<PAGE>
 
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                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549
                                   
                               FORM 10-K/A      
 
[X]Annual Report pursuant to Section 13 or 15(d) of the Securities and
   Exchange Act of 1934 (fee required)
   For the year ended December 31, 1996, or
 
[_]Transition Report pursuant to Section 13 or 15(d) of the Securities and
   Exchange Act of 1934 (no fee required)
 
                        COMMISSION FILE NUMBER 0-27168
 
                                METATOOLS, INC.
            (Exact name of registrant as specified in its charter)
 
<TABLE>
<S>                                            <C>
                  DELAWARE                                   95-4102687
          (State of Incorporation)             (I.R.S. Employer Identification Number)
</TABLE>
 
                6303 CARPINTERIA AVENUE, CARPINTERIA, CA 93013
                   (Address of Principal Executive Offices)
 
                                (805) 566-6200
             (Registrant's Telephone Number, including area code)
 
       SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
   SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: COMMON STOCK,
                               $0.001 PAR VALUE
 
  Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
 
  Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein and will not be contained, to
the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to the Form 10-K. [X]
 
  As of February 28, 1997, there were outstanding 13,287,528 shares of the
registrant's Common Stock, $0.001 par value, which is the only outstanding
class of common or voting stock of the registrant. As of that date, the
aggregate market value of the shares of Common Stock held by non-affiliates,
based upon the last sale price of the shares as reported on the NASDAQ
National Market System on such date, was approximately $86,407,467.
 
                     DOCUMENTS INCORPORATED BY REFERENCE:
       
  Portions of the registrant's definitive proxy statement relating to its 1997
Annual Meeting of Stockholders to be held in May 1997, are incorporated by
reference into Part III.      
 
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<PAGE>
 
                                METATOOLS, INC.
                                       
                                FORM 10-K/A      
 
                               TABLE OF CONTENTS
 
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                                                  PART I
Item 1.   Business..............................................................................   3
Item 2.   Properties............................................................................  19
Item 3.   Legal Proceedings.....................................................................  19
Item 4.   Submission of Matters to a Vote of Security Holders...................................  19
                                                 PART II
Item 5.   Market for Registrant's Common Equity and Related Stockholder Matters.................  21
Item 6.   Selected Financial Data...............................................................  22
Item 7.   Management's Discussion and Analysis of Financial Condition and Results of Operations.  23
Item 8.   Financial Statements and Supplementary Data...........................................  29
Item 9.   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure..  52
                                                 PART III
Item 10.  Directors and Executive Officers of the Registrant....................................  52
Item 11.  Executive Compensation................................................................  52
Item 12.  Security Ownership of Certain Beneficial Owners and Management........................  52
Item 13.  Certain Relationships and Related Transactions........................................  52
                                                 PART IV
Item 14.  Exhibits, Financial Statement Schedules, and Reports on Form 8-K......................  53
Signatures.....................................................................................   55
</TABLE>     
 
                                       2
<PAGE>
 
                                    PART I
 
ITEM 1. BUSINESS
 
  MetaTools, Inc. ("MetaTools" or the "Company") is a leading provider of
visual computing and graphics software and technologies for professionals and
consumers for Windows, Macintosh and other digital editing operating systems.
MetaTools designs, develops, publishes, markets and supports visual computing
software tools and technologies for the creation, editing, and manipulation of
computer graphic images, digital art, and Internet/online content. These tools
enable desktop publishers, production artists, multimedia developers, creative
directors, film and video producers, web site designers, digital imagers and
photographers (collectively, "Creative Professionals") and consumers to
produce and enhance still images, animations, 2D and 3D graphics, digital
video and special effects. Uses of the materials produced include print and
broadcast advertising, merchandising materials, electronic entertainment,
business presentations, film and video special effects, games and
Internet/online graphics, such as for web sites. The Company offers two
principal product types consisting of (i) stand-alone applications and (ii)
plug-in extensions. The Company's plug-in extensions work with and extend the
capabilities of widely available computer graphic imaging and Internet/online
design application platforms, including Adobe Systems, Inc.'s ("Adobe")
PhotoShop, Illustrator, After Effects, and Premiere products; Autodesk, Inc.'s
Animator Studio and 3D Studio products; Corel Corporation's PhotoPaint;
Fractal Design Corporation's Painter; Macromedia, Inc.'s Freehand and X-Res
products; and Micrografx, Inc.'s Picture Publisher.
 
DEFINITIVE MERGER AGREEMENT WITH FRACTAL DESIGN CORPORATION
 
  On February 11, 1997, the Company entered into a definitive merger agreement
with Fractal Design Corporation ("Fractal"). The definitive agreement and plan
of reorganization provides that upon the effective date of the merger, each
share of Fractal common stock shall be converted into 0.749 shares of the
Company's common stock and each option to purchase Fractal common stock will
be converted into options to purchase 0.749 shares of the Company's common
stock at an exercise price equal to the exercise price to purchase Fractal
options prior to the merger divided by 0.749. It is anticipated that
approximately 8,962,000 shares of MetaTools common stock will be issued in
connection with the merger, based upon the number of shares of Fractal common
stock issued and outstanding at December 31, 1996 (which number does not
include shares of MetaTools common stock to be issued to holders of options to
purchase shares of Fractal common stock). The merger is intended to be
accounted for as a pooling of interests and the companies intend to structure
the merger to qualify as a tax free reorganization. The merger is contingent
upon customary conditions including the approval of the stockholders of the
Company and the shareholders of Fractal, the occurrence of no event which
could have a material adverse effect with respect to the other party, and the
satisfaction of any governmental or regulatory requirements to legally effect
the merger. The merger is expected to become effective in the quarter ending
June 30, 1997.
 
ACQUISITIONS
 
 Dive Laboratories, Inc.
 
  On August 31, 1996, the Company acquired Dive Laboratories, Inc. ("Dive"), a
privately held company based in Santa Cruz, California, developing 3D modeling
and rendering environments for high-end applications and the visualization of
streaming online data. In connection with the acquisition, which was accounted
for under the purchase method of accounting, the Company recorded a one-time
charge to earnings of approximately $733,000, comprised of relocation expenses
of $215,000, acquisition costs of $155,000, and in-process research and
development expenses of $363,000, for the year ended December 31, 1996. The
Company paid $509,000 in cash and assumed $224,000 of net liabilities of Dive.
The four Dive research and development personnel have relocated to Santa
Barbara.
 
--------
Kai's Power Tools, KPT, Bryce, and Convolver are registered trademarks and
Kai's Power Goo, Final Effects, PowerPhotos, MetaPhotos, Vector Effects, and
Soap are trademarks of MetaTools, Inc. This Form 10-K also contains trademarks
and tradenames of other companies.
 
                                       3
<PAGE>
 
 Real Time Geometry Corp.
       
  On December 31, 1996, the Company completed the acquisition of Real Time
Geometry Corp. ("RTG"), a privately held development stage company based in
Princeton, New Jersey, developing real time 3D graphics and visualization
technologies. The acquisition was accounted for by the Company under the
purchase method of accounting. Under the terms of the Purchase Agreement, the
stockholders and optionholders of RTG received a combination of shares of the
Company's common stock and options to purchase shares of the Company's common
stock valued at approximately $11,242,000 and $607,000, respectively, at
December 31, 1996, the closing date. In addition, the Company assumed the net
liabilities of RTG, which totaled $1,411,000 at December 31, 1996. As of
December 31, 1996, neither technological feasibility nor commercial viability
had been reached with regard to RTG's core technology, comprised of advanced
geometry-based algorithms which transform images in real-time to a series of
triangles to produce three-dimensional images. Based upon projected future
cash flows, risk-adjusted using a 40% discount rate, RTG's core in-process
technology was valued in excess of the amount written-off as acquired in-
process technology of $13,260,000, which combined with acquisition costs
totaling $1,189,000, resulted in a one time charge to earnings of $14,449,000
for the year ended December 31, 1996.      
 
  The acquisition of RTG is intended to expand MetaTools ability to
participate in the application areas that utilize 3D technology.* The addition
of RTG's technology and development capabilities in real time 3D graphics
helps accelerate MetaTools' strategic expansion in the emerging consumer,
prosumer, and professional markets for 3D tools and applications.* The focus
of RTG's real time 3D technology includes decreasing the time required to
create, render, and display 3D images and environments; enabling the creation
of dynamic, real time resolution changes to 3D models, and improving the
visual resolution and navigation of 3D graphics. The Company plans to
incorporate RTG technology into MetaTool's existing and planned software
products.* The Company also plans to pursue strategic licensing agreements
with third party hardware and software companies, including, for example,
developers of 3D acceleration boards and chips, still and motion imaging,
animation and video graphics products, computer and console games,
architectural and engineering design products, financial visualization, and
medical applications software.* The RTG technologies are being developed on
Windows, Macintosh, SGI, Sun, Sega, and Sony PlayStation platforms. RTG had no
revenues prior to the acquisition and RTG's 21 research and development
personnel will remain in Princeton, New Jersey, continuing visual computing
research and development activities.
 
INDUSTRY BACKGROUND
 
  Computer graphic imaging and visual computing tools are standard tools for
Creative Professionals to develop and present their materials. Creative
Professionals may use digital painting, illustration, composition, page layout
and design, special effects, digitally captured images and video, animation,
text, photographs, music and other audio to produce a wide variety of end
products. Certain Creative Professionals may also use computer modeling tools
to design 3D objects, landscapes and terrains. The images and content
generated by these Creative Professionals increasingly must be deliverable
through a wide variety of media, including print, transparencies, CD-ROMs,
video, film, the Internet and commercial online services. Consumer and
business professionals are also increasingly using graphical and digital
creative productivity software tools in the home and at business.
 
  Factors influencing the use of computer graphic imaging and Internet/online
design tools include:
 
  .  The Proliferation of Graphics and Multimedia Computers and
     Peripherals. The increased performance and affordability of powerful
     personal computers and random access memory ("RAM") and related high
     performance peripheral devices such as digital cameras, digital capture
     devices, scanners, Jazz and Zip drives, high-capacity hard drives, and
     high resolution color printers, have led to a proliferation of graphics
     and multimedia-capable computers in business and the home.
 
--------
* This statement is a forward looking statement reflecting current
  expectations. There can be no assurance that the Company's actual future
  performance will meet the Company's current expectations. Investors are
  strongly encouraged to review the Additional Factors Affecting Future
  Results commencing on page 12 for a discussion of factors that could affect
  future performance.
 
                                       4
<PAGE>
 
  .  The Rapid Expansion of the Internet and Commercial Online
     Environments. The rapid expansion of the Internet and commercial and
     online environments is driving demand for tools to create enhanced
     digital graphic and multimedia content for use in web sites, electronic
     catalogs, shopping and transaction environments, electronic magazines
     and newspapers, online games, educational materials and other forms of
     online visual communication.*
 
  .  The Enhancement of Visual Media for Communications, Entertainment and
     Education. Computer graphic imaging tools are changing the way
     information is communicated. Increasingly, producers of magazines,
     annual reports, marketing brochures, product packaging, advertising and
     newsletters are using software graphic arts tools to create
     sophisticated 2D illustrations and graphic designs for desktop published
     material. Similarly, computer graphic imaging and Internet/online design
     tools provide developers of videos, animations and games with the means
     to create 2D and 3D special effects, scenery, backgrounds, textures and
     materials to create high impact sales presentations, product
     demonstrations, videos, web sites, educational materials and game
     environments and backgrounds.
 
  .  The Growing Availability of Digital Content. There is a growing body of
     professionally produced digital images and electronically produced
     media. The digital nature of this content enables Creative Professionals
     to capture, enhance and manipulate this content in a variety of media,
     including print, video and Internet and commercial online services.
     Information that has been digitized includes photographs, illustrations,
     video, animations, voice and music.
 
  In response to these trends, Creative Professionals are continually seeking
new tools to enhance their productivity and expand their creative
capabilities. Creative Professionals need tools that enable them to produce
and manipulate professional-quality materials quickly and efficiently. As a
result, the Company believes that there is a demand for fast, powerful and
easy to use tools that go beyond the capabilities of existing design
application platforms to increase the productivity and expand the creative
capabilities of Creative Professionals.
 
  Consumers are also looking for productivity tools to creatively manipulate
and display their digital imaging at home and on the web. In addition,
consumers are looking for a visual computing experience in the software
products that they use, in a similar quality to that of television. The
Company believes that high resolution, real time, 3D animation and video are
critical for the future of visual computing at the desktop.
 
THE METATOOLS SOLUTION
 
  MetaTools has developed two types of computer graphic imaging design tools
that provide a broad spectrum of Creative Professionals and consumers with new
methods to increase their productivity and expand their creative capabilities.
These products are primarily based upon MetaTools' proprietary technologies
and employ sophisticated mathematical image creation and processing
capabilities, enabling real time manipulation and rapid prototyping of
creative alternatives. MetaTools products incorporate advanced graphical user
interfaces designed to enhance creativity and facilitate ease of use.
MetaTools offers its own standalone productivity tools as well as tools for
generating photorealistic 3D landscapes and terrains, as well as a number of
products designed to plug into and significantly improve upon the capabilities
of widely-available applications.
 
STRATEGY
 
  The Company's objective is to be the leading supplier of visual computing
software tools and technology, enabling the creation and production of graphic
and design content for business, entertainment, education, edutainment, and
the Internet and commercial online environments. The Company's strategy
includes the following key elements:
 
--------
* This statement is a forward looking statement reflecting current
  expectations. There can be no assurance that the Company's actual future
  performance will meet the Company's current expectations. Investors are
  strongly encouraged to review the Additional Factors Affecting Future
  Results commencing on page 12 for a discussion of factors that could affect
  future performance.
 
                                       5
<PAGE>
 
  Offer Powerful Tools for Creative Professionals. The Company's goal is to
offer powerful, creative design tools that anticipate the evolving needs of
Creative Professionals. These tools are designed to give Creative
Professionals access to powerful, mathematically-intensive real time visual
computing technology controlled through innovative, easy to use, graphical
user interfaces. The Company intends to invest substantial development
resources to maintain and expand its position as a leading provider of such
tools.* This includes introducing its new professional applications for visual
computing in areas that it believes are not being adequately addressed.
 
  Address Consumer Productivity and Creative Entertainment Tools Market. The
Company is focused on developing software productivity tools and creative
entertainment products for consumers which take advantage of the Company's
visual computing technologies. The Company launched its first creative
entertainment product, Kai's Power Goo, in June 1996 and has announced Soap, a
consumer digital imaging productivity tool, for shipment in the second quarter
of 1997.* The Company expects to release additional consumer software products
in 1997.*
 
  License Enabling Visual Computing Technologies. The Company intends to
license certain of its proprietary enabling visual computing technologies to
strategically selected computer hardware and software companies.*
Specifically, the Company is anticipating the licensing of certain core 3D
technologies obtained in the acquisition of Real Time Geometry.*
 
  Address Rapidly Emerging Commercial Online Environments. The Company is
expending substantial resources to address the increasing demand for tools to
create enhanced digital graphic and multimedia content for the Internet and
commercial online environments. The Company's current products are already
being used to create web sites. The Company is also extending certain design
elements of its core products to enable the development of online multi-player
games. The Company participates in America Online, Inc.'s Developer's Studio
and has developed online point-to-point games for America Online.
 
  Provide Scalable, Operating System-Independent Solutions. The Company's
products are designed to work with leading third-party graphic and multimedia
platforms, including Windows, Macintosh and other operating systems, in order
to address a broad audience of potential Creative Professionals. The Company
develops its products in a manner that they can be ported to other operating
systems more readily. Furthermore, images produced with the Company's products
are scalable across a wide variety of output media without loss of resolution
or quality.
 
  Extend MetaTools Brand Awareness to Expand Markets. The Company believes,
based in part on the numerous awards its products have received, that the
MetaTools brand is associated in the market with powerful functionality and
ease of use in visual computing applications. The Company intends to continue
to develop brandname awareness through public relations activities, such as
keynote speeches and lectures at major digital design, multimedia and online
conferences throughout the world.*
 
--------
* This statement is a forward looking statement reflecting current
  expectations. There can be no assurance that the Company's actual future
  performance will meet the Company's current expectations. Investors are
  strongly encouraged to review the Additional Factors Affecting Future
  Results commencing on page 12 for a discussion of factors that could affect
  future performance.
 
                                       6
<PAGE>
 
PRODUCTS
 
  MetaTools focuses its product development efforts on creating affordable,
high performance, high quality and easy to learn and use software tools for
Creative Professionals and consumers. The key features of the Companys
products include the following:
 
  .  Innovative User Interface Design--MetaTools products are designed with
     innovative user interfaces to facilitate ease of learning and use while
     providing access to advanced algorithmic-based graphics design and
     special effects techniques. The Company's products are designed to allow
     Creative Professionals and consumers to control the creative process and
     explore new areas of graphic arts design without requiring a detailed
     understanding of the enabling technology.
 
  .  Portability--The Company develops its products in the C and C++
     programming languages facilitating portability to alternative operating
     systems. The Company will continue to evaluate available hardware and
     software platforms and consider adapting its products for use on such
     platforms as technological advancements and market demands dictate.
 
  .  Power/Performance--MetaTools products are designed to combine
     comprehensive feature sets with high performance to provide efficiency
     and power for creative professionals and consumers.
 
  .  Resolution Independent Imaging Technology--Many of the Company's tools
     create and manipulate images through the application of mathematical
     algorithms, rather than by generating new bit-mapped graphics at each
     stage of the design process. As a result, image manipulations can be
     reordered or reversed, and the resulting output can be generated with
     resolutions that are independent of the resolution of any particular
     input image.
 
  The Company's principal products fall within two product types as follows:
 
STAND-ALONE APPLICATIONS AND APPLICATION PLATFORMS
 
  Kai's Power Goo ("Goo"). Goo, the first consumer product offered by the
Company, allows users to turn pictures into images and then stretch, grow,
animate, fuse, or apply a host of other special effects to the images in real
time. Targeted to users with a wide range of computing and artistic abilities,
Goo features an interface that is designed to encourage exploration and
creativity through direct, intuitive, real-time interaction with images. A
library of images including kids, animals, politicians, world leaders and
artwork, is included, or users can import images from a variety of sources,
including images from 35 mm film transferred to CD-ROM or diskette, digital
cameras, scanners, capture devices, video cameras, or the web. Images can be
printed out or saved for use on personalized t-shirts, mugs, screen savers,
etc., or can be easily dropped into a real-time animation that instantly
transforms the original still image into a movie-like sequence which can be
uploaded to Quicktime and AVI movies. Goo, which is available on CD-ROM for
Windows 95/NT and Macintosh in English, Japanese, German, French, Spanish and
Italian, was first released in second quarter of 1996. The suggested retail
price of Goo is $49.95.
 
  Bryce. Bryce is an application platform that provides Creative Professionals
with the ability to generate natural and supernatural 3D landscapes and
terrains. Bryce provides Creative Professionals with powerful functions,
including materials and texture creation and editing capabilities, and
provides non-graphic arts professionals and consumers unfamiliar with 3D
graphics design an entry point into the development of photorealistic 3D
worlds. Bryce enables advanced, photorealistic creation of skies with natural
cloud formations, humidity, fog and light diffraction as well as rivers, snowy
peaks, desert or ocean floors, supplemented by an array of special effects
including complex textures and reflective surfaces. Bryce was released for the
Macintosh in the third quarter of 1994. Bryce 2 for the Macintosh was released
in the first quarter of 1996, while Bryce 2 for Windows was released in the
third quarter of 1996. Bryce 2 for both Windows and Macintosh is available in
English, Japanese, German and French. The Company expects to release a
consumer version of Bryce in 1997.* The suggested retail price of Bryce is
$179.
--------
* This statement is a forward looking statement reflecting current
  expectations. There can be no assurance that the Company's actual future
  performance will meet the Company's current expectations. Investors are
  strongly encouraged to review the Additional Factors Affecting Future
  Results commencing on page 12 for a discussion of factors that could affect
  future performance.
 
                                       7
<PAGE>
 
  MetaPhotos. The MetaPhotos series are a series of multiple CD-ROM sets of
professional photographs and objects. The MetaPhotos collection provides
Creative Professionals with a variety of high quality royalty-free images that
do not require time consuming touch-up or refinishing. The MetaPhotos series,
which are available for Windows, Windows 95/NT, Macintosh, Silicon Graphics
and Sun platforms, have suggested retail prices ranging from $49 to $199,
depending upon the quantity and bundle of CD-ROMs purchased.
 
  Soap. Soap, a new photo editing software program, was announced on January
7, 1997. Soap will provide consumers the ability to clean, edit, and
manipulate personal photographs and other images in real time, producing
images for color printing, presentations, the web, or output to imaging
software and hardware for further manipulation or integration into desktop
publishing applications. Soap is expected to ship in the second quarter of
1997.*
 
PLUG-IN EXTENSIONS
 
  Kai's Power Tools ("KPT"). Kai's Power Tools is a set of creative and
production extensions to graphics products that support the Adobe plug-in
architecture, including Adobe's PhotoShop, Micrografx Inc.'s Picture
Publisher, Macromedia, Inc.'s X-Res, Corel Corporation's PhotoPaint and other
leading application platforms. KPT allows the creation of new graphic forms
through an advanced user interface design and, in certain cases, integration
of multiple-step image processing functions into a single step. KPT 3 is
available for the Windows, Macintosh and Silicon Graphics platforms in
English, Japanese, German and French. KPT was originally introduced in the
first quarter of 1993; KPT 3 for the Macintosh was released in the third
quarter of 1995; and KPT 3 for Windows 95/NT was released in the fourth
quarter of 1995. The suggested retail price of KPT 3 is $129.
 
  Final Effects and Studio Effects. Final Effects and Studio Effects offer
digital video Creative Professionals sophisticated, workstation-like video and
animation special effects, including particle systems and other advanced
capabilities, on their personal computers. Final Effects plugs into both
Adobe's After Effects and Premiere video products, while Studio Effects plugs
into Adobe's After Effects. Final Effects for After Effects, which was
released for the Macintosh in the fourth quarter of 1995, has a suggested
retail price of $599. Studio Effects for After Effects, which has a suggested
retail price of $599, was released in the third quarter of 1996. Final Effects
for Premiere on the Macintosh platform was released in the first quarter of
1996, while Final Effects for Premiere on the Windows platform was released in
the third quarter of 1996. The suggested retail price for both platforms is
$149.
 
  Vector Effects. Vector Effects is a set of Adobe Postscript-based creative
and production extensions that support the Adobe plug-in standard for vector-
based graphics products. Vector Effects provides real time 3D visualization,
warping and distortion tools that operate within host applications such as
Adobe's Illustrator or Macromedia, Inc.'s Freehand. Vector Effects
significantly reduces the time necessary to accomplish a wide variety of
creative tasks, while providing new creative capabilities that otherwise would
be difficult to achieve. Vector Effects for the Macintosh, which was first
released in the second quarter of 1995, is available in English, Japanese,
German and French, and has a suggested retail price of $129.
 
  Convolver. Convolver is an Adobe plug-in compatible graphics design tool
that allows Creative Professionals to visually create in real time new custom
filters that adjust images in a number of different ways. These filters can be
used to sharpen, blur, posterize, create relief, emboss, tint, color contrast
and unsharp mask images. Convolver provides an advanced user interface to the
filter creation process, allowing end users to define complex filters easily
while previewing their effects on the image in real time. Convolver, which was
first released in the fourth quarter of 1994, is available for Windows,
Windows 95/NT and Macintosh in English, Japanese, German and French. The
suggested retail price of Convolver is $129.
--------
* This statement is a forward looking statement reflecting current
  expectations. There can be no assurance that the Company's actual future
  performance will meet the Company's current expectations. Investors are
  strongly encouraged to review the Additional Factors Affecting Future
  Results commencing on page 12 for a discussion of factors that could affect
  future performance.
 
                                       8
<PAGE>
 
MARKETING, SALES AND DISTRIBUTION
 
  MetaTools develops awareness and demand for its products through public
relations activities, advertising, product reviews, tradeshows, seminars,
keynote speeches and lectures at major digital design, multimedia and online
conferences throughout the world. The Company also utilizes direct mail to
introduce, educate and sell to customers new products and upgrades in
conjunction with activities of the Company's distributors, dealers and in-
house telemarketing operations. In addition, MetaTools sells its products by
distributing a variety of interactive multimedia demonstration materials
directly to prospective customers and then by following up through
telemarketing efforts. More generally, the Company focuses on building a
global graphics community through a number of initiatives, including producing
and co-sponsoring "Digital Media Players" events at major tradeshows, at which
the press, distributors and complementary hardware and software manufacturers
can gather to demonstrate technology, make contacts and exchange ideas
regarding digital graphic arts, multimedia and Internet/online communications.
 
 
  MetaTools sells its products worldwide through multiple distribution
channels, including traditional software distributors, hardware and software
OEMs, international distributors, educational distributors, VARs, computer
superstores, retail dealers, mail order and direct sales. The Company's
primary sales channel is through large software distributors such as Ingram
Micro, Inc., which in turn distribute the Company's products through large
retail chains, catalogs, and smaller retail dealers. In 1996, 1995 and 1994,
Ingram Micro, Inc., the Company's largest distributor, accounted for
approximately 18%, 26%, and 12% of net revenues, respectively. The Company
supports this channel by referring retail dealer sales, educational
distributor sales and mail order sales to these major distributors. The
Company receives inventory and sales reports from its distributors and certain
major retailers to help monitor sales through this channel. As is typical in
the personal computer software industry, the Company grants its distributors
limited rights under a stock balancing policy to return unsold inventories of
the Company's products in exchange for new purchases. In addition, the Company
provides price protection to its distributors in certain instances when it
reduces the price of its products.
 
  The Company currently distributes its products through 62 international
distributors in over 45 countries worldwide, with approximately 36%, 28%, and
18% of the Company's net revenues coming from international markets in 1996,
1995 and 1994, respectively. In some cases, the distributor has exclusive
distribution rights to certain products or for certain operating systems in
its country. In 1995, the Company provided its products to the Japanese market
through BulletProof Software of Japan ("Bulletproof") in an exclusive
publishing arrangement. Effective February 1996, the Company terminated its
distribution agreement with BulletProof and entered into an agreement with
Marubeni Corporation, a leading software distributor in Japan, for the
exclusive distribution rights of certain of its products in Japan. In
addition, during the fourth quarter of 1996, the Company entered into an
similar agreement with Prisma Express Distributionsgesellschaft GmbH, a
leading software distributor in Germany, for the exclusive distribution rights
of certain of its products in Germany, Austria, and Switzerland. The Company
believes that international markets present a strategic opportunity and is
seeking to increase its international sales. The Company actively monitors its
international distribution arrangements and has added over 23 new distributors
in 1996. In addition, the Company established its international operations
headquarters in Dublin, Ireland in September 1996, and maintains market
development and support offices in London and Paris to support the continued
growth and expansion of European sales. The Company intends to make strategic
investments in additional markets throughout Europe, Asia and Latin America.*
 
  MetaTools sells its products to educational institutions primarily through
Douglas Stewart, a distributor which specializes in the education market,
including campus resellers, bookstores and educational mail order houses. The
Company views the education market as a strategic opportunity to establish
product and brand preferences early in the careers of future graphic arts and
business professionals. Accordingly, the Company offers substantial
educational discounts.
--------
* This statement is a forward looking statement reflecting current
  expectations. There can be no assurance that the Company's actual future
  performance will meet the Company's current expectations. Investors are
  strongly encouraged to review the Additional Factors Affecting Future
  Results commencing on page 12 for a discussion of factors that could affect
  future performance.
 
                                       9
<PAGE>
 
  The Company offers product sales and upgrades directly to qualified third-
party resellers and end users. By selling to repeat customers in the Company's
installed base of registered customers, the Company complements its primary
distribution channels. These sales represent a significant percentage of the
Company's net revenues.
 
  MetaTools also actively maintains OEM relationships with many hardware and
software vendors that bundle MetaTools products with their own complementary
hardware or software products and pay the Company royalties. The Company
believes that OEM sales increase the brand recognition of its products and
expand its customer and revenue base. In addition, these relationships give
the Company early access to computer graphic imaging, multimedia and
Internet/online technologies, which helps MetaTools to quickly adapt its
products for compatibility with, or to release new products based on, such
technologies. The Company's principal OEM relationships include relationships
with Apple Computer, Inc.; Corel Corporation; Eastman Kodak Company; Hewlett-
Packard Corporation; International Business Machines Corporation; Macromedia,
Inc.; Miro Computer Products AG; Play, Inc.; Spot Technology; UMAX
Technologies, Inc; and U.S. Robotics Corporation.
 
PRODUCT DEVELOPMENT
 
  The Company's principal current product development efforts include: (i)
utilizing its core enabling technologies to develop additional standalone and
plug-in applications for both professionals and consumers, (ii) expanding its
market position in 3D design and development tools, and (iii) creating
enabling technologies for visual computing. The Company is expending resources
to address the increasing demand for tools to create enhanced digital graphic
and multimedia content for the Internet and commercial online environments. In
addition, the Company plans to continue to develop, and from time to time
acquire, basic software technologies that it considers critical to building
computer graphic imaging and Internet/online design tools.*
 
  The Company has supplemented its internal product development efforts by
licensing on an exclusive basis products developed by or co-developed with
third parties. MetaTools believes that outsourcing certain of its product
development activities enables it to capitalize on the latest technological
innovations without incurring considerable research and development expense.
There can be no assurance that the Company will be able to continue licensing
such product development capabilities on terms favorable to the Company or at
all. If the Company were unable to maintain existing licensing arrangements
and to attract new product development partners then the Company would, at a
minimum, have to increase its research and development expenditures, which
could have a material adverse effect on the Company's business, operating
results, financial condition, and cash flows. There can be no assurance that
such additional research and development expenditures would result in the
production of commercially acceptable products.
 
  The Company's growth will be dependent upon the introduction of new products
and new versions of existing products. There can be no assurance that any such
new products or versions will achieve market acceptance. In addition, the
Company has in the past experienced delays in the development of new products
and the enhancement of existing products, and such delays may occur in the
future. If the Company were unable, due to resource constraints or
technological or other reasons, to develop and introduce such products in a
timely manner, this inability could have a material adverse effect on the
Company's business, operating results, financial condition, and cash flows. In
particular, the introductions of new products or enhanced versions of existing
products, such as Soap or a consumer version of Bryce, are subject to the risk
of development delays. Any delay in the availability of new products could
have a material adverse effect on the Company's business, operating results,
financial condition, and cash flows.
 
  The Company's research and development expenses were approximately $3.4
million, $1.6 million, and $1.1 million for 1996, 1995 and 1994, respectively.
--------
* This statement is a forward looking statement reflecting current
  expectations. There can be no assurance that the Company's actual future
  performance will meet the Company's current expectations. Investors are
  strongly encouraged to review the Additional Factors Affecting Future
  Results commencing on page 12 for a discussion of factors that could affect
  future performance.
 
                                      10
<PAGE>
 
CUSTOMER AND TECHNICAL SUPPORT
 
  The Company has built a customer education and technical support
organization focused on providing value to the Company's customers beyond the
purchase of the Company's products. MetaTools provides customer and technical
support to customers via e-mail on the Internet and through online services,
fax and telephonic communication. The Company has actively promoted the online
environment as its primary technical support environment and has built one of
the leading forums for digital graphic and Internet/online design information
sharing and discussion. Customers are provided technical support via the
Internet/online environment, where Company representatives and a number of
individual experts outside the Company answer questions posed by individuals
seeking guidance. In addition, the Company supports a large, online community
through its forum on America Online, Inc. and its presence on the World Wide
Web, where technical support, tips and tricks and an entire electronic book on
advanced imaging techniques can be found. This venue also supports Live Chats
four nights a week, where customers and other interested parties can discuss
live and online their interests and questions as they relate to digital design
and the Company's products.
 
  The Company also conducts seminars regularly for prospective and current
customers at leading tradeshows and conferences throughout the world,
providing education and insight into the uses of the Company's technology. In
addition, the Company publishes on CD-ROM and online a continuously expanding
series of Power Tips and Tricks for producing advanced graphics and
Internet/online designs and a large library of the most frequently asked
questions.
 
COMPETITION
 
  The Company faces competition from a number of sources, including other
vendors of personal computer graphic imaging and Internet/online design
application platforms and tools, other personal computer software industry
participants and companies that offer graphic and Internet/online design
solutions that are not personal computer based. Many of the Company's
competitors or potential competitors have longer operating histories and
significantly greater financial, management, technology, development, sales,
marketing and other resources than the Company. As the Company competes with
larger competitors across a broader range of product lines, the Company may
face increasing competition from such companies. If these or other competitors
develop products, technologies or solutions that offer significant
performance, price or other advantages over those of the Company, the
Company's business, operating results, financial condition, and cash flows
would be materially adversely affected.
 
  A variety of other possible actions by the Company's competitors could also
have a material adverse effect on the Company's business, operating results,
financial condition, and cash flows, including increased promotion, the
bundling of competitive products with other third-party products such as
application platforms or operating systems, and the introduction of new or
enhanced products. Moreover, in the event that price competition significantly
increases, competitive pressures could cause the Company to reduce the prices
of its products, which would result in reduced margins. Furthermore, new
personal computer platforms and operating systems, such as Windows 95/NT, or
the new software distribution and delivery systems, such as the Internet and
commercial online services, may provide new entrants with opportunities to
obtain a substantial market share in the Company's markets.
 
  The Company may also face competition from general personal computer market
participants who decide to offer graphic arts or multimedia design products.
Such new market entrants could have a significant, disruptive effect on the
markets in which the Company participates. In particular, Microsoft
Corporation currently holds a dominant position in the personal computer
software market in general, allowing it to exert considerable influence
throughout the market. The Company's products also compete with graphic design
and multimedia solutions based on other hardware platforms. For example,
Silicon Graphics, Inc. offers workstations and software specifically designed
for graphics applications, and current and future offerings by Silicon
Graphics, Inc. and other workstation and UNIX market participants could
materially adversely affect the markets' demand for the Company's products.
 
 
                                      11
<PAGE>
 
MANUFACTURING AND SHIPPING
 
  The manufacture of the Company's products consists of the duplicating of
diskettes and/or the pressing of CD-ROMs, the printing of manuals and the
packaging and assembling of final products, all of which are performed in
accordance with the Company's specifications and forecasts. While the
Company's current manufacturer, Stream International, a subsidiary of R.R.
Donnelly and Sons Company, maintains multiple site facilities, there can be no
assurance that their services could not become subject to undue delays. Such
delays, if they occur, may have a material adverse effect on the Company's
business, operating results, financial condition, and cash flows. To date, the
Company has not experienced any material difficulties or delays in the
manufacture or assembly of its products or material returns due to product
defects.
 
ADDITIONAL FACTORS AFFECTING FUTURE RESULTS
 
  In addition to the other information in this Form 10-K, the following
additional factors should be considered carefully in evaluating the Company.
The discussion in this Report contains forward-looking statements that involve
risks and uncertainties. The Company's actual results may differ significantly
from the results discussed in the forward-looking statements. Factors that
could cause or contribute to such differences include, but are not limited to,
those discussed below.
 
 Fluctuations in Quarterly Results
 
  The Company has experienced in the past and expects in the future to
continue to experience significant fluctuations in quarterly operating
results. There can be no assurance that the Company's future revenues,
operating results and cash flows will not also vary substantially. The Company
generally ships products as orders are received and, therefore, has little or
no backlog. As a result, quarterly revenues, operating results and cash flows
of the Company will generally depend on a number of factors that are difficult
to forecast, including, among others, the volume and timing of and ability to
fulfill orders received within a quarter. Quarterly revenues, operating
results and cash flows also may fluctuate due to factors such as demand for
the Company's products; introduction, localization or enhancement of products
by the Company and its competitors; customer or distributor order deferrals in
anticipation of new versions of products; market acceptance of new products;
reviews in the industry press concerning the products of the Company or its
competitors; changes or anticipated changes in pricing by the Company or its
competitors; the mix of distribution channels through which products are sold;
the mix of products sold; returns from distributors; and general economic
conditions. Revenues, operating results and cash flows from the Company's
products also may be negatively affected by delays in the introduction or
availability of new hardware and software products from third parties. The
Company experiences some effect of seasonality in its business, as demand for
its products tends to increase during the quarter ending December 31 as a
result of timing of year-end holiday season buying.
 
  As is common in the software industry, the Company's experience has been
that a disproportionately large percentage of shipments in each fiscal quarter
occurs in the latter half of the third month of that quarter. Because the
Company's staffing and other operating expenses are based in part on
anticipated net revenues, a substantial portion of which may not be realized
until shortly before the end of each fiscal quarter, delays in the receipt or
shipment of orders, including delays that may be occasioned by failures of
third party product fulfillment firms to produce and ship products, can cause
significant variations in revenues, operating results and cash flows from
quarter to quarter. The Company may also be unable to adjust spending in a
timely manner to compensate for any unexpected revenue shortfall. Accordingly,
any significant shortfall in revenues from the Company's products in relation
to expectations could have an immediate adverse impact on business, operating
results, financial condition and cash flows of the Company. In addition, the
Company currently intends to increase its operating expenses to fund greater
levels of research and product development, to increase its sales and
marketing operations and to expand distribution channels. To the extent that
such expenses precede, or are not subsequently followed by, increased
revenues, the business, operating results, financial condition and cash flows
of the Company will be materially and adversely affected.
 
  Due to the foregoing factors, it is likely that the operating results of the
Company for some future quarters will fall below the expectations of
securities analysts and investors. In such event, the trading price of the
Company's Common Stock could be materially and adversely affected.
 
                                      12
<PAGE>
 
       
 Uncertainty as to the Future of the Macintosh Platform and Apple Computer      
           
  Apple Computer, Inc. ("Apple Computer") has recently experienced significant
financial difficulties and losses in market share and acceptance. On April 16,
1997, Apple Computer announced a substantial loss of approximately $708 million
for its second fiscal quarter of 1997 due to the purchase of NeXT Software Inc.
and certain restructuring charges including layoffs. This and previous
announcements, and the overall perception of Apple Computer's prospects and
continuing commercial vitality, may negatively impact the Company's Macintosh-
based business. In particular, the Company has experienced declining momentum in
sales of their Macintosh-based products compared to sales of their Windows-based
products and historic Macintosh sales. The Company attributes this decline in
part to uncertainty regarding the future of Apple Computer and the Macintosh
environment.     
       
  Although the Company offers its principal products on both the Windows and
Macintosh platforms, a significant percentage of the sales of their products
to date have been for the Macintosh platform, which historically has been a
popular platform among art and graphics professionals. During calendar 1996
approximately 37% of the Company's net revenues were from the sales of
products for use on the Macintosh platform. To the extent that other operating
systems become more prevalent among the Company's customers, the Company will
be required to modify its development, personnel recruiting, marketing and
distribution efforts to more effectively address these platforms; however,
there can be no assurance that the Company will be able effectively to do so. 
         
 Product Transitions and Product Returns      
 
  From time to time, the Company and its competitors may announce new
products, product versions, capabilities or technologies that have the
potential to replace or shorten the life cycles of the Company's existing
products. The Company has historically experienced increased returns of a
particular product version following the announcement of a planned release of
a new version of that product. Although the Company provides allowances for
anticipated returns, there can be no assurance that product returns will not
exceed such allowances in the future. The Company has from time to time
offered free upgrades to customers who purchased a product following
announcement of a new release and before shipment of the new version of that
product. Such offers can have a negative effect on revenues, operating results
and cash flows. In addition, the Company may offer price discounts for new
products and product releases in order to facilitate market acceptance, which
also negatively impacts revenue, operating results and cash flows. Moreover,
the announcement of currently planned or other new products may cause
customers to delay their purchasing decisions in anticipation of such
products. Any of the foregoing could have a material adverse effect on the
business, operating results, financial condition and cash flows of the
Company.
 
 Product Concentration; Lack of Product Revenue Diversification
 
  A substantial percentage of the Company's revenues to date have been derived
from a limited number of products, and such products are expected to continue
to account for a substantial majority of the Company's revenues in the near
term. Collective sales of Kai's Power Goo, Kai's Power Tools and Bryce
accounted for a substantial majority of the Company's net revenues in 1996.
Continued market acceptance of the Company's primary products are therefore
critical to the future success of the Company. Any decline in demand for or
failure to achieve continued market acceptance of such products or any new
version of these products, if any, as a result of competition, technological
change, failure of the Company to timely release new versions of these
products, or otherwise, could have a material adverse effect on the business,
operating results, financial condition and cash flows of the Company.
 
 Rapid Technological Change; Dependence on and Need for New Products and
 Product Versions; Potential Delays in Product Releases
 
  The market for visual computing graphics software products, and the personal
computer industry in general, is characterized by rapidly changing technology,
resulting in short product life cycles and strong pricing pressures. As a
result, the success of the Company depends substantially upon its ability to
continue to enhance its existing products, to develop and introduce in a
timely manner new products incorporating technological
 
                                      13
<PAGE>
 
advances and to meet increasing customer expectations. To the extent one or
more competitors introduce products that better address customer needs, the
Company's business could be adversely affected. There can be no assurance that
the Company will be successful in developing and marketing enhancements to its
existing products or new products on a timely basis or that any new or
enhanced products will adequately address the changing needs of the
marketplace. Also, negative reviews of the Company's new products or product
versions in industry publications could have a material adverse effect on
product sales.
 
  The Company intends to continue to significantly increase its research and
development expenditures. To the extent such increases are not accompanied by
increased revenues, the Company's business, operating results, financial
condition and cash flows would be materially adversely affected. The Company
has supplemented its research and development efforts by exclusively licensing
products developed by or co-developed with third parties. There can be no
assurance that the Company will be able to continue to obtain such outside
product development capabilities on terms favorable to the Company or at all.
If the Company was unable to maintain existing development arrangements or to
attract new product development partners, then the Company would, at a
minimum, have to further increase its research and development expenditures,
which could have a material adverse effect on the Company's business,
operating results, financial condition and cash flows. In addition, there can
be no assurance that such additional research and development expenditures
would result in the production of commercially acceptable products.
 
  The Company also depends upon internal efforts for the development of new
products and product enhancements. The Company has in the past experienced
delays in the development of new products and product versions. There can be
no assurance that the Company will not experience further delays in connection
with the current product development or future development activities. Also,
software products as complex as those offered by the Company may contain
undetected errors when first introduced or as new versions are released. The
Company has in the past discovered software errors in certain of their new
products and enhancements after the introduction of these products. There can
be no assurance that errors will not be found in new products or releases
after commencement of commercial shipments, resulting in adverse product
reviews and a loss of or delay in market acceptance, which could have a
material adverse effect upon the Company's business, operating results,
financial condition and cash flows.
       
  The Company is expending significant resources to develop the in-process
research and development obtained in the acquisition of RTG. Presently, the
Company employs 22 people and leases a 6,000 square foot office in Princeton,
New Jersey, dedicated toward these activities. In addition, the Company
anticipates capital expenditures in excess of $1 million during 1997 for
computer and office equipment and furniture to support these development
activities. The market for visual computing graphics software products, and
the personal computer industry in general, is characterized by rapidly
changing technology. There can be no assurances that the further development
of the in-process research and development of the Company will result in
commercially viable products.      
 
 Dependence Upon Third Party Software Developers
 
  The Company uses certain products and technologies of both domestic and
foreign third party software developers, including both complete products
offered as extensions of the Company's product lines and technologies used in
the enhancement of internally developed products. For example, the Company
licenses Final Effects, Studio Effects and the MetaPhotos collection of
royalty free photographs from third party software developers. Such products
and technologies are obtained from third party providers under contractual
license agreements, which in some cases are for limited time periods and may
be terminated under certain circumstances. There can be no assurance that the
Company will be able to maintain adequate relationships with any such third
party providers, that these third party providers will commit adequate
development resources to maintain these products and technologies, or that any
license agreement for a limited time period will be renewed upon termination.
In such circumstances, the Company's inability to obtain or develop substitute
technology could adversely affect the business, results of operations,
financial condition and cash flows of the Company. Unlike internally developed
products, these license arrangements also may limit the Company's ability to
timely create and release product upgrades and to effectively control the
product development process.
 
                                      14
<PAGE>
 
 Limited Operating History; Uncertain Profitability; Fluctuating Rates of
Growth
 
  The Company has only limited operating history on which an evaluation of its
business and prospects can be based. The Company was incorporated in March
1987 and did not introduce its first internally developed product until
January 1993. The Company experienced losses in each quarter of 1994 and in
the first two quarters of 1995. The Company also realized a loss in the fourth
quarter of 1996 due to a one-time write-off of acquired in-process technology
and other acquisition costs charge related to the acquisition of Real Time
Geometry Corp. ("RTG"). There can be no assurance, however, that the net
revenues of the Company will continue at their current level or will grow, or
that the Company will be able to achieve sustained profitability on a
quarterly or annual basis. The Company's historical net revenue growth rates,
both domestically and internationally, have varied significantly between
monthly and quarterly periods. Therefore, recent net revenue comparisons
should not be taken as indicative of the rate of net revenue growth, if any,
that can be expected in the future.
 
 Dependence on Key Personnel and Difficulty of Identifying and Hiring Certain
Personnel
 
  The future performance of the Company is substantially dependent on the
performance of its executive officers and key employees. The loss of the
services of any of the executive officers or other key employees of the
Company for any reason could have a material adverse effect on the business,
operating results, financial condition and cash flows of the Company.
 
  The future success of the Company also depends on its continuing ability to
identify, hire, train and retain other highly qualified technical and
managerial personnel. Competition for such personnel is intense, and the
Company has experienced difficulty in identifying and hiring qualified
engineering personnel. There can be no assurance that the Company will be able
to attract, assimilate or retain other highly qualified technical and
managerial personnel in the future. The inability to attract and retain the
necessary technical and managerial personnel could have a material adverse
effect upon the Company's business, operating results, financial condition and
cash flows.
 
 Highly Competitive Markets
 
  The markets for graphics software products such as those offered by the
Company are intensely competitive, subject to rapid change and characterized
by constant demand for new product features, pressure to accelerate the
release of new products and product enhancements and pressure to reduce
prices. A number of companies currently offer products that compete directly
or indirectly with one or more the Company's products. Competitors include,
among others, Adobe Systems Incorporated ("Adobe"), Corel Corporation
("Corel"), Micrografx Incorporated ("Micrografx"), Macromedia, Inc.
("Macromedia"), Silicon Graphics, Inc. (through its Alias/Wavefront division),
Microsoft Corporation ("Microsoft") and Broderbund Software, Inc.
("Broderbund"). Many of the Company's competitors or potential competitors
have significantly greater financial, managerial, technical, and marketing
resources. A variety of potential actions by any of these competitors,
including a reduction of product prices, increased promotion, announcement or
accelerated introduction of new or enhanced products or features, acquisitions
of software applications or technologies from third parties, product giveaways
or product bundling could have a material adverse effect on the business,
operating results, financial condition and cash flows of the Company. In the
event of price erosion, the Company may be unable to successfully reposition
itself to accommodate these actions.
 
  Present or future competitors may be able to develop products comparable or
superior to those offered by the Company or adapt more quickly to new
technologies or evolving customer requirements. In addition, developers of
personal computer operating systems, including Microsoft and Apple Computer,
may incorporate 3D functionality into their operating systems, which may be
superior to or incompatible with the products of the Company, thus adversely
affecting the Company's operating results. In particular, while the Company
currently is developing additional product enhancements that they believe
address customer requirements, there can be no assurance that the development
or introduction of these additional product enhancements will be successfully
completed on a timely basis or that these product enhancements will achieve
market acceptance. Accordingly, there can be no assurance that the Company
will be able to continue to compete effectively in its markets, that
competition will not intensify or that future competition will not have a
material adverse effect on the business, operating results, financial
condition and cash flows of the Company.
 
                                      15
<PAGE>
 
 Dependence on Distributors and on Other Third Parties
       
  While the Company derives some revenues from direct sales, most of its
revenues are derived from the sale of products through third parties. The
Company sells its products worldwide through multiple distribution channels,
including traditional software distributors, hardware and software OEMs,
international distributors, educational distributors, VARs, hardware
superstores, retail dealers, and direct marketers. In addition, the Company's
products are manufactured by third party manufacturing and fulfillment
providers. Ingram Micro, Inc. ("Ingram") and Prisma Distributionsgesellschaft
GmbH, MetaTools' principal distributors, accounted for approximately 26% and
1% of net revenues, respectively, for the fiscal year ended December 31, 1995,
and approximately 18% and 15% of net revenues, respectively, for the fiscal
year ended December 31, 1996.      
 
  The Company will be dependent on the continued viability and financial
stability of these third parties. Any termination or significant disruption of
the Company's relationship with any major distributor or retailer, or a
significant reduction in sales volume attributable to the Company's principal
resellers could materially and adversely affect the business, operating
results, financial condition and cash flows of the Company. The distribution
channels through which the Company's software products are sold have been
characterized by rapid change, significant margin pressures, consolidation and
financial difficulties, including certain of the Company's current
distributors and retailers. In addition, new distribution channels may develop
and there can be no assurance that the Company will be able to effectively
distribute its products through such channels. The bankruptcy, deterioration
in financial condition or other business difficulties of a distributor or
retailer could render the Company's accounts receivable from such entity
uncollectible, which could result in a material adverse effect on the
Company's business, operating results, financial condition and cash flows.
Retailers of the Company's products typically have a limited amount of shelf
space and promotional resources for which there is intense competition, and
the Company depends in part upon promotional efforts of distributors in
placing products with retailers. There can be no assurance that distributors
and retailers will continue to purchase the Company's products or provide the
Company's products with adequate levels of shelf space and promotional
support. Failure of distributors or retailers to do so could have a material
adverse effect on the business, operating results, financial condition and
cash flows of the Company.
 
  An integral element of the Company's strategy is to enhance and diversify
its channels of distribution both domestically and internationally. The
Company is currently investing, and the Company plans to continue to invest, a
significant portion of its cash and personnel resources to expand its domestic
and international direct sales and marketing force and develop distribution
relationships with additional third-party distributors and resellers. The
Company's ability to achieve significant revenue growth in the future will
depend in large part on its success in recruiting and training sufficient
sales personnel, distributors and resellers.
 
  Certain of the Company's products operate as plug-in extensions and
enhancements for specific print, animation, video and multimedia application
platforms, including Adobe's PhotoShop, Illustrator, After Effects and
Premiere; Autodesk's Animator Studio and 3D Studio; Corel's PhotoPaint;
Macromedia's Freehand; Micrografx's Picture Publisher; and other application
platforms. Market acceptance of the Company's plug-in products is dependent
upon market acceptance of these third-party application platforms as well as
the willingness of the manufacturers of such platforms to permit their
platforms to be extended and enhanced by plug-in products such as those of the
Company. A decline in demand for any such platforms or exclusionary practices
by the manufacturers of such platforms would have a material adverse effect on
the Company's business, operating results, financial condition and cash flows.
 
 Evolving Markets for Computer Graphic Imaging and Internet/Online Design
Tools
 
  The markets for computer graphic imaging and Internet/online design tools
are still emerging. There can be no assurance that the markets for the
Company's existing products will grow, that digital graphic and
Internet/online content developers will adopt the Company's products, that
sufficient distribution resources will be available to market the Company's
products in a timely manner or that such products will be successful in
achieving market acceptance. The demand for computer graphic imaging and
Internet/online design tools is dependent upon a number of variables,
including the installed base of digital graphic and multimedia capable
 
                                      16
<PAGE>
 
personal computers, the widespread availability of digital media and the
number and expertise of skilled content producers. If the markets for such
tools fail to grow or grow more slowly than the Company currently anticipates,
or if the Company's products fail to achieve market acceptance, the Company's
business, operating results, financial condition and cash flows would be
materially adversely affected.
 
 International Operations and Expansion
 
  International sales represented approximately 28% of the Company's net
revenues in the fiscal year ended December 31, 1995 and approximately 36% of
net revenues in the fiscal year ended December 31, 1996. A key component of
the Company's strategy is continued expansion into international markets,
primarily Japan and Western Europe, and the Company currently anticipates that
international sales will represent an increasing portion of the Company's net
revenues. The Company will need to retain effective distributors and hire,
retain and motivate qualified personnel internationally to expand its
international presence. There can be no assurance that the Company will be
able to successfully market, sell, localize and deliver its products in these
international markets.
 
  In addition to the uncertainty as to the Company's ability to expand its
international presence, there are certain risks inherent in doing business on
an international level, such as unexpected changes in regulatory requirements,
problems and delays in collecting accounts receivable, tariffs and other trade
barriers, difficulties in staffing and managing foreign operations, longer
payment cycles, political instability, fluctuations in currency exchange
rates, seasonal reductions in business activity during summer months in Europe
and certain other parts of the world and potentially adverse tax consequences,
any of which could adversely impact the success of international operations.
Sales of products by the Company currently are denominated in U.S. dollars.
Accordingly, any increase in the value of the U.S. dollar as compared to
currencies in the Company's principal overseas markets would increase the
foreign currency-denominated cost of the Company's products, which may
negatively affect the Company's sales in those markets. To date, the Company
has not engaged in currency hedging transactions to reduce the effect of
currency exchange rate fluctuations. In addition, effective copyright and
trade secret protection may be limited or unavailable under the laws of
certain foreign jurisdictions. There can be no assurance that one or more of
such factors will not have a material adverse effect on the Company's
international operations and, consequently, on the business, operating
results, financial condition and cash flows of the Company.
 
 Management of Potential Growth; Integration of Potential Acquisitions
 
  In recent years, the Company has experienced expansion of its operations
that have placed significant demands on its administrative, operational and
financial resources. To manage future growth, if any, the Company must improve
its financial and management controls, management processes, business and
management information systems and procedures on a timely basis and expand,
train and manage its work force. There can be no assurance that the Company
will be able to perform such actions successfully. The Company intends to
continue to invest in improving its financial systems and controls in
connection with higher levels of operations. In the future, the Company may
make additional acquisitions of complementary companies, products or
technologies. Managing acquired businesses entails numerous operational and
financial risks, including difficulties in assimilating acquired operations,
diversion of management's attention to other business concerns, amortization
of acquired intangible assets and potential loss of key employees or customers
of acquired operations. The Company's success will depend, to a significant
extent, on the ability of its executive officers and other members of senior
management to respond to these challenges effectively. There can be no
assurance that the Company will be able to effectively achieve and manage any
such growth, or that its management, personnel or systems will be adequate to
support the Company's operations. Any such inabilities or inadequacies would
have a material adverse effect on the Company's business, operating results,
financial condition and cash flows.
 
                                      17
<PAGE>
 
 Proprietary Rights and Licenses
 
  The Company relies on a combination of copyright, trademark, patent, trade
secret laws, employee and third-party nondisclosure agreements and exclusive
contracts to protect its intellectual and proprietary rights and products. The
Company distributes its software under shrinkwrap license agreements but
generally does not obtain signed license agreements from its end users. In
keeping with software industry standards, the Company does not copy protect
their software. Accordingly, it may be possible for unauthorized third parties
to copy or reverse engineer the Company's products or otherwise obtain and use
information that the Company regards as proprietary. Furthermore, there can be
no assurance that competitors will not independently develop technologies that
are substantially equivalent or superior to the technologies of the Company.
Policing unauthorized use of the Company's products is difficult, and while
the Company is unable to determine the extent to which software piracy of
their products exists, software piracy can be expected to be a persistent
problem. In addition, the laws of certain countries in which the Company's
products are or may be distributed do not protect products and the
intellectual rights to the same extent as do laws in the United States.
 
  As the number of software products in the industry increases and the
functionality of these products further overlaps, the Company believes that
software increasingly will become the subject of claims that such software
infringes the rights of others. There can be no assurance that third parties
will not assert infringement claims against the Company in the future or that
any such assertions will not result in costly litigation or require the
Company to obtain a license to intellectual property rights of third parties.
There can be no assurance that such licenses will be available on reasonable
terms or at all. Furthermore, the Company licenses certain software products
from other companies for distribution or inclusion in their own products.
There can be no assurance that upon the expiration of these licenses, such
licenses will be available again on reasonable terms or at all, or that
similar products could be obtained to substitute for these products. The
inability to license such products could have a material adverse effect on the
Company's business, operating results, financial condition and cash flows.
 
 Possible Volatility of Stock Price
 
  The price of the Company's Common Stock has fluctuated significantly in the
past. The management of the Company believes that such fluctuations may have
been caused by announcements of new products, quarterly fluctuations in the
results of operations and other factors. Stock markets in general have also
experienced extreme price volatility in recent years. This volatility has had
a substantial effect on the market prices of securities issued by the Company
and other software companies, particularly graphics software companies, often
for reasons unrelated to the operating performance of the specific companies.
The Company anticipates that prices for the Company's Common Stock will
continue to be volatile in the future.
 
 Concentration of Stock Ownership
 
  As of February 28, 1997, the directors and executive officers of the Company
and their respective affiliates beneficially own approximately 45% of the
Company's outstanding Common Stock. As a result, these stockholders will be
able to exercise significant influence over all matters requiring stockholder
approval, including the election of directors and approval of significant
corporate transactions.
 
EMPLOYEES
 
  As of February 28, 1997, the Company had 146 full time employees, including
41 in sales and marketing, 63 in development, quality assurance and
documentation, 14 in customer service and technical support, and 28 in
finance, administration and operations. The employees and the Company are not
parties to any collective bargaining agreements, and the Company believes that
its relationships with its employees are good.
 
                                      18
<PAGE>
 
ITEM 2.  PROPERTIES
 
  The Company's primary facility consists of approximately 35,000 square feet
of leased space in a one-story building in Carpinteria, Santa Barbara County,
California. This space houses substantially all of the Company's United States
operations. The lease agreement expires in December 1998, if not renewed. The
Company believes that the current facility is adequate for current and near
term needs and that additional space is available to provide for anticipated
growth.
 
  The facilities for RTG consists of approximately 7,000 square feet of leased
office space in Princeton and Short Hills, New Jersey, pursuant to lease
agreements which expire in December 1999 and May 2000, respectively. The
Company believes that this office space is adequate for the current needs of
RTG and that additional space is available to provide for anticipated growth.
 
  The Company's Irish facility consists of approximately 800 square feet of
leased space in an office building in Dublin, Ireland. At the expiration of
the lease in March 1997, the Company will enter into a new lease for a larger
facility in the Dublin area to allow for continued growth of the international
operations.
 
ITEM 3. LEGAL PROCEEDINGS
 
  The Company is engaged in certain legal actions arising in the ordinary
course of business. The Company believes it has adequate legal defenses and
believes that the ultimate outcome of these actions will not have a material
effect on the Company's consolidated financial position, results of
operations, or cash flows.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
  None.
 
EXECUTIVE OFFICERS OF THE REGISTRANT
 
  The following table sets forth certain information regarding the Company's
current executive officers:
 
<TABLE>
<CAPTION>
 NAME                            AGE POSITION
 ----                            --- --------
 <C>                             <C> <S>
 John J. Wilczak................ 45  Chairman, President and Chief Executive
                                     Officer
 Kai Krause..................... 41  Director and Senior Science and Design
                                     Officer
 Alexander Migdal............... 51  Vice President and Chief Scientist
 Fred Brown..................... 50  Senior Vice President, Sales and
                                     Marketing
 Terance A. Kinninger........... 41  Vice President and Chief Financial
                                     Officer
 James Mervis................... 48  Vice President, Strategic Development and
                                     Business Affairs
 Sallie Olmsted................. 37  Vice President, Corporate Communications
 Robert Rice.................... 42  Vice President, Business Development
</TABLE>
 
  Mr. Wilczak has been Chairman of the Board and Chief Executive Officer since
he co-founded the Company in March 1987. Prior to founding MetaTools, Mr.
Wilczak was a business strategy and marketing consultant from 1984 to 1987.
From February 1982 to December 1983, Mr. Wilczak served as a Senior Consultant
with Touche Ross & Company, and from December 1979 to January 1982 he served
as an internal Senior Consultant performing marketing and business strategy
development services at General Electric Co. Mr. Wilczak holds a B.A. from
Brown University and an M.B.A. from Columbia University.
 
  Mr. Krause co-founded the Company and has been a director since 1992. For
more than eleven years prior to joining the Company on a full-time basis in
1993, Mr. Krause designed and developed advanced graphics, audio and systems
software as an independent consultant. Mr. Krause attended college in Essen,
West Germany, where he majored in foreign languages, math and philosophy. He
also attended the Music Conservatory, where he studied classical piano. During
1992, the Company was Mr. Krause's primary client.
 
                                      19
<PAGE>
 
  Mr. Migdal joined the Company as Vice President and Chief Scientist in
connection with the Company's acquisition of RTG in December 1996. Prior to
co-founding RTG in February 1996, Mr. Migdal was a joint professor of physics
and applied and computational mathematics at Princeton University from 1989 to
1996 and a visiting professor of physics at the University of California, San
Diego in 1988. Before leaving the former Soviet Union in 1988, Mr. Migdal was
the head of the Laboratory of Computational Physics in the Cybernetics Council
of the Soviet Academy of Sciences and was a senior research fellow at the
Landau Institute for Theoretical Physics. Mr. Migdal holds a doctor of science
and Ph.D. from the Landau Institute for Theoretical Physics, a M.S. in Physics
from the Moscow Physical Technical Institute, as well as an honorary degree of
professor from the Cybernetics Council of the Soviet Academy of Sciences.
 
  Mr. Brown joined the Company as Senior Vice President, Sales and Marketing
in November 1995. From November 1994 to November 1995, Mr. Brown was Vice
President, Retail Stores, PCs Worldwide at AT&T Corp. From February 1993 to
November 1994, Mr. Brown served as Vice President of Sales and Marketing at
Xtend Microproducts. From late 1990 to February 1993, Mr. Brown was Vice
President of Sales and Marketing at Cal Circuit Abco, Inc., a Packard Bell
Electronics, Inc. affiliated company. Mr. Brown holds a B.S. from Point Loma
College.
 
  Mr. Kinninger joined the Company as Vice President and Chief Financial
Officer in July 1995. Mr. Kinninger was employed by Delphi Information
Systems, Inc. ("Delphi") from October 1990 to June 1995, initially as Chief
Financial Officer and, from December 1993 to November 1994 as Senior Vice
President of Corporate Development. He then served as Senior Vice President
and General Manager of Delphi's SMART Division from December 1994 to June
1995. Prior to working at Delphi, he served as Chief Financial Officer of
Integral Systems, Inc. from June 1983 to September 1990. Before his tenure at
Integral Systems, Inc., Mr. Kinninger was employed at Coopers & Lybrand. Mr.
Kinninger holds a B.S. from Miami University.
 
  Mr. Mervis became the Company's Vice President, Strategic Development and
Business Affairs in April 1995. From February 1993 to March 1995, Mr. Mervis
was co-founder and Managing Director of Crunch Media, an interactive media
company, where he produced the interactive adventure: A Brief History of Time.
Mr. Mervis was a consultant for the entertainment industry from 1986 to 1992.
From 1979 to 1985, Mr. Mervis served as Vice President of Worldwide Program
Planning at MGM/UA Home Entertainment; Vice President of Program Development
at Showtime Pay Television; and Director of Business Affairs at Viacom
International. From 1973 to 1978, Mr. Mervis was engaged in private legal
practice. Mr. Mervis holds a B.S. from Cornell University and a J.D. from
Fordham University.
 
  Ms. Olmsted joined the Company as Vice President, Corporate Communication in
July 1996. From April 1994 to July 1996, Ms. Olmsted was the Vice President of
the Corporate and Consumer market division of Rogers & Cowan in Los Angeles,
where she also managed the agency's Emerging Technologies practice group.
Prior to joining Rogers & Cowan, she was the director of public affairs at EON
Corporation. Ms. Olmsted holds a B.B.A. in International Business from George
Washington University.
 
  Mr. Rice joined the Company as Vice President, Business Development in
connection with the Company's acquisition of RTG in December 1996. In addition
to co-founding RTG in 1996, Mr. Rice served as its Chairman. From 1983 to
1996, Mr. Rice was a partner at the international law firm of Milbank, Tweed,
Hadley and McCloy. Mr. Rice holds a B.S. and a J.D. from Florida State
University.
 
                                      20
<PAGE>
 
                                    PART II
 
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
MARKET INFORMATION FOR COMMON STOCK
 
  The Company's common stock, $0.001 par value, began trading over the counter
in December 1995, and is quoted on the Nasdaq National Market tier of the
Nasdaq Stock Market under the symbol "MTLS." The following table sets forth,
for the periods indicated, the range of high and low closing sale prices per
share as reported on the Nasdaq National Market System:
 
<TABLE>
<CAPTION>
                                        HIGH   LOW
                                       ------ ------
            <S>                        <C>    <C>
            1996
            ----
            4th Quarter                $27.25 $11.50
            3rd Quarter                 24.75  10.75
            2nd Quarter                 41.00  18.00
            1st Quarter                 27.25  16.25
            1995
            ----
            12/12/95 through 12/31/95  $29.00 $18.00
</TABLE>
 
HOLDERS
 
  As of March 7, 1997, there were approximately 232 holders of record of the
Company's common stock.
 
DIVIDENDS
 
  The Company has not paid any cash dividends on its capital stock to date.
The Company currently anticipates that it will retain all future earnings, if
any, for use in its business and does not anticipate paying any cash dividends
on its capital stock in the foreseeable future.
 
                                      21
<PAGE>
 
ITEM 6. SELECTED FINANCIAL DATA
 
  The following selected condensed financial data should be read in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and the Financial Statements and related notes
thereto appearing elsewhere in this Form 10-K.
 
<TABLE>
<CAPTION>
                                           YEARS ENDED DECEMBER 31,
                                    -------------------------------------------
                                      1996      1995     1994     1993    1992
                                    --------  --------  -------  ------  ------
                                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                 <C>       <C>       <C>      <C>     <C>
STATEMENT OF OPERATIONS DATA
Net revenues......................  $ 28,035  $ 16,731  $ 9,832  $4,524  $1,259
Cost of revenues..................     4,560     4,935    3,503     899     648
                                    --------  --------  -------  ------  ------
 Gross profit.....................    23,475    11,796    6,329   3,625     611
Operating expenses:
 Sales and marketing..............    12,392     8,819    5,386   1,685     800
 General and administrative.......     3,002     1,978    2,051   1,286     689
 Research and development.........     3,437     1,566    1,050     532     108
 Write-off of in-process technol-
  ogy and other acquisition costs.    15,182       --       --      --      --
                                    --------  --------  -------  ------  ------
  Total operating expenses........    34,013    12,363    8,487   3,503   1,597
                                    --------  --------  -------  ------  ------
Income (loss) from operations.....   (10,538)     (567)  (2,158)    122    (986)
Other income (expense)............     2,348        67      (54)     28      10
                                    --------  --------  -------  ------  ------
Income (loss) before provision for
 income taxes.....................    (8,190)     (500)  (2,212)    150    (976)
Provision for income taxes........     1,049       --       --      --      --
                                    --------  --------  -------  ------  ------
Net income (loss).................  $ (9,239) $   (500) $(2,212) $  150  $ (976)
                                    ========  ========  =======  ======  ======
Net income (loss) applicable to
 common stockholders..............  $ (9,239) $   (589) $(2,451) $  150  $ (976)
                                    ========  ========  =======  ======  ======
Net income (loss) per common
 share............................  $   (.78) $   (.11) $  (.43) $  .02  $ (.20)
                                    ========  ========  =======  ======  ======
Weighted average number of shares
 outstanding......................    11,791     5,415    5,647   7,055   4,807
                                    ========  ========  =======  ======  ======
BALANCE SHEET DATA
Cash, cash equivalents and short-
 term investments.................  $ 39,557  $ 46,885  $ 3,257  $  135  $   52
Working capital (deficiency)......    46,431    48,115    4,264    (660)   (790)
Total assets......................    57,029    53,437    7,709   1,989     368
Series B redeemable convertible
 preferred stock..................       --        --     8,359     --      --
Stockholders' equity (deficit)....    50,831    50,188   (3,342)   (455)   (671)
</TABLE>
 
                                      22
<PAGE>
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
 
OVERVIEW
 
  From its formation in 1987 until 1992, the Company was principally engaged
in software consulting activities. In 1992, the Company shifted its business
to developing and marketing personal software tools for designing and
producing computer graphic imaging and currently derives substantially all of
its revenues from sales and licensing of its software products. The Company
has experienced rapid revenue growth since the introduction of its first
significant software product, Kai's Power Tools, in January 1993, and has
subsequently brought more than 16 products to market. This revenue growth has
been achieved through the Company's continued introduction of new products and
the release of enhanced versions of its existing products, as well as its
significant investment in the expansion of its sales and marketing activities
to address broader distribution channels.
 
  The Company's future revenues are substantially dependent upon the continued
market acceptance of the Company's existing leading products: Kai's Power Goo,
Kai's Power Tools, and Bryce. In this regard, revenue from the collective sale
of these products represented a substantial majority of net revenues in 1996.
The Company also has a number of new product development efforts under way,
and a significant portion of future revenues is dependent upon the success of
these activities.
 
  The Company develops its products either internally or through co-
development arrangements with third parties. These co-development arrangements
generally provide the Company with certain exclusive proprietary, copyright or
marketing rights for developed products in exchange for the payment of one-
time and/or ongoing royalties. The Company expects to continue fostering
arrangements with external developers as part of its strategy of expanding its
product portfolio. There can be no assurance, however, that the Company will
be able to continue to supplement its product development efforts in the
future through such relationships on favorable terms or at all.
 
  The Company sells its products primarily to domestic and international
distributors, including mail order resellers and retail outlets. The Company
also sells its products to OEMs for bundling with their hardware or software
products and directly to end users, generally through telesales and direct
mail campaigns. Fluctuations in distributor purchases and the execution of OEM
agreements can cause significant volatility in the Company's revenues.
Distributors generally stock the Company's products at levels which may
fluctuate significantly for a variety of reasons, including the distributors'
ability to finance the purchase of products and to devote shelf space, catalog
space or attention to the products. Distributor purchases may also be affected
by the Company's introduction of a new product or a new version of a product,
the Company's end user promotions programs, anticipated product price
increases, the Company's purchases of display space at retail outlets and
other factors. Further, OEM agreements which generally provide for minimum
guaranteed non-refundable payments to the Company are typically tied to the
planned introduction of OEM bundled product and are often entered into at the
end of the quarter. The timing of the execution of such agreements can
fluctuate substantially throughout the year, causing volatility in the
Company's revenues, operating results, and cash flows.
 
  Since 1992, the Company has focused on building its product portfolio and
establishing brandname awareness of its products. These activities have
resulted in significant increases in all expense categories. In particular,
the Company's shift from direct sales to end users toward expanded indirect
distribution channels has required a substantial increase in the Company's
sales and marketing activities. The Company's recent product development
efforts and acquisitions have also entailed significant research and
development expenditures. These higher expense levels combined with the write-
off of in-process research and development from corporate acquisitions and
fluctuations in net revenues have contributed to the Company's quarterly and
annual losses and the fluctuations in its operating results. The Company
intends to continue to invest significant amounts both in expanding its
product portfolio and in maintaining and enhancing brand awareness of its
products, and accordingly may continue to experience losses and volatility of
net revenues and operating results in future periods.
 
                                      23
<PAGE>
 
OPERATING RESULTS
 
  The following table sets forth certain selected financial information
expressed as a percentage of net revenues for the periods indicated:
 
<TABLE>
<CAPTION>
                                                YEARS ENDED DECEMBER 31,
                                               ------------------------------
                                                 1996       1995       1994
                                               --------   --------   --------
<S>                                            <C>        <C>        <C>
Net revenues..................................    100.0 %    100.0 %    100.0 %
Cost of revenues..............................     16.3       29.5       35.6
                                               --------   --------   --------
  Gross margin................................     83.7       70.5       64.4
Operating expenses:
 Sales and marketing..........................     44.2       52.7       54.8
 General and administrative...................     10.7       11.8       20.9
 Research and development.....................     12.2        9.4       10.7
 Write-off of in-process research and develop-
  ment and other acquisition costs............     54.2        --         --
                                               --------   --------   --------
  Total operating expenses....................    121.3       73.9       86.4
                                               --------   --------   --------
Loss from operations..........................    (37.6)      (3.4)     (22.0)
Other income (expense), net...................      8.4        0.4       (0.5)
                                               --------   --------   --------
Loss before provision for income taxes........    (29.2)      (3.0)     (22.5)
Provision for income taxes....................     (3.7)       --         --
                                               --------   --------   --------
Net loss......................................    (32.9)%     (3.0)%    (22.5)%
                                               ========   ========   ========
</TABLE>
 
 Net Revenues
       
  The Company recognizes revenue from the sale of its products upon shipment
to the customer and satisfaction of significant Company obligations, if any.
Net revenues increased from $16.7 million in 1995 to $28.0 million in 1996, an
increase of 68%. The increase in net revenues was attributed to volume
increases resulting from the Company's release of new products and new
versions of its existing products during 1996 and the second half of 1995,
expansion of the domestic distribution channel, increased expansion of sales
through original equipment manufacturers ("OEM's"), and increased
international sales. The Company released Bryce 2 for Macintosh, Final Effects
for Adobe's Premiere on the Macintosh platform, and PowerPhotos Series III in
the first quarter; Kai's Power Goo, Final Effects for Adobe's Premiere on the
Windows platform, and PowerPhotos Series IV in the second quarter; and Bryce 2
for Windows and MetaPhotos in the third quarter. International sales increased
from 28% of net revenues in 1995 to 36% of net revenues in 1996, primarily
reflecting the increase in revenues from Europe of approximately $5.1 million
over 1995.      
 
  Net revenues increased from $9.8 million in 1994 to $16.7 million in 1995,
an increase of 70%. Net revenues increased in 1995 as a result of the
Company's release of new products and new versions of its existing products
during 1995 and the second half of 1994 along with increased expansion of
sales through its domestic distribution channels and increased international
sales. In particular, the Company released PowerPhotos Series I in the first
quarter of 1995, Vector Effects in the second quarter of 1995, PowerPhotos
Series II and Kai's Power Tools 3 in the third quarter of 1995, and Final
Effects for Adobe's After Effects in the fourth quarter of 1995. International
sales increased from 18% of net revenues in 1994 to 28% of net revenues in
1995.
 
                                      24
<PAGE>
 
  The Company offers two principal product types consisting of stand-alone
applications (principally consisting of Kai's Power Goo, Bryce, Live Picture,
and MetaPhotos) and plug-in extensions (including Kai's Power Tools, Vector
Effects and Final Effects). Sales of Live Picture were discontinued in January
1996. The following table reflects the net revenue contribution by each
product family for the fiscal periods presented:
 
<TABLE>
<CAPTION>
                                                           YEARS ENDED DECEMBER
                                                                   31,
                                                          ----------------------
                                                           1996    1995    1994
                                                          ------- ------- ------
                                                              (IN THOUSANDS)
<S>                                                       <C>     <C>     <C>
Stand-alone applications and application platforms....... $16,342 $ 6,341 $4,456
Plug-in extensions.......................................  11,693  10,390  5,376
                                                          ------- ------- ------
  Total.................................................. $28,035 $16,731 $9,832
                                                          ======= ======= ======
</TABLE>
 
  The Company reserves a portion of revenue from each sale at the time of
recognition to cover returns and allowances. Such reserves as a percentage of
net revenues have varied significantly over recent years, reflecting the
Company's experience in product returns as it has significantly expanded the
proportion of its sales through third-party distribution channels and
increased its product portfolio. The Company expects reserves will continue to
vary in the future. The Company's agreements with its distributors generally
provide the distributors with limited rights to return unsold inventories
under a stock balancing program. The Company monitors the activities of its
distributors in an effort to minimize excessive returns and establishes its
reserves based on its estimates of expected returns. While historically the
Company's returns have been within management's expectations, the
establishment of reserve levels requires judgments regarding such factors as
future competitive conditions and product life cycles, which can be difficult
to predict. As a result, there can be no assurance that established reserves
will be adequate to cover actual future returns.
 
 Cost of Revenues
 
  Cost of revenues includes the costs of goods sold, royalties paid to
external developers, inventory management costs, freight and handling costs
and reserves for inventory obsolescence. Cost of revenues decreased from $4.9
million, or 29% of net revenues, in 1995 to $4.6 million, or 16% of net
revenues, in 1996. The decrease in cost of revenues was due to a higher
percentage of OEM sales, the changing mix of product sales toward lower
royalty products and to improved management of production and inventories.
Royalties represented 3% and 10% of net revenues for 1996 and 1995,
respectively.
 
  Cost of revenues increased from $3.5 million in 1994 to $4.9 million in
1995, but decreased from 36% of net revenues in 1994 to 29% of net revenues in
1995. The changing mix of product sales toward lower royalty products and the
improved management of inventory levels contributed to the decrease in cost of
revenues as a percentage of net revenues. Royalties represented 10% and 13% of
net revenues for 1995 and 1994, respectively. The Company expects that cost of
revenues will increase in the future commensurate with the increase in net
revenues, but may vary as a percentage of net revenues.
 
 Sales and Marketing
 
  Sales and marketing expenses include advertising, promotional materials,
mail campaigns, trade shows and the compensation costs of sales, marketing,
customer service and public relations personnel who promote the Company's
products, including related facilities costs. Sales and marketing expenses
increased from $8.8 million in 1995 to $12.4 million in 1996, but decreased
from 53% of net revenues in 1995 to 44% of net revenues in 1996. The increase
in sales and marketing expenses reflected the Company's continued efforts to
expand its sales and marketing presence and distribution channels, both
domestically and internationally, through the hiring of additional personnel
and increased advertising and mail campaigns.
 
  Sales and marketing expenses increased from $5.4 million in 1994 to $8.8
million in 1995. Sales and marketing expenses represented 55% and 53% of net
revenues in 1994 and 1995, respectively. Such increase
 
                                      25
<PAGE>
 
was a result of the continued efforts to expand sales and marketing activities
and distribution channels, primarily via domestic retail distributors. The
Company intends to continue such expansion and anticipates that sales and
marketing expenses will increase significantly in future periods as the
Company's product offerings expand, although they may vary as a percentage of
net revenues.
 
 General and Administrative
 
  General and administrative expenses include compensation costs related to
executive management, finance and administration personnel of the Company
along with other administrative costs including legal and accounting fees,
insurance, and bad debt expenses. General and administrative expenses
increased from $2.0 million in 1995 to $3.0 million in 1996. General and
administrative expenses represented 12% and 11% of net revenues in 1995 and
1996, respectively. The increase in general and administrative expenses in
1996 reflects the expansion of the Company's executive, accounting, finance
and administration staffing required to support the Company's growth and
expenses related to its first year as a public company. General and
administrative expenses as a percentage of net revenues decreased in 1996 as a
result of the leverage of a larger business.
 
  General and administrative expenses decreased from $2.1 million, or 21% of
net revenues, in 1994, to $2.0 million, or 12% of net revenues, in 1995. The
Company's relocation in the third quarter of 1994 represented approximately
$368,000 in expenses during 1994. The Company continued to expand its internal
staffing to support its growth during 1995. The Company expects that its
general and administrative expenses will increase in the future as the Company
expands its staffing to support expanded operations and to comply with the
responsibilities of a public company, but may vary as a percentage of net
revenues.
 
 Research and Development
 
  Research and development expenses consist primarily of personnel costs,
consultant fees and required equipment and facilities costs related to the
Company's product development efforts. The Company expenses as incurred
research and development costs necessary to establish the technological
feasibility of its internally-developed software products in accordance with
the Statement of Financial Accounting Standard No. 86, "Accounting for the
Costs of Computer Software to be Sold, Leased or Otherwise Marketed." To date,
the establishment of technological feasibility of the Company's products and
general release have substantially coincided. As a result, the Company has not
capitalized any internal software development costs since costs qualifying for
such capitalization have not been significant.
 
  Research and development expenses increased from $1.6 million in 1995 to
$3.4 million in 1996. Research and development expenses were 9% and 12% of net
revenues in 1995 and 1996, respectively. Research and development expenses
increased in 1996 as a result of the Company's continued focus on expanding
its product portfolio, enhancing its products, migrating its existing products
to the Windows operating system, and translating the products to foreign
languages, which required the hiring of additional personnel.
 
  Research and development expenses increased from $1.1 million in 1994 to
$1.6 million in 1995, but decreased from 11% of net revenues in 1994 to 9% of
net revenues in 1995. The increased expenses resulted from increased personnel
required to expand and enhance the Company's product portfolio. The Company
expects research and development expenses will continue to increase in future
periods but may vary as a percentage of net revenues.
 
 Write-off of In-process Research and Development and Other Acquisition Costs
 
  On August 31, 1996, the Company acquired Dive Laboratories, Inc. ("Dive"), a
privately held company based in Santa Cruz, California, developing 3D modeling
and rendering environments for high-end applications and the visualization of
streaming online data. In connection with the acquisition, which was accounted
for under the purchase method of accounting, the Company recorded a one-time
charge to earnings of approximately $733,000, comprised of relocation expenses
of $215,000, acquisition costs of $155,000, and in-process research and
development expenses of $363,000, for the year ended December 31, 1996. The
Company paid $509,000 in
 
                                      26
<PAGE>
 
cash and assumed $224,000 of net liabilities of Dive. The four Dive research
and development personnel have relocated to Santa Barbara.
       
  On December 31, 1996, the Company completed the acquisition of RTG, a
privately held development stage company based in Princeton, New Jersey,
developing real time 3D graphics and visualization technologies. The
acquisition was accounted for by the Company under the purchase method of
accounting. Under the terms of the Purchase Agreement, the stockholders and
optionholders of RTG received a combination of shares of the Company's common
stock and options to purchase shares of the Company's common stock valued at
approximately $11,242,000 and $607,000, respectively, at December 31, 1996,
the closing date. In addition, the Company assumed the net liabilities of RTG,
which totaled $1,411,000 at December 31, 1996. As of December 31, 1996,
neither technological feasibility nor commercial viability had been reached
with regard to RTG's core technology, comprised of advanced geometry-based
algorithms which transform images in real-time to a series of triangles to
produce three-dimensional images. Based upon projected future cash flows,
risk-adjusted using a 40% discount rate, RTG's core in-process technology was
valued in excess of the amount written-off as acquired in-process technology
of $13,260,000, which combined with acquisition costs totaling $1,189,000,
resulted in a one time charge to earnings of $14,449,000 for the year ended
December 31, 1996. RTG's 21 research and development personnel will remain in
Princeton, New Jersey, continuing visual computing research and development
activities.      
 
 Income (Loss) from Operations
 
  Loss from operations increased from $(567,000), or (3)% of net revenues, in
1995, to $(10.5) million, or (38)% of net revenues in 1996, due to the write-
off of in-process technology and other costs related to the acquisitions of
Dive and RTG. Excluding these one-time charges, pro forma operating income for
1996 was $4.6 million, or 17% of net revenues.
 
 Provision for Income Taxes
 
  The Company records income taxes in accordance with Statement of Financial
Accounting Standards No. 109, "Accounting for Income Taxes." As a result of
operating losses, the Company did not record any provisions for income taxes
in 1995 and 1994. The effective tax rate for the year ended December 31, 1996,
differed from the statutory tax rate due to the partial release of the
valuation allowance against the deferred income tax asset, the non-
deductibility of a portion of the write-off of in-process research and
development, as well as the utilization of available net operating losses and
tax credits.
 
 Net Income (Loss)
 
  Net loss increased from $(500,000), or $(0.11) per common share, in 1995 to
$(9.2) million, or $(0.78) per common share, in 1996. Net loss decreased from
$(2.2) million in 1994 to $(500,000) in 1995, or $(0.43) and $(0.11) per
common share, respectively.
 
SEASONALITY; QUARTERLY FLUCTUATION IN REVENUE
 
  The Company has experienced in the past and expects in the future to
continue to experience significant fluctuations in quarterly operating
results. There can be no assurance that the Company's future revenues,
operating results and cash flows will not also vary substantially. The Company
generally ships products as orders are received and, therefore, has little or
no backlog. As a result, quarterly revenues, operating results and cash flows
of the Company will generally depend on a number of factors that are difficult
to forecast, including, among others, the volume and timing of and ability to
fulfill orders received within a quarter. Quarterly revenues, operating
results and cash flows also may fluctuate due to factors such as demand for
the Company's products; introduction, localization or enhancement of products
by the Company and its competitors; customer or distributor order deferrals in
anticipation of new versions of products; market acceptance of new products;
reviews in the industry press concerning the products of the Company or its
competitors; changes or anticipated
 
                                      27
<PAGE>
 
changes in pricing by the Company or its competitors; the mix of distribution
channels through which products are sold; the mix of products sold; returns
from distributors; and general economic conditions. Revenues, operating
results and cash flows from the Company's products also may be negatively
affected by delays in the introduction or availability of new hardware and
software products from third parties. The Company experiences some effect of
seasonality in its business, as demand for its products tends to increase
during the quarter ending December 31 as a result of timing of year-end
holiday season buying.
               
LIQUIDITY AND CAPITAL RESOURCES
 
  Historically, the Company satisfied its cash requirements principally
through the private sale of its securities, borrowings from stockholders and
bank borrowings. In 1995, the Company raised $45.2 million, net of offering
costs, in connection with an initial public offering of its common stock. In
1994, the Company raised $8.1 million from private investors and bank
financings.
 
  The Company has a $3.0 million revolving line of credit with a bank which
expires during November 1997, if not renewed, and is collateralized by
substantially all of the assets of the Company. Borrowings under the credit
facility are limited to a percentage of eligible accounts receivable, as
defined in the credit agreement. As of December 31, 1996, the Company had no
outstanding borrowings under the line of credit.
 
  Historically, net cash used in operating activities and investing activities
of the Company has been significant due to operating losses and working
capital requirements resulting from the growth of the Company including
increases in accounts receivable. Net cash used in operating activities of the
Company totaled $1.6 million, $92,000, and $3.4 million in 1996, 1995, and
1994, respectively. The increase in 1996 is primarily attributed to the
increase in accounts receivable resulting from the continued growth of the
Company and increased product offerings, and to the write-off of in-process
research and development and other costs related to the acquisitions of Dive
and RTG. Net cash used in investing activities, which totaled $22.5 million,
$1.3 million, and $854,000 in 1996, 1995, and 1994, respectively, also
increased significantly in 1996 due to the purchase of short-term investments
and to increased capital expenditures. Net cash (used in) provided by
financing activities totaled $(3.8) million, $45.3 million, and $7.2 million
in 1996, 1995, and 1994. The increase in net cash used in financing activities
in 1996 is due to the repayment of notes payable to stockholders acquired from
RTG and to loans made to two founders of RTG who are now officers of the
Company, offset by proceeds from the exercise of stock options. Net cash
provided by financing activities in 1995 is primarily attributed to the
initial public offering of the Company's common stock.
 
  The Company anticipates investing a significant amount of working capital
during the next twelve months for upgraded management information systems;
equipment and software for development purposes; and leasehold improvements,
furniture, and fixtures related to expansion of the Company's facilities. In
addition, the Company expects that its working capital requirements will
continue to increase to the extent the Company continues to grow.
 
  The Company believes that its current cash balances, cash provided by future
operations, if any, and available borrowings under the Company's line of
credit are sufficient to meet its working capital needs and anticipated
capital expenditure requirements through at least the next twelve months.
 
                                      28
<PAGE>
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
1. Index to Financial Statements
 
  The following financial statements are filed as part of this Report:
 
<TABLE>
<CAPTION>
                                                                       PAGE NO.
                                                                       --------
      <S>                                                              <C>
      Audited Financial Statements
      ----------------------------
      Report of Independent Public Accountants........................    30

      Consolidated Balance Sheets as of December 31, 1996 and 1995....    31

      Consolidated Statements of Operations for each of the three
       years in the period ended December 31, 1996....................    32

      Consolidated Statements of Stockholders' Equity (Deficit) for
       each of the three years in the period ended December 31, 1996..    33

      Consolidated Statements of Cash Flows for each of the three
       years in the period ended December 31, 1996....................    34

      Notes to Consolidated Financial Statements......................    36
</TABLE>
 
2. Index to Financial Statement Schedules
 
  The following financial statement schedule of the Company is filed as part
of this Report and should be read in conjunction with the financial statements
and the notes thereto.
 
<TABLE>       
<CAPTION>
                                                                        PAGE NO.
                                                                        --------
      <S>                                                               <C>
      Schedules
      ---------
      Schedule II  Valuation and Qualifying Accounts...................    51
</TABLE>      
 
  All other schedules are omitted because they are not applicable, or not
required, or because the required information is included in the financial
statements or notes thereto.
 
 
                                      29
<PAGE>
 
                   REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
 
Board of Directors and Stockholders
MetaTools, Inc.
       
  We have audited the accompanying consolidated balance sheets of MetaTools,
Inc. as of December 31, 1996 and 1995, and the related consolidated statements
of operations, stockholders' equity (deficit) and cash flows for each of the
three years in the period ended December 31, 1996, and the related financial
statement schedule as listed in the index on page 29 of this Form 10-K. These
consolidated financial statements and financial statement schedule are the
responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements and financial statement schedule
based on our audits.      
 
  We conducted our audits in accordance with generally accepted auditing
standards. These 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 consolidated financial statements referred to above
present fairly, in all material respects, the financial position of MetaTools,
Inc. as of December 31, 1996 and 1995, and the results of its operations and
its cash flows for each of the three years in the period ended December 31,
1996, in conformity with generally accepted accounting principles. In
addition, in our opinion, the financial statement schedule referred to above,
when considered in relation to the basic financial statements taken as a
whole, presents fairly, in all material respects, the information required to
be included therein.
 
COOPERS & LYBRAND L.L.P.
 
Sherman Oaks, California
       
February 3, 1997, except for Note 16 as      
 to which the date is February 11, 1997
 
                                      30
<PAGE>
 
                                METATOOLS, INC.
 
                          CONSOLIDATED BALANCE SHEETS
 
<TABLE>
<CAPTION>
                                                           DECEMBER 31,
                                                     -------------------------
                                                         1996         1995
                                                     ------------  -----------
<S>                                                  <C>           <C>
ASSETS
Current assets:
  Cash and cash equivalents......................... $ 18,961,000  $46,885,000
  Short-term investments............................   20,596,000          --
  Accounts receivable, net of allowance for returns
   and doubtful accounts of $1,239,000 and
   $1,003,000 in 1996 and 1995, respectively........    9,994,000    2,677,000
  Inventories.......................................      252,000      912,000
  Deferred income taxes.............................      746,000          --
  Prepaid expenses..................................    2,080,000      890,000
                                                     ------------  -----------
    Total current assets............................   52,629,000   51,364,000
Property and equipment, net.........................    3,123,000    1,577,000
Other assets........................................    1,277,000      496,000
                                                     ------------  -----------
    Total assets.................................... $ 57,029,000  $53,437,000
                                                     ============  ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Accounts payable.................................. $  2,269,000  $ 1,795,000
  Accrued expenses..................................    3,527,000      866,000
  Royalties payable.................................      402,000      588,000
                                                     ------------  -----------
    Total current liabilities.......................    6,198,000    3,249,000
Commitments and contingencies
Stockholders' equity:
  Preferred stock, $.001 par value; 5,000,000 shares
   authorized--none issued and outstanding at
   December 31, 1996 and 1995.......................          --           --
  Common stock, $.001 par value; 30,000,000 shares
   authorized--13,253,584 and 11,597,908 shares
   issued and outstanding at December 31, 1996 and
   1995, respectively...............................       13,000       12,000
  Paid-in capital...................................   67,310,000   54,429,000
  Notes receivable from stockholders................   (3,000,000)         --
  Accumulated deficit...............................  (13,492,000)  (4,253,000)
                                                     ------------  -----------
    Total stockholders' equity......................   50,831,000   50,188,000
                                                     ------------  -----------
    Total liabilities and stockholders' equity...... $ 57,029,000  $53,437,000
                                                     ============  ===========
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       31
<PAGE>
 
                                METATOOLS, INC.
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
 
<TABLE>
<CAPTION>
                                               YEARS ENDED DECEMBER 31,
                                         --------------------------------------
                                             1996         1995         1994
                                         ------------  -----------  -----------
<S>                                      <C>           <C>          <C>
Net revenues...........................  $ 28,035,000  $16,731,000  $ 9,832,000
Cost of revenues.......................     4,560,000    4,935,000    3,503,000
                                         ------------  -----------  -----------
Gross profit...........................    23,475,000   11,796,000    6,329,000
Operating expenses:
  Sales and marketing..................    12,392,000    8,819,000    5,386,000
  General and administrative...........     3,002,000    1,978,000    2,051,000
  Research and development.............     3,437,000    1,566,000    1,050,000
  Write-off of acquired in-process
   technology and other acquisition
   costs...............................    15,182,000          --           --
                                         ------------  -----------  -----------
Total operating expenses...............    34,013,000   12,363,000    8,487,000
                                         ------------  -----------  -----------
Loss from operations...................   (10,538,000)    (567,000)  (2,158,000)
Other income (expense):
  Interest and investment income (ex-
   pense), net.........................     2,345,000       72,000      (36,000)
  Other income (expense)...............         3,000       (5,000)     (18,000)
                                         ------------  -----------  -----------
Loss before provision for income taxes.    (8,190,000)    (500,000)  (2,212,000)
Provision for income taxes.............     1,049,000          --           --
                                         ------------  -----------  -----------
Net loss...............................  $ (9,239,000) $  (500,000) $(2,212,000)
                                         ============  ===========  ===========
Net loss...............................  $ (9,239,000) $  (500,000) $(2,212,000)
Amortization of costs related to the
 issuance of mandatory redeemable
 Series B convertible preferred stock..           --       (89,000)     (99,000)
Preferred stock dividend requirement...           --           --      (140,000)
                                         ------------  -----------  -----------
Net loss applicable to common stock-
 holders...............................  $ (9,239,000) $  (589,000) $(2,451,000)
                                         ============  ===========  ===========
Net loss per common share..............  $       (.78) $      (.11) $      (.43)
                                         ============  ===========  ===========
Weighted average number of shares out-
 standing..............................    11,791,000    5,415,000    5,647,000
                                         ============  ===========  ===========
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       32
<PAGE>
 
                                METATOOLS, INC.
 
           CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
              FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
 
<TABLE>
<CAPTION>
                              SERIES A                              PAID-IN       NOTES                        TOTAL
                           PREFERRED STOCK       COMMON STOCK       CAPITAL     RECEIVABLE                 STOCKHOLDERS'
                          ------------------  ------------------- -----------      FROM      ACCUMULATED      EQUITY
                           SHARES    AMOUNT     SHARES    AMOUNT    AMOUNT     STOCKHOLDERS   (DEFICIT)      (DEFICIT)
                          --------  --------  ----------  ------- -----------  ------------  ------------  -------------
<S>                       <C>       <C>       <C>         <C>     <C>          <C>           <C>           <C>
Balances at December 31,
 1993...................   841,000  $841,000   3,200,000  $ 3,000 $    64,000  $   (10,000)  $ (1,353,000)  $  (455,000)
Issuance of common stock
 to employees in
 exchange for services..       --        --       28,500      --        2,000          --             --          2,000
Repurchase of common
 stock..................       --        --     (100,000)     --       (3,000)         --             --         (3,000)
Amortization of costs
 related to the issuance
 of mandatory redeemable
 Series B preferred
 stock..................       --        --          --       --          --           --         (99,000)      (99,000)
Preferred stock dividend
 requirement............       --        --          --       --          --           --        (140,000)     (140,000)
Notes receivable from
 stockholders...........       --        --          --       --          --      (435,000)           --       (435,000)
Net loss................       --        --          --       --          --           --      (2,212,000)   (2,212,000)
                          --------  --------  ----------  ------- -----------  -----------   ------------   -----------
Balances at December 31,
 1994...................   841,000   841,000   3,128,500    3,000      63,000     (445,000)    (3,804,000)   (3,342,000)
Issuance of common stock
 upon the exercise of
 warrants...............       --        --      612,533    1,000      54,000          --             --         55,000
Issuance of common stock
 upon the exercise of
 stock options..........       --        --       13,125      --       12,000          --             --         12,000
Repurchase of common
 stock..................       --        --       (5,750)     --          --           --             --            --
Amortization of costs
 related to the issuance
 of mandatory redeemable
 Series B preferred
 stock..................       --        --          --       --          --           --         (89,000)      (89,000)
Reversal of preferred
 stock dividend
 requirement in
 connection with
 conversion of Series B
 preferred stock........       --        --          --       --     (140,000)         --         140,000           --
Conversion of Series A
 preferred stock........  (841,000) (841,000)  1,682,000    2,000     839,000          --             --            --
Conversion of Series B
 preferred stock........       --        --    3,390,000    3,000   8,445,000          --             --      8,448,000
Issuance of common
 stock, net of offering
 costs totaling
 $1,337,000.............       --        --    2,777,500    3,000  45,156,000          --             --     45,159,000
Repayment of notes
 receivable from
 stockholders...........       --        --          --       --          --       445,000            --        445,000
Net loss................       --        --          --       --          --           --        (500,000)     (500,000)
                          --------  --------  ----------  ------- -----------  -----------   ------------   -----------
Balances at December 31,
 1995...................       --        --   11,597,908   12,000  54,429,000          --      (4,253,000)   50,188,000
Issuance of common stock
 upon the exercise of
 stock options..........       --        --      295,953      --      636,000          --             --        636,000
Issuance of common stock
 in connection with the
 employee stock purchase
 plan...................       --        --        8,232      --      126,000          --             --        126,000
Issuance of common
 stock..................       --        --       19,635      --      138,000          --             --        138,000
Issuance of common stock
 in connection with the
 acquisition of Real
 Time Geometry Corp.....       --        --    1,331,856    1,000  11,241,000          --             --     11,242,000
Tax benefit related to
 stock options..........       --        --          --       --      740,000          --             --        740,000
Notes receivable from
 stockholders...........       --        --          --       --          --    (3,000,000)           --     (3,000,000)
Net loss................       --        --          --       --          --           --      (9,239,000)   (9,239,000)
                          --------  --------  ----------  ------- -----------  -----------   ------------   -----------
Balances at December 31,
 1996...................       --   $    --   13,253,584  $13,000 $67,310,000  $(3,000,000)  $(13,492,000)  $50,831,000
                          ========  ========  ==========  ======= ===========  ===========   ============   ===========
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       33
<PAGE>
 
                                METATOOLS, INC.
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
 
<TABLE>
<CAPTION>
                                              YEARS ENDED DECEMBER 31,
                                        --------------------------------------
                                            1996         1995         1994
                                        ------------  -----------  -----------
<S>                                     <C>           <C>          <C>
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss..............................  $ (9,239,000) $  (500,000) $(2,212,000)
Adjustments to reconcile net loss to
 net cash used in operating
 activities:
  Write-off of acquired in-process
   technology.........................    13,623,000          --           --
  Deferred income taxes...............      (746,000)         --           --
  Depreciation and amortization.......       786,000      305,000       64,000
  Provision for losses on receivables
   and returns........................     2,614,000    1,885,000    1,519,000
  Provision for losses on inventory...       221,000      359,000      175,000
  Issuance of common stock to
   employees in exchange for services.           --           --         2,000
  Changes in operating assets and
   liabilities:
    Accounts receivable...............    (9,931,000)  (1,788,000)  (3,276,000)
    Inventories.......................       439,000     (668,000)    (613,000)
    Prepaid expenses and other assets.      (497,000)    (642,000)     147,000
    Accounts payable and accrued
     expenses.........................     1,365,000      920,000      410,000
    Royalties payable.................      (186,000)      37,000      360,000
                                        ------------  -----------  -----------
      Net cash used in operating
       activities.....................    (1,551,000)     (92,000)  (3,424,000)
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property and equipment...    (1,672,000)  (1,156,000)    (614,000)
Purchases of software technology and
 product rights.......................      (125,000)    (395,000)         --
Purchases of short-term investments...   (50,938,000)         --           --
Proceeds from maturities of short-term
 investments..........................    30,342,000          --           --
Payment in connection with
 acquisition..........................      (139,000)         --           --
Purchase of certificate of deposit--
 restricted use.......................           --           --      (240,000)
Sale of certificate of deposit--
 restricted use.......................           --       240,000          --
                                        ------------  -----------  -----------
      Net cash used in investing
       activities.....................   (22,532,000)  (1,311,000)    (854,000)
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from bank note payable.......           --       415,000      340,000
Repayment of bank note payable........           --      (815,000)         --
Repayment of notes payable to
 stockholders.........................    (1,477,000)         --      (537,000)
Increase in notes receivable from
 stockholders.........................    (3,000,000)         --      (435,000)
Repayment of notes receivable from
 stockholders.........................           --       445,000          --
Proceeds from exercise of stock
 warrants and options.................       636,000       67,000          --
Net proceeds from issuance of
 preferred stock......................           --           --     7,795,000
Net proceeds from issuance of common
 stock................................           --    45,159,000          --
Payment for repurchase of common
 stock................................           --           --        (3,000)
                                        ------------  -----------  -----------
      Net cash (used in) provided by
       financing activities...........    (3,841,000)  45,271,000    7,160,000
                                        ------------  -----------  -----------
Net (decrease) increase in cash and
 cash equivalents.....................   (27,924,000)  43,868,000    2,882,000
Cash and cash equivalents at beginning
 of period............................    46,885,000    3,017,000      135,000
                                        ------------  -----------  -----------
Cash and cash equivalents at end of
 period...............................  $ 18,961,000  $46,885,000  $ 3,017,000
                                        ============  ===========  ===========
</TABLE>
 
                                                  (Table continued on next page)
 
                                       34
<PAGE>
 
                                METATOOLS, INC.
 
                CONSOLIDATED STATEMENT OF CASH FLOWS (CONTINUED)
 
<TABLE>
<CAPTION>
                                                   YEARS ENDED DECEMBER 31,
                                                -------------------------------
                                                   1996        1995      1994
                                                ----------- ---------- --------
<S>                                             <C>         <C>        <C>
SUPPLEMENTAL DISCLOSURE OF CASH FLOW
 ACTIVITIES
Cash paid during the year for interest........  $       --  $   96,000 $ 93,000
Cash paid during the year for income taxes....    1,377,000        --       --
SUPPLEMENTAL DISCLOSURES OF NON-CASH
 ACTIVITIES
Issuance of common stock and stock options in
 connection with acquisition of Real Time
 Geometry Corp................................  $11,849,000 $      --  $    --
Net liabilities acquired in connection with
 acquisitions of Dive Laboratories, Inc. and
 Real Time Geometry Corp.:
  Property and equipment......................      498,000        --       --
  Prepaid expenses and other assets...........       33,000        --       --
  Accounts payable and accrued expenses.......      689,000        --       --
  Notes payable to stockholder................    1,477,000        --       --
Issuance of common stock in connection with
 employee stock purchase plan.................      126,000        --       --
Issuance of common stock in exchange for
 software technology and product rights.......      138,000        --       --
Tax benefit related to stock options..........      740,000        --       --
Covenant not-to-compete with an officer of the
 Company......................................      600,000        --       --
Conversion of Series B redeemable convertible
 preferred stock to common stock..............          --   8,448,000      --
Conversion of Series A convertible preferred
 stock to common stock........................          --     841,000      --
Reversal of preferred stock dividend
 requirement in connection with conversion of
 Series B redeemable convertible preferred
 stock........................................          --     140,000      --
Issuance of Series B redeemable convertible
 preferred stock in exchange for reduction of
 notes payable to stockholders................          --         --   325,000
Issuance of Series B redeemable convertible
 preferred stock in exchange for services
 relating to equity funding received..........          --         --   250,000
</TABLE>
 
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       35
<PAGE>
 
                                METATOOLS, INC.
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
1. BUSINESS AND ORGANIZATION
 
  The consolidated financial statements include the accounts of MetaTools,
Inc. (the "Company") and its wholly-owned subsidiaries. All significant
intercompany accounts and transactions have been eliminated in consolidation.
 
  MetaTools is a leading designer of visual computing and graphics software
and technologies for professionals and consumers for Windows, Macintosh and
other digital editing operating systems. MetaTools designs, develops,
publishes, markets and supports visual computing software tools and
technologies for the creation, editing, and manipulation of computer graphic
images, digital art, and Internet/online content.
 
  The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. The Company monitors the activities of its distributors in
an effort to minimize excessive returns and establishes its reserves based on
its estimates of expected returns. While historically the Company's returns
have been within expectations, the establishing of reserves requires judgments
regarding such factors as future competitive conditions and product life
cycles, which can be difficult to predict. Actual results could differ from
those estimates.
 
  The computer graphic imaging and visual computing markets, and the personal
computer industry in general, are characterized by rapidly changing
technology, resulting in short product life cycles and price declines. The
Company must continuously update its existing products to keep them current
with changing technology and must develop new products to take advantage of
new technologies that could render the Company's existing products obsolete.
The Company's future prospects are highly dependent on its ability to keep
pace with its competitors' innovations, to adapt to new operating systems,
hardware platforms and emerging industry standards, and to provide additional
functionality to the Company's existing products. The inability of the Company
to develop and introduce such products in a timely manner would have a
material adverse effect on the Company's future business, operating results,
financial condition, and cash flows.
 
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
REVENUE RECOGNITION
 
  The Company recognizes revenue in accordance with Statement of Position 91-1
("SOP 91-1"), "Software Revenue Recognition," issued by the American Institute
of Certified Public Accountants. Product revenues are recognized upon shipment
to the customer, satisfaction of significant Company obligations, if any, and
reasonable assurance regarding the collectability of the corresponding
receivable. At the time of shipment, the Company accrues for the estimated
cost of post contract support in accordance with SOP 91-1. The Company
provides an allowance for estimated returns at the time of product shipment
and adjusts this allowance as needed based on actual returns history. At
December 31, 1996 and 1995, the Company had an allowance for potential returns
of approximately $817,000 and $601,000, respectively.
 
  The Company has entered into agreements whereby it licenses products to
original equipment manufacturers and foreign publishers which provide such
customers the right to produce and distribute multiple copies of its software.
Nonrefundable fixed fees are recognized as revenue at delivery of the product
master to the customer, satisfaction of significant Company obligations, if
any, and reasonable assurance regarding the collectability of the
corresponding receivable. Per copy royalties in excess of fixed amounts are
recognized as revenue when such amounts exceed fixed minimum royalties.
 
                                      36
<PAGE>
 
                                METATOOLS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
INVENTORIES
 
  Inventories consist of finished products and software components, primarily
instruction manuals, diskettes, CD ROMs and packaging ready for assembly. The
Company periodically evaluates the carrying value of its inventories,
including a review for potentially excess or obsolete products, and adjusts
these as necessary. At December 31, 1996 and 1995, the Company had reserves of
approximately $211,000 and $534,000, respectively, for potentially excess or
obsolete inventory items. Inventories are stated at the lower of cost or
market, with cost determined using the first-in, first-out method.
 
PROPERTY AND EQUIPMENT
 
  Property and equipment are stated at cost. Assets are depreciated on the
straight-line method over their estimated useful lives, which range from 3 to
7 years. Leasehold improvements are amortized over the shorter of the life of
the lease or the life of the asset. Upon sale, any gain or loss is included in
the consolidated statement of operations. Maintenance and minor replacements
are expensed as incurred.
 
RESEARCH AND DEVELOPMENT
 
  Research and development costs are expensed as incurred.
 
SOFTWARE DEVELOPMENT COSTS
 
  The Company accounts for its software development costs in accordance with
Statement of Financial Accounting Standard ("SFAS") No. 86, "Accounting for
the Costs of Computer Software to be Sold, Leased or Otherwise Marketed." This
statement provides for capitalization of certain software development costs
once technological feasibility is established. The costs so capitalized are
then amortized on a straight-line basis over the estimated product life
(generally eighteen months to three years), or on the ratio of current revenue
to total projected product revenues, whichever is greater. To date, the
establishment of technological feasibility of the Company's products and
general release have substantially coincided. As a result, the Company has not
capitalized any internal software development costs since costs qualifying for
such capitalization have not been significant.
 
ADVERTISING
 
  The Company reports the costs of all advertising as expenses in the periods
in which those costs are incurred. The Company shares portions of certain
distributors' advertising expenses through co-op advertising arrangements.
 
  Advertising expense was approximately $3,384,000, $2,453,000, and $1,328,000
for the years ended December 31, 1996, 1995, and 1994, respectively.
 
CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS
 
  The Company considers all highly liquid investments purchased with an
original maturity of three months or less to be cash equivalents.
 
  The Company considers its investment portfolio available for sale as defined
in SFAS No. 115. The amortized cost of securities, which approximate market
value at December 31, 1996, are adjusted for amortization of premiums and
accretion of discounts to maturity. Such amortization, realized gains and
losses, interest and dividends, and declines in value judged to be other than
temporary are included in investment income. The cost of securities sold is
based on the specific identification method.
 
                                      37
<PAGE>
 
                                METATOOLS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
  The Company invests its cash in accordance with a policy that seeks to
maximize returns while ensuring both liquidity and minimal risk of principal
loss. The policy limits investments to certain types of instruments issued by
institutions with investment grade credit ratings, and places restrictions on
maturities and concentration by type and issuer. The majority of the Company's
portfolio is composed of fixed income investments which are subject to the
risk of market interest rate fluctuations, and all of the Company's
investments are subject to risks associated with the ability of the issuers to
perform their obligations under the instruments.
 
ROYALTY EXPENSE
 
  The Company licenses certain third-party software and code for inclusion in
its products. Royalties are payable to developers of the software or code at
various rates and amounts, generally based on net unit sales or net revenues.
These agreements may include royalty advances against future expected sales,
which advances are recorded as prepaid expenses until such royalties are
earned. Royalty expense, which is included as a component of cost of revenues,
amounted to approximately $895,000, $1,670,000, and $1,312,000 for the years
ended December 31, 1996, 1995, and 1994, respectively.
 
MAJOR CUSTOMERS AND CREDIT RISK
 
  The Company sells its retail products domestically through unaffiliated
distributors and original equipment manufacturers, as well as directly to end-
users. International sales are generally made through distributors in each of
the foreign countries in which the Company markets its products. Credit is
extended based on an evaluation of each customer's financial condition, and
generally collateral is not required. Estimated credit losses and returns, if
any, have been provided for in the financial statements and have generally
been within management's expectations. At December 31, 1996 and 1995, the
Company has an allowance for doubtful accounts of approximately $422,000 and
$402,000, respectively.
 
  For the years ended December 31, 1996, 1995, and 1994, one of the Company's
major domestic distributors accounted for approximately 18%, 26%, and 12% of
net revenues, respectively, and another major domestic distributor accounted
for approximately 2%, 4%, and 10% of net revenues, respectively. Revenues from
international customers, primarily in Western Europe and Japan, accounted for
approximately 36%, 28%, and 18%, of net revenues, for the years ended
December 31, 1996, 1995 and 1994, respectively. Revenues from one of the
international customers included in the above amount accounted for
approximately 15% of net revenues in 1996 and 1% in 1995, while another
international customer, to which the Company did not sell in 1996, accounted
for approximately 11% of net revenues in 1995.
 
  At December 31, 1996, and periodically throughout 1994 to December 31, 1996,
the Company has maintained balances with various financial institutions in
excess of the federally insured limits.
 
FOREIGN CURRENCY TRANSLATION
 
  The Company uses the U.S. dollar as its functional currency. Financial
statements of the Company's foreign subsidiaries are translated to U.S.
dollars for consolidation purposes using current rates of exchange for
monetary assets and liabilities and historical rates of exchange for
nonmonetary assets and related elements of expense. Sales and other expense
elements are translated at rates that approximate the rates in effect on the
transaction dates. Gains and losses from this process are included in the
Company's consolidated statement of operations.
 
INCOME TAXES
 
  The Company accounts for income taxes using the liability method as required
by SFAS No. 109, "Accounting for Income Taxes." Under SFAS No. 109, deferred
taxes are determined based on the differences between the financial statement
and tax bases of assets and liabilities, using enacted tax rates in effect for
the year in which the differences are expected to reverse. Valuation
allowances are established when necessary to reduce deferred tax assets to the
amounts expected to be realized.
 
                                      38
<PAGE>
 
                                METATOOLS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
STOCK-BASED COMPENSATION
 
  The Company grants stock options for a fixed number of shares to employees
with an exercise price equal to the fair value of the shares at the date of
grant. The Company accounts for stock option grants in accordance with APB
Opinion No. 25, "Accounting for Stock Issued to Employees," and accordingly,
recognizes no compensation expense for the stock option grants.
 
  SFAS No. 123, "Accounting for Awards of Stock-Based Compensation to
Employees," provides alternative accounting treatment to APB Opinion No. 25
with respect to stock-based compensation and requires certain additional
disclosures, including disclosures if the Company elects not to adopt the
accounting measurement requirements of SFAS No. 123. The Company has elected
not to adopt the accounting measurement requirements of SFAS No. 123 for stock
options granted to employees; however, the Company has provided the required
additional disclosures in the footnotes to the consolidated financial
statements.
 
NET INCOME (LOSS) PER COMMON SHARE
 
  Net income (loss) per common share is computed using the weighted average
number of shares of common stock and common equivalent shares outstanding.
Common equivalent shares related to stock options, warrants and preferred
stock are excluded from the computation when their effect is antidilutive,
except that, pursuant to the Securities and Exchange Commission Staff
Accounting Bulletins, common and common equivalent shares, issued at prices
below the public offering price during the twelve months immediately preceding
the initial filing date of the Company's initial public offering have been
included in the calculation as if they were outstanding for all periods
presented, using the treasury stock method and the initial public offering
price. The net income (loss) attributable to common stockholders excludes the
impact of approximately $192,000 and $21,000 for the years ended December 31,
1995 and 1994, respectively, which represents the preferred stock dividend on
redeemable convertible preferred stock issued within the twelve-month period
immediately preceding the initial filing (2,044,000 shares) as these shares
were included in the determination of the number of shares used in the per
share calculations.
 
RECLASSIFICATIONS
 
  Certain reclassifications have been made to the 1995 consolidated financial
statements to conform to the 1996 presentation.
 
3. ACQUISITIONS
 
DIVE LABORATORIES
 
  On August 31, 1996, the Company acquired Dive Laboratories, Inc. ("Dive"), a
privately held company based in Santa Cruz, California, developing 3D modeling
and rendering environments for high-end applications and the visualization of
streaming online data. In connection with the acquisition, which was accounted
for under the purchase method of accounting, the Company recorded a one-time
charge to earnings of approximately $733,000, comprised of relocation expenses
of $215,000, acquisition costs of $155,000, and in-process research and
development expenses of $363,000, for the year ended December 31, 1996. The
Company paid $509,000 in cash and assumed $224,000 of net liabilities of Dive.
The operating results of Dive have been included in the accompanying
consolidated financial statements from the date of acquisition.
 
REAL TIME GEOMETRY
 
  On December 31, 1996, the Company completed the acquisition of Real Time
Geometry Corp. ("RTG"), a privately held development stage company based in
Princeton, New Jersey, developing real time 3D graphics and visualization
technologies. The acquisition was accounted for by the Company under the
purchase method
 
                                      39
<PAGE>
 
                                METATOOLS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
       
of accounting. Under the terms of the Purchase Agreement, the stockholders and
optionholders of RTG received a combination of shares of the Company's common
stock and options to purchase shares of the Company's common stock valued at
approximately $11,242,000 and $607,000, respectively, at December 31, 1996,
the closing date. In addition, the Company assumed the net liabilities of RTG,
which totaled $1,411,000 at December  31, 1996. As of December 31, 1996,
neither technological feasibility nor commercial viability had been reached
with regard to RTG's core technology, comprised of advanced geometry-based
algorithms which transform images in real-time to a series of triangles to
produce three-dimensional images. Based upon projected future cash flows,
risk-adjusted using a 40% discount rate, RTG's core in-process technology was
valued in excess of the amount written-off as acquired in-process technology
of $13,260,000, which combined with acquisition costs totaling $1,189,000,
resulted in a one time charge to earnings of $14,449,000 for the year ended
December 31, 1996.      
 
  The operating results of RTG have been included in the accompanying
consolidated financial statements from the date of acquisition. The following
unaudited pro forma information presents a summary of the consolidated results
of operations of the Company and RTG as if the acquisition had taken place on
February 1, 1996 (date of inception of RTG). In management's opinion, the
following unaudited pro forma consolidated information is not indicative of
the actual results that would have occurred had the acquisition been
consummated on February 1, 1996 or of future operations of the consolidated
entities under the ownership and management of the Company:
 
<TABLE>
<CAPTION>
                                                                    (UNAUDITED)
                                                                     YEAR ENDED
                                                                    DECEMBER 31,
                                                                        1996
                                                                    ------------
      <S>                                                           <C>
      Net sales.................................................... $28,035,000
      Net income...................................................   3,150,000
      Net income per common share..................................         .22
</TABLE>
 
4. INVESTMENTS
 
  The Company considers its investment portfolio available-for-sale as defined
in SFAS No. 115. There were no material gross realized or unrealized gains or
losses nor any material differences between the estimated fair values and
costs of securities in the investment portfolio at December 31, 1996. The cost
of the investment portfolio by type of security, contractual maturity, and its
classification in the balance sheet, is a follows:
 
<TABLE>
<CAPTION>
                                                             DECEMBER 31,
                                                        -----------------------
                                                           1996        1995
                                                        ----------- -----------
      <S>                                               <C>         <C>
      Type of security:
        Corporate debt securities...................... $24,491,000 $42,817,000
        U.S. Treasury securities.......................  14,183,000         --
        Money market funds.............................     324,000   3,380,000
        Certificates of deposit........................         --      251,000
                                                        ----------- -----------
                                                        $38,998,000 $46,448,000
                                                        =========== ===========
      Contractual maturity:
        Due in one year or less........................ $26,726,000 $46,448,000
        Due in one to three years......................  12,272,000         --
                                                        ----------- -----------
                                                        $38,998,000 $46,448,000
                                                        =========== ===========
</TABLE>
 
                                      40
<PAGE>
 
                                METATOOLS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
<TABLE>
<CAPTION>
                                                           DECEMBER 31,
                                                      ------------------------
                                                         1996         1995
                                                      -----------  -----------
      <S>                                             <C>          <C>
      Classification in balance sheet:
        Cash and cash equivalents.................... $18,961,000  $46,885,000
        Marketable securities........................  20,596,000          --
                                                      -----------  -----------
                                                       39,557,000   46,885,000
        Less cash....................................     559,000      437,000
                                                      -----------  -----------
                                                      $38,998,000  $46,448,000
                                                      ===========  ===========
 
5. INVENTORIES
 
  Inventories consist of the following:
 
<CAPTION>
                                                           DECEMBER 31,
                                                      ------------------------
                                                         1996         1995
                                                      -----------  -----------
      <S>                                             <C>          <C>
        Finished goods............................... $   229,000  $   488,000
        Materials and supplies.......................      23,000      424,000
                                                      -----------  -----------
                                                      $   252,000  $   912,000
                                                      ===========  ===========
 
6. PROPERTY AND EQUIPMENT
 
  Property and equipment consist of the following:
 
<CAPTION>
                                                           DECEMBER 31,
                                                      ------------------------
                                                         1996         1995
                                                      -----------  -----------
      <S>                                             <C>          <C>
        Computer equipment........................... $ 3,125,000  $ 1,410,000
        Office furniture and equipment...............     991,000      600,000
        Leasehold improvements.......................      64,000          --
                                                      -----------  -----------
                                                        4,180,000    2,010,000
        Less accumulated depreciation and
         amortization................................  (1,057,000)    (433,000)
                                                      -----------  -----------
                                                      $ 3,123,000  $ 1,577,000
                                                      ===========  ===========
 
7. ACCRUED EXPENSES
 
  Accrued expenses consist of the following:
 
<CAPTION>
                                                           DECEMBER 31,
                                                      ------------------------
                                                         1996         1995
                                                      -----------  -----------
      <S>                                             <C>          <C>
        Accrued compensation......................... $ 1,283,000  $   378,000
        Accrued acquisition costs....................     790,000          --
        Covenant not-to-compete......................     600,000          --
        Accrued advertising..........................      48,000      195,000
        Other accrued expenses.......................     806,000      293,000
                                                      -----------  -----------
                                                      $ 3,527,000  $   866,000
                                                      ===========  ===========
</TABLE>
 
                                       41
<PAGE>
 
                                METATOOLS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
8. RELATED PARTY TRANSACTIONS
 
  In April 1993, the Series A Preferred stockholders, an officer and certain
directors loaned $725,000 to the Company as bridge financing until the Series
B Redeemable Convertible Preferred Stock ("Series B Preferred") financing was
completed in February 1994. The loans were convertible into Series B Preferred
at the same purchase price paid by the other Series B Preferred stockholders,
or the loans would begin accruing interest at 6% per annum until paid. A
portion of the above bridge financing totaling $325,000 was converted into
Series B Preferred at $2.50 per share and the remaining amounts were repaid,
including interest totaling $22,000. Further, each Series B Preferred investor
who converted a loan into shares received Series C Warrants, as described in
Note 10.
 
  Additional officer/stockholder loans in the amount of $137,000 were repaid
in 1994.
 
  In 1994, the Company loaned $435,000 to an officer and director of the
Company to relocate his residence, against which he had pledged his stock in
the Company. The loans, consisting of $80,000 at the prime interest rate and
$355,000 at 7% per annum, were repaid during December 1995. Further, the
Company leases space for development activities at this officer's residence at
a rental rate of $2,500 per month.
 
  A director of the Company rendered services to the Company for which he
received $44,000, $42,000, and $30,000 in each of 1996, 1995, and 1994.
 
  In connection with the acquisition of RTG on December 31, 1996 (Note 3), the
Company entered into a noncompetition agreement with one of RTG's founders who
is now an officer of the Company. The agreement, which carries a term of four
years, provides for payments to the officer in the amount of $450,000 in 1997
and $150,000 in 1998. In addition, the Company loaned $2,000,000 and
$1,000,000 to two founders of RTG, who are now officers of the Company. The
loans accrue interest semi-annually at 5.67% and are payable on December 31,
1999. The loans, which are classified as a component of stockholders' equity,
are collateralized by shares of common stock of the Company owned by the
officers.
 
9. NOTES PAYABLE TO BANK
 
  In September 1994, the Company entered into a credit facility (the
"Facility") with its principal lending institution (the "Bank"); the Facility
was collateralized by substantially all of the Company's assets. The Facility
enabled the Company to borrow up to $500,000 as a Term Loan (the "Term Loan")
for new equipment purchased through March 1995 and also included a Line of
Credit (the "Line") under which borrowings could be made based upon eligible
accounts receivable (as defined), up to aggregate amount of $1 million. The
Term Loan accrued interest at 2% above the Bank's prevailing prime interest
rate and the Line accrued interest at 1.5% above the Bank's prevailing prime
interest rate. Borrowings under both the Term Loan and the Line were repaid in
December 1995.
 
  In December 1995, the Company amended its Facility (the "Amended Facility")
with the Bank, increasing available borrowings under the Line to $3 million
and decreasing interest on borrowings under the Line to the Bank's prevailing
prime interest rate. Additionally, the Amended Facility revised the Line to
provide for a $500,000 letter of credit subfacility and a $250,000 foreign
exchange contract subfacility. There were no borrowings against the Line
during the year ended December 31, 1996. In addition, there were no
outstanding letters of credit or foreign exchange contracts at December 31,
1996. The Amended Facility expires in November 1997, if not renewed. Interest
expense for the years ended December 31, 1995 and 1994 totaled $96,000 and
$71,000, respectively. The weighted average interest rate for the years ended
December 31, 1995 and 1994 were 10.8% and 8.6% per annum, respectively.
 
  The Amended Facility contains certain covenants which provide, among other
things, a restriction on dividend payments and the requirement for the
maintenance of certain measures of liquidity and equity.
 
                                      42
<PAGE>
 
                                METATOOLS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
10. STOCKHOLDER'S EQUITY
 
SERIES A CONVERTIBLE PREFERRED STOCK
 
  At December 31, 1994, the Company had authorized 841,000 shares of Series A
Convertible Preferred Stock ("Series A Preferred"), of which 841,000 shares
were issued and outstanding. The Series A Preferred was entitled to
noncumulative, quarterly dividends, if earned and declared, commencing March
1, 1994 at a rate of $0.0125 per share. The Series A Preferred was convertible
into common stock at the rate of two shares of common stock for each share of
preferred stock, had voting rights equal to its common stock conversion, voted
with the common stock and carried a stated value of $1.00 per share and a
liquidation preference of $1.00 per share, plus any dividends declared and
unpaid. During 1995, 841,000 shares of Series A Preferred were converted into
1,682,000 shares of common stock. No shares of Series A Preferred were
authorized at December 31, 1996.
 
SERIES A AND B WARRANTS
 
  The Company had issued 54,000 Series A and 54,000 Series B Warrants to
purchase common stock. During 1995, 54,000 Series A and 54,000 Series B
Warrants were exercised for the purchase of 105,033 net shares of common stock
at $1.00 per share.
 
SERIES C WARRANTS
 
  The Company had authorized and issued 510,000 Series C Warrants to purchase
common stock as follows:
 
  .  In June 1993 and January 1994, the Company issued 100,000 and 20,000
     warrants, respectively, to officers and directors of the Company for
     significant contributions relating to development of the Company's
     products and obtaining a line of credit.
 
 
  .  In February 1994, the Company issued 130,000 warrants to the Series B
     Preferred holders who had converted their bridge loans as discussed in
     Note 8.
 
  .  In January and September 1994, the Company issued 220,000 and 40,000
     warrants, respectively, to a director of the Company as consideration
     for his agreement to extend his bridge loan to the Company and for the
     subordination of such loan in favor of notes payable to a bank (Note 8).
 
  During 1995, 510,000 Series C Warrants were exercised for the purchase of
481,667 net shares of common stock at $1.00 per share.
 
OTHER WARRANTS
 
  In September 1994, the Company issued 30,000 warrants to a bank to purchase
shares of Series B Preferred at a purchase price of $2.50 per share. During
1995, 30,000 warrants were exercised for the purchase of 25,833 net shares of
common stock at $2.50 per share.
 
11. EMPLOYEE BENEFIT PLANS
 
EMPLOYEE STOCK PURCHASE PLAN
 
  The Company's 1995 Employee Stock Purchase Plan (the "1995 Purchase Plan"),
which is qualified under Section 423 of the Internal Revenue Code of 1986, as
amended, permits eligible employees of the Company, via payroll deductions, to
purchase shares of the Company's common stock semi-annually at 85 percent of
the market price, on either the purchase date or the offering date, whichever
is lower. As of December 31, 1996, 8,232 shares of common stock have been
issued under the 1995 Purchase Plan. At December 31, 1996, an aggregate of
141,768 shares of common stock were reserved for future issuance under the
1995 Purchase Plan.
 
                                      43
<PAGE>
 
                                METATOOLS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
401(k) PLAN
 
  In September 1995, the Company adopted a Defined Contribution Plan (the
"401(k) Plan"). Participation in the 401(k) Plan is available to substantially
all employees. Employees can contribute up to 15% of their salary, up to the
Federal maximum allowable limit, on a before tax basis to the 401(k) Plan.
Company contributions to the 401(k) Plan are discretionary. The Company did
not make any contributions to the 401(k) Plan during the years ended December
31, 1996 and 1995.
 
STOCK OPTION PLANS (THE "PLANS")
 
 1992 Incentive Stock Option Plan
 
  The Company's 1992 Incentive Stock Option Plan (the "1992 Plan") provides
for the grant to employees of incentive stock options and nonstatutory stock
options and for the sale or award of restricted common stock to employees and
consultants of the Company. As of December 31, 1996, options to purchase an
aggregate of 718,000 shares of common stock were outstanding under the 1992
Plan, with vesting provisions ranging up to five years. At December 31, 1996,
no shares of common stock were reserved for additional grants of options or
awards of restricted stock under the 1992 Plan.
 
 1994 Incentive Stock Option, Non-Qualified Stock Option and Restricted Stock
Purchase Plan
 
  The Company's 1994 Incentive Stock Option, Non-Qualified Stock Option and
Restricted Stock Purchase Plan (the "1994 Plan") provides for the grant to
employees of incentive stock options and nonstatutory stock options and for
the sale of restricted common stock to employees and consultants of the
Company, with vesting provisions ranging up to five years. As of December 31,
1996, options to purchase an aggregate of 644,000 shares of common stock were
outstanding under the 1994 Plan. At December 31, 1996, no shares of common
stock were reserved for additional grants of options or awards of restricted
stock under the 1994 Plan.
 
 1995 Stock Plan
 
  The Company's 1995 Stock Plan (the "1995 Plan") provides for the grant to
employees (including officers and employee directors) of incentive stock
options and for the grant to employees (including officers and employee
directors) and consultants of nonstatutory stock options and stock purchase
rights. As of December 31, 1996, options to purchase an aggregate of 429,000
shares of common stock have been granted under the 1995 Plan, with vesting
provisions ranging up to four years. At December 31, 1996, an aggregate of
70,000 shares of common stock were reserved for future issuance under the 1995
Plan.
 
 1995 Director Option Plan
 
  The Company's 1995 Director Option Plan (the "Director Plan") provides for
an automatic grant of options to purchase shares of common stock to each non-
employee director of the Company. As of December 31, 1996, 15,000 options have
been granted under the 1995 Director Plan. At December 31, 1996, an aggregate
of 135,000 shares of common stock were reserved for future issuance under the
1995 Director Plan.
 
 1996 Dive Option Plan
 
  In connection with the acquisition of Dive in August 1996 (Note 3), the
Company issued options to purchase an aggregate of 211,000 shares of common
stock to the previous stockholders and employees of Dive (the "Dive Option
Plan"). The non-statutory stock options vest over four years. At December 31,
1996, no shares of common stock were reserved for future issuance under the
Dive Option Plan.
 
 
                                      44
<PAGE>
 
                                METATOOLS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 1996 Nonstatutory Stock Option Plan
 
  The Company's 1996 Nonstatutory Stock Option Plan (the "1996 Nonstatutory
Plan") provides for the grant to employees (including officers and employee
directors) and consultants of nonstatutory stock options and stock purchase
rights. As of December 31, 1996, options to purchase an aggregate of 1,099,000
shares of common stock have been granted under the 1996 Nonstatutory Plan,
with vesting provisions ranging up to four years. At December 31, 1996, an
aggregate of 201,000 shares of common stock were reserved for future issuance
under the 1996 Nonstatutory Plan.
 
 Common Stock Issued Under Plans
 
  In 1994, 28,000 shares of common stock were issued at $0.065 per share and
100,000 shares were repurchased at prices ranging from $0.025 to $0.065 per
share (original issuance prices). The above issuances of common stock were in
exchange for services rendered by employees.
 
  In addition, in January 1994 the Company issued 500 shares of common stock
at $0.50 per share outside the Stock Option Plans in exchange for services
rendered.
 
 Options Issued Under Plans
 
  The Company has adopted the disclosure-only option under SFAS No. 123,
"Accounting for Stock Based Compensation," as of December 31, 1996. The
following summarizes activity in the Plans for the years ended December 31,
1994, 1995, and 1996:
 
<TABLE>
<CAPTION>
                                                        OPTIONS OUTSTANDING
                                                      -------------------------
                                           OPTIONS                  WEIGHTED
                                        AVAILABLE FOR NUMBER OF     AVERAGE
                                            GRANT      SHARES    EXERCISE PRICE
                                        ------------- ---------  --------------
<S>                                     <C>           <C>        <C>
Options outstanding at December 31,
 1993..................................     973,000      55,000      $  .50
  Shares reserved under new plans......   1,089,000         --          --
  Granted--exercise price equal to fair
   value...............................    (834,000)    834,000        1.00
  Exercised............................         --          --          --
  Canceled.............................         --          --          --
                                         ----------   ---------      ------
Options outstanding at December 31,
 1994..................................   1,228,000     889,000         .97
  Shares reserved under new plans......     650,000         --          --
  Reduction in shares reserved under
   plans...............................    (358,000)        --          --
  Granted--exercise price equal to fair
   value...............................  (1,095,000)  1,095,000        5.68
  Exercised............................          --     (13,000)        .92
  Canceled.............................     124,000    (124,000)       2.56
                                         ----------   ---------      ------
Options outstanding at December 31,
 1995..................................     549,000   1,847,000        3.66
  Shares reserved under new plans......   1,511,000         --          --
  Reduction in shares reserved under
   plans...............................     (89,000)        --          --
  Granted--exercise price equal to fair
   value...............................    (910,000)    910,000       15.11
  Granted--exercise price greater than
   fair value..........................    (809,000)    809,000       12.73
  Exercised............................         --     (296,000)       2.16
  Canceled.............................     154,000    (154,000)       8.90
                                         ----------   ---------      ------
Options outstanding at December 31,
 1996..................................     406,000   3,116,000      $ 9.23
                                         ==========   =========      ======
</TABLE>
 
 
                                      45
<PAGE>
 
                                METATOOLS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

  The following summarizes the weighted average fair value of options granted
during the years ended December 31, 1996 and 1995:
 
<TABLE>
<CAPTION>
                                                                   YEARS ENDED
                                                                  DECEMBER 31,
                                                                  -------------
                                                                   1996   1995
                                                                  ------ ------
      <S>                                                         <C>    <C>
      Exercise price equal to fair value......................... $ 9.72 $ 3.66
      Exercise price greater than fair value.....................   7.58    --
</TABLE>
 
  The following summarizes information about stock options outstanding at
December 31, 1996:
 
<TABLE>
<CAPTION>
                                          OUTSTANDING            EXERCISABLE
                                   -------------------------- ------------------
                                                     WEIGHTED           WEIGHTED
                                                     AVERAGE            AVERAGE
                                             AVERAGE EXERCISE           EXERCISE
EXERCISE PRICE RANGE                SHARES   LIFE(a)  PRICE    SHARES    PRICE
--------------------               --------- ------- -------- --------- --------
<S>                                <C>       <C>     <C>      <C>       <C>
$0.50--$1.00......................   718,000   7.72   $ 0.99    445,000  $ 0.99
$1.10--$11.75.....................   825,000   5.00   $ 6.55    262,000  $ 4.43
$12.50--$12.50....................   791,000  10.00   $12.50     96,000  $12.50
$13.75--$25.13....................   782,000   9.46   $16.32    244,000  $15.77
                                   ---------  -----   ------  ---------  ------
Total............................. 3,116,000   8.01   $ 9.23  1,047,000  $ 6.35
                                   =========  =====   ======  =========  ======
</TABLE>
--------
(a) Average contractual life remaining in years.
 
  The Company has accrued compensation expense of $607,000 for the difference
between the grant price and the deemed fair value of the common stock
underlying options, which are fully vested, issued in connection with the RTG
acquisition (Note 3) in December 1996.
 
  Pro forma information regarding net income and earnings per share is
required by SFAS No. 123, and has been determined as if the Company has
accounted for the Plans under the fair value method of the Statement. The fair
value of options issued under the Plans was estimated at the date of grant
using a Black-Scholes option pricing model with the following weighted average
assumptions for both 1995 and 1996: risk-free interest rate of 6.0%, no
dividend yield, volatility factor of the expected market price of the
Company's common stock of .80, and a weighted-average expected life of the
options of 4.3 years. For purposes of pro forma disclosures, the estimated
fair value of the options is amortized to expense over the options' vesting
period. The Company's pro forma net loss, net loss applicable to common
stockholders, and net loss per common share would approximate the following:
 
<TABLE>
<CAPTION>
                                                     AS REPORTED   PRO FORMA
                                                     -----------  ------------
<S>                                                  <C>          <C>
Year Ended December 31, 1996:
  Net loss.......................................... $(9,239,000) $(10,656,000)
  Net loss applicable to common stockholders........  (9,239,000)  (10,656,000)
  Net loss per common share.........................        (.78)         (.90)
Year Ended December 31, 1995:
  Net loss.......................................... $  (500,000) $   (720,000)
  Net loss applicable to common stockholders........    (589,000)     (809,000)
  Net loss per common share.........................        (.11)         (.15)
</TABLE>
 
  The effects of applying SFAS No. 123 in this proforma disclosure are not
indicative of future amounts. SFAS No. 123 does not apply to awards prior to
1995. The Company anticipates grants of additional awards in future years.
 
 
                                      46
<PAGE>
 
                                METATOOLS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
12. SERIES B REDEEMABLE CONVERTIBLE PREFERRED STOCK
 
  At December 31, 1994, the Company had authorized 3,600,000 shares of Series
B Preferred, of which 3,390,000 shares were issued and outstanding. The Series
B Preferred accrued cumulative, quarterly dividends, whether or not earned or
declared, commencing March 1, 1994 at a rate of $0.03125 per share. The Series
B Preferred was convertible into common stock of the Company at a conversion
rate of one share of common stock for each share of preferred, had voting
rights equal to its common stock conversion, voted with the common stock and
carried a stated value of $2.50 per share and a liquidation preference of
$2.50 per share plus any accrued and unpaid dividends, whether or not
declared. At the option of the majority of the holders of the Series B
Preferred, the Series B Preferred was redeemable by the Company based on
certain dates and terms. The Company recorded an increase in the value of the
Series B Preferred of $89,000 and $99,000 for December 31, 1995 and 1994,
respectively, for the amortization of costs related to the issuance of the
Series B Preferred. In addition, the Company recorded an increase in the value
of the Series B Preferred of $140,000 for December 31, 1994, for accrued and
unpaid dividends, which subsequently reversed in 1995 upon the conversion of
3,390,000 shares of Series B Preferred into 3,390,000 shares of common stock.
No shares of Series B Preferred were authorized at December 31, 1995.
 
13. INCOME TAXES
 
  The components of the provision for income taxes for the years ended
December 31, 1996, 1995, and 1994 are as follows:
 
<TABLE>
<CAPTION>
                                                  YEARS ENDED DECEMBER 31,
                                             -----------------------------------
                                                1996        1995        1994
                                             ----------  ----------- -----------
      <S>                                    <C>         <C>         <C>
      Current:
        Federal............................. $1,342,000  $       --  $       --
        State...............................    433,000          --          --
                                             ----------  ----------- -----------
        Total current.......................  1,775,000          --          --
      Deferred:
        Federal.............................   (730,000)         --          --
        State...............................      4,000          --          --
                                             ----------  ----------- -----------
        Total deferred......................   (726,000)         --          --
                                             ----------  ----------- -----------
                                             $1,049,000  $       --  $       --
                                             ==========  =========== ===========
</TABLE>
 
  The differences between the Company's effective income tax rate and the
United States statutory rate are as follows:
 
<TABLE>
<CAPTION>
                                                           YEARS ENDED
                                                          DECEMBER 31,
                                                        ---------------------
                                                        1996    1995    1994
                                                        -----   -----   -----
      <S>                                               <C>     <C>     <C>
      Federal tax benefit at the statutory rate........ (34.0)% (34.0)% (34.0)%
      State income taxes, net of Federal income tax
       benefit.........................................   3.7     --      --
      Nondeductible acquisition costs..................  56.8     --      --
      Nondeductible expenses...........................   2.8    10.5     1.5
      Change in valuation reserve on Federal deferred
       income tax assets............................... (16.5)    --      --
      Loss carryforwards...............................   --     23.5    32.5
                                                        -----   -----   -----
                                                         12.8 %   --  %   --  %
                                                        =====   =====   =====
</TABLE>
 
                                      47
<PAGE>
 
                                METATOOLS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
  Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes, together with net
operating loss and tax credit carryforwards. Significant components of the
Company's deferred tax assets and liabilities are as follows:
 
<TABLE>
<CAPTION>
                                                            DECEMBER 31,
                                                       ------------------------
                                                          1996         1995
                                                       -----------  -----------
<S>                                                    <C>          <C>
Deferred tax assets:
  Allowance for returns and doubtful accounts......... $   537,000  $   434,000
  Inventory reserves..................................     110,000      294,000
  Accrued expenses....................................     130,000      186,000
  State income taxes..................................     136,000      371,000
  Net operating loss carryforwards....................     881,000      390,000
                                                       -----------  -----------
                                                         1,794,000    1,675,000
  Valuation allowance.................................  (1,048,000)  (1,571,000)
                                                       -----------  -----------
    Net deferred tax assets...........................     746,000      104,000
Deferred tax liabilities:
  Depreciation and amortization.......................     (20,000)    (104,000)
                                                       -----------  -----------
    Net deferred tax liabilities......................     (20,000)    (104,000)
                                                       -----------  -----------
Net deferred taxes.................................... $   726,000  $       --
                                                       ===========  ===========
</TABLE>
 
  The net change in the valuation allowance for deferred taxes during the year
ended December 31, 1996 was approximately $523,000. The Company's management
believes a valuation allowance is required for the net operating losses of RTG
due to potential limitations on the Company's ability to utilize the loss
carryforwards pursuant to the ownership rule changes of the Internal Revenue
Code, Section 382. The valuation allowance increased by approximately $227,000
in 1995 as a result of the increase in current temporary differences, offset
by changes in the net operating loss carryforwards.
 
  At December 31, 1996, the Company has net operating loss carryforwards of
approximately $2,591,000 for federal income tax purposes, which begin expiring
in 2011. The Company's net operating loss carryforwards relate to the
Company's acquisition of RTG (Note 3).
 
14. COMMITMENTS
 
  Through September 1994, the Company leased office space in Santa Monica,
California. This lease was terminated in September 1994, at which time the
Company relocated its facilities to Carpinteria, California. The Company
entered into a lease agreement for office space in Carpinteria, which expires
in December 1998, if not renewed. In addition, the Company leases office space
for its research facility in Princeton, New Jersey, its international
headquarters in Dublin, Ireland, and its international sales offices pursuant
to non-cancelable lease agreements with terms through May 2000.
 
  The Company also leases certain equipment and three vehicles for officers of
the Company with lease terms of three to five years. Rent expense for office
space, equipment, and vehicles amounted to approximately $425,000, $331,000,
and $149,000 for the years ended December 31, 1996, 1995, and 1994,
respectively.
 
                                      48
<PAGE>
 
                                METATOOLS, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
  Future minimum lease payments under non-cancelable operating leases for each
twelve-month period subsequent to December 31, 1996 are as follows:
 
<TABLE>
      <S>                                                             <C>
      December 31, 1997.............................................. $  638,000
      December 31, 1998..............................................    637,000
      December 31, 1999..............................................    125,000
      December 31, 2000..............................................     18,000
                                                                      ----------
                                                                      $1,418,000
                                                                      ==========
</TABLE>
 
15. CONTINGENCIES
 
  The Company is engaged in certain legal actions arising in the ordinary
course of business. The Company believes it has adequate legal defenses and
believes that the ultimate outcome of these actions will not have a material
effect on the Company's consolidated financial position, results of
operations, or cash flows.
       
16. SUBSEQUENT EVENTS      
 
  On February 11, 1997, the Company entered into a definitive merger agreement
with Fractal Design Corporation ("Fractal"). The definitive agreement and plan
of reorganization provides that upon the effective date of the merger, each
share of Fractal common stock shall be converted into 0.749 shares of the
Company's common stock and each option to purchase Fractal common stock will
be converted into options to purchase 0.749 shares of the Company's common
stock at an exercise price equal to the exercise price to purchase Fractal
options prior to the merger divided by 0.749. It is anticipated that
approximately 8,962,000 shares of MetaTools common stock will be issued in
connection with the merger, based upon the number of shares of Fractal common
stock issued and outstanding at December 31, 1996 (which number does not
include shares of MetaTools common stock to be issued to holders of options to
purchase shares of Fractal common stock). The merger is intended to be
accounted for as a pooling of interests and the companies intend to structure
the merger to qualify as a tax free reorganization. The merger is contingent
upon customary conditions including the approval of the stockholders of the
Company and the shareholders of Fractal, the occurrence of no event which
could have a material adverse effect with respect to the other party, and the
satisfaction of any governmental or regulatory requirements to legally effect
the merger. The merger is expected to become effective in the quarter ending
June 30, 1997.
       
17. INDUSTRY AND GEOGRAPHIC AREA SEGMENT INFORMATION      
       
  The Company operates in one industry segment, prepackaged software. The
Company designs, develops, publishes, markets and supports visual computing
software tools and technologies for the creation, editing, and manipulation of
computer graphic images, digital art, and Internet/online content.      
       
  All of the Company's international revenues were export sales from the
Company's United States operations. Net revenues by geographic area for the
years ended December 31, 1996, 1995, and 1994 are as follows:      
 
<TABLE>    
<CAPTION>
                                                   YEARS ENDED DECEMBER 31,
                                              ----------------------------------
                                                 1996        1995        1994
                                              ----------- ----------- ----------
   <S>                                        <C>         <C>         <C>
   United States............................. $17,934,000 $12,107,000 $8,107,000
   Europe....................................   7,458,000   2,321,000    454,000
   Pacific Rim...............................   2,021,000   2,172,000  1,192,000
   Rest of world.............................     622,000     131,000     79,000
                                              ----------- ----------- ----------
                                              $28,035,000 $16,731,000 $9,832,000
                                              =========== =========== ==========
</TABLE>     
 
                                      49
<PAGE>
 
                                     
                              METATOOLS, INC.      
                      
          NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)      
       
18. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)       
 
  Summarized quarterly financial information for fiscal years 1996 and 1995,
are as follows:
 
<TABLE>
<CAPTION>
                                              QUARTER ENDED
                             -------------------------------------------------
                              MARCH 31    JUNE 30    SEPTEMBER 30 DECEMBER 31
                             ----------  ----------  ------------ ------------
<S>                          <C>         <C>         <C>          <C>
Fiscal year 1996:
  Net revenues.............. $5,503,000  $6,371,000   $7,241,000  $  8,920,000
  Gross profit..............  4,400,000   5,254,000    6,053,000     7,768,000
  Net income (loss).........    724,000   1,002,000      992,000   (11,957,000)
  Net income (loss) per
   share....................        .06         .08          .08         (1.00)
Fiscal year 1995:
  Net revenues.............. $3,420,000  $3,971,000   $4,404,000  $  4,936,000
  Gross profit..............  2,065,000   2,649,000    3,310,000     3,772,000
  Net income (loss).........   (430,000)   (436,000)      80,000       286,000
  Net income (loss) per
   share....................       (.09)       (.09)         .00           .03
</TABLE>
       
  The net loss incurred for the quarter ended December 31, 1996 resulted from
the write-off of acquired in-process technology and other costs related to the
acquisition of RTG (Note 3).          
 
                                       50
<PAGE>
 
                                METATOOLS, INC.
 
                                  SCHEDULE II
 
                       VALUATION AND QUALIFYING ACCOUNTS
 
              FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
 
<TABLE>
<CAPTION>
                                   BALANCE AT CHARGED TO            BALANCE AT
                                   BEGINNING  COSTS AND               END OF
           DESCRIPTION             OF PERIOD   EXPENSES  DEDUCTIONS   PERIOD
           -----------             ---------- ---------- ---------- ----------
<S>                                <C>        <C>        <C>        <C>
Allowance for Doubtful Accounts:
  Year Ended December 31, 1996.... $  402,000 $  351,000 $  331,000 $  422,000
  Year Ended December 31, 1995....    310,000    210,000    118,000    402,000
  Year Ended December 31, 1994....     71,000    460,000    221,000    310,000
Allowance for Returns:
  Year Ended December 31, 1996.... $  601,000 $2,263,000 $2,047,000 $  817,000
  Year Ended December 31, 1995....    489,000  1,675,000  1,563,000    601,000
  Year Ended December 31, 1994....     95,000  1,059,000    665,000    489,000
Allowance for Inventory Obsoles-
 cence:
  Year Ended December 31, 1996.... $  534,000 $  221,000 $  544,000 $  211,000
  Year Ended December 31, 1995....    175,000    359,000        --     534,000
  Year Ended December 31, 1994....        --     175,000        --     175,000
Valuation Allowance for Deferred
 Tax Assets:
  Year Ended December 31, 1996.... $1,571,000 $      --  $  523,000 $1,048,000
  Year Ended December 31, 1995....  1,344,000    227,000        --   1,571,000
  Year Ended December 31, 1994....    400,000    944,000        --   1,344,000
</TABLE>
 
                                       51
<PAGE>
 
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
 
  Not applicable.
 
                                   PART III
 
  Certain information required by Part III is omitted from this Report since
the Company plans to file with the Securities and Exchange Commission the
definitive proxy statement for its 1997 Annual Meeting of Stockholders (the
"Proxy Statement") not later than 120 days after the end of the fiscal year
covered by this Report, and certain information included therein is
incorporated herein by reference.
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
  The information concerning the Company's directors required by this item is
incorporated by reference to the section in the Company's Proxy Statement
entitled "Election of Board of Directors."
 
  The information concerning the Company's executive officers required by this
item is incorporated by reference herein to Part I, Item 4, entitled
"Executive Officers of the Registrant," on page 19 of this Report.
 
ITEM 11. EXECUTIVE COMPENSATION
 
  The information required by this item, except for such information as need
not be incorporated herein by reference under rules promulgated by the
Securities and Exchange Commission, is incorporated by reference to the
section in the Company's Proxy Statement entitled "Compensation of MetaTools
Executive Officers."
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
  The information concerning the Company's directors required by this item is
incorporated by reference to the section in the Company's Proxy Statement
entitled "Security Ownership of MetaTools Management."
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
  The information concerning the Company's directors required by this item is
incorporated by reference to the section in the Company's Proxy Statement
entitled "Certain Transactions."
 
                                      52
<PAGE>
 
                                    PART IV
 
ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
 
  (a) The following documents are filed as part of this report:
 
  1. Financial Statements and Financial Statement Schedules. See Index to
     Financial Statements at Item 8 on page 29 of this Report.
 
  2. Exhibits.
 
<TABLE>
<CAPTION>
 EXHIBIT
 NUMBER                               EXHIBIT TITLE
 -------                              -------------
 <C>     <S>
  2.1    Form of Agreement and Plan of Merger by and between the Registrant and
         MetaTools, Inc., a California corporation (1)
  2.2    Stock Purchase Agreement between the Registrant and Real Time Geometry
         Corp. dated December 23, 1996 (the exhibits listed therein have been
         omitted and filed separately as Exhibits 10.22, 10.23, 10.24, and
         10.25) (5)
  3.4    Restated Certificate of Incorporation of Registrant (3)
  3.6    Bylaws of Registrant, as amended (3)
  4.1    Specimen of Common Stock Certificate of Registrant (3)
 10.1    Indemnification Agreement for Executive Officers and Directors (1)
 10.2    Investors' Rights Agreement, as amended (1)
 10.3    1992 Incentive Stock Plan (1)
 10.4    1994 Incentive Stock Option, Non-Qualified Stock Option and Restricted
         Stock Purchase Plan (1)
 10.5    1995 Stock Plan, as amended (2) (6)
 10.6    1995 Employee Stock Purchase Plan (2)
 10.7    1995 Director Option Plan (2)
 10.8    Employment Agreement between the Registrant and John J. Wilczak dated
         April 15, 1992, as amended (1)
 10.9    Employment Agreement between the Registrant and Kai Krause dated
         January 26, 1994 (1)
 10.10   Employment Agreement between the Registrant and Terance A. Kinninger
         dated September 27, 1995 (1)
 10.11   Employment Agreement between the Registrant and James Mervis dated
         April 3, 1995 (1)
 10.15   Loan and Security Agreement between the Registrant and Silicon Valley
         Bank dated September 25, 1994, as amended on December 6, 1996 (3)
 10.16*  Distribution Agreement between the Registrant and Ingram Micro Inc.
         dated October 19, 1992, as amended (1)
 10.19   Form of Employee Invention, Copyright, and Secrecy Agreement (1)
 10.20   Employment Agreement between the Registrant and Fred Brown dated
         November 13, 1995 (1)
 10.21*  Software Licensing Agreement between the Registrant and Marubeni
         Corporation dated as of January 31, 1996 (3)
 10.22   Turnkey / Inventory Agreement between the Registrant and Stream
         International Inc. dated as of April 18, 1996 (4)
 10.23   Employment Agreement between the Registrant and Robert Rice dated
         December 31, 1996 (5)
 10.24   Noncompetition Agreement between the Registrant and Alexander Migdal
         dated December 31, 1996 (5)
 10.25   Amended and Restated Investors' Rights Agreement (5)
 10.26   Employment Agreement between the Registrant and Alexander Migdal dated
         December 31, 1996 (5)
</TABLE>
 
                                       53
<PAGE>
 
<TABLE>    
<CAPTION>
 EXHIBIT
 NUMBER                               EXHIBIT TITLE
 -------                              -------------
 <C>     <S>
 10.27   1996 Dive Option Plan (6)
 10.28   1996 Nonstatutory Stock Option Plan (6)
 10.29*  Software Licensing Agreement between the Registrant and Prisma Express
         Distributionsgesellschaft GmbH dated as of December 30, 1996 (7)
 11.1    Statement Regarding Computations of Earnings per Common Share (7)
 21.1    List of Registrant's Subsidiaries (7)
 23.1    Consent of Coopers & Lybrand L.L.P., Independent Accountants
 27.1    Financial Data Schedule (7)
 24.1    Power of Attorney (see page 56 of this Form 10-K)
</TABLE>       
--------
 * Confidential treatment for this exhibit has been requested pursuant to Rule
   24b-2 under the Securities Exchange Act of 1934, as amended.
(1) Incorporated by reference to the Company's Registration Statement on Form
    SB-2, filed December 11, 1995, as amended (File No. 33-98628LA).
(2) Incorporated by reference to the Company's Registration Statement on Form
    S-8, filed on or about April 1, 1996 (File No. 333-3070).
(3) Incorporated by reference to the Company's Annual Report on Form 10-K for
    the year ended December 31, 1995.
(4) Incorporated by reference to the Company's Form 10-Q for the quarter ended
    June 30, 1996.
(5) Incorporated by reference to the Company's Current Report on Form 8-K,
    filed on or about January 15, 1997.
(6) Incorporated by reference to the Company's Registration Statement on Form
    S-8, filed on or about December 3, 1996 (File No. 333-17209).
       
(7) Incorporated by reference to the Company's Annual Report on Form 10-K for
    the year ended December 31, 1996.      
 
  (b) Reports on Form 8-K
 
  No reports have been filed with the Securities and Exchange Commission
during the fourth quarter ended December 31, 1996.
 
  (c) Exhibits
 
  See Item 14(a)(2) above.
 
  (d) Financial Statement Schedules
 
  See Item 14(a)(1) above.
 
                                      54
<PAGE>
 
                                  SIGNATURES
       
  Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Amendment to the
Annual Report to be signed on its behalf by the undersigned, thereunto duly
authorized, in the City of Carpinteria, State of California, on the 23rd day of
April 1997.      
                                       METATOOLS, INC.
 
                                       By: /s/ TERANCE A. KINNINGER
                                          -------------------------------------
                                             Terance A. Kinninger
                                              Vice President and
                                           Chief Financial Officer
 
                                      55
<PAGE>
 
                               POWER OF ATTORNEY
 
  KNOW ALL PERSON BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Terance A. Kinninger, his attorney-in-fact,
with the power of substitution, for him and any and all capacities, to sign
any amendments to this Report on Form 10-K, and to file same, with exhibits
thereto and other documents in connection therewith, with the Securities and
Exchange Commission, hereby ratifying and confirming all that each of said
attorneys-in-fact, or his substitutes, may do or cause to be done by virtue
hereof.
     
  Pursuant to the requirements of the Securities Exchange Act of 1934, this
Amendment to the Annual Report has been signed by the following persons on
behalf of the registrant and in the capacities indicated.      

 
<TABLE>    
<CAPTION>
             SIGNATURE                           TITLE                    DATE
             ---------                           -----                    ----
<S>                                  <C>                           <C>
                 *                   Chairman, President, and        April 23, 1997
____________________________________  Chief Executive Officer
          John J. Wilczak             (Principal Executive
                                      Officer)

    /s/ TERANCE A. KINNINGER         Vice President and Chief        April 23, 1997
____________________________________  Financial Officer
        Terance A. Kinninger          (Principal Financial and
                                      Accounting Officer)

                 *                   Director and Senior Science     April 23, 1997
____________________________________  and Design Officer
             Kai Krause

                 *                   Director                        April 23, 1997
____________________________________
        Samuel H. Jones, Jr.

                 *                   Director                        April 23, 1997
____________________________________
             Bert Kolde

                 *                   Director                        April 23, 1997
____________________________________
        William H. Lane III

                 *                   Director                        April 23, 1997
____________________________________
          Howard L. Morgan

                 *                   Director                        April 23, 1997
____________________________________
        William J. Schroeder
</TABLE>     

     
* By /s/ TERANCE A. KINNINGER
------------------------------------
         Terance A. Kinninger
         Attorney in fact      
                                      56