufacture of its products are
currently purchased only from a sole-source or limited sources, the loss of
which could seriously disrupt the Company's operations. The Company purchases
certain laser and laser amplifier components, power supplies, touch-screen
sensors, single-board computers and SONET overhead terminators used in the
Network Information Computer and the Network Access Agent from a single or a
limited number of contractors. In addition, for the Network Access Agent, the
Company purchases a controller board and an interface board from a single or
limited number of contractors. The Company does not have long-term agreements
with any of these sole or limited sources of supply. Any
 
                                        6
<PAGE>   8
 
interruption in the supply of any of these components, or the inability of the
Company to procure these components from alternate sources at acceptable prices
and within a reasonable time, could have a material adverse effect upon the
Company's business, financial condition and results of operations. The Company
is currently attempting to qualify certain additional suppliers for certain of
the sole-sourced components. However, qualifying additional suppliers is time
consuming and expensive and the likelihood of errors could be greater with new
suppliers.
 
     In connection with its outsourcing strategy, the Company is seeking to
identify and secure additional sources of supply, including additional contract
subassembly and component manufacturers. The Company has experienced in the
past, and may in the future experience, problems with its contract
manufacturers, in areas such as quality, quantity and on-time delivery. In
addition, the Company may in the future experience pricing pressure from its
contract manufacturers.
 
     The Company forecasts product demand on a quarterly basis, based on
anticipated product sales and orders materials and components based on these
forecasts. Lead times for materials and components ordered by the Company vary
significantly, and depend on factors such as the specific supplier, purchase
terms and demand for a component at a given time. If actual orders vary
significantly from the forecasts, the Company may have excess or inadequate
inventory of certain materials and components.
 
ENGINEERING AND DEVELOPMENT
 
     The Company has organized its engineering and development efforts into
product or project teams, currently ranging in size from three to eleven
engineers. The teams are organized around the development of a particular
product, and are responsible for all aspects of the development of that product
and any enhanced features or upgrades. The Company's research and development
teams are located at the Company's corporate headquarters in Clearwater, Florida
and a facility in Wall Township, New Jersey.
 
     As of March 26, 1999, the Company maintained an engineering and development
department of 45 individuals, 39 of whom are full time Company employees and the
remainder of whom are contractors. During fiscal years 1998, 1997 and 1996, the
amounts spent on Company sponsored engineering and development activities were
approximately $14.3 million, $5.3 million and $2.4 million, respectively.
 
INTELLECTUAL PROPERTY
 
     Digital Lightwave relies on a combination of patent, trade secret,
copyright and trademark protection and non-disclosure agreements to protect its
core technology. Although the Company has pursued and intends to continue to
pursue patent protection of certain aspects of its technology that it considers
important, the Company believes that its success will be largely dependent on
its reputation for technology, product innovation, affordability, marketing
ability and response to customers' needs. The Company has been issued two
patents from the United States Patent and Trademark Office relating to the
Network Information Computer and Network Access Agent. The Company intends to
apply for additional patents for its technology. There can be no assurance,
however, that any such future or pending applications will be granted.
 
     The Company believes that the rapid rate of technological change and the
relatively long development cycle for integrated electronic assemblies are also
significant factors in the protection of the Company's intellectual property. As
part of its confidentiality procedures, the Company generally enters into non-
disclosure agreements and proprietary information and inventions agreements with
its employees and suppliers, and limits access to and distribution of its
proprietary information. Despite these precautions, it may be possible for a
third party to copy or otherwise obtain and use the Company's technology without
authorization. Accordingly, there can be no assurance that the Company will be
successful in protecting its intellectual property or that the Company's rights
will preclude competitors from developing products or technology equivalent or
superior to those of the Company. See "Factors That May Affect Operating
Results -- We are dependent on proprietary technology and subject to risks of
infringement."
 
                                        7
<PAGE>   9
 
BACKLOG
 
     The Company's backlog at December 31, 1998 was approximately $1.0 million.
Variations in the size and delivery schedules of purchase orders received by the
Company, as well as changes in customers' delivery requirements, may result in
substantial fluctuations in backlog from period to period. Accordingly, the
Company believes that its backlog cannot be considered a meaningful indicator of
future financial results.
 
SEASONALITY
 
     The Company generally believes that its sales are seasonal in nature with
the largest portion of quarterly sales tied to telecommunications industry
purchasing patterns which usually decrease during the first calendar quarter of
the year.
 
COMPETITION
 
     The market for the Company's products is intensely competitive and is
subject to rapid technological change, frequent product introductions with
improved performance, competitive pricing ratios and shifting industry
standards. The Company believes that the principal competitive factors in its
markets are product capabilities and design, price, customer service and
support, ease of operation and reliability, length of operating history,
industry experience and name recognition, and extent and maturity of sales and
distribution relationships.
 
     The Company believes that there are six principal competitors which
currently offer products that compete with the Network Information Computer,
including Hewlett-Packard Company, Technology Techniques Corporation (TTC) (a
subsidiary of Dynatech Corporation), Anritsu Corporation, Tektronix, Inc.,
Wavetek Wandel Goltermann, Inc. and ANDO Corporation. However, the companies
that offer test instruments in competition with the Network Information Computer
do not provide an integrated comprehensive solution to performance monitoring
transmission speeds from DS-0 through OC-48 in a single, upgradeable, portable
unit. Although there are several companies that offer network monitoring and
test instruments, including Hekimian Laboratories, Inc., TTC, Applied Digital
Access, Inc. and Sage Instruments, none of these companies offer lightwave
network monitoring products in competition with the Company's Network Access
Agents. Accordingly, the Company believes that there are currently no
competitors that provide optical network monitoring capability which cover the
full range of features offered by the Network Access Agent. The Company is aware
of certain companies that are also developing equipment to monitor lightwave
transmissions. Many of the Company's competitors and certain prospective
competitors have significantly longer operating histories, larger installed
bases, greater name recognition and significantly greater technical, financial,
manufacturing and marketing resources than the Company. In addition, a number of
these competitors have long established relationships with the Company's
customers and potential customers. The Company believes it is likely that
competitors will enter the market for most, if not all, of the products which
the Company will offer. See "Factors That May Affect Operating Results -- Our
industry is extremely competitive and such competition may negatively affect our
business."
 
REGULATORY MATTERS
 
     The Company's products must meet industry standards and, in the United
States, the Company's products must comply with various regulations promulgated
by the Federal Communications Commission ("FCC") and Underwriters Laboratories.
Internationally, the Company's future products must comply with standards
established by telecommunications authorities in various countries as well as
with recommendations of the Consultative Committee on International Telegraph
and Telephony. In addition, certain planned products of the Company may be
required to be certified by Bell Communications Research, Inc. ("Bellcore") in
order to be commercially viable. Any inability to obtain on a timely basis or
retain domestic or foreign regulatory approvals or certifications that may be
required in the future or to comply with existing or evolving industry standards
could have a material adverse effect on the Company's business, financial
condition and results of operations.
 
                                        8
<PAGE>   10
 
EMPLOYEES
 
     As of March 26, 1999, the Company employed a full-time staff of 161
employees, of which 75 were engineering and production personnel, and the
remainder were sales and marketing staff and administrative personnel. The
Company believes that its relationship with its employees is good.
 
                   FACTORS THAT MAY AFFECT OPERATING RESULTS
 
     We are uncertain about the future of our business and, in preparing this
Annual Report, have made a number of assumptions and projections. We generally
use words like "expect," "believe" and "intend" to indicate these assumptions
and projections. Our assumptions and projections could be wrong for many
reasons, including the reasons discussed below.
 
WE HAVE A LIMITED OPERATING HISTORY AND CUMULATIVE LOSSES AND WE EXPECT TO INCUR
ADDITIONAL LOSSES
 
     We have a limited operating history. We shipped our first product, the ASA
312 Network Information Computer, in February 1996, and have shipped only
limited quantities of our second product, the Network Access Agent. To date, we
have incurred substantial costs, including costs to:
 
     - Develop and enhance our technology and products;
 
     - Establish our engineering, production and quality assurance operations;
 
     - Recruit and train a sales and marketing group; and
 
     - Build an administrative organization.
 
As a result of these costs, we have incurred operating losses in each fiscal
year through December 31, 1998. Our operating losses, combined with $11.5
million in expenses and settlement amounts recorded in connection with the
settlement of certain lawsuits and a $1.0 million reorganization charge, were
$30.5 million for the year ended December 31, 1998. We anticipate that our costs
will continue to increase in the foreseeable future as we create and introduce
new products and develop new distribution channels. We expect that any related
increases in revenues will lag behind these cost increases foreseeable future.
If we cannot achieve and sustain operating profitability or positive cash flow
from operations, we may not be able to meet our working capital requirements.
This would have a material adverse effect on our business, financial condition
and results of operations.
 
     An investor in our Common Stock must consider the risks, challenges and
difficulties frequently encountered by early stage companies, particularly
companies in intensely competitive and rapidly evolving markets such as the
telecommunications and fiber optic equipment markets. To address these risks, we
must, among other things:
 
     - Respond to competitive and technological developments;
 
     - Continue to attract, retain and motivate qualified personnel;
 
     - Establish, maintain and enhance the Digital Lightwave brand; and
 
     - Increase the scope of our product offerings.
 
     We may be unsuccessful in addressing these risks, which could have a
material adverse affect on our business, financial condition and results of
operations.
 
WE EXPERIENCE FLUCTUATIONS IN OUR OPERATING RESULTS AND OUR SALES ARE SEASONAL
 
     Our quarterly operating results have fluctuated in the past and our future
quarterly operating results are likely to vary significantly due to a variety of
factors, many of which are outside our control. Factors that could affect our
quarterly operating results include:
 
     - The product mix, volume, timing and number of orders we receive from our
       customers;
 
     - The long sales cycle for obtaining new orders;
                                        9
<PAGE>   11
 
     - Our ability to obtain sufficient supplies of sole or limited source
       components for our products;
 
     - Our ability to attain and maintain production volumes and quality levels
       for our products;
 
     - The timing of introduction and market acceptance of new products by us,
       our competitors or our suppliers;
 
     - Our success in developing, introducing and shipping product enhancements
       and new products;
 
     - Pricing actions by us or our competitors;
 
     - Changes in costs of materials;
 
     - Our ability to enter into long term agreements or blanket purchase orders
       with customers; and
 
     - General economic conditions.
 
Because of these factors, our operating results for any particular quarter may
not be indicative of future operating results. These factors have historically
been, and are likely to continue to be, difficult to forecast. Any unfavorable
changes in these or other factors could negatively affect our business,
financial condition and operating results.
 
     Our revenues and operating results generally depend on the volume and
timing of the orders we receive from customers, as well as our ability to
fulfill the orders received. Most of our expenses, particularly employee
compensation and rent, are relatively fixed and cannot be reduced in response to
decreases in revenues. As a result, variations in the timing of revenues could
cause significant variations in results of operations from quarter to quarter
and could result in continuing quarterly losses. The deferral of any large order
from one quarter to another would negatively affect our results of operations
for the earlier quarter. To achieve our revenue objectives, we must obtain
orders during each quarter for shipment in that quarter. If we fail to do this,
we may be unable to achieve or sustain profitability on a quarterly or annual
basis. Quarterly fluctuations in operating results may result in volatility in
the market prices of our Common Stock.
 
     We have experienced and expect to continue to experience seasonality in our
business. Historically, our sales have been affected by a seasonal decrease in
demand in the first quarter of each calendar year budgetary constraints. We
expect this trend to continue, which may contribute to quarterly or annual
fluctuations in our operating results, and could have a material adverse effect
on our business, financial condition and results of operations.
 
WE ARE DEPENDENT ON A LIMITED NUMBER OF PRODUCTS AND ARE UNCERTAIN OF THE MARKET
FOR OUR PRODUCTS AND OUR PLANNED PRODUCTS
 
     We derive the vast majority of our sales from our initial product, the
Network Information Computer, and we expect that sales of Network Information
Computers will continue to account for a substantial portion of our sales for
the foreseeable future. In 1998, we started shipping commercial versions of our
Network Access Agent, which utilizes the same core technology as the Network
Information Computer. Because the market for our products is evolving and
subject to rapid technological change, we are uncertain about the size and scope
of the market for our current and future products. Our future performance will
depend on increased sales of the Network Information Computer, market acceptance
of the Network Access Agent and the successful development, introduction and
market acceptance of other new and enhanced products. If we are delayed in
introducing or producing new products or fail to detect software or hardware
errors in new products (which frequently occur when new products are first
introduced), market acceptance of our products and our credibility with our
customers might be diminished. This could have a material adverse affect on our
business, financial condition and results of operations.
 
                                       10
<PAGE>   12
 
OUR INDUSTRY IS SUBJECT TO RAPID TECHNOLOGICAL CHANGE AND WE ARE DEPENDENT ON
NEW PRODUCT INTRODUCTIONS
 
     To remain competitive, we must develop, manufacture and sell new products
and improve our existing products. Our market is characterized by:
 
     - Rapid technological change;
 
     - Changes in customer requirements and preferences;
 
     - Frequent new product introductions; and
 
     - The emergence of new industry standards and practices.
 
These factors could cause our sales to decrease or render our current products
obsolete. Our success will depend, in part, upon our ability to:
 
     - Create improvements on and enhancements to our existing products;
 
     - Develop, manufacture and sell new products to address the increasingly
       sophisticated and varied needs of our current and prospective customers;
 
     - Respond to technological advances and emerging industry standards and
       practices on a cost effective and timely basis; and
 
     - Increase market acceptance of our products.
 
We cannot assure you that we will be able to meet these objectives. If we fail
to adapt to changing market conditions or customer requirements, our business,
financial condition and operating results would be materially adversely
affected.
 
OUR INDUSTRY IS EXTREMELY COMPETITIVE AND SUCH COMPETITION MAY NEGATIVELY AFFECT
OUR BUSINESS
 
     The market for our products is intensely competitive and is subject to
rapid technological change, frequent product introductions with improved
performance, competitive pricing and shifting industry standards. We believe
that the principal factors on which we compete include:
 
     - Product capabilities and design;
 
     - Price;
 
     - Customer service and support;
 
     - Ease of operation and reliability of products;
 
     - Length of operating history, industry experience and name recognition;
       and
 
     - Extent and maturity of sales and distribution relationships.
 
Our principal competitors are Hewlett-Packard Company, Technology Techniques
Corporation (TTC) (a subsidiary of Dynatech Corporation), Tektronix, Inc.,
Anritsu Corporation, Wavetek Wandel Goltermann, Inc., ANDO Corporation and other
companies which offer network monitoring products. We are a relative newcomer to
the telecom equipment market, and many of these competitors have significantly
longer operating histories, greater name recognition, and greater technical,
financial, manufacturing and marketing resources than we have. A number of our
competitors have long-established relationships with our current and potential
customers. Furthermore, many of our large competitors may offer customers a
broader product line than we currently offer or anticipate offering in the near
future. These companies may have a competitive advantage over us in sales of
similar products or alternative lightwave management solutions. We expect that
competition will increase in the future and that new competitors will enter the
market for most if not all of the products we will offer. Increased competition
could reduce our profit margins and cause us to lose, or prevent us from
gaining, market share. Any of these events could have a material adverse effect
on our business, financial condition and results of operation.
 
                                       11
<PAGE>   13
 
WE ARE DEPENDENT ON A LIMITED NUMBER OF MAJOR CUSTOMERS
 
     For the year ended December 31, 1998, the Company's four largest customers
accounted for approximately 57% of total revenues, with Qwest, MCI WorldCom,
Tellabs, and GTE accounting for approximately 17%, 16%, 13% and 11% of total
sales, respectively. For the year ended December 31, 1997, sales to the
Company's five largest customers comprised 69% of its total revenues, with
WorldCom, Inc. (prior to its acquisition of MCI Communications Corporation) and
its subsidiaries accounting for 42% of total sales. For the year ended December
31, 1996, the Company's five largest customers accounted for approximately 62%
of total revenues, with MCI Communications Corporation (prior to its acquisition
by WorldCom, Inc.), Ameritech Corporation and Pacific Telesis Group accounting
for 23%, 19% and 15% of total sales, respectively. No other customers accounted
for sales of 10% or more during such periods. There can be no assurance
regarding the amount or timing of purchases by any customer in any future
period.
 
     Our success is dependent upon our ability to broaden our customer base to
increase the level of sales. None of our customers has a written agreement with
us that obligates it to purchase additional products, and we cannot assure you
that our customers will purchase additional products. We also cannot assure you
that we will be able to retain our largest customers or to attract additional
major customers. If we lose one or more of our major customers or if we fail to
broaden our customer base, it could have a material adverse affect on our
business, financial condition and results of operations.
 
WE ARE DEPENDENT ON CONTRACT MANUFACTURERS AND SOLE AND LIMITED SOURCE
SUPPLIERS; WE INTEND TO RELOCATE AND INCREASE OUR PRODUCTION AND ASSEMBLY
OPERATIONS
 
     Our operational strategy is to outsource component manufacturing. We
subcontract the manufacture of computer system boards, plastic molds and metal
chassis, and certain subassemblies and components. We do not maintain large
inventories of components for building our products. From time to time, our
suppliers have failed to meet component delivery schedules, have failed to
provide us with sufficient quantities of components and have failed to meet our
component quality standards. We expect that these or other difficulties may
occur in the future. These difficulties may be magnified as we introduce new
products and product enhancements in 1999. If demand for our products increases,
we will need to coordinate our efforts with our contract manufacturers in order
to achieve sufficient production levels. We do not know whether we will be able
to manage our contract manufacturers effectively or whether the manufacturers
will be able to supply us with the quantity and quality of products on the
delivery schedule that we require. Although we are attempting to identify
additional potential component manufacturers, we cannot assure you that we will
be able to obtain sufficient quantities of quality components. If our contract
manufacturers are unable to provide us with adequate supplies of high-quality
products or if we lose any of our contract manufacturers without qualifying
others, our ability to meet orders may be diminished. Such delays could have a
material adverse effect on our business, financial condition and results of
operations.
 
     Several key components used in the manufacture of the Company's products
are currently purchased from a sole-source or limited sources, the loss of which
could seriously disrupt the Company's operations. The Company purchases certain
laser and laser amplifier components, power supplies, touch-screen sensors,
single-board computers and SONET overhead terminators used in the Network
Information Computer and the Network Access Agent from a single or a limited
number of contractors. In addition, for the Network Access Agent, the Company
purchases a controller board and an interface board from a single or limited
number of contractors. The Company does not have long-term agreements with any
of these sole or limited sources of supply. Any interruption in the supply of
any of these components, or the inability of the Company to procure these
components from alternate sources at acceptable prices and within a reasonable
time, could have a material adverse effect upon the Company's business,
financial condition and results of operations. The Company is currently
attempting to qualify certain additional suppliers for certain of the
sole-sourced components. However, qualifying additional suppliers is time
consuming and expensive and the likelihood of errors could be greater with new
suppliers.
 
     In 1998, we began consolidating our production and assembly operations from
our current facility in St. Petersburg, Florida, to our corporate headquarters
in Clearwater, Florida. We anticipate that we will complete
 
                                       12
<PAGE>   14
 
this move by September 1999. The new facility will be configured to assemble all
of our product lines. We may encounter difficulty in consolidating our
production and assembly operations, and we may experience business interruptions
as we relocate our personnel and equipment. Interruptions and transition
difficulties could impair our ability to meet customer orders and lead customers
to cancel orders, which would have a material adverse affect on our business,
financial condition and results of operations.
 
FAILURE TO MANAGE OUR GROWTH MAY AFFECT OUR RESULTS
 
     Successful implementation of our business plan in the rapidly evolving
fiber optic equipment market will require effective planning and management. We
are continuing to expand our product lines and introduce new products and
features and intend to extend our operations internationally. We have expanded
our operations over the past year and our success depends upon continued
expansion. Our growth has placed, and we expect future growth to continue to
place, a significant strain on our management, operational and financial
resources. To manage our growth, we will need to continue to:
 
     - Improve our financial and managerial controls, reporting systems and
       procedures;
 
     - Increase, train and manage our work force;
 
     - Develop our sales and marketing network; and
 
     - Expand our manufacturing, production and assembly capacity.
 
Currently we are pursuing strategic relationships as part of our growth
strategy, and we cannot forecast the impact that any strategic relationships
will have upon our growth. If we experience difficulty in managing our growth,
our business, financial condition and operating results could be materially
adversely affected.
 
FAILURE TO ENTER INTO STRATEGIC RELATIONSHIPS MAY ADVERSELY AFFECT OUR RESULTS
 
     An important component of our business strategy is to enter into strategic
relationships in order to expand our product lines and offer our products and
services to a larger customer base. For example, we are seeking strategic
relationships to market our products on a direct or OEM basis. We have not
negotiated any such arrangements to date. If we do enter into such arrangements,
we anticipate that our pricing to strategic partners would be less than our
pricing to direct sales, resulting in lower gross margins in connection with
these arrangements. We may not be able to successfully enter into such
arrangements or, if we do, we may become overly dependent on our strategic
partners. Either development could have a material adverse effect on our
business, operating results and financial condition.
 
WE ARE DEPENDENT ON KEY PERSONNEL
 
     Our success depends to a significant degree upon the continued
contributions of key management, engineering, sales and marketing, finance and
product assembly personnel, some of whom would be difficult to replace. In
particular, we believe that our future success is highly dependent on Dr. Bryan
J. Zwan, our Chairman. We do not intend to maintain key man life insurance
covering our key personnel. Until 1996, we were in the development stage. Most
of our executive officers joined us during 1997 and 1998 and, therefore, have
been involved only with our most recent operating activities. For example, Mr.
Gerry Chastelet, our new President and CEO joined us on December 31, 1998. Our
success will depend on the performance of our officers, our ability to retain
our executive officers, our ability to integrate new officers into our
operations and the ability of all personnel to work together effectively as a
team.
 
WE ARE DEPENDENT ON PROPRIETARY TECHNOLOGY AND SUBJECT TO RISKS OF INFRINGEMENT
 
     Our success and our ability to compete depends in part upon our proprietary
technology, which we protect through a combination of patent, copyright, trade
secret and trademark law. As of March 17, 1999, in the United States, we have
two issued patents relating to the Network Information Computer and Network
Access Agent. We have filed continuation applications for each of these issued
patents. We may apply for additional patents for our Network Access Agent
technology. We cannot assure you that the patents for which
 
                                       13
<PAGE>   15
 
we have applied or intend to apply will be issued, or that the steps that we
take to protect our technology will be adequate to prevent misappropriation. Our
competitors may independently develop technologies that are substantially
equivalent or superior to our technology. In addition, our growth strategy
includes a plan to enter international markets, and the laws of some foreign
countries may not protect our proprietary rights to the same extent as do the
laws of the United States. If our protective measures are not successful, our
business, financial condition and operating results could be materially and
adversely affected.
 
     From time to time we may either license our proprietary rights to
third-parties or in-license certain technologies from third-parties for use in
our products. The telecommunications industry is characterized by the existence
of a large number of patents and frequent litigation based on allegations of
patent infringement. We have no reason to believe that our technology infringes
on the proprietary rights of others and we have not received any notice of
claimed infringements. Nonetheless, third parties may assert infringement claims
against us in the future that may or may not be successful. If we must defend
ourselves or our customers against such claims, we could incur substantial costs
regardless of the merits of the claims. Parties making such claims may be able
to obtain injunctive or other equitable relief which could effectively block our
ability to sell our products, and could obtain an award of substantial damages.
Any such claim could seriously damage our business. In the event of a successful
claim of infringement against us, we may be required to obtain one or more
licenses from third parties, including our customers. We cannot assure you that
any such licenses would be available on terms acceptable to us, if at all.
 
CERTAIN OF OUR PRODUCTS MUST MEET REGULATORY REQUIREMENTS BEFORE WE CAN SELL
THEM
 
     In the United States, our products must meet industry standards and comply
with various regulations promulgated by the FCC, Underwriters Laboratories, and
Bellcore. Any product we may in the future sell internationally, must comply
with standards established by telecommunications authorities in various foreign
countries, as well as with recommendations of the Consultative Committee on
International Telegraph and Telephony. If we fail to meet industry standards or
regulatory requirements, or if in the future we have difficulty obtaining
regulatory approvals or certifications, our business, financial condition and
results of operations could be materially adversely affected.
 
OUR PRINCIPAL STOCKHOLDER HAS SUBSTANTIAL INFLUENCE OVER OUR COMPANY
 
     As of March 26, 1999, Dr. Bryan J. Zwan, the Chairman of Digital Lightwave,
together with entities affiliated with him, beneficially own approximately 75%
of outstanding shares of Common Stock. Accordingly, Dr. Zwan is able to elect
our directors, has the voting power to approve all matters requiring stockholder
approval and has significant influence over our affairs, including the power to
cause, delay or prevent a change in control of Digital Lightwave.
 
SOME ANTI-TAKEOVER PROVISIONS MAY AFFECT THE PRICE OF OUR COMMON STOCK
 
     Our Board of Directors has the authority to issue up to 20,000,000 shares
of preferred stock and to determine the preferences, rights and privileges of
those shares without any further vote or action by our stockholders. The rights
of the holders and the market value of our Common Stock may be adversely
affected by the rights of the holders of any series of preferred stock that may
be issued in the future. Some provisions of our certificate of incorporation,
our bylaws and Delaware law could have the effect of making it more difficult
for a third party to acquire a majority of our outstanding voting stock, even if
doing so would be beneficial to our stockholders. These include provisions that
prohibit stockholders from taking action by written consent and restrict the
ability of stockholders to call special meetings.
 
                                       14
<PAGE>   16
 
OUR STOCK PRICE MAY BE VOLATILE
 
     The market price of the shares of our Common Stock has been and is likely
in the future to be highly volatile. The price may fluctuate significantly in
response to factors such as:
 
     - Quarterly variations in our operational results;
 
     - Announcements of technological innovations;
 
     - New product introductions by us or our competitors;
 
     - Changes in earnings estimates by analysts or our failure to meet such
       earnings estimates;
 
     - Announcements by us regarding significant acquisitions, strategic
       relationships or capital expenditure commitments;
 
     - Additions or departures of key personnel;
 
     - Sales or issuances of Common Stock; and
 
     - Changes in federal, state or foreign regulations affecting the
       telecommunications industry.
 
     In addition, the stock markets in general, and the stocks of technology
companies in particular, have experienced extreme price and volume fluctuations
recently. These fluctuations often have been unrelated or disproportionate to
the operating performance of these companies. These broad market and industry
factors may have a material adverse affect on the market price of our Common
Stock, regardless of our actual operating performance. In the past, following
periods of volatility in the market price of a company's securities, securities
class action litigation often has been initiated against that company.
Litigation like this, if initiated, could result in substantial costs and divert
attention and resources of our management personnel.
 
WE ARE DEFENDING SIGNIFICANT LITIGATION
 
     As of April 9, 1998, 23 class action complaints (which were subsequently
consolidated into a single action) for violations of the federal securities laws
during certain periods in 1997 and 1998 had been filed in the United States
District Court for the Middle District of Florida, on behalf of purchasers of
our Common Stock. The complaints named as defendants Digital Lightwave, Bryan J.
Zwan, our Chairman, Steven H. Grant, our Executive Vice President, Finance,
Chief Financial Officer and Secretary, and other former corporate officers. The
complaints allege that Digital Lightwave and certain officers during the
relevant time period violated Sections 10(b) and 20(a) of the Securities
Exchange Act by, among other things, issuing to the investing public false and
misleading financial statements and press releases concerning our revenues,
income and earnings, which artificially inflated the price of our Common Stock.
 
     On July 23, 1998, we entered into a memorandum of understanding for the
settlement of these class action complaints. In late October 1998, a Stipulation
of Settlement was filed with the court and on December 21, 1998, the court
preliminarily approved the settlement. On March 12, 1999, the court indicated
that it would grant final approval of the settlement. The settlement is subject
to appeal. The settlement consists of $4.25 million in cash, to be paid to
plaintiffs primarily by a claim on the Company's directors and officers
liability insurance policy, and the issuance of up to 1.8 million shares of
Common Stock. We recorded a charge of $8.5 million during 1998 as a result of
the settlement.
 
     In addition, the Company is aware of a related informal investigation by
the Securities and Exchange Commission, which was commenced in March 1998. The
Company believes that the investigation relates to the circumstances underlying
the restatement of its financial results. The investigation is ongoing. The
Company is unable to predict the outcome of the investigation. There can be no
assurance that such investigation will not have a material adverse effect on the
business, financial condition or results of operations of the Company.
 
     We are from time to time involved in other lawsuits arising in the ordinary
course of business. Our management believes that we have adequate legal defenses
and/or adequate reserves for related costs for these
 
                                       15
<PAGE>   17
 
lawsuits. As of the date of this Annual Report, we were not aware of any
additional lawsuits that were pending that could have a material adverse effect
on our business, financial condition and operating results.
 
WE MAY EXPERIENCE "YEAR 2000" PROBLEMS
 
     Many currently installed computer systems and software products are coded
to accept only two digit entries for the year in the date code field and, as a
result, cannot distinguish 21st century dates from 20th century dates. Failure
to distinguish 21st century dates from 20th century dates could result in
systems failures or miscalculations causing disruptions of operations,
including, among other things, a temporary inability to process transactions,
send invoices or engage in similar normal business activities. As a result, many
companies' software and computer systems may need to be upgraded or replaced in
order to comply with such "Year 2000" requirements.
 
     We have made a preliminary assessment of our Year 2000 readiness. We are in
the process of providing our customers with product upgrades which we believe
are Year 2000 compliant. We have identified and evaluated the actions needed to
upgrade our information technology ("IT") and non-IT embedded systems to Year
2000 compliance. We are preparing to contact certain third-party suppliers of
key components or services regarding their Year 2000 readiness. Following
completion of these items, we will be better able to make a complete evaluation
of our Year 2000 readiness, to determine what additional costs will be necessary
to be Year 2000 compliant and whether we will have to develop contingency plans.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Year 2000 Compliance" for detailed information on our state of
readiness, assessment of costs, potential risks and contingency plans regarding
the Year 2000 issue.
 
                                       16
<PAGE>   18
 
                                    GLOSSARY
 
Asynchronous -- Signals that are not generated from the same timing reference
and are therefore not identical in frequency.
 
ATM (asynchronous transfer mode) -- An information transfer standard that is one
of a general class of technologies that relay traffic by way of an address
contained within the first five Bytes of a standard 53-Byte-long packet or cell.
The ATM format can be used by many different information systems, including the
public telecommunications network, WANs and LANs, to deliver traffic at varying
rates, permitting the efficient delivery of enhanced data services and
multimedia, which is a mix of voice, video and data.
 
Bandwidth -- The range of frequencies that can be transmitted through a medium,
such as glass fibers, without distortion. The greater the bandwidth, the greater
the information-carrying capacity of such medium.
 
Bit -- A contraction of the term binary digit which represents a single digit of
information expressed as a 0 or 1, high or low, or yes or no.
 
Byte -- Abbreviation for binary term. A unit of information consisting of 8
bits. In computer processing, equivalent of a single character such as a letter
of the alphabet, a numeral or punctuation mark.
 
CAP (Competitive Access Provider) -- A company that provides its customers with
an alternative to the Regional Bell Operating Companies for local transport of
private line, special access and interstate transport of telecommunications
service.
 
Competitive Local Exchange Carriers (CLECs) -- Category of telephone service
provider (carrier) that offers local exchange services, as allowed by recent
changes in telecommunications law and regulation. A Competitive Local Exchange
Carrier may also provide other types of service such as long distance, Internet
access, and entertainment.
 
Cross-connect equipment -- Distribution system equipment used to terminate and
administer communication circuits. In a wire cross connect, jumper wires or
patch cords are used to make circuit connections. In an electronic cross
connect, signals are electronically switched to make circuit connections.
 
Demultiplex -- The process of separating two or more signals that were
previously multiplexed.
 
Dense Wave Division Multiplexing (DWDM) -- A technology that permits the
transmission of multiple lightwave signals over a single optical fiber.
 
Digital -- A method of storing, processing and transmitting information through
the use of distinct electronic or optical pulses that represent the binary
digits 0 and 1. Digital transmission and switching technologies (both fiber and
microwave) employ a sequence of these pulses to represent information as opposed
to the continuously variable analog signal.
 
DS-0, DS-1, DS-3 -- Standard telecommunications industry digital signal formats,
which are distinguishable by bit rate (the number of binary digits (0 and 1)
transmitted per second). DS-0 service has a bit rate of 64 Kbps and can transmit
one voice conversation. DS-1 service has a bit rate of 1.544 Mbps and can
transmit 24 simultaneous voice conversations. DS-3 service has a bit rate of 45
Mbps and can transmit 672 simultaneous voice conversations.
 
Ethernet -- A protocol commonly used on LANs.
 
Enhanced data services -- Products and services designed for the transport and
delivery of integrated information to include voice, data and video and any
combination thereof.
 
Fiber optics -- A transmission medium consisting of a core of glass or plastic
surrounded by a protective cladding of similar material, strengthening material
and an outer jacket which guides light pulses introduced into the fiber by a
light source.
 
Firmware -- Software that is contained semi-permanently in a hardware device or
memory and which can be rewritten.
 
                                       17
<PAGE>   19
 
Gate array -- A circuit that has a number of logical circuits arranged in an
array, or regular pattern, normally customized to suit a specific application.
 
Gigabit per second (Gbps) -- One billion bits of information per second. The
information carrying capacity (i.e., bandwidth) of a circuit may be measured in
"gigabits per second."
 
Graphical user interface -- A type of display format that enables the user to
choose commands, start programs and see lists of files and other options by
pointing to pictorial representations and lists of menu items on the screen.
 
Integrated circuit (microprocessor) -- A series of miniaturized interconnected
electronic circuits inseparably associated within a semi-conductor substrate.
 
Internet -- The name used to refer to the world's largest interconnected
network, consisting of thousands of networks which interchange information
through a common communications protocol.
 
ISO 9001 -- An international standard for quality management and assurance.
 
IXC (InterExchange Carrier) -- A company providing long distance services or
service within local access and transport areas on an intrastate or interstate
basis.
 
Kilobit per second (Kbps) -- One thousand bits of information per second. The
information-carrying capacity (i.e., bandwidth) of a circuit may be measured in
"kilobits per second."
 
LAN (Local Area Network) -- A group of computers and other devices dispersed
over a relatively limited area and connected by a communications link that
enables any device to interact with any other on the network.
 
Legacy -- Older generations of transmission or other technologies which continue
to be utilized in telecommunications networks.
 
Lightwave -- Light as a communication signal over fiber-optic cable traveling as
discrete pulses, each representing one bit of digital information.
 
Lightwave management -- The intelligent termination, integration and switching
of lightwave communications.
 
Megabit per second (Mbps) -- One million bits of information per second. The
information-carrying capacity (i.e., bandwidth) of a circuit may be measured in
"megabits per second."
 
Multiplex -- The process of combining two or more signals for transmission over
the same circuit or channel at the same time.
 
Network Access Agent -- A product of the Company designed to be distributed
throughout a network to provide network operators with real-time information
concerning the network segments where the Network Access Agent has been
installed. This product can be centrally monitored and administered.
 
Network element -- A functional entity in a network, such as a multiplexer, a
switch interface or a digital cross-connect.
 
Network Information Computer -- A portable product of the Company designed to
allow users to access and process real time information concerning the
performance of telecommunications networks and transmission equipment.
 
Network Protocol Processors (NPPs) -- Modular electronic assemblies containing
hardware, firmware and software for the processing of information encoded in a
specific protocol over a range of bandwidth.
 
Network Protocol Translators (NPTs) -- Modular gate arrays or field programmable
gate arrays which logically process discrete network information from signals at
specific bandwidths and specific protocols.
 
Non-blocking switch matrix -- An internal switch in a system that has the
ability to switch multiple transmissions to different circuits simultaneously
without causing congestion internally in the switch.
 
                                       18
<PAGE>   20
 
OC-1, OC-3, OC-12, OC-48, OC-192 -- Optical carrier signaling rates, measured in
bits transmitted per second. The basic rate for OC-1 is 51.840 Mbps. All higher
levels are direct multiples of OC-1 (e.g., OC-12 = 12 times 51.840 Mbps).
 
OEM (Original Equipment Manufacturer) -- The maker of equipment marketed by
another vendor, usually under the name of the reseller.
 
Overhead -- Information carried in network transmissions, other than payload,
including routing information, error-checking characters and status and
operational information.
 
Packet -- A bundle of data organized for transmission which includes control
information, the data to be transmitted, and error detection bits.
 
Payload -- User transmitted data, including voice, data and/or video content,
which may include network management and accounting information.
 
PDH (Plesiochronous Digital Hierarchy) -- Two or more signals that are not
generated from the same timing reference but are nominally at the same frequency
to a defined degree of precision.
 
Protocol -- A specific set of rules, procedures or conventions relating to the
format and timing of data transmission between two devices.
 
RAM -- Random access memory. The primary memory in a computer which can be
overwritten with new information. Any bit in memory can be located in the same
amount of time, hence random access.
 
Regional Bell Operating Companies (RBOCs) -- The seven original local telephone
companies (formerly part of AT&T) established by court decree in 1982.
 
SDH (Synchronous Digital Hierarchy) -- An electronics and network architecture
and protocol utilized on most continents other than North America for variable
optical bandwidth products which enables transmission of voice, video and data
(multimedia) at very high speeds.
 
SONET (Synchronous Optical Network Technology) -- An electronics and network
architecture and protocol utilized primarily in North America for variable
optical bandwidth products which enables transmission of voice, video, and data
(multimedia) at very high speeds.
 
Switch -- A device that opens or closes circuits or selects the paths or
circuits to be used for transmission of information. Switching is a process of
interconnecting circuits to form a transmission path between users.
 
Switch matrix -- A series of gate arrays or switches which provide for the
routing of signals from one circuit path to another.
 
T-Carrier or T-1 or T-3 -- Insulated copper wire cables which carry electrically
transmitted digital signals. A T-1 cable carries a DS-1 signal (1.544 Mbps), and
a T-3 cable carries a DS-3 signal (45 Mbps). Also, a generic name for any of
several digitally multiplexed carrier systems originally designed to carry
digitalized voice signals.
 
Test instruments -- Equipment that indicates the state or condition of a signal,
such as on a fiber or metallic cable, primarily measuring level, frequencies and
faults and other conformal signal information.
 
Web or World Wide Web or WWW -- An Internet network that links documents by
providing hypertext links from server to server. It allows a user to jump from
document to related document no matter where it is stored on the Internet. World
Wide Web client programs, or Web browsers, allow users to "browse" the Web.
 
Wide Area Network (WAN) -- A network typically extending a LAN outside the
building over common carrier telephone lines connecting other LANs possibly in
different cities.
 
                                       19
<PAGE>   21
 
ITEM 2.  PROPERTIES
 
     In November 1998, the Company relocated its operations, other than its
production operations, into its corporate headquarters facility of 92,225 square
feet in Clearwater, Florida. The Company also leases space for its software
development operations in Wall Township, New Jersey. Currently, the Company
leases a manufacturing facility in St. Petersburg, Florida, but anticipates that
it will consolidate its manufacturing activities to its corporate headquarters
in Clearwater, Florida by September 1999.
 
     The lease for the Company's Clearwater, Florida headquarters expires in
November 2008; the Wall Township, New Jersey lease expires in December 2002; and
the St. Petersburg, Florida lease expires in July 2000.
 
ITEM 3.  LEGAL PROCEEDINGS
 
     As of April 9, 1998, 23 class action complaints (which were subsequently
consolidated into a single action) for violations of the Federal Securities Laws
during certain periods in 1997 and 1998 had been filed in the United States
District Court for the Middle District of Florida, on behalf of purchasers of
our Common Stock. The complaints named as defendants the Company, Bryan J. Zwan,
the Company's Chairman, Steven H. Grant, the Company's Executive Vice President,
Finance, Chief Financial Officer and Secretary, and other former corporate
officers. The complaints allege that the Company and certain officers during the
relevant time period violated Sections 10(b) and 20(a) of the Securities
Exchange Act by, among other things, issuing to the investing public false and
misleading financial statements and press releases concerning the Company's
revenues, income and earnings, which artificially inflated the price of our
Common Stock.
 
     On July 23, 1998, we entered into a memorandum of understanding for the
settlement of these class action complaints. In late October 1998, a Stipulation
of Settlement was filed with the court and on December 21, 1998, the court
preliminarily approved the settlement. On March 12, 1999, the court indicated
that it would grant final approval of the settlement. The settlement is subject
to appeal. The settlement consists of $4.25 million in cash, to be paid to
plaintiffs primarily by a claim on the Company's directors and officers
liability insurance policy, and the issuance of up to 1.8 million shares of
Common Stock. We recorded a charge of $8.5 million during 1998 as a result of
the settlement.
 
     In addition, the Company is aware of a related informal investigation by
the Securities and Exchange Commission, which was commenced in March 1998. The
Company believes that the investigation relates to the circumstances underlying
the restatement of its financial results. The investigation is ongoing. The
Company is unable to predict the outcome of the investigation. There can be no
assurance that such investigation will not have a material adverse effect on the
business, financial condition or results of operations of the Company.
 
     On November 5, 1997, Hugh Brian Haney ("Plaintiff") commenced an action in
the United States District Court for the Southern District of Ohio against Bryan
J. Zwan, the Company's Chairman of the Board and then Chief Executive Officer,
and the Company ("Defendants"). An amended complaint filed December 15, 1997
alleged violations of Section 10 (b) of the Securities Exchange Act, violations
of state corporation statutes, and various common law violations by Defendants
in connection with Plaintiff's sale to the Company's predecessor in November
1995, pursuant to a previously granted option exercisable by Dr. Zwan and/or the
Company's predecessor, of 4,900 shares of stock in the Company's predecessor, an
amount equivalent to 19,215,686 shares of the Company's common stock. The
amended complaint sought, among other things, (1) rescission of the sale of the
shares transferred by Plaintiff and (2) damages of $235 million, together with
interest. On October 20, 1998, the Company and Dr. Zwan entered into an
agreement with Plaintiff to settle the action. The settlement agreement
provides, among other things, for dismissal of the action with prejudice, for a
$500,000 payment by the Company to Plaintiff for his attorneys' fees and grants
Plaintiff an option, for 10 years, to purchase for $1 per share 2 million shares
of Dr. Zwan's stock in the Company. Pursuant to that agreement, the action was
dismissed with prejudice on November 13, 1998. The Company recorded a $3.0
million charge to earnings consisting of the cash payment and the valuation of
the options upon settlement.
 
                                       20
<PAGE>   22
 
ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
     During the fourth quarter of 1998, no matters were submitted to a vote of
stockholders through the solicitation of proxies or otherwise.
 
                                    PART II
 
ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
     The Company's shares of Common Stock have traded on the Nasdaq National
Market System under the symbol "DIGL" since February 7, 1997. The prices set
forth below represent quotes between dealers and do not include commissions,
mark-ups or mark-downs, and may not necessarily represent actual transactions.
 
<TABLE>
<CAPTION>
                                                              COMMON STOCK
                                                            -----------------
                                                             HIGH       LOW
                                                            -------    ------
<S>                                                         <C>        <C>
1997
1st Quarter (from February 7, 1997).......................  $12.875    $7.125
2nd Quarter...............................................    9.250     3.250
3rd Quarter...............................................   17.750     7.875
4th Quarter...............................................   23.750    12.000
 
1998
1st Quarter...............................................  $16.813    $2.000
2nd Quarter...............................................    6.469     3.000
3rd Quarter...............................................    4.500     1.281
4th Quarter...............................................    4.375     1.156
</TABLE>
 
On March 26, 1999, the closing bid and ask prices of the Company's Common Stock
were $3.000 and $3.063, respectively. As of March 31, 1999, there were
approximately 200 holders of record of the Company's Common Stock.
 
DIVIDEND POLICY
 
     The Company has not paid any dividends since its inception and does not
contemplate payment of dividends in the foreseeable future. The Company
anticipates that any earnings in the near future will be retained from the
development and expansion of its business. Certain of the Company's credit
facilities require consent from the banks prior to payments of dividends.
 
RECENT SALES OF UNREGISTERED SECURITIES
 
     During the fiscal year ended December 31, 1998, there were no sales of
unregistered securities.
 
                                       21
<PAGE>   23
 
ITEM 6.  SELECTED CONSOLIDATED FINANCIAL DATA
 
                      SELECTED CONSOLIDATED FINANCIAL DATA
                (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
 
     The following selected consolidated financial data are derived from the
Consolidated Financial Statements of the Company. The selected consolidated
financial data should be read in conjunction with "Item 7. Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
the Consolidated Financial Statements of the Company and Notes thereto.
 
<TABLE>
<CAPTION>
                                                        YEARS ENDED DECEMBER 31,
                                   -------------------------------------------------------------------
                                      1998          1997          1996          1995          1994
                                   -----------   -----------   -----------   -----------   -----------
<S>                                <C>           <C>           <C>           <C>           <C>
Consolidated Statement of
  Operations:
Sales............................  $    24,191   $     9,081   $     6,044   $        --   $        --
Cost of goods sold...............        9,219         3,124         2,079            --            --
                                   -----------   -----------   -----------   -----------   -----------
  Gross Profit...................       14,972         5,957         3,965            --            --
Operating expenses:
  Engineering and development....       14,335         5,342         2,403         1,509         1,241
  Selling and marketing..........       11,363         5,260         1,706           199            67
  General and administrative.....        7,223         3,812         1,380         1,017           260
  Reorganization charges(1)......        1,018            --            --            --            --
  Litigation settlements(2)......       11,500            --            --            --            --
                                   -----------   -----------   -----------   -----------   -----------
          Total operating
            expenses.............       45,439        14,414         5,489         2,725         1,568
                                   -----------   -----------   -----------   -----------   -----------
Loss from operations.............      (30,467)       (8,457)       (1,524)       (2,725)       (1,568)
Other income (expense)...........          642         1,767          (584)         (609)         (114)
                                   -----------   -----------   -----------   -----------   -----------
Net loss.........................      (29,825)       (6,690)       (2,108)       (3,334)       (1,682)
                                   ===========   ===========   ===========   ===========   ===========
Loss per share...................        (1.13)         (.25)         (.10)         (.08)         (.04)
                                   ===========   ===========   ===========   ===========   ===========
Weighted average shares(3).......   26,475,749    26,084,208    21,829,235    39,443,614    41,044,921
Consolidated Balance Sheet Data:
  Working capital (deficit)......        2,267        32,495         2,349        (8,595)       (1,939)
  Total assets...................       27,558        44,361         6,374         1,277           332
  Total long-term debt...........          281            25           983         7,985         2,102
  Stockholders' equity
     (deficit)...................       12,320        39,419         3,449        (8,163)       (2,328)
</TABLE>
 
---------------
 
(1) Includes a one-time expense of $1.0 million for reorganization charges as
    described under "Management's Discussion and Analysis of Financial Condition
    and Results of Operations -- Overview" and Note 14 of the Consolidated
    Financial Statements -- Reorganization Charges.
(2) Includes a charge of $8.5 million made in connection with the settlement of
    a class action legal proceeding and a one-time charge of $3.0 million made
    in connection with the settlement of the Haney litigation as described under
    Note 15 of the Consolidated Financial Statements -- Legal Proceedings.
(3) On November 30, 1995, the Company purchased 19,215,686 shares of Common
    Stock from a former stockholder pursuant to an option granted to the Company
    by the former stockholder in February 1995. See "Factors That May Affect
    Operating Results -- We are defending significant litigation," "Item 3 --
    Legal Proceedings" and Notes 9 and 15 of the Consolidated Financial
    Statements -- Related Party Transactions and Legal Proceedings.
 
                                       22
<PAGE>   24
 
ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
 
     This report contains certain statements of a forward-looking nature
relating to future events or the future performance of the Company. Prospective
and current investors are cautioned that such statements are only predictions
and that actual events or results may differ materially. In evaluating such
statements as well as the future prospects of the Company generally, such
investors should specifically consider various factors identified in this Report
on Form 10-K, including the matters set forth therein under the caption "Factors
That May Affect Operating Results," which could cause actual results to differ
materially from those indicated by such forward-looking statements. Factors that
may affect the Company's results of operations include but are not limited to
the Company's limited operating history and cumulative losses, dependence on
limited products, uncertain market acceptance of planned products, rapid
technological change, dependence on new product introductions, competition,
expansion of manufacturing operations, dependence on contract manufacturing and
sole or limited source suppliers, dependence on key personnel, management of
growth, anticipated fluctuations in operating results, dependence on proprietary
technology, customer concentration, product certifications, control by principal
stockholder, factors inhibiting takeover, shares eligible for future sale,
possible volatility of stock price, success in defending significant litigation,
liquidity risks and future capital needs, potential year 2000 problems and
government regulations. The Company participates in a highly concentrated
industry, and has limited visibility with regard to customer orders and the
timing of such orders. The Company may also encounter difficulty obtaining
sufficient supplies to staff and meet production schedules. As a result,
quarter-to-quarter and year-to-year financial performance is highly dependent
upon the timely receipt of orders from its customers during fiscal periods.
 
OVERVIEW
 
     Digital Lightwave designs, develops, markets and supports diagnostic
products that monitor, maintain and manage fiber optic-based networks. The
Company's products provide telecommunications service providers and equipment
manufacturers with capabilities to cost-effectively deploy and manage fiber
optic networks to address the rapidly increasing demand for bandwidth.
 
     From inception in 1990 through 1996, the Company focused its primary
activities on developing the necessary technology and infrastructure required to
launch its first product, the Network Information Computer. The Company had no
sales until February 1996, when it began shipping the Network Information
Computer. As of December 31, 1998, the Company had sold 1,100 Network
Information Computers to approximately 80 customers such as MCI WorldCom,
Ameritech Corporation, Tellabs, Qwest, GTE and AT&T Corporation. In 1998, the
Company commenced limited sales of the Network Access Agent. Net sales for the
Company were $24,191,000, $9,081,000 and $6,044,000 for the years ended December
31, 1998, 1997 and 1996, respectively.
 
     The Company's net sales are generated from sales of its products, less an
estimate for customer returns. Net sales are recognized when products are
shipped to a customer. The average sales price ("ASP") of the Network
Information Computer was approximately $33,459, $33,022 and $35,345 for the
years ended December 31, 1998, 1997, and 1996, respectively. The Company expects
that the ASP of its Network Information Computers will fluctuate based on a
variety of factors, including product configuration, potential volume discounts
to customers, the timing of new product introductions and enhancements and the
introduction of competitive products. Because the cost of goods sold tends to
remain relatively stable for any given product, fluctuations in the ASP may have
a material adverse effect on the Company's results of operations.
 
     The Company sells its products through a direct sales force to
telecommunications service providers and equipment manufacturers. The sales
cycle for new customers tends to be long. In addition, the telecommunications
industry historically has had a limited number of competitors. Given long sales
cycles and few industry participants, sales of the Company's products have
tended to be concentrated, and the Company expects that sales will continue to
be concentrated in the future. For the year ended December 31, 1998, the
Company's four largest customers accounted for approximately 57% of total
revenues, with Qwest, MCI Worldcom, Tellabs, and GTE accounting for
approximately 17%, 16%, 13% and 11% of total sales, respectively. For the
 
                                       23
<PAGE>   25
 
year ended December 31, 1997, sales to the Company's five largest customers
comprised 69% of its total revenues, with WorldCom, Inc. (prior to its
acquisition of MCI Communications Corporation) and its subsidiaries accounting
for 42% of total sales. For the year ended December 31, 1996, the Company's five
largest customers accounted for approximately 62% of total revenues, with MCI
Communications Corporation (prior to its acquisition by WorldCom, Inc.),
Ameritech Corporation and Pacific Telesis Group accounting for 23%, 19% and 15%
of total sales, respectively. No other customers accounted for sales of 10% or
more during such periods. There can be no assurance regarding the amount or
timing of purchases by any customer in any future period. See "Factors That May
Affect Operating Results -- We are dependent on a limited number of major
customers."
 
     To date, the Company has not entered into long-term agreements or blanket
purchase orders for the sale of its products, but generally obtains purchase
orders for immediate shipment and other cancelable purchase commitments. As a
result, the Company does not expect to carry substantial quarterly backlog from
quarter to quarter in the future. The Company's sales during a particular
quarter are, therefore, highly dependent upon orders placed by customers during
the quarter. Consequently, sales may fluctuate significantly from quarter-
to-quarter and year-to-year due to the timing and amount of orders from
customers, among other factors. Because most of our expenses, particularly
employee compensation and rent, are relatively fixed and cannot be reduced in
response to decreased revenues, quarterly fluctuations in sales have a
significant effect on net income.
 
     Since inception the Company has incurred substantial net operating losses
as a result of significant investment in research and development, sales and
marketing and administrative expenses. As of December 31, 1998, the Company had
an accumulated deficit of approximately $46 million and net operating loss
carryforwards of approximately $39.0 million for tax purposes. The Company
intends to continue to build its organization in anticipation of growth and
believes that its operating expenses will continue to increase accordingly due
to a variety of factors including: (1) increased research and development
expenses associated with the completion of the products in development and the
continued enhancement of existing products; and (2) increased selling, general
and administrative expenses associated with continued expansion of sales and
marketing capabilities, product advertising and promotion. There can be no
assurance that the Company will achieve profitability, or that if profitability
is achieved that it will be sustained.
 
     In January 1998, the Company restated its revenues from the second and
third quarters of fiscal 1997. The Company's decision to restate the 1997
results of operations resulted from the discovery of certain errors in the
timing of revenue recognition and a review of related accounting policies and
procedures. A committee consisting of the outside members of the Company's board
of directors was established to review the policies, procedures and
circumstances which may have been factors in the restatement of revenue and made
recommendations regarding the adoption of appropriate revenue recognition
policies and procedures. In April 1998, 23 class action lawsuits (which were
subsequently consolidated into a single action) were filed against the Company
arising out of such restatement and alleged violations of the federal securities
laws. The Company has a proposed settlement pending in connection with the class
action and recorded a charge of $8.5 million in the second quarter of 1998 as a
result of the proposed settlement. Pursuant to the terms of the settlement, the
Company will pay $4.25 million in cash, which payment will be primarily funded
by the Company's directors' and officers' liability insurance policy, and issue
1.8 million shares of Common Stock of the Company, all of which may be freely
tradable. In late October 1998, a Stipulation of Settlement was filed with the
court and on December 21, 1998, the court preliminarily approved the settlement.
On March 12, 1999, the court indicated that it would grant final approval of the
settlement. The settlement is subject to appeal. See "Factors That May Affect
Operating Results -- We are defending significant litigation," Note 15 and 16 of
the Consolidated Financial Statements, and "Item 3 -- Legal Proceedings."
 
     During February 1995, the Company entered into a Stock Purchase Option (the
"Option") with a former stockholder to repurchase the 19,215,686 shares of the
then outstanding class of common stock held by the former stockholder for a
purchase price of $2.5 million. The purchase price was subsequently reduced to
$800,522. On November 30, 1995, the Company exercised the Option and retired the
shares of treasury stock acquired. In November 1997, the former stockholder
commenced an action in the United States District Court alleging violations of
Section 10(b) of the Securities Exchange Act, violations of state corporation
                                       24
<PAGE>   26
 
statutes, and various common law violations in connection with the exercise of
the Option. On October 20, 1998, the Company and Dr. Zwan entered into an
agreement with Plaintiff to settle the action. The settlement agreement
provides, among other things, for dismissal of the action with prejudice, for a
$500,000 payment by the Company to plaintiff for his attorneys' fees and grants
Plaintiff an option, for 10 years, to purchase for $1 per share 2 million shares
of Dr. Zwan's stock in the Company. Pursuant to that agreement, the action was
dismissed with prejudice on November 13, 1998. The Company recorded a $3.0
million charge to earnings consisting of the cash payment and the valuation of
the options upon settlement. See "Factors That May Affect Operating
Results -- We are defending significant litigation" and Note 15 of the
Consolidated Financial Statements and "Item 3 -- Legal Proceedings."
 
     In order to decrease costs and improve operating efficiencies, the Company
began streamlining its management and operating structure in February 1998 and
eliminated 20 full time positions resulting in a one-time charge of $1.0 million
in connection with this restructuring. Additionally, the Company eliminated
approximately 55 full time positions in August 1998 which did not result in a
significant charge to earnings. During 1998, the Company also significantly
enhanced its management team by hiring new executives, including a new President
and Chief Executive Officer hired at the end of the year.
 
RESULTS OF OPERATIONS
 
     The following table sets forth, for the periods indicated, certain
financial data expressed as a percentage of net sales.
 
<TABLE>
<CAPTION>
                                                 FISCAL YEAR ENDED DECEMBER 31,
                                                 -------------------------------
                                                 1998         1997         1996
                                                 -----        -----        -----
<S>                                              <C>          <C>          <C>
Net sales......................................   100%         100%         100%
Cost of goods sold.............................    38           34           34
                                                 ----          ---          ---
Gross profit...................................    62           66           66
Operating expenses:
Engineering and development expenses...........    59           58           40
Sales and marketing expenses...................    47           58           28
General and administrative expenses............    30           42           23
Reorganization and litigation charges..........    52           --           --
                                                 ----          ---          ---
     Total operating expenses..................   188          158           91
                                                 ----          ---          ---
Operating loss.................................  (126)         (92)         (25)
Other income (expense), net....................     3           19           (8)
                                                 ----          ---          ---
Net loss.......................................  (123)%        (73)%        (33)%
                                                 ====          ===          ===
</TABLE>
 
YEAR ENDED DECEMBER 31, 1998 COMPARED WITH YEAR ENDED DECEMBER 31, 1997
 
  Net Sales
 
     Net sales include total revenues from customer purchases of Network
Information Computers and, to a limited extent, Network Access Agents, net of
accrual for product returns. Net sales for the year ended December 31, 1998
increased by $15.1 million, or 166%, to $24.2 million from $9.1 million in
fiscal 1997. Sales to existing customers for the year represented 77% of sales,
or $18.6 million as compared to 55% of sales, or $5.0 million for fiscal 1997.
During fiscal 1998, the Company shipped 723 units of the Network Information
Computer in varying configurations at an ASP of $33,459 compared with 275 units
at an ASP of $33,022 for fiscal 1997.
 
     Sales to existing customers continue to represent a large portion of the
Company's net sales. The Company believes repeat sales to an existing customer
are an important measure of growing product acceptance in the highly
concentrated telecommunications industry. While this longer-term trend may not
continue, management believes that new product offerings including upgrades of
existing products offer the
 
                                       25
<PAGE>   27
 
Company's existing customers an opportunity to continue to extend the life of
their initial investment in the Company's products.
 
  Cost of Goods Sold
 
     Costs of goods sold principally includes inventory, labor and overhead,
management costs, facility rental and depreciation of equipment. Cost of goods
sold for the year ended December 31, 1998 increased by $6.1 million to $9.2
million, or 38% of net sales, from $3.1 million, or 34% of net sales in fiscal
1997. The primary reason for the increase in cost of goods sold is the increase
in the volume of units sold.
 
  Gross Profit
 
     Gross profit for the year ended December 31, 1998 increased by $9.0 million
to $15.0 million from $6.0 million last year. As a percentage of sales, gross
margin for the year ended December 31, 1998 decreased to 62% from 66% in 1997.
 
     The increase in gross profit is directly related to the increase in sales
for the year ended December 31, 1998. Despite the increase in sales, gross
margin percentages have decreased for the year. The primary reason for the
decline is the relatively flat ASP burdened with a higher average cost per unit
in 1998. The higher average cost per unit was affected by the introduction of
the new OC-48 configuration which costs more to produce than the lower speed
optical configurations and the sale of units produced in previous periods
requiring additional labor and overhead costs in order to provide the customer
with the most current configuration available.
 
  Engineering and Development
 
     Engineering and development expenses principally include compensation
attributable to engineering and development personnel, depreciation of
production assets, outside consulting fees and other development expenses.
Engineering and development expenses for the year ended December 31, 1998
increased by $9.0 million to $14.3 million, or 59% of net sales, from $5.3
million, or 58% of net sales, last year.
 
     The increase is primarily related to the ongoing engineering and
development efforts on products such as the Network Access Agents, and
enhancements to the Company's Network Information Computers (most significantly,
the OC-48 option). In addition, during the last two quarters of 1998, the
Company incurred a significant level of overhead costs that could not be
absorbed into inventory production due to a lower level of production activity
during the last six months. Although the Company's efforts to lower overhead
costs by reducing the number of manufacturing personnel were successful, some
fixed costs such as facility rental and depreciation of production assets could
not be reduced. Accordingly, a disproportionate share of overhead expenses could
not be capitalized as part of inventory costs.
 
  Sales and Marketing
 
     Sales and marketing expenses principally include salaries and commissions
paid on sales of products, travel expenses, tradeshow costs, and costs of
promotional materials and customer incentives. Sales and marketing expenses for
the year ended December 31, 1998 increased by $6.1 million to $11.4 million from
$5.3 million last year. As a percentage of net sales, sales and marketing
expenses in the year ended December 31, 1998 declined to 47%, from 58% in 1997.
The dollar increase is directly related to a larger sales force, higher
commissions resulting from the increased sales activity, and an increase in
marketing related expenses.
 
  General and Administrative
 
     General and administrative expenses principally include professional fees,
facility rentals, compensation, and information systems related to general
management functions. General and administrative expenses for the year ended
December 31, 1998 increased by $3.4 million to $7.2 million from $3.8 million
last year. As a percentage of net sales, general and administrative expenses
declined to 30%, from 42% in 1997. The dollar
 
                                       26
<PAGE>   28
 
increase is primarily due to professional fees associated with outstanding
litigation and various legal matters. These fees increased approximately $3.3
million for the year ended December 31, 1998.
 
  Reorganization Charges
 
     During the year ended December 31, 1998, the Company has actively pursued
streamlining its management and operating structure. During the first quarter,
the Company focused on its management structure and eliminated 20 positions
which resulted in a one-time charge of approximately $1.0 million. In August
1998, the Company streamlined its operating structure by eliminating
approximately 55 full-time positions which did not result in a material charge
to earnings. The Company believes that these reductions in force did not
materially affect the Company's ability to operate.
 
  Litigation Settlement
 
     The Company signed a memorandum of understanding and a Stipulation of
Settlement for the settlement of class action complaints filed against it in
U.S. District Court for alleged violations of federal securities laws. The
settlement has resulted in a charge of approximately $8.5 million recorded
during the second quarter of 1998. In addition, Dr. Bryan Zwan and the Company
entered into an agreement to settle an action commenced by Hugh Brian Haney.
Pursuant to that agreement, the action was dismissed with prejudice on November
13, 1998. The Company recorded a non-cash charge to earnings of approximately
$2.5 million and a $0.5 million accrual of related legal expenses during the
fourth quarter of 1998.
 
  Other Income (Expense)
 
     Other income for the year ended December 31, 1998 decreased by $1.1 million
to $0.6 million from $1.7 million last year. The decrease is the result of the
utilization of cash reserves to fund the Company's operations which caused a
decrease in interest earned on invested cash balances.
 
  Net Loss
 
     Net loss for the year ended December 31, 1998 increased by $23.1 million to
a net loss of $29.8 million or $1.13 per share, from a net loss of $6.7 million
or $.25 per share in 1997. The increase in net loss for the year ended December
31, 1998 was adversely impacted by the charges of approximately $8.5 million to
record the settlement of outstanding securities litigation, $3.0 million to
record the settlement of the Haney litigation, $1.0 million to record the
reorganization, $1.3 million in legal expenses, and $0.3 million of other
special charges. Without these charges, the pro-forma net loss would have been
$15.7 million or a loss of $.59 per share.
 
YEAR ENDED DECEMBER 31, 1997 COMPARED WITH YEAR ENDED DECEMBER 31, 1996
 
  Net Sales
 
     Net sales in 1997 increased $3.1 million to $9.1 million from $6.0 million
in 1996. Sales to existing customers in 1997 represented 55% of sales, or $5.0
million as compared to 48% of sales, or $2.9 million in 1996. During 1997 the
Company shipped 275 units of the Network Information Computer in varying
configurations at an ASP of $33,022 compared with 171 units of the Network
Information Computer at an ASP of $35,345 in 1996.
 
  Cost of Goods Sold
 
     Cost of goods sold in 1997 increased by $1.0 million to $3.1 million from
$2.1 million in 1996, and remained constant at 34% of net sales in both years.
The primary reason for the increase in cost of goods sold in 1997 relates to the
increase in volume of units produced and the increased infrastructure and
manufacturing costs incurred in supporting these efforts. While the overall cost
of goods sold has increased, the average cost of goods sold per unit has
declined as a result of absorption of fixed production costs over a larger
volume of units produced and the component cost reductions associated with the
purchase of larger lot sizes. During the
 
                                       27
<PAGE>   29
 
quarter ended September 30, 1997, the Company moved its manufacturing operation
to a new expanded facility and the Company recorded certain non-recurring
expenses in connection with this move.
 
  Gross Profit
 
     Gross profit in 1997 increased by $2.1 million to $6.0 million from $3.9
million in 1996. As a percentage of sales, gross margin for the years ended
December 31, 1997 and 1996 was 65.6%. As highlighted above, the increase in
gross profit in 1997 is directly related to the increase in sales.
 
  Engineering and Development
 
     Engineering and development expenses in 1997 increased by $2.9 million to
$5.3 million, or 58% of net sales from $2.4 million, or 40% of net sales, in
1996. The increase is primarily related to the addition of engineering and
quality control personnel and the other expenses associated with the Company's
ongoing research and development efforts on products such as the Network Access
Agents and enhancements to the Company's Network Information Computers.
 
  Sales and Marketing
 
     Sales and marketing expenses in 1997 increased by $3.6 million to $5.3
million, or 58% of net sales, from $1.7 million, or 28% of net sales in 1996.
The increase is related to the addition of personnel for the Company's direct
sales force and marketing functions, an increase in trade show appearances, and
customer incentives.
 
  General and Administrative
 
     General and administrative expenses in 1997 increased by $2.4 million to
$3.8 million, or 42% of net sales, from $1.4 million, or 23% of net sales in
1996. The increase is due to the expansion of facilities, personnel, and
information systems to support the growth of the Company's business.
 
  Other Income (Expense)
 
     Other income in 1997 increased by $2.2 million to an income of $1.7 million
from an expense of $0.5 million in 1996. The increase relates to interest income
generated primarily from the investment of proceeds from the Company's initial
public offering in 1997 ("IPO").
 
  Net Loss
 
     Net loss in 1997 increased by $4.6 million to a net loss of $6.7 million or
$.25 per share, from a net loss of $2.1 million or $.10 per share in 1996. The
computation of weighted shares outstanding for the 1997 periods reflect a higher
number of shares outstanding as a result of the completion of the Company's IPO.
 
LIQUIDITY AND CAPITAL RESOURCES
 
     From its inception through December 31, 1998, the Company has financed its
operations primarily through private sales of its Common Stock, cash from
operations and the initial public offering of 4,600,000 shares of its Common
Stock. The Company completed its IPO in February 1997, resulting in net proceeds
to the Company of $39.6 million. During 1997, the Company used the net proceeds
to fund the repayment of notes payable for approximately $0.8 million, to
purchase computer equipment, software, test equipment and other assets for
approximately $6.0 million and to fund product research and development for
approximately $5.3 million. In addition, approximately $3.5 million was used to
fund the Company's expansion in the form of additional manufacturing and
administrative space and a significant increase in engineering, production and
financial management personnel to support the Company's growth.
 
     Cash and cash equivalents at December 31, 1998 were approximately $3.8
million compared to approximately $24.0 million at December 31, 1997. As of
December 31, 1998, the Company's working capital was approximately $2.3 million
as compared to $32.5 million at December 31, 1997. The decrease in working
capital was primarily associated with cash used in operations as a result of
operating losses during the fiscal
                                       28
<PAGE>   30
 
year ended December 31, 1998, as detailed in the Company's Consolidated
Statements of Cash Flows, and the proposed settlement of the litigation
previously discussed. For the year ended December 31, 1998, capital expenditures
were approximately $4.5 million. Future capital expenditures will depend on
several factors including timing of introductions of new products and
enhancements to existing products as well as continued product development
efforts.
 
     The Company entered into an accounts receivable agreement dated December
28, 1998 with EAB Leasing Corp. ("EAB") providing for the sale of the Company's
accounts receivable to EAB. The aggregate maximum amount the Company can borrow
at one time under this agreement is $2.9 million through June 28, 1999 with a
maximum of $2.0 million available on a monthly basis. As of March 26, 1999,
there were no borrowings under this agreement. In connection with this
agreement, the Company has granted EAB a security interest in its accounts,
accounts receivable, contract rights, equipment, chattel paper, general
intangibles, instruments, inventory and all proceeds of the foregoing The annual
interest rate equivalent charged to the Company under this agreement is the
prime rate plus 1.5%. The agreement also provides that the Company pay a minimum
monthly service fee in the amount of $10,000.
 
     On March 31, 1999, the Company entered into a financing agreement with
certain investors pursuant to which the Company has agreed to issue $3.0 million
of 9% Secured Bridge Notes due January 17, 2000. These notes will be
collateralized by all of the Company's assets and will be subordinated to the
accounts receivable agreement with EAB and the proposed line of credit agreement
with Emergent Business Capital described in the following paragraph. In
connection with the financing agreement, the Company agreed to issue warrants to
purchase an aggregate of 550,000 shares of the Company's common stock at an
exercise price of $2.75 per share, the market price of the stock on the date
prior to the issuance of the warrants. The warrants will have a term of five
years from the date of issuance. The Company has agreed to register the warrants
and the common stock issuable upon exercise thereof under the Securities Act of
1933.
 
     On March 31, 1999, the Company entered into a Letter of Commitment with
Emergent Business Capital pursuant to which Emergent Business Capital would
provide the Company with a $5.0 million line of credit (the "Emergent Line of
Credit"). Under the Emergent Line of Credit, the Company would be entitled to
borrow up to $5.0 million, subject to certain borrowing limitations based on
amounts of the Company's accounts receivable and other assets. The Emergent Line
of Credit will have a term of two years. All indebtedness outstanding under the
Emergent Line of Credit Agreement will be collateralized by substantially all of
the Company's assets.
 
YEAR 2000 READINESS DISCLOSURE
 
  Year 2000 Issues and State of Readiness
 
     The Company is aware of the issues associated with existing
computer-controlled systems properly recognizing and processing information
relating to dates in and after the Year 2000. Systems that cannot adequately
process dates beyond the year 1999 could generate erroneous data or cause a
system to fail. The problem may affect internal information technology ("IT")
systems used by the Company for product development, accounting, distribution
and planning. The problem may also affect non-IT embedded systems such as
building security systems, machine controllers, and other equipment. The Company
has made a preliminary assessment of its Year 2000 readiness for its operations
relating to (1) the Company's software products, (2) the Company's internal IT
and non-IT systems and (3) third party customers, vendors and others with whom
the Company does business.
 
     The Company believes that the current versions of its products (ASA 312
Network Information Computer software versions 3.500 and later and Network
Access Agents) are Year 2000 compliant. The Company's products use time and
dates only as a "time stamp" for data-logging events, for file dates, for
display of elapsed time, and setting the test duration. The products' internal
system calendar years are entered as a 2-digit number in the range of "95" (for
1995) through "94" (for 2094). Since there is never a reason for "back dating,"
this provides an unambiguous means of entry for the year. The date is displayed
in a 4-digit year format (e.g., 01-Jan-1998) to enhance understandability. Based
on the foregoing, it is not expected that the Company's current products will be
adversely affected by date changes in the Year 2000.
 
                                       29
<PAGE>   31
 
     Certain customers of the Company may be running earlier versions of the
Company's products that are not Year 2000 compliant. These earlier software
versions, like the compliant versions, rely on time and dates only as a "time
stamp" for data-logging events, for file dates, for display of elapsed time, and
setting the test duration and do not prohibit function of the equipment. The
Company has made its policy statement regarding its product line available on
the Internet as well as providing written copies at customer request. This
alerts customers to the noncompliance of earlier versions of the ASA 312
software. Of these earlier versions, 3.100 through prior to 3.500 partially
comply, although if allowed to run past 1999 and into January 1, 2000, the date
after power-down will be incorrectly set to 1980. Instructions regarding
correcting this are provided both on the Internet and via customer inquiry. This
leaves only versions lower than 3.100 which are truly non-compliant. The
suggested solution for these products is an upgrade to a more recent, compliant
version of the software at the cost of the Company. The Company has evaluated
the number of customers still operating with these non-compliant versions. Of
these customers, it is estimated that approximately half have already received
the desired upgrades. As of March 26, 1999, the cost to upgrade the remaining
units is estimated to total $36,000 which would not have a material adverse
impact on the Company's business, operating results or financial condition.
 
     With respect to IT systems, the Company has inventoried its internal
software and electronic hardware devices currently in use to determine which of
these devices rely on a valid date in order to function. Of these, certain
operating, accounting, and telephony systems were identified as critical.
Resources required to make these systems Year 2000 compliant were evaluated
based on availability and cost of the related upgrade. In general, the Company
is obtaining Year 2000 compliant versions from third party software vendors and
modifying these systems, which the Company expects to complete during the second
quarter of 1999. Total costs of such remediation are estimated at $21,000.
Non-IT embedded systems, consisting primarily of security systems, the emergency
power generator, HVAC controls and elevators have also been reviewed. These
systems were found to be year 2000 compliant.
 
     The Company also has certain key relationships with suppliers and
subcontractors. We are preparing to contact certain third-party suppliers of key
components or services regarding their Year 2000 readiness. Following completion
of contacting these vendors, the Company will be better able to make a complete
evaluation of the costs associated with identifying alternative vendors if the
need arises.
 
  Risks Associated with Year 2000 and Contingency Plan
 
     Based on information currently available to the Company, the Company
believes that the most reasonably likely worst case Year 2000 scenarios with
respect to the Company relate to the potential failure of third party suppliers,
subcontractors and customers to become Year 2000 compliant. The inability of
suppliers and subcontractors to complete their Year 2000 remediation processes
in a timely fashion could result in delays in introducing new products, reduced
sales of new or existing products and disruptions in any future strategic
relationships. The failure of these entities to become Year 2000 compliant could
in turn have a material and adverse effect on the Company's results of
operations and financial condition. The effect of non-compliance by suppliers,
subcontractors and customers is not reasonably quantifiable.
 
     The Company believes that the purchasing patterns of customers and
potential customers may be affected by Year 2000 issues. Many companies are
expending significant resources to correct or upgrade their current systems for
Year 2000 compliance. These expenditures may result in reduced funds available
to purchase testing products such as those offered by the Company. This could
have a material adverse effect upon the Company's business, operating results
and financial condition.
 
     The Company anticipates that generally throughout the computer industry
substantial litigation may be brought against software vendors of non-compliant
operating environments. The Company believes that any such claims against the
Company, with or without merit, could have a material adverse effect on the
Company's business, operating results and financial condition.
 
     The Company currently does not have any Year 2000 contingency plan. The
most significant aspect of any such plan would involve the ability of the
Company to identify alternative vendors if the need arose. The Company believes
it has that ability.
                                       30
<PAGE>   32
 
     The Company is not aware of any Year 2000 compliance problems relating to
its current products or its IT or non-IT systems that would have a material
adverse effect on the Company's business, results of operations and financial
condition. However, the Company may discover Year 2000 problems in its products
that will require substantial revisions. In addition, third-party software or
hardware incorporated into the Company's products and material IT and non-IT
systems may need to be revised or replaced, all of which could be time consuming
and expensive. If material Year 2000 problems are discovered, the failure of the
Company to fix its products or fix or replace third-party software, third party
software incorporated into its products and in its IT systems could result in
lost revenues, increased operating costs, the loss of customers and other
business interruptions, any of which could have a material adverse effect on the
Company's business, results of operations and financial conditions.
 
  Expenses Related to Year 2000 Compliance
 
     The total cost of the Year 2000 preparedness effort is funded through
operating cash flows and the Company is expensing these costs. The Company has
not established any specific reserves for these costs. The Company has not
incurred significant expense in becoming Year 2000 compliant as both the
majority of our product software and the infrastructure of our internal systems
were developed after the Year 2000 risks were realized. Future costs related to
Year 2000 compliance are not expected to have a material adverse effect on the
Company's results of operations or financial condition. However, the Company may
experience serious unanticipated negative consequences and/or material costs
caused by undetected errors or defects in the technology used in its internal
systems, which are composed predominantly of third party software and hardware
technology with embedded software, and the Company's own products.
 
NEW ACCOUNTING PRONOUNCEMENTS
 
     Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting
Comprehensive Income". In June 1997, the Financial Accounting Standards Board
(FASB) issued SFAS No. 130, effective for fiscal periods beginning after
December 15, 1997. The new standard requires that comprehensive income, which
includes net income as well as certain changes in assets and liabilities
recorded in common equity, be reported in the financial statements. The Company
adopted SFAS No. 130 during the year ended December 31, 1998. For the years
ended December 31, 1998, 1997, and 1996, there were no components of
comprehensive income other than net income.
 
     SFAS No. 131, "Disclosures about Segments of an Enterprise and Related
Information".  In 1998, the Company adopted SFAS No. 131, which requires a
"management" approach of disclosing segment information. The management approach
designates the internal organization that is used by management for making
operating decisions and assessing performance as the source of the Company's
reportable segments. SFAS No. 131 also requires disclosures about products and
services, geographic areas, and major customers. For the years ended December
31, 1998, 1997, and 1996, there was no impact on the Company's financial
statements.
 
     SFAS No. 132, "Employers' Disclosures about Pensions and Other
Postretirement Benefits".  In February 1998, the FASB issued SFAS No. 132 which
is effective for periods ending after December 15, 1998. The new standard
revises employers' disclosures about pensions and other postretirement benefits.
For the years ended December 31, 1998, 1997, and 1996, there was no impact on
the Company's financial statements.
 
     SFAS No. 133, "Accounting for Derivative Investments and Hedging
Activities".  SFAS No. 133 is effective for all fiscal quarters of fiscal years
beginning after June 15, 1999. This statement establishes accounting and
reporting standards for derivative instruments and hedging activities. The
Company does not currently maintain any derivative investments nor does it
conduct any hedging activities, therefore, SFAS No. 133 is not expected to
impact the Company.
 
ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
 
     Not applicable.
                                       31
<PAGE>   33
 
ITEM 8.  CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
     The consolidated financial statements of the Company are included in this
Report as pages 33 through 51.
 
<TABLE>
<CAPTION>
                                                              PAGE
                                                              ----
<S>                                                           <C>
Report of Independent Certified Public Accountants..........   33
Consolidated Balance Sheets.................................   34
Consolidated Statements of Operations.......................   35
Consolidated Statements of Stockholders' Equity (Deficit)...   36
Consolidated Statements of Cash Flows.......................   37
Notes to Consolidated Financial Statements..................   38
</TABLE>
 
                                       32
<PAGE>   34
 
               REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
 
To the Board of Directors and Stockholders of Digital Lightwave, Inc.
 
     In our opinion, the accompanying consolidated balance sheets and the
related consolidated statements of operations, stockholders' equity and cash
flows present fairly, in all material respects, the financial position of
Digital Lightwave, Inc. (the "Company") at December 31, 1998 and 1997, and the
results of its operations and its cash flows for each of the three years in the
period then ended December 31, 1998, in conformity with generally accepted
accounting principles. 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 of these
statements in accordance with generally accepted auditing standards which
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, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for the opinion expressed above.
 
                                          PRICEWATERHOUSECOOPERS LLP
 
Tampa, Florida
January 29, 1999, except for Note 16, as to
which the date is March 31, 1999
 
                                       33
<PAGE>   35
 
                            DIGITAL LIGHTWAVE, INC.
 
                          CONSOLIDATED BALANCE SHEETS
                       (IN THOUSANDS, EXCEPT SHARE DATA)
 
<TABLE>
<CAPTION>
                                                              DECEMBER 31,    DECEMBER 31,
                                                                  1998            1997
                                                              ------------    ------------
<S>                                                           <C>             <C>
                                          ASSETS
Current assets:
  Cash and cash equivalents.................................    $  3,848        $ 24,031
  Accounts receivable.......................................       7,152           4,780
  Inventories...............................................       5,476           8,120
  Prepaid expenses and other current assets.................         748             481
                                                                --------        --------
          Total current assets..............................      17,224          37,412
Property and equipment, net.................................       9,274           6,785
Other assets................................................       1,060             164
                                                                --------        --------
          Total assets......................................    $ 27,558        $ 44,361
                                                                ========        ========
                           LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Accounts payable and accrued liabilities..................    $  6,468        $  4,917
  Accrued settlement charges................................       8,489              --
                                                                --------        --------
          Total current liabilities.........................      14,957           4,917
Long-term liabilities.......................................         281              25
                                                                --------        --------
          Total liabilities.................................      15,238           4,942
                                                                --------        --------
Commitments and contingencies (Notes 7, 8, 10 and 15)
Stockholders' equity:
  Preferred stock, $.0001 par value; authorized 20,000,000
     shares; no shares issued or outstanding................          --              --
  Common stock, $.0001 par value; authorized 200,000,000
     shares; issued and outstanding 26,535,332 and
     26,440,878 shares, respectively........................           3               3
  Additional paid-in capital................................      57,927          55,201
  Accumulated deficit.......................................     (45,610)        (15,785)
                                                                --------        --------
          Total stockholders' equity........................      12,320          39,419
                                                                --------        --------
          Total liabilities and stockholders' equity........    $ 27,558        $ 44,361
                                                                ========        ========
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
                                       34
<PAGE>   36
 
                            DIGITAL LIGHTWAVE, INC.
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                (IN THOUSANDS, EXCEPT SHARE AND PER-SHARE DATA)
 
<TABLE>
<CAPTION>
                                                            FOR THE YEARS ENDED DECEMBER 31,
                                                         --------------------------------------
                                                            1998          1997          1996
                                                         ----------    ----------    ----------
<S>                                                      <C>           <C>           <C>
Sales..................................................  $   24,191    $    9,081    $    6,044
Cost of goods sold.....................................       9,219         3,124         2,079
                                                         ----------    ----------    ----------
Gross profit...........................................      14,972         5,957         3,965
                                                         ----------    ----------    ----------
Operating expenses:
  Engineering and development..........................      14,335         5,342         2,403
  Sales and marketing..................................      11,363         5,260         1,706
  General and administrative...........................       7,223         3,812         1,380
  Reorganization charges...............................       1,018            --            --
  Litigation settlement................................      11,500            --            --
                                                         ----------    ----------    ----------
          Total operating expenses.....................      45,439        14,414         5,489
                                                         ----------    ----------    ----------
Operating loss.........................................     (30,467)       (8,457)       (1,524)
                                                         ----------    ----------    ----------
Other income (expense):
  Interest income......................................         649         1,826           211
  Interest expense.....................................         (37)          (66)         (595)
  Other income (expense), net..........................          30             7          (200)
                                                         ----------    ----------    ----------
          Total other income (expense).................         642         1,767          (584)
                                                         ----------    ----------    ----------
Loss before income taxes...............................     (29,825)       (6,690)       (2,108)
Provision for income taxes.............................          --            --            --
                                                         ----------    ----------    ----------
          Net loss.....................................  $  (29,825)   $   (6,690)   $   (2,108)
                                                         ==========    ==========    ==========
Basic and diluted loss per share of common stock.......  $    (1.13)   $    (0.25)   $    (0.10)
                                                         ==========    ==========    ==========
  Weighted average common shares outstanding...........  26,475,749    26,084,208    21,829,235
                                                         ==========    ==========    ==========
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
                                       35
<PAGE>   37
 
                            DIGITAL LIGHTWAVE, INC.
 
           CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
              FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
                       (IN THOUSANDS, EXCEPT SHARE DATA)
 
<TABLE>
<CAPTION>
                                                                                   NOTE
                                  COMMON STOCK       ADDITIONAL                 RECEIVABLE
                               -------------------    PAID-IN     ACCUMULATED      FROM
                                 SHARES     AMOUNT    CAPITAL       DEFICIT     STOCKHOLDER    TOTAL
                               ----------   ------   ----------   -----------   -----------   --------
<S>                            <C>          <C>      <C>          <C>           <C>           <C>
Balance, January 1, 1996.....  20,000,000     $2      $   522      $ (6,987)      $(1,700)    $ (8,163)
Issuance of common stock in
  exchange for debt..........   1,013,924     --        4,820            --            --        4,820
Sale of common stock.........     221,992     --        2,602            --            --        2,602
Issuance of common stock upon
  exercise of stock
  options....................      31,334     --           39            --            --           39
Issuance of common upon
  exercise of warrants.......   1,251,667     --        6,259            --            --        6,259
          Net loss...........          --     --           --        (2,108)           --       (2,108)
                               ----------     --      -------      --------       -------     --------
Balance, December 31, 1996...  22,518,917      2       14,242        (9,095)       (1,700)       3,449
Issuance of common stock from
  Initial Public Offering,
  net........................   3,658,860      1       39,591            --            --       39,592
Issuance of common stock.....     263,101     --        1,368            --            --        1,368
Repayment of note receivable
  from stockholder...........          --     --           --            --         1,700        1,700
          Net loss...........          --     --           --        (6,690)           --       (6,690)
                               ----------     --      -------      --------       -------     --------
Balance, December 31, 1997...  26,440,878      3       55,201       (15,785)           --       39,419
Issuance of common stock.....      94,454     --          226            --            --          226
Settlement of Haney
  Litigation.................          --     --        2,500            --            --        2,500
          Net loss...........          --     --           --       (29,825)           --      (29,825)
                               ----------     --      -------      --------       -------     --------
Balance, December 31, 1998...  26,535,332     $3      $57,927      $(45,610)      $    --     $ 12,320
                               ==========     ==      =======      ========       =======     ========
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
                                       36
<PAGE>   38
 
                            DIGITAL LIGHTWAVE, INC.
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                              FOR THE YEARS ENDED DECEMBER 31,
                                                              ---------------------------------
                                                                1998         1997        1996
                                                              ---------    --------    --------
<S>                                                           <C>          <C>         <C>
Cash flows from operating activities:
  Net loss..................................................  $(29,825)    $(6,690)    $(2,108)
  Adjustments to reconcile net loss to cash used by
     operating activities:
     Interest expense converted to equity...................        --          --         205
     Depreciation and amortization..........................     2,254         778         204
     Loss on disposal of property...........................        33          --           8
     Litigation settlement..................................     9,925          --          --
  Changes in operating assets and liabilities:
     Increase in accounts receivable........................    (2,372)     (2,270)     (2,499)
     Decrease (increase) in inventories.....................     2,645      (7,270)       (228)
     Increase in prepaid expenses and other assets..........    (1,163)        (37)       (499)
     Increase in accounts payable and accrued liabilities...     1,386       2,647         479
     Decrease in other long-term liabilities................        --          --          (5)
     Increase in accrued settlement charges.................     1,064          --          --
                                                              --------     -------     -------
          Net cash used by operating activities.............   (16,053)    (12,842)     (4,443)
                                                              --------     -------     -------
Cash flows from investing activities:
  Purchases of property and equipment.......................    (4,381)     (5,994)       (635)
  Proceeds from sale of assets..............................        68          --          --
                                                              --------     -------     -------
          Net cash used by investing activities.............    (4,313)     (5,994)       (635)
                                                              --------     -------     -------
Cash flows from financing activities:
  Repayment of stockholder receivable.......................        --       1,700          --
  Proceeds from notes payable...............................        --          --       2,350
  Principal payments on notes payable.......................        --        (750)     (3,000)
  Principal payments on notes payable, related party........        --          --        (202)
  Principal payments, capital lease obligations.............       (43)       (208)       (195)
  Proceeds from sale of common stock, net of expense........       226      40,960          --
  Cash paid for common stock................................        --          --       7,218
                                                              --------     -------     -------
          Net cash provided by financing activities.........       183      41,702       6,171
                                                              --------     -------     -------
Net (decrease) increase in cash and cash equivalents........   (20,183)     22,866       1,093
Cash and cash equivalents at beginning of period............    24,031       1,165          72
                                                              --------     -------     -------
Cash and cash equivalents at end of period..................  $  3,848     $24,031     $ 1,165
                                                              ========     =======     =======
Other supplemental disclosures:
  Cash paid for interest....................................  $     37     $    66     $   547
Non-cash investing and financing activities:
  Capital lease obligations incurred........................  $    382     $    --     $   355
  Fixed asset additions included in accounts payable at year
     end....................................................        82         327          --
  Disposals of property and equipment.......................        --          --          18
  Notes payable converted to equity.........................        --          --       6,295
  Accounts receivable related to capital leases.............       847          --          --
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
                                       37
<PAGE>   39
 
                            DIGITAL LIGHTWAVE, INC.
 
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
 
GENERAL
 
     Digital Lightwave, Inc. (the "Company") was incorporated on October 12,
1990 in the state of California, and subsequently reincorporated in Delaware on
March 18, 1996 through a merger into a newly formed Delaware corporation. The
Company commenced business on February 15, 1991 and manufactures and sells
advanced computer systems that provide information concerning the performance of
fiberoptic (or "lightwave") telecommunications networks and transmission
equipment. The Company's major product, the ASA 312, is a portable
software-based network information computer that is lightweight, compact and
easily operated through a touch sensor over a full color display. The ASA 312
enables users to understand and process information, simultaneously and without
interruption, from telecommunications networks utilizing legacy T-Carrier
protocol, lightwave SONET protocol and lightwave ATM protocol. The Company sells
its products to InterExchange Carriers ("IXCs"), Regional Bell Operating
Companies ("RBOCs"), Competitive Access Providers ("CAPs"), independent
telephone companies, network equipment manufacturers, equipment leasing
companies and private network operators.
 
     On January 6, 1998, Digital Lightwave Leasing Corporation ("DLLC") was
incorporated in the State of Delaware. The Company commenced business
immediately and provides financing for the purchase of the Company's product in
the form of capital leases as well as equipment rental to the Company's
customers. DLLC is a wholly-owned subsidiary of the Company and all significant
intercompany transactions and balances are eliminated in consolidation.
 
CASH EQUIVALENTS
 
     The Company considers all highly liquid investments with an initial
maturity of three months or less to be cash equivalents.
 
INVENTORIES
 
     Inventories are stated at the lower of cost (first-in, first-out) or
market.
 
PROPERTY AND EQUIPMENT
 
     The Company's property and equipment, including certain assets under
capital leases, are stated at cost, less accumulated depreciation and
amortization. Depreciation and amortization are provided using the straight-line
method over estimated useful lives of 5 to 7 years, or over the lesser of the
term of the lease or the estimated useful life of assets under the capital
lease. Maintenance and repairs are expensed as incurred while renewals and
betterments are capitalized. Upon the sale or retirement of property and
equipment, the accounts are relieved of the cost and the related accumulated
depreciation and amortization, and any resulting gain or loss is included in the
results of operations.
 
ACCRUED WARRANTY
 
     The Company provides the customer a warranty with each product sold and
accrues warranty expense based upon a percentage of sales. Actual warranty costs
incurred are charged against the accrual when paid.
 
REVENUE RECOGNITION
 
     Revenue is recognized when a purchase order or contract has been received
from the customer, and the product has been shipped to the Company's customer
or, in the case of sales to a distributor, when the product is shipped to the
distributor's end user because distributors generally have a right of return on
any product that does not sell within time periods specified in the agreement
with the distributor. Returns from individual
 
                                       38
<PAGE>   40
                            DIGITAL LIGHTWAVE, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
customers are recorded as a reduction in sales during the period in which the
return was made. To date, the Company has not experienced a significant amount
of product returns.
 
     In addition, beginning January 1, 1998, revenue from the sale of the
Company's product is recognized in accordance with SOP 97-2, Software Revenue
Recognition. SOP 97-2 requires the total contract revenue to be allocated to the
various elements of the contract based upon objective evidence of the fair
values of such elements and allows for only the allocated revenue to be
recognized upon completion of those elements. The effect of the adoption of SOP
97-2 was not significant to the Company's results of operations for the year
ended December 31, 1998.
 
     Revenue representing interest income on leasing transactions is recognized
over the life of the lease as the payments become due.
 
DEFERRED REVENUE
 
     Deferred revenue, which represents amounts billed to customers in advance
of shipment or amounts billed to distributors prior to the distributors sale of
the goods, is recorded at the date of billing. Revenue is subsequently
recognized at the date of shipment or, in the case of distributor sales, at the
time the distributor ships the product to the end user.
 
RESEARCH AND DEVELOPMENT
 
     Software and product development costs are included in engineering and
development and are expensed as incurred. SFAS No. 86, "Accounting for the Costs
of Computer Software to be Sold, Leased, or Otherwise Marketed," requires the
capitalization of certain software development costs during the period following
the time that technological feasibility is established until general release of
the product to customers. The capitalized cost is then amortized over the
estimated product life. To date, the period between achieving technological
feasibility and the general release to customers has been short and, therefore,
software development costs qualifying for capitalization have been
insignificant.
 
INCOME TAXES
 
     The Company accounts for income taxes under Statement of Financial
Accounting Standards No. 109, "Accounting for Income Taxes," which requires
recognition of deferred tax liabilities and assets for the expected future tax
consequences of events that have been included in the consolidated financial
statements or tax returns. Under this method, deferred tax liabilities and
assets are determined based on the difference between the consolidated financial
statement and the tax bases of assets and liabilities using enacted tax rates in
effect for the year in which the differences are expected to reverse.
 
COMPUTATION OF NET LOSS PER SHARE
 
     Basic loss per share is based on the weighted average number of common
shares outstanding during the periods presented. For the years ended December
31, 1998 and 1997, diluted loss per share, which includes the effect of
incremental shares from common stock equivalents using the treasury stock
method, is not included in the calculation of net loss per share as the
inclusion of such equivalents would be anti-dilutive. The table
 
                                       39
<PAGE>   41
                            DIGITAL LIGHTWAVE, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
below shows the calculation of basic weighted average common shares outstanding
and the incremental number of shares arising from common stock equivalents under
the treasury stock method:
 
<TABLE>
<CAPTION>
                                            FOR THE YEAR ENDED DECEMBER 31,
                                        ---------------------------------------
                                           1998          1997           1996
                                        ----------    -----------    ----------
<S>                                     <C>           <C>            <C>
Basic:
  Weighted average common shares
     outstanding......................  26,475,749     26,084,208    21,375,584
                                        ----------    -----------    ----------
          Total basic.................  26,475,749     26,084,208    21,375,584
Diluted:
  Incremental shares for common stock
     equivalents......................      18,690*       976,013*      453,651
                                        ----------    -----------    ----------
          Total dilutive..............  26,494,439     27,060,221    21,829,235
                                        ==========    ===========    ==========
</TABLE>
 
           * not included in loss per share calculations due to anti-dilutive
             effect
 
     Pursuant to the requirements of the Securities and Exchange Commission,
common stock, stock options and warrants issued by the Company during the twelve
months immediately preceding the Initial Public Offering date have been included
in the calculation of the weighted average shares outstanding for the year ended
December 31, 1996 using the treasury stock method based on the Initial Public
Offering price. Accordingly, weighted average common shares includes 1,375,584
of common stock equivalent shares issued during the year ended December 31, 1996
shown as outstanding. Incremental shares for common stock equivalents includes
453,651 common stock equivalent shares for options issued during the year ended
December 31, 1996.
 
CONCENTRATIONS OF CREDIT RISK
 
     Financial instruments that potentially subject the Company to
concentrations of credit risk consist principally of cash and cash equivalents
and receivables. As of December 31, 1998, 1997 and 1996, substantially all of
the Company's cash balances, including amounts representing outstanding checks,
were deposited with what management believes to be high quality financial
institutions. During the normal course of business, the Company extends credit
to customers conducting business primarily in the telecommunications industry
both within the United States and internationally.
 
USE OF ESTIMATES
 
     The preparation of consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements. Estimates also affect the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
 
NEW ACCOUNTING PRONOUNCEMENTS
 
     Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting
Comprehensive Income". In June 1997, the Financial Accounting Standards Board
(FASB) issued SFAS No. 130, effective for fiscal periods beginning after
December 15, 1997. The new standard requires that comprehensive income, which
includes net income as well as certain changes in assets and liabilities
recorded in common equity, be reported in the financial statements. The Company
adopted SFAS No. 130 during the year ended December 31, 1998. For the years
ended December 31, 1998, 1997, and 1996, there were no components of
comprehensive income other than net income.
 
                                       40
<PAGE>   42
                            DIGITAL LIGHTWAVE, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
     SFAS No. 131, "Disclosures about Segments of an Enterprise and Related
Information".  In 1998, the Company adopted SFAS No. 131, which requires a
"management" approach of disclosing segment information. The management approach
designates the internal organization that is used by management for making
operating decisions and assessing performance as the source of the Company's
reportable segments. SFAS No. 131 also requires disclosures about products and
services, geographic areas, and major customers. For the years ended December
31, 1998, 1997, and 1996, there was no impact on the Company's financial
statements.
 
     SFAS No. 132, "Employers' Disclosures about Pensions and Other
Postretirement Benefits".  In February 1998, the FASB issued SFAS No. 132 which
is effective for periods ending after December 15, 1998. The new standard
revises employers' disclosures about pensions and other postretirement benefits.
For the years ended December 31, 1998, 1997, and 1996, there was no impact on
the Company's financial statements.
 
     SFAS No. 133, "Accounting for Derivative Investments and Hedging
Activities".  SFAS No. 133 is effective for all fiscal quarters of fiscal years
beginning after June 15, 1999. This statement establishes accounting and
reporting standards for derivative instruments and hedging activities. The
Company does not currently maintain any derivative investments nor does it
conduct any hedging activities, therefore, SFAS No. 133 is not expected to
impact the Company.
 
RECLASSIFICATIONS
 
     Certain prior year amounts have been reclassified to conform with the 1998
presentation.
 
2.  INVENTORIES
 
     Inventories at December 31, 1998 and 1997 are summarized as follows:
 
<TABLE>
<CAPTION>
                                                              1998      1997
                                                             ------    ------
                                                              (IN THOUSANDS)
<S>                                                          <C>       <C>
Raw materials..............................................  $2,166    $1,266
Work-in progress...........................................   1,443     1,875
Finished goods.............................................   1,867     4,979
                                                             ------    ------
                                                             $5,476    $8,120
                                                             ======    ======
</TABLE>
 
3.  PROPERTY AND EQUIPMENT
 
     Property and equipment at December 31, 1998 and 1997 are summarized as
follows:
 
<TABLE>
<CAPTION>
                                                            1998       1997
                                                           -------    -------
                                                             (IN THOUSANDS)
<S>                                                        <C>        <C>
Test equipment...........................................  $ 4,418    $ 2,569
Computer equipment and software..........................    3,555      2,895
Tooling..................................................      487        455
Tradeshow fixtures and equipment.........................      242         59
Office furniture, fixtures and equipment.................    2,255      1,381
Leasehold improvements...................................    1,214        582
                                                           -------    -------
                                                            12,171      7,941
Less accumulated depreciation............................   (2,897)    (1,156)
                                                           -------    -------
                                                           $ 9,274    $ 6,785
                                                           =======    =======
</TABLE>
 
                                       41
<PAGE>   43
                            DIGITAL LIGHTWAVE, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
     Equipment under capital lease and related accumulated amortization,
included above at December 31, 1998 and 1997 are summarized as follows:
 
<TABLE>
<CAPTION>
                                                              1998     1997
                                                              -----    -----
                                                              (IN THOUSANDS)
<S>                                                           <C>      <C>
Test equipment..............................................  $425     $ 75
Computer equipment and software.............................   117       37
                                                              ----     ----
                                                               542      112
Less accumulated amortization...............................   (96)     (39)
                                                              ----     ----
                                                              $446     $ 73
                                                              ====     ====
</TABLE>
 
4.  ACCOUNTS PAYABLE AND ACCRUED LIABILITIES
 
     Accounts payable and accrued liabilities at December 31, 1998 and 1997 are
summarized as follows:
 
<TABLE>
<CAPTION>
                                                              1998      1997
                                                             ------    ------
                                                              (IN THOUSANDS)
<S>                                                          <C>       <C>
Accounts payable...........................................  $3,594    $3,541
Deferred revenue...........................................     124       765
Current portion of capital lease obligations...............     153        42
Accrued expenses and other.................................   2,597       569
                                                             ------    ------
                                                             $6,468    $4,917
                                                             ======    ======
</TABLE>
 
5.  INCOME TAXES
 
     The tax effected amounts of temporary differences at December 31, 1998 and
1997 are summarized as follows:
 
<TABLE>
<CAPTION>
                                                            1998       1997
                                                          --------    -------
                                                            (IN THOUSANDS)
<S>                                                       <C>         <C>
Current:
  Deferred tax asset:
     Deferred compensation..............................  $     64    $    33
     Accrued liabilities................................     3,194         --
     Other..............................................       774        408
     Valuation allowance................................    (3,869)      (418)
                                                          --------    -------
          Total current deferred tax asset..............       163         23
                                                          --------    -------
          Net current deferred tax asset................  $    163    $    23
                                                          --------    -------
Non-current:
  Deferred tax asset:
     Net operating loss carry forward...................  $ 14,686    $ 5,628
     Other..............................................        --         --
     Research and experimentation credit................       549        142
     Valuation allowance................................   (14,621)    (5,464)
                                                          --------    -------
          Total non-current deferred tax asset..........       614        306
                                                          --------    -------
</TABLE>
 
                                       42
<PAGE>   44
                            DIGITAL LIGHTWAVE, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
<TABLE>
<CAPTION>
                                                            1998       1997
                                                          --------    -------
                                                            (IN THOUSANDS)
<S>                                                       <C>         <C>
Deferred tax liability:
  Property related......................................  $   (777)   $  (329)
                                                          --------    -------
          Total non-current deferred tax liability......      (777)      (329)
                                                          --------    -------
          Net deferred tax asset........................  $      0    $     0
                                                          ========    =======
</TABLE>
 
     Management believes that it is more likely than not that the tax benefit
associated with these deferred tax assets will not be realized and, therefore as
of December 31, 1998, the Company has established a valuation allowance of
approximately $18.5 million. The result is an increase in the valuation
allowance from December 31, 1997 of approximately $12.6 million.
 
     As of December 31, 1998, the Company had net operating loss carry forwards
of approximately $39.0 million for tax purposes. Due to certain change of
ownership requirements of Section 382 of the Internal Revenue Code ("IRC"),
utilization of the Company's net operating losses incurred prior to July 1, 1993
is expected to be limited to approximately $7,500 per year. This limitation in
conjunction with the expiration period for these pre-July 1, 1993 net operating
losses results in the Company's total net operating losses available being
limited to approximately $38.2 million. Loss carry forwards will expire between
the years 2008 and 2018.
 
     As of December 31, 1998, the Company also had general business credit carry
forwards of approximately $500,000 which expire between the years 2008 and 2011.
These credits are also subject to the Section 382 annual limitation.
Approximately $15,000 of these credits are subject to the Section 382 annual
limitation.
 
     Following is a reconciliation of the applicable federal income tax as
computed at the federal statutory tax rate to the actual income taxes reflected
in the statement of operations.
 
<TABLE>
<CAPTION>
                                                 FOR THE YEAR ENDED DECEMBER 31,
                                                 -------------------------------
                                                   1998         1997       1996
                                                 ---------    --------    ------
                                                         (IN THOUSANDS)
<S>                                              <C>          <C>         <C>
Tax benefit at U.S. Federal income tax rate....  $(10,140)    $(2,275)    $(717)
State income tax benefit, net of Federal.......    (1,083)       (243)      (76)
Other, net.....................................      (979)       (410)        6
Valuation allowance increase...................    12,609       2,928       787
Research and experimentation credit............      (407)         --        --
                                                 --------     -------     -----
Provision for income taxes.....................  $      0     $     0     $   0
                                                 ========     =======     =====
</TABLE>
 
6.  NOTES PAYABLE
 
     On February 28, 1997 the Company repaid all notes payable with proceeds
from the Initial Public Offering. At December 31, 1996 notes payable amounted to
$750,000. This note was unsecured, subordinated to all secured debt and any
future lines of credit up to $2 million, bore interest at 18% per annum with
interest due and payable August 30, 1996, November 30, 1996, February 29, 1997
and May 31, 1997.
 
                                       43
<PAGE>   45
                            DIGITAL LIGHTWAVE, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
7.  LEASES
 
     The Company is obligated under various non-cancelable leases for equipment
and office space. Future minimum lease commitments under operating and capital
leases were as follows as of December 31, 1998:
 
<TABLE>
<CAPTION>
                                                            CAPITAL    OPERATING
                                                            LEASES      LEASES
                                                            -------    ---------
                                                               (IN THOUSANDS)
<S>                                                         <C>        <C>
1999......................................................   $196       $ 1,891
2000......................................................    169         2,314
2001......................................................    110         2,291
2002......................................................     --         2,314
2003......................................................     --         2,314
Thereafter................................................     --        13,006
                                                             ----       -------
                                                              475       $24,130
                                                                        -------
Less: Amount representing interest........................     69
                                                             ----
Present value of minimum lease payments...................    406
Less: Current portion.....................................    155
                                                             ----
                                                             $251
                                                             ====
</TABLE>
 
     Total rental expense was approximately $1,162,900, $506,000 and $241,500
for the years ended December 31, 1998, 1997, and 1996, respectively.
 
8.  COMMITMENTS
 
     At December 31, 1998, the Company had outstanding purchase order
commitments to purchase certain inventory items totaling approximately $2.5
million.
 
     On January 13, 1998 the Company entered into a ten year lease agreement,
which was amended on February 18, 1998, for a three story office building with
92,225 square feet of rentable space. The building was completed in November
1998 and the Company relocated certain of its operations to the building on
November 30, 1998. The Company is currently leasing 67% of the rentable space at
a cost of $13.43 per square foot per annum in base rent and $5.38 per square
foot per annum in operating expenses. At the beginning of year two, the rental
costs will increase to $14.175 and $6.00 for base rent and operating expenses,
respectively. Thereafter, the rental costs shall increase by 2.5% per lease
year.
 
     The Company was required to pay a tenant improvement allowance of $900,000
during 1998. The allowance is held in escrow by the landlord to secure the
Company's obligations under the lease. The Company has an option to terminate
the lease at the conclusion of the seventh lease year. Such option, if
exercised, will invoke a termination fee of $1,941,749 plus six months of
estimated operating expenses. The Company also has an option to purchase the
building for approximately $14.5 million which may be exercised at any time
during the initial lease term and will require a $300,000 deposit when notice to
exercise is given.
 
     As required by the lease agreement, the Company has put in place a standby
letter of credit to the benefit of the landlord in the amount of $2,300,000,
which is collateralized by a three month certificate of deposit with a financial
institution. The lease agreement calls for a declining letter of credit over the
life of the lease.
 
     In accordance with the terms of the lease, the Landlord also issued a
letter of credit to the benefit of the Company in the amount of $1,000,000,
which secured the landlord's performance obligations under the lease and was
terminated upon occupancy.
 
                                       44
<PAGE>   46
                            DIGITAL LIGHTWAVE, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
     The Company entered into an accounts receivable agreement dated December
28, 1998 with EAB Leasing Corp. ("EAB") providing for the sale of the Company's
accounts receivable to EAB. The aggregate maximum amount the Company can borrow
at one time under this agreement is $2.9 million through June 28, 1999, with a
maximum of $2.0 million available on a monthly basis. In connection with this
agreement, the Company has granted EAB a security interest in its accounts,
accounts receivables, contract rights, equipment, chattel paper, general
intangibles, instruments, inventory and all proceeds of the foregoing. The
annual interest rate equivalent charged to the Company under this agreement is
the prime rate plus 1.5%. The agreement also provides that the Company pay a
minimum monthly service fee in the amount of $10,000. As of December 31, 1998,
no sales had been made under this agreement.
 
9.  RELATED PARTY TRANSACTIONS
 
     During December 1995, a stockholder borrowed $1,700,000 from the Company.
This note accrued interest at 9% with interest payments due monthly. The
principal sum and accrued interest thereon was repaid by the stockholder in
September 1997. The accompanying consolidated financial statements include the
note as a decrease in stockholders' equity, as well as accrued interest of
approximately $31,300 as of December 31, 1996.
 
     During December 1998, a stockholder borrowed $100,000 from the Company.
This note is accruing interest at 9% with the principal sum and accrued interest
thereon payable no later than December 31, 1999.
 
     In 1998, a director received $12,750 for services performed as a consultant
to the Company.
 
10.  COMMON STOCK, STOCK OPTIONS, AND WARRANTS
 
STOCK OPTIONS
 
     During 1995, the Company entered into option agreements with certain
parties to purchase an aggregate of up to 701,000 shares of common stock at the
price to the public per share, in the event of an initial public offering of
common stock of the Company, at an aggregate purchase price equal to $154,500.
The Company subsequently terminated several agreements which reduced the
aggregate shares subject to such options to 470,000, at an aggregate price equal
to $39,000. The options were exercised during July, 1996.
 
SUBORDINATED NOTE
 
     On January 2, 1996, the Company issued (i) its 16% Subordinated Promissory
Note due January 2, 1999 in the original principal amount of $1 million, and
(ii) warrants to purchase 200,000 shares of Common Stock at an exercise price of
$5.00 per share. The warrants terminate on the earlier to occur of: (i) thirty
(30) days following the filing of a registration statement for an underwritten
initial public offering of the Common Stock of the Company, (ii) thirty (30)
days following an announcement of a change in control of the Company; or (iii)
January 2, 1999. On August 27, 1996, the noteholder surrendered the Subordinated
Promissory Note in exercise of the warrants.
 
CORPORATE MERGER
 
     Pursuant to an Agreement and Plan of Merger (the Merger) dated January 9,
1996, Digital Lightwave, Inc., a California corporation merged into Digital
Lightwave, Inc., a Delaware corporation effective March 18, 1996. The merger
increased the number of shares of common stock authorized from 1,000,000, no par
value, to 80,000,000, $.0001 par value. In connection with the merger, the
Company also authorized 20,000,000 shares of $.0001 par value preferred stock.
Each share of outstanding common stock of the California corporation was
converted into 3,921.5686 shares of common stock of the Delaware corporation.
All applicable share and per share amounts in the accompanying consolidated
financial statements have been retroactively adjusted to reflect these events.
 
                                       45
<PAGE>   47
                            DIGITAL LIGHTWAVE, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
     Effective July 25, 1996, the Board of Directors authorized an increase in
the number of authorized shares of common stock from 80,000,000 shares to
200,000,000 shares.
 
EMPLOYEE STOCK OPTION PLAN
 
     The Company's 1996 Stock Option Plan (the "Option Plan") became effective
on March 5, 1996. A reserve of 5,000,000 shares of the Company's Common Stock
has been established for issuance under the Option Plan. Transactions related to
the Option Plan during 1998, 1997 and 1996 are summarized as follows:
 
<TABLE>
<CAPTION>
                                                                WEIGHTED AVERAGE
                                                    SHARES        OPTION PRICE
                                                  ----------    ----------------
<S>                                               <C>           <C>
Outstanding at 1/1/96...........................          --            --
  Granted.......................................   1,250,037         $5.17
  Exercised.....................................          --            --
  Forfeited.....................................     (80,540)         5.24
                                                  ----------
Outstanding at 12/31/96.........................   1,169,497          5.16
  Granted.......................................   1,221,015          8.72
  Exercised.....................................    (257,843)         5.03
  Forfeited.....................................     (81,884)         5.37
                                                  ----------
Outstanding at 12/31/97.........................   2,050,785          7.29
  Granted.......................................   2,362,643          3.62
  Exercised.....................................          --            --
  Forfeited.....................................  (1,723,282)         7.39
                                                  ----------         -----
Outstanding at 12/31/98.........................   2,690,146         $3.98
                                                  ==========         =====
</TABLE>
 
     The following table summarizes information about stock options outstanding
to employees and directors at December 31, 1998:
 
<TABLE>
<CAPTION>
                                           NUMBER                           NUMBER
                                         OUTSTANDING       WEIGHTED       EXERCISABLE
                                             AT            AVERAGE            AT
EXERCISE PRICE PER SHARE                  12/31/98      REMAINING LIFE     12/31/98
------------------------                 -----------    --------------    -----------
<S>                                      <C>            <C>               <C>
     $2.3130...........................    600,000           6.00                 0
      2.5630...........................    478,616           5.97                 0
      4.4375...........................    320,800           5.38            75,000
      4.6875...........................    666,230           5.23            50,000
       5.000...........................    117,083           3.18            69,296
       5.250...........................    423,487           4.73           163,666
       7.250...........................     25,000           7.10             8,333
       9.000...........................     50,000           7.10            16,666
      13.125...........................      8,930           4.78             2,972
</TABLE>
 
     All options issued vest in one-third increments over a three year period,
with the exception of three option agreements which provide for various vesting
schedules throughout the same three-year vesting period. Option agreements
generally expire six years from date of issue if not exercised. Unvested options
are generally forfeited upon termination of employment with the Company. Total
shares exercisable were 385,933, 421,566 and 0 as of December 31, 1998, 1997 and
1996, respectively.
 
                                       46
<PAGE>   48
                            DIGITAL LIGHTWAVE, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
EMPLOYEE STOCK PURCHASE PLAN
 
     The Company's 1997 Employee Stock Purchase Plan became effective on August
25, 1997 in order to provide employees with the opportunity to purchase shares
of the Company's Common Stock. An aggregate of 300,000 shares of the Company's
Common Stock was reserved for issuance under the Plan. At December 31, 1998 a
total of 99,712 shares had been purchased by employees participating in the plan
at a weighted average price per share of $2.98.
 
     In 1995, the Financial Accounting Standards Board issued FAS 123,
"Accounting for Stock -- Based Compensation" ("FAS 123"), effective for fiscal
years beginning after December 15, 1995. The Company continues to apply the
prior accounting rules under "APB No. 25, Accounting for Stock Issued to
Employees," in recognizing expense for stock-based compensation, and therefore,
no compensation expense has been recognized for the stock options granted under
the Option Plan. Had compensation cost for the Company's stock options granted
been determined based on the Black-Scholes option pricing model at the date of
grant, consistent with the method of FAS 123, the Company's net loss and loss
per share would have been increased to the pro forma amounts shown below:
 
<TABLE>
<CAPTION>
                                                 1998       1997       1996
                                               --------    -------    -------
                                                       (IN THOUSANDS)
<S>                                            <C>         <C>        <C>
Pro forma net loss:
  As reported................................  $(29,825)   $(6,690)   $(2,108)
  As adjusted (unaudited)....................   (35,502)    (8,769)    (3,417)
Pro forma basic loss per share:
  As reported................................  $  (1.13)   $ (0.25)   $ (0.10)
  As adjusted (unaudited)....................     (1.34)     (0.34)     (0.16)
</TABLE>
 
     No options were granted prior to 1996.
 
     These pro forma amounts were determined using the Black-Scholes valuation
model with the following key assumptions: (a) a discount rate of 4.86%, 5.84%,
and 6.00% for December 31, 1998, 1997 and 1996, respectively; (b) a volatility
factor based upon the week ending price for comparable public companies for
periods matching the terms of the options granted; (c) an average expected
option life of 4.0, 4.2 and 5.0 years for December 31, 1998, 1997 and 1996,
respectively; (d) there have been no options that have expired; and (e) no
payment of dividends.
 
SUBSCRIPTION AGREEMENTS
 
     During 1995, the Company entered into subscription agreements (the
Agreements) with certain noteholders for the issuance of an aggregate of 782,898
shares of common stock for the surrender of the outstanding balance on the notes
(excluding certain accrued interest) of an aggregate of $4,074,000. Pursuant to
the Agreements, the Company issued warrants to purchase 1,050,000 and 18,747
shares of common stock at an exercise price of $5.00 and $9.00 per share,
respectively. The warrants expire on the earlier of: (i) three years from their
respective dates of issuance; (ii) thirty (30) days following the filing of a
registration statement for an underwritten initial public offering of the common
stock of the Company; or (iii) a change of control of the Company. During the
year ended December 31, 1996, 1,050,000 and 1,667 shares of Common Stock were
issued upon the exercise of warrants at a price of $5.00 and $9.00 per share,
respectively. The remaining 17,080 warrants expired in connection with the
initial public offering. See Note 13. On May 29, 1996, the Company entered into
a subscription agreement with an institutional investor for the issuance of
66,667 shares of common stock at a price of $18.00 per share. In the event that
on or before May 23, 1997 the Company completed an Initial Public Offering of
its Common Stock, then the price of the shares would be adjusted by: (i) payment
by the stockholder to the Company in the amount equal to the excess, if any,
over $18.00 per share of the price to the public per share times 75% (the 75%
price), or by (ii) a payment by the
 
                                       47
<PAGE>   49
                            DIGITAL LIGHTWAVE, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
Company to the stockholder equal to the excess, if any, of $18.00 per share over
the 75% price. The Company recorded a liability of $400,000 as of December 31,
1996, based upon management's estimate of the expected payment to the
institutional investor. In February 1997 the Company completed its Initial
Public Offering at a price of $12.00 per share. Accordingly, the Company has
made payment to the institutional investor as required by the terms of the
subscription agreement.
 
PRIVATE PLACEMENT
 
     During the period March 13, 1996 through April 30, 1996, the Company sold
155,326 shares of Common Stock, par value $.0001 per share, at a price of $9.00
per share.
 
REVERSE SPLIT
 
     Effective October 31, 1996, the Company effected a two-for-three reverse
split of its outstanding Common Stock. All share amounts included herein have
been adjusted to give historical effect to such reverse split for all periods
presented.
 
11.  DEFINED CONTRIBUTION PLAN
 
     During 1997, the Company implemented a defined contribution plan which
qualifies under IRC section 401(k). All full-time employees are eligible to
participate in the plan after three months of service with the Company.
Employees may contribute up to 15% of their salary to the plan, subject to
certain Internal Revenue Service limitations. The Company matches the first 6%
of such voluntary contributions at 50% of the amount contributed by the
employee. The Company does not make unmatched contributions. For the years ended
December 31, 1998 and 1997, total Company contributions to the plan were
approximately $141,000 and $27,000, respectively.
 
12.  SIGNIFICANT CUSTOMERS
 
     For the year ended December 31, 1998, the Company's four largest customers
accounted for approximately 57% of total revenues, with Qwest, MCI WorldCom,
Tellabs, and GTE accounting for approximately 17%, 16%, 13%, and 11% of total
sales, respectively. For the year ended December 31, 1997, sales to the
Company's five largest customers comprised 69% of its total revenues, with
WorldCom, Inc. (prior to its acquisition of MCI Communications Corporation) and
its subsidiaries accounting for 42% of total sales. For the year ended December
31, 1996, the Company's five largest customers accounted for approximately 62%
of total revenues, with MCI Communications Corporation (prior to its acquisition
by WorldCom, Inc.), Ameritech Corporation and Pacific Telesis Group accounting
for 23%, 19% and 15% of total sales, respectively. No other customers accounted
for sales of 10% or more during such periods.
 
13.  INITIAL PUBLIC OFFERING
 
     Effective February 5, 1997, the Company sold 3,658,860 shares of common
stock, $.0001 par value, in connection with an Initial Public Offering. Gross
proceeds to the Company approximated $40,800,000.
 
14.  REORGANIZATION CHARGES
 
     In order to reduce costs and improve operating efficiencies, the Company
began streamlining its management and operating structure in February 1998 and
eliminated 20 full-time positions resulting in a one-time charge to earnings of
$1.0 million in connection with this restructuring. Additionally, the Company
eliminated 55 full-time positions in August 1998 which did not result in a
significant charge to earnings. Notes and related interest receivable from
employees terminated in the restructurings totaling approximately $280,000 were
forgiven and are included in the $1.0 million restructuring charge.
 
                                       48
<PAGE>   50
                            DIGITAL LIGHTWAVE, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
15.  LEGAL PROCEEDINGS
 
     As of April 9, 1998, 23 class action complaints (which were subsequently
consolidated into a single action) for violations of the Federal Securities Laws
during certain periods in 1997 and 1998 had been filed in the United States
District Court for the Middle District of Florida, on behalf of purchasers of
our Common Stock. The complaints named as defendants the Company, Bryan J. Zwan,
the Company's Chairman, Steven H. Grant, the Company's Executive Vice President,
Finance, Chief Financial Officer and Secretary, and other former corporate
officers. The complaints allege that the Company and certain officers during the
relevant time period violated Sections 10(b) and 20(a) of the Securities
Exchange Act by, among other things, issuing to the investing public false and
misleading financial statements and press releases concerning the Company's
revenues, income and earnings, which artificially inflated the price of our
Common Stock.
 
     On July 23, 1998, the Company entered into a memorandum of understanding
for the settlement of these class action complaints. In late October 1998, a
Stipulation of Settlement was filed with the court and on December 21, 1998, the
court preliminarily approved the settlement. The settlement is still subject to
final approval by the court. The preliminarily approved settlement consists of
$4.26 million in cash, to be paid to plaintiffs primarily by a claim on the
Company's directors and officers liability insurance policy, and the issuance of
up to 1.8 million shares of Common Stock. The Company recorded a one-time charge
of $8.5 million during 1998 as a result of the preliminarily approved
settlement.
 
     On November 5, 1997, Hugh Brian Haney ("Plaintiff") commenced an action in
the United States District Court for the Southern District of Ohio against Bryan
J. Zwan, the Company's Chairman of the Board and then Chief Executive Officer,
and the Company ("Defendants"). An amended complaint filed December 15, 1997
alleged violations of Section 10(b) of the Securities Exchange Act, violations
of state corporation statutes, and various common law violations by Defendants
in connection with Plaintiff's sale to the Company's predecessor in November
1995, pursuant to a previously granted option exercisable by Zwan and/or the
Company's predecessor, of 4,900 shares of stock in the Company's predecessor, an
amount equivalent to 19,215,686 shares of the Company's common stock. The
amended complaint sought, among other things, (1) rescission of the sale of the
shares transferred by Plaintiff and (2) damages of $235 million, together with
interest. On October 20, 1998, the Company and Zwan entered into an agreement
with Plaintiff to settle the action. The settlement agreement provides, among
other things, for dismissal of the action with prejudice, for a $500,000 payment
by the Company to Plaintiff for his attorneys' fees and grants Plaintiff an
option, for 10 years, to purchase for $1 per share 2 million shares of Zwan's
stock in the Company. Pursuant to that agreement, the action was dismissed with
prejudice on November 13, 1998. The Company recorded a $3.0 million charge to
earnings consisting of the cash payment and the valuation of the options upon
settlement.
 
     The Company from time to time is involved in lawsuits arising in the
ordinary course of business. With respect to these matters, management believes
that it has adequate legal defenses and/or provided adequate accruals for
related costs. The Company is not aware of any additional lawsuits that were
pending that could have a material adverse effect on the Company's business,
financial condition and results of operations.
 
16.  SUBSEQUENT EVENTS
 
     On March 12, 1999, the United States District Court for the Middle District
of Florida indicated that it would grant final approval of the settlement of the
class action complaints discussed at Note 15 -- Legal Proceedings. The
settlement is subject to appeal.
 
     On March 31, 1999, the Company entered into a financing agreement with
certain investors pursuant to which the Company has agreed to issue $3.0 million
of 9% Secured Bridge Notes due January 17, 2000. These notes will be
collateralized by all of the Company's assets and will be subordinated to the
accounts receivable agreement with EAB (see Note 8 -- Commitments) and the
proposed line of credit agreement with
 
                                       49
<PAGE>   51
                            DIGITAL LIGHTWAVE, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
Emergent Business Capital described in the following paragraph. In connection
with the financing agreement, the Company agreed to issue warrants to purchase
an aggregate of 550,000 shares of the Company's common stock at an exercise
price of $2.75 per share, the market price of the stock on the date prior to the
issuance of the warrants. The warrants will have a term of five years from the
date of issuance. The Company has agreed to register the warrants and the common
stock issuable upon exercise thereof under the Securities Act of 1933.
 
     On March 31, 1999, the Company entered into a Letter of Commitment with
Emergent Business Capital pursuant to which Emergent Business Capital would
provide the Company with a $5.0 million line of credit (the "Emergent Line of
Credit"). Under the Emergent Line of Credit, the Company would be entitled to
borrow up to $5.0 million, subject to certain borrowing limitations based on
amounts of the Company's accounts receivable and other assets. The Emergent Line
of Credit will have a term of two years. All indebtedness outstanding under the
Emergent Line of Credit Agreement will be collateralized by substantially all of
the Company's assets.
 
17.  QUARTERLY OPERATING RESULTS (UNAUDITED)
 
     The following table presents unaudited quarterly operating results for each
of the last eight quarters. This information has been prepared by the Company on
a basis consistent with the Company's consolidated financial statements and
includes all adjustments, consisting only of normal recurring accruals, in
accordance with generally accepted accounting principles. Such quarterly results
are not necessarily indicative of future operating results.
 
     On January 22, 1998, the Company issued a press release and related Form
8-K indicating that the Company would restate its financial results for quarters
ending June 30, 1997 and September 30, 1997, respectively. The table below gives
effect to such restatement:
 
<TABLE>
<CAPTION>
                                                           QUARTER ENDED
                                      --------------------------------------------------------
                                       MARCH 31,     JUNE 30,     SEPTEMBER 30,   DECEMBER 31,
                                         1998          1998           1998            1998
                                      -----------   -----------   -------------   ------------
                                               (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                   <C>           <C>           <C>             <C>
Sales...............................  $     5,432   $     3,517    $     6,915    $     8,327
Gross Profit........................        3,329         2,183          4,295          5,165
Operating loss......................       (4,839)      (14,747)        (4,617)        (6,264)
Net loss............................       (4,560)      (14,580)        (4,515)        (6,169)
Loss per share(1)...................         (.17)         (.55)          (.17)          (.23)
Weighted average shares
  outstanding.......................   26,441,775    26,461,151     26,484,670     26,512,397
</TABLE>
 
<TABLE>
<CAPTION>
                                                           QUARTER ENDED
                                      --------------------------------------------------------
                                       MARCH 31,     JUNE 30,     SEPTEMBER 30,   DECEMBER 31,
                                         1997          1997           1997            1997
                                      -----------   -----------   -------------   ------------
                                               (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                   <C>           <C>           <C>             <C>
Sales...............................  $     1,498   $     2,601    $     1,240    $     3,742
Gross Profit........................          931         1,806            814          2,406
Operating loss......................       (1,605)       (1,116)        (3,126)        (2,610)
Net loss............................       (1,312)         (577)        (2,615)        (2,186)
Loss per share(1)...................         (.05)         (.02)          (.10)          (.08)
Weighted average shares
  outstanding.......................   24,754,887    26,321,990     26,374,388     27,596,955
</TABLE>
 
---------------
(1) Earnings per share were calculated for each three month and twelve month
    period on a stand-alone basis.
 
     It is anticipated that as the Company matures, the Company's sales and
operating results may fluctuate from quarter-to-quarter and from year-to-year
due to a combination of factors, certain of which are outside the
 
                                       50
<PAGE>   52
                            DIGITAL LIGHTWAVE, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
control of the Company, including, among others (i) the timing and amount of
significant orders from the Company's customers, (ii) the ability to obtain
sufficient supplies of sole or limited source components for the Company's
products, (iii) the ability to attain and maintain production volumes and
quality levels for its products, (iv) the mix of distribution channels and
products, (v) new product introductions by the Company's competitors, (vi) the
Company's success in developing, introducing and shipping product enhancements
and new products, (vii) pricing actions by the Company or its competitors,
(viii) changes in material costs and (ix) general economic conditions. Any
unfavorable changes in these or other factors could have a material adverse
effect on the Company's business, financial condition and results of operations.
The Company does not anticipate that its backlog at the beginning of each
quarter will be sufficient to achieve expected revenue for that quarter. To
achieve its revenue objectives, the Company expects that it will have to obtain
orders during a quarter for shipment in that quarter. As a result of all of the
foregoing, there can be no assurance that the Company will be able to sustain
profitability on a quarterly or annual basis. See "Item 1. Factors That May
Affect Operating Results -- We experience fluctuations in our operating results
and our sales are seasonal."
 
                                       51
<PAGE>   53
 
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE
 
     None.
 
                                    PART III
 
ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
EXECUTIVE OFFICERS AND DIRECTORS
 
     The executive officers and directors of the Company and their ages as of
the date of this report are as follows:
 
<TABLE>
<CAPTION>
NAME                                        AGE                         POSITION
----                                        ---                         --------
<S>                                         <C>   <C>
Dr. Bryan J. Zwan.........................  51    Chairman of the Board
Gerry Chastelet...........................  52    President and Chief Executive Officer and Director
Steven H. Grant...........................  39    Executive Vice President, Finance, Chief Financial
                                                  Officer and Secretary
George Matz...............................  49    Executive Vice President and General Manager,
                                                  Network Products
Ali Haider................................  48    Senior Vice President, Engineering
Joe Fuchs.................................  47    Vice President, Quality Management
Dr. William F. Hamilton(1)(2).............  58    Director
William Seifert(1)(2).....................  48    Director
</TABLE>
 
---------------
 
(1) Member of the Audit Committee
(2) Member of the Compensation Committee
 
Following is a description of the background of each of the Company's executive
officers and directors:
 
     Dr. Zwan founded the Company in October 1990 and has served as Chairman of
the Board since its inception. In addition, Dr. Zwan served as the Company's
Chief Executive Officer from the Company's inception until December 1998 and
served as its President from inception until March 1996 and from October 1996
until December 1998. From 1987 to 1991, Dr. Zwan was Chief Executive Officer of
Digital Photonics, Inc. ("DPI"), a SONET multiplexer manufacturer which he
founded in 1987. DPI was purchased in December 1990 by Digital Transmission
Systems, Inc., a manufacturer of digital cross-connect equipment and DS1 modems.
From 1985 to 1987, Dr. Zwan was Vice President, Optical Products at DSC
Communications Corporation, a global provider of telecommunication transmission,
cross-connect and network access equipment. Dr. Zwan was a member of the
Research Facility Staff at the Massachusetts Institute of Technology for two
years, and holds a Ph.D. in Space Physics from Rice University and B.S. degrees
in Physics and Chemistry from the University of Houston.
 
     Mr. Chastelet currently serves as President and Chief Executive Officer and
a Director and joined the Company on December 31, 1998. Prior to joining the
Company, Mr. Chastelet served as President and Chief Executive Officer of Wandel
& Goltermann Technologies, Inc., a global supplier of communications test and
measurement equipment, from December 1995 to October 1998. From June 1993 to
November 1995, he served as Vice President Sales, Marketing and Service-Americas
and Asia Pacific for Network Systems Corporation, a supplier of channel-attached
communications solutions for large mainframe computers. From 1989 to 1993, he
was Vice President Sales, Marketing and Service for Infotron/Gandalf Systems
Corporation. Mr. Chastelet holds a degree in Electronics Engineering from Devry
Institute of Technology and is a graduate of the University of Toronto Executive
MBA Program.
 
                                       52
<PAGE>   54
 
     Mr. Grant currently serves as Executive Vice President, Finance, Chief
Financial Officer and Secretary and joined the Company in September 1997. Prior
to joining the Company, Mr. Grant served as Executive Vice President, Chief
Financial Officer, Treasurer and Corporate Secretary at Precision Systems Inc.
from July 1996 through September 1997. Mr. Grant also served as Executive Vice
President, Chief Financial/ Administrative Officer and Treasurer for Silver King
Communications Inc. from December 1992 through July 1996, and as Director of
Corporate Finance, Investor Relations and Assistant Treasurer at Home Shopping
Network from February 1989 through December 1992. Mr. Grant holds a Bachelor's
Degree in Accounting from the University of Alabama and holds an MBA in Finance
from the University of South Florida.
 
     Mr. Matz currently serves as Executive Vice President and General Manager,
Network Products and joined the Company in May 1998. Mr. Matz joined the Company
as the Executive Vice President of Global Marketing and Sales and switched to
his current position in February, 1999. Prior to joining the Company, Mr. Matz
served as Vice President of Global Sales at Boston Technology, Inc., a supplier
of systems, software and services to telecommunications companies, from December
1995 to May 1998. From August 1994 to December 1995, Mr. Matz served as
Executive Director of Global Sales at Dale, Gesek, McWilliams and Sheridan,
Inc., an international supplier of telecommunications products and services.
From March 1990 to August 1994, Mr. Matz served as Director of North American
Sales at Summa Four, Inc. Mr. Matz holds a B.S. degree from Wilkes University.
 
     Mr. Haider currently serves as Senior Vice President, Engineering and
joined the Company in September 1997. Prior to joining the Company, Mr. Haider
was a Director, Technical Support Center at AT&T/Paradyne Corporation from May
1996 to September 1997, Director, Engineering from May 1991 to May 1996, and
Engineering Manager from July 1984 through May 1991. Mr. Haider holds a Masters
Degree in Electrical Engineering from the University of Houston, a B.S. in
Electrical Engineering from the University of Engineering and Technology,
Lahore, Pakistan, and a B.S. in Physics and Math from Gordon College, University
of Punjab.
 
     Mr. Fuchs currently serves as Vice President, Quality Management and joined
the Company in January 1997. Prior to joining the Company, Mr. Fuchs was a
System Test Lead and Project Manager at AT&T/Paradyne from May 1992 through
December 1996. Mr. Fuchs also worked at AT&T Bell Laboratories as a member of
technical staff in the Transmission Center and the Quality Assurances Center
from 1981 though 1992. Mr. Fuchs holds a B.S. in Electrical Engineering from the
Pratt Institute and a M.S. in Electrical Engineering from Columbia University.
 
     Dr. Hamilton has served as a Director since 1997.  He is the Landau
Professor of Management and Technology at the Wharton School of the University
of Pennsylvania and has been a professor at the University of Pennsylvania since
July 1967. He is also a director of the following public companies: Centocor,
Inc., Hunt Manufacturing Co., Marlton Technologies, Inc. and Neose Technologies,
Inc.
 
     Mr. Seifert has served as a Director since 1997.  He is currently an
entrepreneur/engineer. Prior to this he served as Chief Executive Officer of
Agile Networks, Inc., a wholly-owned subsidiary of Lucent Technologies, Inc.
from 1991 to 1997. Prior to founding Agile Networks, Inc. in 1991, Mr. Seifert
was also the founder of Wellfleet Communications, now Bay Networks.
 
SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
 
     Section 16(a) under the Securities Exchange Act of 1934, as amended, (the
"Exchange Act"), requires the Company's officers and directors, and persons who
own more than ten (10) percent of a registered class of the Company's equity
securities, to file reports of ownership and changes in ownership with the SEC.
Officers, directors and greater than ten-percent stockholders are required by
regulations of the SEC to furnish the Company with copies of all Section 16(a)
forms that they file. To the Company's knowledge, based solely on review of the
copies of such reports furnished to the Company and written representation that
no other reports were required, the Company's officers, directors and greater
than ten percent stockholders complied with all applicable Section 16(a) filing
requirements, except that Dr. Bryan Zwan filed one late Form 4 for a transaction
and Messrs. Joe Fuchs and Ali Haider each filed one late Form 5 for a
transaction.
 
                                       53
<PAGE>   55
 
ITEM 11.  EXECUTIVE COMPENSATION
 
EXECUTIVE COMPENSATION
 
     The following table shows, for the year ended December 31, 1998, the cash
and other compensation awarded to, earned by or paid to Dr. Zwan and each other
executive officer who earned in excess of $100,000 for all services in all
capacities (the "Named Executive Officers"):
 
                           SUMMARY COMPENSATION TABLE
 
<TABLE>
<CAPTION>
                                                                           LONG TERM COMPENSATION
                                                                         ---------------------------
                                                                              AWARDS
                                            ANNUAL COMPENSATION             RESTRICTED       PAYOUTS
                                     ---------------------------------   -----------------   -------       ALL
                                                          OTHER ANNUAL   STOCK    OPTIONS/    LTIP        OTHER
                                      SALARY     BONUS    COMPENSATION   AWARDS     SARS     PAYOUTS   COMPENSATION
NAME AND PRINCIPAL POSITION   YEAR     ($)        ($)         ($)         ($)       (#)        ($)         ($)
---------------------------   ----   --------   -------   ------------   ------   --------   -------   ------------
<S>                           <C>    <C>        <C>       <C>            <C>      <C>        <C>       <C>
Bryan J. Zwan(1)(2).........  1998   $309,587        --         --         --        --         --             --
  Chairman of the Board       1997   $305,779        --         --         --        --         --             --
  and Former President        1996   $300,000        --         --         --        --         --       $215,340
  and CEO
Gerry Chastelet(3)..........  1998   $  1,060        --         --         --        --         --             --
  President and Chief         1997         --        --         --         --        --         --             --
  Executive Officer           1996         --        --         --         --        --         --             --
Steven H. Grant.............  1998   $193,333   $40,000         --         --        --         --       $  1,800(4)
  Executive Vice President,   1997   $ 40,615        --         --         --        --         --       $    500(4)
  Finance, Chief Financial    1996         --        --         --         --        --         --             --
  Officer and Secretary
George Matz.................  1998   $148,415   $50,000         --         --        --         --       $  8,000(5)
  Executive Vice President    1997         --        --         --         --        --         --       $     --
  and General Manager,        1996         --        --         --         --        --         --       $     --
  Networks Products
Ali Haider..................  1998   $149,443   $22,275         --         --        --         --       $  1,963(4)
  Senior Vice President,      1997   $ 34,788   $25,000         --         --        --         --             --
  Engineering                 1998         --        --         --         --        --         --       $     --
Joe Fuchs...................  1998   $117,878        --         --         --        --         --             --
  Vice President, Quality     1997   $ 86,018   $ 1,000         --         --        --         --             --
  Management                  1996         --        --         --         --        --         --             --
</TABLE>
 
---------------
 
(1) Dr. Zwan served as Chief Executive Officer until his resignation from that
    position on December 31, 1998.
(2) Amounts include the payment of $9,587 and $5,779 of earned and unused
    vacation from 1997 and 1996, which were paid in 1998 and 1997, respectively,
    and 1995 deferred compensation of $215,340 which was paid in 1996.
(3) Mr. Chastelet commenced employment on December 31, 1998.
(4) Reflects 401(k) matching contributions.
(5) Reflects Automobile Allowance.
 
1996 STOCK OPTION PLAN
 
     The Company's 1996 Stock Option Plan (the "Option Plan") became effective
on March 5, 1996. The purpose of the Option Plan is to attract and retain
qualified personnel, to provide additional incentives to employees, officers,
directors and consultants of the Company and to promote the success of the
Company's business. A reserve of 5,000,000 shares of Common Stock has been
established for issuance under the Option Plan. The Option Plan is administered
by the Board who may delegate the administration of the plan to a committee of
the Board. The Board now has, and such committee would have, complete discretion
to determine which eligible individuals are to receive option grants, the number
of shares subject to each such grant, the status of any granted option as either
an incentive stock option or a non-statutory option, the vesting
 
                                       54
<PAGE>   56
 
schedule to be in effect for the option grant and the maximum term for which any
granted option is to remain outstanding.
 
     Each option granted under the Option Plan has a maximum term of ten years,
subject to earlier termination following the optionee's cessation of service
with the Company. Options granted under the Option Plan may be exercised only
for fully vested shares. The exercise price of incentive stock options and non-
statutory stock options granted under the Option Plan must be at least 100% and
85%, respectively, of the fair market value of the stock subject to the option
on the date of grant (or 110% with respect to holders of more than 10% of the
voting power of the Company's outstanding stock). The Board or, when appointed,
such committee, has the authority to determine the fair market value of the
stock. The purchase price is payable immediately upon the exercise of the
option. Such payment may be made in cash, in outstanding shares of Common Stock
held by the participant, through a promissory note payable in installments over
a period of years or any combination of the foregoing.
 
     The Board may amend or modify the Option Plan at any time, provided that no
such amendment or modification may adversely affect the rights and obligations
of the participants with respect to their outstanding options or vested shares
without their consent. In addition, no amendment of the Option Plan may, without
the approval of the Company's stockholders (i) modify the class of individuals
eligible for participation, (ii) increase the number of shares available for
issuance, except in the event of certain changes to the Company's capital
structure, or (iii) extend the term of the Option Plan. The Option Plan will
terminate on March 4, 2006, unless sooner terminated by the Board.
 
     Section 162(m) of the IRC limits the Company's deduction in any one fiscal
year for federal income tax purposes to $1 million per person with respect to
the Company's Chief Executive Officer and its four (4) other highest paid
executive officers who are employed on the last day of the fiscal year unless
the compensation was not otherwise subject to the deduction limit. Certain
performance-based compensation is not included in this $1 million limitation.
Stock options may qualify for exclusion from this limitation if the plan under
which they are granted meets certain conditions. At present, the Option Plan
does not satisfy these conditions. Accordingly, the Company will not be able to
claim a tax deduction for certain exercises of NSOs or disqualifying
dispositions of ISOs by the CEO (should it grant any in the future) and its four
(4) other highest paid executive officers to the extent that the income from
such exercises or dispositions, combined with such executive's other taxable
compensation for the year, exceeds $1 million.
 
     As of December 31, 1998, the Company had outstanding options under the
Option Plan exercisable into an aggregate of 2,690,146 shares of Common Stock.
 
                                       55
<PAGE>   57
 
     The following table sets forth information concerning stock options awarded
to each of the Named Executive Officers during Fiscal 98. All such options were
awarded under the Option Plan.
 
                       OPTION GRANTS IN LAST FISCAL YEAR
 
<TABLE>
<CAPTION>
                                                                                      POTENTIAL REALIZABLE
                                              % OF TOTAL                                VALUE AT ASSUMED
                                               OPTIONS                                   ANNUAL RATES OF
                                  SHARES      GRANTED TO                            STOCK PRICE APPRECIATION
                                UNDERLYING   EMPLOYEES IN   EXERCISE                   FOR OPTION TERM(1)
                                 OPTIONS        FISCAL       PRICE     EXPIRATION   -------------------------
                                 GRANTED         YEAR        ($/SH)       DATE          5%           10%
                                ----------   ------------   --------   ----------   ----------   ------------
<S>                             <C>          <C>            <C>        <C>          <C>          <C>
Bryan J. Zwan.................        --           --            --           --           --             --
Gerry Chastelet...............   600,000        25.40        2.3130     12/31/04      471,583      1,070,241
Steven H. Grant...............   200,000         8.47        4.6875     03/26/04      704,117      1,232,662
George Matz...................   300,000        12.70        4.4375     05/19/04      477,879      1,060,357
Ali Haider....................    48,000         2.03        4.0235     12/19/04      129,244        233,089
Joe Fuchs.....................    30,000         1.27        3.9793     12/19/04       79,122        143,032
</TABLE>
 
---------------
 
(1) Potential realizable value is based on the assumption that the Common Stock
    appreciates at the annual rate shown (compounded annually) from the date of
    grant until the expiration of the option term. These numbers are calculated
    based on the requirements of the SEC and do not reflect the Company's
    estimate of future price growth.
 
     The following table sets forth certain information regarding options to
purchase shares of Common Stock held as of December 31, 1998 by each of the
Named Executive Officers.
 
                AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR
 
<TABLE>
<CAPTION>
                                                             NUMBER OF UNEXERCISED         VALUE OF UNEXERCISED
                                                                  OPTIONS AT              IN-THE-MONEY OPTIONS AT
                                SHARES                             FY-END(#)                   FY-END($)(1)
                              ACQUIRED ON      VALUE      ---------------------------   ---------------------------
                              EXERCISE(#)   REALIZED($)   EXERCISABLE   UNEXERCISABLE   EXERCISABLE   UNEXERCISABLE
                              -----------   -----------   -----------   -------------   -----------   -------------
<S>                           <C>           <C>           <C>           <C>             <C>           <C>
Bryan J. Zwan...............         --       $    --           --              --        $    --        $    --
Gerry Chastelet.............         --            --           --         600,000             --             --
Steven H. Grant.............         --            --       50,000         150,000             --             --
George Matz.................         --            --       75,000         225,000             --             --
Ali Haider..................         --            --           --          48,000             --             --
Joe Fuchs...................         --            --        4,999          25,001             --             --
</TABLE>
 
---------------
 
(1) Values shown in these columns reflect the difference between the closing
    price of $2.313 on December 31, 1998 and the exercise price of the options
    and does not include the federal and state taxes due upon exercise.
 
STOCK PURCHASE PLAN
 
     On August 25, 1997, the Board approved the Stock Purchase Plan whereby
300,000 shares of Common Stock were reserved for issuance and purchase by
employees of the Company to assist them in acquiring a stock ownership interest
in the Company and to encourage them to remain employees of the Company. The
Stock Purchase Plan is intended to qualify under Section 423 of the Internal
Revenue Code and permits eligible employees to purchase shares of Common Stock
at a discount through payroll deductions during specified six-month offering
periods. No employee may purchase more than $25,000 worth of stock in any
calendar year or 1,500 shares of Common Stock in any one offering period. The
Stock Purchase Plan is administered by an Administrative Committee appointed by
the Board and provides generally that the purchase price must not be less than
85% of the fair market value of the Common Stock on the first or last day of the
offering period, whichever is lower. As of March 31, 1998, 123,153 shares have
been purchased under the Stock Purchase Plan.
 
                                       56
<PAGE>   58
 
EMPLOYMENT AGREEMENTS AND SEVERANCE ARRANGEMENTS
 
     The Company entered into a letter agreement dated as of December 31, 1998
(the "Chastelet Agreement"), with Gerry Chastelet, the Company's Chief Executive
Officer and President. The Chastelet Agreement provides for: (1) employment at
will; (2) an annual salary of $275,000; (3) a $150,000 signing bonus payable
over two years; and (4) a performance bonus of up to 50% of his base salary to
be paid based on 80% quantitative and 20% qualitative criteria to be established
by the Company's board of directors. In addition, the Company granted to Mr.
Chastelet stock options to purchase 600,000 shares of Common Stock at an
exercise price of $2.313 per share, of which 100,000 stock options vest after
each six months of employment. In the event of a "change in control" Mr.
Chastelet's unvested options will accelerate.
 
     The Company entered into a letter agreement dated as of April 13, 1998 and
an addendum to the letter agreement dated February 9, 1999 (the "Matz
Agreements"), with George J. Matz, the Company's Executive Vice President,
Global Marketing and Sales. The Matz Agreements provide for: (1) employment at
will; (2) an annual salary of $225,000; (3) a $150,000 sign-on bonus payable
over three years; and (4) a performance bonus of 20% for the first year. In
addition, the Company granted to Mr. Matz stock options to purchase 300,000
shares of Common Stock at an exercise price of $4.4375 per share, of which
75,000 stock options vest on December 31, 1999, and 75,000 vest on each of the
second and third of his employment anniversary dates. In the event of a "change
in control" Mr. Matz's unvested options will accelerate.
 
     The Company entered into an employment agreement effective as of February
27, 1998 (the "Grant Agreement"), with Steven H. Grant, the Company's Executive
Vice President, Finance, Chief Financial Officer and Secretary. The Grant
Agreement provides for: (1) an employment term of three years which
automatically renews for an additional two years unless either Mr. Grant or the
Company provides reasonable notice of non-renewal prior to expiration; (2) an
annual salary of $200,000; and (3) a $40,000 bonus (which is primarily an
acceleration of a deferred sign-on bonus) to be paid upon completion of the
Company's filings with the SEC for the year ended December 31, 1997. The Grant
Agreement also provides that the Company will provide to Mr. Grant on an annual
basis sufficient funds to purchase a term life insurance policy payable to his
heirs and a disability insurance policy to provide comparable compensation,
including benefits over the life of the agreement. In addition, the Company
granted to Mr. Grant stock options to purchase 200,000 shares of Common Stock at
an exercise price of $4.6875 per share, of which 50,000 stock options vest on
the date of grant and 50,000 stock options vest on each of the three
anniversaries following the date of grant. As a result of this new option grant,
the previously issued grant for 75,000 shares was canceled. In the event that
Mr. Grant's employment with the Company terminates, all stock options that have
not yet vested will continue to vest except in the event of a "change in
control" whereby the unvested options will accelerate. In the event of his
termination without "cause," including due to a "change in control" or a "change
in duties" (as such terms are defined in the Grant Agreement), Mr. Grant will be
entitled to severance compensation, including all benefits, for a period of 18
to 24 months. The Company is not obligated to pay compensation and benefits
under the Grant Agreement if Mr. Grant's employment is terminated for "cause."
 
     The Company entered into a letter agreement dated as of September 8, 1997
as modified by letters dated July 27, 1998 and August 4, 1998 with Ali Haider
(the "Haider Agreements"), the Company's Senior Vice President, Engineering. The
Haider Agreements provide for: (1) an annual salary of $170,000; and (2) a
performance bonus of $22,275 for positive first and second quarter 1998
performance. In addition, the Company agreed to grant to Mr. Haider certain
stock options. In the event of the termination of Mr. Haider's employment for
any reason (other than a criminal act), Mr. Haider is entitled to severance pay
in the amount of six months base salary at the greater of Mr. Haider's base
salary as of the date of any termination of employment or as of July 27, 1998.
 
SECTION 401(K) PLAN
 
     In 1997, the Company adopted a 401(k) Salary Savings Plan (the "401(k)
Plan") covering the Company's full-time employees located in the United States.
The 401(k) Plan is intended to qualify under
 
                                       57
<PAGE>   59
 
Section 401(k) of the Internal Revenue Code, so that contributions to the 401(k)
Plan by employees or by the Company, and the investment earnings thereon, are
not taxable to employees until withdrawn from the 401(k) Plan, and so that
contributions by the Company, if any, will be deductible by the Company when
made. Pursuant to the 401(k) Plan, employees may elect to reduce their current
compensation by up to the statutorily prescribed annual limit ($10,000 in 1998)
and to have the amount of such reduction contributed to the 401(k) Plan. The
401(k) Plan permits, but does not require, additional matching contributions to
the 401(k) Plan by the Company on behalf of all participants in the 401(k) Plan.
Currently, the Company matches the first 6% of such voluntary contributions at
50% of the amount contributed by the employee.
 
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
 
     In 1998, the Compensation Committee of the Board consisted of Messrs.
Marshall and Seifert. No executive officer of the Company served on the
compensation committee of another entity or on any other committee of the board
of directors of another entity performing similar functions during Fiscal 98.
Additionally, no member of the Compensation Committee is currently or was
formally an officer or employee of the Company. Effective December 8, 1997, Mr.
Seifert began serving as a consultant to the Company. In 1998, Mr. Seifert
received $12,750 for services performed as a consultant to the Company.
 
COMPENSATION OF DIRECTORS
 
     Directors of the Company who are not officers or employees of the Company
receive an annual fee of $10,000. Directors are also reimbursed for travel and
other expenses relating to attendance at meetings of the Board or committees. In
addition, in connection with their services on a special investigative committee
formed by the Board to investigate the class action litigation and the related
underlying restatement issues, Messrs. Hamilton and Seifert received $4,750 and
$6,250 respectively. Effective December 8, 1997, Mr. Seifert began serving as a
consultant to the Company. In 1998, Mr. Seifert received $12,750 for services
performed as a consultant to the Company. Under the Option Plan, non-employee
directors are also eligible to receive stock options in consideration for their
services. In fiscal 1998, none of the non-employee directors were granted
options.
 
                                       58
<PAGE>   60
 
ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
     The following table sets forth certain information regarding beneficial
ownership of the Common Stock as of April 1, 1999 by (i) each person who is
known by the Company to own beneficially more than five percent (5%) of the
outstanding shares of Common Stock, (ii) each director of the Company, (iii) all
of the executive officers including executive officers named in the Summary
Compensation Table (the "Named Executive Officers"), and (iv) all directors and
executive officers of the Company as a group. To the knowledge of the Company,
all persons listed below have sole voting and investing power with respect to
their shares of Common Stock, except to the extent authority is shared by
spouses under applicable law, and such persons may be contacted at 15550
Lightwave Drive, Clearwater, Florida 33760.
 
<TABLE>
<CAPTION>
                                                              SHARES BENEFICIALLY
                                                                    OWNED(1)
                                                              --------------------
NAME                                                            NUMBER     PERCENT
----                                                          ----------   -------
<S>                                                           <C>          <C>
Bryan J. Zwan(2)............................................  20,000,000    74.56%
Hugh Brian Haney(3).........................................   2,000,000     7.45
Gerry Chastelet.............................................          --        *
Steven H. Grant(4)..........................................     107,430        *
George Matz(5)..............................................      75,000        *
Ali Haider(6)...............................................      14,304        *
Joe Fuchs(7)................................................      21,165        *
William F. Hamilton(8)......................................      33,332        *
William M. Seifert(8).......................................      33,332        *
All executive officers and directors as a group (9
  persons)(9)...............................................  20,284,563    75.62
</TABLE>
 
---------------
 
 *  Less than one percent
(1) Beneficial ownership is determined in accordance with the rules of the
    Securities and Exchange Commission (the "SEC") that deem shares to be
    beneficially owned by any person who has or shares voting or investment
    power with respect to such shares. Unless otherwise indicated below, the
    persons and entities named in the table have sole voting and sole investment
    power with respect to all shares beneficially owned, subject to community
    property laws where applicable. Shares of Common Stock subject to options
    that are currently exercisable or exercisable within 60 days of April 1,
    1999 are deemed to be outstanding and to be beneficially owned by the person
    holding such options for the purpose of computing the percentage ownership
    of such person but are not treated as outstanding for the purpose of
    computing the percentage ownership of any other person.
(2) Includes 2,000,000 shares for which an option has been granted to Hugh Brian
    Haney, pursuant to a litigation settlement and 15,000,000 shares held by
    Bryan J. Zwan through his wholly owned Nevada corporation, ZG Nevada, Inc.
(3) Represents 2,000,000 shares for which an option has been granted by Bryan J.
    Zwan, pursuant to a litigation settlement. Mr. Haney's address is c/o Law
    Office of Eric L. Brown Co., L.P.A., Suite 550, 172 East State Street,
    Clearwater, Florida 33755.
(4) Consists of 7,430 shares of Common Stock and 100,000 shares issuable upon
    exercise of options that are currently exercisable or exercisable within 60
    days of April 1, 1999.
(5) Consists of 75,000 shares issuable upon exercise of options that are
    currently exercisable or exercisable within 60 days of April 1, 1999.
(6) Consists of 3,304 shares of Common Stock and 11,000 shares issuable upon
    exercise of options that are currently exercisable or exercisable within 60
    days of April 1, 1999.
(7) Consists of 9,500 shares of Common Stock and 11,665 shares issuable upon
    exercise of options that are currently exercisable or exercisable within 60
    days of April 1, 1999.
(8) Consists of 33,332 shares issuable upon exercise of options that are
    currently exercisable or exercisable within 60 days of April 1, 1999.
(9) Consists of 20,020,234 shares of Common Stock and 264,329 shares issuable
    upon exercise of options that are currently exercisable or exercisable
    within 60 days of April 1, 1999.
 
                                       59
<PAGE>   61
 
ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
     On December 15, 1998, the Company loaned $100,000 to Dr. Zwan, the
Company's Chairman of the Board. The loan has a simple interest rate of 9% per
annum, is evidenced by an unsecured promissory note and is due December 14,
1999. As of March 15, 1999, $100,000 was the balance outstanding on such loan
plus accrued and unpaid interest thereon. In accordance with the Company's
policy on related party transactions, the loan was approved by the independent
members of the Audit Committee of the Board of Directors.
 
                                    PART IV
 
ITEM 14.  EXHIBITS, CONSOLIDATED FINANCIAL STATEMENTS, AND REPORTS ON FORM 8-K
 
     (a)(1)Index to Consolidated Financial Statements.
 
           Index to consolidated financial statements appears on 32.
 
     (b) Reports on Form 8-K.  No reports on Form 8-K were filed during the
fourth quarter of the period covered by this Report.
 
     (c) Exhibits.
 
<TABLE>
<C>      <C>  <S>
 3.01(1)  --  Certificate of Incorporation of the Company
 3.02(1)  --  Amendment to Certificate of Incorporation of the Company
              dated January 8, 1997
 3.03(1)  --  Amended and Restated By-laws of the Company
 4.01(1)  --  Specimen Certificate for the Common Stock
10.01(1)  --  Executive Employment Agreement dated September 30, 1996,
              between the Company and Seth P. Joseph
10.02(1)  --  Lease Agreement dated October 7, 1994, between the Company
              and Atrium at Clearwater, Limited
10.03(1)  --  First Lease Agreement Amendment dated February 16, 1996,
              between the Company and Atrium at Clearwater, Limited
10.04(1)  --  Form of Indemnification Agreement between the Company and
              officers and directors of the Company
10.05(1)  --  Digital Lightwave, Inc. 1996 Stock Option Plan
10.06(3)  --  Digital Lightwave, Inc. Employee Stock Purchase Plan
10.07(2)  --  Second Lease Amendment, dated September 10, 1997, between
              the Company and Atrium At Clearwater, Limited
10.08(2)  --  Lease Agreement, dated June 30, 1997, between the Company
              and Pinellas Business Center, Inc.
10.09(2)  --  Lease Agreement, dated September 26, 1997, between the
              Company and Monmouth/Atlantic Realty Associates
10.10(3)  --  L.P. Lease Agreement, dated January 9, 1998, between the
              Company and Orix Hogan-Burt Pinellas Venture.
10.11(3)  --  First Lease Amendment, dated February 18, 1998, between the
              Company and Orix Hogan-Burt Pinellas Venture.
10.12(3)  --  First Lease Amendment, dated September 25, 1997, between the
              Company and Monmouth/ Atlantic Realty Associates L.P.
10.13(3)  --  Second Lease Amendment, dated February 23, 1998, between the
              Company and Monmouth/ Atlantic Realty Associates L.P.
10.14(3)  --  Executive Employment Agreement, dated February 27, 1998,
              between the Company and Steven H. Grant.
10.15     --  Accounts Receivable Agreement dated December 28, 1998
              between the Company and Bankers Capital.
</TABLE>
 
                                       60
<PAGE>   62
<TABLE>
<C>      <C>  <S>
10.16     --  Stock Option Agreement dated November 13, 1998 among the
              Company, Dr. Brian J. Zwan and Hugh Brian Haney.
10.17     --  Mutual General Release dated November 13, 1998, by and among
              Hugh Brian Haney, Great American Fun Corp., Great American
              Fun (HK) Ltd., Dr. Bryan J. Zwan, the Company and Logical
              Magic, Inc.
10.18     --  Settlement Agreement dated November 13, 1998 by and among
              Hugh Brian Haney, Dr. Bryan J. Zwan and the Company.
10.19     --  Letter Agreement dated as of December 31, 1998 between the
              Company and Gerry Chastelet.
10.20     --  Letter Agreement dated April 13, 1998 and addendum thereto
              dated February 9, 1999 between the Company and George J.
              Matz.
10.21     --  Form of Stock Purchase Agreement, dated March 31, 1999,
              between the Company and certain Purchasers, with exhibits
              thereto.
10.22     --  Letter of Commitment between the Company and Emergent Asset
              Based Lending, L.L.C. d/b/a Emergent Business Capital, dated
              March 31, 1999.
10.23     --  Letter Agreement dated as of September 8, 1997 between the
              Company and Ali Haider as amended and supplemented by the
              Letter Agreements dated July 27, 1998 and August 4, 1998.
21.01     --  Subsidiaries of the Registrant
23.01     --  Consent of PricewaterhouseCoopers LLP
24.01     --  Power of Attorney (included on the signature page to this
              Report)
27.01     --  Financial Data Schedule
</TABLE>
 
---------------
(1) Incorporated by reference to the similarly described exhibits filed in
    connection with the Registrant's Registration Statement on Form S-1, File
    No. 333-09457, declared effective by the Securities and Exchange Commission
    on February 5, 1997.
 
(2) Incorporated by reference to the exhibit filed in connection with the
    Registrant's Quarterly Report on Form 10-Q for the quarterly period ended
    September 30, 1997.
 
(3) Incorporated by reference to the similarly described exhibits filed in
    connection with the Registrant's Annual Report on Form 10-K for the fiscal
    year ended December 31, 1997.
 
                                       61
<PAGE>   63
 
                                   SIGNATURES
 
     Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
 
                                          DIGITAL LIGHTWAVE, INC.
 
                                          By: /s/ GERRY CHASTELET
                                            ------------------------------------
                                            President and Chief Executive
                                              Officer
 
Date: April 5, 1999
 
                               POWER OF ATTORNEY
 
     KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Gerry Chastelet and Steven H. Grant, jointly and
severally, as his or her attorney-in-fact, each with the power of substitution,
for him or her in any and all capacities, to sign any amendments to this Report
and to file the same, with exhibits thereto and other documents in connection
therewith, with the Commission, hereby ratifying and confirming all that each of
said attorneys-in-fact, or his substitute or substitutes, may do or cause to be
done by virtue hereof.
 
     Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
 
<TABLE>
<CAPTION>
                       NAME                                         TITLE                      DATE
                       ----                                         -----                      ----
<C>                                                  <S>                                   <C>
 
                 /s/ BRYAN J. ZWAN                   Chairman of the Board                 April 5, 1999
---------------------------------------------------
                   Bryan J. Zwan
 
                /s/ GERRY CHASTELET                  President, Chief Executive Officer    April 5, 1999
---------------------------------------------------  and Director
                  Gerry Chastelet
 
                /s/ STEVEN H. GRANT                  Executive Vice President, Finance     April 5, 1999
---------------------------------------------------  Chief Financial Officer and
                  Steven H. Grant                    Secretary
 
              /s/ WILLIAM F. HAMILTON                Director                              April 5, 1999
---------------------------------------------------
              Dr. William F. Hamilton
 
                /s/ WILLIAM SEIFERT                  Director                              April 5, 1999
---------------------------------------------------
                  William Seifert
</TABLE>
 
                                       62