SECURITIES AND EXCHANGE COMMISSION
                              WASHINGTON, DC 20549
                                    FORM 10-K
                ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
                       THE SECURITIES EXCHANGE ACT OF 1934

                   For the Fiscal Year Ended December 31, 1998

                          Commission File Number 0-8828

                                 OPTELECOM, INC.
                                 ---------------
             (Exact name of registrant as specified in its charter)

                                    DELAWARE
                                    --------
         (State or other jurisdiction of incorporation or organization)

                                   52-1010850
                                   ----------
                      (IRS employer identification number)

                 9300 GAITHER ROAD, GAITHERSBURG, MARYLAND 20877
                ------------------------------------------------
               (Address of principal executive offices)(Zip code)



<TABLE>
<S>                                                          <C>
Registrant's telephone number, including area code:          (301) 840-2121.
Securities registered pursuant to Section 12(b) of the Act:  None.
Securities registered pursuant to Section 12(g) of the Act:  Common Stock $0.03 Par Value.
</TABLE>

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes  X   No ___

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulations S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ X ]

At March 17, 1999, shares of the registrant's Common Stock, $0.03 Par Value,
held by persons other than "affiliates" of the registrant had an aggregate
market value of $6,065,317, based on the average closing bid and asked prices as
reported by the National Association of Securities Dealers Automated Quotation
System for such date.

At March 17, 1999, the registrant had outstanding 2,156,557 shares of Common
Stock, $.03 Par Value.

                       DOCUMENTS INCORPORATED BY REFERENCE

Form 8-KA filed on February 25, 1998, reporting required financial information
from the Paragon acquisition.

Form 8-A12G filed June 30, 1998, reporting Shareholders Rights Agreement.


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<PAGE>


                                     PART I

ITEM 1.   BUSINESS

GENERAL

Optelecom, Inc. (the Company) is a Delaware corporation that was organized in
1972. The Company's business consists primarily of the development, manufacture,
and sale of fiber optic communications products and laser systems for commercial
and military customers and, through it's subsidiary, the Company provides
multi-media integrated products for sending data to the desktop over copper
wire.

The Company is organized into three operating segments: the Communications
Products Division (CPD) which develops, manufactures, and sells optical
fiber-based data communication equipment to the commercial marketplace, the
Government Products Division (GPD) which is primarily focused on electro-optic
technology development for government-related defense business, and Paragon
Audio Visual Ltd. (Paragon) which designs and markets electronic communication
products and systems utilizing copper cabling as the primary transmission
medium. Paragon, a wholly-owned UK subsidiary, was acquired in December 1997.

Fiber optic communication equipment, the main thrust of the Company's sales, is
an area of unprecedented growth and change. Technology development is constantly
and rapidly improving the capability to transmit ever increasing data rates over
even greater distances with fiber-based communication systems.

Most signals, voice, video and data, are in electrical form. The transmission of
electrical signals from one point to another by converting them to optical
(light) signals has many advantages over electrical transmissions. Compared to
copper wire, optical fibers can transmit signals at a much greater data rate
over a greater distance and without disturbance from electrical machinery,
lightning or other noise sources.

The fiber optic communication business has many parts, but can be divided
generally into two segments: the optical fiber/cable portion which supplies the
media for transporting optical signals, and the transmission equipment portion
which generates and receives optical signals. A few companies manufacture
optical fiber, while many more manufacture optical fiber cables. Optelecom
provides the equipment that interfaces electrical signals to optical signals at
the transmitter end of a fiber optic communication link and provides
complementary equipment that converts the optical signals to electrical form at
the other end of the communications link. Optelecom sells its equipment to users
of these communication systems or to system integrators that install the
Company's equipment in large communication nets.

There are a large number of communication applications that require different
communication rates, distances and signal formats. Optelecom provides equipment
specifically designed for transmission of various combinations of voice, data
and video for a range of applications. The Company also addresses U.S.
Government defense related markets for specialized and proprietary applications
of fiber optic and laser system technology which the Company believes makes it
unique among traditional fiber optic communication equipment manufacturers.
While government business can provide an offset to periodic cycles in the
commercial sector, it is also subject to changing world conditions. Therefore,
the Company attempts to balance revenues generated by both types of markets to
avoid severe changes in 


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<PAGE>

its business posture. The Company is unable to predict future defense business
activity or the related impact on the Company's business.

The table below displays the Company's three-year revenue and pretax income
(loss) by segment.

<TABLE>
<CAPTION>
                                  1998                         1997                       1996
                    -------------------------------------------------------------------------------------
                                     PRETAX                       PRETAX                     PRETAX
                                     (LOSS)                       INCOME                     INCOME
OPERATING SEGMENTS    REVENUE        INCOME        REVENUE        (LOSS)       REVENUE       (LOSS)

<S>                 <C>           <C>            <C>           <C>            <C>           <C>
Company
 Totals             $16,333,749   $(3,130,652)   $12,271,057   $ 1,367,219    $ 8,910,263   $ 1,032,217  
                                                                                                         
CPD                 $ 8,742,232   $  (237,357)   $ 9,734,088   $   574,789    $ 6,453,686   $    17,543  
GPD                 $ 1,549,730   $   107,423    $ 2,372,950   $   806,011    $ 2,456,577   $ 1,014,674  
                                                                                                         
PARAGON AUDIO                                                                                            
VISUAL LIMITED      $ 6,041,787   $(3,000,718)   $   164,019   $   (13,581)            --            --  

</TABLE>


See Note 14 to the financial statements for long-lived assets by segment.

PRODUCTS AND MARKETS

GOVERNMENT PRODUCTS DIVISION (GPD)

GPD consists of two operating groups: 1) The Electro/Optics Technology Group
("E/O") that provides technology development and engineering services to the
U.S. Government and its prime contractors and investigates techniques for design
and manufacture of specialized sensing coils for fiber optic gyros which is a
unique field and has few competitors; and 2) the Laser Illuminator Technology
Group ("L/I") that derives its revenues entirely from the U.S. Government and
its agencies. During 1998, GPD started a research and development effort focused
on high speed optical components for the commercial market sector.

In 1998 the group's activities continued to concentrate on interferometric fiber
optic gyros (IFOGs), which are rotation sensing instruments that are beginning
to replace mechanical and laser gyros in aircraft, missiles, and other vehicles.
Optelecom has used its expertise derived from prior activities to develop
winding technology for IFOG coils, and to manufacture these coils in production.
In 1998 significant strides were made in improving process and quality control
and increasing production capacity. A major portion of revenue is also derived
from sales of custom optical fiber coils for fiber gyro sensors and other
applications.

All the revenues generated by the L/I Group are related to its contract with the
U.S. Air Force GLINT program. GLINT is an acronym associated with the U.S. Air
Force's C-130 Gunship laser illuminator system supported by Optelecom. Due to
the nature of the application of this system, contractual revenues are dependent
on government budgets, the worldwide political situation, and specific crew
training schedules. In January 1996 the Company received a $6.5 million,
four-year contract (one base year and three one-year options) to provide
services for refurbishment of equipment for this system. The Company anticipates
additional refurbishment requirements will be completed by the end of 1999
coinciding with the contract period. Continued revenue under the contract is
highly dependent on the continued requirements of the United States Air Force.


                                       3
<PAGE>

COMMUNICATION PRODUCTS DIVISION (CPD)

The Communication Products Division addresses business opportunities in the
worldwide commercial communication equipment marketplace, and specializes in
optical fiber technology. Currently, the majority of its revenues are provided
from several niche market areas including original equipment manufacturer (OEM)
equipment for process control and communications systems for highway traffic
monitoring and advanced air traffic control video monitor displays.

The CPD segment offers many product solutions to address its customers' needs.
The products are classified into the following categories:

Data Communications Products

Data Communications Products include Fiber Optic RS232, RS422, RS485, T1 and E1
Modems for market applications, including specialty data and timing distribution
modems for the military, aerospace and satellite earth station markets as well
as commercial, industrial, traffic control and surveillance markets. These
products are included in or are compatible with products in our new Series 9000
product line, as discussed in the next paragraph.

CCTV  & Broadcast Video (FM), Audio and Data Products

This category includes fiber optic video only, audio only, video and data, audio
and data, and video, audio and data products, which use our traditional FM, PFM
and PCM transmission techniques. Most of these products are included in our 9000
series product line, which began shipping in late 1998, with a full promotion
being launched in March 1999. Significant additions to our product offerings are
an eight channel video multiplexer, a four channel video multiplexer with
bi-directional data and/or audio and a new rack mount chassis and power supplies
which provide dense packaging and operate over a wide temperature range. Also
significant is the new Windows based Graphical User Interface System Management
Software which allows the user to view the operating status of his whole fiber
optic transmission network from a PC, greatly facilitating maintenance. Markets
for these products include video surveillance, intelligent highways, robotics,
process control, military, distance learning and simulation markets.

High Resolution RGB Video Transmission Products

RGB Video Transmission Products include those used to remote a high-resolution
display, such as a monitor or projector, from the video source. Because of the
high bandwidth and fidelity required to transmit these signals, fiber optics may
be the only means to transmit them farther than a few hundred feet. While
relatively low resolution VGA video, in the 600 x 400 pixel range, may be
transmitted via copper using copper baluns (such as offered by Paragon) up to
distances approaching 1000 feet, the bandwidth required to transmit ultra high
resolution 2048 x 2048 pixel RGB video limits the transmission distance possible
over copper to less than 100 feet. Applications for this technology include air
traffic control, military control rooms, remote conference rooms, financial
trading desks and process control. Optelecom is not aware of any other fiber
optic RGB video transmission system that meets the performance requirements for
the SONY 2Kx2K video monitor.


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<PAGE>


Compressed Digital Video Products

These products involve the digitization and compression of NTSC and PAL video
signal sources, allowing transmission via T1, E1, or Ethernet, via IP (Internet
Protocol). Currently this product group includes three products. One, the
DVS-100, using motion JPEG compression standards and a second, the Transform
100, using MPEG-2 compression standards, include a T1/E1 inverse multiplexing
network interface for video, audio and data transmission over one or two telecom
standard T1 or E1 channels. A third, the Transform 200, uses MPEG-2 compression
standards and includes a 10base10/100 interface for transmission using IP.
Applications include remote surveillance, distance learning and video
conferencing.

PARAGON AUDIO VISUAL, LTD.  (PARAGON)

Paragon was organized in 1994 and designs and markets electronic products and
systems for multi-media applications utilizing unshielded twisted-pair copper of
"structured" cabling for in-house computer data networking applications. Such
products include baluns (Balanced to Unbalanced) devices that match the
different impedance of traditional coaxial and data networking cables. The use
of active baluns with higher-grade cables and high performance integrated
circuit devices allows for the transmission of high-resolution video, voice and
data signals without noticeable signal degradation. Paragon has been very active
in supporting networking applications for market data information and business
television services pertaining to financial markets.

Structured cable communications systems and fiber optic communications systems
offer comparable services in some applications and have distinct advantages or
disadvantages in others. For example, the use of baluns with structured cabling
has become common for in-house computer networking applications, while fiber
optic systems afford increased distance and higher bandwidths to information
systems. The Company believes that its acquisition of Paragon will enable it to
participate in and benefit from the development and growth of both technologies
and their joint applications.

Paragon markets a range of advanced product components for the display and
integration of multimedia information at the user's desktop. Not all products
are proprietary to Paragon, and the Company has close relationships with other
product suppliers where appropriate. Together, these products comprise a
complete family of product components that can be flexibly configured to build
complete multimedia information integration solutions to meet customer's
specific requirements.

Paragon is focused primarily (but not exclusively) on the financial systems
marketplace; i.e., financial and commercial organizations that deal on
national/international financial markets trading in a variety of instruments
(e.g. equities, foreign exchange, commodities, money markets, and derivatives).
The Company also markets to non-financial commercial organizations requiring the
integration of business television and video telephony services.

Paragon's products and services are grouped into four major categories:

    o   Multimedia Integration (Paragon active baluns, multi-function keyboards,
        specialized display adapters)
    o   Business Television Distribution (head-end, switching and distribution
        products)
    o   Video telephony
    o   Services (consultancy, integration of 3rd party products, configuration,
        installation and support)


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<PAGE>

Paragon is completely independent of any underlying trading room platform
technology, utilized for the distribution of digital market data, and is able to
operate independently of any distribution platform.

SALES AND MARKETING

GOVERNMENT PRODUCTS DIVISION

The E/O Group markets its services to both Government and commercial customers.
However, for the past five years all of its business has been obtained from
systems based on requirements of the Government, its prime contractors, and
contractors of foreign Governments. Successfully marketing new technology
initiatives directly to Government applications is difficult due to increased
competition from larger companies with far greater resources. As a result of the
utilization of IFOG sensing coil technology developed by Optelecom in 1993 and
the Company's prior experience with the development of fiber coils for high
speed payout, the Company identified the area of optical fiber gyro coil winding
as providing opportunity for new business development. Gyro coils are a defense
related Government program area that the Company sees receiving continued focus
amid shrinking defense spending. Although the customer base is small, the demand
is expected to increase over the next few years. Revenue from manufacturers of
custom optical fiber gyro coils represented the majority of income for the group
in 1998 and will be a major source of income in 1999.

The marketing efforts undertaken in 1998 are expected to provide additional
contracts in 1999 with technology development contracts in the IFOG
manufacturing and other areas.

The sole customer for the L/I Group is the Warner-Robins Air Logistics Support
Center of the U.S. Air Force. Optelecom maintains a very close working
relationship with the individual component item managers assigned at
Warner-Robins and the operations group at Hurlburt Field, Florida.

COMMUNICATION PRODUCTS DIVISION

The Communication Products Division (CPD) sells its products domestically
through direct sales and through select commercial integrators and resellers.
Additionally, CPD has several OEM accounts to different market sectors. Foreign
sales are made through agents and OEM accounts. The Company intends to add to
CPD additional direct sales personnel in additional territories in the United
States.

The sales process for new contracts generally requires a significant investment
in time and money and takes several months. This process involves senior
executives, sales personnel, engineering and systems integrators. The collective
sales group works together to properly specify and apply highly technical
products in the intelligent transportation control and surveillance market
segment.


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<PAGE>


PARAGON

Paragon has developed close and mutually productive partnerships with suppliers
of "system component" products, where the partner has strong technical expertise
but very weak routes to market or poorly developed integration skills. These
products include multi-functional keyboard solutions, specialized graphic
display adapters and video conferencing systems.

This business model enables Paragon to deliver a broad portfolio of products,
establishing a single source of cohesive multimedia solutions and integration
services to the financial marketplace. This has enabled Paragon to derive
additional revenue from its existing client base, and also to appeal to new
prospects within the financial marketplace as well as new markets.

Paragon currently offers technical consulting and various product solutions
consisting of both its own and third party products, which matches the evolving
requirements currently required within the financial marketplace. Paragon's
offerings now range from complex integration at the user desk through to visual
distribution technologies.

RESEARCH AND DEVELOPMENT

<TABLE>
<CAPTION>
FINANCIAL INFORMATION RELATING TO COMPANY
SPONSORED RESEARCH AND DEVELOPMENT                     1998          1997         1996
<S>                                                  <C>             <C>          <C>
Expenditures on Company sponsored research and
development activities                               $1,309,000      $874,000     $518,000
</TABLE>


Research and Development expense for 1998 increased significantly over 1997.
During 1998, the Company invested resources approximating $426,000 on a new
research effort. The product under development is a high speed optical component
that has numerous commercial applications. The Company has applied for three
patents related to the new product.

The Company's major effort in the CPD engineering area continues to focus on
compressed digital video development. The most recent product (MPEG2 digital
video) was released at the end of 1998 and market acceptance has been positive.
Another significant engineering effort within CPD has been directed to the
ongoing upgrade and improvement of our current product line with the
introduction of the new 9000 Series at the end of 1998.

Paragon defines all product specifications but currently subcontracts actual
product development and manufacturing. Looking forward, it is intended to
utilize Optelecom's engineering and manufacturing capabilities where possible in
order to increase Paragon's competitive advantage. This opportunity will be
fully explored during 1999.

MANUFACTURING PROCESSES

QUALITY ASSURANCE

Beginning in mid-1996, the Company initiated a corporate-wide effort to
implement a Quality Assurance system fully compliant with the requirements of
ISO-9001 (an internationally recognized quality system standard for companies
that design and manufacture products). In June 1996 all operating divisions of
the Company received certification to the standard. Paragon outsources all of
its manufacturing to specialized manufacturers and it does not

                                       7
<PAGE>

maintain manufacturing facilities. During 1998 Paragon received certification of
the ISO-9002 standard, which fits Paragon's non-manufacturing status.

GOVERNMENT PRODUCTS DIVISION

E/O TECHNOLOGY GROUP

In 1991 the Company developed a winding machine to fabricate coils of optical
fiber wound in very specific configurations for fiber gyro systems. Additional
work in this area through 1996 was conducted to develop a winding machine
concept directed toward automated techniques. During 1998 Optelecom invested in
the manufacture of additional winding machinery to meet customer demands.
Currently, four machines are employed in satisfying contract winding production
requirements. The number of companies from which the group obtains raw materials
and optical fiber to meet these requirements is limited. However the Company
does not anticipate any problems with adequate supplies.

LASER ILLUMINATOR TECHNOLOGY GROUP

Optelecom has established a specialized facility adjacent to its headquarters to
support fabrication and repair operations for the GLINT laser illuminator
system. The processes used to fabricate laser modules for this system are
proprietary to Optelecom and depend on sophisticated understanding of specific
semiconductor processing techniques. Proper use of the equipment and materials
associated with these activities depends on highly skilled personnel whose
technical knowledge is key to the successful fabrication of the final product.
The number of companies from which the group obtains raw materials is limited,
although the materials are considered general items of commerce. Consequently,
the Company does not anticipate any problems with adequate supplies.

COMMUNICATION PRODUCTS DIVISION

The Company performs routine and specialized manufacturing, assembly, and
product testing functions in its corporate headquarters. The Company uses
equipment which automatically assembles components onto printed circuit boards
at high speed, which lowers manufacturing costs and reduces the time-to-market
for new product designs. The Company also maintains a quality assurance function
and testing area that performs optical and electrical testing and quality
control. Raw materials and supplies used in the Company's business include
optical materials, plastic products, and various electronic components, most of
which are available from numerous sources. The number of companies from which
the division can obtain optical emitters and detectors for use in its circuit
assemblies is limited. However, Optelecom has negotiated long-term supply
contracts with these vendors and does not anticipate significant supply
problems.

PARAGON

Paragon currently subcontracts all product manufacture and it is not the
intention to change this in the short-term. In the medium term, however, Paragon
intends to work closer with Optelecom and to utilize Optelecom's manufacturing
capabilities where practical and possible.

COMPETITION

The Company's products fall within three (3) separate and distinct markets. As
such, the characteristics of competition in these markets differ greatly.


                                       8
<PAGE>

Optelecom's Communication Products Division competes mainly with other companies
of roughly equal size that have similar resources. For low technology products,
such as fiber optic data modems, competition is intense, because these products
have reached a commodity status. In the areas of engineering products for
specific applications, Optelecom competes against companies of the same size or
larger. Competitors with larger research staffs have an advantage in these
markets.

Larger defense prime contractors dominate the market in which the E/O Technology
group competes. These companies have greater marketing, manufacturing,
financial, research, and personnel resources than Optelecom. In addition, as
Department of Defense contracting activity has declined, these companies have
started to compete in markets which were primarily addressed by companies with
resources similar to Optelecom's. As a result, the E/O Technology group is at a
competitive disadvantage when competing against prime contractors. Optelecom
feels that its IFOG coil winding technology is at least equal to the technology
developed by much larger prime contractors and in this market it can compete
equally.

Paragon competes primarily with both large and similar sized companies that have
similar products and addresses worldwide markets in financial market data
information and business television services. These markets have numerous
suppliers who compete with Paragon. However Paragon's strategy of providing its
customers with superior products and support services has enabled it to achieve
a pre-eminent position in the financial data information market.

The L/I Group is a sole-source provider of the products it supplies to the U.S.
Air Force. The services it provides pursuant to its current contract with the
U.S. Air Force that expires at the end of 1999.

SEASONALITY

The Company's products are based on communications equipment technology. As
such, seasonality does not materially affect the Company's revenues.

PATENTS

The Company holds certain patents. However, its business as a whole is not
materially dependent upon its ownership of any one patent or group of patents.
The Company does not license any patents from other parties, nor is it aware of
any restrictions on its current backlog business imposed by patents of other
parties.

BACKLOG

At the end of 1998 the backlog for each segment was as follows: Communications
Products Division $651,000, Paragon Audio Visual $168,000 and Government
Products Division $419,000.

EMPLOYEES

At December 31, 1998, the Company had a total of 84 full-time employees
worldwide, including 15 in research, development and engineering, 21 in sales,
marketing and service, 35 in manufacturing and 13 in general management,
administration and finance. The number of employees by operating segment is as
follows: Communication Products Division - 58; Paragon Audio Visual -17;
Government Products Division - 9. Subsequent to year end, Paragon


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<PAGE>

reduced its employees from 17 to 10 and CPD from 58 to 50. The Company intends
to hire additional personnel during the next 12 months in all areas except
general management, administration and finance. The Company's future success
will depend in part on its ability to attract, train, retain and motivate highly
qualified employees, who are in great demand. There can be no assurance that the
Company will be successful in attracting and retaining such personnel. The
Company's employees are not represented by any collective bargaining
organization and its employee relations are good.

RISK FACTORS

The statements contained in this report on Form 10-K that are not purely
historical are "forward-looking statements" within the meaning of the Private
Securities Litigation Reform Act of 1995 and Section 21E of the Securities
Exchange Act of 1934, including, without limitations, statements regarding the
Company's expectations, hopes, beliefs, anticipations, commitments, intentions
and strategies regarding the future. Forward-looking statements include, but are
not limited to, statements contained in "Item 1. Business," and "Item 7.
Management's Discussion and Analysis of Financial Condition and Results of
Operations" regarding the Company's business and strategies, products markets,
sales, marketing, customer support and service, research and development,
manufacturing, competition, backlog, employees, financial performance, revenue
and expense levels in the future, Year 2000 status and the sufficiency of its
existing assets to fund future operations and capital spending needs in Business
regarding the Company's products and its strategy. Actual results could differ
from those projected in any forward-looking statements for the reasons, among
others, detailed under "Risk Factors" in this Report on Form 10-K. The fact that
some of the risk factors may be the same or similar to the Company's past
filings means only that the risks are present in multiple periods. The Company
believes that many of the risks detailed here are part of doing business in the
industry in which the Company competes and will likely be present in all periods
reported. The fact that certain risks are endemic to the industry does not
lessen the significance of the risk. The forward-looking statements are made as
of the date of this Form 10-K and the Company assumes no obligation to update
the forward-looking statements, or to update the reasons why actual results
could differ from those projected in the forward-looking statements.

Fluctuations In Financial Performance

The Company has experienced and may in the future continue to experience
fluctuations in its quarterly and annual operating results. Factors that may
cause the Company's operating results to vary include, among other things,
customer purchasing patterns, changing technology, new product transitions,
delays in new product introductions, shortages of system components, changes in
the mix of products and services sold, the timing of investments in additional
personnel, facilities and research and development. As a result of the impact of
these and other factors, past financial performance should not be considered to
be a reliable indicator of the future performance in any particular fiscal
period. Moreover, because the Company has been increasing its operating expenses
for personnel, facilities and product development and is limited in its ability
to reduce expenses quickly in response to any revenue shortfalls, the Company's
business, financial condition and operating results would be adversely affected
if increased revenues are not achieved. For example, the Communications Products
Division had revenues of $8,742,232 for the twelve months ended December 31,
1998 compared to $9,734,087 for the same period in 1997, but an operating loss
of $237,357 in 1998 compared to operating income of $574,789 for the same period
in 1997. The decline in operating profits resulted in part because the Division
increased its product development expenses, experienced a lower rate of increase
in revenues than anticipated and

                                       10
<PAGE>

was unable to reduce its expenses quickly once the lower rate of revenue
increase became known. Total revenues increased to $16,333,749 for the twelve
months ended December 31, 1998 compared to $12,271,057 for the same period in
1997. The increase was attributable in large part to the acquisition of Paragon
Audio Visual Limited ("Paragon") in December, 1997; Paragon's revenues of
$6,041,787 were included with those of the Company for the twelve months ended
December 31, 1998 but not for the same period in 1997. The Company's results of
operations was a net loss of $2,811,344 for the twelve months ended December 31,
1998 compared to net income of $948,729 for the same period in 1997. The major
factors contributing to the loss in 1998 included: acquisition expenses of
Paragon of $2,200,000 (valuation write-down of $1.4 million, amortization
expense of goodwill and intangibles in the amount of $465,000 and interest
expense of $335,000), an increase of inventory and accounts receivables reserves
of $543,000, employee termination related charges of $620,000 and a change in
product mix as revenues shifted from Glint to Paragon. The Company has taken
significant steps to reduce its expenses, but there can be no assurance that the
Company will return to profitability in any future period.

Dependence On Major Customers

Historically, a relatively small number of customers have accounted for a
significant portion of the Company's revenues in any particular period. For the
twelve months ended December 31, 1998 approximately 30% of the Company's
revenues were accounted for by sales to the U.S. Government and three commercial
customers. The loss of the Company's contract with the U.S. Air Force (discussed
below) or its contract with one of these commercial customers, Fisher Control
Systems (an original equipment manufacturer), and Reuters could have a material
adverse effect on the company. The Company anticipates that sales of its
products to relatively few customers will diminish in magnitude over the next
few years. In the event of a reduction, delay or cancellation of orders from one
or more significant customers or if one or more significant customers select
products from one of the Company's competitors for inclusion in future product
generations, the Company's business, financial condition and operating results
could be materially and adversely affected. There can be no assurance that the
Company's current customers will continue to place orders with the Company, that
orders by existing customers will continue at current or historical levels or
that the Company will be able to obtain orders from new customers. The loss of
one or more of the Company's current significant customers could materially and
adversely affect the Company's business, financial condition and operating
results.

One contract with the U.S. Air Force accounted for 7% of the Company's revenues
and contributed $521,000 in operating income. The Company received the contract
in January 1996. It is a four year contract, with one base year and three
one-year options exercisable at the discretion of the Air Force, under which the
Company provides services for refurbishment of equipment for the C-130 Gunship
laser illuminator system (the "Glint Contract"). At December 31, 1998 the
contract had a remaining funded contract value of $400,000.

Government contracts are subject to audits, and contract payments in excess of
allowable costs are subject to adjustment and repayment. Audits have been
completed through 1993. Based on its interpretation of contracting regulations
and past experience, the Company believes that cost disallowances, if any, on
Government contracts will not be material, but there can be no assurance in that
regard. There can also be no assurance that the Company will receive
continuations of its existing contracts or additional contracts in the future or
that the federal government will not exercise its contractual rights to suspend
or cancel contracts, in whole or in part, on short notice. The future revenues
which the Company receives under the Glint Contract are also dependent on U.S.
Government and Air Force budgets, the defense

                                       11
<PAGE>

industry, the worldwide political situation and the continued requirements of
the Air Force, including its specific crew training schedules.

Technological Change

The Company's communication products are sold in markets that are subject to
rapid technological change. The Company's future success will depend in part
upon its ability to enhance its current products and to develop and introduce
new products that keep pace with technological developments and emerging
industry standards and that address the increasingly sophisticated needs of its
customers. There can be no assurance that the Company will be successful in
developing and marketing such products or producing enhancements that meet these
changing demands, that the Company will not experience difficulties that could
delay or prevent the successful development, introduction and marketing of these
products or that its new products and product enhancements will adequately meet
the demands of the marketplace and achieve market acceptance. The Company's
inability to develop and introduce new products or product enhancements in a
timely manner, or its failure to achieve market acceptance of a new product
could have a material adverse effect on the Company.

Competition

The Company faces intense and increasing competition from a large number of
competitors, some of which are larger than the Company and have larger product
development, research and sales staffs. To enhance the technological innovation
of its products, the Company has recently increased the size of its engineering
and development staff. There can be no assurance, however, that the Company's
competitors will not develop products that are more effective than the Company's
or that would render the Company's products obsolete or non-competitive.
Furthermore, the Company's ability to expand commercial sales of its products is
dependent in part upon its becoming more competitive with respect to
manufacturing efficiency and marketing capabilities. The Company has recently
increased its investment in manufacturing facilities and the size of its sales
and production staffs for communication products. There can be no assurance,
however, that these additions will provide the efficiencies and experience
necessary for an expansion of sales.

Paragon Operations

In December 1997 the Company acquired Paragon Audio Visual Limited ("Paragon").
The integration of Paragon proved to be costly in time and resources. As a
result of the length of time to integrate the acquisition, the Paragon operation
accumulated a loss of $3,000,718 during 1998, including employee severance
charges and write offs of intangibles acquired at the acquisition of Paragon.
During 1998, the Company invested in Paragon an additional $790,000 to fund
working capital requirements.

At the end of 1998, the Chairman of Paragon was terminated. Subsequently, the
remaining Directors of Paragon were terminated. Optelecom has named a new
management team from existing Paragon employees that has significant experience
in Paragon's markets and expects that the operations will return to
profitability during 1999. Paragon expects to return to profitability in 1999 by
materially reducing its overhead costs. Significant reductions include employee
terminations, closing of its New York City office, elimination of company
vehicles, travel and entertainment expenses. Sales for 1999 are expected to
remain constant with 1998 levels. However, there can be no assurance that
profitability will, in fact, be achieved.

                                       12
<PAGE>

With the acquisition of Paragon, the Company expects to expand its presence in
international markets and may in the future derive an even more significant
portion of its revenues from these markets. The Company's current and future
international business activities are subject to a variety of potential risks,
including political, regulatory and trade and economic policy risks. The Company
will also be subject to the risks attendant to translations in foreign
currencies. These factors could have a material adverse effect on the Company.

Future Capital Needs; Uncertainty Of Additional Funding

The Company believes that its existing capital resources and future operating
cash flows will generate the funds needed for its long-term cash requirements.
If the Company's growth rate should exceed expectations, or if the Company
should fail to generate the anticipated operating cash flows, the Company would
be required to seek additional funding. In those circumstances, the Company
would consider public or private debt or equity financings. There can be no
assurance that additional financing will be available in a timely manner or on
acceptable terms. If additional funds are raised by issuing equity securities,
further dilution to existing stockholders may result. If adequate funds are not
available when needed, the Company may be required to delay, scale back or
eliminate its product research and development and overhead costs.

Need To Attract And Retain Key Employees

The Company is substantially dependent on the business and technical expertise
of its senior management and on its ability to attract and retain key management
and technical employees. The loss of members of senior management or of other
key employees or the Company's inability to attract and retain other employees
with necessary business or technical skills in the future would have a material
adverse effect on the Company's business.

Year 2000 Potential Issues

Many of the world's computer systems currently record years in a two-digit
format. Such computer systems will be unable to properly interpret dates beyond
the year 1999, which could lead to business interruptions. The Company has
established an internal committee to address this problem.

The Company is currently engaged in a comprehensive project to upgrade its
information, technology, and manufacturing and facilities computer software to
programs that will consistently and properly recognize the Year 2000. Many of
the Company's systems include new hardware and packaged software recently
purchased from large vendors who have represented that these systems are already
Year 2000 compliant. The Company is in the process of obtaining assurances from
vendors that timely updates will be made available to make all remaining
purchased software Year 2000 compliant.

The Company will utilize both internal and external resources to reprogram or
replace and test all of its software for Year 2000 compliance, and the Company
expects to complete the project in mid 1999. Failure by the Company and/or
vendors and customers to complete Year 2000 compliance work in a timely manner
could have a material adverse effect on certain of the Company operations. The
cost of this project is being funded through operating cash flows. The estimated
cost of this project is not deemed to be significant, and it has not been, and
is not anticipated to be, material to the Company's financial position or
results of operations in any fiscal year. These costs and the time at which the
Company plans to complete any Year 2000 modifications are based on management's
best estimates, which

                                       13
<PAGE>

were derived utilizing numerous resources, third party modification plans and
other factors. There can be no assurance that these estimates will be achieved,
and actual results could differ from those plans.

Price Volatility In Public Market

The Company's Common Stock currently trades on the NASDAQ SmallCap Market. The
securities markets have from time-to-time experienced significant price and
volume fluctuations that may be unrelated to the operating performance of the
Company. In addition, the market prices of the common stock of many publicly
traded technology companies have in the past been, and can in the future be
expected to be, especially volatile. Announcements of technological innovations
or new products of the Company or its competitors, developments or disputes
concerning proprietary rights, publicity regarding products under development by
the Company or its competitors, regulatory developments in both the United
States and foreign countries, and economic and other external factors, as well
as period-to-period fluctuations in the Company's operating and product
development results, may have a significant impact on the market price of the
Company's Common Stock.

Absence Of Dividends; Dilution

The Company has not paid any cash dividends since its inception and does not
intend to pay any cash dividends in the foreseeable future. Dilution will occur
upon the exercise of outstanding stock options of the Company and may occur upon
future equity financings of the Company that could be required to fund
operations.

CONTRACT RENEGOTIATION AND TERMINATION

None of the Company's current contracts are subject to price re-negotiation.
However, the Company's contracts with the U.S. Government are always subject to
termination, which is a standard clause in any contract with the Government

ITEM 2.   PROPERTIES

In 1992 the Company moved its operations to new leased facilities at 9300
Gaither Road, Gaithersburg, Maryland, near Washington, DC. The facilities
consist of space in two adjacent buildings, one occupying 21,000 square feet,
with a ten-year lease term beginning September 1, 1992, and the other occupying
4,000 square feet, with a one-year term beginning in December, 1992 and one-year
renewal options. Current monthly rent is $17,592 on the larger space and $2,662
on the smaller one. On September 1, 1997, Optelecom rented additional space of
8,056 square feet co-located with its existing facilities. Current monthly rent
on this space is $5,186. All of the facilities are in good repair and are
adequate for the Company's current production requirements. Paragon rents
facilities in Beedon and London, England. These facilities consist of
approximately 3,234 square feet of office space with a total rent of $6,420 per
month and have leases that expire in March 2001.

ITEM 3.   LEGAL PROCEEDINGS

On March 18, 1999, David Brown, formerly Chairman and Marketing Director of
Paragon Audio Visual Ltd., lodged an Originating Application with the Employment
Tribunal of the United Kingdom in Reading, England. Mr. Brown alleges that
Paragon dismissed Mr. Brown unlawfully and in breach of his alleged employment
contract rights. He seeks an award of money in an unspecified amount. The time
within which Paragon may file a response has not

                                       14
<PAGE>

yet expired and the Company has not yet filed a response. The Company believes
that Mr. Brown's claims are without merit and intends to present a vigorous
defense. The Company also believes that it may have counterclaims that may be
asserted against Mr. Brown in this proceeding and is considering the assertion
of such counter-claims.

From time to time, the Company is involved in legal proceedings and litigation
arising in the ordinary course of business. As of the date of this report,
except as described above, the Company is not a party to any litigation or other
legal proceeding that, in the opinion of management, could have a material
adverse effect on the Company's business, financial condition or results of
operations.

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

No matters were submitted during the fourth quarter of 1998 to a vote of
security-holders.

                                     PART II

ITEM 5.   MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS

The Company's Common Stock, $0.03 par value (Common Stock) is traded in the
over-the-counter market. Set forth below are the highest and lowest closing bid
prices for the Common Stock as reported by the National Association of
Securities Dealers Automated Quotation Service (NASDAQ) during each quarter for
the two years ended December 31, 1998 and 1997, respectively. The quoted prices
are reflective of a three-for-two common stock split issued to shareholders of
record on November 17, 1997. Such quotations do not necessarily reflect actual
transactions.

                                                     Bid Price
                                                     ---------
               Quarter Ended                   High              Low
               -------------                   ----              ---
               December 31, 1998              5 13/16     -     2 3/8
               September 30, 1998            10 7/16      -     6
               June 30, 1998                 11 1/2       -     6 1/8
               March 31, 1998                10 1/8       -     6 1/2

               December 31, 1997             10 1/8       -     6
               September 30, 1997            12           -    11 11/16
               June 30, 1997                  9 3/8       -     9 3/16
               March 31, 1997                 8 5/16      -     6 7/8


There are approximately 892 record-holders of the Common Stock as of March 17,
1999.

The Company has not declared any cash dividends to date and does not expect to
do so in the foreseeable future.


                                       15
<PAGE>


ITEM 6.   SELECTED FINANCIAL DATA

Set forth below is selected financial data for the Company's most recent five
fiscal years.

<TABLE>
<CAPTION>
                                                    YEAR ENDED DECEMBER 31,
                                  1998           1997           1996          1995           1994
                            --------------------------------------------------------------------------
<S>                         <C>             <C>            <C>            <C>             <C>         
Net Revenue                 $ 16,333,749    $ 12,271,057   $  8,910,263   $  6,430,136    $  7,036,069

Net (Loss) Income           $ (2,811,344)   $    948,729   $    722,081   $   (208,384)   $    382,347

Basic (Loss) Earnings per   
Common Share                      $(1.34)          $0.51          $0.41         $(0.12)          $0.25

Diluted (Loss) Earnings     
per Share                         $(1.34)          $0.48          $0.39         $(0.12)          $0.25

Total Assets                $  8,631,948    $ 12,209,741   $  4,466,463   $  3,674,004    $  3,617,298

Long-Term Obligations       $  1,726,672    $  2,291,668   $     11,607   $     46,426              --

Stockholders' Equity        $  3,290,632    $  5,799,819   $  3,041,631   $  2,188,777    $  2,384,303

Cash Dividends Declared     
per Common Share                    $.00            $.00           $.00           $.00            $.00
</TABLE>


ITEM 7.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
          RESULTS OF OPERATIONS

FINANCIAL CONDITION

Due to the nature of the Company's business, the key components of its financial
condition constitute receivables, inventory, fixed assets, accounts payable, and
debt. The Company saw a decrease in net worth to $3,290,632 in 1998. Prior year
trends of key financial indicators show a change in corporate net worth from
$5,799,819 for 1997 compared to $3,041,631 in 1996. The 1998 current ratio
decreased to 1.34 from 1.62 in 1997 and 2.95 in 1996. This was due to increases
in current notes payable and other current liabilities.

Total corporate accounts receivable after allowance for doubtful accounts but
including Paragon were $1,426,306. Year-end 1998 billed accounts receivable was
$1,727,778. Billed accounts receivable was $3,052,207 at year-end 1997 and
$1,324,564 in 1996. The decrease in accounts receivable was due to the general
decrease in business experienced in the fourth quarter of 1998. In 1998 Days
Sales Outstanding in receivables was 51 days compared to 58 days in 1997 and 52
days in 1996. The decrease from 1997 was primarily a result of the Company's
aggressive approach to account collections and the Company will maintain its
aggressive accounts collection program. The 1998 increase in allowance for
doubtful accounts reflects management's attempt to properly reserve against
write offs and also due to specific identification of problem accounts at year
end. The Company also uses a careful screening process and performs credit
qualification of customers before accepting their orders. For any new account,
credit checks are always conducted, and questionable situations are either
placed on a COD or a letter of credit basis. Accounts receivable is closely
monitored; those that are delinquent are continuously contacted until payment is
received.


                                       16
<PAGE>


The overall composition of the inventory has changed somewhat over the last
three years as shown in the following chart: (Paragon inventory is included
which is composed solely of finished goods.)

INVENTORY COMPOSITION                         1998          1997        1996
Production Materials (net of allowance)   $  407,022   $  499,084   $  765,783
Work In Process                              381,659      455,648      397,123
Finished Goods                             1,058,432      798,141      342,062
                                          ----------   ----------   ----------
TOTAL                                     $1,847,113   $1,752,873   $1,504,968

One of the tools the Company uses for trend analysis is a comparison of r
inventory levels to total sales. In 1998, this level was 11% compared to 14% in
1997 and 17% in 1996. The value of the raw material and work in process
inventory decreased by approximately $166,000 in 1998 compared to 1997. The
increase in Finished Goods reflects growth in CPD inventory and the addition of
the Paragon inventory. Although the Company's objective is to reduce inventory
levels as much as possible, the value of finished goods inventory increased
substantially in 1998 to provide products available from stock. This action was
taken to meet competitive pressures, as customers are demanding shorter product
delivery times. The Company has reduced the amount of raw material inventory to
partially offset the higher level of finished goods inventory. The Company
believes that its reserve for inventory obsolescence is adequate to properly
value any excess quantities of this inventory.

In 1998, fixed asset additions were $505,616 compared to $701,529 in 1997,
excluding the Paragon acquisition and $219,119 in 1996.

RESULTS OF OPERATIONS

1998 versus 1997

Consolidated sales in 1998 were $16.3 million, which represents an increase over
1997 sales of $4.06 million or 33%. The increase in sales in 1998 is directly
related to Optelecom's acquisition of Paragon whose sales contributed $6.04
million in 1998. Although the company achieved record revenues in 1998, the
operating results were significantly lower than expectations. The Company
recorded a net loss of $2.81 million or $1.34 per share in 1998 compared to a
profit of $949,000 or $0.48 per share in 1997. These losses were attributed to
various factors with the most significant factor the costs incurred related to
the acquisition of Paragon. Paragon had a loss of $3,000,718 during 1998.

In total, the Company recorded losses before income tax benefit aggregating $3.4
million relating to the acquisition of Paragon, which includes the write off of
$1.4 million in intangibles related to employment commitments by the former
Paragon shareholders. In the beginning of 1999, the Company replaced the former
owners with a new management team. Significant reductions in overheads were
implemented with the expectation that Paragon will achieve operating profits in
1999.

The Company made a significant investment in its research and development
efforts. The most significant investment was the allocation of $426,000 to a new
research effort related to the development of high-speed optical components. The
Company is committed to invest in this project until the middle of 1999, by
which time it intends to seek outside funding to continue with the product
development efforts. There can be no assurance that the Company will be
successful in securing outside funding.

                                       17
<PAGE>

Additional valuation reserves aggregating $543,000 were recorded in 1998 to
write-down inventory and accounts receivables. They were recorded to account for
obsolescence of some products and for failure to collect a portion of current
accounts receivable.

Another factor contributing to the downturn in profits from 1997 was lower sales
from the GLINT program and lower sales in the CPD segment. The GLINT contract is
slowly winding down and, as such, revenues are expected to decline. The Company
expects that revenues from the GLINT contract will terminate after 1999. CPD
sales were down as a result of a lack of new large contract sales in 1998
compared to 1997 and the delay in the introduction of a new product, the 9000
series.

1997 versus 1996

Consolidated 1997 revenues were 38% higher than 1996. Consolidated 1997 revenues
include $164,040 from Paragon subsequent to the December 12, 1997 acquisition
date. A net profit of $948,729, which represented 8% of revenue for 1997,
compares to a net profit of $722,081 (8%) for 1996.

Operating Segments

Optelecom's products and services are categorized into three operating segments:
Communications Products, Government Products and Paragon Products. The financial
results for the three operating segments have been prepared on a basis that is
consistent with the manner in which Optelecom management internally evaluates
financial information for the purpose of assisting in making internal operating
decisions. In this regard, certain common expenses have been allocated among
segments differently than would be required for stand alone financial
information prepared in accordance with generally accepted accounting
principles.

COMMUNICATION PRODUCTS DIVISION

<TABLE>
<CAPTION>
                                     1998          %         1997        %         1996          %
<S>                               <C>           <C>      <C>          <C>       <C>           <C>  
 Net sales                        $8,742,232    100.0    $9,734,087   100.0     $6,453,685    100.0
 Gross profit                      4,039,724     46.2     4,387,639    45.1      2,657,056     41.2
 Total operating expense           4,277,081     48.9     3,812,850    39.2      2,639,513     40.9
 Operating (loss) income           (237,357)    (2.7)       574,789     5.9         17,543       .3
</TABLE>


In 1998, the CPD group underwent significant changes. Key members of management
were replaced as the group regained its focus on its core competencies.
Expansion efforts in 1997 severely impeded the organization, as revenue growth
expectations did not materialize. The Company implemented cost reductions in
1998 and recorded approximately $300,000 related to legal costs associated with
employee terminations.

Sales in the CPD segment were down almost $1 million compared to 1997. The
decline in sales is partly due to a delay in the introduction of the 9000
product series. Additionally, significant changes in the sales organization
during 1998 had a negative impact on sales expectations. Two large contracts in
1997 resulted in a significant growth from the previous year. However, these
contracts did not repeat in 1998. Gross profits declined by $348,000 due to the
reduction in sales levels from 1997. The gross profit margin was 46% in 1998
compared with 45% in 1997. Operating expenses increased by $360,000 or 9.5%
primarily due to increases in engineering and general and administrative costs.
Engineering increased by

                                       18
<PAGE>

$235,000 to reflect additional resources added to the engineering group. General
and administrative costs increased as a result of termination charges related to
employee terminations.

In 1997, the Communication Products Division revenues increased by 51% over 1996
and resulted in an operating profit of $605,271 compared to a profit of $56,784
in 1996. The product sales mix was more favorable in 1997, with system
integrator sales up significantly and low margin product sales down compared to
1996. New products in fiber optic trader desk and air traffic control video
monitors and lower cost designs helped increase revenues in 1997. The Company
was successful in implementing product designs specifically intended to be
produced by automatic assembly processes to minimize direct costs.

Gross profits increased in 1997 as a percent of sales due to higher sales volume
and the reduction in price discounts compared to 1996.

Operating expenses increased in 1997 by $1,182,096 over 1996 expenses.
Commercial Product engineering development costs has increased, reflecting
increased staff size and workload. During 1997, development focussed on
additions to the product line for compressed digital video equipment and air
traffic control equipment. The Company implemented changes to the sales and
marketing staff to more closely align the technical aspects of the selling
process with customer requirements and also changed the corporate management
staff to strengthen the division's efforts.

GOVERNMENT PRODUCTS DIVISION

<TABLE>
<CAPTION>
                                  1998          %         1997        %         1996         %
<S>                             <C>           <C>      <C>          <C>      <C>            <C>  
 Net sales                      $1,549,731    100.0    $2,372,950   100.0    $2,456,577     100.0
 Gross profit                      875,628     56.5     1,371,284    57.8     1,383,285      56.3
 Total operating expense           768,205     49.6       565,273    23.8       368,606      15.0
 Operating income                  107,473      6.9       806,011    34.0     1,014,679      41.3
</TABLE>

Sales decreased by $823,000 in 1998 compared with 1997. The decline in sales is
related to lower revenue on the GLINT contract ($585,000) and a reduction in
sales in the Electro/Optics group related to DARPA and Honeywell Systems
($239,000). The decline in revenue is expected to continue in 1999 as the GLINT
contract requirements are completed. Gross profit declined by $495,000 in 1998
due to the decline in sales. The gross profit margin remained unchanged at 56%
in 1998 and in 1997. Operating expenses increased by $203,000 as a result of a
$426,000 investment in new research and development efforts and was offset by
declines in allocated administrative charges.

Sales declined $83,627 in 1997 compared to 1996. E/O Technology Group's 1997
revenues increased 16% compared to 1996. The increase occurred primarily due to
additional work from DARPA and Honeywell Systems and contract coil winding work.
The Laser Illuminator technology group's revenue for 1997 was $1,684,260
compared to $1,863,596 in 1996 and $715,296 in 1995. The slight decrease in the
level of revenue in 1997 compared to 1996 was due to fewer Air Force
requirements based on the number of serviceable aircraft. Gross profits remain
constant in 1997 compared to 1996. The increase in operating expenses in 1997
over 1996 reflects a higher corporate allocation to GPD, which is apportioned on
the basis of percent of segment revenue compared to total Company revenue.


                                       19
<PAGE>


PARAGON AUDIO VISUAL LIMITED

Paragon was acquired in December 1997. Accordingly, 1998 was the first year of
its operations within Optelecom. During 1998, Paragon had a pretax loss of
$(3,412,991). The components of Paragon's loss can be summarized as follows:

<TABLE>
<CAPTION>
                                                                            1998
<S>                                                                    <C>       
Revenues                                                               $ 6,041,784
Gross margins                                                            1,545,596
Operating expenses                                                       2,560,776
Operating (loss)                                                        (1,015,180)

The following expenses were incurred during 1998 related to Paragon:
     Amortization of intangibles                                           265,178
     Amortization of goodwill                                              200,722
     Acquisition interest                                                  233,207
     License fee                                                           175,000
     Write down of intangible assets related to employment commitments   1,462,500
Financing Costs:
     Interest expense of working capital loan                               61,206
</TABLE>

Revenues for 1998 represented increased sales in Paragon's products in its
traditional market. Paragon sold minimal Optelecom fiber products, as there were
product certification and market issues that delayed the selling efforts. The
gross margin was 26%. This rate reflects the fact that Paragon subcontracts its
product design and manufacturing. Significant improvements in gross margins are
expected to be realized once Paragon products are developed and manufactured by
the Company. Operating expenses increased at a much higher rate than expected.
The number of employees doubled in 1998 from 1997 and facilities increased both
by expanding the headquarters and opening a sales office in London and New York
City. Significant reserves were recorded for accounts receivable and inventory.
Paragon previously had not recorded provisions for bad debts or inventory
obsolescence.

As a result of the operating losses, cost reductions were taken by terminating
positions and closing down the New York City office. All the original Directors
of Paragon were terminated and their positions either eliminated or replaced by
existing Paragon employees. The Company moved to reduce all unnecessary costs.
The Company has taken the steps to bring expenses in line with revenues. Paragon
recorded $320,000 related to the cost reductions. The expectations for 1999 are
that Paragon will achieve operating profits.

OTHER OPERATING EXPENSES

Corporate

Income tax (benefit) expense was $(319,308) in 1998, $418,490 in 1997 and
$310,136 in 1996. The effective tax rate was (10.2%) in 1998, 30.5% in 1997 and
30% in 1996. In 1998 the effective tax rate was (10.2%) as a result of the net
operating loss during the year. The effective tax rate in 1997 and 1996 is
positively influenced by increased overseas sales, since certain tax advantages
can be realized through our Foreign Sales Corporation (FSC).


                                       20
<PAGE>

Interest expense was $334,749 in 1998 compared to $19,653 for 1997 and increased
from $19,460 in 1996. The majority of the interest expense, $290,480 in 1998, is
reflective of increased borrowings related to the Paragon acquisition.

Impact of Inflation

Inflation has not had any significant effect on the operations of the Company
during 1998, and we do not expect it to have any significant effect during 1999.

LIQUIDITY AND CAPITAL RESOURCES

The Company has financed its operations through cash generated from operations
and investing activities, primarily through its bank line-of-credit. In 1998,
net cash provided from operations was $513,127 compared to $526,794 and $387,304
in 1997 and 1996, respectively. Noncash items for depreciation and amortization
amounted to $2,334,665 in 1998. Noncash outlays for these items in 1997 were
$300,232 and $235,431 in 1996. Net cash used in investing activities in 1998
amounted to $502,644 used for the purchase of capital equipment, general office
equipment and facility upgrades. In 1997, the cash used in investing activities
was $3,343,380 of which $2,750,851 was used in the purchase of Paragon Audio
Visual Ltd. In 1996, the cash used in investing activities was $219,119 for the
purchase of manufacturing equipment and general office equipment. The Company
generated $134,924 from its financing activities in 1998, $2,879,667 in 1997 and
$35,954 in 1996. Borrowings on the line-of-credit was the primary source in
1998. Borrowings on a long-term note (for the purchase of Paragon) was the
primary source in 1997 and proceeds from exercise of stock options was the
primary source in 1996. The Company has the ability, provided there are
sufficient eligible receivables, to borrow up to $1,700,000 under its line of
credit as of December 31, 1998. The Company's line-of-credit expires on April
30, 1999; however, management expects to renew the line-of credit under
substantially similar terms through April 30, 2000. The Company is required to
comply with certain financial ratios including maintaining a minimum current
ratio and a minimum ratio of cash flow to fixed obligations. The Company was in
violation of the cash flow covenant as of December 31, 1998. At the end of 1998
the outstanding balance under the line of credit agreement was $650,000.

As of December 31, 1997, the Company's subsidiary, Paragon, had been advanced
$363,000 under a factoring agreement. In February 1998, the Company terminated
the factoring agreement and settled all outstanding liabilities under the
agreement. Paragon's future working capital needs are expected to be financed by
its operating cash flows or inter-company loans from the Company. Paragon is
operating as a stand-alone entity. Should the need arise for increased cash due
to increased business activity, additional funding needs will be addressed.
Management anticipates that operating cash flows will generate the long-term
cash requirements of Optelecom and Paragon. If the level of business should
dictate, other infusions of capital may be needed. Paragon's business is
transacted in British Pounds. The results of operations may be affected by
foreign exchange gains/losses. Currently neither Optelecom nor Paragon have
hedging strategies in place.


                                       21
<PAGE>


Contingencies


On March 18, 1999, David Brown, formerly Chairman and Marketing Director of
Paragon Audio Visual Ltd., lodged an Originating Application with the Employment
Tribunal of the United Kingdom in Reading, England. Mr. Brown alleges that
Paragon dismissed Mr. Brown unlawfully and in breach of his alleged employment
contract rights. He seeks an award of money in an unspecified amount. The time
within which Paragon may file a response has not yet expired and the Company has
not yet filed a response. The Company believes that Mr. Brown's claims are
without merit and intends to present a vigorous defense. The Company also
believes that it may have counterclaims that may be asserted against Mr. Brown
in this proceeding and is considering the assertion of such counter-claims.

YEAR 2000

The Year 2000 is an issue because many computers, software and other devices
with embedded technology use programs written using two digits rather than four
to identify the applicable year and this may prevent them from accurately
processing information with dates beyond 1999. This could result in system
failures or miscalculations causing disruptions of operations, including, among
other things, a temporary inability to manufacture products, acquire or ship
inventory, process transactions or engage in other normal business activities.

The Company has developed and is well into implementing a Company-wide Year 2000
plan to identify all systems which will require modification or replacement and
to establish appropriate contingency plans to avoid an impact on the Company's
ability to provide its products and


                                       22
<PAGE>

services. This plan encompasses the Company's products, financial reporting and
operating systems, external suppliers and facilities. The Company's plan
includes a series of initiatives to ensure that all of the Company's computer
equipment and software will function properly and includes broad identification,
assessment, remediation and testing efforts.

Based upon its inventory of systems and assessment efforts to date, the Company
believes that certain of its computer equipment and software will require
replacement or modification. In addition, in the ordinary course of business,
the Company replaces computer equipment and software, and in so doing, seeks to
acquire only Year 2000 compliant software and hardware. The Company believes
that its planned modifications or replacements will be completed on a timely
basis so as to avoid any disruptions or malfunctions due to any Year 2000
related problems.

The Company has substantially completed its compliance review of virtually all
of its products and has not learned of any products which it manufactures that
will cease functioning or experience an interruption of operation as a result of
the transition to the Year 2000.

The Company is currently assessing the Year 2000 readiness of suppliers to
determine the extent to which the Company may be vulnerable if those parties
fail to properly identify and fix their own Year 2000 issues. The Company
intends to monitor the progress made by these parties and formulate appropriate
contingency plans.

The costs of the plan are based on management's best estimates and are not
expected to be material to the Company's financial condition. The Company's
total cost of the Year 2000 plan, which will be funded through operating cash
flow, is estimated to be approximately $500,000 of which $200,000 is anticipated
to be spent on capital assets. These estimated costs include the internal costs,
including training, and those of external resources to implement any new
software needed to become Year 2000 compliant.

Management believes, based on the information currently available to them, that
the most likely worst case scenario would be: failure to be able to serve
customers, increased operation costs due to manual processing, legal risks,
including customer, supplier or shareholder lawsuits over failure to provide
contracted services, product failures or heath and safety issues and inability
to bill or invoice resulting in a loss of revenue. Although the Company believes
that Year 2000 compliance will be achieved by December 31, 1999, there can be no
assurance that the Year 2000 problem will not have a material adverse affect on
the Company's business, financial condition and results of operations.

The Company's plan requires that contingency plans be developed and validated in
the event that any critical system cannot be corrected and certified before the
system's failure date. In many cases, the Company already has arrangements with
suppliers of goods and services so that in the event a commitment is not met; a
substitute is available to the Company. Although the Company is in the process
of installing new enterprise-wide systems that are Year 2000 compliant,
management believes the Company can readily upgrade its critical financial and
operating systems with vendor provided version upgrades that are Year 2000
compliant. The Company currently has an informal contingency plan and it will
formalize its contingency plan during the first half of 1999.


                                       23
<PAGE>

New Accounting Standard

In June 1998 the Financial Accounting Standards Board issued SFAS No. 133
"Accounting for Derivative Instruments and Hedging Activities." The Company does
not currently use derivatives, and it does not expect adoption of this Standard
to have a material impact on its financial position or results of operations.

In March 1998 the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants issued Statement of Position (SOP)
98-1 entitled "Accounting for the Costs of Computer Software Developed or
Obtained for Internal Use." The pronouncement will become effective January 1,
1999. The Company does not believe that the SOP will have a material impact on
the Company's financial position or results of operation.

Item 7A Quantitative and Qualitative Disclosure about Market Risks.

    Not Applicable.


                                       24
<PAGE>



Item 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                                 OPTELECOM, INC.

       Consolidated Financial Statements as of December 31, 1998 and 1997,
           and the Three Years in the period ended December 31, 1998,
                        and Independent Auditors' Report


                                       25
<PAGE>




OPTELECOM, INC.
<TABLE>
<CAPTION>
TABLE OF CONTENTS
--------------------------------------------------------------------------------
                                                                                      Page
<S>                                                                                   <C>
INDEPENDENT AUDITORS' REPORT ..........................................................26

CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE YEARS IN THE PERIOD ENDED
   DECEMBER 31, 1998, 1997 and 1996:


   Consolidated Balance Sheets.........................................................27  

   Consolidated Statements of Operations...............................................28  

   Consolidated Statements of Comprehensive (Loss) Income..............................29

   Consolidated Statements of Stockholders' Equity.....................................30  

   Consolidated Statements of Cash Flows...............................................31  

   Notes to Consolidated Financial Statements..........................................32

   Schedule of Valuation and Qualifying Accounts.......................................49
</TABLE>


                                       25
<PAGE>



INDEPENDENT AUDITORS' REPORT

To the Board of Directors and
  Stockholders of Optelecom, Inc.:

We have audited the accompanying consolidated balance sheets of Optelecom, Inc.
and subsidiaries (the Company) as of December 31, 1998 and 1997, and the related
consolidated statements of operations, comprehensive (loss) income,
stockholders' equity and cash flows for each of the three years in the period
ended December 31, 1998. Our audits also included the financial statement
schedule listed in the accompanying index. These financial statements and
financial statement schedule are the responsibility of the Company's management.
Our responsibility is to express an opinion on the financial statements and
financial statement schedule based on our audits.

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

In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of the Company as of December 31, 1998
and 1997, and the results of their operations and their cash flows for each of
the three years in the period ended December 31, 1998, in conformity with
generally accepted accounting principles. Also, in our opinion, such financial
statement schedule, when considered in relation to the basic consolidated
financial statements taken as a whole, presents fairly, in all material
respects, the information set forth therein.

/s/Deloitte & Touche LLP

McLean, VA
March 26, 1999


                                       27
<PAGE>



OPTELECOM, INC.
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 1998 AND 1997

<TABLE>
<CAPTION>
------------------------------------------------------------------------------------------------------
                                 ASSETS                                         1998           1997
<S>                                                                       <C>             <C>
CURRENT ASSETS:
   Cash and cash equivalents                                              $    394,096    $    242,656
   Restricted cash (Note 14)                                                   328,700         728,000
   Accounts and contracts receivable (Note 3)                                1,426,306       3,102,904
   Note receivable - related party (Note 4)                                         --          40,000
   Inventories, net (Note 5)                                                 1,847,113       1,752,873
   Prepaid expenses and other assets                                           344,448         334,530
   Deferred tax asset                                                          307,960         200,874
                                                                          ------------    ------------
        Total current assets                                                 4,648,623       6,401,837

Intangible assets, net (Notes 2 and 6)                                       2,351,563       4,239,062
Goodwill, net (Note 2)                                                         238,493         289,785
Property and equipment, net (Note 7)                                         1,361,095       1,265,550
Deferred tax asset                                                              32,174          13,507
                                                                          ------------    ------------
TOTAL  ASSETS                                                             $  8,631,948    $ 12,209,741
                                                                          ============    ============

                  LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
   Bank line-of-credit payable (Note 8)                                   $    650,000    $    300,000
   Accounts payable                                                            765,971       1,640,460
   Payable under factoring agreement (Note 14)                                      --         362,868
   Accrued payroll                                                             204,888         405,597
   Income taxes payable (Notes 9 and 14)                                       328,700         728,000
   Other current liabilities                                                   892,848         300,384
   Current portion of notes payable (Note 10)                                  624,996         208,332
                                                                          ------------    ------------
        Total current liabilities                                            3,467,403       3,945,641
                                                                          ------------    ------------

LONG-TERM LIABILITIES:
   Notes payable (Note 10)                                                   1,726,672       2,291,668
   Deferred rent liability                                                     147,241         172,613
                                                                          ------------    ------------
               Total liabilities                                             5,341,316       6,409,922
                                                                          ------------    ------------

Commitments and contingencies (Note 11)                                             --              --

STOCKHOLDERS' EQUITY (Note 12):

   Common stock, $.03 par value - shares authorized, 15,000,000; issued
        and outstanding, 2,156,557 and 2,032,137 shares                         64,697          60,964
   Discount on common stock                                                    (11,161)        (11,161)
   Additional paid-in capital                                                4,105,029       3,812,638
   Foreign currency translation adjustment                                       6,033              --
   Retained earnings (deficit)                                                (873,966)      1,937,378
                                                                          ------------    ------------
        Total stockholders' equity                                           3,290,632       5,799,819
                                                                          ------------    ------------
TOTAL LIABILITIES AND STOCKHOLDERS'  EQUITY                               $  8,631,948    $ 12,209,741
                                                                          ============    ============
</TABLE>


See notes to consolidated financial statements.


                                       28
<PAGE>



                                 OPTELECOM, INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS
                        FOR THE YEARS ENDED DECEMBER 31,

--------------------------------------------------------------------------------
<TABLE>
<CAPTION>
                                                          1998              1997            1996
<S>                                                 <C>             <C>            <C>         
Revenues                                            $ 16,333,749    $ 12,271,057   $  8,910,263
Cost of goods sold                                     9,967,408       6,462,447      4,869,922
                                                    ------------    ------------   ------------
Gross profit                                           6,366,341       5,808,610      4,040,341

Operating expenses:
        Engineering                                    1,773,904       1,031,724        678,222
        Selling and marketing                          2,367,408       1,548,005      1,180,296
        General and administrative                     3,520,210       1,833,750      1,130,146
                                                    ------------    ------------   ------------
               Total operating expenses                7,661,522       4,413,479      2,988,664

Operating (loss) income                               (1,295,181)      1,395,131      1,051,677

Other expenses:
        Interest expense                                 334,749          19,653         19,460
        Write-down of intangible assets (Note 15)      1,462,500              --             --
        Amortization of goodwill                          38,222           8,259             --
                                                    ------------    ------------   ------------
               Total other expenses                    1,835,471          27,912         19,460

(Loss) income before (benefit) provision for
income taxes                                          (3,130,652)      1,367,219      1,032,217

(Benefit) provision for income taxes                    (319,308)        418,490        310,136
                                                    ------------    ------------   ------------
Net (loss) income                                   $ (2,811,344)   $    948,729   $    722,081
                                                    ============    ============   ============
Basic (loss) earnings per share                     $      (1.34)   $       0.51   $       0.41
                                                    ============    ============   ============
Diluted (loss) earnings per share                   $      (1.34)   $       0.48   $       0.39
                                                    ============    ============   ============
</TABLE>


See notes to consolidated financial statements.


                                       29
<PAGE>

OPTELECOM, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996

<TABLE>
<CAPTION>
                                               1998           1997          1996
<S>                                        <C>            <C>           <C>        
Net (Loss) Income                          $(2,811,344)   $   948,729   $   722,081

Foreign Currency Translation Adjustments         6,033             --            --
                                           -----------    -----------   -----------
Comprehensive (Loss) Income                $(2,805,311)   $   948,729   $   722,081
                                           ===========    ===========   ===========
</TABLE>



See notes to consolidated financial statements.


                                       30
<PAGE>






OPTELECOM, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996


<TABLE>
<CAPTION>
                                                                             ADDITIONAL CAPITAL
                                                                           -----------------------
                                                    NUMBER       COMMON       DISCOUNT      PAID-IN     
                                                      OF         STOCK       ON COMMON      CAPITAL     
                                                    SHARES                     STOCK                    
<S>                                                <C>        <C>          <C>           <C>            
BALANCE, JANUARY 1, 1996                           1,171,042  $    35,131  $   (11,161)  $ 1,898,239    
                                                                                                        
   Common stock issued                                36,532        1,096           --       129,677    
                                                                                                        
Net income                                                --           --           --            --    
                                                   ---------  -----------  -----------   -----------    
BALANCE, DECEMBER 31, 1996                         1,207,574       36,227      (11,161)    2,027,916    
                                                                                                        
   Common stock issued from exercise of                                                                 
    options and for services provided                 49,511        1,485           --       124,608    
                                                                                                        
   Tax effect of options exercised                        --           --           --        67,352    
                                                                                                        
   Three-for-two stock split (see Note 10)           603,800       18,114           --       (18,114)   
                                                                                                        
   Issuance of Common stock for acquisition of                                                          
     Paragon, net of issuance cost of $8,986         171,252        5,138           --     1,610,876    
                                                                                                        
   Net Income                                             --           --           --            --    
                                                   ---------  -----------  -----------   -----------    
BALANCE, DECEMBER 31, 1997                         2,032,137       60,964      (11,161)    3,812,638    
                                                                                                        
   Common stock issued from exercise of                                                                 
    Options                                          124,420        3,733           --       292,391    
                                                                                                        
   Foreign currency translation adjustment                --           --           --            --    
                                                                                                        
   Net Loss                                               --           --           --            --    
                                                   ---------  -----------  -----------   -----------    
BALANCE, DECEMBER 31, 1998                         2,156,557  $    64,697  $   (11,161)  $ 4,105,029    
                                                   =========  ===========  ===========   ===========    
                                                  

                                                 
<CAPTION>
                                                    RETAINED       FOREIGN        TOTAL      
                                                    EARNINGS      CURRENCY    STOCKHOLDERS'  
                                                    (DEFICIT)    TRANSLATION     EQUITY      
                                                                 ADJUSTMENT                  
<S>                                               <C>            <C>         <C>    
BALANCE, JANUARY 1, 1996                          $   266,568            --  $ 2,188,777     
                                                                                             
   Common stock issued                                     --            --      130,773     
                                                                                             
Net income                                            722,081            --      722,081     
                                                  -----------   -----------  -----------     
BALANCE, DECEMBER 31, 1996                            988,649            --    3,041,631     
                                                                                             
   Common stock issued from exercise of                                                      
    options and for services provided                      --            --      126,093     
                                                                                             
   Tax effect of options exercised                         --            --       67,352     
                                                                                             
   Three-for-two stock split (see Note 10)                 --            --           --     
                                                                                             
   Issuance of Common stock for acquisition of                                               
     Paragon, net of issuance cost of $8,986               --            --    1,616,014     
                                                                                             
   Net Income                                         948,729            --      948,729     
                                                  -----------   -----------  -----------     
BALANCE, DECEMBER 31, 1997                          1,937,378            --    5,799,819     
                                                                                             
   Common stock issued from exercise of                                                      
    Options                                                --            --      296,124     
                                                                                             
   Foreign currency translation adjustment                 --         6,033        6,033     
                                                                                             
   Net Loss                                        (2,811,344)           --   (2,811,344)    
                                                  -----------   -----------  -----------     
BALANCE, DECEMBER 31, 1998                        $  (873,966)  $     6,033  $ 3,290,632     
                                                  ===========   ===========  ===========     
</TABLE>







See notes to consolidated financial statements.

                                       31
<PAGE>




                                          OPTELECOM, INC.
                                  CONSOLIDATED STATEMENTS OF CASH
                                  FOR THE YEARS ENDED DECEMBER 31,

--------------------------------------------------------------------------------
<TABLE>
<CAPTION>
                                                                    1998           1997         1996
<S>                                                             <C>           <C>           <C>
Cash Flows From Operating Activities
Net (loss) income                                               $(2,811,344)  $   948,729   $   722,081
Adjustments to reconcile net (loss) income to net cash
provided by operating activities:
   Depreciation and amortization                                    872,165       300,232       235,431
   Write-down of intangible assets                                1,462,500            --            --
   Loss (gain) on sale/disposal of equipment                            835       (15,357)           --
   Deferred rent                                                    (25,372)      (19,343)      (13,489)
   Common stock issued for services                                      --         8,000            --
   Deferred taxes                                                  (125,753)      (68,560)     (145,821)
Change in assets and liabilities:
   Accounts and contracts receivable                              1,676,598      (880,155)      (52,217)
   Inventories                                                      (94,240)      (50,828)     (424,627)
   Prepaid expenses and other assets                                 40,472        (1,595)     (197,660)
   Restricted cash                                                  399,300      (728,000)           --

   Accounts payable                                                (874,489)      316,214      (208,727)
   Accrued payroll                                                 (200,709)      111,554        46,794
   Income tax refund receivable                                          --            --       215,693
   Other current liabilities                                        592,464      (122,097)      209,846
   Income taxes payable                                            (399,300)      728,000            --
                                                                -----------   -----------   -----------
Net cash provided by operating activities                           513,127       526,794       387,304

Cash Flows From Investing Activities
   Proceeds from sale of equipment                                    2,972        22,000            --
   Capital expenditures                                            (505,616)     (701,529)     (219,119)
   Investment in Paragon, net of cash acquired                           --    (2,750,851)           --
                                                                -----------   -----------   -----------
   Net cash used in investing activities                           (502,644)   (3,430,380)     (219,119)

Cash Flows From Financing Activities
   Borrowings on bank line-of-credit payable                      2,158,526       800,000       340,000
   Payments on bank line-of-credit payable                       (1,808,526)     (500,000)     (400,000)
   Payments under factoring agreement                              (362,868)           --            --
   Payments on long term debt                                      (208,332)      (46,426)      (34,819)
   Borrowings of long term debt                                      60,000     2,500,000            --
   Proceeds from exercise of stock options                          296,124       126,093       130,773
                                                                -----------   -----------   -----------
   Net cash provided by financing activities                        134,924     2,879,667        35,954

Effect on cash from currency translation adjustment                   6,033            --            --
                                                                -----------   -----------   -----------
Net increase (decrease) in cash and cash equivalents                151,440       (23,919)      204,139

Cash and cash equivalents - beginning of year                       242,656       266,575        62,436
                                                                -----------   -----------   -----------
Cash and cash equivalents - end of year                         $   394,096   $   242,656   $   266,575
                                                                ===========   ===========   ===========

Supplemental Disclosures of Cash Flow Information
   Cash paid during the year for interest                       $   336,250   $    12,715   $    24,731
                                                                ===========   ===========   ===========
   Cash paid during the year for income taxes                   $   403,846   $   604,948   $   276,477
                                                                ===========   ===========   ===========
</TABLE>


See notes to consolidated financial statements.


                                       32
<PAGE>


OPTELECOM, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996

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


1.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

        NATURE OF BUSINESS - Optelecom, Inc. (the Company) is a Delaware
        corporation that was organized in 1972. The Company's business consists
        primarily of the development, manufacture, and sale of fiber optic
        communications products and laser systems for commercial and military
        customers.

        The Company is organized into three operating segments: the
        Communications Products Division (CPD), which develops, manufactures,
        and sells optical fiber based data communication equipment to the
        commercial marketplace, the Government Products Division (GPD) which is
        primarily focused on electro-optic technology development for
        government-related defense business and the Paragon division (acquired
        in December 1997), which designs and markets electronic products and
        systems utilizing copper cabling. The principal markets for the
        Company's products and services are located in California and several
        Southeastern and Southwestern regions of the United States.
        Additionally, the Company generates a portion of its revenues from
        several countries in Europe, including Paragon's business, which is
        primarily in the U.K.

        PRINCIPLES OF CONSOLIDATION - The consolidated financial statements
        include the accounts of the Company and its wholly owned subsidiaries,
        Optelecom UK Limited (Optelecom UK), and Paragon Audio Visual Limited.
        All significant intercompany transactions and balances have been
        eliminated.

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

        REVENUE RECOGNITION - Revenues from cost-plus-fixed-fee contracts are
        recognized to the extent of costs incurred during the period plus a
        proportionate amount of the fee earned. Revenues from fixed-price
        contracts are recognized on the percentage-of-completion method based on
        costs incurred in relation to total estimated costs. Revenues from
        time-and-materials contracts are recorded at the contract rates times
        the labor hours plus other direct costs as incurred. Sales of products
        are recognized at the time completed units are delivered. Provisions for
        estimated losses on uncompleted contracts and product sales returns are
        made in the period in which such losses are determined.

        INVENTORIES - Production materials are valued at the lower of cost or
        market applied on a weighted average cost basis. Work-in-process
        represents direct labor, materials, and overhead incurred on products
        not delivered to date. Finished goods inventories are valued at the
        lower of cost or market, cost being determined using standards that
        approximate actual costs on a specific identification basis.

        PROPERTY, EQUIPMENT, AND DEPRECIATION - Property and equipment are
        stated at cost. Depreciation is computed using the straight-line method
        over the estimated useful lives


                                       33
<PAGE>


        of the assets, which range from 5 to 10 years. Leasehold improvements
        are amortized over the terms of the respective leases or the service
        lives of the assets, whichever is shorter.

        INTANGIBLE ASSETS AND GOODWILL - Intangible assets consist primarily of
        technology, trade names, customer lists and employment agreements that
        are being amortized on the straight-line method over their estimated
        useful lives, which range from three to fifteen years. Goodwill
        represents the cost in excess of fair value of the identifiable net
        assets acquired, which is being amortized on the straight-line method
        over 10 years. The Company periodically reviews the carrying value of
        intangible assets, including goodwill, for impairment. If the facts and
        circumstances indicate an asset is impaired, the asset will be reduced
        to its estimated fair value.

        RESEARCH AND DEVELOPMENT COSTS - Research and development costs are
        expensed as incurred. The Company incurred research and development
        costs of approximately $1,309,000, $874,000 and $518,000 for the years
        ended December 31, 1998, 1997, and 1996, respectively.

        INCOME TAXES - The Company recognizes income tax expense for financial
        statement purposes following the asset and liability approach for
        computing deferred income taxes. Under this method, deferred tax assets
        and liabilities are determined based on the difference between financial
        reporting and tax basis of assets and liabilities based on enacted tax
        rates. Deferred tax assets are reduced by a valuation allowance when, in
        the opinion of management, it is more likely than not that some portion
        or all of the deferred tax assets will not be realized.

        STOCK-BASED COMPENSATION - The Company follows Statement of Financial
        Accounting Standard No. 123 (SFAS No. 123), ACCOUNTING FOR STOCK-BASED
        COMPENSATION, for disclosure purposes only. The Company continues to
        measure compensation expense for its stock-based employee compensation
        plans using the intrinsic value method prescribed by APB No. 25,
        ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, and has provided pro forma
        disclosures of the effect on net (loss) income and (loss) earnings per
        share as if the fair value-based method prescribed by SFAS 123 had been
        applied in measuring compensation expense.

        FOREIGN CURRENCY TRANSLATION - The Company translates the assets and
        liabilities of its foreign subsidiaries into U.S. dollars at the current
        exchange rate in effect at the end of the year. The gains and losses
        that result from this process, and gains and losses on inter-company
        transactions that are long-term in nature and that the Company does not
        intend to repatriate, are shown in the foreign currency translation
        adjustment balance in the stockholder's equity section of the balance
        sheet. The revenue and expense accounts of the foreign subsidiaries are
        translated into U.S. dollars at the average rates that prevailed during
        the period.

        CASH AND CASH EQUIVALENTS - For the purpose of presentation in the
        statements of cash flows, cash and cash equivalents are defined as cash
        and liquid investments with original maturities of three months or less.

        RESTRICTED CASH - The Company has deposited into escrow amounts that it
        is obligated to pay to U.K. tax authorities resulting from its December
        1997 purchase transaction (see Notes 2 and 11). Accordingly, such
        amounts are classified as restricted cash.


                                       34
<PAGE>


        FAIR VALUE OF FINANCIAL INSTRUMENTS - The fair value of the Company's
        long-term debt is estimated using discounted cash flow analysis based on
        the incremental borrowing rates currently available to the Company for
        loans with similar terms and maturities. At December 31, 1998 and 1997,
        the fair value approximated the carrying amount. The fair value of trade
        receivables, trade payables, payable under factoring agreement, and the
        revolving credit agreement approximate their carrying amount because of
        the short maturity of these instruments.

        RECLASSIFICATIONS - Certain reclassifications have been made to prior
        years amounts to conform to current year presentation.

2.   ACQUISITION

        On December 12, 1997, the Company acquired Paragon Audio Visual Limited
        (Paragon), a United Kingdom company. Paragon designs and markets
        electronic products and systems utilizing copper cabling for in-house
        computer data networking applications. The total cost of the acquisition
        was $4,422,000, consisting of $2.5 million in cash and 171,252 shares of
        common stock of the Company (with a fair value of $1,625,000 at the
        acquisition date), plus acquisition costs, in exchange for all common
        shares of Paragon. The cash payment was financed under a new debt
        agreement entered into by the Company (see Note 10). The acquisition was
        accounted for as a purchase and the purchase price was allocated to the
        net assets acquired based upon the estimated fair value of such assets.
        Goodwill recorded as a result of this transaction will be amortized on a
        straight-line basis over its estimated useful life of 10 years. The
        Company's consolidated financial statements include the operating
        results of Paragon since December 12, 1997.

        During 1998, the Company continued to evaluate the fair value of the
        assets acquired from Paragon and the goodwill associated with the
        purchase. As a result of this evaluation, the Company determined that a
        portion of the purchase price paid related to contractual employment
        obligations by Paragon's four selling shareholders, who were related
        family members, employees, officers and Board members of Paragon
        (hereafter "the Paragon individuals"). The purchase agreement required
        the Paragon individuals to fulfill these employment obligations or
        return up to $1,625,000 of the purchase price to the Company.
        Accordingly, the Company reclassified $1,625,000 from goodwill to other
        intangibles - employment agreements, and such amounts were to be
        amortized over the employment period of three years. Additionally, the
        Company performed an internal valuation and analysis of the assets
        acquired and determined that identified intangibles acquired included
        technology, customer lists and trade names. Accordingly, the Company
        reclassified the fair value of the acquired intangibles to these
        specific intangible assets.


                                       35
<PAGE>


        The following supplemental unaudited pro forma information has been
        prepared as though the acquisition had occurred at January 1, 1996.

<TABLE>
<CAPTION>
                                                                    1997                1996
        <S>                                                     <C>                  <C>        
        Revenue                                                 $16,710,000          $12,355,000
        Net Income                                                  451,000              294,000
                                                                -----------          -----------
        Per Share:
                Basic                                           $      0.25          $      0.15
                                                                -----------          -----------
                Diluted                                         $      0.23          $      0.14
                                                                -----------          -----------
</TABLE>

3.   ACCOUNTS AND CONTRACTS RECEIVABLE

        Accounts and contracts receivable at December 31, 1998 and 1997,
        consisted of the following:

<TABLE>
<CAPTION>
                                                               1998          1997
        <S>                                                <C>           <C>
        Billed                                             $ 1,727,778   $ 3,052,207
        Unbilled - net of cumulative progress billings of
                $124,891 for 1998 and $495,047 for 1997            760       102,234
        Less:  Allowance for doubtful accounts                (302,232)      (51,537)
                                                           -----------   -----------
                                                           $ 1,426,306   $ 3,102,904
                                                           ===========   ===========
</TABLE>

        Approximately 18%, 25%, and 40% of the Company's revenues in 1998, 1997,
        and 1996, respectively, were derived from contracts with agencies of the
        United States Government and their prime contractors. The Company
        performs the services and ships equipment according to the specific
        contract terms. Contracts with the United States Department of Defense
        allow the Defense Contract Audit Agency (DCAA) to audit the contract
        costs and the Company's compliance with the Federal Acquisition
        Regulations. The DCAA has audited the costs under contracts for years
        through 1993. The Company believes that the ultimate outcome of DCAA
        audits for subsequent years will not have a material effect on the
        financial statements. Generally, the contract terms for both government
        and commercial customers require payment of invoices in 30 days.

4.   NOTE RECEIVABLE RELATED PARTY

        At December 31, 1997, the Company had a $40,000 non-interest bearing
        note receivable from a former officer and board member of the Company,
        which was due on December 15, 1998. This receivable was written off in
        1998.

5.   INVENTORIES

        Inventories at December 31, 1998 and 1997 consist of the following:

                                       1998           1997
        Production materials       $   771,157   $   591,768
        Work in process                381,659       455,648
        Finished goods               1,058,432       798,141
        Less: inventory allowance     (364,135)      (92,684)
                                   -----------   -----------
        Net                        $ 1,847,113   $ 1,752,873
                                   ===========   ===========




                                       36
<PAGE>

6.   INTANGIBLE ASSETS

        Intangible assets at December 31, 1998 and 1997 (see Note 2) consist of
        the following:

                                       1998          1997
        Technology                $   800,000   $   800,000
        Customer lists                725,000       725,000
        Employment agreements              --     1,625,000
        Trade names                 1,100,000     1,100,000
                                  -----------   -----------
                                    2,625,000     4,250,000

        Accumulated amortization     (273,437)      (10,938)
                                  -----------   -----------
        Net                       $ 2,351,563   $ 4,239,062
                                  ===========   ===========

        During December 1998, the Company properly terminated for cause one of
        the Paragon individuals, who at the time was also a member of the
        Company's Board of Directors, and it began discussions with the three
        other Paragon individuals regarding their future management and
        operating responsibilities. In February 1999, the Company properly
        terminated for cause the other three Paragon individuals. The Company is
        seeking its contractual right for a return of a portion of the purchase
        price. As a result of these terminations, the Company wrote off
        $1,462,500 during the fourth quarter of the remaining unamortized
        intangible asset related to the employment agreements.

        The Company has installed new management at Paragon and revised
        Paragon's operating plan. The Company has evaluated the recoverability
        of Paragon's other assets, intangibles and goodwill, and based on its
        cash flow projections, the Company believes that such recorded assets
        continue to be recoverable.

7.   PROPERTY AND EQUIPMENT

        Property and equipment at December 31, 1998 and 1997 consist of the
following:

<TABLE>
<CAPTION>
                                                            1998          1997
        <S>                                             <C>           <C>        
        Laboratory equipment                            $ 1,419,678   $ 1,231,446
        Office equipment                                  1,275,850     1,070,367
        Furniture and fixtures                               99,776        90,756
        Leasehold improvements                              641,560       553,154
        Motor vehicles                                       13,524         8,255
                                                          3,450,388     2,953,978
                                                        -----------   -----------
        Less accumulated depreciation and amortization   (2,089,293)   (1,688,428)
                                                        -----------   -----------
        Net property and equipment                      $ 1,361,095   $ 1,265,550
                                                        ===========   ===========
</TABLE>

                                       37
<PAGE>

8.   DEMAND NOTE PAYABLE TO BANK

        The Company has a revolving credit agreement with a bank whereby it may
        borrow up to $1,700,000 with interest at the bank's prime rate plus 1/2%
        (8.25% at December 31, 1998). The total amount of borrowings that may be
        outstanding at any given time is based upon a percentage of certain
        eligible receivables. Amounts under the agreement are due in full on
        April 30, 1999. The Company expects the credit agreement to be renewed
        for one year with substantially similar terms. The balance outstanding
        under the agreement was $650,000 and $300,000 at December 31, 1998 and
        1997, respectively. The amount available under the Agreement was
        $1,050,000 at December 31, 1998.

        The Company is required to comply with certain financial ratios
        including maintaining a minimum current ratio and a minimum ratio of
        cash flow to fixed obligations. The Company was in violation of the cash
        flow covenant as of December 31, 1998. However, the bank has provided a
        waiver of such covenant violation at December 31, 1998.

9.   INCOME TAXES

        The components of the (benefit) provision for income taxes for the years
        ended December 31, 1998, 1997, and 1996 are summarized as follows:

                                          1998        1997        1996

        Current                        $(174,487)  $ 487,050   $ 455,957
        Deferred                        (789,821)    (68,560)      4,179
        Change in valuation allowance    645,000          --    (150,000)
                                       ---------   ---------   ---------
                                       $(319,308)  $ 418,490   $ 310,136
                                       =========   =========   =========

        No U.S. income taxes have been provided for unremitted earnings of
        foreign subsidiaries as the Company intends to reinvest those profits
        overseas. The Company's 1998 tax provision includes the benefit of the
        carryback of the net taxable loss to prior years. The difference between
        the Federal income tax expense (benefit) and the amount computed
        applying the statutory Federal income tax rate for the years ended
        December 31, 1998, 1997, and 1996 are summarized as follows:

<TABLE>
<CAPTION>
                                                                     1998    1997  1996
                                                                       %       %     %
        <S>                                                         <C>     <C>   <C>
        Federal income tax (benefit) expense at statutory rates      (34)     34    34

        (Reduction) increase of taxes:
           State taxes, net of federal benefit                      (1.8)    3.5     4
           Valuation allowance related to net deferred tax assets    20.5     --  (15)
           Losses of foreign subsidiary                               5.6     --    --
           Other                                                    (0.5)    (7)     7
                                                                    -----   ----   ---
        Effective income tax rate                                  (10.2)   30.5    30
                                                                    =====   ====   ===
</TABLE>





                                       38
<PAGE>


        Deferred income taxes reflect the net tax effects of temporary
        differences between the amount of assets and liabilities for income tax
        and financial reporting purposes. The components of deferred income tax
        liabilities and assets as of December 31, 1998 and 1997 are as follows:

<TABLE>
<CAPTION>
                                                                          1998         1997
        <S>                                                         <C>           <C>
        Deferred liabilities:
           Amortization                                             $    (8,632)  $   (11,188)
           State taxes                                                  (33,080)      (10,666)
           Retainage receivable on long-term contracts                       --          (790)
                                                                    -----------   -----------

        Gross deferred tax liabilities                                  (41,712)      (22,644)

        Deferred tax assets:
           Excess book depreciation                                       3,529        16,796
           Capitalized overhead and inventory obsolescence reserve      217,650       109,126
           Accrued vacation                                              39,470        42,921
           Deferral of rent expense                                      56,057        68,182
           Amortization                                                 694,911            --
           Note reserve                                                  15,229            --
                                                                    -----------   -----------
        Gross deferred tax assets                                     1,026,846       237,025

        Less: valuation allowance                                      (645,000)           --
                                                                    -----------   -----------
        Net deferred tax assets                                     $   340,134   $   214,381
                                                                    ===========   ===========
</TABLE>

        The Company assumed certain income tax liabilities upon the acquisition
        of Paragon (see Note 11).

        Prepaid expenses and other assets as of December 31, 1998 included
        income tax receivables of approximately $28,000.

10.  NOTES PAYABLE

        In December 1997 the Company entered into a promissory note agreement to
        finance the purchase of Paragon (see Note 2). The note is collateralized
        by substantially all the assets and contracts of the Company, and
        includes certain financial and other covenants. The Company was in
        violation of one of its covenants as of December 31, 1998 and the bank
        has provided a waiver of the debt covenant. The principal amount of the
        note is $2,500,000, which is payable in monthly installments of $52,083
        through August 2002. Interest is payable monthly at prime plus 1% (8.75%
        at December 31, 1998 and 9.5% at December 31, 1997).

        In December 1998, the Company received a loan of $60,000 from the
        Economic Development Fund of Montgomery County, Maryland to maintain or
        establish jobs and an economic presence in Montgomery County, Maryland.
        Under the terms of the loan agreement, the loan will convert to a grant
        if certain conditions at specific dates are met, primarily certain job
        levels and the maintaining of a place of business within Montgomery
        County, Maryland. All grants convert back to a loan if the Company does
        not maintain a majority of its business interests within Montgomery
        County, Maryland for at least eight years from the date of the receipt
        of the loan.

        Interest is at the rate of five percent (5%) per annum. No principal or
        interest is payable until January 2002, at which time principal and
        interest payments, including interest during 1999-2001, will be made
        over a five year period.

                                       39
<PAGE>

        The required principal payments of the notes payable are as follows:

              1999                                         $624,996
              2000                                          624,996
              2001                                          624,996
              2002                                          428,680
              2003                                           12,000
              Thereafter                                     36,000
                                                         ----------
              Total                                      $2,351,668

11.  COMMITMENTS AND CONTINGENCIES

        OPERATING LEASE - During 1992, the Company entered into a 10-year
        non-cancelable operating lease expiring August 31, 2002 for corporate
        office and manufacturing facilities. As an inducement to enter the new
        lease, the Company received certain incentives such as a rent abatement
        and assumption of existing lease obligations. Additionally, the lease
        provided for scheduled rent increases. These lease incentives are being
        amortized over the lease period. Rent expense is being recognized on a
        straight-line basis. In addition to the basic rentals, the lease
        agreement provides for increases based on payment by the Company of its
        share of real estate and insurance taxes.

        Paragon has entered into leases for office and sales facilities, which
        expire March 24, 2001.

        As of December 31, 1998, future net minimum rental payments required
        under operating leases that have initial or remaining non-cancelable
        terms in excess of one year are as follows:

        Year Ended December 31,
               1999                  $  349,000 
               2000                     354,000 
               2001                     303,000 
               2002                     193,000 
                                     ---------- 
                                     $1,199,000 
                                     ========== 
                              
        Rental expense was approximately $364,000, $242,000 and $222,000 in
        1998, 1997, and 1996, respectively.

        PARAGON ACQUISITION - In conjunction with the acquisition described in
        Note 2, the Company deposited $728,000 into a restricted escrow account
        to pay income tax liabilities to U.K. tax authorities assumed upon
        acquisition of Paragon. During 1998, a payment was made to the U.K. tax
        authorities in the amount of $400,000.

        At the acquisition date, Paragon had a factoring agreement with a
        financing company. Under the agreement, the financing company purchased
        Paragon's accounts receivable at a discount and provided Paragon with
        operating funds. Paragon incurred a liability until the purchased
        accounts receivable were fully collected by the financing company. At
        December 31, 1997, the Company had a liability of $363,000 to the
        financing


                                       40
<PAGE>

        company. In February 1998, the Company terminated the factoring
        agreement and settled all outstanding liabilities.

        LEGAL PROCEEDINGS - The Company is involved in certain other legal
        proceedings that arise in the ordinary course of business. Management
        believes that the final disposition of these matters in the aggregate,
        will not have a material effect on the Company's financial position,
        results of operations or cash flows.

        On March 18, 1999, David Brown, formerly Chairman and Marketing Director
        of Paragon Audio Visual Ltd., lodged an Originating Application with the
        Employment Tribunal of the United Kingdom in Reading, England. Mr. Brown
        alleges that Paragon dismissed Mr. Brown unlawfully and in breach of his
        alleged employment contract rights. He seeks an award of money in an
        unspecified amount. The time within which Paragon may file a response
        has not yet expired and the Company has not yet filed a response. The
        Company believes that Mr. Brown's claims are without merit and intends
        to present a vigorous defense. The Company also believes that it may
        have counterclaims that may be asserted against Mr. Brown in this
        proceeding and is considering the assertion of such counter-claims.

        
12.  STOCKHOLDER'S EQUITY

        On November 11, 1997, the Company's Board of Directors approved a
        three-for-two common stock split to be distributed in the form of a
        stock dividend. As a result, 603,800 shares were issued to shareholders
        of record on November 17, 1997. Par value remained at $0.03 per share
        that resulted in the Company transferring $18,114 to common stock from
        paid-in capital, representing the aggregate par value of the shares
        issued under the stock split. Share amounts presented in the
        consolidated financial statements reflect the actual share amounts
        outstanding for each period presented. All agreements concerning stock
        options and other commitments payable in shares of the Company's common
        stock provide for the issuance of additional shares due to the
        declaration of the stock split. All references to number of shares,
        except shares authorized, stock option agreements, and to per-share
        information in the consolidated financial statements have been adjusted
        to reflect the stock split on a retroactive basis. At December 31, 1998,
        367,561 shares were reserved for issuance under stock option agreements
        and the employee stock bonus plan.

                                       41
<PAGE>

        Reconciliations of the numerator and denominator for earnings per common
        share and diluted earnings per common share are shown below.

<TABLE>
<CAPTION>
                                                                                     1998        1997       1996
        <S>                                                                     <C>          <C>         <C>
        Basic Earnings Per Share:

          (Loss) Income available to common stockholders                        $(2,811,344) $  948,729  $ 722,081
                                                                                ===========  ==========  =========

        Weighted average common shares outstanding                                2,098,819   1,845,399  1,774,880
                                                                                ===========  ==========  =========

        Basic (Loss) Earnings per share                                         $     (1.34) $     0.51  $    0.41
                                                                                ===========  ==========  =========

        Diluted Earnings Per Share:

         (Loss) income available to common stockholders                          (2,811,344)    948,729    722,081
                                                                                ===========  ==========  =========

        Weighted average common shares

          Shares outstanding                                                      2,098,819   1,845,399  1,774,880
                                                                                ===========  ==========  =========

        Dilutive Shares                                                                  --     120,799     53,460
                                                                                -----------  ----------  ---------

        Diluted Shares                                                            2,098,819   1,966,198  1,828,340
                                                                                ===========  ==========  =========

        Diluted (loss) earnings per share                                       $     (1.34) $     0.48  $    0.39
                                                                                ===========  ==========  =========
</TABLE>

        Shareholders Rights Plan

        On June 15, 1998, the Company adopted a shareholders rights plan that
        provides for a dividend distribution of one right for each outstanding
        share of common stock. In the event that, following the Distribution
        Date (as defined) a person is or becomes the beneficial owner of 10% or
        more of the then-outstanding shares of Common Stock, each Right Holder
        may purchase three (3) shares of Common Stock at a price per share equal
        to 50% of the then current market price of the Common Stock. As of
        December 31, 1998, the Company has reserved 5,400,000 shares of
        authorized but unissued common stock for issuance under the shareholders
        rights plan.

        Stock Options

        In May 1996, the 1991 Stock Option Plan (the 1991 Plan) was amended to
        increase the number of options available to purchase shares of common
        stock from 200,000 to 800,000 shares. The options may be granted to
        officers (including officers who are directors), other key employees of,
        and consultants to, the Company.

        The exercise price of each option is the fair market value of the stock
        at the grant date. Options issued prior to April 1, 1996 are exercisable
        in whole or in part any time after one year from the date of grant.
        Options issued after April 1, 1996 are exercisable after one year from
        the date of grant and in equal increments over four years. Options
        issued prior to April 1, 1996 expire three years after the date of grant
        and, in most cases, upon termination of employment. Options issued after
        April 1, 1996, expire five years from the date of grant and, in most
        cases, upon termination of employment. The 1991 Plan will terminate on
        May 31, 2001, unless terminated sooner by the Board.


                                       42
<PAGE>

        A summary of stock option activity during the years ended December 31,
        1998, 1997, and 1996 is as follows:

           <TABLE>
           <CAPTION>
                                                          1998                          1997                          1996
                                                 -------------------------      ------------------------     -----------------------
                                                                  WEIGHTED                      WEIGHTED                    WEIGHTED
                                                                   AVERAGE                       AVERAGE                    AVERAGE
                                                  NUMBER OF       EXERCISE      NUMBER OF       EXERCISE     NUMBER OF     EXERCISE
                                                     SHARES          PRICE         SHARES          PRICE        SHARES        PRICE
           <S>                                   <C>                 <C>        <C>                <C>        <C>            <C>  
           Outstanding, January 1                   309,012          $5.11        205,460          $2.78        93,750        $1.76
           Granted                                  117,650           7.96        127,927           8.36       151,085         3.11
           Exercised                              (115,129)           2.34       (23,625)           2.16      (25,500)         2.12
           Canceled                                (19,384)           7.48          (750)           2.08      (13,875)         2.92
                                                 ----------          -----      ---------          -----      --------        -----
           Outstanding, December 31                 292,149          $7.23        309,012          $5.11       205,460        $2.78
                                                 ==========          =====      =========          =====      ========        =====
           Exercisable options, end of year         130,163          $6.82        163,021          $3.10        58,875        $1.43
                                                 ==========          =====      =========          =====      ========        =====
</TABLE>

        The following table summarizes information about stock options
        outstanding at December 31, 1998:

<TABLE>
<CAPTION>
                                     OPTIONS OUTSTANDING                 OPTIONS EXERCISABLE
                          ------------------------------------------ -----------------------------
                                              WEIGHTED
                                               AVERAGE                                   WEIGHTED
                                             REMAINING     WEIGHTED                       AVERAGE
                                    TOTAL      LIFE IN      AVERAGE           TOTAL      EXERCISE
                              OUTSTANDING        YEARS        PRICE     EXERCISABLE         PRICE
                                 <S>               <C>        <C>           <C>            <C>
                                   24,000          2.8        $1.96          24,000         $1.96
                                   27,387          2.8         3.22           5,775          3.25
                                  114,135          3.4         6.91          55,916          7.14
                                  108,989          4.1         9.19          39,641          9.34
                                   17,638          3.9        10.52           4,831         10.91
                                  -------                                   -------
                                  292,149                                   130,163
                                  =======                                   =======
</TABLE>

        On December 7, 1992, the Board of Directors approved the 1993 Directors'
        Stock Option Plan (1993 Directors' Plan). Under this plan, each
        non-employee director who attends a Board of Directors meeting is, at
        his election, granted an option to purchase 675 shares of common stock
        at the fair market value at the grant date in lieu of receiving a
        certain dollar value of the stock on the date of such Board meeting. The
        options are exercisable upon grant and expire three years thereafter.
        The Board of Directors replaced this plan with a 1996 Director's Plan
        and no additional options were granted under this plan after December
        31, 1995.


                                       43
<PAGE>

        A summary of stock option activity during the years ended December 31,
        1998, 1997, and 1996 is as follows:


<TABLE>
<CAPTION>
                                                         1998                      1997                     1996
                                                  ----------------------   ----------------------  ----------------------
                                                                WEIGHTED                 WEIGHTED                WEIGHTED
                                                  NUMBER OF      AVERAGE   NUMBER OF      AVERAGE  NUMBER OF      AVERAGE
                                                     SHARES     EXERCISE      SHARES     EXERCISE     SHARES     EXERCISE
                                                                   PRICE                    PRICE                   PRICE
         <S>                                         <C>          <C>       <C>           <C>       <C>           <C>  
         Outstanding, January 1                       2,025        $1.92     14,175        $2.28     41,175       $ 2.59
         Granted                                         --           --         --           --         --           --
         Exercised                                   (2,025)        1.92    (12,150)        2.34    (24,300)        2.63
         Canceled                                        --           --         --           --    ( 2,700)        3.81
                                                     ------        -----    -------       ------     ------       ------
         Outstanding, December 31                        --        $  --      2,025       $ 1.92     14,175       $ 2.28
                                                     ======        =====    =======       ======     ======       ======

         Exercisable options                             --        $  --      2,025       $ 1.92     14,175       $ 2.28
                                                     ======        =====    =======       ======     ======       ======
</TABLE>


        In February 1996, the Board of Directors approved the 1996 Directors'
        Stock Option Plan (1996 Directors' Plan), which replaced the 1993
        Directors' Plan. Under this plan, each non-employee director who attends
        a Board of Directors meeting is granted an option to purchase 750 shares
        of common stock at fair market value on the date of such Board meeting.
        The options are exercisable upon grant and expire five years thereafter.

        A summary of stock option activity during the year ended December 31,
        1998, 1997 and 1996 (as adjusted for the three-for-two stock split) is
        as follows:

<TABLE>
<CAPTION>
                                            1998                  1997                 1996
                                       -----------------  --------------------  --------------------
                                                WEIGHTED              WEIGHTED             WEIGHTED
                                       NUMBER    AVERAGE               AVERAGE              AVERAGE
                                       OF       EXERCISE     NUMBER   EXERCISE     NUMBER  EXERCISE
                                       SHARES      PRICE  OF SHARES      PRICE  OF SHARES     PRICE

        <S>                            <C>         <C>       <C>         <C>       <C>          <C>
        Outstanding, January 1         45,000      $7.16     24,000      $3.49         --       $--
        Granted                        19,500       7.30     32,250       8.59     24,000      3.49
        Exercised                      (3,750)      3.48    (11,250)      3.25         --        --
        Canceled                           --         --         --         --         --        --
                                       ------      -----     ------      -----     ------     -----
        Outstanding, December 31       60,750      $7.43     45,000      $7.16     24,000     $3.49
                                       ======      =====     ======      =====     ======     =====
        Exercisable options            60,750      $7.43     45,000      $7.16     24,000     $3.49
                                       ======      =====     ======      =====     ======     =====
</TABLE>




                                       44
<PAGE>


        The following table summarizes information about stock options
        outstanding at December 31, 1998:

<TABLE>
<CAPTION>
                                     OPTIONS OUTSTANDING                 OPTIONS EXERCISABLE
                              -------------------------------------- -----------------------------
                                              WEIGHTED
                                               AVERAGE                                   WEIGHTED
                                             REMAINING     WEIGHTED                       AVERAGE
                                    TOTAL      LIFE IN      AVERAGE           TOTAL      EXERCISE
                              OUTSTANDING        YEARS        PRICE     EXERCISABLE         PRICE
                                   <S>            <C>        <C>             <C>           <C>   
                                   10,500         3.33       $ 3.24          10,500        $ 3.24
                                    8,250         3.30         5.97           8,250          5.97
                                   13,500         3.87         6.89          13,500          6.89
                                   14,250         3.89         8.78          14,250          8.78
                                   14,250         4.01        10.54          14,250         10.54
                                   ------                                    ------
                                   60,750                                    60,750
                                   ======                                    ======
</TABLE>

        In June 1990, the Board of Directors adopted a stock option plan (the
        Chairman's Plan) under which the Chairman of the Board is the sole
        participant. On each January 1, the Participant was granted an option to
        purchase 2,500 shares of common stock at fair market value on the grant
        date. Each option granted under this plan will expire three years after
        the date of grant. Effective December 31, 1996, no additional options
        were granted under this plan and all options granted were either
        exercised or cancelled during 1997.

        A summary of stock option activity during the years ended December 31,
        1997 and 1996 is as follows:

<TABLE>
<CAPTION>
                                                        1997                  1996
                                               ----------------------  -------------------
                                                             WEIGHTED             WEIGHTED
                                                              AVERAGE              AVERAGE
                                               NUMBER        EXERCISE  NUMBER     EXERCISE
                                               OF SHARES        PRICE  OF SHARES     PRICE

                <S>                             <C>           <C>          <C>      <C>      
                Outstanding, January 1             5,000        $2.59      7,500     $2.89
                Granted                                -            -      2,500      1.92
                Exercised                        (2,500)         1.92    (2,500)      2.09
                Canceled                         (2,500)         3.25    (2,500)      3.33
                                                 -------         ----    -------     -----
                Outstanding, December 31             --       $    --      5,000     $2.59
                                                 =======      =======      =====     =====

                Exercisable options                  --       $    --      5,000     $2.59
                                                 =======      =======      =====     =====
</TABLE>



        The Company has adopted the disclosure provisions of Statement of
        Financial Accounting Standards No. 123 ("SFAS 123"), ACCOUNTING FOR
        STOCK BASED COMPENSATION. The required disclosures include pro forma net
        income (loss) and basic earnings (loss) per share as if the fair
        value-based method of accounting had been used.


                                       45
<PAGE>


        If compensation cost for the Company's 1998, 1997, and 1996 grants for
        stock-based compensation had been determined consistent with the fair
        value based method of accounting per SFAS 123, the Company's pro forma
        net income (loss) and pro forma basic (loss) earnings per share for the
        years ended December 31, 1998, 1997, and 1996, would be as follows:

<TABLE>
<CAPTION>
                                                        1998               1997              1996
        <S>                                          <C>                  <C>              <C>
        Net (loss) income
                As reported                          $(2,811,344)         $948,729         $722,081
                Pro forma                            $(3,048,288)         $708,932         $538,647

        Basic (loss) earnings per share
                As reported                             $  (1.34)           $ 0.51           $ 0.41
                Pro forma                               $  (1.45)           $ 0.38           $ 0.30
</TABLE>


        The weighted average fair value at date of grant for options granted
        during 1998, 1997 and 1996 was $4.14, $4.27 and $4.66 per option. The
        fair value of the option grant is estimated on the date of grant using
        the Black-Scholes option pricing model with the following assumptions:

<TABLE>
<CAPTION>
                                                           1998             1997             1996
<S>                                                      <C>              <C>         <C>
        Expected dividend yield                                0%               0%               0%
        Expected stock price volatility                       74%             300%             244%
        Risk-free interest rate                             5.13%            6.12%            6.37%
        Expected option term                              3 years          5 years    3 and 4 years
</TABLE>


        On December 31, 1998, the Company authorized the cancellation and
        reissuance of employee stock options held by employees at the manager
        level and lower with exercise prices in excess of fair market value. The
        employees had 30 days during which they could elect to accept the
        repricing offer. A total of 49,469 options with an average price of
        $8.23 were cancelled in January 1999 and reissued at an average price of
        $3.06.

13.  EMPLOYEE BENEFIT PLANS

        The Company has a noncontributory Profit-Sharing Retirement Plan
        covering substantially all employees. Vesting occurs over a period of
        four years from the date of entry into the plan (date of employment).
        Under the plan, the Company's contribution is determined annually by the
        Board of Directors and is funded as accrued. The profit-sharing expense
        for 1998, 1997 and 1996 was $0, $152,722 and $113,329, respectively.

        The Company has established a contributory cash and deferred profit
        sharing plan qualified under Section 401(k) of the Internal Revenue Code
        for all of the Company's full-time employees. The Company matches
        employee contributions to the plan up to a maximum of 2.5%. Total
        matching contributions were $101,831, $83,203 and $62,827 in 1998, 1997
        and 1996, respectively.


                                       46
<PAGE>


        In 1980, the Company adopted an employee cash/stock bonus plan for which
        12,500 shares of the Company's common stock have been set aside to be
        issued to employees at the discretion of management. During 1998, 1,000
        shares were issued under the plan and no shares were issued in 1997 and
        1996. In the aggregate, 4,320 shares have been issued under the plan.

14.  SEGMENT INFORMATION

        Optelecom has three reportable segments: the Communications Products
        Division (CPD), which develops, manufactures, and sells optical
        fiber-based data communication equipment to the commercial marketplace,
        the Government Products Division (GPD) which is primarily focused on
        electro-optic technology development for government-related defense
        business and the Paragon division (acquired in December 1997), which
        designs and markets electronic products and systems utilizing copper
        cabling. The segments reflect management's internal reportable
        information analysis and approximates the Company's strategic business
        units' financial results reported before income taxes. The accounting
        policies of the segments are the same as those described in the summary
        of significant accounting policies. The Company accounts for
        intersegment revenues as if the revenues were from third parties, that
        is, at current market prices. There were no intersegment revenues or
        expenses during 1997 or 1996. The Company does not allocate income
        taxes, interest or other corporate expenses to segments.

<TABLE>
<CAPTION>
                                                         YEAR ENDED DECEMBER 31, 1998
                                         --------------------------------------------------------
                                          COMMUNICATION   GOVERNMENT     PARAGON
                                            PRODUCTS       PRODUCTS       AUDIO
                                            DIVISION       DIVISION    VISUAL LTD.       TOTAL
                                         ------------   ------------  ------------   ------------
        <S>                              <C>            <C>           <C>            <C>         
        Revenues                         $  8,860,852   $  1,549,730  $  6,041,787   $ 16,452,369
        Intersegment revenues                (118,620)            --            -- 
                                         ------------   ------------  ------------   ------------
                                                                                         (118,620)
           Total Revenues                   8,742,232      1,549,730     6,041,787     16,333,749
        Operating (loss) income               174,916        107,423    (3,412,991)    (3,130,652)
        Intersegment expenses                (412,273)            --       412,273             --
                                         ------------   ------------  ------------   ------------
           Total (loss) income before taxes  (237,357)       107,423    (3,000,718)    (3,130,652)
        Corporate assets                           --             --            --        958,566
        Identifiable assets                 7,935,721        370,587     1,541,808      9,848,116
        Intersegment assets                (2,174,734)            --            --     (2,174,734)
                                         ------------   ------------  ------------   ------------
           Total identifiable assets     $  5,760,987   $    370,587  $  1,541,808   $  8,631,948
                                         ============   ============  ============   ============
        Gross additions to property and
        equipment:
           Identifiable                  $    290,121   $    142,485  $     73,010   $    505,616
                                         ------------   ------------  ------------   ------------
        Depreciation and amortization:
           Identifiable                  $    337,692   $     28,497  $    505,976   $    872,165
                                         ============   ============  ============   ============
</TABLE>



                                       47
<PAGE>

<TABLE>
<CAPTION>
                                                                       YEAR ENDED DECEMBER 31, 1997
                                                           ---------------------------------------------------
                                                          COMMUNICATION   GOVERNMENT   PARAGON
                                                             PRODUCTS      PRODUCTS     AUDIO
                                                             DIVISION      DIVISION   VISUAL LTD.    TOTAL
                                                           ---------------------------------------------------
        <S>                                                <C>          <C>          <C>           <C>        
        Revenues                                           $ 9,734,088  $ 2,372,950  $   164,019   $12,271,057
        Operating income (loss)                                574,789      806,011      (13,581)    1,367,219

        Identifiable assets                                  9,885,518      367,113    1,165,543    11,418,174
        Corporate assets                                            --           --           --       791,567
                                                           -----------  -----------  -----------   -----------
        Total assets                                         9,885,518      367,113    1,165,543    12,209,741
                                                           ===========  ===========  ===========   ===========

        Gross additions to property and equipment:
           Identifiable                                        592,150       36,757           --       628,907
           Corporate
                                                                    --           --           --        72,622
                                                           -----------  -----------  -----------   -----------
        Total                                              $   592,150  $    36,757  $        --   $   701,529
                                                           ===========  ===========  ===========   ===========

        Depreciation and  amortization:
           Identifiable                                    $   299,623  $        --  $       609   $   300,232
                                                           ===========  ===========  ===========   ===========
</TABLE>

<TABLE>
<CAPTION>
                                                          YEAR ENDED DECEMBER 31, 1996
                                                    -------------------------------------------
                                                 COMMUNICATION  GOVERNMENT   PARAGON
                                                    PRODUCTS     PRODUCTS     AUDIO
                                                    DIVISION     DIVISION   VISUAL LTD. TOTAL
                                                    -------------------------------------------

        <S>                                         <C>         <C>         <C>      <C>       
        Revenues                                    $6,453,686  $2,456,577  $    --  $8,910,263
        Operating income (loss)                         17,543   1,034,134       --   1,051,677

        Identifiable assets                          3,186,605     510,278       --   3,696,883
        Corporate assets                                    --          --       --     769,580
                                                    ----------  ----------  -------  ----------
        Total assets                                 3,186,605     510,278            4,466,463
                                                    ==========  ==========  =======  ==========
        Gross additions to property and equipment:
           Identifiable                                219,119          --       --     219,119
                                                    ==========  ==========  =======  ==========
        Depreciation and amortization:
           Identifiable                             $  235,431  $       --  $    --  $  235,431
                                                    ==========  ==========  =======  ==========
</TABLE>

        The Company is engaged primarily in the development, manufacture, and
        sale of optical fiber communications products and laser systems. Revenue
        represents shipments and services provided to third parties. Contract
        costs and operating expenses directly traceable to individual segments
        were deducted from revenue to arrive at operating income. Identifiable
        assets by segment are those assets that are used in the Company's
        operations in each segment. Corporate assets consist primarily of cash,
        prepaid expenses, deferred taxes, and long-term assets.


                                       48
<PAGE>


15.  SIGNIFICANT CUSTOMERS AND FOREIGN EXPORTS

        The Company's primary business is with commercial customers and the U.S.
        Government and its prime contractors. In 1998, one commercial customer
        accounted for 14% of sales and no other customer accounted for more than
        5% of sales. In 1997, two commercial customers each accounted for 10%
        and one customer accounted for 7% of sales. In 1996, sales to three
        commercial customers were 21%, 8% and 8% of sales, respectively. The
        Company has operations outside of the United States in the United
        Kingdom. Included in revenues are export sales of $2,097,000, $2,130,000
        and $1,159,000 for 1998, 1997 and 1996, respectively. Foreign sales as a
        result of Paragon Audio Visual Ltd. were $6,034,000 for 1998 and
        $164,000 for 1997 (see Note 2). Long-lived assets reported for the
        Paragon segment are located in the United Kingdom. All other long-lives
        assets are located in the United States.

16.  EFFECT OF NEW ACCOUNTING PROUNCEMENTS

        In June 1998, the FASB issued SFAS No. 133 "Accounting for Derivative
        Instruments and Hedging Activities." This statement requires companies
        to record derivatives on their balance sheet as assets or liabilities,
        measured at fair value. Gains or losses resulting from changes in the
        values of those derivatives would be accounted for depending on the use
        of the derivative and whether it qualifies for hedging accounting. SFAS
        No. 133 will be effective for the Company's fiscal year ending December
        31, 2000. The Company had no derivative or hedging activity in any of
        the periods presented.

                                   * * * * * *

                                       49
<PAGE>



                                                                     SCHEDULE II

OPTELECOM, INC.

SCHEDULE OF VALUATION AND QUALIFYING ACCOUNTS
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996

--------------------------------------------------------------------------------
<TABLE>
<CAPTION>
                                     BALANCE   CHARGED TO              BALANCE
                                  AT BEGINNING COSTS AND                AT END
DESCRIPTION                         OF PERIOD   EXPENSES  DEDUCTIONS  OF PERIOD
<S>                               <C>        <C>         <C>         <C> 
Year Ended December 31, 1996

Reserves and allowances
deducted
    from assets accounts:
    Obsolescence reserve for
        Inventory                 $  97,005  $  92,494   $(113,250)  $  76,249
    Allowance for uncollectible
        Accounts receivable              --     78,186          --      78,186


Year Ended December 31, 1997

Reserves and allowances 
deducted 
    from asset accounts:
    Obsolescence reserve for
        Inventory                 $  76,249  $  88,466   $ (72,031)  $  92,684
    Allowance for uncollectible
        Accounts receivable          78,186    (15,000)    (11,649)     51,537

Year Ended December 31, 1998

Reserves and allowances 
deducted 
    from asset accounts:
    Obsolescence reserve for
        Inventory                 $  92,684  $ 292,790   $ (21,339)  $ 364,135
    Allowance for uncollectible
        Accounts receivable          51,537    250,695          --     302,232
</TABLE>



                                       50
<PAGE>



ITEM 9. CHANGES IN AND DISAGREEMENT WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
        DISCLOSURE

        None


                                       51
<PAGE>



INDEPENDENT AUDITORS' CONSENT

We consent to the incorporation by reference in Registration Statement No.
33-53145 of Optelecom, Inc. on Form S-3 of our report dated March 26, 1999,
appearing in this Annual Report on Form 10-K of Optelecom, Inc. for the year
ended December 31, 1998.

McLean, VA
March 26, 1999


                                       52
<PAGE>


                                    PART III

ITEM 10.  DIRECTORS, EXECUTIVE OFFICERS AND SIGNIFICANT   EMPLOYEES OF THE
          REGISTRANT

    Executive officers are selected annually and serve at the discretion of the
    board of directors. No family relationships exist between any of the
    executive officers or directors of the Company. The following table sets
    forth certain information with respect to each person who is an executive
    officer, key employee or director of the Company as of March 17, 1999.

<TABLE>
<CAPTION>
                   NAME                 AGE                          POSITION
      <S>                               <C>    <C>
      Executive Officers
         Edmund Ludwig                  59     President, Chief Executive Officer and Director
         Carole Argo                    37     Vice President, Chief Financial Officer

      Significant Employees
         James Coffman                  51     Vice President, Engineering
         Anthony DeVito                 51     Director, Sales and Marketing
         Thomas Driscoll                46     Controller
         John Kinnaman                  40     Manufacturing Manager
         Michael Weight                 40     Managing Director, Paragon Audio Visual Ltd.

      Outside Directors
         Alexander Karpinski(1)(2)      67     Chairman of the Board, Optelecom, Inc.
         Gordon Smith(1)(2)             64     Director, Optelecom, Inc.
         Clyde Heintzelman              60     Director, Optelecom, Inc.
         Richard Kreter                 52     Director, Optelecom, Inc.
</TABLE>

-----------------------------
1.      Member of the Audit Committee

2.      Member of the Executive Compensation Committee

     Executive Officers

     Edmund Ludwig - President and Chief Executive Officer of the Company. Mr.
     Ludwig joined Optelecom in 1974 as Executive Vice President managing the
     development of fiber optic technology systems for communications and
     sensors as well as continuing with management of laser illuminator systems
     contracts. He assumed roles of increasing responsibility culminating in
     election to President and CEO in January 1991. Prior to Optelecom, Mr.
     Ludwig was employed by IBM Federal Systems Division as Manager of
     semiconductor laser illuminator system development.


                                       53
<PAGE>


     Carole Argo - Vice President, Chief Financial Officer of the Company since
     August 3, 1998. From July 1991 - June 1997, Ms. Argo was employed by, BYK
     GARDNER USA, a manufacturer of electro-optical instrument system for
     analysis of color and other appearance attributes in the role of Vice
     President of Finance and Operations (January 1994- June 1997) and
     Controller (July 1991-December 1993).

     Significant Employees

     James Coffman - Vice President, Engineering. Mr. Coffman has been with
     Optelecom since 1978 in various management positions within the Engineering
     group. Prior to Optelecom, he was employed by E Systems.

     Anthony DeVito - Director, Sales and Marketing. Mr. DeVito joined the
     Company in May 1997 as Southeast Regional Sales Manager and was named to
     his current position in February 1999. Prior to joining Optelecom, he
     worked at Pirelli Cables Corporation from 1995 to 1997 as Southeast
     Regional Sales Manager. From 1971 to 1995 he was Manager Telecommunications
     at Bell South.

     Thomas Driscoll - Controller. Mr. Driscoll joined the Company in September
     1998. Previously Mr. Driscoll was Controller of GSE Systems, Inc. from 1997
     to 1998. From 1987 - 1997, Tom was Controller, International Filler
     Corporation, New York.

     John Kinnaman - Manager, Manufacturing. Mr. Kinnaman joined the Company in
     December 1998. Prior to joining Optelecom, he was employed at
     Telecommunications Techniques Corporation as Director of Telecommunications
     Manufacturing Operations from 1996 to 1997; and Product Line Manager from
     1988 to 1996.

     Michael Weight - Managing Director, Paragon. Mr. Weight joined Paragon in
     May 1998 as Chief Engineer and was appointed Managing Director in February
     1999. From October 1997 to May 1998, he was Product Manager for all trading
     room desktop products for Open Trade Technologies, Ltd. From January 1995
     to October 1997, Mr. Weight was Product Manager for Management
     Technologies, Inc. From October 1990 to December 1994, Mr. Weight held
     various management positions in Research and Development for Digital
     Equipment Company.

     Outside Directors

     Alexander Karpinski has been a Director of the Company since April 1996 and
     Chairman since May 1998. Mr. Karpinski is Founder and President of Alex
     International, Inc., a telecommunications consulting firm to business and
     Government clients since April 1985. From April 1992 to June 1995, he was a
     Telecommunications Project Manager for teleconsultant under contract for
     the U.S. agency for International Development in Warsaw, Poland. He was
     with Chesapeake and Potomac Telephone Company and then Bell Atlantic in
     various capacities at the General Manager level including engineering,
     marketing and operations after an assignment at Bell Telephone
     Laboratories.


                                       54
<PAGE>


     Gordon Smith has been a Director of the Company since October 1995. He has
     been Vice President, Eastern Region of Vanguard Research, Inc. from June
     1995 to present and President and CEO of Datatape, Inc. from August 1990 to
     September 1994. Dr. Smith has advised the Company that he will not run for
     re-election at the end of his term in 1999.

     Clyde Heintzelman has been a Director of the Company since December 1998.
     Mr. Heintzelman is President and CEO of SAVVIS Communications, Inc., an
     internet company, since December 1998. Prior to his role at SAVVIS, Mr.
     Heintzelman was President and Chief Operating Officer of Digex, Inc., also
     an internet company, from 1995 through 1997. During 1992 through 1994, he
     also participated as a founder in a start-up firm (CSI) which focused on
     building products (hardware/software for switched wide area networks using
     ISDN technology). Prior to these start-up firms, Mr. Heintzelman spent 28
     years (1964-1992) with Bell Atlantic and its predecessor companies.

     Richard Kreter was appointed a Director of the Company in March 1999. Mr.
     Kreter is currently Managing Partner of Kreter & Associates, a private
     management consulting firm. Mr. Kreter served as Director of Corporate
     Development for Marriott International before founding his own firm.

     The current Directors are elected pursuant to the terms of the Company's
     By-Laws. The Board of Directors is divided into three classes, as nearly
     equal in number as the then total number of Directors, constituting the
     Whole Board permits, with the term of office of one class expiring each
     year. No class of directors will contain more than one director more than
     any other class. Class I will expire at the annual meeting of stockholders
     to be held in 1999, Class II will expire at the annual meeting of 2000 and
     Class III will expire at the annual meeting of 2001. At each annual meeting
     of stockholders, the successors to directors whose terms will then expire
     will be elected to serve from the time of election and qualification until
     the third annual meeting following election and until their successors have
     been duly elected and qualified, or until their earlier resignation or,
     removal, if any. Richard Kreter and Gordon Smith have been designated Class
     I Directors. Clyde Heintzelman and Alexander Karpinski have been designated
     Class II Directors. Edmund Ludwig has been designated a Class III Director.

                                       55
<PAGE>

ITEM 11.  EXECUTIVE COMPENSATION

     Summary of Compensation. The following table shows a three-year history of
     the Company's compensation of its Chief Executive Officer and the other two
     most highly compensated executive officers of the Company (the "Named
     Executives") serving as such as of the end of 1998, each of whose total
     salary and bonus for the year ended December 31, 1998 was in excess of
     $100,000 for services rendered in all capacities for such year.

                                        SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>
                                                                           LONG-TERM
                                             ANNUAL COMPENSATION          COMPENSATION
                                     --------------------------------------------------
                                                                           SECURITIES                
     NAME AND PRINCIPAL       YEAR    SALARY     BONUS     OTHER ANNUAL    UNDERLYING    ALL OTHER
          POSITION                                         COMPENSATION   OPTIONS (#)   COMPENSATION
  ---------------------------------------------------------------------------------------------------
<S>                           <C>    <C>          <C>           <C>         <C>          <C>
  Edmund Ludwig, President,   1998   $147,433     $34,000(1)     -             -             -
  Chief Executive Officer and 1997    133,613      30,000(1)     -           12,000       $ 6,810
  Director                    1996    105,000      -             -           22,500       $56,712(2)
  ---------------------------------------------------------------------------------------------------
  Andrew Brown, Managing      1998   $102,920       -            -             -             -
  Director, Paragon Audio     1997      -           -            -             -             -
  Visual Ltd. (3)(5)          1996      -           -            -             -             -
  ---------------------------------------------------------------------------------------------------
  David Brown, Chairman       1998   $102,920       -            -             -             -
  And Marketing Director,     1997      -           -            -             -             -
  Paragon Audio Visual,       1996      -           -            -             -             -
  Ltd. and Director(4)(5)
  ---------------------------------------------------------------------------------------------------
</TABLE>


(1)  Bonus paid for the prior fiscal year-end results.

(2)  Includes debt forgiveness of $22,207 to cover income tax expense incurred
     in acquiring shares under an escrow plan and $34,505 associated with cost
     of living adjustments for years 1984 through 1995, which was included in
     employment contract of 1984.

(3)  On February 26, 1999, the Company terminated Andrew Brown's employment.

(4)  On December 21, 1998, the Company terminated David Brown's employment. On
     February 19, 1999, David Brown resigned as a Director of the Company. 

(5)  The Company acquired Paragon Audio Visual, Ltd. in December 1997.

     Aggregated Option Exercises in Last Year and Year-End Option Values. The
     Company did not grant any stock options to any Named Executives during
     1998. The following table shows information regarding the stock options
     exercised by the Company's Named Executives during 1998 and the number and
     value of unexercised stock options at December 31, 1998. The value of
     unexercised stock options is based on the closing price of $2-13/16 per
     share of common stock on December 31, 1998, the last trading day of 1998.

AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION
VALUES

<TABLE>
<CAPTION>
                                                 Number of Securities                               
                                                Underlying Unexercised      Value of Unexercised
                                                      Options at           In-the-Money Options at
                                                 December 31, 1998 (#)      December 31, 1998 ($)
                     Shares Acquired                                                                
         Name          on Exercise    Value    
                           (#)        Realized Exercisable  Unexercisable Exercisable Unexercisable
   ----------------- ---------------- -------- ------------ ------------- ----------- --------------
   <S>                   <C>          <C>        <C>           <C>            <C>          <C>
   Edmund Ludwig         30,000       $29,490    27,000        13,500         $0           $0
   David Brown              -            -          -            -            -             -
   Andrew Brown             -            -          -            -            -             -
</TABLE>


                                       56
<PAGE>

     BENEFICIAL OWNERSHIP REPORTING COMPLIANCE

     Compliance with Section 16(a) of the Securities Exchange Act of 1934

     Section 16(a) of the Securities Exchange Act of 1934 requires the Company's
     officers and directors, and persons who own more than ten percent of a
     registered class of the Company's equity securities, to file reports of
     ownership and changes in ownership with the Securities and Exchange
     Commission (SEC) and the NASD. Officers, directors and greater than
     ten-percent stockholders are required by SEC regulations to furnish the
     Company with copies of all Section 16(a) forms they file.

     Based solely on a review of the copies of such forms furnished to the
     Company, or written representations that no Forms 4 were required, the
     Company believes that during 1998 it has complied with all Section 16(a)
     filing requirements applicable to its officers, directors and greater than
     ten-percent beneficial owners.

     COMPENSATION OF DIRECTORS

     As compensation for attending each meeting of the Board of Directors,
     Directors who are not also employees of the Company (outside Directors),
     receive options to purchase 750 shares of Optelecom, Inc. stock with an
     option price equal to the market price of Optelecom, Inc. stock on the day
     of the meeting. Outside Directors are also paid their expenses for
     attending meetings. Directors who are also employees receive no
     compensation for attending meetings of the Board of Directors.

     EMPLOYMENT CONTRACTS

     Edmund Ludwig, CEO, is compensated pursuant to an employment agreement,
     which expires on December 31, 1999 and continues for successive one-year
     periods thereafter unless terminated by either party upon at least sixty
     (60) days notice. The Board of Directors establishes Mr. Ludwig's salary
     for each succeeding year. Should Mr. Ludwig die while employed under this
     agreement, the Company will pay his estate one year's salary.


                                       57
<PAGE>


ITEM 12.   OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     The following table sets forth, as of December 31, 1998, the name and
     address of each person (other than directors of the Company) who is known
     by the Company to be the beneficial owner of more than 5% of the Company's
     outstanding Common Stock, the number of shares Common Stock so owned
     beneficially owned by each such person, and the percentage of the Company's
     outstanding.

<TABLE>
<CAPTION>
     NAME AND ADDRESS                                                AMOUNT OF            PERCENT
     OF BENEFICIAL OWNER                                       BENEFICIAL OWNERSHIP       OF CLASS
     -------------------                                       --------------------       --------
     <S>                                                           <C>                    <C>
     Andrew Sean Brown                                                                              
     Coombe Folley, The Grove Park Lane                            40,668(1)               1.89%
     Thatcham, Berkshire RG18 4NI                         

     Darren Neil Brown                                                                              
     Waverley House, Long Lane                                     40,668(1)               1.89%
     Thatcham, Berkshire RG19 9QT                         

     Mark David Brown                                                                               
     Sandhill House, Long Lane, Hermitage                          40,668(1)               1.89%
     Newbury, Berkshire RG18 9XU                          

     David Arthur Brown                                                                             
     Waverly, Long Lane, Hermitage                                 40,668(1)               1.89%
     Newbury, Berkshire RG18 9QT                          

     Adventatum Jersey Limited (a company formed                                                    
     under the laws of Jersey), Wellington House,                  8,580(1)                 .40%
     Union Street, St. Helier, Jersey.                    

     Modelege Limited (a company formed under the                                                   
     laws of England), 64 Queen Street, London,                    8,580(1)(2)              .40%
     England.                                             

                                                 TOTAL              179,832                8.36%
</TABLE>

---------------------
1.       According to the SEC Form 13D/A filed on March 1, 1999, the parties
         make a statement that although the reporting persons may be deemed to
         constitute a "group" within the meaning of Section 13 (d)(3) of the
         Securities Exchange Act of 1934, as amended, each reporting person
         disclaims the existence of any such group.

2.       These shares are owned by record by Adventatum Jersey Limited.


                                       58
<PAGE>

     SECURITY OWNERSHIP OF MANAGEMENT

     The following table sets forth certain information with respect to the
     beneficial ownership of the common stock of the Company as of March 17,
     1999 by each director, nominee for director, Named Executives and all
     current directors and executive officers as a group.

<TABLE>
<CAPTION>
                                                              NUMBER OF SHARES      PERCENT
     NAME OF BENEFICIAL OWNER                                BENEFICIALLY OWNED(1) OF CLASS
     ------------------------                                ------------------    --------
     <S>                                                     <C>                      <C> 
     Edmund Ludwig                                            116,310(2)(3)            5.4%
     ------------------------------------------------------ --------------------- ------------
     Alexander Karpinski                                       38,250(2)                *
     ------------------------------------------------------ --------------------- ------------
     Clyde Heintzelman                                          3,750(2)                *
     ------------------------------------------------------ --------------------- ------------
     Gordon Smith                                              51,525(2)                *
     ------------------------------------------------------ --------------------- ------------
     Richard Kreter                                             7,750(2)                *
     ------------------------------------------------------ --------------------- ------------
     ALL DIRECTORS AND EXECUTIVE OFFICERS AS A GROUP         217,585(2)(3)          10.09%
     (6 PERSONS)
</TABLE>

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

     *    Less than 1%.

     (1)  Beneficial ownership is determined in accordance with the rules of the
          Securities and Exchange Commission and generally includes voting or
          investment power with respect to securities. Shares of Common Stock
          subject to options currently exercisable within sixty (60) days are
          deemed to be outstanding for computing the percentage of the person
          holding such options or warrants, but are not deemed outstanding for
          computing the percentage of any other person. Except as indicated by
          footnote, and subject to community property laws where applicable, the
          persons named in the table have sole voting and investment power with
          respect to all shares of Common Stock shown as beneficially owned by
          them.

     (2)  Includes shares of common stock, which were subject to options
          entitling the holder to acquire the shares subject thereto within
          sixty (60) days. As of March 17, 1999, Mr. Heintzelman, Mr. Karpinski,
          Mr. Kreter, Mr. Ludwig and Dr. Smith held such options for the
          purchase of 3,750, 22,400, 1,500, 4,500 and 30,000 shares,
          respectively.

     (3)  Includes 19,997 shares held in trust by the Company for Mr. Ludwig and
          23,693 shares, which Mr. Ludwig owns jointly with his wife, Mrs.
          Roberta Ludwig.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED PARTIES


      During 1998, the Company retained Kreter & Associates to perform
      consulting services in connection with certain financial and operations
      matters. Mr. Richard Kreter, now a Director, is managing partner of Kreter
      & Associates. Total fees paid to Kreter & Associates for its work for
      Optelecom amounted to approximately $54,000 for strategic planning for the
      research and development project and $61,000 for accounting, finance and
      budgetary consulting during the absence of a company Chief Financial
      Officer.


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                                           PART IV

ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

     1.   Consolidated Financial Statements and Financial Statement Schedules

          Report of Independent Certified Public Accountants

     Statements

     Consolidated Balance Sheets as of December 31, 1998 and 1997

     Consolidated Statements of Operations for the Years Ended December 31,
     1998, 1997 and 1996

     Consolidated Statements of Stockholders' Equity for the Years Ended
     December 31, 1998, 1997 and 1996

     Consolidated Statements of Comprehensive (Loss) Income for the Years Ended
     December 31, 1998, 1997 and 1996

     Consolidated Statements of Cash Flows for the Years Ended December 31,
     1998, 1997 and 1996

     Summary of Accounting Policies

     Notes to Consolidated Financial Statements

     2.   Financial Statement Schedules

     Schedule II Valuation and Qualifying Accounts, Years Ended December 31,
     1998 and 1997 and 1996

     Other schedules are omitted because they are not applicable or information
     is shown elsewhere in the financial statements or notes thereto.

     3.   Exhibits

     Item 3(i) Restated Certificate of Incorporation of Optelecom, Inc. as in
     effect March 23, 1998

     Item 3(i)(1) Amended and Restated By-Laws of Optelecom, Inc. as in effect
     December 1, 1998

     Item 4(1) Rights Agreement dated June 15, 1998, incorporated by reference
     from the Company's Form 8A-12 dated June 30, 1998

     Item 10(1) 1991 Stock Option Plan incorporated by reference from the
     Company's Form S-8 dated November 11, 1991

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<PAGE>

     Item 10(2) 1996 Directors Stock Option Plan incorporated by reference from
     the Company's Form S-8 dated August 14, 1995

     Item 10(3) Agreement dated December 12, 1997 among the Company, Paragon
     Audio Visual Ltd., David Brown, Mark Brown, Andrew Brown, Darren Brown and
     Modeledge Ltd., hereby incorporated by reference to the exhibits to the
     Company's Form 8-K filed with the Commission on December 23, 1997.

     Item 21 - The significant subsidiaries of the Registrant, as defined in
     Section 1-02(w) of regulations S-X are:

          Paragon Audio Visual, Ltd. (Paragon), acquired by the Company on
          December 12, 1997.

     4.   Reports on Form 8-K

          None.


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<PAGE>


                                   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.

                                           OPTELECOM, INC.

Date:                                      By   /s/Edmund D. Ludwig
                                                --------------------------------
                                                Edmund D. Ludwig
                                                DIRECTOR AND PRESIDENT AND CEO

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.

                                           OPTELECOM, INC.

Date:                                      By   /s/Alexander L. Karpinski
                                                --------------------------------
                                                Alexander L. Karpinski
                                                CHAIRMAN

Date:                                      By   /s/Clyde Heintzelman
                                                --------------------------------
                                                Clyde Heintzelman
                                                DIRECTOR

Date:                                      By   /s/Gordon A. Smith
                                                --------------------------------
                                                Gordon A. Smith
                                                DIRECTOR

Date:                                      By   /s/Richard C. Kreter
                                                --------------------------------
                                                Richard C. Kreter
                                                DIRECTOR

Date:                                      By   /s/Carole D. Argo
                                                --------------------------------
                                                Carole D. Argo
                                                CHIEF FINANCIAL OFFICER


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