SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                   FORM 10-KSB

                ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF
                       THE SECURITIES EXCHANGE ACT OF 1934

(Mark One)
[X] Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act
    of 1934 [Fee  Required]

For the fiscal  year  ended  December  31,  1998 or

[ ]  Transition report pursuant to Section 13 or 15(d) of the Securities
     Exchange Act of 1934 [No Fee  Required]

For the  transition  period from  _______________  to ________________

Commission File No. 33-86242


                             PROTOSOURCE CORPORATION
                  ---------------------------------------------
                 (Name of Small Business Issuer in its Charter)


         California                                       77-0190772
-------------------------------                     ---------------------
(State or other jurisdiction of                       (I.R.S. Employer 
incorporation or organization)                      Identification Number)

2800 28th Street, Suite 170
Santa Monica, California                                      90405
----------------------------------------                     --------
(Address of principal executive offices)                    (Zip Code)



Issuer's telephone number:  (310) 314-9801

Securities registered pursuant to Section 12(b) of the Act:  None

Securities registered pursuant to Section 12(g) of the Act:


                            No Par Value Common Stock
                    Redeemable Common Stock Purchase Warrants
                                (Title of Class)


<PAGE>



Check  whether  the  Registrant  (1) 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
                                    -----       -----

     As of February 28, 1999,  1,787,300 shares of the Registrant's no par value
Common Stock were outstanding.  As of February 28, 1999, the market value of the
Registrant's no par value Common Stock, excluding shares held by affiliates, was
$12,511,100 based upon a closing bid price of $7.00 per share of Common Stock on
the Nasdaq SmallCap Market.

     Check if there is no disclosure  contained  herein of delinquent  filers in
response to Item 405 of Regulation  S-B, and will not be contained,  to the best
of the Registrant's  knowledge,  in definitive  proxy or information  statements
incorporated  by reference  in Part III of this Form 10-KSB or any  amendment to
this Form 10-KSB. [ X ]

         The  Registrant's  revenues  for  its  most  recent  fiscal  year  were
$882,651.

     The following  documents are incorporated by reference into Part III, Items
9 through 12 hereof: None.



                                       2
<PAGE>



                                     PART I

ITEM 1.  DESCRIPTION OF BUSINESS
-------  -----------------------

     The following is a summary of certain information  contained in this Report
and is  qualified  in its entirety by the  detailed  information  and  financial
statements that appear elsewhere herein.  Except for the historical  information
contained herein,  the matters set forth in this Report include  forward-looking
statements  within the meaning of the "safe  harbor"  provisions  of the Private
Securities Litigation Reform Act of 1995. These  forward-looking  statements are
subject  to risks and  uncertainties  that may cause  actual  results  to differ
materially. These risks and uncertainties are detailed throughout the Report and
will be further  discussed from time to time in the Company's  periodic  reports
filed with the Commission. The forward-looking statements included in the Report
speak only as of the date hereof.

Introduction

     The Company  provides  Internet access,  Web  development,  Web hosting and
related  services to  individuals,  public agencies and businesses on a national
level.  The Company  operates its own  Internet  network  facilities  in Central
California  and  offers  Internet  access  nationwide   through  two  "backbone"
providers with which it has agreements. As of December 31, 1998, the Company had
approximately  3,700  subscribers  for whom it  provided  Internet  access.  The
Company  seeks to  acquire  other  small  Internet  providers  in  markets  with
populations less than 500,000.  The Company believes that certain of these local
Internet providers  currently doing business in the Company's target markets may
not be able to  effectively  manage the  financial  and  administrative  burdens
imposed by the continuing  consumer demand for local Internet  services,  unless
these providers are integrated into larger,  more diversified  Internet products
and services  companies.  The Company has addressed these kinds of financial and
administrative  burdens  by  (i)  expanding  its  operations  nationwide,   (ii)
developing  diversified  services  similar  to its larger  competitors,  such as
special access packages for business and high speed access,  and (iii) investing
in automated  billing and  administrative  systems.  The Company  believes these
resources will not only allow it to compete effectively with larger access firms
entering the Company's  markets,  but also will facilitate the Company's efforts
to attract small Internet providers.

History

     From July 1988 until August 1996,  the  Company's  primary  business was to
design,  develop and market  software  programs  (and related  hardware) for the
agri-business  industry  including produce broker accounting  programs,  product
tracking  programs,  crop chemical usage reports,  crop cost and billing systems
and fruit  accounting  programs.  The programs were packaged under the Company's
"Classic" line of products and were divided by function,  sophistication and the
size of the  customer.  The Company also designed and sold  customized  computer
system  configurations  which  integrated  hardware  and  software.  The Classic
product  line  together  with the  Company's  design  services  and hardware and
software sales is collectively referred to as the "Classic Line."

                                       3

<PAGE>


     In July 1995, the Company acquired ValleyNet Communications  ("ValleyNet"),
a small  Internet  access  provider  for $50,000 in cash and the issuance of 334
shares of the Company's Common Stock. At the time of its acquisition,  ValleyNet
operated  out of one  location in Fresno,  California  and had 250  subscribers.
Since that time,  the  Company has  increased  its  capacity  to offer  Internet
services nationwide and increased its subscribers to 3,700 at December 31, 1998.

     In December 1996,  the Company sold the Classic Line to a Canadian  company
for $300,000 in cash and an unsecured  promissory note which the Company has not
carried  as an asset on its  financial  statements,  due to the high  degree  of
uncertainty  as to  the  payment  of  the  promissory  note.  As a  part  of the
transaction,  the  Company  received  an  exclusive  worldwide  license  through
December  2006 to market the Classic Line subject to the payment of a royalty of
16% of gross  sales  to the  Canadian  company.  To date,  the  Company  has not
incurred any liability to pay royalties.

     In January 1997, the Company sold the remaining  assets of the Classic Line
to SSC  Technologies,  Inc. ("SSC") for $770,850  evidenced by a promissory note
bearing interest at 10% per annum payable in January 2007, and the assumption by
SSC of all the  liabilities  of the Classic Line and certain other  liabilities,
aggregating approximately $500,000. Under the terms of the asset sales agreement
(the  "Divestiture  Agreement"),  the Company  acquired  25% of the  outstanding
Common Stock of SSC for  $500,000 in cash (less  $200,000 of  liabilities  which
were paid by the Company and deducted  from the  $500,000) and the remaining 75%
of the  outstanding  Common  Stock was  issued to other  stockholders  including
Charles T.  Howard,  David L.  Green,  Ding Yang and  Steven L.  Wilson who were
previously officers and directors of the Company (the "SSC Principals"). As part
of the  Divestiture  Agreement,  the SSC  Principals  also (i) canceled  900,000
shares of Convertible  Preferred  Stock held by them (and one other  individual)
which were previously  exercisable  into shares of Common Stock on a fifteen for
one basis, (ii) agreed not to sell an aggregate of 30,300 shares of Common Stock
owned by them until October 1999, (iii) agreed to sublease office space from the
Company at a monthly rental of $12,000  through  February 28, 1998, (iv) granted
to Steven A. Kriegsman,  a former director of the Company, an option to purchase
up to 10,000 shares of Common Stock held by the SSC Principals at any time until
October 2001, and (v) personally  guaranteed,  on a joint and several basis, the
$770,850 promissory note and all other obligations of SSC to the Company.

     In May 1998,  the Company sold  1,137,000  units of its securities at $5.75
per unit (the "May 1998 Public  Offering").  Each unit consisted of one share of
Common Stock and one  redeemable  Common Stock purchase  warrant  exercisable at
$6.33 per share until May 13, 2003.

     In June 1998, the Company entered into a settlement  agreement with SSC and
the SSC Principals  pursuant to which it settled  certain claims  asserted by it
and the SSC  Principals  by  accepting a $275,000  promissory  note from the SSC
Principals  payable  interest only until June 2000. The interest payable portion
of the $275,000 promissory note is currently in default.

                                       4

<PAGE>


     The Company was  incorporated in the State of California as SHR Corporation
in July 1988, and changed its name to "ProtoSource Corporation" in October 1994.
The Company's principal executive offices are located at 2800 28th Street, Suite
170, Santa Monica, California 90405, telephone (310) 314-9801.

Strategy

     The Company's  strategy is to provide low cost direct  Internet  access and
other  Internet  related  products and services to  subscribers  or customers in
target  markets.  The Company will seek to effectuate this strategy by acquiring
small  Internet  providers,  by expanding  marketing  operations in its existing
markets,  by offering  Internet  related  products and services and by acquiring
other  computer  oriented  companies.  The  Company  will also seek to  generate
additional  revenues  by (i)  increasing  monthly  Internet  access  fees  while
offering  additional  Internet  products and services,  (ii) providing  Internet
consulting services, and (iii) generating marketing service fees from businesses
seeking a Web site on the  Internet.  The Company  believes that it can increase
the profitability of its monthly access fees by developing economies of scale as
a result of increasing total access subscribers and earning additional  revenues
from such subscribers by providing additional access services.

     Increasing Monthly Internet Access Fees. The Company intends to continue to
provide    low-priced    direct    Internet   access   through   the   Company's
telecommunication  network  infrastructure  which is comprised of two high speed
dedicated data lines that connect directly to the backbone of the Internet.  The
Company  plans  to add  additional  high-speed  dedicated  data  lines,  enhance
system-wide  access software in order to offer additional  Internet products and
services, and expand the number of POPs in local markets in order to attract and
support  additional  subscribers.  By increasing the number of POPs, the Company
will offer more users access to the Internet  through  local phone calls to more
geographic areas which in turn may promote growth in its subscriber base.

     The Company also provides  Integrated Services Digital Network ("ISDN") and
high-speed Internet access using dedicated data lines to business customers. The
Company believes that the demand for high-speed  Internet access and the ability
to integrate Internet access into a corporate-wide  computer network is becoming
increasingly more important.

     Providing Internet Consulting Services.  The Company provides its customers
with a number of  Internet  services  such as  consulting  services  for network
setup,  Internet  application  implementation,  Intranet  design,  and Web  site
implementation.

     Generating  Marketing  Service Fees.  The Company  designs and develops Web
sites for its clients with sophisticated graphics to attract user attention. The
Company  also  provides  all  necessary  hardware  and  software  and stores its
clients' Web pages on its dedicated servers,  which are monitored and maintained
24 hours a day, 365 days a year, to assure subscriber access.

                                       5

<PAGE>


Acquisition Strategies

     The Company will seek to acquire  local  Internet  access  providers in its
target  markets.  The  criteria  for  such  acquisition   candidates  calls  for
attracting  companies  that (i) are located in markets with a  population  under
500,000,  (ii) have been in business a minimum of one year,  (iii) have at least
300  subscribers,  (iv) have  current  owners  and staff with  strong  technical
backgrounds,  (v) enjoy  strong  community  contacts,  and (vi) offer  projected
annual  growth  rates in excess of 200%.  The Company may also  acquire or enter
into partnership or joint venture  agreements with other small computer oriented
companies.

Marketing

     The Company primarily markets to customers who are new to the Internet, and
who  seek to  access  information  using  point-and-click  graphical  interface.
Affinity group marketing is conducted through a dedicated sales force consisting
of two  salesmen,  one  responsible  for  affinity  group  marketing  in central
California,   and  the  other  responsible  for  marketing  to  affinity  groups
nationwide. The Company offers a discount on its monthly rates to affinity group
members and pays a  commission  to the  affinity  group itself as a fund raising
function for the affinity group.  The Company also seeks customers by direct and
telemarketing techniques,  participating in industry trade shows and educational
seminars and through referrals from existing customers. In addition, the Company
seeks strategic  alliances with computer retailers who offer Internet access fee
discounts  to  their  customers  and  through  joint  advertising  efforts  with
television and radio stations.

Competition

     The  Internet  services  business is highly  competitive  and there are few
significant barriers to entry. Currently,  the Company competes with a number of
national and local California Internet service providers.  In addition, a number
of multinational  corporations,  including giant communications carriers such as
AT&T,  MCI,  Sprint  and some of the  regional  Bell  operating  companies,  are
offering, or have announced plans to offer, Internet access or on-line services.
The  Company  also  faces   significant   competition   from   Internet   access
consolidators  such as Verio,  Earthlink,  MindSpring,  and from on-line service
firms such as America  OnLine (AOL) and Prodigy.  The Company  believes that new
competitors which may include computer software and services,  telephone, media,
publishing,  cable  television  and  other  companies,  are  likely to enter the
on-line services market.

     The ability of some of the Company's  competitors to bundle Internet access
software with other popular  products and services could give those  competitors
an advantage over the Company.  For example,  MCI and PSI offer retail  software
packages and AOL and Prodigy bundle their software with new PCs.

                                       6

<PAGE>


     Many of the Company's competitors possess financial resources significantly
greater than those of the Company and,  accordingly,  could initiate and support
prolonged  price   competition  to  gain  market  share.  If  significant  price
competition  were to develop,  the Company  might be forced to lower its prices,
possibly for a protracted period,  which would have a material adverse effect on
its  financial  condition  and  results of  operations  and could  threaten  its
economic viability.  In addition, the Company believes that the Internet service
and on-line  service  businesses will further  consolidate in the future,  which
could  result in  increased  price and other  competition  in the  industry  and
consequently adversely impact the Company. In the last year, a number of on-line
services have lowered their monthly service fees, which may cause the Company to
lower its monthly fees in order to compete.

     The Company  believes that the primary  competitive  factors among Internet
access  providers  are  price,  customer  support,  technical  expertise,  local
presence  in a  market,  ease  of  use,  variety  of  value-added  services  and
reliability.  The  Company  believes  it is able to compete  favorably  in these
areas. The Company's success in its markets will depend heavily upon its ability
to provide high quality Internet  connectivity and value-added Internet services
targeted in select target markets.  Other factors that will affect the Company's
success in these  markets  include the  Company's  continued  ability to attract
additional experienced marketing, sales and management talent, and the expansion
of support, training and field service capabilities.

Employees

     As of December 31, 1998,  the Company  employed 19 full-time  employees and
two part time employees.  The Company  believes it maintains good relations with
its employees.  None of the Company's employees are represented by a labor union
or covered by a collective bargaining agreement.

Year 2000 Issues

     The Year 2000 issue revolves around the inability of many computer  systems
to correctly  process  dates after  December  31, 1999.  In the 1960s and 1970s,
computer  storage and memory were very  expensive.  To  conserve  resources  and
space,  programmers stored year information as two digits instead of four (e.g.,
"59" rather than  "1959").  Beginning  in the year 2000,  these date fields will
need to accept four digit  entries to  distinguish  21st century dates from 20th
century (or  earlier)  dates.  As a result,  computer  systems  and/or  software
products used by many companies may need to be upgraded to comply with Year 2000
requirements.

     As defined by the Company,  Year 2000 compliance refers to applications and
systems  which  are  capable  of  correct   identification,   manipulation   and
calculation using dates outside the 1900-1999 year range and have been tested as
such. In this regard,  the Company recognizes the complexity and significance of
the Year  2000  issue  and has  created a project  team  comprised  of  internal
personnel to identify products and systems where the Year 2000 problem may exist
and to renovate,  replace or retire those  products or systems.  The Company has
set September 30, 1999, as the target date for Year 2000  compliance  for all of

                                       7

<PAGE>

its major  systems.  The Company's  Year 2000  compliance  plan consists of four
phases: inventory, assessment,  correction and testing. The Company is currently
in the assessment phase.

     Taking inventory of the Company's entire business  environment is the first
step in  determining  what  additional  steps  need to be taken to  successfully
transition  the  Company  into the year 2000.  The  information  compiled in the
inventory  phase will be used to organize the next phase,  assessment,  in which
manufacturers  of all  inventoried  items will be contacted  to ascertain  which
elements are Year 2000 compliant and which are not. Additionally, the Company is
gathering  information  about third party vendors and suppliers  regarding their
progress in identifying and addressing  problems that their computer systems may
face in correctly  processing  date  information  related to the Year 2000.  The
assessment phase will in turn define what corrective action is necessary and how
time-consuming it will be.

     Correction will consist of upgrading,  replacing or repairing  hardware and
software  as   appropriate.   Testing  and  validation  of  systems  will  begin
immediately as components are brought into compliance.

     Presently,  the  Company  believes  that the cost of  addressing  Year 2000
issues is not material to its future  business,  operating  results or financial
position.  However,  the Company cannot predict whether third parties' inability
to meet their  critical  completion  dates will  adversely  impact the Company's
September 30, 1999 target date.  Further, in the event that any of the Company's
significant   suppliers  do  not  successfully  and  timely  achieve  Year  2000
compliance,  the Company's  business or operations could be adversely  affected.
Moreover, the Company's expectations that it will be able to upgrade its systems
to address the Year 2000 issue and its expectation  regarding  associated  costs
are forward-looking  statements,  and, as such, subject to a number of risks and
uncertainties.

ITEM 2.  DESCRIPTION OF PROPERTY
--------------------------------

     In September  1994, the Company  acquired,  under a 20-year  non-cancelable
capital lease, an office building,  including land and improvements,  located at
2580 West Shaw,  Fresno,  California  93711. In June 1998, the landlord canceled
the lease at the  Company's  request in exchange  for a cash payment of $150,000
and delivery of the Company's 25% Common Stock interest in SSC.

     The Company leases  approximately  400 square feet for its corporate office
space at 2800 28th  Street,  Suite  170,  Santa  Monica,  California  90405 on a
month-to-month  lease for $1,025 per month. The Company also leases 4,000 square
feet of space for its offices and operating  facilities  at 2300 Tulare  Street,
Suite 210, Fresno,  California  93721. The lease term is five years,  ending May
2002 and requires minimum annual payments of $40,250  increasing every year to a
maximum of $55,375 in 2002.

                                       8

<PAGE>


ITEM 3.  LEGAL PROCEEDINGS
--------------------------

         Not applicable.

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

         Not applicable.


                                       9
<PAGE>

                                     PART II

ITEM 5.  MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
-----------------------------------------------------------------

     The Company's  Common Stock traded on the Nasdaq  SmallCap Market under the
symbol "PSCO" from February 9, 1995,  until July 10, 1996,  when it was delisted
from Nasdaq and commenced  trading on the  Electronic  Bulletin  Board under the
symbol  "PSCO."  In May 1998,  the Common  Stock was again  listed on the Nasdaq
SmallCap Market under the symbol "PSCO."

     The following table sets forth for the quarters indicated the range of high
and low closing  prices of the Company's  Common Stock as reported by Nasdaq and
the Electronic  Bulletin  Board but does not include retail markup,  markdown or
commissions.

                                                                  Price
                                                             -------------
By Quarter Ended:                                            High      Low
-----------------                                            ----      ---

March 31, 1999 (through February 28, 1999) ................ $7.25      $6.25

December 31, 1998 ......................................... $6.75      $5.38
September 30, 1998 ........................................ $5.50      $5.38
June 30, 1998 ............................................. $6.50      $5.38
March 31, 1998 ............................................ $5.81      $5.25

December 31, 1997 ......................................... $6.50      $5.00
September 30, 1997 ........................................ $6.30      $5.25
June 30, 1997 ............................................. $5.50      $3.15
March 31, 1997 ............................................ $4.65      $3.15

     As of February  28,  1999,  the Company  had  approximately  900 record and
beneficial stockholders.

Dividend Policy

     The Company has never paid cash  dividends  on its Common Stock and intends
to retain  earnings,  if any,  for use in the  operation  and  expansion  of its
business.  The amount of future  dividends,  if any,  will be  determined by the
Board of  Directors  based upon the  Company's  earnings,  financial  condition,
capital requirements and other conditions.

                                       10


<PAGE>



ITEM 6.  MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
-------  ---------------------------------------------------------

     The Company  provides  Internet access and related services to individuals,
public agencies and businesses nationwide.  As of December 31, 1998, the Company
had 3,700 subscribers for whom it provided Internet access.

Results of Operations

Year Ended December 31, 1998 vs. Year Ended December 31, 1997

     Net Sales

     For calendar 1998, Internet services revenues were $882,651 versus $749,796
in calendar 1997, an increase of 17.7%. The increase in revenue is primarily due
to an  increase  in the  Internet  access  subscriber  base and Web  development
projects.  Management believes revenues will continue to increase as the Company
(i) develops and implements marketing programs focusing on increasing name brand
recognition and differentiation of service offerings (i.e., Internet access, Web
site development and electronic commerce),  and (ii) by entering into agreements
with or acquiring other computer oriented companies.

     Operating Expenses

     1998 operating  expenses totaled $2,068,145 versus $1,818,698 in 1997. This
increase of $249,447 is primarily attributed to higher bad debt expense, network
lines,  salary,  legal,  and  advertising  costs.  The increase in network lines
expense of $81,370 is attributed to the expansion of the local Internet  serving
area.  Two new points of presence  (POPs) were added  during the year.  Bad debt
expeense totaled  $211,628 and was primarily  attributed to a note receivable of
$273,000 that was deemed not  collectable.  The Company  incurred  approximately
$40,000 of legal fees associated with acquisition activities.  In June 1998, the
Company canceled its Shaw Avenue Capital lease and its Visalia, California lease
resulting in lower depreciation,  utility and property tax expense in the second
half  of  the  year.  Management  has  implemented  several  cost  reduction  or
containment steps but believes that operating expenses will increase as revenues
increase.

     Operating Loss

     The Company's 1998 operating loss totaled  $1,185,494  versus $1,068,902 in
1997. This increase in operating loss of $116,592 is primarily attributed to bad
debt expense of $211,628 and lower than expected Internet access revenue growth.
Management believes that operating results will improve as revenues increase.


                                       11
<PAGE>

     Interest Expense (Net)

     Net interest  expense for 1998 totaled  $577,261  versus  $546,607 in 1997.
$561,059 of the 1998 interest  expense total of $705,021 is  attributable to the
expensing of 1998 debt issuance cost of $527,333 and associated interest expense
in connection  with the 1997 Bridge Loan  financing of $33,726.  The majority of
the remaining  1998  interest  expense  ($114,143)  is associated  with the Shaw
Avenue  capital lease that was canceled in June 1998.  The interest  expense was
somewhat  offset by the  interest  earned on cash or short term  investments  of
$127,760.  The Company  believes that the  cancellation of the capital lease and
the successful May 1998 sale of 1,137,000 units of the Company's securities (one
share of Common  Stock and one  warrant to purchase  one share of Common  Stock)
will substantially reduce future interest expense.

     Other Income

     Net other income  decreased  from $218,959 in 1997 to $73,479 in 1998.  Net
other income for 1998 is comprised  entirely of rental income on the sublease of
the Company's  office  building.  The decrease of $145,480 net other income is a
result of the June 1998 cancellation of the Company's Shaw Avenue capital lease.
Management  believes that with the cancellation of the Shaw Avenue capital lease
rental income will be eliminated from Other Income in future reporting periods.

Year Ended December 31, 1997 vs. Year Ended December 31, 1996

     Net Sales

     For calendar 1997, Internet services revenues were $749,796 versus $697,581
in calendar  1996, an increase of 7.5%. The increase in revenue is primarily due
to an  increase  in the  subscriber  base.  Management  believes  revenues  will
continue to increase as the Company  implements  marketing  programs focusing on
increasing  name brand  recognition  and  differentiation  of service  offerings
(i.e., Internet access, Web site development and electronic commerce).

     Operating Expenses

     1997 operating  expenses totaled $1,818,698 versus $1,121,773 in 1996. This
increase of $696,925  was  primarily  attributed  to costs  associated  with the
Company's  May 1997  Registration  Statement  covering  the May 1997  Securities
including $102,971 of legal and accounting fees, increased rent expense,  higher
salary  expense,   and  increased  bad  debt  expense.   Bad  debt  expense  was
approximately  $132,000 and is comprised of write-offs of accounts receivable of
approximately  $25,000,  establishment of a reserve for  uncollectible  accounts
receivable  of  $7,500  and for the  uncollectability  of a note  receivable  of
$100,000. Management has implemented several cost reduction or containment steps
but believes that  operating  expenses will increase as revenues  increase.  The
Company  will  also  seek to  reduce  operating  expenses  by  renegotiating  or
canceling  its Shaw Avenue  Capital  lease and its  Visalia,  California  lease.


                                       12

<PAGE>

     Operating Loss

     The Company's  1997 operating loss totaled  $1,068,902  versus  $424,192 in
1996. This increase in operating loss of $644,710 is attributed to a significant
rise in 1997  operating  expenses  coupled with less than  anticipated  Internet
service revenue growth.  Management believes that operating results will improve
as revenues increase.

     Interest Expense (Net)

     Net interest expense for 1997 totaled $546,607 versus $268,721 in 1996. The
increase of $277,886 is attributable  to obtaining  bridge loan financing in the
amount of $750,000.  This net interest expense includes the amortization of debt
issuance costs of $320,167 in connection  with the issuance of 150,000 shares of
Common Stock in the Bridge Loan, commissions of $97,500 and Bridge Loan interest
expense of $45,049.  The interest  expense was  somewhat  offset by the interest
earned on cash and short term investments of $77,399.

     Other Income

     1997 net other income  increased to $218,959  from  $146,122 in 1996.  This
increase of $72,837 is a result of the rental income  generated by the Company's
Shaw Avenue office building and  miscellaneous  sales. Net other income for 1997
is comprised  entirely of rental income on the sub-lease of the Company's office
building.  Rental income  recognized from SSC totals $144,000,  all of which was
collected in 1997.

Liquidity and Capital Resources

     For the year ended December 31, 1998, the Company used cash of $798,167 for
operating  activities.  The  Company  had a working  capital  of  $3,769,731  at
December 31, 1998. This surplus is primarily  attributed to the May 1998 sale of
1,137,000  units of the Company's  securities (one share of Common Stock and one
warrant to purchase  one share of Common  Stock) at $5.75.  As of  December  31,
1998,  the Company had $3,885,884 in cash and cash  equivalents  and $351,025 of
total liabilities.

     Capital  expenditures  relating  primarily  to  the  purchase  of  computer
equipment,  furniture, fixtures and other assets amounted to $54,082 and $77,552
for the years  ended  December  31,  1998 and 1997,  respectively.  The  capital
investment  is mainly in computer  equipment to sustain the future growth of the
Company.

     The Company  acquired  computer  equipment  under capital  leases  totaling
$80,515 for its Internet operations during the year ended December 31, 1998. The
computer equipment acquired allows the Company to meet the requirements of their
customers.

                                       13

<PAGE>


     In connection with the  cancellation of the Shaw Avenue capital lease,  the
Company agreed to purchase  15,112 shares of its Common Stock from the landlord.
The stock was purchased in September  1998 for $77,165 ($5.11 per share) and was
subsequently retired to the corporate treasury.

ITEM 7.  FINANCIAL STATEMENTS
-----------------------------





                                       14


<PAGE>


                             PROTOSOURCE CORPORATION


                          INDEX TO FINANCIAL STATEMENTS



Financial Statements                                                      Page
--------------------                                                      ----

 Independent Auditors' Report                                             F-2

 Balance Sheet as of December 31, 1998                                    F-3

 Statements of Operations for the years ended
  December 31, 1998 and 1997                                              F-5

 Statements of Changes in Stockholders' Equity for the
  years ended December 31, 1998 and 1997                                  F-6

 Statements of Cash Flows for the years ended
  December 31, 1998 and 1997                                              F-7

 Notes To Financial Statements                                            F-9











                                       F-1


<PAGE>



                          INDEPENDENT AUDITORS' REPORT



To the Board of Directors
ProtoSource Corporation


We have audited the accompanying balance sheet of ProtoSource  Corporation as of
December  31,  1998  and  the  related  statements  of  operations,  changes  in
stockholders'  equity and cash flows for the years ended  December  31, 1998 and
1997.  These  financial  statements  are  the  responsibility  of the  Company's
management.  Our  responsibility  is to express  an  opinion on these  financial
statements based on our audits.

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

In our opinion,  the financial  statements  referred to above present fairly, in
all material respects,  the financial position of ProtoSource  Corporation as of
December 31, 1998 and the results of its  operations  and its cash flows for the
years ended  December 31, 1998 and 1997 in conformity  with  generally  accepted
accounting principles.




                                                Angell & Deering
                                                Certified Public Accountants

Denver, Colorado
February 18, 1999















                                       F-2


<PAGE>



                             PROTOSOURCE CORPORATION
                                  BALANCE SHEET
                                DECEMBER 31, 1998



                                     ASSETS
                                     ------

Current Assets:
  Cash and cash equivalents                                         $ 3,885,884
  Accounts receivable - trade, net of allowance
   for doubtful accounts of $7,500                                       54,099
  Prepaid expenses and other                                             96,258
                                                                    -----------

         Total Current Assets                                         4,036,241
                                                                    -----------
Property and Equipment, at cost:
  Equipment                                                             944,776
  Furniture                                                             122,083
  Leasehold improvements                                                  2,956
                                                                    -----------
                                                                      1,069,815
  Less accumulated depreciation and amortization                       (655,543)
                                                                    -----------

         Net Property and Equipment                                     414,272
                                                                    -----------
Other Assets:
  Goodwill, net of accumulated amortization
   of $4,839                                                             16,406
  Note receivable, net of allowance for uncollectibility
   of $273,000                                                             --
  Deposits                                                               15,824
                                                                    -----------

         Total Other Assets                                              32,230
                                                                    -----------

         Total Assets                                               $ 4,482,743
                                                                    ===========






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

                                       F-3


<PAGE>



                             PROTOSOURCE CORPORATION
                                  BALANCE SHEET
                                DECEMBER 31, 1998




                      LIABILITIES AND STOCKHOLDERS' EQUITY
                      ------------------------------------

Current Liabilities:
  Accounts payable                                                 $    121,718
  Accrued expenses:
    Payroll taxes and wages                                              50,309
    Other                                                                10,288
  Deferred revenue                                                       13,747
  Current portion of long-term debt                                      70,448
                                                                   ------------

         Total Current Liabilities                                      266,510
                                                                   ------------
Long-Term Debt, net of current portion above:
  Obligations under capital leases                                      154,963
  Less current portion above                                            (70,448)
                                                                   ------------

         Total Long-Term Debt                                            84,515
                                                                   ------------

Commitments and contingencies                                              --

Stockholders' Equity:
  Preferred stock, no par value; 5,000,000 shares
   authorized, none issued and outstanding                                 --
  Common stock, no par value; 10,000,000 shares
   authorized, 1,787,300 shares issued and outstanding               10,884,194
  Additional paid in capital                                             10,658
  Accumulated deficit                                                (6,763,134)
                                                                   ------------

         Total Stockholders' Equity                                   4,131,718
                                                                   ------------

         Total Liabilities and Stockholders' Equity                $  4,482,743
                                                                   ============














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

                                       F-4


<PAGE>



                             PROTOSOURCE CORPORATION
                            STATEMENTS OF OPERATIONS
                 FOR THE YEARS ENDED DECEMBER 31, 1998 AND 1997



                                                      1998              1997
                                                  -----------       -----------
Net Revenues:
 Internet service fees and other                  $   882,651       $   749,796
                                                  -----------       -----------

       Total Revenues                                 882,651           749,796

Operating expenses                                  2,068,145         1,818,698
                                                  -----------       -----------

       Operating Loss                              (1,185,494)       (1,068,902)
                                                  -----------       -----------

Other Income (Expense):
 Interest income                                      127,760            77,399
 Interest expense                                    (705,021)         (624,006)
 Rent and other income                                 73,479           218,959
 Loss on disposal of assets                            (6,953)           (2,018)
 Other, net                                              --                 368
                                                  -----------       -----------

       Total Other Income (Expense)                  (510,735)         (329,298)
                                                  -----------       -----------

Loss From Operations Before
 Provision For Income Taxes                        (1,696,229)       (1,398,200)

Provision for income taxes                               --              72,350
                                                  -----------       -----------

Net Loss                                          $(1,696,229)      $(1,470,550)
                                                  ===========       ===========

Net Loss Per Share of Common Stock:
  Basic                                           $     (1.24)      $     (2.49)
  Diluted                                         $     (1.24)      $     (2.49)

Weighted Average Number of
 Common Shares Outstanding:
  Basic                                             1,365,484           589,702
  Diluted                                           1,365,484           589,702












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

                                       F-5


<PAGE>
<TABLE>
<CAPTION>
                                              PROTOSOURCE CORPORATION
                                        STATEMENTS OF STOCKHOLDERS' EQUITY
                                  FOR THE YEARS ENDED DECEMBER 31, 1998 AND 1997



                                                                                  
                                                         Common Stock                  Additional
                                                  ------------------------              Paid In              Accumulated
                                                  Shares            Amount               Capital               Deficit
                                                  ------            ------               -------               -------

<S>                                            <C>              <C>                   <C>                  <C>          
Balance at December 31, 1996                    515,333          $  4,839,485          $       --           $ (3,596,355)

Issuance of common stock                           --                     970                  --                   --

Issuance of common stock in
 connection with bridge loans                   150,000               750,000                  --                   --

Net loss                                           --                    --                    --             (1,470,550)
                                           ------------          ------------          ------------         ------------

Balance at December 31, 1997                    665,333             5,590,455                  --             (5,066,905)

Issuance of common stock and
 warrants in public offering
 (net of offering costs of
 $1,166,846)                                  1,137,000             5,370,904                  --                   --

Repurchase of common stock
 for cash                                       (15,112)              (77,165)                 --                   --

Issuance of fractional shares
 from 1997 stock splits                              79                  --                    --                   --

Issuance of stock options
 to Directors                                      --                    --                  10,658                 --

Net loss                                           --                    --                    --             (1,696,229)
                                           ------------          ------------          ------------         ------------

Balance at December 31, 1998                  1,787,300          $ 10,884,194          $     10,658         $ (6,763,134)
                                           ============          ============          ============         ============


















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

                                                        F-6
</TABLE>


<PAGE>
<TABLE>
<CAPTION>
                                           PROTOSOURCE CORPORATION
                                          STATEMENTS OF CASH FLOWS
                               FOR THE YEARS ENDED DECEMBER 31, 1998 AND 1997



                                                                               1998                    1997
                                                                           -----------             -----------
Cash Flows From Operating Activities:
<S>                                                                        <C>                     <C>         
  Net loss                                                                 $(1,696,229)            $(1,470,550)
  Adjustments to reconcile net loss to net cash
   provided (used) by operating activities:
    Depreciation and amortization                                              748,917                 544,670
    Provision for bad debts                                                    173,000                 107,500
    Deferred income taxes                                                         --                    71,550
    Compensation from issuance of stock options to Directors                    10,658                    --
    (Gain) loss on disposal of equipment                                          --                     2,018
    Loss on termination of capital lease                                         6,953                    --
    Changes in operating assets and liabilities:
     Accounts receivable                                                       (31,609)                 20,563
     Inventories                                                                  --                     8,980
     Deposits and other assets                                                 (34,550)                 12,586
     Accounts payable                                                           25,611                 (99,587)
     Accrued liabilities                                                       (14,665)               (191,966)
     Customer deposits                                                            --                    (1,500)
     Deferred revenue                                                           13,747                    --
                                                                           -----------             -----------

Net Cash (Used) By Operating Activities                                       (798,167)               (995,736)
                                                                           -----------             -----------

Cash Flows From Investing Activities:
  Purchase of property and equipment                                           (54,082)                (77,552)
  Payment for termination of capital lease                                    (150,000)                   --
  Increase in note receivable                                                  (24,999)                   --
  Receipt of principal on note receivable                                      250,817                 207,579
                                                                           -----------             -----------

Net Cash Provided By Investing Activities                                       21,736                 130,027
                                                                           -----------             -----------

Cash Flows From Financing Activities:
  Payments on notes payable                                                   (828,095)                (73,447)
  Proceeds from borrowing                                                         --                   750,000
  Issuance of common stock                                                   6,537,750                     970
  Offering costs incurred                                                   (1,068,323)                (98,523)
  Debt issuance costs incurred                                                    --                   (97,500)
  Purchase of common stock                                                     (77,165)                   --
                                                                           -----------             -----------

Net Cash Provided By Financing Activities                                    4,564,167                 481,500
                                                                           -----------             -----------







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

                                                        F-7
</TABLE>


<PAGE>
<TABLE>
<CAPTION>



                                              PROTOSOURCE CORPORATION
                                             STATEMENTS OF CASH FLOWS
                                  FOR THE YEARS ENDED DECEMBER 31, 1998 AND 1997



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

<S>                                                                 <C>                    <C>        
Net Increase (Decrease) in Cash and Cash Equivalents                $3,787,736             $ (384,209)

Cash and Cash Equivalents at Beginning of Year                          98,148                482,357
                                                                    ----------             ----------

Cash and Cash Equivalents at End of Year                            $3,885,884             $   98,148
                                                                    ==========             ==========

Supplemental Disclosure of Cash Flow Information:
  Cash paid during the year for:
    Interest                                                        $  222,737             $  258,790
    Income taxes                                                         1,600                    800

Supplemental Disclosure of Noncash
  Investing and Financing Activities:
   Acquisition of equipment under capital leases                    $   80,515             $   69,959
   Issuance of common stock in connection with financing                  --                  750,000



</TABLE>
















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

                                                        F-8
<PAGE>



                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


1. Summary of Significant Accounting Policies
   ------------------------------------------ 
     Description of Business
     -----------------------
          ProtoSource Corporation,  formerly SHR Corporation,  doing business as
          Software  Solutions Company (the "Company"),  was incorporated on July
          1, 1988, under the laws of the state of California.  The Company is an
          Internet service provider.

     Stock Split
     -----------
          On February 28, 1997, the Company's  shareholders adopted a resolution
          approving  a one  for  ten  reverse  stock  split  of the  issued  and
          outstanding common shares, effective April 2, 1997.

          On April 25, 1997,  the  Company's  shareholders  adopted a resolution
          approving  a three  for two  reverse  stock  split of the  issued  and
          outstanding  common  shares,  effective  April  25,  1997.  All  share
          information  and per share date have been  retroactively  restated for
          all periods presented to reflect the reverse stock splits.

     Revenue Recognition
     -------------------
          Revenue from the Internet operations is recognized over the period the
          services are provided.  Deferred revenue consists primarily of monthly
          subscription  fees  billed  in  advance.   Advance  payments  for  web
          development  services  received  prior to  completion  of the services
          performed are also recorded as deferred revenue until the services are
          completed.

     Cash and Cash Equivalents
     -------------------------
          For purposes of the  statements of cash flows,  the Company  considers
          all highly liquid  investments with a maturity of three months or less
          at the date of purchase to be cash equivalents.

     Property and Equipment
     ----------------------
          Depreciation and amortization of equipment, furniture and vehicles are
          computed using the straight-line method over estimated useful lives of
          three to seven years. Assets held under capital lease obligations, are
          amortized  using the  straight-line  method  over the  shorter  of the
          useful lives of the assets or the term of the lease.  Depreciation  of
          property and equipment charged to operations was $220,168 and $223,086
          for the years ended December 31, 1998 and 1997, respectively.

     Amortization
     ------------
          Goodwill is being  amortized  using the  straight-line  method over an
          estimated useful life of 15 years.

          Debt issuance costs are being amortized using the straight-line method
          over the fifteen month term of the loans.

     Investment
     ----------
          The Company has a 25%  ownership  interest in SSC  Technologies,  Inc.
          ("SSC").  The Company  received the equity interest in connection with
          the divestiture of three  operating  divisions of the Company in 1996.
          The cost of its  investment  is $-0-,  and since the Company  does not
          have the ability to exercise  influence  over  operating and financial
          policies of SSC, the Company is accounting  for its  investment in SSC
          utilizing the cost method of  accounting.  Under the cost method,  net
          accumulated  earnings  of  an  investee  subsequent  to  the  date  of
          investment   are  recognized  by  the  investor  only  to  the  extent
          
                                       F-9


<PAGE>



                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


1. Summary of Significant Accounting Policies (Continued)
   ------------------------------------------------------
     Investment (Continued)
     ---------------------
          distributed by the investee as dividends. Dividends received in excess
          of earnings  subsequent  to the date of  investment  are  considered a
          return of investment and are recorded as reductions of the cost of the
          investment.  The Company disposed of its investment in connection with
          the termination of its capital lease for its former office building.

     Deferred Offering Costs
     -----------------------
          In  connection  with the  Company's  public  offering  (Note 4), costs
          incurred to complete the offering  were  deferred and have been offset
          against the proceeds of the offering which was completed in May 1998.

     Stock-Based Compensation
     ------------------------
          During the year ended December 31, 1996, the Company adopted Statement
          of Financial  Accounting  Standards  (SFAS) No. 123,  "Accounting  for
          Stock-Based  Compensation".  The  Company  will  continue  to  measure
          compensation expense for its stock-based  employee  compensation plans
          using the  intrinsic  value method  prescribed  by APB Opinion No. 25,
          "Accounting  for Stock Issued to Employees".  See Note 8 for pro forma
          disclosures  of net  income  and  earnings  per  share  as if the fair
          value-based  method  prescribed  by SFAS No.  123 had been  applied in
          measuring compensation expense.

     Long-Lived Assets
     -----------------
          In accordance with Statement of Financial  Accounting Standards (SFAS)
          No. 121,  "Accounting for the Impairment of Long-Lived  Assets and for
          Long-Lived  Assets to be Disposed  Of",  the  Company  reviews for the
          impairment of long-lived assets, certain identifiable intangibles, and
          associated  goodwill,  whenever  events or  changes  in  circumstances
          indicate that the carrying  value of an asset may not be  recoverable.
          An impairment loss would be recognized when the estimated  future cash
          flows is less than the  carrying  amount of the asset.  No  impairment
          losses have been identified by the Company.

     Income Taxes
     ------------
          Deferred income taxes are provided for temporary  differences  between
          the financial  reporting and tax bases of assets and liabilities using
          enacted  tax laws and  rates for the years  when the  differences  are
          expected to reverse.

     Net Income (Loss) Per Share of Common Stock
     -------------------------------------------
          As of December 31, 1997,  the Company  adopted  Statement of Financial
          Accounting  Standards  (SFAS) No. 128,  "Earnings  Per  Share",  which
          specifies the method of computation,  presentation  and disclosure for
          earnings  per share.  SFAS No. 128 requires  the  presentation  of two
          earnings per share amounts, basic and diluted.

          Basic  earnings per share is  calculated  using the average  number of
          common shares  outstanding.  Diluted earnings per share is computed on
          the basis of the average number of common shares  outstanding plus the
          dilutive  effect of  outstanding  stock  options  using the  "treasury
          stock" method.

          The  basic and  diluted  earnings  per  share  are the same  since the
          Company  had a net loss for 1998 and 1997 and the  inclusion  of stock
          options and other  incremental  shares would be antidilutive.  Options
          and  warrants to purchase 1,673,333 and 277,334 shares of common stock

                                      F-10


<PAGE>



                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


1. Summary of Significant Accounting Policies (Continued)
   ------------------------------------------------------
     Net Income (Loss) Per Share of Common Stock (Continued)
     -------------------------------------------------------
          at  December  1998 and 1997,  respectively  were not  included  in the
          computation  of diluted  earnings per share  because the Company had a
          net loss and their effect would be antidilutive.

     Estimates
     ---------
          The  preparation of the Company's  financial  statements in conformity
          with generally accepted  accounting  principles requires the Company's
          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 amount of revenues and expenses during the reporting  period.
          Actual results could differ from those estimates.

3. Long-Term Debt
   --------------
     Long-term debt consists of the following:

     Obligations Under Capital Leases
     ---------------------------------
        11.1% to 23.0% installment notes due in 1999
        to 2001, collateralized by equipment.                   $ 154,963
                                                                ---------

            Total Long-Term Debt                                  154,963
            Less current portion of long-term debt                (70,448)
                                                                ---------

            Long-Term Debt                                       $ 84,515
                                                                 ========
                                  

          Installments due on debt principal,  including the capital leases,  at
          December 31, 1998 are as follows:

          Year Ending
          December 31,
             1999                                                $ 70,448
             2000                                                  63,441
             2001                                                  21,074
                                                                 --------
             Total                                               $154,963
                                                                 ========

3. Income Taxes
   ------------
     The components of the provision for income taxes are as follows:

                                                       1998               1997
                                                    ---------           --------
             Current:
                 Federal                            $      --           $     --
                 State                                     --                800
                                                    ---------           --------
                   Total                                   --                800
                                                    ---------           --------
             Deferred:
                 Federal                                   --             60,635
                 State                                     --             10,915
                                                    ---------            -------
                   Total                                   --             71,550
                                                    ---------            -------

             Total Provision For Income Taxes       $      --            $72,350
                                                    =========            =======

                                      F-11


<PAGE>



                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


3. Income Taxes (Continued)
   ------------------------
          The  provision for income taxes  reconciles to the amount  computed by
          applying the federal statutory rate to income before the provision for
          income taxes as follows:

                                                           1998         1997
                                                           ----         ----
             Federal statutory rate                        (25)%        (25)%
             State franchise taxes,
              net of federal benefits                       (4)          (4)
             Valuation allowance                            29           29
                                                         -----        -----

                 Total                                      --%          --%
                                                         =====        =====

          Significant  components  of deferred  income  taxes as of December 31,
          1998 are as follows:

             Net operating loss carryforward                   $ 1,876,900
             Vacation accrual                                        6,500
             Allowance for bad debts                                96,200
                                                              ------------

             Total deferred tax asset                            1,979,600
                                                              ------------

             Accelerated depreciation                              (32,300)
                                                              ------------

             Total deferred tax liability                          (32,300)
             Less valuation allowance                           (1,947,300)
                                                              ------------

             Net Deferred Tax Asset                           $         --
                                                              ============

          The  Company  has  assessed  its past  earnings  history  and  trends,
          budgeted  sales,  and  expiration  dates  of  carryforwards   and  has
          determined that it is more likely than not that no deferred tax assets
          will be realized.  The valuation allowance of $1,947,300 is maintained
          on deferred tax assets which the Company has not determined to be more
          likely  than  not  realizable  at this  time.  The net  change  in the
          valuation  allowance  for  deferred  tax  assets  was an  increase  of
          $516,420.  The Company  will  continue to review this  valuation  on a
          quarterly basis and make adjustments as appropriate.

          At December  31,  1998,  the Company  had federal and  California  net
          operating  loss   carryforwards   of   approximately   $6,500,000  and
          $3,300,000,  respectively. Such carryforwards expire in the years 2007
          through  2018  and  1999  through  2003  for  federal  and  California
          purposes, respectively.

4. Stockholders' Equity
   --------------------
     Public Stock Offering
     ---------------------
          The closing for the Company's  secondary  offering occurred on May 20,
          1998. The Company sold 1,137,000 units of the Company's  securities at
          $5.75  per unit and paid the  Underwriter  a 10%  commission  and a 3%
          non-accountable expense allowance. Each unit consisted of one share of
          the Company's  common stock and one  redeemable  common stock purchase
          warrant.  Each warrant is  exercisable to purchase one share of common
          stock at $6.33 per share until May 13, 2003 and may be redeemed by the
          Company  anytime  after  May 13,  1999  if the  closing  price  of the
          Company's  common stock is at least $8.63 per share for 20 consecutive
          trading days.


                                      F-12


<PAGE>



                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


4. Stockholder's Equity (Continued)
   --------------------------------
     Public Stock Offering (Continued)
     ---------------------------------
          In connection with the offering,  the Company issued the Underwriter a
          warrant,   for  $10,  to  purchase  up  to  105,000  units  which  are
          exercisable  at $9.49 per unit  (equal to 165% of the public  offering
          price of the Units).  The  Underwriter's  warrant is exercisable for a
          period of four years  beginning May 13, 1999. The units subject to the
          Underwriter's  warrant are  identical to the units sold to the public.
          The  Company  has  also  retained  the   Underwriter  as  a  financial
          consultant  for a period  of one year at a  monthly  fee of  $5,000 (a
          total of  $60,000)  which  was  paid in full  upon  completion  of the
          Offering.

5. Preferred Stock
   ---------------  
          The authorized  preferred  stock of the Company  consists of 5,000,000
          shares, no par value. The preferred stock may be issued in series from
          time  to  time  with  such   designation,   rights,   preferences  and
          limitations  as the Board of Directors of the Company may determine by
          resolution. The rights, preferences and limitations of separate series
          of  preferred  stock may differ with respect to such matters as may be
          determined by the Board of Directors,  including  without  limitation,
          the rate of  dividends,  method and  nature of  payment of  dividends,
          terms of  redemption,  amounts  payable on  liquidation,  sinking fund
          provisions  (if any),  conversion  rights (if any), and voting rights.
          Unless the nature of a particular  transaction and applicable statutes
          require  approval,  the Board of Directors  has the authority to issue
          these shares without shareholder approval.

6. Stock Options and Warrants
   --------------------------
     Incentive Stock Option Plan
     ---------------------------
          In November 1994, the Company's Board of Directors  authorized and the
          shareholders  approved,  a stock  option plan which  provides  for the
          grant of incentive and nonqualified  options to eligible  officers and
          key  employees of the Company to purchase up to 150,000  shares of the
          Company's  common stock. The purchase price of such shares shall be at
          least  equal to the fair  market  value  at the  date of  grant.  Such
          options vest at the  discretion of the Board of  Directors.  The stock
          option plan expires in 2004.  No options  were granted  under the Plan
          prior to 1998.  Under the  Company's  stock option  plan,  outstanding
          options vest over three years from the grant date.

          The following  table  contains  information on the stock options under
          the  Company's  plan  for  the  year  ended  December  31,  1998.  The
          outstanding agreements expire from May 2004 to December 2004.

                                                  Number of    Weighted Average
                                                   Shares       Exercise Price
      Options outstanding at December 31, 1997          --         $   --
       Granted                                      56,750           5.75
       Exercised                                        --             --
       Canceled                                     (2,750)          5.75
                                                   -------          -----

      Options outstanding at December 31, 1998      54,000          $5.75
                                                   =======          =====

     Financing Warrants
     ------------------
          As a part of a  restructuring  of its  operations in 1996, the Company
          granted an  Underwriter  and a financial  consulting  firm warrants to
          purchase common stock. The warrants are exercisable at $3.75 per share
          for a four year period  through  October 31, 2001.  As of December 31,
          1998, 186,666 warrants are outstanding.

                                      F-13


<PAGE>



                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


6. Stock Options and Warrants (Continued)
   -------------------------------------
     Employment Warrants
     -------------------
          The Company issued 36,667 warrants to its Chief  Executive  Officer in
          connection  with  his  employment  agreement  in  November  1996.  The
          warrants  vest as to 13,333  warrants  on January  1, 1997,  13,334 on
          January  1, 1998 and  10,000 on January  1,  1999.  The  warrants  are
          exercisable at $3.75 per share at any time through October 2001.

     Board of Directors Options
     --------------------------
          The Company  issued  45,000  stock  options to its three  Non-Employee
          Directors in October  1998.  The options vest over a three year period
          and are  exercisable at $6.00 per share and the options are for a five
          year term.

     Underwriter Warrants
     --------------------
          In connection  with the Company's IPO in 1995,  the Company issued the
          Underwriter  a warrant  to  purchase  4,000  shares  of the  Company's
          securities.  The warrant is  exercisable  until  February 9, 2000 at a
          price of $99.00 per share.

     Warrants From Secondary Offering
     --------------------------------
          The Company issued warrants in connection with a secondary offering of
          its common stock (Note 4).

7. Commitments and Contingencies
   -----------------------------
     Leases
     ------
          The Company  leases  certain  computer  equipment  and  furniture  and
          fixtures under  noncancellable  capital leases. The Company leases its
          facilities  and  certain  computer   equipment  under   noncancellable
          operating leases.

          The  following  is a schedule  of future  minimum  lease  payments  at
          December 31, 1998 under the Company's  capital  leases  (together with
          the present value of minimum lease payments) and operating leases that
          have initial or remaining  noncancellable lease terms in excess of one
          year:



       Year Ending                         Capital       Operating
      December 31,                         Leases         Leases        Total
      ------------                         ------         ------        -----
         1999                              $ 91,856       $ 53,841     $145,697
         2000                                73,493         54,918      128,411
         2001                                22,375         56,016       78,391
         2002                                    --         23,340       23,340
                                           --------       --------     --------

 Total Minimum Lease
  Payments                                  187,724       $188,115     $375,839
                                                          ========     ========

 Less amount representing interest          (32,761)
                                           --------
 Present Value of Net Minimum
  Lease Payments                           $154,963
                                           ========

          Rent  expense  amounted to  approximately  $62,703 and $69,806 for the
          years ended December 31, 1998 and 1997, respectively.

  
                                      F-14


<PAGE>



                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


7. Commitments and Contingencies (Continued)
   -----------------------------------------
     Leases (Continued)
     ------------------
          Leased  equipment  under capital  leases as of December 31, 1998 is as
          follows:

             Equipment                                             $ 281,918
             Less accumulated amortization                          (120,914)
                                                                   ---------
             Net Property and Equipment Under Capital Lease        $ 161,004
                                                                   =========

     The Year 2000
     -------------
          The Company is currently  working to resolve the  potential  impact of
          the Year 2000 on the processing of  date-sensitive  information by the
          Company's  computerized  information systems. The Year 2000 problem is
          the result of computer programs being written using two digits (rather
          than  four)  to  define  the  applicable  year.  Any of the  Company's
          programs that have time-sensitive  software may recognize a date using
          "00" as the year 1900 rather than the year 2000, which could result in
          miscalculations  or system  failures.  Costs of  addressing  potential
          problems  are  expensed  as  incurred  and are not  expected to have a
          material adverse impact on the Company's financial  position,  results
          of operations or cash flows in future periods. However, if the Company
          or its  vendors  are unable to  resolve  such  processing  issues in a
          timely  manner,  it  could  result  in  a  material   financial  risk.
          Accordingly,  the Company plans to devote the  necessary  resources to
          resolve all significant Year 2000 issues in a timely manner. While the
          Company does not at this time  anticipate  significant  problems  with
          suppliers and customers, it is developing contingency plans with these
          third parties due to the possibility of compliance issues.

8. Stock-Based Compensation Plans
   ------------------------------
          The Company  adopted  SFAS No. 123 during the year ended  December 31,
          1996. In accordance  with the  provisions of SFAS No. 123, the Company
          applies  APB  Opinion  No.  25,   "Accounting   for  Stock  Issued  to
          Employees",  and related  interpretations  in accounting for its plans
          and  does  not  recognize  compensation  expense  for its  stock-based
          compensation plans other than for options granted to non-employees. If
          the Company had elected to recognize  compensation  expense based upon
          the fair  value  at the  grant  date  for  awards  under  these  plans
          consistent  with  the  methodology  prescribed  by SFAS No.  123,  the
          Company's  net income and  earnings  per share would be reduced to the
          following pro forma amounts:

                                                        1998            1997
                                                     -----------    ------------
          Net Loss:
            As reported                              $(1,696,229)   $(1,470,550)
            Pro forma                                $(1,732,742)   $(1,507,063)

          Net Loss Per Share of Common Stock:
            As reported                              $     (1.24)   $     (2.49)
            Pro forma                                $     (1.27)   $     (2.56)

          These  pro  forma  amounts  may  not  be   representative   of  future
          disclosures  since  the  estimated  fair  value  of stock  options  is
          amortized to expense over the vesting  period and  additional  options
          may be granted in future  years.  The fair value for these options was
          estimated at the date of grant using the Black-Scholes  option pricing
          model with the following  assumptions  for the year ended December 31,
          1998:




                                      F-15


<PAGE>



                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


8. Stock-Based Compensation Plans (Continued)
   -----------------------------------------
                                                            1998
                                                            ----
             Risk free interest rate                          5.28%
             Expected life                                5.0 years
             Expected volatility                             41.25%
             Expected dividend yield                             0%

          The Company did not grant any stock options in 1997.

          The  Black-Scholes  option  valuation  model was  developed for use in
          estimating  the fair  value of traded  options  which  have no vesting
          restrictions and are fully transferable. In addition, option valuation
          models require the input of highly  subjective  assumptions  including
          the expected stock price  volatility.  Because the Company's  employee
          stock options have characteristics  significantly different from those
          of traded options, and because changes in subjective input assumptions
          can  materially  affect  the fair  value  estimates,  in  management's
          opinion,  the existing  models do not  necessarily  provide a reliable
          single  measure  of  the  fair  value  of  its  employee   stock-based
          compensation plans.

          The weighted  average fair value price of options  granted in 1998 was
          $2.48.

          The  following  table   summarizes   information   about   stock-based
          compensation plans outstanding at December 31, 1998:
<TABLE>
<CAPTION>


                                              Options Outstanding                           Options Exercisable
                                              -------------------                           -------------------

                                                   Weighted
                                                    Average         Weighted                             Weighted
                Range of                           Remaining         Average                              Average
                Exercise           Number         Contractual       Exercise            Number           Exercise
                 Prices          Outstanding      Life-Years          Price           Exercisable          Price
                 ------          -----------      ----------          -----           -----------          -----
<S>              <C>               <C>               <C>              <C>              <C>               <C>    
                 $5.75             54,000            5.50             $5.75                --                --
                 =====             ======            ====             =====               ====              ====   
</TABLE>

     Compensation Expense
     --------------------
          The Company recorded  compensation expense of $10,658 and $-0- for the
          years ended December 31, 1998 and 1997, respectively, for the value of
          certain options granted to Non-Employee  Directors of the Company. The
          valuation of the options and warrants granted to employees is based on
          the difference  between the exercise price and the market value of the
          stock on the measurement date. The valuation of the options granted to
          non-employees  is estimated  using the  Black-Scholes  option  pricing
          model.

9. Concentration of Credit Risk
   ----------------------------
          Financial   instruments  which  potentially  subject  the  Company  to
          concentrations  of credit risk consist  principally  of temporary cash
          investments  and  accounts  receivable.  The  Company  places its cash
          equivalents  and  short  term  investments  with high  credit  quality
          financial  institutions  and limits its credit  exposure  with any one
          financial  institution.  The Company  provides  credit,  in the normal
          course of  business,  to a large  number of  companies in the Internet
          services  industry.  The Company's  accounts  receivable  are due from
          customers  located  primarily  in  central  California.   The  Company
          performs  periodic  credit  evaluations  of its  customers'  financial
          condition and generally requires no collateral.  The Company maintains
          reserves  for  potential  credit  losses,  and  such  losses  have not
          exceeded management's expectations.

                                      F-16


<PAGE>



                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


10. Sale of Software
    ----------------
          In December  1995,  the Company  entered into an agreement to sell its
          "Classic"   Software   to  a   Canadian   Limited   Partnership   (the
          "Partnership") for a promissory note in the amount of $8,080,000.  The
          Partnership  acquired  all of the  Company's  interest  in the Classic
          Software defined as follows; all existing and future updates, upgrades
          additions,  improvements  and enhancements and any new versions of the
          software. The Partnership sold limited partnership units in Canada and
          the promissory  note was replaced by cash and promissory  notes as the
          units were sold.

          The  Company  also  entered  into a  Distribution  Agreement  with the
          Partnership,  whereby  the  Company  was  appointed  as the  exclusive
          distributor of the Classic Software throughout the world for a term of
          twenty  years.  Under  the  terms of the  Distribution  Agreement  the
          Company  will  purchase  copies of the Classic  Software for resale to
          third parties.  Until December 31, 2000, the Company shall pay various
          percentage of sales for each copy of the Software  purchased  from the
          Partnership.

          Since the Company  was  responsible  for  maintaining,  upgrading  and
          developing  future revisions of the Software,  the transaction was not
          accounted  for as a sale  by  the  Company.  In  addition,  the  notes
          receivable  were not  recorded  by the  Company  as a result  of their
          long-term  nature and they are primarily  expected to be repaid as the
          Company  sells  software to third  parties  and makes  payments to the
          Partnership   pursuant  to  terms  of  the   Distribution   Agreement.
          Therefore,  repayment will only occur out of revenue  generated by the
          Company.  This  transaction was accounted for by the Company on a cost
          recovery basis and the cash received from the Partnership  reduced the
          capitalized  software  costs since the Company,  in essence,  retained
          substantially all rights of ownership.

          The software and all rights to the above  agreements  were sold by the
          Company in connection with the divestiture of the software development
          division in 1996.

11. Employee Benefit Plan
    ----------------------
          Effective May 29, 1997, the Company  adopted a 401(K) savings plan for
          employees who are not covered by any collective  bargaining agreement,
          have attained age 21 and have completed one year of service.  Employee
          and Company matching contributions are discretionary. The Company made
          matching  contributions  of $3,070  and  $1,799  for the  years  ended
          December 31, 1998 and 1997,  respectively.  Company contributions vest
          as follows:

             Years of Service                                 Percent Vested
             ----------------                                 --------------
                     1                                              33%
                     2                                              66%
                     3                                             100%

12. Fair Value of Financial Instruments
    -----------------------------------
          Disclosures  about  Fair  Value  of  Financial   Instruments  for  the
          Company's  financial  instruments  are  presented  in the table below.
          These calculations are subjective in nature and involve  uncertainties
          and  significant  matters of judgment  and do not  include  income tax
          considerations.  Therefore,  the  results  cannot be  determined  with
          precision and cannot be  substantiated  by  comparison to  independent
          market  values and may not be realized in actual sale or settlement of
          the instruments.  There may be inherent  weaknesses in any calculation
          technique,  and  changes  in the  underlying  assumptions  used  could
          

                                      F-17


<PAGE>


                             PROTOSOURCE CORPORATION
                          NOTES TO FINANCIAL STATEMENTS


12. Fair Value of Financial Instruments (Continued)
    -----------------------------------------------
          significantly  affect the  results.  The  following  table  presents a
          summary of the  Company's  financial  instruments  as of December  31,
          1998:

                                                            1998
                                                 ---------------------------
                                                  Carrying         Estimated
                                                   Amount         Fair Value
                                                 ----------       ----------
            Financial Assets:
             Cash and cash equivalents           $3,885,884       $3,885,884

            Financial Liabilities:
             Long-term debt                         154,963          154,963

          The  carrying  amounts  for cash and  cash  equivalents,  receivables,
          accounts payable and accrued  expenses  approximate fair value because
          of the  short  maturities  of these  instruments.  The  fair  value of
          long-term debt, including the current portion, approximates fair value
          because of the market rate of interest on the  long-term  debt and the
          interest rate implicit in the obligations under capital leases.





















                                      F-18



<PAGE>



ITEM 8.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURE
------------------------------------------------------------------------

         None.


                                       15

<PAGE>



                                    PART III

ITEM 9.  DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
         COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT
-----------------------------------------------------------------------

Officers and Directors

     The name, age and position of each of the Company's  executive officers and
directors are set forth below:

                                                                     Officer/
                                                                     Director
        Name                Age            Position                   Since
--------------------------------------------------------------------------------

Raymond J. Meyers        42          Chief Executive Officer          1996
                                     Chief Financial Officer
                                     and Director

David A. Appell          35          Director                         1997

Andrew Stathopoulos      49          Director                         1998

William Conis            52          Director                         1998


     Directors  hold office for a period of one year from their  election at the
annual meeting of  stockholders  or until their  successors are duly elected and
qualified.  Officers of the Company are elected by, and serve at the  discretion
of,  the  Board  of  Directors.  Board  members  receive  $100 per hour for time
expended on behalf of the Company  including  attendance at Board meetings.  The
Company's  audit  committee  is  composed  of all four  members  of its Board of
Directors.   The  Company's   compensation  committee  is  composed  of  Messrs.
Stathopoulos and Conis.

Background

     The  following  is a summary of the business  experience,  for at least the
last five years, of each executive officer and director of the Company:

     Raymond J. Meyers became the Company's Chief Executive  Officer in December
1996. From 1985 to 1996, he was employed by Transamerica  Corporation  holding a
variety of positions,  most recently (from 1991 to 1996) as Director of Business
Services for Transamerica Telecommunications.  Mr. Meyers graduated from Rutgers
University in 1979, with a Bachelor of Arts degree in Economics.

                                       16

<PAGE>


     David A. Appell became a Director of the Company in September  1997.  Since
January 1997, he has served as an investment banker first for the underwriter of
the Company's May 1998 public  offering and  subsequently,  for Mercury  Equity.
Since  February  1992, he has also been engaged in the private  practice of law.
Mr.  Appell  also  serves as a  director  of Allied  Capital  Services,  LLC,  a
consulting firm which provides financing and real estate  development  services.
From April 1996 to January  1997 he served as Managing  Director  of  Investment
Banking for R.D.  White & Co.,  Inc.  Mr.  Appell is the General  Partner of HPH
Capital Growth L.P., a New York Limited  Partnership created to raise and manage
funds for equity investments. From December 1993 through April 1996 he served as
house  counsel for Comart,  Inc.,  an  introducing  broker  registered  with the
commodities futures trading commission. Mr. Appell received a Judicial Doctorate
degree  from  Cardozo  Law  School  and  holds  a BBA in  Accounting  from  Pace
University.  He is a Member of the New York State Bar and New Jersey  State Bar.
He is a registered options principal, general securities representative, uniform
securities agent and general  securities  principal.  He is also registered as a
commodity trading advisor and commodity pool operator.

     Andrew  Stathopoulos has over 25 years  experience in finance,  operations,
marketing, mergers and acquisitions,  engineering, manufacturing and consulting.
In March 1998,  he joined the Bank of New York as a Vice  President  to launch a
software and hardware vendor management  program.  He is also currently involved
in the Bank's  efforts to meet Year 2000  compliance.  From 1996 to 1997, he was
Vice President of Finance for New Alliance Corp., an emerging markets investment
bank specializing in Eastern Europe. He was responsible for financial reporting,
internal audit and controls, mid-office and back-office operations,  information
systems, and management  reporting.  From 1994 to 1996, he was Vice President of
Business  Development for Nautical  Technology  Corp.,  an independent  software
developer for the maritime  industry.  He was  responsible  for  developing  and
implementing a new marketing and sales program,  seeking strategic  partners and
providing  general  business  advice.  Also,  from  1994 to  1996,  he was  Vice
President of Business  Development for Interbank of New York, a Greek commercial
bank where he was  responsible  for  identifying  and marketing new products and
pursuing  new  business  opportunities.  From  1992 to  1994,  he was  the  Vice
President of Finance and  Administration  for Societe Generale  Energie,  an oil
trading products firm. He was responsible for establishing  financial  controls,
accounting and reporting  procedures;  monitoring  cash flow and working capital
requirements;   managing  human  resources  administration;   and  dealing  with
auditors,  insurers and vendors. From 1989 to 1991, he was a principal of Forest
Development,  a  privately-held  investment and consulting  group.  From 1985 to
1989, he was the Director of Business  Development  and Planning for Empire Blue
Cross and Blue  Shield,  a leading  health  insurer.  From 1977 to 1985,  he was
Director of Assets Management for Ogden Corporation, a diversified conglomerate.
From 1973 to 1977, he held positions in finance,  planning and  engineering  for
International  Paper, a leading  manufacturer  of paper and wood  products.  Mr.
Stathopoulos  holds a BS degree in Industrial  Engineering  and an MBA degree in
Finance and International Business, both from Columbia University.


                                       17
<PAGE>



     William  Conis has been Vice  President--Eastern  Region  of  Hitachi  Data
Systems since July 1997, and was Hitachi's New York-based  District Manager from
July  1995  to July  1997.  From  1984 to July  1995,  Mr.  Conis  was a  senior
consultant  for the Kappa  Group.  He earned a  Bachelor's  degree and  Master's
degree in  Electrical  Engineering  from New York  University  in 1968 and 1971,
respectively.

ITEM 10.  EXECUTIVE COMPENSATION
--------------------------------

     None of the Company's  executive  officers or directors  currently  receive
compensation  in excess of $100,000 per year except Mr.  Meyers,  the  Company's
Chief Executive Officer,  who receives a salary of $140,000 per year pursuant to
an Employment Agreement which expires on June 30, 1999. The Employment Agreement
also  provides  for (i) a cash  bonus to Mr.  Meyers of up to 20% of his  salary
based upon certain increases in the Company's  revenues and (ii) the issuance of
10,000 stock options  exercisable  at $6.00 per share for each increase of 3,500
in the number of the Company's Internet access  subscribers.  In connection with
his employment, Mr. Meyers was also granted options to purchase 36,667 shares of
Common Stock vesting over a three year period at $3.75 per share  exercisable at
any time until  October 2001.  Other than Mr.  Meyers,  no executive  officer or
director  received  compensation  in excess of $100,000 for the  calendar  years
ended December 31, 1998 or 1997.  Compensation for all officers and directors as
a group for the calendar year ended December 31, 1998, aggregated $158,753.

     The following table discloses  certain  compensation  paid to the Company's
Chief Executive Officer for the calendar years ended December 31, 1998 and 1997.

<TABLE>
<CAPTION>

                                   Summary Compensation Table

                                                                             Long Term Compensation
                               Annual Compensation                           Awards          Payouts
                               -------------------                           ------------------------
    (a)          (b)          (c)         (d)               (e)          (f)            (g)             (h)              (i)
Name
and
Prin-                                                      Other                                                          All
cipal                                                     Annual      Restricted                                         Other
Posi-                                                     Compen-        Stock        Options/          LTIP            Compen-
tion            Year       Salary($)    Bonus($)         sation($)    Award(s)($)      SARS(#)       Payouts($)        sation($)
-----           ----       ---------    --------         ---------    -----------      -------       ----------        ---------
<S>               <C>        <C>         <C>             <C>          <C>              <C>           <C>              <C>

Raymond J.
Meyers           1998     $140,003         -0-              -0-           -0-            -0-            -0-              -0-
                 1997     $130,000         -0-              -0-           -0-          36,667           -0-              -0-

</TABLE>



                                                            18
<PAGE>


Option Grants in Last Year and Stock Option Grant

     The following  table provides  information on option grants during the year
ended December 31, 1998, to the named executive officers:

                                Individual Grants

                             % of Total Options
                                  Granted to
                     Options      Employees
         Name        Granted       in Year     Exercise Price    Expiration Date
         ----        -------       -------     --------------    ---------------

Raymond J. Meyers      -0-          0%            -----                  ----


Aggregate Option Exercise of Last Fiscal year and Fiscal Year-End Option Values

     The  following  table  provides  information  on the  value  of  the  named
executive  officers'  unexercised  options at December  31,  1998.  No shares of
Common Stock were acquired upon exercise of options during the fiscal year ended
December 31, 1998.
                                                                Value of
                       Number of Unexercised           Unexercised In-The-Money
                       Options at Year End (1)         Options at Year End (1)
      Name          Exercisable   Unexercisable      Exercisable   Unexercisable
      ----          ---------------------------      ---------------------------

Raymond J. Meyers     26,666         10,001            $66,665        $25,003

(1)  The closing  price of the Common Stock on December 31, 1998, as reported by
     on the Nasdaq SmallCap Market was $6.25.

1995 Stock Option Plan

     In November  1994,  the Company  adopted a stock  option plan (the  "Plan")
which provides for the grant of options  intended to qualify as "incentive stock
options" and  "nonqualified  stock options" within the meaning of Section 422 of
the United States  Internal  Revenue Code of 1986 (the "Code").  Incentive stock
options are issuable  only to eligible  officers,  directors,  key employees and
consultants of the Company.

     The Plan is  administered  by the  Board of  Directors  and  terminates  in
November 2004. At December 31, 1998, the Company had reserved  150,000 shares of
Common Stock for issuance under the Plan. Under the Plan, the Board of Directors
determines which individuals shall receive options, the time period during which
the options may be partially or fully exercised,  the number of shares of Common
Stock that may be purchased under each option and the option price.

                                       19
<PAGE>


     The per share  exercise  price of the Common Stock may not be less than the
fair  market  value of the Common  Stock on the date the option is  granted.  No
person who owns,  directly  or  indirectly,  at the time of the  granting  of an
incentive stock option,  more than 10% of the total combined voting power of all
classes of stock of the Company is eligible to receive  incentive  stock options
under the Plan unless the option price is at least 110% of the fair market value
of the Common Stock subject to the option on the date of grant.

     No options may be transferred by an optionee other than by will or the laws
of descent and distribution,  and during the lifetime of an optionee, the option
may only be  exercisable  by the optionee.  Options may be exercised only if the
option holder remains continuously  associated with the Company from the date of
grant to the date of  exercise.  Options  under the Plan must be granted  within
five  years  from the  effective  date of the Plan and the  exercise  date of an
option  cannot be later than ten years from the date of grant.  Any options that
expire  unexercised or that terminate upon an optionee's  ceasing to be employed
by the Company  become  available  once again for  issuance.  Shares issued upon
exercise of an option will rank equally with other shares then outstanding.

     As of the date of this Report,  54,000  options have been granted under the
Plan.

ITEM 11.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
------------------------------------------------------------------------

     The  following  table sets forth  information  concerning  the  holdings of
Common Stock by each person who, as of the date of this Report,  holds of record
or is known by the Company to hold  beneficially  or of record,  more than 5% of
the Company's Common Stock, by each director, and by all directors and executive
officers  as a group.  All shares are owned  beneficially  and of record and all
share  amounts  include  stock  options  and  Common  Stock  purchase   warrants
exercisable  within 60 days from the date hereof.  The address of all persons is
in care of the Company at 2800 28th Street, Suite 170, Santa Monica,  California
90405.

                                            Amount of        Percent of
Name                                       Ownership             Class
---------------                            ----------       ------------
Raymond J. Meyers (1)                        36,667             2.0%
David A. Appell (2)                           5,000              .3%
Andrew Stathopoulos (3)                       5,000              .3%
William Conis                                  -0-              0.0%
All officers and
directors as  a
group (4 persons)(1)(2)(3)                   46,667             2.5%

(1)  Represents  stock  options to purchase  26,666 shares at $3.75 per share at
     any time until  October 2001.  Mr. Meyers holds an additional  10,001 stock
     options which vest in 1999.

                                       20
<PAGE>



(2)  Represents stock options to purchase 5,000 shares at $6.00 per share at any
     time until November 2003.

(3)  Represents stock options to purchase 5,000 shares at $6.00 per share at any
     time until November 2003.

ITEM 12.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
--------------------------------------------------------

     Management of the Company  believes that the  transactions  described below
were no less  fair  than the  terms of  transactions  which  the  Company  might
otherwise have entered into with third party nonaffiliated entities. All related
party  transactions must be approved by a majority of the disinterested  members
of the Company's Board of Directors.

     In November 1994,  the Company  issued  857,140  shares of its  Convertible
Preferred  Stock to five of the  Company's  then  officers and  directors,  (and
42,860 to another  individual  not otherwise  affiliated  with the Company) each
share of which was convertible for no additional consideration into one share of
Common Stock for each fifteen shares of Preferred  Stock.  All 900,000 shares of
Convertible  Preferred  Stock were  canceled  and returned to the Company by the
five holders in connection with the Divestiture Agreement described below.

     In October 1996, the Company issued 146,666 Common Stock purchase  warrants
to the Kriegsman Group ("KG") for consulting  services.  Steven A. Kriegsman who
subsequently  became a director of the Company is the President and  controlling
stockholder  of KG.  KG  assigned  35,666  of such  warrants  to Andy  Chu,  the
Company's  President and a director.  KG also assigned 3,333 of the 10,000 Stock
Options it received  from the SSC  Principals  to Mr. Chu to provide him with an
equity  stake in the  Company.  KG  believed  that  the  Company's  success  and
therefore the economic success of its investment in the Company depended in part
upon the participation of Mr. Chu as the Company's then President.

     In October 1996, the Company issued 146,667 Common Stock purchase  warrants
to Andrew,  Alexander,  Wise & Company,  Inc.  ("AAWC") as  compensation  for it
assisting  the  Company  in the  private  placement  of  400,000  shares  of the
Company's  Common  Stock to a group of  investors  for  $3.75  per  share.  AAWC
subsequently  assigned 56,667 of such warrants to Howard P. Silverman,  a former
director of the  Company,  for his  assistance  to AAWC in  connection  with the
private placement. At the time the subject Warrants were assigned, Mr. Silverman
was  not a  director  of the  Company.  The  Company  also  paid  to AAWC a cash
commission of 10% of the gross proceeds raised  ($150,000) and a  nonaccountable
expense allowance of 3% of such gross proceeds ($45,000). In June 1997, AAWC and
Mr. Silverman returned 106,667 warrants to the Company without consideration.

     In January 1997, the Company sold the remaining  assets of the Classic Line
to SSC  Technologies,  Inc. ("SSC") for $770,850  evidenced by a promissory note
bearing interest at 10% per annum payable in January 2007, and the assumption by
SSC of all the  liabilities  of the Classic Line and certain other  liabilities,
aggregating approximately $500,000. Under the terms of the asset sales agreement

                                       21

<PAGE>

(the  "Divestiture  Agreement"),  the Company  acquired  25% of the  outstanding
Common Stock of SSC for  $500,000 in cash (less  $200,000 of  liabilities  which
were paid by the Company and deducted  from the  $500,000) and the remaining 75%
of the  outstanding  Common  Stock was  issued to other  stockholders  including
Charles T.  Howard,  David L.  Green,  Ding Yang and  Steven L.  Wilson who were
previously  officers and  directors of the Company.  As part of the  Divestiture
Agreement,  the SSC Principals  also (i) canceled  900,000 shares of Convertible
Preferred  Stock held by them which were previously  exercisable  into shares of
Common Stock on a fifteen for one basis, (ii) agreed to refrain from the sale of
an aggregate of 30,300  shares of Common Stock owned by them until October 1999,
except with the prior written  consent of AAWC,  (iii) agreed to sublease office
space from the Company at a monthly rental of $12,000 through February 28, 1998,
(iv) granted to Steven A. Kriegsman,  then a director of the Company,  an option
to purchase up to 10,000  shares of Common Stock held by the SSC  Principals  at
any time until  October  2001,  and (v)  personally  guaranteed  ,on a joint and
several basis, the $770,850  promissory note and all other obligations of SSC to
the Company.

ITEM 13.  EXHIBITS AND REPORTS ON FORM 8-K
-------------------------------------------

     a.    Exhibits:

    Exhibit No.             Title
    -----------             -----

      2.01              Restated Articles of Incorporation of the Registrant (1)

      2.02              Bylaws of the Registrant (1)

     10.01              1995 Incentive Stock Option Plan (1)

     10.02              Capitalized Lease Agreement (1)

     10.12              Divestiture Agreement (2)

     10.13              Selling Agreement with AAWC (2)

     10.14              Warrant Agreement with AAWC (2)

     10.15              Lock-up Agreement (2)

     10.16              Registration Rights Agreement (2)

     10.17              Employment Agreement with Mr. Meyers (3)

     10.18              Bridge Loan Agreement (3)

     10.19              Incentive Compensation Plan (Mr. Meyers)



                                       22
<PAGE>

(1)  Incorporated  by reference to the  Registrant's  Registration  Statement on
     Form SB-2 declared  effective by the  Commission on February 9, 1995,  file
     number 33-86242.

(2)  Incorporated  by reference to the  Registrant's  Registration  Statement on
     Form SB-2, file number 333-20543, declared effective on May 14, 1997.

(3)  Incorporated  by reference to the  Registrant's  Registration  Statement on
     Form SB-2, file number 333-40743, filed February 10, 1998.


                                       23
<PAGE>




                                   SIGNATURES

In accordance  with Section 13 or 15(d) of the Exchange Act, the  Registrant has
duly caused this Report to be signed on its behalf by the undersigned, thereunto
duly authorized, in Santa Monica, California, on March 26, 1999.


                                               PROTOSOURCE CORPORATION



                                               By  /s/ Raymond J. Meyers
                                                   -----------------------------
                                                   Raymond J. Meyers
                                                   Chief Executive Officer


Pursuant to the requirements of the Securities Exchange Act of 1934, as amended,
this  Report  has  been  signed  below by the  following  persons  on the  dates
indicated.

      Signature                           Title                      Date
      ---------                           -----                      ----


/s/ Raymond J. Meyers             Chief  Executive Officer       March 26, 1999
--------------------------        Chief Financial Officer             
Raymond J. Meyers                 (Principal Accounting
                                  Officer), and Director


/s/ David A. Appell               Director                       March 26, 1999
--------------------------
David A. Appell


/s/ Andrew Stathopoulos           Director                       March 26, 1999
--------------------------
Andrew Stathopoulos

/s/ William Conis                 Director                       March 26, 1999
--------------------------
William Conis

                                       24