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                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549
 
                               ---------------
 
                                   FORM 10-K
 
  (MARK ONE)
 
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
   ACT OF 1934 (NO FEE REQUIRED)
 
  FOR THE FISCAL YEAR ENDED APRIL 30, 1998, OR
 
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
   EXCHANGE ACT OF 1934 (NO FEE REQUIRED)
 
  FOR THE TRANSITION PERIOD FROM       TO
 
  COMMISSION FILE NUMBER 0-19253
 
                               ---------------
 
                              VIDEO UPDATE, INC.
            (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
               DELAWARE                              41-1461110
     (STATE OR OTHER JURISDICTION                 (I.R.S. EMPLOYER
   OF INCORPORATION OR ORGANIZATION)             IDENTIFICATION NO.)
 
        3100 WORLD TRADE CENTER                         55101
        30 EAST SEVENTH STREET                       (ZIP CODE)
          ST. PAUL, MINNESOTA
    (ADDRESS OF PRINCIPAL EXECUTIVE
               OFFICES)
 
                                (651) 222-0006
             (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:
 
                     CLASS A COMMON STOCK, $.01 PAR VALUE
                                CLASS B WARRANT
                               (TITLE OF CLASS)
 
  Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days.
 
                                Yes X    No
 
  Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.  X
 
  Aggregate market value of registrant's voting stock held by non-affiliates
as of July 29, 1998: Class A Common Stock, $.01 par value: $35,222,388.31,
based on a closing price of $1.31 per share.
 
  Number of shares outstanding of each of the registrant's classes of common
stock, as of July 29, 1998: Class A Common Stock, $.01 par value: 29,278,518
shares.
 
                     DOCUMENTS INCORPORATED BY REFERENCE:
 
  Note: The discussions in this Form 10-K contain forward looking statements
that are subject to risks and uncertainties. The actual results of Video
Update, Inc. and subsidiaries (the "Company") could differ significantly from
those set forth herein. Factors that could cause or contribute to such
differences include, but are not limited to, those discussed in "Business" and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" as well as those discussed elsewhere in this Form 10-K. Statements
contained in this Form 10-K that are not historical facts are forward looking
statements that are subject to the safe harbor created by the Private
Securities Litigation Reform Act of 1995. A number of important factors could
cause the Company's actual results for fiscal 1999 and beyond to differ
materially from those expressed or implied in any forward looking statements
made by, or on behalf of, the Company.
 
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<PAGE>
 
                                    PART I
 
ITEM 1. BUSINESS
 
GENERAL
 
  Video Update, Inc. ("Video Update" or the "Company") owns and operates video
specialty stores throughout North America. As of April 30, 1998, the Company
owned and operated 681 stores located in 31 states and six provinces in Canada
and franchised 72 additional video specialty stores predominantly in the
United States. As of April 30, 1998, 479, or approximately 86%, of the
Company's stores in the United States, and 125, or approximately 93% of the
Company's Canadian stores, were superstores, defined as retail video stores
that carry more than 7,500 rental units. The Company believes that, as of the
end of its most recent fiscal year, it is the third largest video specialty
retailer in the United States and the third largest video specialty retailer
in Canada based on the number of superstores it operates. Video Update stores
in the United States and Canada offer on average approximately 10,700 and
8,500 rental units, respectively, including multiple copies of new and popular
releases and video games, in a visually appealing and customer friendly
layout.
 
  The Company franchised its first store in January, 1983 and opened its first
company-owned store in September, 1989. By July, 1994, when the Company
completed its initial public offering, the Company had grown to 15 company-
owned stores and 30 franchised stores and had developed a cost-effective
superstore format that distinguished the Company from other video retailers by
providing it with the flexibility to expand into desirable sites in both small
and large markets without compromising profitability, or decreasing the number
of viable markets into which it could expand. During fiscal 1998, the Company
rapidly grew in size from 343 to 681 Company-owned stores. During this period,
the Company acquired 267 video stores in its acquisition of Moovies, Inc.,
("Moovies") opened 84 new video superstores and closed 13 stores, including
stores closed related to acquisitions. Same store sales during fiscal 1998
increased by approximately 2%. As a result of this acquisition, new superstore
openings and increases in same store sales, the Company's revenues increased
from approximately $91,799,000 in fiscal 1997 to approximately $156,154,000 in
fiscal 1998.
 
 The Home Video Industry
 
  The home video retail industry has experienced significant growth over the
last several years. According to industry reports, gross rental revenues for
the home video industry in the United States have grown from approximately
$2.6 billion for rentals in 1985 to approximately $7.5 billion for rentals in
1997. Industry reports also show that over 80% of American households owning
televisions also owned a VCR and that nearly one quarter of all Americans make
a trip each week to their video store. Convenience, limited out-of-pocket
expense and reliability are all factors that make video rentals the preferred
medium of entertainment for millions of customers.
 
  According to industry reports, the home video market remains the largest
single source of revenue to movie studios, accounting for more than 50% of
movie studios' total revenues. Of the many movies produced by major studios
and released in the United States each year, relatively few are profitable for
the studios based on box office revenue alone. In addition to purchasing box
office hits, video specialty stores typically purchase movies on video that
were not as successful at the box office because customers will often rent a
video that they might not view at a theater. The Company believes that the
consumer is more likely to view movies that were not box office hits on a
rented video than on any other medium because video specialty stores provide
an inviting opportunity to browse and make an impulse choice among a very
broad selection of movie titles at a relatively low price. These purchases by
the video stores provide the major movie studios with a reliable source of
revenue for the majority of their movies. In addition, many of the major
studios have entered into revenue-sharing arrangements with a few of the
larger national chains, such as Video Update. The Company expects that such
revenue-sharing arrangements will allow retailers to offer a greater quantity
of titles to meet consumer demand, enhancing the interdependent relationship
between the studios and the larger national chains.
 
                                       1
<PAGE>
 
  The Company believes that the home video industry remains highly fragmented.
Over the last five years, the industry has been characterized by significant
consolidation, with larger regional and national chains of superstores
acquiring smaller chains and locations. The Company also believes that there
has been a recent trend toward consolidation in the retail video industry
driven by the recognition by store operators of the competitive advantages
that larger organizations enjoy in terms of access to working capital,
marketing efficiencies and other economies of scale and the enhanced ability
to obtain quality retail locations. The Company expects that this
consolidation will continue and that larger national chains, such as Video
Update, will continue to gain market share from smaller "mom and pop"
operations.
 
  Although the domestic video retail industry includes both rentals and sales,
the consumer market for videos has primarily been a rental market. Movie
studios determine the suggested retail prices of videos and, through that
pricing influence, the relative levels of video rentals and sales. Videos
released at a relatively high price, generally $60 or more, are generally
purchased by video retailers and made available for rental. Videos released at
a relatively low price, typically between $15 and $25, are generally purchased
by video retailers for both sale and rental and may be purchased by consumers
at a variety of retail locations. The Company believes that movie studios
attempt to maximize total revenue from video releases by maintaining retail
prices at a relatively high level during the first four months to one year
after a new video release, during which time sales are made primarily to video
retailers for rental, and then releasing the video at a lower price to promote
sales to consumers. From time to time, however, certain movies that are
believed to have mass appeal or family appeal such as Titanic, Lost in Space
and Godzilla, are initially released for sale at a relatively low price. Video
retailers purchase a large portion of these titles at the same low price,
which titles thereafter become low cost rentals for such retailers. These
lower priced releases are more attractive rentals to the retailer because of
the relatively few number of rentals required to recover their cost and
provide a favorable economic return to the retailer.
 
  Historically, new technologies have led to the creation of additional
distribution channels for movie studios. Movie studios seek to maximize their
revenues by releasing movies in sequential release date "windows" to various
movie distribution channels. These distribution channels currently include, in
release date order, movie theaters, video specialty stores, pay-per-view,
basic cable television, and foreign, network and syndicated television. The
Company believes that this method of sequential release has allowed movie
studios to increase their total revenue with relatively little adverse effect
on the revenue derived from previously established channels and that movie
studios will continue the practice of sequential release as new distribution
channels become available. According to Paul Kagan Associates, Inc., many
movie studios have recently agreed to extend the length of the exclusive
window on many new release videos for video specialty stores from the current
practice of 30 days to between 60 and 90 days and longer. The Company believes
that the length of time between the movie theater release date and the release
date to video specialty stores is also getting shorter. The Company believes
that studios are also starting to bypass the movie theaters by releasing high
quality and popular movie sequels such as Lion King 2 and Pocahantas 2,
directly to video specialty stores.
 
OPERATING STRATEGY
 
  The Company's management has substantial experience in the video retailing
industry. Through the management team, the Company has developed a cost-
effective superstore format that distinguishes the Company from other video
retailers by providing it with the flexibility to expand into desirable sites
in both small and large markets without compromising profitability or
decreasing the number of viable markets into which it can expand. Management's
depth of experience in and knowledge of the industry are reflected in the
Company's operating strategy, the key elements of which include the following:
 
  Provide Extensive Selection of Videocassettes. At April 30, 1998, 479, or
approximately 86%, of the Company's stores in the United States and 125, or
approximately 93%, of the Company's Canadian stores were superstores.
Superstores are video rental stores that have more than 7,500 rental units.
The Company believes that an extensive selection of videocassettes is a key
determinant that consumers consider in choosing to visit and patronize a
particular video store. The Company tailors the videocassettes available for
rent in a given store
 
                                       2
<PAGE>
 
according to the market served by that store. Additionally, catalog
videocassettes (those in release for more than one year) are displayed in a
library style (spine-out method) allowing for significantly more
videocassettes per square footage of rental space. As a result, the Company
believes that it is able to provide an extensive selection, yet retain greater
flexibility than many of its competitors in terms of store size in which it
can operate.
 
  Effectively Manage Inventories. The Company maintains an integrated point of
sale ("POS") system that provides it with immediate access to and feedback on
records related to, among other things, videocassette rentals, individual
title performance, category rental performance, shrinkage and overdue rentals.
The Company endeavors to convert the POS systems of acquired stores to that of
the Company's as quickly as is practicable. The Company utilizes its POS
system to manage its inventory turns, purchase new inventory, and balance
customer demand and rental trends, all of which the Company believes maximizes
each store's profitability.
 
  Aggressive Marketing. The Company utilizes an aggressive marketing program
designed to attract new customers and increase the frequency of rentals by
current customers. The Company focuses its marketing on individual stores and
the local markets in which they operate. Direct mailings, including postcards
and flyers, are utilized regularly. Additionally, the Company extensively
promotes with couponing and cross promotions. The Company's popular "Two-for-
$.99 Tuesday" rental promotion is used throughout its system and has been
effective in building customer loyalty and increasing revenue on a day of the
week that historically has not been a significant rental volume day.
 
  Geographic Concentration. The Company has locations in 31 states and six
provinces in Canada. For fiscal year 1999, the Company intends to focus on
maximizing the operating efficiencies of these locations and on completing the
build out of new stores in locations for which the Company has signed lease
commitments, rather than on aggressively expanding with new superstores in
additional metropolitan areas where it does not presently have locations. The
Company expects that the geographic concentration of its existing stores
together with acquired stores will allow the Company to more easily monitor
store operations through its regional management offices and to achieve
operating efficiencies in inventory management, marketing, distribution,
training and store supervision. Because the Company operates multiple stores,
it is able to receive relatively large aggregate cooperative advertising
credits from its distributors. The Company receives cooperative advertising
credits for each store it operates, and by operating multiple stores in a
single geographic market, it can more effectively use cooperative advertising
credits to maximize the impact of its advertising.
 
  Consistency of Image and Operations. The Company strives to create a
national presence and name recognition. To achieve this objective and to most
efficiently and effectively operate its stores, the Company attempts to
maintain consistency among its company-owned and franchised stores. This
consistency of operations includes signage, store layout, marketing,
management information systems and customer service. The Company attempts to
fully integrate acquired stores into its overall format as quickly as is
practicable. Such integration typically involves the prompt installation of
the management information systems and interior signage, supplementing the
existing base stock of titles, processing acquired videocassettes, training
existing management and sales personnel, and completing limited build-out of
the facilities. Subject to permit requirements and other such regulatory
controls, the Company installs exterior signage as soon as practicable. To
expedite the integration of acquired businesses, the Company has developed a
uniform approach that management believes minimizes the time necessary to
fully assimilate an acquired store's operations into those of the Company.
 
GROWTH STRATEGY
 
  During fiscal 1997 and 1998, the Company grew in size from 204 to 681
company-owned stores, including the acquisition of 267 stores from Moovies,
Inc., in March, 1998. As a result of acquisitions and the previous rapid
growth rate, for fiscal 1999 the Company intends to focus on maximizing the
operating efficiencies of the acquired locations as well as its existing
locations. The key elements of the Company's development and growth strategy
include the following:
 
                                       3
<PAGE>
 
  Targeted Superstore Development. During fiscal 1998, exclusive of the
Moovies acquisition, the Company opened 84 new video superstores and closed 13
stores, including stores closed related to acquisitions. The Company intends
to open a limited number of superstores (currently estimated to be no more
than 20 new superstores) in fiscal 1999 in its existing markets and selected
new markets where attractive opportunities are available. The Company believes
that the selection of locations for its superstores has been and will continue
to be critical to the success of its operations. Important criteria for
selection of a new superstore location include density of local residential
population, traffic count on roads immediately adjacent to the superstore
location, visibility of the superstore to passing motorists, easy
accessibility and ample parking. Video Update estimates that each new
superstore currently requires up to 24 months of operations in order to ramp-
up to its expected level of mature operations.
 
  Targeted Acquisitions. The Company believes that acquiring chains of stores
is often the most cost-effective means of entering a new market, particularly
when the stores are in desirable locations. The Company also believes that the
rental video industry has experienced a recent trend toward consolidation
driven by the recognition by store operators of the competitive advantages
that larger organizations enjoy in terms of access to working capital,
marketing efficiencies and other economies of scale and the enhanced ability
to obtain quality retail locations. This trend has created an opportunity for
the Company to grow further through acquisitions. The Company believes that it
will continue to be presented with attractive acquisition opportunities. The
Company's ability to resume an acquisition growth strategy is dependent upon
its ability to generate cash flow from operations and to raise additional
capital.
 
  Franchise Operations. Franchised superstores operate under substantially the
same hours and methods of operation as Company-owned stores. The Company
currently intends to franchise stores primarily in areas where the Company
does not expect to pursue new superstore development or acquisitions.
 
STORE OPERATIONS AND LOCATIONS
 
  Each Video Update store operates under substantially the same plan of
operation. Company-owned stores are open 365 days a year with daily hours
generally from 10:00 a.m. to 11:00 p.m. Sunday through Thursday and from 10:00
a.m. to 12 midnight Friday and Saturday. The Company's stores use a self-
service system, whereby customers select products from the shelves and proceed
to the checkout counter. Video Update stores in the United States and Canada
average approximately 5,900 and 4,600 square feet in size, respectively.
 
                                       4
<PAGE>
 
  The Company seeks to locate its stores in geographic areas that will enable
it to achieve operating efficiencies in inventory management, advertising,
marketing, distribution, training and store supervision. The following table
sets forth the locations of existing Company-owned and franchised stores as of
April 30, 1998:
 
<TABLE>
<CAPTION>
                                                 NUMBER OF   NUMBER OF
                                               COMPANY OWNED FRANCHISED TOTAL OF
   STATE OR PROVINCE                              STORES       STORES    STORES
   -----------------                           ------------- ---------- --------
   <S>                                         <C>           <C>        <C>
   Alaska.....................................        3         --          3
   Arizona....................................       43         --         43
   Arkansas...................................        2         --          2
   California.................................        1         --          1
   Colorado...................................       11         --         11
   Connecticut................................        3         --          3
   Florida....................................      --            4         4
   Georgia....................................       37         --         37
   Illinois...................................       24         --         24
   Indiana....................................       26         --         26
   Iowa.......................................       19         --         19
   Kentucky...................................      --           33        33
   Michigan...................................       20         --         20
   Minnesota..................................       63          10        73
   Missouri...................................       13         --         13
   Nebraska...................................        4         --          4
   Nevada.....................................        8         --          8
   New Hampshire..............................      --            7         7
   New Jersey.................................        6         --          6
   New Mexico.................................        1         --          1
   New York...................................       12         --         12
   North Carolina.............................       39         --         39
   Ohio.......................................       32         --         32
   Oklahoma...................................        7         --          7
   Oregon.....................................        2         --          2
   Pennsylvania...............................       30           1        31
   South Carolina.............................       34         --         34
   South Dakota...............................        5         --          5
   Tennessee..................................        2         --          2
   Texas......................................       23         --         23
   Utah.......................................        4         --          4
   Virginia...................................       27          12        39
   Washington.................................       40         --         40
   Wisconsin..................................        6           1         7
   Alberta....................................       62           1        63
   British Columbia...........................       63           3        66
   Manitoba...................................        5         --          5
   Ontario....................................        2         --          2
   Saskatchewan...............................        1         --          1
   Yukon......................................        1         --          1
                                                    ---         ---       ---
     Total....................................      681          72       753
                                                    ===         ===       ===
</TABLE>
 
MANAGEMENT INFORMATION SYSTEMS
 
  The Company believes the accurate and efficient management of purchasing,
inventory and sales records has been important to the Company's success. The
Company maintains information, updated daily, regarding
 
                                       5
<PAGE>
 
revenue, current and historical sales and rental activity, demographics of
store membership and videocassette rental patterns. This information can be
organized by store, by region or for all operations.
 
  The Company maintains a national POS system and a corporate information
system. All rental and sales transactions are recorded by the POS system when
scanned at the time of customer checkout. Nightly, the POS system transmits
each store's data from operations into the corporate information system. The
systems track all rental and sales products from the videocassette
distribution center to each store using scanned bar code information. The
systems also maintains the detailed rental history of each customer and title.
This information produces the reports used by the Company, including those
used in making purchasing decisions on new releases. All of the Company's
stores use the Company's POS system when opened or converted to the Video
Update concept, in the case of an acquired store.
 
PRODUCTS
 
  Videocassette Rental. The Company's primary source of revenue is the rental
of videocassettes. Video rental prices per night generally range from $2.49 to
$3.49 for new releases to $1.99 for catalog titles. Videocassettes are
available for one-night, two-night or multiple night rental. The Company's
stores generally carry approximately 10,700 and 8,500 videos for rent in its
United States and Canadian stores, respectively, representing approximately
8,200 and 6,300 titles, respectively. Movie titles are classified into at
least 23 categories, such as "Action," "Drama," "Family," and "Children" and
are displayed alphabetically within those categories. The Company determines
its rental prices for titles and duration of rentals based on the length of
time the title has been available on videocassette. The Company believes that
its rental prices are competitive with those of other video stores, and its
videocassettes are available for one-day and multiple-day rentals.
 
  Video Games. In addition to videocassette rentals, stores also rent video
games for use with Sony Playstation(TM), Nintendo(TM), Nintendo64(TM) and Sega
Genesis(TM) video game machines.
 
  Additional Products. The Company rents audio books, which are available in a
majority of its stores. The selection of audio books includes fiction and non-
fiction classics, and educational materials and books. For the convenience of
its customers, the Company also sells blank videocassettes and video cleaning
equipment and rents videocassette and video game players. In addition, the
Company sells previously viewed videocassettes and new and used video games.
 
FRANCHISE OPERATIONS
 
  The Company currently intends to franchise superstores in areas where it
does not expect to pursue new superstore development or acquisitions.
 
  The standard Company franchise agreement generally requires the franchisee
to pay the Company a continuing monthly royalty fee equal to five percent of
the franchisee's gross monthly rental revenue, as calculated under the terms
of the franchise agreement. The franchisee is also generally obligated to pay
a continuing monthly royalty fee of one percent of gross monthly product
revenues derived specifically from the sale of certain video products. The
monthly royalty fees are calculated and due from the date that the franchised
superstore opens for business. In addition to the royalty payments,
franchisees generally also are required to pay a monthly advertising fee equal
to one percent of the franchisee's gross monthly revenue for the preceding
month.
 
  Under the Company's current franchising program, the Company will grant to a
franchise owner the right to develop one or a specified number of Video Update
superstores at an approved location or future locations (within specific
geographic areas) pursuant to the terms of a franchise agreement. The
exclusivity accorded to a franchisee is individually negotiated but generally
does not extend beyond a radius of one mile from the
 
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<PAGE>
 
franchised location. Prior to the actual store opening, the Company provides
advice to the franchisee on promotions, store displays and inventory control
as well as a comprehensive five day training course.
 
  The Company monitors franchisees' compliance with ongoing obligations on the
basis of monthly revenue reports and inventory reports. The franchise
agreement generally also grants the Company the right to audit the
franchisee's books, business records, sales reports, financial statements, and
tax returns at any time. The franchise agreement allows the Company to
terminate the franchise under certain conditions, including without
limitation, failure to comply with the Company's operating guidelines, failure
to obtain and maintain the necessary retail licenses and permits, operation of
a competitive venture, and understatement of gross monthly revenues for any
two operating periods by more than two percent. To date, the Company has
experienced no material problems it is aware of relating to the understatement
of revenues by franchisees.
 
MARKETING AND ADVERTISING
 
  The Company primarily relies on direct mail advertising to promote its
business and increase the familiarity of potential customers with the Company.
The Company's direct mail typically consists of pricing-related promotions
such as two-for-one coupons or a free rental coupon for new customers. The
Company's general practice of opening several Company-owned or franchised
stores within a geographic region enables it to maximize the effectiveness of
its advertising expenditures. The cost of these activities is generally funded
by cooperative movie advertising promotions made available by studios or
suppliers to promote certain videocassettes. The Company also benefits from
the advertising and marketing of studios and theaters in connection with their
efforts to promote films and increase box office revenues. The Company
generally relies on referrals from current franchisees and advertising in
franchise-oriented publications in marketing its franchises.
 
SUPPLIERS
 
  The Company acquires its inventory of videocassettes and video games and
accessories from several videocassette suppliers, including local divisions of
Sight and Sound Distributors of St. Louis, Missouri ("Sight and Sound"), the
Shannock Corporation of Canada ("Shannock") and Ingram Entertainment
Incorporated of Nashville, Tennessee ("Ingram").
 
  The videocassette inventory in each Company-owned and franchised store
consists of catalog titles and new release titles. To develop its inventory of
titles for store openings, the Company transfers videocassettes from existing
stores and purchases videocassettes from suppliers.
 
  The Company currently purchases new release rental videocassettes at an
average cost of approximately $45. The Company believes that, if its
relationship with Sight and Sound, Ingram or Shannock were terminated, the
Company could obtain videocassettes from other suppliers at prices and on
terms comparable to those available from such entities.
 
  Suppliers generally provide the Company with a comprehensive monthly listing
of all new video releases. In addition, movie studios generally provide the
Company with several copies of a new release video for preview by the Company.
The Company's movie selection committee uses listings of new releases, video
previews, knowledge of the popularity of past video releases and the Company's
computerized information on the past performance of titles rented by the
Company to select the titles and number of copies of each title to be acquired
for rental in each of its stores. The Company is permitted to return unopened
or defective videocassettes to its suppliers in certain circumstances. The
Company purchases video game software from a variety of distributors, based on
price and availability.
 
  In addition to traditional inventory purchasing, in July, 1998, the Company
entered into a direct license revenue-sharing agreement with a major motion
picture studio. Under the terms of the agreement, the Company can choose
titles that it wants and may obtain them directly from the studio, although
the Company remains
 
                                       7
<PAGE>
 
able to obtain the titles through regular distribution channels on a title by
title basis. For each title obtained, the Company will share the greater of an
agreed-upon percentage of the rental revenue or dollar amount per rental
transaction, which percentage declines over a period of weeks following the
release of the title for video rental. The Company is already obtaining titles
under this agreement in fiscal 1999 and is aggressively pursuing additional
direct licensing revenue-sharing agreements with other studios, although no
assurances can be given that such agreements will be obtained.
 
  The Company believes that such revenue-sharing agreements could be a cost
effective source for larger orders of an individual title, particularly new
release titles. Such agreements would enable Video Update to order larger
numbers, up to three times the normal order, of copies of a particular title
to satisfy customer demand than could be cost-effective if the copies were
purchased for rental. To obtain the full benefits of such revenue sharing
agreements, the Company must correctly identify the new release and other
titles that it should offer on this basis. No assurances can be given that the
Company will be able to use such revenue sharing agreements to obtain the
intended results.
 
  The Company also is a party to an agreement with Rentrak Corporation (the
"Rentrak Agreement"), a distributor of prerecorded videocassettes and other
media, which agreement superseded in all substantial respects a previous
agreement between Rentrak and recently acquired Moovies, Inc. The Rentrak
Agreement includes a requirement that the Company obtain a minimum annual
dollar amount of new release titles from Rentrak. The minimum dollar amount is
subject to increase or decrease depending on the Company's gross revenues from
video rental/sales and the number of major studios participating in Rentrak.
In addition, under the Rentrak Agreement the Company is allowed to choose
which stores offer a title from Rentrak, but if a store obtains a copy of a
new release title from Rentrak, it must obtain all copies of that title from
Rentrak.
 
  In May, 1998, the Company filed suit in federal court in Delaware against
Rentrak, alleging that the Rentrak Agreement is in conflict with federal
antitrust law, given Rentrak's position in the market and its exercise of
monopoly power. The parties have not yet entered into discovery in the matter.
Although this suit is not pursuant to or arising from the Rentrak Agreement, a
resolution of the action may affect some or all of the provisions of the
agreement as well as similar agreements in the video industry or may leave the
agreement unaffected. The Company has not ordered any titles from Rentrak
under the agreement or otherwise. Further, the court in the action may
determine that some or all of any monies paid to Rentrak under the Rentrak
Agreement are subject to offset or recoupment.
 
INVENTORY
 
  New release videocassettes are ordered by the Company and delivered directly
to stores where they are offered for rental or sale on the studio release date
for the title. Previously viewed inventory for existing and new stores is
received, processed and stored in the Company's approximately 34,000 square
foot central distribution facility located in St. Paul, Minnesota. New release
and previously viewed videocassettes and games are processed for rental
according to uniform Company-wide standards. Each videocassette is removed
from its original carton and placed in a standard Video Update rental case
with a magnetic security device. Bar codes are then affixed to each
videocassette and video game. For previously viewed videocassettes, the
artwork from the original carton is cut out and inserted into clear pockets on
the standard Video Update rental case for shelf display. For new release
videocassettes, the original carton is displayed separately in front of the
standard Video Update rental case containing the videocassette.
 
COMPETITION
 
  The video rental industry is highly competitive. The Company competes with
other video retail stores, including Blockbuster Entertainment, a division of
Viacom, Inc. ("Blockbuster") and other superstores, and with supermarkets,
pharmacies, convenience stores, bookstores, mass merchants, mail order
operations, vending machines and other retailers, as well as with
noncommercial sources such as libraries. In addition to competing with other
video retailers, the Company competes with other leisure-time activities,
especially entertainment activities such as movie theaters, sporting events,
network television and cable television.
 
                                       8
<PAGE>
 
  The Company also competes with other distribution channels for studio
movies, including pay-per-view television on basic cable service, which
currently offer only a limited number of channels and monthly movie
selections. Recently developed digital compression technology combined with
fiber optics and other technology will eventually permit cable companies,
direct broadcast satellite companies and other telecommunications companies to
transmit a much greater number of movies to homes at scheduled intervals
throughout the day. Ultimately, these technologies could lead to the
availability of movies on demand to the consumer. Certain cable and other
telecommunications companies have tested and are continuing to test movie on
demand services in some markets.
 
  Some of the Company's competitors, including Blockbuster, have entered into
direct revenue-sharing arrangements with the major motion picture studios.
Such arrangements could allow these competitors to order and stock a greater
number of new release and other titles, thus increasing competition in those
areas in which each of the Company and its competitors have retail locations
and diminishing the potential benefits of similar revenue sharing
arrrangements entered into by the Company, which could have a material adverse
effect on operations. In addition, certain of the Company's larger, better
capitalized competitors may seek to acquire some of the same video specialty
stores that the Company seeks to acquire. Such competition for acquisitions
would likely increase acquisition prices and related costs and result in fewer
attractive acquisition opportunities, which could have a material adverse
effect on the Company's growth.
 
  The Company's franchise operations compete with numerous franchise
operations in many industries that have significantly greater financial and
human resources and more experience in selling franchises than does the
Company. Potential franchisees may believe that these franchisers offer
greater opportunities for success than the Company.
 
SERVICE MARKS
 
  The Company has a federal registration for its service mark "Video
Update(R)" and logos that include its service mark. The Company also holds
registrations in Canada for its service marks and logos. The Company considers
its service marks to be important to its business and intends to actively
protect them.
 
GOVERNMENT REGULATION
 
  The Company is subject to various federal, state and local laws, including
the Federal Videotape Privacy Protection Act and similar state laws that
govern the disclosure and destruction of video rental records. The Company
also must comply with various regulations affecting its business, including
state and local licensing, zoning, land use, construction and environmental
regulations.
 
  The Company has not made, nor does it anticipate making, any material
capital expenditures in order to comply with environmental regulations. No
assurance can be given, however, that new environmental regulations will not
be adopted that will require the Company to make material capital expenditures
for compliance.
 
  The Company also is subject to the Federal Trade Commission's Trade
Regulation Rule entitled "Disclosure Requirements and Prohibitions Concerning
Franchising and Business Opportunity Ventures" (the "FTC Franchise Rule") and
state laws and regulations that govern the offer and sale of franchises. To
offer and sell franchises, the Company is required by the FTC Franchise Rule
to furnish each prospective franchisee a current franchise offering circular
prior to the sale of a franchise. In addition, a number of states require a
franchisor to comply with registration or filing requirements prior to
offering a franchise in the state and to provide a prospective franchisee with
a current franchise offering circular complying with the state's laws, prior
to the sale of the franchise. Although no assurance can be given, the Company
intends to maintain a franchise offering circular that complies with all
applicable federal and state franchise sales laws. However, if the Company is
unable to comply with the franchise sales laws and regulations of any state
that regulates the offer and sales of franchises, the Company will be unable
to offer and sell franchises in such state.
 
                                       9
<PAGE>
 
  The Company is required to update its franchise offering circular to reflect
material changes, under applicable law, regarding its franchise offering and
to comply with changes in disclosure requirements. The occurrence of any such
material changes may, from time to time, require the Company to stop offering
and selling franchises until its franchise offering circular is updated. No
assurance can be given that the Company's franchising program will not be
adversely affected by its failure to register or file in certain states
consistent with its expansion plans, or because compliance with applicable law
necessitates that the Company cease offering and selling franchises in certain
states until its franchise offering circular is updated, or because of its
inability to comply with existing or future franchise laws.
 
  The Company also is subject to a number of state laws and regulations that
regulate certain substantive aspects of the franchisor-franchisee
relationship, including those governing the termination or nonrenewal of a
franchise agreement (such as requirements that "good cause" exist as a basis
for such termination and that a franchisee be given advance notice of, and a
right to cure, a default prior to termination), requirements that the
franchisor deal with its franchisees in good faith, prohibitions against
interference with the right of free association among franchisees and those
regulating discrimination among franchisees in charges, royalties or fees.
 
  Compliance with federal and state franchise laws is costly and time
consuming, and no assurance can be given that the Company will not encounter
difficulties or delays in this area or that it will not require significant
capital for franchising activities.
 
EMPLOYEES
 
  As of April 30, 1998, the Company employed 9,097 persons, including 8,771 in
Company-owned stores and 326 in the Company's corporate, administrative and
warehousing operations. Of the employees, approximately 1,547 were full-time
and 7,550 were part-time. The typical required staffing for a Video Update
store is 8 to 14 employees, including a store manager. Store managers are
supervised by district managers who in turn are supervised by regional
managers. Regional managers report directly to the Company's Vice Presidents
of Store Operations who in turn report to the Executive Vice President of
Store Operations or the Chief Operations Officer. The Company believes that
its employee relations are satisfactory.
 
  The Company has an incentive bonus plan under which store managers are
eligible for monthly bonuses. The performance of each manager is evaluated on
a variety of criteria, including store revenue, payroll, cash overages and
shortages and inventory control.
 
ITEM 2. PROPERTIES
 
  The Company leases substantially all of the sites (including buildings and
improvements) where its Company-owned video stores are located. The occupancy
expense for these sites for the years ended April 30, 1996, 1997 and 1998 was
approximately $10,304,000, $20,777,000, and $39,156,000 respectively. These
leases generally have a term of three to ten years and provide options to
renew for periods ranging from three to five additional years. The Company is
generally responsible for real estate taxes, insurance and utilities under all
leases. (see Note 9 "Lease Agreements," Notes to Consolidated Financial
Statements). The Company expects that most future video superstores will also
occupy leased premises. The Company owns three locations for Company-owned
superstores, one of which is subject to a mortgage, (see "Management's
Discussion and Analysis of Financial Condition and Results of Operations
Liquidity and Capital Resources").
 
  The Company's franchisees enter into leases individually for their
respective superstore locations. These leases are on terms substantially
similar to the terms for Company-owned superstore leases. Generally, the
Company does not guarantee and is not a party to such leases.
 
 
                                      10
<PAGE>
 
  The Company's corporate headquarters are located at 3100 World Trade Center,
30 East Seventh Street, St. Paul, Minnesota 55101 and consists of
approximately 22,000 square feet of office space. The Company's central
distribution facility is located at a different location in St. Paul,
Minnesota and consists of approximately 34,000 square feet. The Company's
headquarters and distribution facilities are leased pursuant to agreements
that expire on October 31, 2001 and August 31, 2001, respectively. In
addition, the Company maintains other locations for the offices of district
and regional managers and for limited storage purposes. The Company expects
that suitable additional space will be available in the Twin Cities area, when
needed, on commercially reasonable terms.
 
ITEM 3. LEGAL PROCEEDINGS
 
  In connection with the acquisition of the assets of Videoland, Inc.
("Videoland") in November 1995, the Company issued 239,163 shares of its Class
A Common Stock (the "Videoland Shares") to the sellers of the assets of
Videoland (the "Videoland Sellers"). With respect to the Videoland Shares, the
Company agreed to make a deficiency payment in October 1996 to the Videoland
Sellers if the gross proceeds received by such sellers from the sale of the
Videoland Shares during the six months from March 1996 through September 1996
was not equal to the number of shares of Videoland Shares sold multiplied by
$12.00. The Videoland Sellers were subject to certain "lockup" or sale
restrictions as a condition to any deficiency payment. The Videoland Sellers
requested a deficiency payment of approximately $1,220,000 in October 1996
based on a sale of all of the Videoland Shares. The Company initiated an
action in federal district court in Minnesota for a declaratory judgment that
the Videoland Sellers are not entitled to any deficiency payment. In January
26, 1998, the court entered a judgment against Video Update in the amount of
approximately $1,220,000 plus interest from October, 1996, and attorney's
fees. Video Update is appealing the matter. Although no assurances can be
given as to the outcome of such action, the Company intends to vigorously
pursue the matter.
 
  In December, 1997, Valley Record Distributors, assignee of Star Video, a
vendor of Moovies, Inc., filed a lawsuit in state court (Court of Common
Pleas, Greenville, South Carolina) against Moovies, Inc. claiming among other
things that Moovies, Inc. has failed to pay its invoices (approximately
$2,900,000) for product purchased. The Company has filed an answer in the
action, is contemplating counterclaims, and intends to defend the matter
vigorously.
 
  In May, 1998, Rousnam Video, Inc., a Michigan corporation and Hani (Al)
Monsour (collectively "Monsour") filed a lawsuit in state court (Macomb County
Michigan) claiming amounts due pursuant to post-closing adjustments
contemplated in connection with an Asset Purchase Agreement among Monsour and
Moovies, Inc. dated as of March 14, 1997, and the alleged default on a
Promissory Note among Monsour and Moovies, Inc. in the amount of $2,000,000.
The Company has filed an answer in the action, is contemplating counterclaims
and intends to defend the matter vigorously.
 
  In May, 1998, four stockholders filed suit in the US District Court for the
Central District of California. The Plaintiff stockholders allege that Mr.
Potter and the Company made false and misleading statements or omitted
material information about the Company and the video industry during the
period April, 1995 to September, 1996, the date of its subsequent public
offering. Plaintiffs are seeking "at least the sum of $967,967," plus
interest, additional damages and attorneys' fees. The Company and Mr. Potter
deny any liability, believe that they have meritorious defenses and intend to
defend the matter vigorously. A motion to dismiss the action has been filed.
 
  Also, in May, 1998, the Company filed suit in federal court in Delaware
against Rentrak Corporation ("Rentrak"), an Oregon corporation. The Company
alleges that its revenue sharing agreement with Rentrak is in conflict with
federal antitrust law, given Rentrak's position in the market and its exercise
of monopoly power. The parties have not yet entered into discovery in the
matter.
 
  If the lawsuits are not resolved satisfactorily for the Company, the
Company's future financial condition and results of operations could be
materially adversely affected. The Company does not believe that the ultimate
liability in the suit filed by the four stockholders is estimable or probable,
and therefore, no provision for any liability that may result from the actions
has been recognized in the accompanying consolidated financial statements.
However, the Company has made certain provisions for potential liabilities
that may result from the Videoland, Valley Record Distributors, Monsour and
Rentrak Corporation lawsuits which amounts have been recognized in the
accompanying consolidated financial statements.
 
                                      11
<PAGE>
 
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
 
  The Company held a Special Meeting in Lieu of Annual Meeting of Stockholders
(the "Special Meeting") on March 2, 1998, at the offices of the Company, 3100
World Trade Center, 30 East Seventh Street, St. Paul, Minnesota to consider
and vote upon the following proposals, each of which is more particularly
described in the Company's Joint Proxy Statement/Prospectus dated January 27,
1998.
 
  1. The issuance of shares of the Class A Common Stock, $.01 par value per
share, of the Company, in exchange for shares of the Common Stock, $.01 par
value per share, of Moovies, Inc. ("Moovies"), including in connection with
the conversion of all outstanding Moovies stock options under the Moovies 1995
Stock Plan and warrants, pursuant to the Agreement and Plan of Merger (the
"Merger Agreement") dated as of July 9, 1997 and amended as of October 27,
1997 among the Company, VUI Merger Corp., a Delaware corporation and a wholly
owned subsidiary of the Company, and Moovies (the "Merger Proposal");
 
  2. The termination and cancellation of the terms of the Escrow Agreement,
dated July 20, 1994, by and among the Company, American Stock Transfer & Trust
Company, and certain stockholders of the Company (the "Escrow Proposal");
 
  3. The election of seven (7) members of the Company's Board of Directors
(the "Board of Directors Proposal");
 
  4. The ratification of the selection of Ernst & Young LLP as independent
auditors for the Company for the fiscal year ending April 30, 1998 (the
"Auditors Proposal"); and
 
  5. To consider and vote upon a proposal to approve the Company's 1998 Stock
Option Plan providing for the issuance of up to 1,750,000 shares (the "Plan
Proposal").
 
  The results of the voting for each of the foregoing proposals at the Special
Meeting were as follows.
 
  1. The Merger Proposal:
 
   22,155,758 VOTES FOR
   224,471 VOTES AGAINST
   27,150 ABSTAINING
 
  Accordingly, approval was given for this proposal.
 
  2. The Escrow Proposal:
 
   11,894,770 VOTES FOR
   449,007 VOTES AGAINST
   63,602 ABSTAINING
 
  Accordingly, approval was given for this proposal.
 
  3. The Board of Directors Proposal:
 
   Daniel A. Potter
 
   26,620,717 VOTES FOR
   398,716 WITHELD AUTHORITY
 
   John M. Bedard
 
   26,642,317 VOTES FOR
   377,116 WITHELD AUTHORITY
 
                                      12
<PAGE>
 
   Daniel C. Howard
 
   26,642,317 VOTES FOR
   377,116 WITHELD AUTHORITY
 
   Paul M. Kelnberger
 
   26,551,117 VOTES FOR
   468,316 WITHELD AUTHORITY
 
   Bernard Patriacca
 
   26,551,617 VOTES FOR
   467,816 WITHELD AUTHORITY
 
   Robert E. Yager
 
   26,533,895 VOTES FOR
   485,538 WITHELD AUTHORITY
 
   Jana Webster Vaughn
 
   26,528,967 VOTES FOR
   490,466 WITHELD AUTHORITY
 
  Accordingly, each of the above-referenced seven persons was elected as a
member of the Board of Directors. In connection with the Merger Agreement, Mr.
Yager and Ms. Vaughn resigned from the Board of Directors following the
consummation of the transactions contemplated by the Merger Agreement. Also in
connection with the Merger Agreement and following the transactions
contemplated thereby, Messrs. Theodore J. Coburn and F. Andrew Mitchell,
formerly directors of Moovies, were appointed by the Company's Board of
Directors to serve as Directors until the next annual meeting of stockholders
or until their successors are duly elected and qualified.
 
  4. The Auditors Proposal:
 
   26,935,253 VOTES FOR
   60,805 VOTES AGAINST
   23,375 ABSTAINING
 
  Accordingly, approval was given for this proposal.
 
  5. The Plan Proposal:
 
   20,521,062 VOTES FOR
   1,600,697 VOTES AGAINST
   285,620 ABSTAINING
 
  Accordingly, approval was given for this proposal.
 
                                      13
<PAGE>
 
                                    PART II
 
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED MATTERS
 
  From May 1, 1995 until May 7, 1995, the Company's Class A Common Stock was
traded on the NASDAQ Small Cap Market. From May 8, 1995 to date, the Company's
Class A Common Stock has traded on the NASDAQ National Market System under the
symbol "VUPDA." The Company's Class A Common Stock began trading on NASDAQ on
July 20, 1994. On April 30, 1998, the closing price for the Class A Common
Stock as reported by NASDAQ was $2.813 per share.
 
  For the period indicated, the following table sets forth the range of high
and low sale prices for the Class A Common Stock as reported on the NASDAQ
National Market System.
 
                             CLASS A COMMON STOCK
 
<TABLE>
<CAPTION>
                                                                 HIGH     LOW
                                                                ------- --------
      <S>                                                       <C>     <C>
      FISCAL 1997
      Quarter ended July 31, 1996.............................. $9 3/4  $6 3/8
      Quarter ended October 31, 1996...........................  8 1/8   3 3/4
      Quarter ended January 31, 1997...........................  4 3/4   3 1/2
      Quarter ended April 30, 1997.............................  6 1/8   3 3/4
      FISCAL 1998
      Quarter ended July 31, 1997..............................  5 5/16  3 3/8
      Quarter ended October 31, 1997...........................  3 7/8   2 5/8
      Quarter ended January 31, 1998...........................  3 1/8   1 15/16
      Quarter ended April 30, 1998.............................  3 9/16  2 3/8
</TABLE>
 
  As of April 30, 1998, there were 313 stockholders of record of the Company's
Class A Common Stock.
 
  During the fiscal year ended April 30, 1998, the Company did not pay any
dividends on its Common Stock and management does not anticipate the payment
of any dividends to its stockholders in the foreseeable future. The Company
currently intends to reinvest earnings, if any, in the development and
expansion of its business. The declaration of dividends in the future will be
at the discretion of the Board of Directors and will depend upon the earnings,
capital requirements and financial position of the Company, general economic
conditions and other pertinent factors, including covenants relating to bank
indebtedness.
 
                                      14
<PAGE>
 
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
 
<TABLE>
<CAPTION>
                                     FISCAL YEAR ENDED APRIL 30,
                          ------------------------------------------------------
                           1994      1995      1996(1)       1997      1998(2)
                          -------  ---------  ----------  ----------  ----------
                           (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                       <C>      <C>        <C>         <C>         <C>
STATEMENT OF OPERATIONS
 DATA:
Revenues................  $ 4,989  $   9,051  $   50,504  $   91,799  $  156,154
Income (loss) from con-
 tinuing operations.....  $   301  $     213  $    1,628  $    4,620  $  (14,480)
Income (loss) per share
 from continuing
 operations, diluted....  $   .33  $     .10  $      .15  $      .28  $    (0.71)
Weighted average
 shares(3)..............  904,000  2,226,000  10,663,000  16,262,000  20,412,000
OPERATING DATA:
Increase in same store
 sales(4)...............       26%        21%         16%          5%          2%
Number of stores open at
 end of period:
  Company-owned.........       15         33         204         343         681
  Franchised............       31         22          25          30          72
                          -------  ---------  ----------  ----------  ----------
                               46         55         229         373         753
                          =======  =========  ==========  ==========  ==========
Number of stores opened
 by the Company during
 the period(5)..........        2          4          35          65          71
Number of stores
 acquired by the Company
 during the period......      --          14         136          74         267
BALANCE SHEET DATA:
Total assets............  $ 3,489  $  19,450  $   79,518  $  133,607  $  278,431
Notes payable...........  $ 1,568  $   1,278  $    4,859  $   20,564  $  104,488
Total liabilities.......  $ 2,614  $   4,279  $   18,018  $   42,615  $  169,132
Stockholders' equity....  $   875  $  15,171  $   61,500  $   90,992  $  109,299
</TABLE>
--------
(1) During the fourth quarter of fiscal 1996, the Company adopted a new method
    of amortizing videocassette rental inventory. The effect of the change for
    recognizing salvage value of base stock and the effect of the application
    of the new method of amortizing videocassette copies in excess of the base
    stock to May 1, 1995 had the impact, in total, of increasing amortization
    expense by $2,773,000 and decreasing net income by $1,604,000, or $.15 per
    share, in fiscal 1996. See Note 2 to Notes to Consolidated Financial
    Statements.
(2) During the fourth quarter of fiscal 1998, the Company took significant
    one-time charges of approximately $17 million. Exclusive of the one-time
    charges, the net loss would have been $2,701,000 or $0.11 per share.
(3) See Note 1 of Notes to Consolidated Financial Statements for calculation
    of weighted average shares for fiscal 1996, 1997 and 1998.
(4) The stores included in same store sales are Company-owned stores that have
    been owned and operated by the Company for more than 12 months.
(5) The Company opened 84 new video superstores and closed 13 stores,
    including stores closed related to acquisitions.
 
                                      15
<PAGE>
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
 
  The following discussion of the financial condition and results of
operations should be read in conjunction with the Company's audited
consolidated financial statements and notes thereto appearing elsewhere
herein.
 
OVERVIEW
 
  The Company franchised its first store in January 1983 and opened its first
company-owned store in September, 1989. By July, 1994, when the Company
completed its initial public offering, the Company had grown to 15 Company-
owned stores and 30 franchised stores. Subsequently, the Company substantially
accelerated its growth and as of April 30, 1998, operates 681 Company-owned
stores in 31 states and six provinces in Canada, and has 72 franchised stores
predominantly in the United States.
 
  In March, 1998, the Company acquired Moovies, Inc., and its 267 video retail
stores. The acquired assets and liabilities related to this acquisition are
recorded in the Company's balance sheet at their estimated fair market value
at the date of the acquisition. As a result of the acquisition, the Company
anticipates that its results of operations will be reduced by the increase in
amortization of goodwill of approximately $38,320,000 with an increase in
anticipated quarterly non-cash charges of approximately $479,000 (see
"Significant Future Charges to Earnings Arising from Amortization of Goodwill"
following "Liquidity and Capital Resources" in Item 7). The Company
anticipates that future acquisitions could involve the recording of additional
significant amounts of goodwill and deferred charges on its balance sheet.
 
  The Company's Board of Directors approved a resolution changing the
Company's fiscal year-end from April 30 to January 31, effective January 31,
1999.
 
  The Company generates revenues primarily from the rental of videocassettes
and video games, from service fees from its franchisees, and from the sale of
products. As reflected in the chart below, rental revenues at Video Update
stores have accounted for the substantial majority of the Company's revenues.
The Company expects that this trend will continue.
 
  Overall revenues, including same store sales, did not meet management
expectations for fiscal 1998, due in significant part to certain factors,
including: (i) the delay in closing the acquisition of Moovies, which required
significant management attention from July 1997, when initial documents for
the transaction were signed until March 1998, when the transaction was closed;
(ii) the unseasonably warm late winter weather in the major Midwest and
Southeast markets in which the Company has locations; (iii) the revenues of
new Company stores opened in fiscal 1998 not meeting expectations, due
primarily (management believes) to new release titles during the period not
generating consumer interest or retail traffic at a time when the new store
revenues have not yet reached a mature (two years from opening) level of
operations; and, (iv) the recent direct studio revenue sharing arrangements
obtained by some of the Company's largest competitors, including the
Blockbuster Entertainment division of Viacom, Inc. Management is proceeding
with immediate actions intended to enhance prospects for revenue growth for
fiscal 1999, including layout and marketing conversion of the acquired Moovies
locations to integrate them into the Company's operations as quickly as
possible, the closing of underperforming locations and the aggressive pursuit
of direct revenue sharing arrangements with major motion picture studios, the
first of which has been obtained in July 1998.
 
<TABLE>
<CAPTION>
                                                        FISCAL YEAR ENDED APRIL
                                                                  30,
                                                        ------------------------
                                                         1996    1997     1998
                                                        ------- ------- --------
                                                             (IN THOUSANDS)
   <S>                                                  <C>     <C>     <C>
   Revenues:
     Rental revenue.................................... $46,592 $83,489 $138,279
     Service fees......................................     491     567      800
     Product sales.....................................   3,421   7,743   17,075
                                                        ------- ------- --------
       Total revenues.................................. $50,504 $91,799 $156,154
                                                        ======= ======= ========
</TABLE>
 
                                      16
<PAGE>
 
OPERATING RESULTS
 
  The table below sets forth the percentage of revenues represented by certain
items included in the Company's statement of operations for the periods
indicated.
 
<TABLE>
<CAPTION>
                                                           FISCAL YEAR ENDED
                                                               APRIL 30,
                                                           -------------------
                                                           1996   1997   1998
                                                           -----  -----  -----
<S>                                                        <C>    <C>    <C>
Revenues:
  Rental revenue..........................................  92.2%  91.0%  88.6%
  Service fees............................................   1.0    0.6    0.5
  Product sales...........................................   6.8    8.4   10.9
                                                           -----  -----  -----
    Total revenues........................................ 100.0  100.0  100.0
Costs and expenses:
  Store operating expenses................................  78.6   75.6   82.6
  Selling, general and administrative.....................  10.6    9.0   16.5
  Cost of product sales...................................   3.7    4.9    7.4
  Store closing charge....................................   --     --     3.2
  Amortization of goodwill................................   2.1    1.7    1.5
                                                           -----  -----  -----
    Total cost and expenses...............................  95.0   91.2  111.2
                                                           -----  -----  -----
Operating income (loss)...................................   5.0    8.8  (11.2)
Other income (expense):
  Interest expense........................................  (0.5)  (0.6)  (2.4)
  Other income............................................   1.1    0.5     .4
                                                           -----  -----  -----
    Total other income (expense)..........................   0.6   (0.1)  (2.0)
                                                           -----  -----  -----
Income (loss) before income taxes.........................   5.6    8.7  (13.2)
Income tax expense (benefit)..............................   2.4    3.7   (3.9)
                                                           -----  -----  -----
Net income (loss).........................................   3.2%   5.0%  (9.3)%
                                                           =====  =====  =====
</TABLE>
 
FISCAL 1998 COMPARED TO FISCAL 1997
 
  Rental revenue. Rental revenue was approximately $138,279,000 and
$83,489,000 or 88.6% and 91.0% of total revenues for fiscal 1998 and 1997,
respectively. The increase in rental revenues of $54,790,000 was derived
primarily from the 267 video stores acquired during the period, from the
opening of 71 company-owned stores, net of closings, during fiscal 1998, and
from a 2% increase in same store revenues.
 
  Service fees. Service fees were approximately $800,000 and $567,000 or .5%
and .6% of total revenues of fiscal 1998 and 1997, respectively. Continuing
service fees and royalties from franchisees account for 95% of total service
fees from fiscal 1998 and 1997. The decrease in service fees as a percentage
of total revenues was due to a significant increase in the number of company-
owned stores without a corresponding increase in the number of franchise
stores, until 42 franchise stores were acquired in the Moovies transaction.
 
  Product sales. Product sales were approximately $17,075,000 and $7,743,000,
or 10.9% and 8.4% of total revenues for fiscal 1998 and 1997, respectively.
The increase in products sales of $9,332,000 was a result of product sales by
the video stores acquired during the period, the opening of 71 company-owned
video stores, net of closings, and an increase in sales of inventory and
fixtures to franchisees. The increase as a percentage of total revenues was
primarily due to: (i) an increased demand for the purchase of video games,
especially in Canada; (ii) the introduction of confection items in selected
markets; and, (iii) increased sales of holiday videocassettes.
 
  Store operating expenses. Store operating expenses consist primarily of
compensation and related expenses, occupancy expenses, and depreciation and
amortization expenses. Operating expenses were
 
                                      17
<PAGE>
 
approximately $128,971,000 and $69,366,000, or 82.6% and 75.6% of total
revenues for fiscal 1998 and 1997, respectively. The increase in store
operating expenses of $59,605,000, was primarily the result of video
stores acquired during the period and the opening of 71 company-owned video
stores, net of closings, during fiscal 1998. The increase in store operating
expenses as a percentage of total revenues was primarily due to revenues of
new stores not meeting management's expectations due primarily (management
believes) to new release titles not generating consumer interest or rental
traffic and corresponding higher costs associated with the opening of new
video stores prior to revenue reaching maturity during the first two years of
operations.
 
  Compensation and related expenses were approximately $35,877,000 and
$20,278,000, or 23.0% and 22.1% of total revenues for fiscal 1998 and 1997,
respectively. The increase of $15,599,000 was primarily the result of the
video stores acquired during the period and the opening of 71 company-owned
video stores, net of closings, during fiscal 1998.
 
  Occupancy expenses were approximately $37,956,000 and $20,777,000, or 24.3%
and 22.6% of total revenues for fiscal 1998 and 1997, respectively. The
increase of $17,179,000 was primarily the result of the video stores acquired
during the period and the opening of 71 company-owned video stores, net of
closings, during fiscal 1998.
 
  Depreciation and amortization expenses were approximately $43,436,000 and
$23,074,000, or 27.8% and 25.1% of total revenues for fiscal 1998 and 1997,
respectively. Depreciation and amortization expense reflects the depreciation
of store equipment and fixtures and the amortization of videocassettes. The
increase of $20,362,000 was primarily the result of video stores acquired
during the period and the opening of 71 Company-owned video stores net of
closings during fiscal 1998. Amortization expense as a percentage of revenues
for future periods may vary based on the Company's purchase of videocassette
inventory, which is subject to change based on the Company's rate of
expansion, studio release schedules and anticipated market demand.
 
  Selling, general and administrative. Selling, general and administrative
expenses were approximately $25,813,000 and $8,231,000, or 16.5% and 9.0% of
total revenues for fiscal 1998 and 1997, respectively. The increase of
$17,582,000 was primarily due to the following significant charges the Company
recorded during the fourth quarter: (i) a $3,500,000 non-cash, non-tax
deductible charge to compensation expense related to the release of 1,170,000
shares of Class B common stock from escrow (see Note 12 "Stockholders' Equity"
to the Consolidated Financial Statements); (ii) $3,200,000 non-cash charge
relating to the restated employment agreements for the Company's Chief
Executive Officer and its President, representing amounts to be applied to
their existing stock option related loan obligations and $3,900,000 will be
used by the executives primarily to pay income taxes arising from the stock
option related transaction; and, (iii) $700,000 for previously capitalized
bank fees related to the Company's previous Revolving Credit Facility which
was repaid prior to its maturity.
 
  Cost of product sales. Cost of product sales was approximately $11,513,000
and $4,544,000, or 7.4% and 4.9% of total revenues for fiscal 1998 and 1997,
respectively. The cost of product sales as a percentage of total product sales
revenue was approximately 67.4% and 58.7% for fiscal 1998 and 1997,
respectively. The increase in the cost of product sales as a percentage of
total product sales was primarily the result of a different mix of products
sold in video stores acquired which generally provided smaller margins.
 
  Amortization of goodwill. Amortization of goodwill was approximately
$2,353,000 and $1,613,000, or 1.5% and 1.7% of total revenues for fiscal 1998
and 1997, respectively. The increase of $740,000 was primarily attributable to
the increase in goodwill associated with the Company's continuing acquisitions
of video stores in the current year and prior periods and the related
amortization thereof.
 
  Interest expense. Interest expense was approximately $3,702,000 and
$544,000, or 2.4% and .6% of total revenues for fiscal 1998 and 1997,
respectively. The increase of $3,158,000 was primarily attributable to
interest on borrowings under the Company's bank line of credit.
 
 
                                      18
<PAGE>
 
  Other income. Other income was approximately $684,000 and $461,000, or .4%
and .5% of total revenues for fiscal 1998 and 1997, respectively. The increase
of $223,000 was primarily attributable to an increase in volume rebates on
product purchases.
 
FISCAL 1997 COMPARED TO FISCAL 1996
 
  Rental revenue. Rental revenue was approximately $83,489,000 and
$46,592,000, or 91.0% and 92.2% of total revenues for fiscal 1997 and 1996,
respectively. The increase in rental revenue of $36,897,000 was derived
primarily from the 74 video stores acquired during the period, from the
opening of 71 new company-owned stores during fiscal 1997, and from a 5.3%
increase in same store revenues.
 
  Service fees. Service fees were approximately $567,000 and $491,000, or .6%
and 1.0% of total revenues for fiscal 1997 and 1996, respectively. Continuing
service fees and royalties from franchisees accounted for 95% of total service
fees for fiscal 1997 and 1996. The decrease in service fees as a percentage of
total revenues was due to a significant increase in the number of company-
owned stores without a corresponding increase in the number of franchise
stores.
 
  Product sales. Product sales were approximately $7,743,000 and $3,421,000,
or 8.4% and 6.8% of total revenues for fiscal 1997 and 1996, respectively. The
increase in product sales of $4,322,000 was a result of product sales by the
video stores acquired during the period, the opening of 71 company-owned video
stores, and an increase in sales of inventory and fixtures to franchisees. The
increase in product sales as a percentage of total revenues was a result of
higher product sales as a percentage of total revenues by video stores
acquired during the period and increased sales of inventory and fixtures to
franchisees which have lower margins.
 
  Store operating expenses. Store operating expenses consist primarily of
compensation and related expenses, occupancy expenses, and depreciation and
amortization expenses. Operating expenses were approximately $69,366,000 and
$39,685,000, or 75.6% and 78.6% of total revenues for fiscal 1997 and 1996,
respectively. The increase in store operating expenses of $29,681,000, was
primarily the result of the 74 video stores acquired during the period and the
opening of 71 company-owned video stores during fiscal 1997. The decrease in
store operating expenses as a percentage of total revenues was primarily due
to improved control of compensation and related benefits expenses.
 
  Compensation and related expenses were approximately $20,278,000 and
$12,601,000, or 22.1% and 25.0% of total revenues for fiscal 1997 and 1996,
respectively. The increase of $7,677,000 was primarily due to the 74 video
stores acquired during the period and the opening of 71 company-owned video
stores. The decrease as a percentage of total revenues was primarily due to
improved control of compensation and related benefits expenses at the stores.
 
  Occupancy expenses were approximately $20,777,000 and $10,304,000, or 22.6%
and 20.4% of total revenues for fiscal 1997 and 1996, respectively. The
increase of $10,473,000, was primarily due to the 74 video stores acquired
during the period, the expansion of several stores in fiscal 1997 and the
opening of 71 company-owned stores. The increase as a percentage of total
revenues was primarily due to two factors. The first was higher occupancy
costs associated with the video stores acquired during the period when
compared to company-owned stores. In addition, new video stores experience
higher costs as a percentage of total revenues prior to revenue reaching
maturity during the first year of operations.
 
  Depreciation and amortization expenses were approximately $23,074,000 and
$13,894,000, or 25.1% and 27.5% of total revenues for fiscal 1997 and 1996,
respectively. Depreciation and amortization expense reflects the depreciation
of store equipment and fixtures and the amortization of videocassettes. The
increase of $9,180,000 was primarily attributable to the addition of new
release videocassette inventory for new, existing, and acquired stores.
Amortization expense as a percentage of revenues for future periods may vary
based on the Company's purchase of videocassette inventory which is subject to
the Company's rate of expansion, studio release schedules and anticipated
market demand.
 
                                      19
<PAGE>
 
  Selling, general and administrative. Selling, general and administrative
expenses were approximately $8,231,000 and $5,362,000, or 9.0% and 10.6% of
total revenues for fiscal 1997 and 1996, respectively. The increase of
approximately $2,869,000 was primarily due to adding management personnel and
administrative staff to support the Company's growth and related expenditures.
The decrease as a percentage of total revenues was due to the increases in
total revenues without a proportional increase in corporate overhead.
 
  Cost of product sales. Cost of product sales was approximately $4,544,000
and $1,880,000, or 4.9% and 3.7% of total revenues for fiscal 1997 and 1996,
respectively. The cost of product sales as a percentage of total product sales
revenue was approximately 58.7% and 55.0% for fiscal 1997 and 1996,
respectively. The increase in the cost of product sales as a percentage of
total product sales was primarily the result of a different mix of products
sold in video stores acquired which generally provided smaller margins.
 
  Amortization of goodwill. Amortization of goodwill was approximately
$1,613,000 and $1,072,000, or 1.7% and 2.1% of total revenues for fiscal 1997
and 1996, respectively. The increase was primarily attributable to the
increase in goodwill associated with the Company's continuing acquisitions of
video stores in the current year and prior periods and the related
amortization thereof.
 
  Interest expense. Interest expense was approximately $544,000 and $232,000,
or .6% and 0.5% of total revenues for fiscal 1997 and 1996, respectively. The
increase of $312,000 was primarily attributable to interest on borrowings
under the Company's bank line of credit.
 
  Other income. Other income was approximately $461,000 and $548,000, or .5%
and 1.1% of total revenues for fiscal 1997 and 1996, respectively. The
decrease of $87,000 was primarily due to less funds available for investment.
 
LIQUIDITY AND CAPITAL RESOURCES
 
  The Company has funded its operations through cash from operations, the
proceeds of prior equity and debt offerings, borrowings under bank facilities,
trade credit and equipment leases. The Company's principal capital
requirements are for the opening and building out of targeted new superstores,
the purchase of rental inventory, each of which varies based on market
conditions and expansion plans and the conversion of the acquired Moovies
stores.
 
  At April 30, 1998, the Company had cash and cash equivalents of
approximately $1,433,000. The Company uses an unclassified balance sheet in
its financial statements, and as a result, does not classify its assets or
liabilities as current or noncurrent. If the Company were to use a classified
balance sheet, a portion of videocassette rental inventories would be
classified as noncurrent because they are not assets that are reasonably
expected to be completely realized in cash or sold in one year. The
acquisition cost of these inventories, however, would be reflected in current
liabilities. The Company believes that classification of videocassette rental
inventories as noncurrent assets would be misleading because it would not
indicate the level of assets expected to be converted into cash in the next
year as a result of rentals or sales of these videocassettes.
 
  For the year ended April 30, 1998, net cash provided by operating activities
was approximately $42,865,000. Net cash used in investment activities was
approximately $77,510,000, consisting primarily of approximately $17,458,000
for new and remodeled stores, and approximately $61,752,000 for the purchase
of videocassette inventory for existing and new stores, and for the conversion
of stores acquired during the period. Net cash generated from financing
activities was approximately $33,654,000.
 
  In March 1998 the Company completed the acquisition of Moovies, Inc. The
Company issued approximately 9.3 million shares of Class A common stock in
exchange for Moovies common stock. The transaction was treated as a tax-free
exchange for federal income tax purposes and recorded under the purchase
method of accounting.
 
 
                                      20
<PAGE>
 
  Simultaneous with the closing of the Moovies transaction, the Company
announced that a syndicate led by Banque Paribas had extended it a $120
million credit/term loan facility (the "Senior Facility"). This Senior
Facility replaced the Company's previous line of credit. The Senior Facility
consists of the following: (i) two term loans totaling $95.0 million; (ii) a
$15.0 million capital expenditure line; and, (iii) a $10.0 million revolving
line. The Company borrowed the $95.0 million of the two term loans in
conjunction with the closing of the merger and the proceeds were used to: (i)
refinance approximately $35,000,000 of outstanding indebtedness including
accrued interest under the Company's previous line of credit; (ii) refinance
approximately $50,000,000 of indebtedness of Moovies under Moovies' previous
credit agreement; and, (iii) pay transaction fees and expenses relating to the
Merger of approximately $10,000,000, (including legal fees, accounting fees,
and registration fees). The capital expenditure line is primarily available to
fund the conversion of the acquired Moovies stores and integration costs, the
opening of new stores and selected acquisitions. As of April 30, 1998, the
Company had $4.5 million outstanding under this facility. The revolving line
is available for normal working capital needs. As of April 30, 1998 the
Company had $4.2 million outstanding under this facility.
 
  Amounts borrowed under the Senior Facility bear interest at variable rates
based on the "base rate" (i.e. the higher of the federal funds rate, plus 1/2
of 1% or the prime commercial lending rate) or the interbank Eurodollar rate
(approximately 8.5% and 5.69% per annum, respectively as of April 30, 1998)
plus an applicable margin rate that could range from .5% to 3.75%. Amounts
currently outstanding at April 30, 1998, had a weighted average rate of 9.29%.
 
  The Senior Facility includes negative, affirmative and financial covenants
including, but not limited to, minimum pretax earnings, minimum free cash
flow, minimum net worth, maximum indebtedness, maximum leverage, minimum fixed
charge coverage, a prohibition or restriction on capital expenditures, debt
and guarantees, liens and encumbrances on any property, mergers,
consolidations, investments, advances, divestitures, change or business or
conduct of business, joint ventures, partnerships, the creation of new
subsidiaries, dividends, distributions, repurchases or redemptions of
outstanding stock (including options or warrants), the voluntary prepayment,
repurchase redemption or defeasance of debt, and the acquisition, sale or
transfer, lease or sale-leaseback of assets. The Senior Facility is secured by
substantially all of the Company's assets as well as by pledges of its stock
in its subsidiaries, which subsidiaries also have provided guarantees of the
Company's obligations.
 
  As a result of the one-time charges recorded by the Company and its
operating results for the fourth quarter, the Company was not in compliance
with certain of the financial covenants of its Senior Facility for the quarter
ended April 30, 1998. The Company has received a waiver from the bank
syndicate for these non-complying conditions for this period. In addition,
because of its expected results for the first quarter of fiscal 1999, the
Company sought and obtained a similar waiver for the quarter ended July 31,
1998. Additionally, the Company and the bank syndicate amended the terms of
the Senior Facility to, among other things: (i) revise certain financial
covenants; (ii) increase immediate availability under the Senior Facility by
$5 million for Company operating activities; (iii) increase the overall
interest rate by .5%; and, (iv) reprice warrants held by the bank syndicate to
a more current market price. No assurances can be given that future waivers or
amendments will be obtained if the Company is unable to maintain a level of
operations necessary to meet the covenants and requirements of the Senior
Facility. If the Company is unable to maintain such a level of operations, it
will be required to reduce its overall expenditures and expansion plans to
comply with the covenants and requirements of the Senior Facility.
Additionally, any failure by the Company to maintain its level of operations
within the covenants and requirements of the Senior Facility could cause the
Company to be in default thereunder, allowing the lenders to take legal action
against the Company, including but not limited to, the immediate acceleration
of payment of borrowed funds, which could materially and adversely affect the
Company's operations. The immediate acceleration of debt thereunder or the
lack of further borrowing capacity, in whole or in part, would have a material
adverse effect on the Company's operations and financial condition.
 
  During fiscal 1999, the Company expects to focus on maximizing the operating
efficiencies of its existing and previously acquired locations and on
completing the build out of new stores in locations for which the Company has
signed lease commitments, rather than on aggressively expanding with new
superstores in additional metropolitan areas where it does not presently have
locations. The Company has maintained a
 
                                      21
<PAGE>
 
longstanding and satisfactory relationship with its primary product vendors
and has negotiated extended payment terms with several of these vendors. The
loss of its primary product vendors could have a material adverse effect on
the Company. Assuming the Company is able to maintain a satisfactory
relationship with its selected vendors and its bank lenders, the Company
expects that cash from operations, trade credits, equipment leases, available
revenue sharing arrangements, and available borrowing under the Senior
Facility will be sufficient to fund future inventory purchases and other
working capital needs for the next twelve months, although no assurances can
be given that the Company will not require additional sources of financing as
a result of store openings or build outs currently in progress, disappointing
operating results, unavailability under the Senior Facility as a result of
disappointing operating results, or unanticipated cash needs or opportunities.
Moreover, no assurances can be given that such additional funds will be
available on satisfactory terms, if at all. If the Company is unable to obtain
such additional financing, the Company may be required to reduce its overall
expenditures and the Company's ability to maintain or expand its current level
of operations could be materially and adversely affected.
 
  Each of Messrs. Potter and Bedard have issued notes to the Company (the
"Recourse Notes") in connection with stock option exercises, for approximately
$2,080,147 and $1,155,637, respectively, including accrued interest through
April 30, 1998. The Recourse Notes were issued by the executives upon their
exercise in August 1995 of 420,000 options granted to them under the Stock
Option Plans in May 1995 at an exercise price of $4.3125, the fair market
value of the stock on the date the options were granted. The Recourse Notes
represent the total exercise price of such options plus amounts advanced by
the Company to such executives to satisfy then anticipated tax liabilities.
The Recourse Notes, which provide for full recourse against the respective
officer's personal assets and Company stockholdings, are evidenced by
promissory notes bearing accrued interest at a rate of 8% per annum (through
April 30, 1998) with payment of principal and interest due on October 4, 1999.
In the event that the obligors sell shares of the Company's stock, the net
proceeds thereof will be applied to payment, in part or in full, of the
Recourse Notes.
 
  In connection with restated employment agreements for Mr. Potter and Mr.
Bedard, the Board has approved an accrual of bonuses that will be directed
primarily to satisfying obligations arising from the Recourse Notes. For
fiscal year 1998, bonus payments aggregating $816,580 were awarded as
reimbursement of previous payments of principal and interest on the recourse
notes and accompanying tax liability to the recipients. In addition, the Board
has approved the subsequent payment of additional aggregate bonuses of
approximately $6,345,000 to be used primarily to satisfy the Recourse Notes as
well as the anticipated income tax liabilities to these executives, subject to
any required approval of the Company's bank lenders. If such bonuses are not
effected, the Recourse Notes will remain outstanding.
 
  In addition, during fiscal 1998, the Company forgave a note receivable from
the President of the Company for approximately $33,000. The note represented
advances from the Company to the President from January 1994 to April 1994,
together with accrued interest.
 
  The Company generally does not offer lines of credit or guarantees for the
obligations of its franchisees, although on occasion, the Company has made
short term loans to current franchisees. The Company intends to evaluate the
possibility of providing loans or limited guarantees for certain franchisee
obligations, which in the aggregate are not expected to be material to the
Company's financial condition.
 
  Substantially all company-owned stores are in leased premises, except for
three stores that are located on premises owned by the Company. The Company
expects that most future stores will occupy leased premises.
 
  This Annual Report on Form 10-K contains a number of forward looking
statements. Any statements contained herein (including without limitation
statements to the effect that the Company or its management
 
                                      22
<PAGE>
 
"believes", "expects", "anticipates", "plans" and similar expressions) that
are not statements of historical fact should be considered forward looking
statements. There are a number of important factors that could cause the
Company's results to differ materially from those indicated by such forward
looking statements. These factors include, without limitation, the following:
 
 Cash Requirements
 
  As a result of the one-time charges recorded by the Company and its
operating results for the fourth quarter, the Company was not in compliance
with certain of the financial covenants of its Senior Facility for the quarter
ended April 30, 1998. The Company has received a waiver from the bank
syndicate for these non-complying conditions for this period. In addition,
because of its expected results for the first quarter of fiscal 1999, the
Company sought and obtained a similar waiver for the quarter ended July 31,
1998. Additionally, the Company and the bank syndicate amended the terms of
the Senior Facility to, among other things: (i) revise certain financial
covenants; (ii) increase immediate availability under the Senior Facility by
$5 million for Company operating activities; (iii) increase the overall
interest rate by .5%; and, (iv) reprice warrants held by the bank syndicate to
a more current market price. No assurances can be given that future waivers or
amendments will be obtained if the Company is unable to maintain a level of
operations necessary to meet the covenants and requirements of the Senior
Facility. If the Company is unable to maintain such a level of operations, it
will be required to reduce its overall expenditures and expansion plans to
comply with the covenants and requirements of the Senior Facility.
Additionally, any failure by the Company to maintain its level of operations
within the covenants and requirements of the Senior Facility could cause the
Company to be in default thereunder, allowing the lenders to take legal action
against the Company, including but not limited to, the immediate acceleration
of payment of borrowed funds, which could materially and adversely affect the
Company's operations. The immediate acceleration of debt thereunder or the
lack of further borrowing capacity, in whole or in part, would have a material
adverse effect on the Company's operations and financial condition.
 
  During fiscal 1999, the Company expects to focus on maximizing the operating
efficiencies of its existing and previously acquired locations and on
completing the build out of new stores in locations for which the Company has
signed lease commitments, rather than on aggressively expanding with new
superstores in additional metropolitan areas where it does not presently have
locations. The Company has maintained a longstanding and satisfactory
relationship with its primary product vendors and has negotiated extended
payment terms with several of these vendors. The loss of its primary product
vendors could have a material adverse effect on the Company. Assuming the
Company is able to maintain a satisfactory relationship with its selected
vendors and its bank lenders, the Company expects that cash from operations,
trade credits, equipment leases, available revenue sharing arrangements, and
available borrowing under the Senior Facility will be sufficient to fund
future inventory purchases and other working capital needs for the next twelve
months, although no assurances can be given that the Company will not require
additional sources of financing as a result of store openings or build outs
currently in progress, disappointing operating results, unavailability under
the Senior Facility as a result of disappointing operating results, or
unanticipated cash needs or opportunities. Moreover, no assurances can be
given that such additional funds will be available on satisfactory terms, if
at all. If the Company is unable to obtain such additional financing, the
Company may be required to reduce its overall expenditures and the Company's
ability to maintain or expand its current level of operations could be
materially and adversely affected.
 
 Integration of Former Moovies Locations
 
  The Company completed the acquisition of Moovies, Inc. in March, 1998.
Integrating the operations of the former Moovies locations (including
inventory purchasing, distribution of inventory to stores, marketing plans and
activities, employee hiring and training and expansion strategy) is a time
consuming process. Although the Company now has all of the acquired locations
on-line with Company information and computer systems and expects to adjust
location layout and marketing by late Fall, no assurances can be given as to
the timing of the
 
                                      23
<PAGE>
 
integration of acquired locations or that the integration of the locations
will result in immediate improvement in the Company's operating results.
Moreover, the integration of the acquired locations requires the dedication of
management resources, which may distract attention from the day-to-day
business of the Company. The inability of management to successfully or
expeditiously integrate the acquired locations could have a material adverse
effect on the business and operating results of the Company.
 
 Fluctuations in Quarterly Operating Results
 
  The Company has experienced in the past, and may continue to experience in
the future, fluctuations in its quarterly operating results. No assurance can
be given that the Company will have positive earnings in any quarter, or that
earnings in any particular quarter will not fall short of either a prior
fiscal quarter or investors' expectations. Factors such as the number of new
store openings (newer stores generally are less profitable than mature
stores), public acceptance and interest in new release titles, weather
(particularly on weekends and holidays), the mix of products rented and sold,
pricing actions of competitors, special or unusual events affecting retailers
in general, the level of advertising and promotional expenses, seasonality,
and one-time charges associated with acquisitions or other events could
contribute to quarterly variability in operating results. In addition, the
Company's expense levels are based in part on expectations of future sales
levels, and a shortfall in expected sales could therefore result in a
disproportionate decrease in net income.
 
 Significant Future Charges to Earnings Arising from Amortization of Goodwill
 
  At April 30, 1998, the Company had approximately $80,664,000 of goodwill on
its balance sheet that resulted primarily from the acquisition of video rental
stores, which will be amortized over 20 years. The Company expects that its
operating results for future quarters over the next 20 years will reflect
quarterly, non-cash charges of approximately $1,134,000 for amortization of
goodwill from these acquisitions. The Company also anticipates that future
acquisitions will involve the recording of a significant amount of goodwill on
its balance sheet, which will be amortized over varying periods of time of up
to 20 years.
 
 Competition
 
  The video rental industry is highly competitive. The Company competes with
other video retail stores, including Blockbuster Entertainment, a division of
Viacom, Inc. ("Blockbuster") and other superstores, and with supermarkets,
pharmacies, convenience stores, bookstores, mass merchants, mail order
operations, vending machines and other retailers, as well as with
noncommercial sources such as libraries. In addition to competing with other
video retailers, the Company competes with other leisure-time activities,
especially entertainment activities such as movie theaters, sporting events,
network television and cable television.
 
  The Company also competes with other distribution channels for studio
movies, including pay-per-view television on basic cable service, which
currently offer only a limited number of channels and monthly movie
selections. Recently developed digital compression technology combined with
fiber optics and other technology will eventually permit cable companies,
direct broadcast satellite companies and other telecommunications companies to
transmit a much greater number of movies to homes at scheduled intervals
throughout the day. Ultimately, these technologies could lead to the
availability of movies to the consumer on demand. Certain cable and other
telecommunications companies have tested and are continuing to test movie on
demand services in some markets.
 
  Some of the Company's competitors, including Blockbuster, have entered into
direct revenue-sharing arrangements with the major motion picture studios.
Such arrangements could allow these competitors to order and stock a greater
number of new release and other titles, thus increasing competition in those
areas in which each of the Company and its competitors have retail locations
and diminishing the potential benefits of similar revenue sharing
arrrangements entered into by the Company, which could have a material adverse
effect on operations. In addition, certain of the Company's larger, better
capitalized competitors may seek to acquire some of the same video specialty
stores that the Company seeks to acquire. Such competition for acquisitions
would likely increase acquisition prices and related costs and result in fewer
attractive acquisition opportunities, which could have a material adverse
effect on the Company's growth.
 
                                      24
<PAGE>
 
  The Company's franchise operations compete with numerous franchise
operations in many industries that have significantly greater financial and
human resources and more experience in selling franchises than does the
Company. Potential franchisees may believe that these franchisers offer
greater opportunities for success than the Company.
 
 Expansion
 
  The Company currently intends to focus on maximizing the operating
efficiencies of existing locations and on opening a very limited number of new
stores in selected locations rather than aggressively expanding new
superstores in additional metropolitan areas where it does not presently have
locations. Expansion is, and is expected to remain, dependent on a number of
factors, including cash flow, the availability of bank and other financing
resources, the ability to hire, train, retain and assimilate competent
management and store-level
employees, the ability to identify new markets in which it can successfully
compete, to locate suitable superstore sites and negotiate acceptable lease
terms and to adapt its purchasing, management information and other systems to
accommodate expanded operations. Expansion is also dependent on the timely
fulfillment by landlords and others of their contractual obligations, the
maintenance of construction schedules and the speed at which local zoning and
construction permits can be obtained. No assurance can be given that the
Company will be able to undertake any substantial near-term expansion with new
superstores or that such expansion, if possible, will be profitable. Any
expansion, including growth through acquisitions, will place increasing
pressure on the management controls of the Company. No assurance can be given
that the Company's new stores will achieve sales or profitability comparable
to its existing stores.
 
 Possible Adverse Effect of New Technologies on the Video Rental Business
 
  The Company also currently competes with pay-per-view cable television
systems. Recently developed digital compression technology combined with fiber
optics and other technology will eventually permit cable companies, direct
broadcast satellite companies and other telecommunications companies to
transmit a much greater selection of movies to homes at scheduled intervals
throughout the day. Ultimately, these technologies could lead to the
availability of movies on demand to the consumer. Certain cable and other
telecommunications companies have tested and are continuing to test movie on
demand services in some markets. Technological advances could have a material
adverse effect on the business of the Company.
 
 Changes in Studio Distribution and Pricing
 
  Changes in the manner in which movies are marketed by the studios that
produce them, primarily related to an earlier release of movie titles to
alternative distribution channels, could substantially decrease the demand for
video rentals, which could have a material adverse effect on the Company's
financial condition and results of operations. In addition, changes in the
movie studios' wholesale pricing structure for videos could result in a
competitive disadvantage for all video specialty stores, including those of
the Company.
 
 Supply Relationships
 
  In addition to traditional inventory purchasing in July, 1998, the Company
entered into a direct license revenue-sharing agreement with a major motion
picture studio. Under the terms of the agreement, the Company can choose
titles that it wants and may obtain them directly from the studio, although
the Company remains
able to obtain the titles through regular distribution channels on a title by
title basis. For each title obtained, the Company will share the greater of an
agreed-upon percentage of the rental revenue or dollar amount per rental
transaction, which percentage declines over a period of weeks following the
release of the title for video rental. The Company is already obtaining titles
under this agreement during fiscal 1999 and is aggressively pursuing
additional direct licensing revenue-sharing agreements with other studios,
although no assurances can be given that such agreements will be obtained.
 
  Video Update believes that such revenue-sharing agreements could be a cost
effective source for larger orders of an individual title, particularly new
release titles. Such agreements would enable Video Update to order
 
                                      25
<PAGE>
 
larger numbers, up to three times the normal order, of copies of a particular
title to satisfy customer demand than could be cost-effective if the copies
were purchased for rental. To obtain the full benefits of such revenue sharing
agreements, the Company must correctly identify the new release and other
titles that it should offer in each location on this basis. No assurances can
be given that the Company will be able to use such revenue sharing agreements
to obtain its intended results.
 
 Consumer Acceptance of New Release Movie Titles
 
  The Company depends significantly on availability and consumer acceptance of
new release videocassette titles available for rental. To the extent that
available new release titles fail to stimulate consumer interest and retail
traffic, operating results could be materially adversely affected.
 
 Management of Growth
 
  The Company's business, including sales, number of stores and number of
employees, has grown dramatically over the past several years. In addition,
the Company has consummated a number of significant acquisitions in the last
few years, and may make additional acquisitions in the future. This internal
growth, together with the acquisitions made, have resulted in integration
costs and placed significant demand on the Company's management and
operational systems. To manage its growth effectively, the Company will be
required to continue to upgrade its operational and financial systems, expand
its management team and increase and manage its employee base.
 
 Seasonality and Other Factors
 
  The Company's business is somewhat seasonal, with revenues in April, May,
September and October generally lower than in other months of the year. Future
operating results may be affected by many factors, including variations in the
number and timing of store openings and acquisitions, weather (particularly
on weekends and holidays), the public acceptance of new release titles
available for rental, competition, marketing programs, special or unusual
events and other factors that may affect retailers in general. Revenues may be
reduced temporarily if viewers prefer to watch such events rather than rent
videocassettes. Also, any concentration of new superstore openings and the
related pre-opening costs in any particular fiscal quarter could have a
material adverse effect on the Company's operating results for that quarter.
 
 Year 2000
 
  Like many other companies, Video Update is currently in the process of
evaluating its computer software and databases to determine whether or not
modifications will be required to prevent problems related to the Year 2000.
These problems, which have been widely reported in the media, could cause
malfunctions in certain software and databases with respect to dates on or
after January 1, 2000, unless corrected. The costs associated with this
process have been and are being expensed as incurred and, at the present time,
have not been and are not expected to be material in amount.
 
 Franchise Sales
 
  The sale of franchises is regulated by various state laws as well as by the
Federal Trade Commission (the "FTC"). The FTC requires that franchisors make
extensive disclosure to prospective franchisees but does not require
registration. A number of states require registration or disclosure in
connection with franchise offers and sales. In addition, several states have
"franchise relationship laws" or "business opportunity laws" that limit the
ability of franchisors to terminate franchise agreements or to withhold
consent to the renewal or transfer of these agreements. Although the
franchising operations are not materially adversely affected, to date, by such
existing regulations, the management of the Company cannot predict the effect
any future legislation or regulation may have on its business operations or
financial condition.
 
 Dependence on Key Personnel
 
  The Company's future success depends to a significant extent on the
continued contributions of Daniel A. Potter, the Company's Chairman and Chief
Executive Officer, and John M. Bedard, the Company's President. The loss of
the services of either of these officers could have a material adverse effect
on the Company. The
 
                                      26
<PAGE>
 
Company's continued growth and profitability also depends on its ability to
attract, motivate, and retain other management personnel, including qualified
store managers. No assurance can be given that the Company will be successful
in attracting, motivating and retaining such personnel.
 
 Retention of Employees
 
  The success of the Company will depend in part upon the retention of key
employees. Competition for qualified personnel in the video rental industry is
very intense. Stock options, which generally become exercisable only over a
period of several years of employment, serve as an important incentive for
retaining key employees. Although the Company is engaged in ongoing efforts to
retain key employees, retaining such employees may be more difficult in the
future.
 
 Antitakeover Effects; Shareholders' Rights Plan; Delaware Law and Certain
Charter and   Bylaw Provisions; Preferred Stock
 
 
  The Company's Board of Directors has the authority to issue up to five
million shares of Preferred Stock and to determine the price, rights,
preferences and privileges of those shares without any further vote or action
by the stockholders. The rights of the holders of Class A Common Stock and
Class B Warrants will be subject to, and may be adversely affected by, the
rights of the holders of any shares of Preferred Stock that may be issued in
the future. The issuance of Preferred Stock could have the effect of making it
more difficult for a third party to acquire a majority of the outstanding
voting stock of the Company, thereby delaying, deferring or preventing a
change of control of the Company. In addition, certain provisions in the
Company's Certificate of Incorporation and Bylaws containing restrictions on
calling special meetings of stockholders and restrictions on amendments to the
Bylaws may discourage or make more difficult any attempt by a person or group
of persons to obtain control of the Company.
 
  The Company is subject to the anti-takeover provisions of Section 203 of the
Delaware General Corporation Law. In general, the statute prohibits a publicly
held Delaware corporation from engaging in a "business combination" with an
"interested stockholder" for a period of three years after the date of the
transaction in which the person became an interested stockholder, unless the
business combination is approved in a prescribed manner. For purposes of
Section 203, a "business combination" includes a merger, asset sale or other
transaction resulting in a financial benefit to the interested stockholder,
and an "interested stockholder" is a person who, together with affiliates and
associates, owns (or within three years prior, did own) 15% or more of a
corporations' voting stock.
 
  In addition, options issued pursuant to the Company's stock option plans
generally will vest immediately upon a change in control as described in the
option grant letters.
 
  In April 1998, the Company's Board of Directors adopted a Rights Agreement
(the "Rights Agreement"). Under the Rights Agreement, a dividend of one right
("Right") to purchase a fraction of a share of newly created series of
preferred stock, was declared for each share of Class A Common Stock and each
Class B Warrant outstanding at the close of business on April 24, 1998. The
Rights, which expire on April 24, 2008, may be exercised only if certain
conditions are met, such as the acquisition (or the announcement of a tender
offer the consummation of which would result in the acquisition) of a
beneficial ownership of 15 percent or more of the Class A Common Stock by a
person or affiliated group. The Rights, if exercised, would cause substantial
dilution to a person or group of persons that attempts to acquire the Company
without the prior approval of the Board of Directors. The Board of Directors
may cause the Company to redeem the Rights for nominal consideration. The
Rights Agreement may discourage or make more difficult any attempt by a person
or group of persons to obtain control of the Company.
 
 Volatility of Stock Price
 
  The market prices of Video Update's Class A Common Stock and its Class B
Warrants have been, and may continue to be, extremely volatile. In addition,
prices of stocks of companies in the video store industry
 
                                      27
<PAGE>
 
(including Video Update) have been subject to a generally declining trend for
approximately the past 24 months. Factors such as new product announcements by
the Company or its respective competitors, quarterly fluctuations in operating
results, challenges associated with integration of business and general
conditions in the data networking market may have a significant impact on the
market price of Video Update Class A Common Stock and Class B Warrants. These
conditions, as well as factors which generally affect the market for stocks of
retail companies, could cause the price of Video Update Class A Common Stock
to fluctuate substantially.
 
  The Company's Class A Common Stock has been listed, and has traded, on the
Nasdaq National Market since July 1994, when the Company completed its initial
public offering. Among other requirements, the rules of the Nasdaq National
Market require that as a condition of the continued listing of the Company's
securities on such market, the minimum bid price of the Company's shares must
equal or exceed $1.00 (assuming that the value of the Company's net tangible
assets equals or exceeds $4,000,000). The closing price of the Company's Class
A Common Stock on July 31, 1998 was $1.28 per share. If, due to market
volatility, or other reasons, the bid price of the Company's Class A Common
Stock becomes less than $1.00 per share on a consistent basis, then the
Company may not meet Nasdaq National Market continued listing criteria. In
such event, the Company may make an application for listing on the Nasdaq
SmallCap Market. If the bid price of the Company's Class A Common Stock falls
below $1.00 and the securities are not approved for listing on the Nasdaq
SmallCap Market, then quotes for the shares of the Company's Class A Common
Stock will likely be maintained by the National Quotation Bureau, Inc. or the
NASD Electronic Bulletin Board. In such event, the liquidity of the Company's
Class A Common Stock and the ability of the Company to raise capital could be
adversely affected. In addition, a low trading price for the Company's Class A
Common Stock may have an adverse impact upon the efficient operation of the
trading market in the securities.
 
 Inflation
 
  To date, inflation has not had a material effect on the Company's business.
The Company anticipates that its business will be affected by general economic
trends. Although the Company has not operated during a period of high
inflation, it believes that it would generally be able to pass increased costs
resulting from inflation on to customers.
 
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
  Not applicable.
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
  The following financial statements are filed as part of this report.
<TABLE>
<CAPTION>
                                                                          PAGE
                                                                          ----
   <S>                                                                    <C>
   Report of Independent Auditors........................................ F-2
   Consolidated Balance Sheets as of April 30, 1997 and 1998............. F-3
   Consolidated Statements of Operations for the years ended April 30,
    1996, 1997 and 1998.................................................. F-4
   Consolidated Statement of Stockholders' Equity for the years ended
    April 30, 1996, 1997 and 1998........................................ F-5
   Consolidated Statements of Cash Flows for the years ended April 30,
    1996, 1997 and 1998.................................................. F-6
   Notes to Consolidated Financial Statements............................ F-7
</TABLE>
 
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
 
  None.
 
                                      28
<PAGE>
 
                                   PART III
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
 
BACKGROUND
 
  The Directors and executive officers of the Company, their positions held in
the Company, and their ages are as follows:
 
<TABLE>
<CAPTION>
         NAME                                AGE                  POSITION
         ----                                ---                  --------
   <S>                                       <C> <C>
   Daniel A. Potter.........................  40 Chairman and Chief Executive Officer
   John M. Bedard...........................  40 President and Director
   Daniel C. Howard.........................  37 Chief Operations Officer and Director
   Stephen L. Reynolds......................  34 Chief Financial Officer
   Richard Bedard...........................  44 Executive Vice President
   Bruce D. Carlson.........................  37 Vice President of Real Estate
   Michael G. Schifsky......................  42 Senior Vice President of Store Development
   F. Andrew Mitchell.......................  45 Director
   Theodore Coburn..........................  44 Director
   Paul M. Kelnberger.......................  54 Director
   Bernard Patriacca........................  54 Director
</TABLE>
 
  Each director is elected for a period of one year at the Company's annual
meeting of stockholders and serves until his successor is duly elected by the
stockholders.
 
  The following is a brief summary of the background of each director,
executive officer, and significant employee of the Company:
 
  Daniel A. Potter, Chairman and Chief Executive Officer. Mr. Potter co-
founded the Company in 1983 and has served as the Company's Chairman and Chief
Executive Officer since its inception. Mr. Potter holds a B.A. degree from the
University of Minnesota and a J.D. degree from William Mitchell College of
Law. Mr. Potter is a member of the nominating committee.
 
  John M. Bedard, President and Director. Mr. Bedard co-founded the Company in
1983 with Mr. Potter and has served as the Company's President and as a
Director since its inception. Mr. Bedard, together with Mr. Potter, devised
and implemented the Company's real estate development program and operations.
Mr. Bedard is the brother of Richard Bedard, an Executive Vice President of
the Company.
 
  Daniel C. Howard, Chief Operations Officer and Director. Mr. Howard has
served as the Company's Chief Operations Officer since 1990, has coordinated
the Company's operations since 1983, and has served as a Director since August
1994. He holds a B.S. degree from the University of Minnesota School of
Management. Mr. Howard is a member of the executive compensation committee.
 
  Stephen L. Reynolds, Chief Financial Officer. Mr. Reynolds has served as the
Company's Chief Financial Officer since January 6, 1998. From August 1995 to
January 5, 1998, Mr. Reynolds served as Vice President and Controller of
Moovies, Inc. From 1987 to 1995, Mr. Reynolds was with KPMG Peat Marwick LLP
in Greenville, South Carolina attaining the level of Senior Manager. Mr.
Reynolds holds a B.A. degree from Furman University and is a Certified Public
Accountant.
 
  Richard Bedard, Executive Vice President. Mr. Bedard has served as an
Executive Vice President of the Company since September 1995. From 1986 to
1995, he served as the Company's Vice President of Franchise Development. Mr.
Bedard is the brother of John M. Bedard, the Company's President and a
Director.
 
 
                                      29
<PAGE>
 
  Bruce D. Carlson, Vice President of Real Estate. Mr. Carlson has served as
the Company's Vice President of Real Estate Operations since 1990. From 1984
to 1990, Mr. Carlson held the positions of Director of Advertising and
Regional Corporate Store Manager.
 
  Michael G. Schifsky, Senior Vice President of Store Development. Mr.
Schifsky has served as Vice President of Store Development since rejoining the
Company in 1990. Mr. Schifsky has also served as a District Manager of the
Company from 1984 to 1988. From 1988 to 1990, he was the principal stockholder
of Bankshot Investments, Inc., a privately held company engaged in the
development of billiard facilities.
 
  Paul M. Kelnberger, Director. Mr. Kelnberger has served as a Director since
August 1994. Mr. Kelnberger has been a member of Johnson, West & Co., PLC
("Johnson, West & Co."), a certified public accounting firm with its principal
offices in St. Paul, Minnesota, since 1975. In addition, since November 1995
Mr. Kelnberger has served as a Director of Leuthold Funds, a publicly held
mutual fund. Johnson, West & Co. performed auditing services for the Company
prior to the fiscal year ended April 30, 1993. Since that time, Johnson West &
Co. has provided and continues to provide to the Company accounting services
in connection with the Company's acquisitions and sales and use tax planning.
Mr. Kelnberger is a certified public accountant and holds a Certificate of
Accounting from the Academy of Accountancy in Minneapolis, Minnesota. He
chairs the Board's audit committee and is a member of the executive
compensation committee. See "Certain Relationships and Related Transactions."
 
  Bernard Patriacca, Director. Mr. Patriacca has served as a Director since
April 1997. Since November 1997, he has served as the Vice President and
Controller of Summit Technology, Inc., a publicly held developer, manufacturer
and seller of opthalmic laser systems and related products designed to correct
vision disorders. Since 1994, he also has served as Vice President of Errands
Etc., Inc., a privately held homeowner's personal service company. From 1973
to 1991, Mr. Patriacca served in various capacities at Dunkin' Donuts
Incorporated, including Chief Financial Officer and Director. From 1991 to
1994, Mr. Patriacca held senior financial management positions at several
privately held consumer services companies. He also serves as a director of
Smith-Midland Corporation, a publicly held developer and manufacturer of
precast concrete products. Mr. Patriacca is a certified public accountant and
holds Bachelor's and Master's degrees in finance and accounting from
Northeastern University. Mr. Patriacca is a member of the audit committee and
executive compensation committee.
 
  F. Andrew Mitchell, Director. F. Andrew Mitchell has served as a director of
the Company since March, 1998. Mr. Mitchell is currently Executive Vice
President and Chief Financial Officer of Ranger Aerospace Corporation, a
privately held aviation services company. Prior to this, from March 1995 to
March 1998, Mr. Mitchell served as Chief Financial Officer and as a Director
of Moovies, Inc. From 1987 to March 1995 Mr. Mitchell was a partner with KPMG
Peat Marwick LLP and was managing partner of the 70-person Greenville, South
Carolina office for the last three and a half years. During his 20-year career
with KPMG he had extensive experience serving public and privately-held
clients in the financial institution, entertainment and franchise restaurant
industries. Mr. Mitchell serves as a director of First Savers Bank, a publicly
held savings bank. Mr. Mitchell is a certified public accountant and holds a
B.B.A. in accounting from the University of Cincinnati. Mr. Mitchell is a
member of the audit committee and nominating committee.
 
  Theodore J. Coburn, Director. Theodore J. Coburn has been a director of the
Company since March 1998. Mr. Coburn served as a director of Moovies, Inc.
from June 1995 to March 1998. Since 1991, Mr. Coburn has been a partner and a
director of Brown, Coburn & Co., an investment banking firm. From 1986 until
1991, he was a Managing Director of Global Equity Transactions and a member of
the Board of Directors of Prudential Securities. From 1983 to 1986 Mr. Coburn
served as Managing Director of Merrill Lynch Capital Markets. Mr. Coburn
serves as a director of Measurement Specialties, Inc., a publicly held company
and as a director of Ariel Corporation, a publicly held company. Mr. Coburn
serves as a director of the Nicholas-Applegate Fund, Inc. and as a trustee of
the Nicholas-Applegate Mutual Funds. He also serves as a director of the
Emerging Germany Fund. Mr. Coburn received his B.S. from the University of
Virginia in 1975 and an M.B.A. from Columbia
 
                                      30
<PAGE>
 
University Graduate School of Business in 1978 and holds masters degrees from
Harvard University Graduate School of Education and its Divinity School. Mr.
Coburn is a member of the nominating committee.
 
SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
 
  Section 16(a) ("Section 16(a)") of the Securities Exchange Act of 1934, as
amended (the "Exchange Act"), requires executive officers and directors, and
persons who beneficially own more than ten percent (10%) of the Company's
Common Stock, to file initial reports of ownership on Form 3 and reports of
changes in ownership on Form 4 with the Securities and Exchange Commission
(the "SEC") and any national securities exchange on which the Company's
securities are registered. Executive officers, directors and greater than ten
percent (10%) beneficial owners are required by SEC regulations to furnish the
Company with copies of all Section 16(a) forms they file.
 
  Based solely on a review of the copies of such forms furnished to the
Company and written representations from the executive officers and directors
that no other reports were required, the Company believes that during fiscal
1998, its executive officers, directors and greater than ten percent (10%)
beneficial owners complied with all applicable Section 16(a) filing
requirements.
 
ITEM 11. EXECUTIVE COMPENSATION.
 
BOARD COMPENSATION COMMITTEE REPORT ON EXECUTIVE COMPENSATION
 
  Set forth below is the report of the Company's Compensation Committee
regarding executive compensation:
 
  Report of the Video Update Compensation Committee On Executive Compensation
 
 Overview
 
  The Executive Compensation Committee of the Board of Directors of Video
Update, Inc. is composed of two non-employee directors and one employee
director. The Executive Compensation Committee reviews the compensation of the
Company's Chief Executive Officer and its President at least annually. The
Executive Compensation Committee believes the actions of the top two
executives of the Company have a profound impact on the short-term and long-
term profitability of the Company. Therefore, the Executive Compensation
Committee gives significant attention to the design of the Company's
compensation package for such individuals.
 
  The Company's compensation package consists of two parts and is relatively
simple in design. The two primary parts are a base salary and stock-based
incentive compensation. No significant perquisites other than automobile
expenses and insurance are provided to the two executive officers.
 
 Base Salary
 
  The Executive Compensation Committee believes it is important for the two
executive officers of the Company to receive acceptable salaries so that the
Company can recruit and retain the talent it needs. In setting salaries, the
Executive Compensation Committee takes into consideration the individual
employee's performance, length of service to the Company, and a subjective
judgment regarding the impact the individual has on the Company. The base
salary for each executive officer set forth in their respective employment
agreements was set on a subjective basis, bearing in mind an overall
impression of that executive's relative skills, experience and contribution to
the Company. The Executive Compensation Committee does not attempt to address
the relative weight assigned to the various factors, which are evaluated on a
subjective overall basis by each individual member of the Executive
Compensation Committee. Salaries of the Company's Chief Executive Officer and
its President are reviewed annually by the Executive Compensation Committee.
 
 
                                      31
<PAGE>
 
 Stock-Based Incentives
 
  Stock-based incentives have been a supplemental component of compensation
for the Company's Chief Executive Officer and its President, and certain other
employees, since the Company's initial public offering in 1994. The Company
adopted formal incentive stock option plans in 1994, 1995, 1996 and 1998. The
Executive Compensation Committee recommends grants of stock options under the
Company's option plan for the Chief Executive Officer and the President.
 
  Historically, grants made by the Company have generally vested at a rate of
33% per year beginning one year from the date of grant. These options also
usually expire upon termination of employment or a limited period thereafter,
except in the event of disability or death, in which case the term of the
option may continue for some time thereafter.
 
  The Executive Compensation Committee believes that the Company's stock
option program has been effective in focusing attention on stockholder value
since the gain to be realized by these two executive officers upon exercise of
options will change as the stock price changes. The Executive Compensation
Committee also believes that the long-term nature of the options encourages
the Company's top two executive officers to remain with the Company. The
number of shares to be granted was established utilizing the procedure
described above at "Base Salary." No new stock options were granted to either
the Chief Executive Officer or the President in fiscal 1998. With respect to
previous stock option grants to such executives, the Executive Compensation
Committee subjectively determined the number of shares to be granted based on
its analysis of the number that would provide an adequate incentive to each of
its top two executive officers.
 
  In general, the granting of stock-based incentives is considered by the
Committee to be justified when the Company's revenues and earnings, coupled
with the individual executive's performance, warrant supplemental compensation
in addition to the salary and bonus paid with respect to a given year. Each of
these factors is weighed subjectively by Committee members in determining
whether or not a stock-based incentive should be granted, and such incentives
are not granted routinely.
 
 Compensation of the Chief Executive Officer
 
  The Compensation Committee has reviewed and approved the annual salary of
Daniel A. Potter, Chief Executive Officer of the Company, which is set at
$360,000. This exhibits the philosophy of the Executive Compensation Committee
as set forth at "Base Salary" above. This salary was reflected in Mr. Potter's
restated employment agreement entered into in April 1998, following the
completion of the Moovies acquisition. Under the previous employment agreement
with Mr. Potter, the term of which would have expired in fiscal 1999, the
Company had significant financial obligations to Mr. Potter if he left at a
time when he had outstanding loan obligations to the Company, such as the
recourse note in the principal amount of $2,080,147 (as of April 30, 1998),
which was issued in connection with the exercise of stock options. The Board
believes that the new restated employment agreement allows the Company to
eliminate the uncertainty relating to such an obligation in the future and the
Board has approved an accrual of bonuses that will be directed primarily to
satisfying obligations arising from this outstanding loan. In addition, under
the new restated employment agreement, the Company has obtained a lengthened
noncompetition obligation from Mr. Potter (three years versus the one year
commitment in the previous employment agreement) following any termination of
the restated employment agreement. Mr. Potter's compensation is subject to
annual review by the Board of Directors. The Board believes the compensation
of Mr. Potter, a founder of the Company, reflects the Committee's subjective
opinion that Mr. Potter has provided solid leadership, particularly in
connection with the acquisition of Moovies, Inc., and fulfilled the functions
of an executive officer of the Company at the highest level.
 
 Deductibility of Executive Compensation
 
  Section 162(m) of the Internal revenue Code generally disallows a tax
deduction to public companies for compensation over $1 million paid to its
chief executive officer and its four other most highly compensated executives.
Performance based compensation is excluded from the compensation taken into
account for purposes
 
                                      32
<PAGE>
 
of the limit if certain requirements are met. In addition, in the future, the
Committee currently intends to structure its salary and stock option packages
granted to executives in a manner that complies with the performance based
requirements of the statute, although the Committee retains the discretion to
make awards that do not qualify for the exemption if such arrangements are in
the best interests of the Company and its stockholders. Further, because of
ambiguities and uncertainties as to the application and interpretation of
Section 162(m) and the regulations issued thereunder, no assurances can be
given, notwithstanding the Company's efforts, that compensation intended by
the Company to satisfy the requirements for deductibility under Section 162(m)
does in fact do so.
 
 Conclusion
 
  The Executive Compensation Committee believes that its mix of a cash salary
and a long-term stock incentive compensation program represents a balance that
has motivated and will continue to motivate the Company's management team to
produce the best results possible given overall economic conditions and the
difficulty of predicting the Company's performance in the short term.
 
      Executive Compensation Committee:           Board of Directors:
      PAUL M. KELNBERGER                          DANIEL A. POTTER
      BERNARD PATRIACCA                           JOHN M. BEDARD
      DANIEL C. HOWARD                            DANIEL C. HOWARD
                                                  PAUL M. KELNBERGER
                                                  BERNARD PATRIACCA
                                                  F. ANDREW MITCHELL
                                                  THEODORE COBURN
 
                                      33
<PAGE>
 
PERFORMANCE GRAPH
 
  Set forth below is a line-graph presentation comparing the cumulative
stockholder return on the Company's Class A Common Stock, on an indexed basis,
against cumulative total returns of the Nasdaq Stock Market (U.S. Companies)
and a "peer group" selected by Management of the Company. The peer group
selected for inclusion in this proxy statement includes Hollywood
Entertainment Corporation ("Hollywood"), Movie Gallery, Inc. ("MGI"), and West
Coast Entertainment Corp. ("West Coast") (collectively, the "Peer Group
Companies"). Hollywood, MGI, and West Coast have securities traded on the
Nasdaq Stock Market. The Peer Group Companies were selected because they are
frequently utilized as a basis for comparison with the Company in reports by
analysts. Viacom, Inc. ("Viacom"), which operates "Blockbuster" video
specialty stores, is not included in the peer group. Viacom is a large
entertainment conglomerate with only a small portion of its business in the
retail videotape industry, and its stock is traded on the American Stock
Exchange. The returns for the peer group were weighted according to each
issuer's market capitalization. The Performance Graph shows total return on
investment for the period beginning July 20, 1994 (the date of the Company's
initial public offering) and ended April 30, 1998, (the Company's most recent
fiscal year end).
 
 
 
                                   [GRAPH] 

 
 
VALUE OF $100 INVESTED ON JULY 20, 1994 AT:
 
<TABLE>
<CAPTION>
                                         7/20/94 4/30/95 4/30/96 4/30/97 4/30/98
                                         ------- ------- ------- ------- -------
   <S>                                   <C>     <C>     <C>     <C>     <C>
   VIDEO UPDATE......................... 100.00   87.50  162.50   82.50   56.25
   PEER GROUP INDEX(1).................. 100.00  166.71  155.91  144.62   90.56
   NASDAQ MARKET INDEX.................. 100.00  108.27  151.13  161.09  239.26
</TABLE>
 
Total return assumes reinvestment of dividends.
--------
(1) West Coast is included Peer Group only as of April 30, 1997. West Coast's
    stock began trading publicly in May, 1996.
 
 
                                      34
<PAGE>
 
SUMMARY COMPENSATION TABLE
 
  Set forth below is a Summary Compensation Table concerning the compensation
of the named executive officers for the last three completed fiscal years.
 
                          SUMMARY COMPENSATION TABLE
 
<TABLE>
<CAPTION>
                                                                     LONG TERM
                                         ANNUAL COMPENSATION        COMPENSATION
                                   -------------------------------- ------------
                                                                       AWARDS
                                                                    ------------
                           FISCAL                                    SECURITIES
                            YEAR                       OTHER ANNUAL  UNDERLYING   ALL OTHER
                           ENDED    SALARY    BONUS    COMPENSATION OPTIONS/SARS COMPENSATION
   NAME AND PRINCIPAL     APRIL 30  (1)($)    (2)($)      (3)($)       (4)(#)       (5)($)
      POSITION (A)          (B)      (C)       (D)         (E)          (G)          (I)
   ------------------     -------- -------- ---------- ------------ ------------ ------------
<S>                       <C>      <C>      <C>        <C>          <C>          <C>
Daniel A. Potter .......    1998   $300,000 $4,603,665  $1,926,973        --       $26,195
 Chairman and               1997   $300,000 $      --   $      --     300,000      $26,307
 Chief Executive Officer    1996   $248,002 $      --   $  894,357    270,000      $21,122
John M. Bedard..........    1998   $200,000 $2,557,590  $1,557,019        --       $27,934
 President and Director     1997   $200,000 $      --   $      --     165,000      $17,952
                            1996   $158,755 $      --   $  496,875    150,000      $18,081
Daniel C. Howard........    1998   $ 87,890 $      --   $   62,278        --       $12,673
 Chief Operations Offi-     1997   $ 78,000 $      --   $      --      36,000      $ 8,113
 cer(6)
                            1996   $ 75,150 $      --   $      --      45,000      $ 2,043
Stephen L. Reynolds.....    1998   $ 56,539 $      --   $      --      40,000      $ 3,552
 Chief Financial Offi-
 cer(7)
Christopher J. Gondeck..    1998   $136,290 $      --   $      --         --       $ 7,468
 Chief Financial Offi-
  cer(8)                    1997   $125,000 $      --   $      --      60,000      $14,033
                            1996   $114,548 $      --   $      --      45,000      $ 2,854
</TABLE>
--------
(1) Amounts shown indicate cash compensation earned and received by executive
    officers; no amounts were earned but deferred at the election of those
    officers. Executive officers participate in the Company's group health
    insurance plan.
(2) Amounts shown reflect the bonus amounts accrued by the Company in
    conjunction with Messrs. Potter and Bedard's restated employment
    agreements. Amounts totaling $524,945 and $291,635 were paid to Messrs.
    Potter and Bedard respectively in fiscal 1998 as reimbursement of previous
    payments of principal and interest on their recourse notes to the Company
    and accompanying tax liabilities.
(3) Amounts for fiscal 1996 shown reflect the difference between the aggregate
    exercise price of the options exercised by Messrs. Potter and Bedard
    during the period, and the aggregate fair market value of the shares of
    Class A Common Stock issued to Messrs. Potter and Bedard upon such
    exercises, as of the date of issuance. Amounts for fiscal 1998 reflect the
    release of 635,755, 513,698 and 20,547 shares from escrow to Messrs.
    Potter, Bedard and Howard respectively, at the market price on the date of
    release.
(4) Amounts shown reflect grants of options to purchase Class A Common Stock
    pursuant to the Company's Stock Option Plans. During fiscal years 1996
    through 1998, the Company made no awards of restricted stock and did not
    have a long-term incentive plan.
(5) Amounts shown reflect payment for automobile, insurance and other
    expenses.
(6) Mr. Howard's base salary as of January 1998 is set at $128,400. The amount
    of $87,890 represents salary paid through April 30, 1998.
(7) Mr. Reynolds was appointed Chief Financial Officer of the Company on
    January 6, 1998. Mr. Reynolds' base salary is set at $175,000. The amount
    of $56,539 represents salary paid through April 30, 1998.
(8) Mr. Gondeck resigned as Chief Financial Officer of the Company on December
    31, 1997.
 
                                      35
<PAGE>
 
OPTION/SAR GRANTS IN FISCAL YEAR 1997
 
  Set forth below is an Option/SAR Grants table concerning individual grants
of stock options and SARs made during the last completed fiscal year to each
of the named executive officers.
 
                     OPTION/SAR GRANTS IN FISCAL YEAR 1998
 
<TABLE>
<CAPTION>
                                                                                       POTENTIAL
                                                                                       REALIZABLE
                                                                                        VALUE AT
                                                                                        ASSUMED
                                                                                         ANNUAL
                                                                                        RATES OF
                                                                                      STOCK PRICE
                                                                                      APPRECIATION
                                                                                       FOR OPTION
                                                 INDIVIDUAL GRANTS                      TERM(1)
                                ---------------------------------------------------- --------------
                                 NUMBER OF
                                 SECURITIES  PERCENT OF TOTAL
                                 UNDERLYING    OPTIONS/SARS
                                OPTIONS/SARS    GRANTED TO    EXERCISE OF
                                  GRANTED      EMPLOYEES IN   BASE PRICE  EXPIRATION
      NAME                          (#)       FISCAL YEAR(2)    ($/SH)     DATE(3)   5%($)  10%($)
      (A)                           (B)            (C)            (D)        (E)      (F)     (G)
      ----                      ------------ ---------------- ----------- ---------- ------ -------
<S>                             <C>          <C>              <C>         <C>        <C>    <C>
Daniel A. Potter...............       --           --              --           --      --      --
John M. Bedard.................       --           --              --           --      --      --
Daniel C. Howard...............       --           --              --           --      --      --
Stephen L. Reynolds(4).........    40,000          6.8%          $3.18     09/30/08  79,995 202,724
Christopher J. Gondeck(5)......       --           --              --           --      --      --
</TABLE>
--------
(1) The dollar gains under these columns result from calculations assuming
    hypothetical growth rates as set by the Commission and are not intended to
    forecast future price appreciation of the Class A Common Stock.
(2) In fiscal 1998, options to purchase a total of 585,500 shares of the
    Company's Class A Common Stock were granted to employees of the Company,
    including executive officers.
(3)These options are subject to earlier termination upon certain events
related to termination of employment.
(4) Mr. Reynolds was appointed Chief Financial Officer of the Company on
    January 6, 1998.
(5) Mr. Gondeck resigned as Chief Financial Officer of the Company on December
    31, 1997.
 
AGGREGATED OPTION/SAR EXERCISES AND FISCAL YEAR-END OPTION/SAR VALUE TABLE
 
  Set forth below is a table concerning each exercise of stock options (or
tandem SAR's) and freestanding SARs during the last completed fiscal year by
each of the named executive officers and the fiscal year-end value of
unexercised options and SARs.
 
     AGGREGATED OPTION/SAR EXERCISES FOR FISCAL YEAR ENDED APRIL 30, 1998
                         AND FY-END OPTION/SAR VALUES
 
<TABLE>
<CAPTION>
                                                                    NUMBER OF
                                                                    SECURITIES
                                                                    UNDERLYING         VALUE OF
                                                                   UNEXERCISED       UNEXERCISED
                                                                   OPTIONS/SARS      IN-THE-MONEY
                                                                 AT FISCAL YEAR-     OPTIONS/SARS
                                              SHARES     VALUE         END        AT FISCAL YEAR-END
                                           ACQUIRED ON  REALIZED (#) EXERCISABLE/  ($) EXERCISABLE/
      NAME                                 EXERCISE (#)   ($)     UNEXERCISABLE    UNEXERCISABLE(1)
      (A)                                      (B)        (C)          (D)               (E)
      ----                                 ------------ -------- ---------------- ------------------
<S>                                        <C>          <C>      <C>              <C>
Daniel A. Potter..........................      --         --    100,000/200,000          --
John M. Bedard............................      --         --     55,000/110,000          --
Daniel C. Howard..........................      --         --      63,406/93,500          --
Stephen L. Reynolds(2)....................      --         --      32,813/40,000          --
Christopher J. Gondeck(3).................      --         --                0/0          --
</TABLE>
--------
(1) In-the-money options are those options for which the fair market value of
    the underlying Common Stock is greater than the exercise price of the
    option. On April 30, 1998, the fair market value of the Company's Class
 
                                      36
<PAGE>
 
   A Common Stock underlying the options (as determined by the last sale price
   quoted on the NASDAQ National Market) was $2.813. None of the options
   listed under column D were in-the-money at Fiscal Year End.
(2) Mr. Reynolds was appointed Chief Financial Officer of the Company on
    January 6, 1998.
(3) Mr. Gondeck resigned as Chief Financial Officer of the Company on December
    31, 1997.
 
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
 
  Compensation decisions for the Company's Chief Executive Officer and
President are made by the Executive Compensation Committee, comprised of
Messrs. Kelnberger, Howard and Patriacca.
 
  None of the executive officers of the Company have served on the Board of
Directors of any other entity that has had any of such entity's officers serve
either on the Company's Board of Directors or Compensation Committee.
 
  During fiscal 1998, the Company paid approximately $511,000 to Johnson, West
& Co. for accounting services in connection with the Company's acquisitions
and for tax return preparation services. Mr. Kelnberger is a member of
Johnson, West & Co.
 
EMPLOYMENT CONTRACTS, TERMINATION OF EMPLOYMENT, OFFICER LOANS AND CHANGE IN
CONTROL ARRANGEMENTS
 
  In April 1998, the Company entered into restated employment agreements (the
"Employment Agreements") with Daniel A. Potter, its Chairman and Chief
Executive Officer and John Bedard, its President, each of whom also is a
director through April 2001. Mr. Potter and Mr. Bedard are to receive salaries
of $360,000 and $240,000, respectively. Such compensation may be increased and
bonuses may be awarded at the discretion of the Board of Directors of the
Company. Each of Messrs. Potter and Bedard have agreed to devote their full
time and best efforts to fulfill their duties and responsibilities to the
Company. Each of them will be entitled to participate in employee benefit
plans.
 
  Each of Messrs. Potter and Bedard have issued notes to the Company (the
"Recourse Notes") in connection with stock option exercises, for approximately
$2,080,147 and $1,155,637, respectively, including accrued interest through
April 30, 1998. The Recourse Notes were issued by the executives upon their
exercise in August 1995 of 420,000 options granted to them under the Stock
Option Plans in May 1995 at an exercise price of $4.3125, the fair market
value of the stock on the date the options were granted. The Recourse Notes
represent the total exercise price of such options plus amounts advanced by
the Company to such executives to satisfy then anticipated tax liabilities.
The Recourse Notes, which provide for full recourse against the respective
officer's personal assets and Company stockholdings, are evidenced by
promissory notes bearing accrued interest at a rate of 8% per annum (through
April 30, 1998) with payment of principal and interest due on October 4, 1999.
In the event that the obligors sell shares of the Company's stock, the net
proceeds thereof will be applied to payment, in part or in full, of the
Recourse Notes.
 
  In connection with the restated employment agreements for Mr. Potter and Mr.
Bedard, the Board has approved an accrual of bonuses that will be directed
primarily to satisfying obligations arising from the Recourse Notes. For
fiscal year 1998, bonus payments aggregating $816,580 were awarded as
reimbursement of previous payments of principal and interest on the Recourse
Notes and accompanying tax liability to the recipients. In addition, the Board
has approved the subsequent payment of additional aggregate bonuses of
approximately $6,345,000 to be used primarily to satisfy the Recourse Notes,
as well as the anticipated income tax liabilities to the executives subject to
any required approval of the Company's bank lenders. If such bonuses are not
effected, the Recourse Notes will remain outstanding.
 
  Under the Employment Agreements, the Company has a right to terminate each
of the agreements for "cause" as defined in the agreements or as a result of
the employee's disability. Except in the case of termination for cause, upon
early termination of the agreements of the Company, each of Messrs. Potter and
Bedard shall be entitled to receive their salary plus fringe benefits for 36
months from the date of termination. In addition, the Employment Agreements
provide that any amount owed by Messrs. Potter or Bedard to the Company will
be forgiven (with any necessary payment to cover any resulting tax liability
incurred by such executive) if such executive leaves the Company while his
Recourse Note remains outstanding. In the event of a change of control
 
                                      37
<PAGE>
 
of the Company, Messrs. Potter and Bedard have the option to terminate their
employment subject to the provisions of the employment agreements and to
receive severance and fringe benefits for 36 months subject to the provisions
of their agreements. A "change in control" includes an acquisition of 15% of
the voting power of the securities of the Company by any person, certain
changes in the composition of the Board of Directors, and an approval by the
stockholders of the Company of a merger, consolidation, reorganization,
liquidation, dissolution or sale of all or substantially all of the assets of
the Company.
 
  Each of Messrs. Potter and Bedard has agreed not to disclose any
confidential information of the Company during the term of his employment or
to compete with the Company during the term of his employment or for a period
of three years following termination of his employment except in accordance
with the employment agreement.
 
  In January, 1998, the Company entered into an employment agreement with
Daniel C. Howard, its Chief Operating Officer and a director and stockholder.
As compensation, Mr. Howard is to receive an annual base salary of $128,400,
plus bonuses and stock options as determined by the Board of Directors. The
agreement is for an initial term of two years, and is automatically renewed
for successive one-year terms, unless terminated by the Company or Mr. Howard.
Upon termination in accordance with the agreement, Mr. Howard is entitled to
receive severance pay of at least twelve months' base salary and at most
twenty-four months' base salary, less certain amounts provided in the
agreement. In the event Mr. Howard's employment is terminated after a change
in control, Mr. Howard is entitled to receive an amount equal to two times his
average total annual compensation during the two years preceding the
termination. A "change in control" occurs when any person or entity acquires
at least 51% of the voting power of the securities of the Company, the
stockholders of the Company approve a plan of liquidation, or the Company
engages in a merger, sale of assets or other business combination that results
in the security holders of the Company holding less than a majority of the
combined voting power after the transaction. Mr. Howard has agreed not to
disclose any confidential information of the Company during his employment and
thereafter, and not to compete with the Company during his employment and for
two years thereafter, including soliciting customers and employees of the
Company.
 
  In addition during fiscal 1998, the Company forgave a note receivable from
the President of the Company for approximately $33,000. The Note represented
advances from the Company to the President from January 1994 to April 1994,
together with accrued interest.
 
  In connection with the acquisition of Moovies, Inc., the Company is
obligated to make certain "change of control" payments to F. Andrew Mitchell,
one of the Company's directors, and to Stephen L. Reynolds, the Company's
Chief Financial Officer, both of whom were formerly employed by Moovies. As of
July 15, 1998, the total aggregate amount remaining due to Messrs. Mitchell
and Reynolds was $310,000 and $174,000 respectively.
 
  Mr. Potter's brother-in-law Robert Yager, formerly a director of the
Company, is employed as a regional manager of the Company. Mr. John Bedard is
the brother of Richard Bedard and Glenn Bedard, Company executive vice
presidents and Paul Bedard, a Company vice president. Each of the non-
executive employees receives an annual compensation ranging from $69,800 to
$98,700 .
 
COMPENSATION OF DIRECTORS
 
  Members of the Board of Directors who are not employees of the Company
receive $1,000 for each meeting of the Board of Directors and for each
committee meeting of the Board of Directors attended by such director, in
addition to reimbursement of reasonable expenses incurred in attending such
meetings, and receive $2,000 for each quarter of service as a director.
Additionally, non-employee directors receive options under the Formula Plan,
as follows: (i) all non-employee directors (currently Messrs. Patriacca,
Kelnberger, Mitchell and Coburn) each receive options annually to purchase
1,500 shares of Class A Common Stock, which vest in two equal annual
installments on the first two anniversaries of the date of grant and which are
exercisable at a price equal to the fair market value of the Class A Common
Stock on the date of grant, provided that each of them is a director on the
date of the grant and each of them has attended at least 75% of the meetings
he or she was eligible to attend; and, (ii) any non-employee directors
appointed in the future will receive on the date of such appointment, options
to purchase 3,000 shares of Class A Common Stock, which will vest in three
equal annual installments on the first three anniversaries of the date of
grant and which will be exercisable at a price equal to the fair market value
of the Class A Common Stock on the date of grant.
 
                                      38
<PAGE>
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
  The following table sets forth, as of July 29, 1998, the number and
approximate percentage of shares of Class A Common Stock beneficially owned
by: (i) all persons known by the Company to be the beneficial owner of more
than five percent (5%) of the outstanding Class A Common Stock; (ii) "each
named executive officer" (as defined in Item 402 to Regulation S-K under the
Securities Act of 1933, as amended) and director; and, (iii) all directors and
executive officers of the Company as a group.
 
<TABLE>
<CAPTION>
                                                              NUMBER OF
                                                               CLASS A
                                                                SHARES    PERCENTAGE OF
               NAME AND ADDRESS OF                           BENEFICIALLY CLASS A SHARES
               BENEFICIAL OWNER(1)                             OWNED(2)   OUTSTANDING(2)
               -------------------                           ------------ --------------
   <S>                                                       <C>          <C>
   Daniel A. Potter,.......................................   1,396,120         4.8%
    Chairman and Chief Executive Officer(3)
   John M. Bedard,.........................................   1,036,039         3.5%
    President and Director(4)
   Daniel C. Howard,.......................................      96,285           *%
    Chief Operating Officer and Director(5)
   Stephen L. Reynolds,....................................      32,813           *%
    Chief Financial Officer(6)
   Richard Bedard,.........................................      42,000           *%
    Executive Vice President(7)
   Bruce D. Carlson,.......................................      63,406           *%
    Vice President of Real Estate(8)
   Michael G. Schifsky,....................................      63,150           *%
    Senior Vice President of Store Development(9)
   F. Andrew Mitchell,.....................................     137,283           *%
    Director(10)
   Paul M. Kelnberger,.....................................       5,250           *%
    Director(11)
   Theodore J. Coburn,.....................................     116,250           *%
    Director(12)
   Bernard Patriacca,......................................       1,000           *%
    Director(13)
   Investment Advisers, Inc.(14)...........................   2,033,000         6.9%
   Stein Roe & Farnham, Inc.(15)...........................   1,539,500         5.3%
   Wellington Management Company, LLP(16)..................   1,553,800         5.3%
   All Directors and Executive officers as a group.........   2,989,596        10.0%
    (11 persons)(2)(3)(4)(5)(6)(7)(8)(9)(10)(11)(12)(13)
</TABLE>
--------
  * Less than one percent (1%) of the outstanding shares of Class A Common
    Stock.
 (1) The address of Messrs. Potter, John Bedard, Howard, Reynolds, Richard
     Bedard, Carlson, Schifsky, Mitchell, Coburn, Kelnberger and Patriacca is
     c/o Video Update, Inc. 3100 World Trade Center, 30 East Seventh Street,
     St. Paul, Minnesota 55101. The address of Investment Advisers, Inc. is
     3700 First Bank Place, Box 357, Minneapolis, Minnesota 55440. The address
     of Stein Roe & Farnham, Inc. is One South Wacker Drive, 35th Floor,
     Chicago, Illinois 60606. The address of Wellington Management Company,
     LLP is 75 State Street, Boston, MA 02109.
 (2) For the purposes of this table, shares of Class A Common Stock which, to
     the Company's knowledge, an individual or group has a right to acquire
     within sixty (60) days upon the exercise of options or warrants, are
     deemed outstanding for the purposes of computing the number and
     percentage of shares beneficially
 
                                      39
<PAGE>
 
    owned by such individual or group. Such shares are not deemed to be
    outstanding for the purpose of computing the percentage of shares
    beneficially owned by any other individual or group shown in the table.
    This table does not include an approximate aggregate amount of 9,160
    shares of Class A Common Stock held by the executive officers of the
    Company through the Company's 401(k) plan. This table does not include an
    aggregate amount of 1,083,000 shares of Class A Common Stock beneficially
    owned by Dimensional Fund Advisors, Inc. ("Dimensional"), 1299 Ocean
    Avenue, 11th Floor, Santa Monica, California 90401, as reported in
    Dimensional's Form 13G filed with the Commission on February 10, 1998. As
    of July 29, 1998, such number of shares represents approximately 3.7% of
    the Company's issued and outstanding shares.
 (3) Includes an aggregate of 100,000 shares of Class A Common Stock issuable
     on exercise of various stock options. Includes an aggregate of 36,947
     shares of Class A Common Stock held in custodial accounts for Mr.
     Potter's children. Excludes an aggregate of 200,000 shares of Class A
     Common Stock issuable upon the exercise of various stock options that
     have not yet vested. Does not include 26,250 shares of Class A Common
     Stock owned by Mr. Potter's father, in which Mr. Potter disclaims
     beneficial ownership.
 (4) Includes an aggregate of 55,000 shares of Class A Common Stock issuable
     on exercise of various stock options. Includes 39,515 shares of Class A
     Common Stock held by Mr. Bedard's mother, but subject to a voting trust
     of which Mr. Bedard is a trustee. Excludes an aggregate of 110,000 shares
     of Class A Common Stock issuable upon the exercise of stock options that
     have not yet vested.
 (5) Includes an aggregate of 63,406 shares of Class A Common Stock issuable
     upon the exercise of various stock options. Excludes an aggregate of
     30,094 shares of Class A Common Stock issuable upon the exercise of
     various stock options that have not yet vested.
 (6) Includes an aggregate of 32,813 shares of Class A Common Stock issuable
     upon exercise of various stock options that have vested. Excludes an
     aggregate of 47,500 shares of Class A Common Stock issuable upon the
     exercise of stock options that have not vested.
 (7) Includes an aggregate of 42,000 shares of Class A Common Stock issuable
     upon the exercise of various stock options that have vested. Excludes an
     aggregate of 126,000 shares of Class A Common Stock issuable upon the
     exercise of stock options that have not vested.
 (8) Includes an aggregate of 63,406 shares of Class A Common Stock issuable
     upon the exercise of various stock options that have vested. Excludes an
     aggregate of 69,094 shares of Class A Common Stock issuable upon the
     exercise of stock options that have not vested.
 (9) Includes an aggregate of 63,150 shares of Class A Common Stock issuable
     upon the exercise of various stock options that have vested. Excludes an
     aggregate of 68,850 shares of Class A Common Stock issuable upon the
     exercise of stock options that have not vested.
(10) Includes 1,500 shares of Class A Common Stock held by Mr. Mitchell's
     spouse as custodian for his minor children. Excludes an aggregate of
     3,000 shares of Class A Common Stock issuable upon the exercise of stock
     options that have not vested.
(11) Includes an aggregate of 3,750 shares of Class A Common Stock issuable
     upon the exercise of various stock options that have vested. Excludes an
     aggregate of 3,750 shares of Class A Common Stock issuable upon the
     exercise of stock options that have not vested.
(12) Includes an aggregate of 116,250 shares of Class A Common Stock issuable
     upon the exercise of various stock options and warrants that have vested.
     Excludes an aggregate of 3,000 shares of Class A Common Stock issuable
     upon the exercise of stock options that have not vested.
(13) Includes an aggregate of 1,000 shares of Class A Common Stock issuable
     upon the exercise of various stock options that have vested. Excludes an
     aggregate of 3,500 shares of Class A Common Stock issuable upon the
     exercise of stock options that have not vested.
(14) Includes 1,552,000 shares of Class A Common Stock of which the beneficial
     owner has sole voting power and sole dispositive power and 481,000 shares
     of Class A Common Stock of which the beneficial owner has shared voting
     power and shared dispositive power. The information with respect to the
     beneficial owner has been taken from the beneficial owner's Form 13G
     filed with the Commission on February 2, 1998.
(15) Includes 1,539,500 shares of Class A Common Stock of which the beneficial
     owner has sole dispositive power. The information with respect to the
     beneficial owner has been taken from the beneficial owner's Form 13G
     filed with the Commission on February 11, 1998.
(16) Includes 837,500 shares of Class A Common Stock of which the beneficial
     owner has shared voting power and 1,553,800 shares of Class A Common
     Stock of which the beneficial owner has shared dispositive power. The
     information with respect to the beneficial owner has been taken from the
     beneficial owner's Form 13G filed with the Commission on February 9,
     1998.
 
                                      40
<PAGE>
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
  Craig Belisle, the brother-in-law of John Bedard, the Company's President
and a Director, owned a majority interest in two franchise stores as of April
30, 1998. The amount of service fees earned from these franchisees was
approximately $67,152 for the year ended April 30, 1998. The amount due from
Mr. Belisle, as a franchisee at April 30, 1998 approximated $4,189.
 
  Effective August 31, 1995, the Company entered into a Purchase Agreement
with Bedard Entertainment, Inc. ("BEI"), and the stockholders of BEI. Under
the Purchase Agreement, the Company acquired substantially all of the assets
of BEI in exchange for 15,000 shares of Class A Common Stock and the
assumption of indebtedness of BEI in the amount of approximately $275,000. The
two stockholders of BEI who owned all of the outstanding stock of BEI are the
brother and sister-in-law of the Company's President and Director, John
Bedard.
 
  During the years ended April 30, 1996, 1997 and 1998, the Company paid
approximately $245,000, $271,000, and $511,000 respectively, to Johnson, West
& Co., PLC ("Johnson, West & Co.") for accounting and tax services. Paul
Kelnberger, a Director of the Company, is a member of Johnson, West & Co.
 
  Constance Koppenhaver, the daughter of Mr. Kelnberger, owned an interest in
one franchise store as of December 1997. The amount due from that franchisee
at April 30, 1998 was $69,133, consisting of amounts due for construction,
fixtures, inventory, signage and initial franchise fees.
 
  In connection with the acquisition of Moovies, Inc., the Company is
obligated to make certain "change of control" payments to F. Andrew Mitchell,
one of the Company's directors, and to Stephen L. Reynolds, the Company's
Chief Financial Officer, both of whom were formerly employed by Moovies. As of
July 15, 1998, the total aggregate amount remaining due to Messrs. Mitchell
and Reynolds was $310,000 and $174,000 respectively.
 
  Mr. Potter's brother-in-law Robert Yager, formerly a director of the
Company, is employed as a regional manager of the Company. Mr. John Bedard is
the brother of Richard Bedard and Glenn Bedard, Company executive vice
presidents and Paul Bedard, a Company vice president. Each of the non-
executive employees receives an annual compensation ranging from $69,800 to
$98,700.
 
  The Company believes that the above arrangements were on terms at least as
favorable as could be obtained from unaffiliated parties.
 
  Each of Messrs. Potter and Bedard have issued notes to the Company (the
"Recourse Notes") in connection with stock option exercises, for approximately
$2,080,147 and $1,155,637, respectively, including accrued interest through
April 30, 1998. The Recourse Notes were issued by the executives upon their
exercise in August 1995 of 420,000 options granted to them under the Stock
Option Plans in May 1995 at an exercise price of $4.3125, the fair market
value of the stock on the date the options were granted. The Recourse Notes
represent the total exercise price of such options plus amounts advanced by
the Company to such executives to satisfy then anticipated tax liabilities.
The Recourse Notes, which provide for full recourse against the respective
officer's personal assets and Company stockholdings, are evidenced by
promissory notes bearing accrued interest at a rate of 8% per annum (through
April 30, 1998) with payment of principal and interest due on October 4, 1999.
In the event that the obligors sell shares of the Company's stock, the net
proceeds thereof will be applied to payment, in part or in full, of the
Recourse Notes.
 
  In connection with the restated employment agreements for Mr. Potter and Mr.
Bedard, the Board has approved an accrual of bonuses that will be directed
primarily to satisfying obligations arising from the Recourse Notes. For
fiscal year 1998, bonus payments aggregating $816,580 were awarded as
reimbursement of previous payments of principal and interest on the Recourse
Notes and accompanying tax liability to the recipients. In addition, the Board
has approved the subsequent payment of additional aggregate bonuses of
approximately $6,345,000 to be used primarily to satisfy the Recourse Notes as
well as the anticipated income tax liabilities to the executives, subject to
any required approval of the Company's bank lenders. If such bonuses are not
effected, the Recourse Notes will remain outstanding.
 
  In addition during fiscal 1998, the Company forgave a note receivable from
the President of the Company for approximately $33,000. The Note represented
advances from the Company to the President from January 1994 to April 1994,
together with accrued interest.
 
                                      41
<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
 
  All financial statements of the Company as set forth under Item 8 of this
report.
 
  2. Financial Statement Schedules
 
  No financial statement schedules have been included since they are either not
applicable or the information is included elsewhere herein.
 
  3. Exhibits
 
  The following exhibits are filed herewith:
 
<TABLE>
<CAPTION>
 EXHIBIT
 NUMBER                                           DESCRIPTION
 -------                                          -----------
 <C>     <S>    <C>
  1       --     Form of Purchase Agreement by and between Video Update, Inc. (the "Company"),
                 Piper Jaffray Inc. and The Robinson Humphrey Company, Inc. (filed as Exhibit 1
                 to the Company's Pre-Effective Amendment No. 2 to its Form S-3 Registration
                 Statement filed with the Securities and Exchange Commission (the "Commission")
                 on September 27, 1996 and incorporated herein by reference) (replaced and
                 superseded a corresponding exhibit previously filed with the Commission).
  2.1     --     Agreement and Plan of Merger dated as of July 9, 1997, as amended by Amendment
                 to Agreement and Plan of Merger dated as of October 27, 1997, by and among the
                 Company, VUI Merger Corp. and Moovies, Inc. ("Moovies") (filed as Exhibit 2.1
                 to the Company's Form S-4 Registration Statement filed with the Commission on
                 January 23, 1998 and incorporated herein by reference).
  2.2     --     Purchase Agreement by and among Video Update Canada Inc., Hill and Cassidy
                 Retail Corp., Byron Hill, Patricia Hill and Mel Cassidy, dated as of April 1,
                 1997 (filed as Exhibit 2 to the Company's Current Report on Form 8-K filed with
                 the Commission on April 7, 1997 and incorporated herein by reference).
  2.3     --     Purchase Agreement by and among the Company, Cox Video Corporation, and Robert
                 W. Cox, dated as of February 28, 1997 (filed as Exhibit 2a to the Company's
                 Current Report on Form
                 8-K filed with the Commission on April 4, 1997 and incorporated herein by
                 reference).
  2.4     --     Purchase Agreement by and among the Company, Susan Janae Kingston, and Larry
                 Peterman, dated as of March 17, 1997 (filed as Exhibit 2b to the Company's
                 Current Report on Form 8-K filed with the Commission on April 4, 1997 and
                 incorporated herein by reference).
  2.5     --     Purchase Agreement by and among the Company, Video Warehouse, Inc., and Donald
                 and Katherine Cianci, dated as of January 15, 1997 (filed as Exhibit 2 to the
                 Company's Current Report on Form8-K filed with the Commission on January 29,
                 1997 and incorporated herein by reference).
  2.6     --     Purchase Agreement by and among Video Update Canada Inc., Video View Ltd., and
                 Gordon and Joanne Hillman, dated as of January 1, 1997 (filed as Exhibit 2 to
                 the Company's Current Report on Form 8-K filed with the Commission on January
                 10, 1997 and incorporated herein by reference).
  2.7     --     Purchase Agreement by and between the Company, Videoland, Inc. and the
                 Stockholder of Videoland, Inc., dated as of November 14, 1995 (filed as Exhibit
                 2 to the Company's Current Report on Form 8-K/A filed with the Commission on
                 January 26, 1996 and incorporated herein by reference).
</TABLE>
 
                                       42
<PAGE>
 
<TABLE>
<CAPTION>
 EXHIBIT
 NUMBER                                           DESCRIPTION
 -------                                          -----------
 <C>     <S>    <C>
  2.8     --     Purchase Agreement by and among the Company, 94 Video West, Inc. and Michael
                 Bennett and Paul Levens, dated as of October 2, 1995 (filed as Exhibit 2a to
                 the Company's Current Report on Form8-K filed with the Commission on October
                 13, 1995 and incorporated herein by reference).
  2.9     --     Purchase Agreement by and among the Company, Talerico Enterprises, Inc. ("TEI")
                 and the stockholder of TEI, dated as of October 5, 1995 (filed as Exhibit 2b to
                 the Company's Current Report on Form 8-K filed with the Commission on October
                 13, 1995 and incorporated herein by reference).
  2.10    --     Purchase Agreement by and between the Company, and the Stockholders of Indy
                 Video, Inc., dated as of September 26, 1995 (filed as Exhibit 2 to the
                 Company's Current Report on Form 8-K filed with the Commission on September 27,
                 1995 and incorporated herein by reference).
  2.11    --     Stock Purchase and Sale Agreement by and among the Company, Wilderness Video
                 Group Ltd., Richard Walton, the Walton Family Trust Alexsay Holdings Ltd.,
                 Barclays Bank of Canada, Allstate Life Insurance Company of Canada, and Ontario
                 Municipal Employees Retirement Board, dated as of August 22, 1995 (filed as
                 Exhibit 2a to the Company's Current Report on Form 8-K filed with the
                 Commission on August 30, 1995 and incorporated herein by reference).
  2.12    --     Stock Purchase and Sale Agreement by and between the Company and Glenn Forth,
                 dated August 23, 1995 (filed as Exhibit 2b to the Company's Current Report on
                 Form 8-K filed with the Commission on August 30, 1995 and incorporated herein
                 by reference).
  2.13    --     Stock Purchase and Sale Agreement by and between the Company and Seig Badke,
                 dated August 23, 1995 (filed as Exhibit 2c to the Company's Current Report on
                 Form 8-K filed with the Commission on August 30, 1995 and incorporated herein
                 by reference).
  2.14    --     Stock Purchase and Sale Agreement by and among the Company, 443972 B.C., Ltd.,
                 Dale Mounzer and Jim Collen dated August 22, 1995 (filed as Exhibit 2d to the
                 Company's Current Report on Form 8-K filed with the Commission on August 30,
                 1995 and incorporated herein by reference).
  2.15    --     Purchase Agreement by and between the Company and the Stockholders of AV Video,
                 dated as of July 14, 1995 (filed as Exhibit 2 to the Company's Current Report
                 on Form 8-K filed with the Commission on July 26, 1995 and incorporated herein
                 by reference).
  2.16    --     Purchase Agreement by and between the Company and the Proprietors of Video
                 Powerstore, dated as of June 2, 1995 (filed as Exhibit 2 to the Company's
                 Current Report on Form 8-K filed with the Commission on June 29, 1995 and
                 incorporated herein by reference).
  2.17    --     Second Amendment to the Agreement and Plan of Merger by and among the Company,
                 Schmidt & Schmidt Limited ("SSL"), and the Stockholders of SSL, dated February
                 28, 1995 (filed as Exhibit 2a to the Company's Form Quarterly Report on Form
                 10-QSB for the quarter ended January 31, 1995 filed with the Commission on
                 March 17, 1995 and incorporated herein by reference).
  2.18    --     Agreement and Plan of Merger by and among the Company, Jarzig Enterprises,
                 Inc., and the Stockholders of Jarzig Enterprises, Inc., dated October 25, 1994
                 (filed as Exhibit 2b to the Company's Quarterly Report on Form 10-QSB for the
                 quarter ended October 31, 1994, filed with the Commission on December 15, 1994
                 and incorporated herein by reference).
  2.19    --     Agreement and Plan of Merger by and among the Company, Schmidt & Schmidt
                 Limited, and the Stockholders of Schmidt & Schmidt Limited, dated September 16,
                 1994 (filed as Exhibit 2a to the Company's Current Report on Form 8-K filed
                 with the Commission on October 3, 1994 and incorporated herein by reference).
</TABLE>
 
                                       43
<PAGE>
 
<TABLE>
<CAPTION>
 EXHIBIT
 NUMBER                                           DESCRIPTION
 -------                                          -----------
 <C>     <S>    <C>
  2.20    --     Agreement and Plan of Merger by and among the Company, Halgrimson Enterprises,
                 Inc., and the Stockholders of Halgrimson Enterprises, Inc., dated September 16,
                 1994 (filed as Exhibit 2b to the Company's Current Report on Form 8-K filed
                 with the Commission on October 3, 1994 and incorporated herein by reference).
  2.21    --     Agreement and Plan of Merger by and among the Company, Koonrod, Inc., and the
                 Stockholders of Koonrod, Inc., dated September 2, 1994 (filed as Exhibit 2 to
                 the Company's Quarterly Report on Form 10-QSB for the quarter ended July 31,
                 1994, filed with the Commission on September 10, 1994 and incorporated herein
                 by reference).
  3.1     --     Restated Certificate of Incorporation (filed as Exhibit 3 to the Company's
                 Current Report on
                 Form 8-K filed with the Commission on January 20, 1997 and incorporated herein
                 by reference).
  3.2     --     Bylaws of the Company, as amended on June 23, 1998 (filed as Exhibit 3 to the
                 Company's Current Report on Form 8-K filed with the Commission July 7, 1998 and
                 incorporated herein by reference).
  4.1     --     Form of Unit Purchase Option (filed as Exhibit 4a to the Company's Pre-
                 Effective Amendment No. 1 to its Form SB-2 Registration Statement (No. 33-
                 89018) originally filed with the Commission on March 31, 1995 and incorporated
                 herein by reference).
  4.2     --     Specimen Class A Common Stock Certificate (filed as Exhibit 4a to the Company's
                 Form SB-2 Registration Statement (No. 33-79292-C) declared effective by the
                 Commission on July 20, 1994 and incorporated herein by reference).
  4.3     --     Specimen Class B Common Stock Certificate (filed as Exhibit 4b to the Company's
                 Form SB-2 Registration Statement (No. 33-79292-C) declared effective by the
                 Commission on July 20, 1994 and incorporated herein by reference).
  4.4     --     Form of Warrant Agreement, including Form of Class A and Class B Warrant
                 Certificates (filed as Exhibit 4c to the Company's Form SB-2 Registration
                 Statement (No. 33-79292-C) declared effective by the Commission on July 20,
                 1994 and incorporated herein by reference).
  4.5     --     Form of Unit Purchase Option of D.H. Blair Investment Banking Corp. (filed as
                 Exhibit 4d to the Company's Form SB-2 Registration Statement (No. 33-79292-C)
                 declared effective by the Commission on July 20, 1994 and incorporated herein
                 by reference).
  4.6     --     Rights Agreement by and between the Company and American Stock Transfer and
                 Trust Company (filed as Exhibit 4 to the Company's Form 8-K filed April 14,
                 1998 and incorporated herein by reference).
 10.1     --     Amended and Restated Voting Agreement, dated October 27, 1997 among the
                 Company, Moovies, and directors and certain officers of the Company and Moovies
                 (filed as Exhibit 10 to the Company's Form 10-Q for the fiscal quarter ended
                 October 31, 1997 and incorporated herein by reference).
 10.2     --     Amended and Restated Undertaking Agreement, dated October 27, 1997 among the
                 Company, Moovies, Daniel A. Potter, John M. Bedard and Daniel C. Howard (filed
                 as Exhibit 10.2 of the Company's Form S-4 Registration Statement filed with the
                 Commission on January 23, 1998 and incorporated herein by reference).
 10.3     --     Form of 1998 Stock Option Plan (filed as Exhibit 10.3 of the Company's Form S-4
                 Registration Statement filed with the Commission on January 23, 1998 and
                 incorporated herein by reference).
 10.4     --     Agreement between Rentrak Corporation and the Company (filed as Exhibit 10.4 of
                 the Company's Form S-4 Registration Statement filed with the Commission on
                 January 23, 1998 and incorporated herein by reference).
</TABLE>
 
                                       44
<PAGE>
 
<TABLE>
<CAPTION>
 EXHIBIT
 NUMBER                                           DESCRIPTION
 -------                                          -----------
 <C>     <S>    <C>
 10.5     --     Form of Employment Agreement between the Company and Daniel C. Howard (filed as
                 Exhibit 10.6 of the Company's Form S-4 Registration Statement filed with the
                 Commission on January 23, 1998 and incorporated herein by reference).
 10.6     --     Credit Agreement entered into as of March 6, 1998, among the Company, Video
                 Update Canada Inc., various lending institutions and Banque Paribas, as agent
                 (the "Credit Agreement") (filed as Exhibit 10.1 to the Company's Current Report
                 on Form 8-K filed with the Commission on March 11, 1998 and incorporated herein
                 by reference).
 10.7     --     U.S. Pledge Agreement in favor of Banque Paribas, as Collateral Agent, dated as
                 of March 6, 1998 (filed as Exhibit 10.2 to the Company's Current Report on Form
                 8-K filed with the Commission on March 11, 1998 and incorporated herein by
                 reference).
 10.8     --     U.S. Security Agreement among the Company, Various U.S. Subsidiaries of the
                 Company, and Banque Paribas, as Collateral Agent, dated as of March 6, 1998
                 (filed as Exhibit 10.3 to the Company's Current Report on Form 8-K filed with
                 the Commission on March 11, 1998 and incorporated herein by reference).
 10.9     --     Subsidiaries Guarantee Agreement among Various Subsidiaries of the Company, and
                 Banque Paribas, as Collateral Agent and as Pledgee, dated as of March 6, 1998
                 (filed as Exhibit 10.4 to the Company's Current Report on Form 8-K filed with
                 the Commission on March 11, 1998 and incorporated herein by reference).
 10.10    --     Warrant Purchase Agreement between the Company, and Banque Paribas, Grand
                 Cayman Branch, dated as of March 6, 1998 (filed as Exhibit 10.5 to the
                 Company's Current Report on Form 8-K filed with the Commission on March 11,
                 1998 and incorporated herein by reference).
 10.11    --     Warrant Agreement between the Company and Banque Paribas, Grand Cayman Branch,
                 dated as of March 6, 1998 (filed as Exhibit 10.6 to the Company's Current
                 Report on Form 8-K filed with the Commission on March 11, 1998 and incorporated
                 herein by reference).
 10.12    --     Registration Rights Agreement between the Company and Banque Paribas, Grand
                 Cayman Branch, dated as of March 6, 1998 (filed as Exhibit 10.7 to the
                 Company's Current Report on Form 8-K filed with the Commission on March 11,
                 1998 and incorporated herein by reference).
 10.13    --     1996 Stock Option Plan (filed as Exhibit 10a to the Company's Quarterly Report
                 on Form 10-QSB for the fiscal quarter ended July 31, 1996 and incorporated
                 herein by reference).
 10.14    --     Form of Franchise Offering Circular (filed as Exhibit 10b to the Company's
                 Quarterly Report on Form 10-QSB for the fiscal quarter ended July 31, 1996 and
                 incorporated herein by reference).
 10.15    --     Restated Employment Agreement between the Company and Daniel A. Potter,
                 effective as of April 30, 1998.
 10.16    --     Restated Employment Agreement between the Company and John M. Bedard, effective
                 as of April 30, 1998.
 10.17    --     Form of Merger and Acquisition Agreement between the Company and D.H. Blair
                 Investment Banking Corp. (filed as Exhibit 10a to the Company's Pre-Effective
                 Amendment No. 1 to its Form SB-2 Registration Statement (No. 33-89018)
                 originally filed with the Commission on March 31, 1995 and incorporated herein
                 by reference).
 10.18    --     Form of Amendment to Warrant Agreement dated July 20, 1994 between the Company,
                 American Stock Transfer & Trust Company and D.H. Blair Investment Banking Corp.
                 (filed as Exhibit 10b to the Company's Pre-Effective Amendment No. 1 to its
                 Form SB-2 Registration Statement (No. 33-89018) originally filed with the
                 Commission on March 31, 1995 and incorporated herein by reference).
</TABLE>
 
                                       45
<PAGE>
 
<TABLE>
<CAPTION>
 EXHIBIT
 NUMBER                                           DESCRIPTION
 -------                                          -----------
 <C>     <S>    <C>
 10.19    --     Stock Exchange Agreement by and between the Company and certain stockholders of
                 Tinseltown Video, Inc. (filed as Exhibit 10a to the Company's Current Report on
                 Form 8-K filed with the Commission on February 16, 1995 and incorporated herein
                 by reference).
 10.20    --     Formula Stock Option Plan (filed as Exhibit 10a to the Company's Form SB-2
                 Registration Statement (No. 33-89018) filed with the Commission on January 31,
                 1995 and incorporated herein by reference).
 10.21    --     Form of Franchise Agreement between the Company and Franchisees (filed as
                 Exhibit 10d to the Company's Form SB-2 Registration Statement (No. 33-79292-C)
                 declared effective by the Commission on July 20, 1994 and incorporated herein
                 by reference).
 10.22    --     Form of Consulting Agreement between the Company and D.H. Blair Investment
                 Banking Corp. (filed as Exhibit 10f to the Company's Form SB-2 Registration
                 Statement (No. 33-79292-C) declared effective by the Commission on July 20,
                 1994 and incorporated herein by reference).
 10.23    --     Form of Agency Agreement between the Company and D.H. Blair Investment Banking
                 Corp. (filed as Exhibit 10aa to the Company's Form SB-2 Registration Statement
                 (No. 33-79292-C) declared effective by the Commission on July 20, 1994 and
                 incorporated herein by reference).
 10.24    --     1994 Stock Option Plan (filed as Exhibit 10bb to the Company's Form SB-2
                 Registration Statement (No. 33-79292-C) declared effective by the Commission on
                 July 20, 1994 and incorporated herein by reference).
 10.25    --     Form of Second Amendment and Waiver to the Credit Agreement, dated as of August
                 12, 1998.
 10.26    --     Form of First Amendment to Warrant Agreement, dated as of August 12, 1998.
 18       --     Letter on Change in Accounting Principles (filed as Exhibit 18 to the Company's
                 Annual Report on Form 10-KSB for the fiscal year ended April 30, 1996 and
                 incorporated herein by reference).
 21       --     List of the Company's Subsidiaries.
 23       --     Consent of Ernst & Young LLP.
 27       --     Financial Data Schedule.
 27.1     --     Financial Data Schedule--Restated 1996.
 27.2     --     Financial Data Schedule--Restated 1997.
</TABLE>
 
  (b) Reports on Form 8-K
 
  Set forth below is a list of reports on Form 8-K that were filed during the
last quarter of the period covered by this report, listing the items reported,
any financial statements filed, and the dates of such reports.
 
  1. Form 8-K filed March 11, 1998, reporting the following:
 
    a. Closing of the Agreement and Plan of Merger by and among the Company,
  VUI Merger Corp. and Moovies dated as of July 9, 1997 and amended as of
  October 27, 1997.
 
    b. Credit Agreement among the Company, Various Lending Institutions and
  Banque Paribas, as agent, dated as of March 6, 1998.
 
  2. Form 8-K filed April 14, 1998 reporting the following:
 
    a. Rights Agreement by and between the Company and American Stock
  Transfer & Trust Company, as Rights Agent, dated April 13, 1998.
 
    b. Amendment to the Company's Bylaws, effective April 9, 1998.
 
  3. Form 8-K/A filed May 8, 1998, amending the Form 8-K filed March 11, 1998
to include the financial   statements of Moovies and the Company's pro forma
financial information.
 
                                      46
<PAGE>
 
                                  SIGNATURES
 
  IN ACCORDANCE WITH SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF
1934, AS AMENDED, THE REGISTRANT CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF
BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED.
 
                                          Video Update, Inc.
 
Date: August 13, 1998                              /s/ Daniel A. Potter
                                          By: _________________________________
                                               DANIEL A. POTTER CHAIRMAN AND
                                                  CHIEF EXECUTIVE OFFICER
 
  In accordance with the Securities Exchange Act of 1934, as amended, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the date indicated.
 
 
              SIGNATURE                        TITLE                 DATE
 
        /s/ Daniel A. Potter           Chairman and Chief      August 13, 1998
-------------------------------------   Executive Officer
          DANIEL A. POTTER              (Principal
                                        executive officer)
 
         /s/ John M. Bedard            President and           August 13, 1998
-------------------------------------   Director
           JOHN M. BEDARD
 
        /s/ Daniel C. Howard           Chief Operations        August 13, 1998
-------------------------------------   Officer and
          DANIEL C. HOWARD              Director
 
       /s/ Stephen L. Reynolds         Chief Financial         August 13, 1998
-------------------------------------   Officer (Principal
         STEPHEN L. REYNOLDS            financial and
                                        accounting officer)
 
         /s/ Paul Kelnberger           Director                August 13, 1998
-------------------------------------
           PAUL KELNBERGER
 
        /s/ Bernard Patriacca          Director                August 13, 1998
-------------------------------------
          BERNARD PATRIACCA
 
       /s/ F. Andrew Mitchell          Director                August 13, 1998
-------------------------------------
         F. ANDREW MITCHELL
 
         /s/ Theodore Coburn           Director                August 13, 1998
-------------------------------------
           THEODORE COBURN
 
                                      47
<PAGE>
 
                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
 
<TABLE>
<CAPTION>
                                                                           PAGE
                                                                           ----
<S>                                                                        <C>
Report of Independent Auditors...........................................  F-2
Consolidated Balance Sheets as of April 30, 1997 and 1998................  F-3
Consolidated Statements of Operations for the years ended April 30, 1996,
 1997 and 1998...........................................................  F-4
Consolidated Statement of Stockholders' Equity for the years ended April
 30, 1996, 1997 and 1998.................................................  F-5
Consolidated Statements of Cash Flows for the years ended April 30, 1996,
 1997 and 1998...........................................................  F-6
Notes to Consolidated Financial Statements...............................  F-7
</TABLE>
 
                                      F-1
<PAGE>
 
                        REPORT OF INDEPENDENT AUDITORS
 
Board of Directors
Video Update, Inc.
 
  We have audited the accompanying consolidated balance sheets of Video
Update, Inc. and subsidiaries as of April 30, 1997 and 1998, and the related
consolidated statements of operations, stockholders' equity and cash flows for
each of the three years in the period ended April 30, 1998. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
 
  We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
 
  In our opinion, these financial statements present fairly, in all material
respects, the consolidated financial position of Video Update, Inc. at April
30, 1997 and 1998, and the consolidated results of its operations and its cash
flows for each of the three years in the period ended April 30, 1998 in
conformity with generally accepted accounting principles.
 
  As discussed in Note 2 to the consolidated financial statements, in 1996 the
Company changed its method of accounting for the amortization of its
videocassette rental inventory.
 
                                          /s/ Ernst & Young LLP
 
Minneapolis, Minnesota
August 13, 1998
 
                                      F-2
<PAGE>
 
                               VIDEO UPDATE, INC.
 
                          CONSOLIDATED BALANCE SHEETS
 
<TABLE>
<CAPTION>
                                                            APRIL 30,  APRIL 30,
                                                              1997       1998
                                                            ---------  ---------
                                                              (IN THOUSANDS)
<S>                                                         <C>        <C>
                          ASSETS
Cash and cash equivalents.................................. $  2,424   $  1,433
Accounts receivable........................................    3,776      4,737
Notes receivable from related parties......................    1,394        --
Inventory..................................................    7,318     12,449
Videocassette rental inventory--net........................   45,479     94,452
Property and equipment--net................................   33,069     69,720
Prepaid expenses...........................................      783      4,162
Income taxes receivable....................................      --       2,430
Deferred income taxes......................................      --       2,592
Goodwill--net..............................................   37,716     80,664
Other assets...............................................    1,648      5,792
                                                            --------   --------
    Total assets........................................... $133,607   $278,431
                                                            ========   ========
           LIABILITIES AND STOCKHOLDERS' EQUITY
Notes payable.............................................. $ 20,564   $104,488
Accounts payable...........................................   12,196     39,045
Accrued expenses...........................................    2,415     12,841
Accrued rent...............................................    2,238      5,073
Accrued compensation.......................................    1,779      7,685
Income taxes payable.......................................    1,096        --
Deferred income taxes......................................    2,327        --
Commitments and contingencies
Stockholders' equity:
Preferred Stock, par value $.01 per share:
  Authorized shares--5,000,000
  Issued shares-- none.....................................      --         --
Class A Common Stock, par value $.01 per share:
  Authorized shares--60,000,000
  Issued and outstanding shares--18,170,341 at April 30,
   1997 and 29,278,518 at April 30, 1998...................      182        293
Class B Common Stock, par value $.01 per share:
  Authorized, issued and outstanding shares--20,000,000 at
   April 30, 1997 and none at April 30, 1998                      20        --
  Additional paid-in capital...............................   86,085    117,641
  Retained earnings (deficit)..............................    6,806     (7,674)
  Foreign currency translation.............................     (421)      (961)
                                                            --------   --------
                                                              92,672    109,299
  Notes receivable from officers for the exercise of op-
   tions...................................................   (1,680)       --
                                                            --------   --------
    Total stockholders' equity.............................   90,992    109,299
                                                            --------   --------
    Total liabilities and stockholders' equity............. $133,607   $278,431
                                                            ========   ========
</TABLE>
 
                            See accompanying notes.
 
                                      F-3
<PAGE>
 
                               VIDEO UPDATE, INC.
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
 
<TABLE>
<CAPTION>
                                         FISCAL YEAR ENDED APRIL 30,
                                  --------------------------------------------
                                      1996           1997            1998
                                  -------------  -------------  --------------
                                   (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                               <C>            <C>            <C>
Revenues:
  Rental revenue................. $      46,592  $      83,489  $      138,279
  Service fees...................           491            567             800
  Product sales..................         3,421          7,743          17,075
                                  -------------  -------------  --------------
                                         50,504         91,799         156,154
Costs and expenses:
  Store operating expenses.......        39,685         69,366         128,971
  Selling, general and adminis-
   trative.......................         5,362          8,231          25,813
  Cost of product sales..........         1,880          4,544          11,513
  Store closing charge...........           --             --            5,082
  Amortization of goodwill.......         1,072          1,613           2,353
                                  -------------  -------------  --------------
                                         47,999         83,754         173,732
                                  -------------  -------------  --------------
Operating income (loss)..........         2,505          8,045         (17,578)
Interest expense.................          (232)          (544)         (3,702)
Other income.....................           548            461             684
                                  -------------  -------------  --------------
                                            316            (83)         (3,018)
                                  -------------  -------------  --------------
Income (loss) before income tax-
 es..............................         2,821          7,962         (20,596)
Income tax expense (benefit).....         1,193          3,342          (6,116)
                                  -------------  -------------  --------------
Net income (loss)................ $       1,628  $       4,620  $      (14,480)
                                  =============  =============  ==============
Net income (loss) per share, ba-
 sic............................. $        0.17  $        0.29  $        (0.71)
                                  =============  =============  ==============
Net income (loss) per share, di-
 luted........................... $        0.15  $        0.28  $        (0.71)
                                  =============  =============  ==============
</TABLE>
 
 
                            See accompanying notes.
 
                                      F-4
<PAGE>
 
                               VIDEO UPDATE, INC.
 
                 CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
                         (IN THOUSANDS, EXCEPT SHARES)
 
<TABLE>
<CAPTION>
                                                                 ADDITIONAL RETAINED    FOREIGN   OFFICERS'
                               CLASS A            CLASS B         PAID-IN   EARNINGS   CURRENCY     NOTES
                            COMMON STOCK       COMMON STOCK       CAPITAL   (DEFICIT) TRANSLATION RECEIVABLE
                          ------------------ ------------------  ---------- --------- ----------- ----------
                          NUMBER OF          NUMBER OF
                            SHARES    AMOUNT   SHARES    AMOUNT    AMOUNT    AMOUNT     AMOUNT      AMOUNT    TOTAL
                          ----------  ------ ----------  ------  ---------- --------- ----------- ---------- --------
<S>                       <C>         <C>    <C>         <C>     <C>        <C>       <C>         <C>        <C>
Balance at April 30,
 1995...................   4,138,366   $ 41   2,000,000  $  20    $ 14,522   $   558     $ --       $  --    $ 15,171
Issuance of shares in
 connection with the
 overallotment option
 related to the
 Subsequent Public
 Offering...............     345,970      3         --     --          989       --        --          --         992
Issuance of shares in
 connection with the
 Company's
 acquisitions...........   1,603,444     17         --     --       14,746       --        --          --      14,763
Issuance of shares in
 connection with the
 redemption of the Class
 A Warrants.............   4,502,105     45         --     --       28,369       --        --          --      28,414
Issuance of shares
 related to employee
 stock options
 exercised..............     427,850      4         --     --        1,842       --        --          --       1,846
Notes issued by the
 officers for the
 exercise of stock
 options................         --     --          --     --          --        --        --       (1,811)    (1,811)
Tax benefit resulting
 from the exercise of
 non-qualified
 stock options..........         --     --          --     --          531       --        --          --         531
Foreign currency
 translation............         --     --          --     --          --        --        (34)        --         (34)
Net income..............         --     --          --     --          --      1,628       --          --       1,628
                          ----------   ----  ----------  -----    --------   -------     -----      ------   --------
Balance at April 30,
 1996...................  11,017,735    110   2,000,000     20      61,029     2,186       (34)     (1,811)    61,500
Payment on notes issued
 by officers for
 exercise of options....         --     --          --     --          --        --        --          131        131
Issuance of shares in
 connection with the
 Subsequent Public
 Offering net of
 registration expenses..   7,015,000     70         --     --       24,962       --        --          --      25,032
Issuance of shares in
 connection with the
 Company's
 acquisitions...........     136,606      2         --     --           90       --        --          --          92
Issuance of shares
 related to employee
 stock options
 exercised..............       1,000    --          --     --            4       --        --          --           4
Foreign currency
 translation............         --     --          --     --          --        --       (387)        --        (387)
Net income..............         --     --          --     --          --      4,620       --          --       4,620
                          ----------   ----  ----------  -----    --------   -------     -----      ------   --------
Balance at April 30,
 1997...................  18,170,341    182   2,000,000     20      86,085     6,806      (421)     (1,680)    90,992
Adjustment of shares
 issued in acquisition..     (65,750)   --          --     --         (500)      --        --          --        (500)
Issuance of shares in
 connection with the
 Moovies acquisition....   9,303,927     93         --     --       28,107       --        --          --      28,200
Release, partial
 forfeiture and
 conversion of
 escrow shares..........   1,170,000     11  (1,300,000)   (13)      3,546       --        --          --       3,544
Issuance of warrants in
 connection with the
 Senior Facility........         --     --          --     --        1,730       --        --          --       1,730
Conversion of Class B to
 Class A common stock...     700,000      7    (700,000)    (7)        --        --        --          --         --
Acquisition related
 deficiency payments....         --     --          --     --       (1,327)      --        --          --      (1,327)
Forgiveness of officers
 note receivable........         --     --          --     --          --        --        --        1,680      1,680
Foreign currency
 translation............         --     --          --     --          --        --       (540)        --        (540)
Net loss................         --     --          --     --          --    (14,480)      --          --     (14,480)
                          ----------   ----  ----------  -----    --------   -------     -----      ------   --------
Balance at April 30,
 1998...................  29,278,518   $293         --   $ --     $117,641   $(7,674)    $(961)       $--    $109,299
                          ==========   ====  ==========  =====    ========   =======     =====      ======   ========
</TABLE>
                            See accompanying notes.
 
                                      F-5
<PAGE>
 
                               VIDEO UPDATE, INC.
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
 
<TABLE>
<CAPTION>
                                                FISCAL YEAR ENDED APRIL 30,
                                               -------------------------------
                                                 1996       1997       1998
                                               ---------  ---------  ---------
                                                      (IN THOUSANDS)
<S>                                            <C>        <C>        <C>
Operating activities
  Net income (loss)........................... $   1,628  $   4,620   $(14,480)
  Adjustments to reconcile net income (loss)
   to net cash provided by operating
   activities:
    Depreciation and amortization.............    15,241     25,702     48,459
    Accrued rent..............................       472      1,516      2,834
    Deferred income taxes.....................        31      1,486     (4,356)
    Compensation expense from release of
     escrow shares............................       --         --       3,546
    Compensation expense related to restated
     employment agreements....................       --         --       7,161
    Charge for business restructuring plan....       --         --       5,100
  Changes in operating assets and liabilities,
   net of acquisitions of businesses:
    Accounts receivable.......................      (385)    (3,332)      (191)
    Inventory.................................    (2,563)    (2,772)      (960)
    Other assets..............................      (801)    (1,270)    (5,873)
    Accounts payable..........................     5,921      3,504      6,230
    Income taxes..............................     1,130        503     (3,397)
    Other liabilities.........................    (1,319)       483     (1,208)
                                               ---------  ---------  ---------
        Net cash provided by operating
         activities...........................    19,355     30,440     42,865
Investing activities
  Purchase of videocassette rental inventory..   (22,739)   (33,434)   (61,752)
  Purchase of property and equipment..........   (12,301)   (14,951)   (17,458)
  Investment in businesses, net of cash
   acquired...................................   (17,391)   (21,340)     3,027
  Payment of deficiency on stock guarantee....       --         --      (1,327)
  Notes receivable from officers..............    (1,252)       --         --
  Payments on notes receivable from officers..      (272)       292        --
                                               ---------  ---------  ---------
        Net cash used in investing
         activities...........................   (53,955)   (69,433)   (77,510)
Financing activities
  Net proceeds (payments) of bank line........       --         --     (20,000)
  Proceeds from notes payable.................     4,100     26,326    103,700
  Payments of notes payable...................    (3,838)   (10,621)       (46)
  Payment of acquisition debt.................       --         --     (50,000)
  Proceeds from exercise of employee options..        35          4        --
  Proceeds from exercise of Class A warrants..    28,414        --         --
  Proceeds from issuance of common stock......       992     25,032        --
                                               ---------  ---------  ---------
        Net cash provided by financing
         activities...........................    29,703     40,741     33,654
                                               ---------  ---------  ---------
Increase (decrease) in cash and cash
 equivalents..................................    (4,897)     1,748       (991)
Cash and cash equivalents at beginning year...     5,573        676      2,424
                                               ---------  ---------  ---------
Cash and cash equivalents at end of year...... $     676  $   2,424  $   1,433
                                               =========  =========  =========
</TABLE>
 
                            See accompanying notes.
 
                                      F-6
<PAGE>
 
                              VIDEO UPDATE, INC.
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
                                APRIL 30, 1998
 
1. SIGNIFICANT ACCOUNTING POLICIES
 
 Nature of Business
 
  Video Update, Inc. and subsidiaries (the "Company") own and operate retail
video stores and sell and support retail video franchises. Company-owned
stores are located in the United States and Canada with franchises located
principally in the United States.
 
 Consolidation
 
  The accompanying financial statements present the consolidated financial
position, results of operations and cash flows of the Company. All
intercompany accounts and transactions have been eliminated.
 
 Use of Estimates
 
  The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the consolidated financial
statements and accompanying notes. The most significant estimates and
assumptions relate to the amortization methods and useful lives of
videocassette rental inventory and goodwill. These estimates and assumptions
could change and actual results could differ from these estimates.
 
 Basis of Presentation
 
  The Company utilizes an unclassified balance sheet presentation. This format
was adopted on the basis that the videocassette rental inventory represents
assets used by the Company to generate current operating income, and
management believes that to classify all of these costs as noncurrent would be
misleading to the readers of the financial statements because it would not
indicate the level of assets expected to be converted into cash in the next
year as a result of the rentals of the videocassettes.
 
 Service Fees
 
  The Company receives continuing monthly royalty and other fee revenue from
its franchisees based on a percentage of the franchisees' gross monthly
revenue. Royalty fee and other fee revenues will continue for the initial
terms of the franchise agreements, after which the revenues will be based upon
renewed franchise agreements. Origination franchise fees collected are
deferred and not recorded as revenue in the statement of operations until the
franchisee has executed a lease or a letter of intent of a franchised store
location.
 
 Cash Equivalents
 
  The Company considers all highly liquid investments with a remaining
maturity of three months or less when purchased to be cash equivalents.
 
 Inventory
 
  Inventory is stated at the lower of cost (first in, first out) or market.
Inventory consists of videocassettes held as base stock for the opening of new
stores, videocassettes held for sale and supplies available for sale to
franchisees.
 
                                      F-7
<PAGE>
 
                              VIDEO UPDATE, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
 Videocassette Rental Inventory
 
  Videocassette rental inventory is stated at cost, and is amortized over the
estimated economic life as follows:
 
<TABLE>
<CAPTION>
         NUMBER OF COPIES
        OF TITLE PER STORE                     AMORTIZATION POLICY
        ------------------                     -------------------
   <S>                           <C>
   One through three............ Straight-line over 36 months to a salvage value
                                 of $6.00 per videocassette.
   Four through nine............ Straight-line over 6 months to a book value
                                 of $6.00 and then straight-line over 30 months.
   Ten and over................. Straight-line over 6 months to a book value
                                 of $6.00 and then straight-line over 3 months.
</TABLE>
 
 Property and Equipment
 
  Furniture and equipment are recorded at cost and depreciated using the
straight-line method over the estimated economic life of the asset of five to
ten years. Leasehold improvements are recorded at cost and depreciated using
the straight-line method over the estimated economic life of the lease term.
 
 Goodwill
 
  Goodwill, consisting principally of excess cost over net assets from the
acquisitions of businesses, is net of accumulated amortization of
approximately $2,768,000 and $2,353,002 at April 30, 1997 and 1998,
respectively and is being amortized on a straight-line basis over twenty
years. If facts and circumstances suggest that the goodwill will not be
recoverable, as determined based on the undiscounted cash flows of the assets
acquired over the remaining amortization period, the Company's carrying value
of goodwill will be reduced by the estimated shortfalls of cash flows.
 
 Income Taxes
 
  The Company accounts for income taxes in accordance with SFAS No. 109
"Accounting for Income Taxes." Deferred income taxes are recorded to reflect
the tax consequences of differences between the tax and financial reporting
bases of assets and liabilities.
 
 Stock-based Compensation
 
  The Company implemented only the net earnings and earnings per share
disclosure provisions of Statement of Financial Accounting Standards (SFAS)
No. 123, "Accounting for Stock-Based Compensation," in fiscal 1997. The
Company has elected to recognize compensation expense for its stock based
compensation plans in accordance with Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees." Accordingly, no compensation
expense is recognized for stock options with exercise prices equal to, or in
excess of, the market value of the underlying shares of stock at the date of
grant.
 
 Long-Lived Assets
 
  The Company adopted SFAS No. 121, "Accounting for the Impairment of Long-
Lived Assets and for Long-Lived Assets to Be Disposed Of," effective May 1,
1996. SFAS 121 prescribes the accounting treatment for long-lived assets,
identifiable intangibles and goodwill related to those assets when there are
indications that the carrying values of those assets may not be recoverable.
In performing such review for recoverability, the Company compares the
expected future cash flows to the carrying value of long-lived assets and
identifiable intangibles. If the anticipated undiscounted future cash flows
are less than the carrying amount of such assets, the Company's carrying
amount will be reduced to its estimated fair value.
 
 
                                      F-8
<PAGE>
 
                              VIDEO UPDATE, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 Fair Value of Financial Instruments
 
  At April 30, 1997 and 1998, the carrying value of financial instruments such
as cash and cash equivalents, accounts payable and notes payable approximated
their fair values.
 
 Earnings Per Share
 
  In 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 128, Earnings per Share. Statement 128
replaced the previously reported primary and fully diluted earnings per share
with basic and diluted earnings per share. Unlike primary earnings per share,
basic earnings per share excluded any dilutive effect of options, warrants and
convertible securities. Diluted earnings per share is very similar to the
previously reported fully diluted earnings per share. All earnings per share
amounts for all periods have been presented, and when necessary, restated to
conform to the Statement 128 requirements.
 
  The following table is a reconciliation of the basic and diluted earnings
per share computation:
 
<TABLE>
<CAPTION>
                                                   FISCAL YEAR ENDED APRIL 30,
                                                  -----------------------------
                                                    1996     1997       1998
                                                  ------------------ ----------
                                                    (IN THOUSANDS, EXCEPT PER
                                                          SHARE AMOUNT)
   <S>                                            <C>      <C>       <C>
   NUMERATOR:
   Net income (loss)............................  $  1,628 $   4,620 $  (14,480)
                                                  ======== ========= ==========
   Numerator for basic and diluted earnings per
    share--income (loss) available to common
    stockholders................................    $1,628   $ 4,620   $(14,480)
                                                  ======== ========= ==========
   DENOMINATOR:
   Denominator for basic earnings per share--
    weighted-average shares
     Class A common shares......................     8,826    15,185     20,412
     Class B common shares......................       700       700        --
                                                  -------- --------- ----------
                                                     9,526    15,885     20,412
   Effect of dilutive securities:
     Employee stock options.....................       991       200        --
     Contingent stock acquisition...............       146       177        --
                                                  -------- --------- ----------
   Dilutive potential common shares.............     1,137       377        --
                                                  -------- --------- ----------
   Denominator for diluted earnings per share--
    adjusted weighted-average shares and assumed
    conversions.................................    10,663    16,262     20,412
                                                  ======== ========= ==========
   Basic net income (loss) per share............  $    .17 $     .29 $     (.71)
                                                  -------- --------- ----------
   Diluted net income (loss) per share..........  $    .15 $     .28 $     (.71)
                                                  ======== ========= ==========
</TABLE>
 
 Recently Issued Accounting Standards
 
  In June 1997, the FASB issued Statement No. 130, "Reporting Comprehensive
Income." Statement No. 130 is effective for fiscal years beginning after
December 15, 1997. Statement 130 establishes standards for the reporting of
comprehensive income in a full set of general purpose financial statements.
Management believes the adoption of Statement No. 130 will not have a material
effect on the Company's financial statements.
 
  Also in June 1997, the FASB issued Statement No. 131, "Disclosures about
Segments of an Enterprise and Related Information." Statement No. 131 is
effective for years beginning after December 15, 1997. Statement No. 131
establishes standards for disclosures about operating segments, products and
services, geographic areas and major customers. Management believes the
adoption of Statement No. 131 will not have a material effect on the Company's
financial statements.
 
                                      F-9
<PAGE>
 
                              VIDEO UPDATE, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
 Reclassification
 
  Certain reclassifications have been made to the prior year financial
statements to conform with the 1998 presentation.
 
2. CHANGE IN AMORTIZATION METHOD FOR VIDEOCASSETTE RENTAL INVENTORY
 
  Effective February 1, 1996, the Company changed the amortization policy for
videocassettes to the method as described in Note 1. The change, which
represents in part a change in accounting principle and a change in accounting
estimate, has been reflected in the accompanying financial statements in total
as a change in an estimate in fiscal 1996.
 
  Prior to February 1, 1996, base stock videocassettes were amortized over 36
months on a straight-line basis with no salvage value. Prior to May 1, 1995,
new release videocassettes were amortized as follows: copies one through three
of each title per store were amortized as base stock; the fourth through ninth
copies of each title per store were amortized 40% in the first year and 30% in
each of the second and third years; and the tenth and any succeeding copies of
each title per store were amortized over nine months on a straight-line basis.
 
  The new method of amortization was adopted because the Company believes
accelerating expense recognition for new release videocassettes (copies four
and greater) during the first six months more closely matches the typically
higher revenue generated following a title's release, and believes that $6.00
represents a reasonable salvage value for base stock videocassettes after 36
months.
 
  The effect of the change for recognizing salvage value of base stock and the
retroactive application of the new method of amortizing videocassette copies
in excess of the base stock to May 1, 1995, had the impact, in total, of
increasing amortization expense by $2,773,000 and decreasing income from
continuing operations, and net income by $1,604,000, or $0.15 per share, for
fiscal 1996, after the effect of income taxes of $1,169,000.
 
3. MOOVIES, INC. ACQUISITION
 
  In March 1998 the Company completed the acquisition of Moovies, Inc. in a
tax-free reorganization, whereby Moovies stockholders received .75 shares of
Video Update Class A common stock in exchange for each share of Moovies common
stock. Video Update issued approximately 9.3 million shares in this
transaction. The acquisition will be accounted for under the purchase method
of accounting and the excess of the cost over the estimated fair value of the
assets acquired, estimated to be approximately $47,166,000 will be amortized
over 20 years.
 
  In March 1998, the stockholders in conjunction with the Moovies transaction
approved the termination and cancellation of the Escrow Agreement by and among
American Stock Transfer & Trust Company, Video Update and certain stockholders
of Video Update. As a result: (i) 10% or 130,000 of the 1,300,000 Class B
shares of common stock held in escrow were forfeited and canceled; (ii) the
remaining 1,170,000 shares of common stock were released from escrow,
resulting in a one-time compensation expense charge of approximately $3.5
million which the Company recognized as general and administrative expense in
the fourth quarter of fiscal 1998; and, (iii) all 1,870,000 shares of Class B
common stock were converted into Class A common stock and the preferential
voting rights were eliminated.
 
  Simultaneously with the closing of the Moovies acquisition, the Company
obtained through a syndicate led by Banque Paribas a $120 million credit/term
loan facility (the "Senior Facility"). The Senior Facility replaced the
Company's previous $60 million revolving credit facility. The Senior Facility
consists of the following: (i) two term loans totaling $95.0 million; (ii) a
$15.0 million capital expenditure line; and, (iii) a $10.0 million revolving
line. The Company borrowed the $95.0 million of the two term loans in
conjunction with the closing of the merger and the proceeds were used to
refinance the current indebtedness of Moovies and Video Update and pay
transaction expenses. The capital expenditure line is primarily available to
fund the conversion of the Moovies stores and integration costs, the opening
of new stores and selected acquisitions. The revolving line is available for
normal working capital needs. The facility is secured by all of the Company's
assets. In connection with the Senior Facility, the Company also issued five
year warrants to Banque Paribas to purchase one million shares of the
Company's Class A common stock at an exercise price of $2.68. The warrants
were valued at
 
                                     F-10
<PAGE>
 
                              VIDEO UPDATE, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
$1,730,000 and resulted in an increase in paid in capital and corresponding
discount on debt. This discount, as well as related bank fees, will be
amortized over the life of the Senior Facility.
 
  During the fourth quarter of 1998, the Company performed an analysis of the
stores acquired in the acquisition of Moovies, Inc. and adopted a business
plan to close approximately 17 of the acquired stores. This resulted in a
reserve of approximately $1,843,000 of future cash outlays for lease
terminations and miscellaneous closing costs, which was recorded in the
balance sheet as a result of purchase accounting.
 
4. PROVISION FOR STORE CLOSING AND OTHER CHARGES
 
  During the fourth quarter of 1998 the Company began and completed an
extensive analysis of its base store performance and adopted a business
restructuring plan to close approximately 24 of its stores. This analysis
resulted in the Company recording a pretax charge of approximately a
$5,100,000. The components of the restructuring charge included approximately
$2,700,000 in reserves of future cash outlays for lease terminations and
miscellaneous closing costs, as well as approximately $2,400,000 in asset
write downs comprised of $1,596,000 and $804,000 for property and equipment
and goodwill, respectively. The revenues of stores identified for closure were
not material for the fiscal years ended April 30, 1996, 1997 and 1998.
 
  In addition, during the fourth quarter of fiscal 1998, the Company recorded
approximately the following significant charges in its general and
administrative expenses: (i) $3,800,000 related to the Moovies acquisition,
$3,500,000 of which was a non-cash, non-tax deductible charge to compensation
expense related to the release of 1,170,000 shares of Class B common stock
from escrow (see Note 12 "Stockholders' Equity"); (ii) $3,200,000 non-cash
charge relating to the restated employment agreements for the Company's Chief
Executive Officer and its President, representing amounts which will be
applied to this existing stock option related loan obligations to the Company
and $3,900,000 which will be used by the executives to pay income taxes and
loans arising from the same stock option transaction (see Note 8 "Related
Party Transactions"); and, (iii) $700,000 for the previous capitalized bank
fees related to the Company's previous Revolving Credit Facility which was
repaid prior to its maturity (see Note 7 "Notes Payable").
 
5. VIDEOCASSETTE RENTAL INVENTORY--NET
<TABLE>
<CAPTION>
                                                                 APRIL 30,
                                                             ------------------
                                                               1997      1998
                                                             --------  --------
                                                              (IN THOUSANDS)
   <S>                                                       <C>       <C>
   Videocassette rental inventory........................... $ 81,618  $167,790
   Accumulated amortization.................................  (36,139)  (73,338)
                                                             --------  --------
                                                             $ 45,479  $ 94,452
                                                             ========  ========
</TABLE>
  Amortization expense for videocassette rental inventory, which is included
in store operating expenses, was $12,532,000, $20,317,000 and $37,613,989 for
the years ended April 30, 1996, 1997 and 1998, respectively.
 
6. PROPERTY AND EQUIPMENT--NET
<TABLE>
<CAPTION>
                                                                 APRIL 30,
                                                              -----------------
                                                               1997      1998
                                                              -------  --------
                                                               (IN THOUSANDS)
   <S>                                                        <C>      <C>
   Land...................................................... $   473  $    488
   Buildings.................................................   1,403     1,403
   Furniture and equipment...................................  22,385    45,720
   Leasehold improvements....................................  14,369    34,454
   Accumulated depreciation..................................  (5,561)  (12,345)
                                                              -------  --------
                                                              $33,069  $ 69,720
                                                              =======  ========
</TABLE>
  Depreciation expense was $1,607,000, $3,307,000 and $6,880,000 for the years
ended April 30, 1996, 1997 and 1998, respectively.
 
                                     F-11
<PAGE>
 
                              VIDEO UPDATE, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
7. NOTES PAYABLE
 
  Simultaneously with the closing of the Moovies transaction the Company
announced that a syndicate lead by Banque Paribas had extended it a $120
million Senior Facility, which replaced the previous revolving credit
facility. The notes payable balance consists of the following:
 
<TABLE>
<CAPTION>
                                                                  APRIL 30,
                                                               ----------------
                                                                1997     1998
                                                               ------- --------
                                                                (IN THOUSANDS)
   <S>                                                         <C>     <C>
   Senior Facility with banks:
    two term loans of $52,500,000 and $42,500,000; interest
    at 9.19% and 9.44%, respectively; with payments beginning
    in January, 1999, maturing in January, 2002 and January,
    2003, respectively and secured by substantially all
    assets of the Company....................................  $   --  $ 95,000
   Capital expenditure loan with banks; interest payable
    April 30, 1998 at 9.19%; with quarterly payments
    beginning July, 1998, and final maturity April, 2000.
    Secured by substantially all assets of the Company.......      --     4,500
   Revolving loan with banks; interest payable April 30, 1998
    at 9.19%; maturity April, 2002. Secured by substantially
    all assets of the Company................................      --     4,200
   Note payable with interest at 6.25%; maturing in March,
    1999.....................................................      --     2,000
   Note payable in monthly installments of $6,180 until
    December 2004, with a balloon payment of approximately
    $294,000, interest at the United States government
    treasury securities rate plus 4.5% (9.98% at April 30,
    1998). The note is secured by a mortgage and specific
    assets of the Company....................................      529      507
   Note payable with monthly installment of approximately
    $1,000 with interest rate of 12% maturing on May 1999.          35       11
   Revolving credit facility with a bank; quarterly payments
    of interest at the prime rate plus 1/2% or the Eurodollar
    rate secured by all assets of the Company................   20,000      --
   Discount on debt for 1,000,000 bank warrants; expiring
    March, 2003 (see Note 3).................................      --    (1,730)
                                                               ------- --------
                                                               $20,564 $104,488
                                                               ======= ========
</TABLE>
 
  The weighted-average interest rate on borrowings outstanding was 8.25%,
7.61% and 9.29% at April 30, 1996, 1997 and 1998, respectively.
 
  The aggregate maturities of the notes payable at April 30, 1998 are as
follows:
 
<TABLE>
<CAPTION>
                                                                  (IN THOUSANDS)
       <S>                                                        <C>
       1999......................................................    $  5,679
       2000......................................................      14,543
       2001......................................................      17,093
       2002......................................................      23,568
       2003......................................................      34,793
       Thereafter................................................      10,542
                                                                     --------
                                                                     $106,218
       Discount on debt..........................................      (1,730)
                                                                     --------
                                                                     $104,488
                                                                     ========
</TABLE>
 
                                     F-12
<PAGE>
 
                              VIDEO UPDATE, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
  The Senior Facility includes negative, affirmative and financial covenants
including, but not limited to, minimum pretax earnings, minimum free cash
flow, minimum net worth, maximum indebtedness, maximum leverage, minimum fixed
charge coverage, a prohibition or restriction on capital expenditures, debt
and guarantees, liens and encumbrances on any property, mergers,
consolidations, investments, advances, divestitures, change or business or
conduct of business, joint ventures, partnerships, the creation of new
subsidiaries, dividends, distributions, repurchases or redemptions of
outstanding stock (including options or warrants), the voluntary prepayment,
repurchase redemption or defeasance of debt, and the acquisition, sale or
transfer, lease or sale-leaseback of assets. The Senior Facility is secured by
substantially all of the Company's assets as well as by pledges of its stock
in its subsidiaries, which subsidiaries also have provided guarantees of the
Company's obligations. The Company was not in compliance of certain of the
financial covenants of the Senior Facility at April 30, 1998, and July 31,
1998. The Company has obtained waivers with respect to the non-complying
conditions and has further amended the Senior Facility (see Note 17
"Management's Plan").
 
8. RELATED PARTY TRANSACTIONS
 
  Family members of stockholders and a Board Director own a majority interest
at April 30, 1996, 1997 and 1998 in one, one and three franchise stores,
respectively. The amount of service fees earned from these franchisees was
approximately $20,000, $25,000 and $73,104 for the years ended April 30, 1996,
1997 and 1998, respectively. The amount due from the franchisees at April 30,
1996, 1997 and 1998 approximated $2,500, $2,850 and $73,322, respectively.
 
  During the years ended April 30, 1996, 1997 and 1998, the Company incurred
expenses of approximately $245,000, $271,000 and $561,000, respectively, to
Johnson, West & Co., PLC ("Johnson, West & Co.") for accounting and tax
services. A director of the Company is a member of Johnson, West & Co.
 
  Each of Messrs. Potter and Bedard have issued notes to the Company (the
"Recourse Notes") in connection with stock option exercises, for approximately
$2,080,147 and $1,155,637, respectively, including accrued interest through
April 30, 1998. The Recourse Notes were issued by the executives upon their
exercise in August 1995 of 420,000 options granted to them under the Stock
Option Plans in May 1995 at an exercise price of $4.3125, the fair market
value of the stock on the date the options were granted. The Recourse Notes
represent the total exercise price of such options plus amounts advanced by
the Company to such executives to satisfy then anticipated tax liabilities.
The Recourse Notes, which provide for full recourse against the respective
officer's personal assets and Company stockholdings, are evidenced by
promissory notes bearing accrued interest at a rate of 8% per annum (through
April 30, 1998) with payment of principal and interest due on October 4, 1999.
In the event that the obligors sell shares of the Company's stock, the net
proceeds thereof will be applied to payment, in part or in full, of the
Recourse Notes.
 
  In connection with restated employment agreements, the Board has approved an
accrual of bonuses that will be directed primarily to satisfying obligations
arising from the Recourse Notes. For fiscal year 1998, bonus payments
aggregating $816,580 were awarded as reimbursement of previous payments of
principal and interest on the Recourse Notes and accompanying tax liability to
the recipients. In addition, the Board has approved the subsequent payment of
additional aggregate bonuses of approximately $6,345,000 to be used primarily
to satisfy the Recourse Notes as well as the anticipated income tax
liabilities to the executives, subject to any required approval of the
Company's bank lenders. If such bonuses are not effected, the Recourse Notes
will remain outstanding. The Company has recorded compensation expense of
approximately $7,162,000 in general and administrative expense in 1998 to
reflect these revisions. The resultant accrual for compensation expense has
been recorded as an offset to the officers' loan obligations, in essence
treated as loan forgiveness, with the balance of the accrual included in
accrued compensation in the balance sheet as of April 30, 1998 (see Note 4).
 
 
 
                                     F-13
<PAGE>
 
                              VIDEO UPDATE, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
  In addition, during fiscal 1998, the Company forgave a note receivable from
the President of the Company for approximately $33,000. The note represented
advances from the Company to the President from January 1994 to April 1994,
together with accrued interest.
 
9. COMMITMENTS AND CONTINGENCIES
 
 Employment Contracts
 
  In fiscal 1998, the Company entered into employment agreements with three of
its executive officers. The agreements provide for annual base salary amounts
as well as provisions for potential bonuses and stock option grants. The
agreements further provide for specified additional payments in the event of
termination or transactions that would result in change of control of the
Company.
 
 Lease Agreements
 
  The Company leases office and retail space under operating leases with terms
of 6 to 144 months. These leases generally have a term of three to ten years
and provide options to renew for periods ranging from three to five additional
years. Under the leasing agreements, the Company is generally responsible for
the real estate taxes, insurance, and other expenses related to the property.
The leases expire at varying dates through 2012. The Company also leases
vehicles and computer equipment.
 
  At April 30, 1998, minimum annual rental commitments under non-cancelable
operating leases are as follows:
 
<TABLE>
<CAPTION>
                                                                  (IN THOUSANDS)
   <S>                                                            <C>
   1999..........................................................    $ 49,161
   2000..........................................................      43,340
   2001..........................................................      35,935
   2002..........................................................      30,811
   2003..........................................................      28,371
   Thereafter....................................................     123,724
                                                                     --------
   Total minimum lease payments..................................    $311,342
                                                                     ========
</TABLE>
 
  Rent expense, principally retail and office space, under operating leases
amounted to $7,675,000, $13,513,000 and $28,180,000 for the years ended April
30, 1996, 1997 and 1998, respectively,
 
 Supplier Agreement
 
  The Company has an agreement with a supplier of videocassette rental tapes.
Under the terms of the agreement, the Company is required to obtain a minimum
annual dollar amount of new release titles from the supplier. The minimum
dollar amount is subject to increase or decrease depending on the Company's
gross revenues from video rental or sales and the number of major studios
participating with the supplier (currently approximates less than 10% of the
Company's total purchase of videocassette rental tapes).
 
10. INCOME TAXES
 
  Income (loss) from continuing operations before income taxes in fiscal 1996,
1997 and 1998 of $2,821,000, $7,962,000 and $(20,596,000), respectively, is
comprised of $2,412,000 in the United States and $409,000 in Canada for fiscal
1996, $5,525,000 in the United States and $2,437,000 in Canada for fiscal 1997
and $(21,308,000) in the United States and $712,000 in Canada for fiscal 1998.
 
 
                                     F-14
<PAGE>
 
                              VIDEO UPDATE, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
  Income tax expense is as follows:
 
<TABLE>
<CAPTION>
                                                 FISCAL YEAR ENDED APRIL 30,
                                                 -----------------------------
                                                   1996      1997      1998
                                                 --------- --------- ---------
                                                       (IN THOUSANDS)
   <S>                                           <C>       <C>       <C>
   Current:
     Federal.................................... $    833  $  1,384  $  (1,812)
     State......................................      164       422         52
     International..............................      165        50        --
                                                 --------  --------  ---------
                                                    1,162     1,856     (1,760)
   Deferred:
     Federal....................................       39       413     (3,706)
     State......................................      (53)      (15)    (1,062)
     International..............................       45     1,088        412
                                                 --------  --------  ---------
                                                       31     1,486     (4,356)
                                                 --------  --------  ---------
   Total income tax expense (benefit)........... $  1,193  $  3,342  $  (6,116)
                                                 ========  ========  =========
</TABLE>
 
  Components of the net deferred tax asset (liability), resulting from
differences in book and income tax accounting methods, are as follows:
 
<TABLE>
<CAPTION>
                                                                APRIL 30,
                                                           ---------------------
                                                            1997     1998
                                                           -------  -------
                                                             (IN THOUSANDS)
   <S>                                                     <C>      <C>      <C>
   Deferred income tax asset (liability):
     Tax over book depreciation and amortization.......... $(2,794) $(4,798)
     Tax over book merger basis adjustment................    (286)    (254)
                                                           -------  -------
                                                            (3,080)  (5,052)
   Deferred income tax asset:
     Book over tax rent expense...........................     753    1,613
     Book over tax employment related accruals............     --     2,414
     Net operating loss carryforwards.....................     --     1,649
     Book over tax restructuring and other accruals.......     --     1,968
                                                           -------  -------
                                                               753    7,644
                                                           -------  -------
   Net deferred income tax asset (liability).............. $(2,327) $ 2,592
                                                           =======  =======
</TABLE>
 
  The reconciliation of the federal statutory rate (34%) to the Company's
effective income tax rate is as follows:
 
<TABLE>
<CAPTION>
                                                 FISCAL YEAR ENDED APRIL 30,
                                                 -----------------------------
                                                   1996      1997      1998
                                                 --------- --------- ---------
   <S>                                           <C>       <C>       <C>
     Federal tax at statutory rate..............     34.0%     34.0%     (34.0)%
     State tax, net of federal benefit..........      2.6       2.8       (3.3)
     Release of escrow shares...................      --        --         5.8
     International..............................      2.0       3.5        0.5
     Goodwill...................................      2.0       1.0        0.7
     Other......................................      1.7       0.7        0.6
                                                 --------  --------  ---------
     Effective rate.............................     42.3%     42.0%     (29.7)%
                                                 ========  ========  =========
</TABLE>
 
                                     F-15
<PAGE>
 
                              VIDEO UPDATE, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
  At April 30, 1998, the Company has United States federal and state tax loss
carryforwards of approximately $26,327,000, which expire between the year's
2007 to 2013. For the nine months ending January 31, 1999, approximately
$5,665,000 of net operating loss is available. Thereafter, the remaining
available net operating loss carryforward is limited to $1,450,000 each year
in accordance with the Internal Revenue Code.
 
11. SUPPLEMENTAL CASH FLOW INFORMATION
 
<TABLE>
<CAPTION>
                                                   FISCAL YEAR ENDED APRIL 30,
                                                   ----------------------------
                                                    1996     1997       1998
                                                   ----------------- ----------
                                                          (IN THOUSANDS)
   <S>                                             <C>     <C>       <C>
   Interest paid.................................. $   226 $     390 $    3,223
   Income taxes paid.............................. $    29 $   1,394 $    1,725
   Common stock issued in Moovies acquisition..... $    -- $      -- $   28,200
</TABLE>
 
12. STOCKHOLDERS' EQUITY
 
 Class A Common Stock; Class B Common Stock
 
  In connection with the Company's IPO, all of the holders of the Company's
Class B Common Stock placed on a pro rata basis, an aggregate of 1,300,000
shares (the "Escrow Shares") into escrow. As a result of the Stockholder's
vote to release 90% of the shares from Escrow in fiscal 1998, the remaining
130,000 shares were forfeited. The shares released from Escrow and the
remaining 700,000 shares of Class B Stock outstanding were converted into
Class A common stock. As a result, as of April 30, 1998, there were no shares
of Class B stock outstanding.
 
  The Securities and Exchange Commission requires that the release of Escrow
Shares to officers, directors, employees and consultants of the Company be
recognized as a compensatory non-cash compensation expense in the statement of
operations with a corresponding offset as an increase to additional paid-in
capital. As such, stockholders' equity in total did not change. The expense of
$3,546,270 was equal to the fair market value of the Escrow Shares on the date
of release.
 
 Shareholders' Rights Agreement
 
  In April 1998, the Board of Directors approved the declaration of a dividend
of one preferred share purchase right (a "Right") for each outstanding share
of Class A Common Stock, par value $.01 per share (the "Common Shares") and
for each outstanding Class B Warrant ("Warrants"), of the Company. The
dividend was paid on April 24, 1998 (the "Record Date") to the stockholders
and Class B Warrantholders of record on that date. Each Right entitles the
registered holder to purchase from the Company one one-hundredth of a share of
Series A Junior Participating Preferred Stock, par value $.01 per share (the
"Preferred Shares"), of the Company at a price of $20.00 per one one-hundredth
of a Preferred Share (the "Purchase Price") subject to adjustment.
 
  Until the earlier to occur of (i) 10 days following a public announcement
that a person or group of affiliated or associated persons have acquired
beneficial ownership of 15% or more of the outstanding Common Shares (an
"Acquiring Person") or (ii) 10 business days (or such later date as may be
determined by action of the Board of Directors prior to such time as any
person or group of affiliated persons becomes an Acquiring Person) following
the commencement of, or announcement of an intention to make, a tender offer
or exchange offer the consummation of which would result in the beneficial
ownership by a person or group of 15% or more of the outstanding Common Shares
(the earlier of such dates being called the "Distribution Date"), the Rights
will be evidenced, with respect to any of the Common Share or the Warrant
certificates outstanding as of the Record Date, by such Common Share
certificate or such Warrant certificate, as the case may be.
 
 
                                     F-16
<PAGE>
 
                              VIDEO UPDATE, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
  In the event that any person or group of affiliated of associated persons
becomes an Acquiring Person, proper provision shall be made so that each
holder of a Right, other than Rights beneficially owned by the Acquiring
Person (which will thereafter be void), will thereafter have the right to
receive upon exercise--in lieu of Preferred Shares--that number of Common
Shares having a market value of two times the exercise price of the Right. At
any time after any person or group becomes an Acquiring Person and prior to
the acquisition by such person or group of 50% or more of the outstanding
Common Shares, the Board of Directors of the Company may exchange the Rights
(other than Rights owned by such person or group which will have become void),
in whole or in part, at an exchange ratio of one Common Share, or one one-
hundredth of a Preferred Share (or of a share of a class or series of the
Company's preferred stock having equivalent rights, preferences and
privileges), per Right (subject to adjustment).
 
  Until a Right is exercised, the holder thereof, as such, will have no rights
as a stockholder of the Company, including, without limitation, the right to
vote or to receive dividends.
 
 Warrants--Class A and B
 
  Each of the units sold in connection with the Company's public offerings
consisted of one share of Class A Common Stock of the Company, one Class A
Warrant and one Class B Warrant. The components of the units were separately
transferable immediately. When issued, each Class A Warrant, upon its
exercise, entitled the holder to purchase one share of the Company's Class A
Common Stock and one Class B Warrant. The Class A Warrant exercise price was
$6.50 per share subject to certain adjustments. In August 1995, the Company
called for redemption all of its outstanding Class A Warrants. The redemption
date set forth in the Notice of Redemption was September 7, 1995.
Approximately 4,502,000 Class A Warrants were exercised resulting in net
proceeds to the Company of approximately $28,414,000. At April 30, 1998, the
Company has Class B Warrants outstanding enabling the holders the ability to
purchase approximately 8,005,000 shares of Class A Common Stock at $8.75 per
share. Such warrants expire in July 1999. In addition, there are 500,000 Class
B Warrants outstanding that were issued by the Company in a 1994 bridge
financing. These warrants provide the holders the ability to purchase the
underlying Class A Common Stock of the Company at $8.75 per share and expire
July 1999.
 
 Blair Options
 
  At April 30, 1998 the Company has 117,500 shares of Class A Common Stock
reserved for issuance upon exercise of the Unit Purchase Option (the "Initial
Option") at an aggregate exercise price of $734,375, issued to D.H. Blair
Investment Banking Corp. ("Blair") in connection with its services as
underwriter of the Company's initial public offering; 230,550 shares of Class
A Common Stock reserved for issuance upon exercise of the Unit Purchase Option
(the "Subsequent Option") at an aggregate exercise price of $1,033,500, issued
to Blair or its' affiliates in connection with its services as underwriter of
the Company's subsequent public offering (collectively, the Initial Option and
the Subsequent Option are referred to as the "Blair Options"); 348,050 shares
of Class A Common Stock reserved for issuance upon exercise of the redeemable
Class A Warrants (the "Class A Warrants") underlying the Blair Options, at an
exercise price of $6.50 per share; 696,100 shares of Class A Common Stock
issuable upon exercise of the Class B Warrants underlying the Blair Options,
at an exercise price of $8.75 per share.
 
13. STOCK OPTION PLANS
 
  In April 1994, the Company established an incentive stock option plan (the
"1994 Stock Plan") whereby 150,000 shares of Class A Common Stock have been
reserved. The options can be either incentive stock options or non-qualified
options, as defined by Section 422 of the Internal Revenue Code ("Section
422") to be granted to eligible individuals. The exercise price for the
incentive stock options granted under the 1994 Stock Plan may not be less than
the fair market value of the Class A Common Stock on the date the option is
granted.
 
                                     F-17
<PAGE>
 
                              VIDEO UPDATE, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  In May 1995, the Company established an additional stock option plan (the
"1995 Plan") whereby 850,000 shares were reserved for grant to eligible
individuals to purchase Class A Common Stock of the Company. Options under the
1995 Plan may be incentive stock options or non-qualified options. The
exercise price for the incentive stock options granted under the 1995 Plan may
not be less than fair market value of the Class A Common Stock on the date the
option is granted. In August 1995, 420,000 options were exercised by the CEO
and President of the Company.
 
  The remaining options granted to employees under the stock plans vest over a
three year period from the date of issue, or vest according to income and
share price targets set forth in the escrow share agreement of the Class B
Common shares.
 
  In September 1994, the Board of Directors approved the Formula Stock Option
Plan (the "Formula Plan") whereby 50,000 shares of Class A Common Stock have
been reserved. The Formula Plan provides for the granting of options to non-
management directors of the Company. As of April 30, 1998 options to purchase
12,000 shares of Class A Common Stock under the Formula Plan are outstanding.
The exercise price for the incentive stock options granted under the plan may
not be less than the fair market value of the Class A Common Stock on the date
the option is granted. To date, none of these options have been exercised.
 
  In June 1996, the Board of Directors approved an additional stock option
plan (the "1996 Plan"). The 1996 Plan provides for the granting of up to
820,000 options to eligible individuals to purchase shares of Class A Common
Stock of the Company. Options under the 1996 Plan may be incentive stock
options or non-qualified stock options. The exercise price for the incentive
stock options granted under the plan, may not be less than the fair market
value of the Class A Common Stock on the date the option is granted. To date,
none of these options granted under such plan have been exercised.
 
  In January, 1998, the Board of Directors approved an additional stock option
plan (the "1998 Plan"). The 1998 Plan provides for the granting of up to
1,750,000 options to eligible individuals to purchase shares of Class A Common
Stock of the Company. Options under the 1998 Plan may be incentive stock
options or non-qualified stock options. The exercise price for the incentive
stock options granted under the plan may not be less than the fair market
value of the Class A Common Stock on the date the option is granted. To date,
none of these options have been exercised.
 
  In fiscal 1997, the Company adopted the disclosure-only provision of
Statement of Financial Accounting Standards No. 123 for Stock-based
Compensation (SFAS 123). SFAS 123 allows companies to continue to account for
those plans using the accounting prescribed by APB Opinion 25, "Accounting for
Stock Issued to Employees". The Company has elected to continue to account for
stock-based compensation using APB 25, making pro forma disclosure of net
earnings and earnings per share as if the fair value based method had been
applied.
 
  Accordingly, no compensation expense has been recorded for the stock option
plans. Had compensation expense for the stock option plans been determined
based on the fair value at the date of grant for awards in fiscal 1996, 1997
and 1998, consistent with SFAS No. 123, the Company's net earnings and
earnings per share for the fiscal years shown below would have been reported
as follows:
 
<TABLE>
<CAPTION>
                                                      1996    1997     1998
                                                     -------------------------
                                                          (IN THOUSANDS,
                                                     EXCEPT PER SHARE AMOUNT)
   <S>                                               <C>     <C>     <C>
   Net income (loss)--pro forma..................... $ 1,427 $ 4,217 $ (15,700)
   Basic net income (loss) per share--pro forma..... $   .15 $   .27 $    (.77)
   Diluted net income (loss) per share--pro forma... $   .13 $   .26 $    (.77)
</TABLE>
 
                                     F-18
<PAGE>
 
                              VIDEO UPDATE, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
  The fair market value of each option grant is estimated on the date of the
grant using the Black-Scholes option-pricing model with the following weighted
average assumptions:
 
<TABLE>
<CAPTION>
                                                          1996    1997    1998
                                                         ------  ------  ------
   <S>                                                   <C>     <C>     <C>
   Expected dividend yields.............................      0%      0%      0%
   Expected stock price volatility......................   42.5%   42.5%   88.9%
   Risk free interest rate..............................    5.1%    5.1%    5.5%
   Expected life of options............................. 5 yrs.  5 yrs.  5 yrs.
</TABLE>
 
  The pro forma effect of net income and earnings per share is not
representative of the pro forma earnings in future years because it does not
take into consideration pro forma compensation expense related to grants made
prior to 1996.
 
  The weighted average fair value for options granted during fiscal 1996, 1997
and 1998 is $2.26, $1.89 and $1.45 per share, respectively.
 
  Option activity is summarized as follows:
 
<TABLE>
<CAPTION>
                                                                    WEIGHTED
                                                    OUTSTANDING AVERAGE EXERCISE
                                                      OPTIONS   PRICE PER SHARE
                                                    ----------- ----------------
   <S>                                              <C>         <C>
   Outstanding at April 30, 1995...................    138,300       $5.30
     Granted.......................................    830,000        4.71
     Exercised.....................................   (427,850)       4.31
     Canceled......................................     (6,000)       7.63
                                                     ---------
   Outstanding at April 30, 1996...................    534,450        5.15
     Granted.......................................    861,200        4.14
     Exercised.....................................     (1,000)       4.31
     Canceled......................................    (13,700)       5.45
                                                     ---------
   Outstanding at April 30, 1997...................  1,380,950        4.53
     Granted.......................................  1,015,402        6.93
     Exercised.....................................        --          --
     Canceled......................................    193,650        4.49
                                                     ---------
   Outstanding at April 30, 1998...................  2,202,702        5.64
                                                     =========
   Exercisable at April 30, 1996...................    192,005        5.26
   Exercisable at April 30, 1997...................    293,480        5.40
   Exercisable at April 30, 1998...................  1,021,578        7.85
</TABLE>
 
  The following table summarizes information concerning currently outstanding
and exercisable options:
 
<TABLE>
<CAPTION>
                                  WEIGHTED
                                  AVERAGE   WEIGHTED              WEIGHTED
                                 REMAINING  AVERAGE               AVERAGE
       RANGE OF        OPTIONS   CONTRACTED EXERCISE    NUMBER    EXERCISE
   EXERCISE PRICES   OUTSTANDING    LIFE     PRICE   EXERCISEABLE  PRICE
   ----------------  ----------- ---------- -------- ------------ --------
   <S>               <C>         <C>        <C>      <C>          <C>
        $0 to $3.50     594,500     9.87     $3.18          --     $3.18
     $3.51 to $5.00     921,400     8.19      4.07      432,300     4.13
     $5.01 to $8.00     367,551     3.70      6.32      270,027     6.53
    $8.01 to $12.00      83,188     4.51     10.57       83,188    10.57
   $12.01 to $16.00     236,063     2.26     15.19      236,063    15.19
   ----------------   ---------     ----     -----    ---------    -----
       $0 to $16.00   2,202,702     7.12     $5.64    1,021,578    $7.85
   ================   =========     ====     =====    =========    =====
</TABLE>
 
                                     F-19
<PAGE>
 
                              VIDEO UPDATE, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
14. ACQUISITIONS
 
  During fiscal year 1996, 1997 and 1998, the Company acquired, in 23
transactions, 1 video retail stores previously operated by Video Update
franchisees, and 477 video retail stores operated by unaffiliated third party
operators (the "Acquisitions"). The purchase method of accounting has been
used to account for each of the Acquisitions and the Acquisitions are included
in the Company's consolidated financial statements from the date of
acquisition.
 
  During fiscal 1996, the Company acquired, in 12 transactions, 136 retail
stores. The aggregate purchase price of these acquisitions totaling
approximately $40,114,000 included $17,391,000 in cash, $3,319,000 in
promissory notes, $4,641,000 in assumed indebtedness and transaction costs,
and 1,603,444 shares of Class A Common Stock valued at $14,763,000 and an
option to purchase 20,000 shares of Class A Common Stock at a price equal to
the fair market value at the date of issuance. The excess of the cost over the
estimated fair value of the assets acquired of $24,352,000 (goodwill and
deferred charges) is being amortized over 20 years on a straight-line basis.
 
  During fiscal 1997, the Company acquired, in 10 transactions, 74 retail
stores. The aggregate purchase price of these acquisitions totaling
approximately $22,513,000 included approximately $20,977,000 in cash,
approximately $927,000 in transaction costs, and 136,500 shares of Class A
Common Stock valued at approximately $609,000. The excess of the cost over the
estimated fair value of the assets acquired of approximately $13,367,000
(goodwill) is being amortized over 20 years on a straight-line basis.
 
  During fiscal 1998, the Company acquired, in 1 transaction, 267 retail
stores. The aggregate purchase price of this acquisition totaled approximately
$83,458,900 included approximately $50,171,200 in assumed indebtness,
approximately $5,087,500 in transaction costs, and 9,303,927 shares of Class A
Common Stock valued at approximately $28,200,200. The excess of the cost over
the estimated fair value of the assets acquired of approximately $47,166,400
(goodwill) is being amortized over 20 years on a straight-line basis.
 
  In connection with an acquisition that the Company completed in fiscal 1996,
the Company may be obligated to make a deficiency payment to the sellers with
respect to 10,000 shares equal to the difference between the guaranteed price
of $15.00 for each share issued, and the actual market price obtained for such
shares as of specified dates. The remaining deficiency payment is estimated to
be approximately $108,750 based on the closing stock price of $4.125 at April
30, 1998. The Company is currently disputing a deficiency payment allegedly
due with respect to 239,163 shares which were issued to a seller in the
Videoland acquisition (see footnote 15); the seller is claiming a deficiency
payment of approximately $1,220,000 based on proceeds from the sale of Class A
Common Stock during the six month period of March 1996 to September 1996. The
Company has the option of satisfying approximately $1,220,000 (with respect to
239,163 shares) at April 30, 1998 through the issuance of additional shares of
Class A Common Stock. In addition, in fiscal 1998 65,750 shares placed in
escrow as a result of an acquisition were cancelled.
 
  During October 1996, a cash deficiency payment was made with regard to one
acquisition in the cash amount of $87,135. During November 1996, a cash
deficiency payment was made with regard to one acquisition in the amount of
$88,547. Also, during November 1996, the Company satisfied a deficiency
payment of $77,951 with regard to one acquisition with 15,106 shares of Class
A Common Stock. During fiscal 1998, cash deficiency payments were made with
regard to one acquisition in the amount of $1,327,000
 
  The following unaudited pro forma information presents the consolidated
results of operations of the Company as if the acquisitions had been completed
at the beginning of the year in which the acquisition occurred and the
immediately preceding year. In the opinion of the Company's management, all
adjustments necessary to present fairly such pro forma summary have been made
based on the terms and structure of the transactions.
 
 
                                     F-20
<PAGE>
 
                              VIDEO UPDATE, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
<TABLE>
<CAPTION>
                                             FISCAL YEAR ENDED APRIL 30,
                                        -------------------------------------
                                           1996         1997         1998
                                        ------------------------ ------------
                                        (IN THOUSANDS, EXCEPT PER SHARE DATA)
   <S>                                  <C>         <C>          <C>
   Revenues............................ $    78,927 $    200,244 $    248,134
   Net income (loss) from continuing
    operations......................... $     4,287 $      9,558 $    (28,562)
   Basic net (loss) income per share... $       .45 $        .33 $       (.98)
   Diluted net income (loss) per
    share.............................. $       .40 $        .32 $       (.98)
</TABLE>
 
  This unaudited pro forma financial summary does not necessarily indicate the
actual results had the Acquisitions occurred at the beginning of the
respective periods, nor do they purport to indicate the results of future
operations of the Company.
 
 Geographic Business Operations
 
  The Company owns and operates retail video stores in the United States and
in Canada. A summary of the Company's operations by geographic area is
presented for fiscal 1996, 1997 and 1998. All intercompany revenues and
expenses have been eliminated.
 
<TABLE>
<CAPTION>
                                                        OPERATING
                                             REVENUES INCOME (LOSS) TOTAL ASSETS
                                             -------- ------------- ------------
                                                       (IN THOUSANDS)
   <S>                                       <C>      <C>           <C>
   Fiscal 1996
     United States.......................... $ 40,372   $  2,107      $ 70,582
     Canada.................................   10,132        398         8,936
                                             --------   --------      --------
                                             $ 50,504   $  2,505      $ 79,518
                                             ========   ========      ========
   Fiscal 1997
     United States.......................... $ 71,650   $  5,607      $120,923
     Canada.................................   20,149      2,438        12,684
                                             --------   --------      --------
                                             $ 91,799   $  8,045      $133,607
                                             ========   ========      ========
   Fiscal 1998
     United States.......................... $116,958   $(18,215)     $269,805
     Canada.................................   39,196        637         8,626
                                             --------   --------      --------
                                             $156,154   $(17,578)     $278,431
                                             ========   ========      ========
</TABLE>
 
15. LEGAL PROCEEDINGS
 
  In connection with the acquisition of the assets of Videoland, Inc.
("Videoland") in November 1995, the Company issued 239,163 shares of its Class
A Common Stock (the "Videoland Shares") to the sellers of the assets of
Videoland (the "Videoland Sellers"). With respect to the Videoland Shares, the
Company agreed to make a deficiency payment in October 1996 to the Videoland
Sellers if the gross proceeds received by such sellers from the sale of the
Videoland Shares during the six months from March 1996 through September 1996
is not equal to the number of shares of Videoland Shares sold multiplied by
$12.00. The Videoland Sellers were subject to certain "lockup" or sale
restrictions as a condition to any deficiency payment. The Company initiated
an action in federal district court in Minnesota for a declaratory judgment
that the Videoland Sellers are not entitled to any deficiency payment. In
January, 1998, the court entered a judgment against Video Update in the amount
of $1,220,000 plus interest from October, 1996, and attorney's fees. Video
Update is appealing the matter. Although no assurances can be given as to the
outcome of such action, the Company intends to vigorously pursue the matter.
 
  In December, 1997, Valley Record Distributors assignee of Star Video, a
vendor of Moovies, Inc., filed a lawsuit in state court (Court of Common
Please, Greenville, South Carolina) against Moovies, Inc. claiming among other
things that Moovies, Inc. has failed to pay its invoices (approximately
$2,900,000) for product
 
                                     F-21
<PAGE>
 
                              VIDEO UPDATE, INC.
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
purchased. The Company has filed an answer in the action, is contemplating
counterclaims, and intends to defend the matter vigorously.
 
  In May, 1998, Rousnam Video, Inc., a Michigan corporation and Hani (Al)
Monsour (collectively "Monsour") filed a lawsuit in state court (Macomb County
Michigan) claiming amounts due pursuant to post-closing adjustments
contemplated in connection with an Asset Purchase Agreement among Monsour and
Moovies, Inc. dated as of March 14, 1997, and the alleged default on a
Promissory Note among Monsour and Moovies, Inc. in the amount of $2,000,000
which is currently reflected in notes payable. The Company has filed an answer
in the action, is contemplating counterclaims and intends to defend the matter
vigorously.
 
  In May, 1998, four stockholders filed suit in the US District Court for the
Central District of California. The Plaintiff stockholders allege that Mr.
Potter and the Company made false and misleading statements or omitted
material information about the Company and the video industry during the
period April, 1995 to September, 1996, the date of its subsequent public
offering. Plaintiffs are seeking "at least the sum of $967,967," plus
interest, additional damages and attorneys' fees. The Company and Mr. Potter
believe that the claims are unsubstantiated, without merit and they intend to
defend the matter vigorously. A motion to dismiss the action has been filed.
 
  Also, in May, 1998, the Company filed suit in federal court in Delaware
against Rentrak corporation, an Oregon Corporation. The Company alleges that
its revenue sharing agreement with Rentrak is in conflict with federal
antitrust law, given Rentrak's position in the market and its exercise of
monopoly power. The parties have not yet entered into discovery in the matter.
 
  The Company is involved in various legal proceedings arising during the
normal course of conducting business. Management believes that the resolution
of these proceedings will not have any material adverse impact on the
Company's financial statements.
 
16. CHANGE IN FISCAL YEAR END
 
  In June 1998, the Company's Board of Directors approved a resolution
changing the Company's fiscal year-end from April 30 to January 31, effective
January 31, 1999.
 
17. MANAGEMENT'S PLAN
 
  As a result of the one-time charges recorded by the Company, its operating
results for the fourth quarter of fiscal 1998 and its expected results for the
first quarter of fiscal 1999, the Company obtained a waiver through January
31, 1998 with respect to violations of certain covenants at April 30, 1998 and
July 31, 1999. The Company's bank agreements also were amended to, among other
things: (i) revise certain financial covenants; (ii) increase immediate
availability under the Senior Facility by $5 million for Company operating
activities; (iii) increase the overall interest rate by .5%; and, (iv) reprice
warrants held by the bank syndicate to a more current market price. The
Company also has negotiated extended payment terms from its major vendors. The
Company believes that these developments, combined with its expected cash flow
from operations, trade credit, equipment leases and available revenue sharing
arrangements, will provide sufficient liquidity to fund inventory purchases
and other working capital needs for the next twelve months.
 
  Additionally, the Company is proceeding with immediate actions intended to
enhance prospects for revenue growth for fiscal 1999, including layout and
marketing conversion of the acquired Moovies locations as quickly as possible,
the closing of 41 identified underperforming locations, and the aggressive
pursuit of direct revenue sharing arrangements with the major motion picture
studios, which arrangements allow the Company to provide additional copies of
rental titles without an increase in the initial cash outlay. The Company
continues to evaluate opportunities to reduce costs and improve revenues.
However, if the Company is unable to effectively manage its cash flow, it will
be required to reduce its overall expenditures and the Company's ability to
maintain or expand its current level of operations could be materially
adversely affected.
 
                                     F-22
<PAGE>
 
                                 EXHIBIT INDEX
 
<TABLE>
<CAPTION>
 EXHIBIT
 NUMBER                                           DESCRIPTION
 -------                                          -----------
 <C>     <S>    <C>
  1       --     Form of Purchase Agreement by and between Video Update, Inc. (the "Company"),
                 Piper Jaffray Inc. and The Robinson Humphrey Company, Inc. (filed as Exhibit 1
                 to the Company's Pre-Effective Amendment No. 2 to its Form S-3 Registration
                 Statement filed with the Securities and Exchange Commission (the "Commission")
                 on September 27, 1996 and incorporated herein by reference) (replaced and
                 superseded a corresponding exhibit previously filed with the Commission).
  2.1     --     Agreement and Plan of Merger dated as of July 9, 1997, as amended by Amendment
                 to Agreement and Plan of Merger dated as of October 27, 1997, by and among the
                 Company, VUI Merger Corp. and Moovies, Inc. ("Moovies") (filed as Exhibit 2.1
                 to the Company's Form S-4 Registration Statement filed with the Commission on
                 January 23, 1998 and incorporated herein by reference).
  2.2     --     Purchase Agreement by and among Video Update Canada Inc., Hill and Cassidy
                 Retail Corp., Byron Hill, Patricia Hill and Mel Cassidy, dated as of April 1,
                 1997 (filed as Exhibit 2 to the Company's Current Report on Form 8-K filed with
                 the Commission on April 7, 1997 and incorporated herein by reference).
  2.3     --     Purchase Agreement by and among the Company, Cox Video Corporation, and Robert
                 W. Cox, dated as of February 28, 1997 (filed as Exhibit 2a to the Company's
                 Current Report on Form
                 8-K filed with the Commission on April 4, 1997 and incorporated herein by
                 reference).
  2.4     --     Purchase Agreement by and among the Company, Susan Janae Kingston, and Larry
                 Peterman, dated as of March 17, 1997 (filed as Exhibit 2b to the Company's
                 Current Report on Form 8-K filed with the Commission on April 4, 1997 and
                 incorporated herein by reference).
  2.5     --     Purchase Agreement by and among the Company, Video Warehouse, Inc., and Donald
                 and Katherine Cianci, dated as of January 15, 1997 (filed as Exhibit 2 to the
                 Company's Current Report on Form8-K filed with the Commission on January 29,
                 1997 and incorporated herein by reference).
  2.6     --     Purchase Agreement by and among Video Update Canada Inc., Video View Ltd., and
                 Gordon and Joanne Hillman, dated as of January 1, 1997 (filed as Exhibit 2 to
                 the Company's Current Report on Form 8-K filed with the Commission on January
                 10, 1997 and incorporated herein by reference).
  2.7     --     Purchase Agreement by and between the Company, Videoland, Inc. and the
                 Stockholder of Videoland, Inc., dated as of November 14, 1995 (filed as Exhibit
                 2 to the Company's Current Report on Form 8-K/A filed with the Commission on
                 January 26, 1996 and incorporated herein by reference).
  2.8     --     Purchase Agreement by and among the Company, 94 Video West, Inc. and Michael
                 Bennett and Paul Levens, dated as of October 2, 1995 (filed as Exhibit 2a to
                 the Company's Current Report on Form8-K filed with the Commission on October
                 13, 1995 and incorporated herein by reference).
  2.9     --     Purchase Agreement by and among the Company, Talerico Enterprises, Inc. ("TEI")
                 and the stockholder of TEI, dated as of October 5, 1995 (filed as Exhibit 2b to
                 the Company's Current Report on Form 8-K filed with the Commission on October
                 13, 1995 and incorporated herein by reference).
  2.10    --     Purchase Agreement by and between the Company, and the Stockholders of Indy
                 Video, Inc., dated as of September 26, 1995 (filed as Exhibit 2 to the
                 Company's Current Report on Form 8-K filed with the Commission on September 27,
                 1995 and incorporated herein by reference).
</TABLE>
<PAGE>
 
<TABLE>
<CAPTION>
 EXHIBIT
 NUMBER                                           DESCRIPTION
 -------                                          -----------
 <C>     <S>    <C>
  2.11    --     Stock Purchase and Sale Agreement by and among the Company, Wilderness Video
                 Group Ltd., Richard Walton, the Walton Family Trust Alexsay Holdings Ltd.,
                 Barclays Bank of Canada, Allstate Life Insurance Company of Canada, and Ontario
                 Municipal Employees Retirement Board, dated as of August 22, 1995 (filed as
                 Exhibit 2a to the Company's Current Report on Form 8-K filed with the
                 Commission on August 30, 1995 and incorporated herein by reference).
  2.12    --     Stock Purchase and Sale Agreement by and between the Company and Glenn Forth,
                 dated August 23, 1995 (filed as Exhibit 2b to the Company's Current Report on
                 Form 8-K filed with the Commission on August 30, 1995 and incorporated herein
                 by reference).
  2.13    --     Stock Purchase and Sale Agreement by and between the Company and Seig Badke,
                 dated August 23, 1995 (filed as Exhibit 2c to the Company's Current Report on
                 Form 8-K filed with the Commission on August 30, 1995 and incorporated herein
                 by reference).
  2.14    --     Stock Purchase and Sale Agreement by and among the Company, 443972 B.C., Ltd.,
                 Dale Mounzer and Jim Collen dated August 22, 1995 (filed as Exhibit 2d to the
                 Company's Current Report on Form 8-K filed with the Commission on August 30,
                 1995 and incorporated herein by reference).
  2.15    --     Purchase Agreement by and between the Company and the Stockholders of AV Video,
                 dated as of July 14, 1995 (filed as Exhibit 2 to the Company's Current Report
                 on Form 8-K filed with the Commission on July 26, 1995 and incorporated herein
                 by reference).
  2.16    --     Purchase Agreement by and between the Company and the Proprietors of Video
                 Powerstore, dated as of June 2, 1995 (filed as Exhibit 2 to the Company's
                 Current Report on Form 8-K filed with the Commission on June 29, 1995 and
                 incorporated herein by reference).
  2.17    --     Second Amendment to the Agreement and Plan of Merger by and among the Company,
                 Schmidt & Schmidt Limited ("SSL"), and the Stockholders of SSL, dated February
                 28, 1995 (filed as Exhibit 2a to the Company's Form Quarterly Report on Form
                 10-QSB for the quarter ended January 31, 1995 filed with the Commission on
                 March 17, 1995 and incorporated herein by reference).
  2.18    --     Agreement and Plan of Merger by and among the Company, Jarzig Enterprises,
                 Inc., and the Stockholders of Jarzig Enterprises, Inc., dated October 25, 1994
                 (filed as Exhibit 2b to the Company's Quarterly Report on Form 10-QSB for the
                 quarter ended October 31, 1994, filed with the Commission on December 15, 1994
                 and incorporated herein by reference).
  2.19    --     Agreement and Plan of Merger by and among the Company, Schmidt & Schmidt
                 Limited, and the Stockholders of Schmidt & Schmidt Limited, dated September 16,
                 1994 (filed as Exhibit 2a to the Company's Current Report on Form 8-K filed
                 with the Commission on October 3, 1994 and incorporated herein by reference).
  2.20    --     Agreement and Plan of Merger by and among the Company, Halgrimson Enterprises,
                 Inc., and the Stockholders of Halgrimson Enterprises, Inc., dated September 16,
                 1994 (filed as Exhibit 2b to the Company's Current Report on Form 8-K filed
                 with the Commission on October 3, 1994 and incorporated herein by reference).
  2.21    --     Agreement and Plan of Merger by and among the Company, Koonrod, Inc., and the
                 Stockholders of Koonrod, Inc., dated September 2, 1994 (filed as Exhibit 2 to
                 the Company's Quarterly Report on Form 10-QSB for the quarter ended July 31,
                 1994, filed with the Commission on September 10, 1994 and incorporated herein
                 by reference).
  3.1     --     Restated Certificate of Incorporation (filed as Exhibit 3 to the Company's
                 Current Report on
                 Form 8-K filed with the Commission on January 20, 1997 and incorporated herein
                 by reference).
</TABLE>
<PAGE>
 
<TABLE>
<CAPTION>
 EXHIBIT
 NUMBER                                           DESCRIPTION
 -------                                          -----------
 <C>     <S>    <C>
  3.2     --     Bylaws of the Company, as amended on June 23, 1998 (filed as Exhibit 3 to the
                 Company's Current Report on Form 8-K filed with the Commission July 7, 1998 and
                 incorporated herein by reference).
  4.1     --     Form of Unit Purchase Option (filed as Exhibit 4a to the Company's Pre-
                 Effective Amendment No. 1 to its Form SB-2 Registration Statement (No. 33-
                 89018) originally filed with the Commission on March 31, 1995 and incorporated
                 herein by reference).
  4.2     --     Specimen Class A Common Stock Certificate (filed as Exhibit 4a to the Company's
                 Form SB-2 Registration Statement (No. 33-79292-C) declared effective by the
                 Commission on July 20, 1994 and incorporated herein by reference).
  4.3     --     Specimen Class B Common Stock Certificate (filed as Exhibit 4b to the Company's
                 Form SB-2 Registration Statement (No. 33-79292-C) declared effective by the
                 Commission on July 20, 1994 and incorporated herein by reference).
  4.4     --     Form of Warrant Agreement, including Form of Class A and Class B Warrant
                 Certificates (filed as Exhibit 4c to the Company's Form SB-2 Registration
                 Statement (No. 33-79292-C) declared effective by the Commission on July 20,
                 1994 and incorporated herein by reference).
  4.5     --     Form of Unit Purchase Option of D.H. Blair Investment Banking Corp. (filed as
                 Exhibit 4d to the Company's Form SB-2 Registration Statement (No. 33-79292-C)
                 declared effective by the Commission on July 20, 1994 and incorporated herein
                 by reference).
  4.6     --     Rights Agreement by and between the Company and American Stock Transfer and
                 Trust Company (filed as Exhibit 4 to the Company's Form 8-K filed April 14,
                 1998 and incorporated herein by reference).
 10.1     --     Amended and Restated Voting Agreement, dated October 27, 1997 among the
                 Company, Moovies, and directors and certain officers of the Company and Moovies
                 (filed as Exhibit 10 to the Company's Form 10-Q for the fiscal quarter ended
                 October 31, 1997 and incorporated herein by reference).
 10.2     --     Amended and Restated Undertaking Agreement, dated October 27, 1997 among the
                 Company, Moovies, Daniel A. Potter, John M. Bedard and Daniel C. Howard (filed
                 as Exhibit 10.2 of the Company's Form S-4 Registration Statement filed with the
                 Commission on January 23, 1998 and incorporated herein by reference).
 10.3     --     Form of 1998 Stock Option Plan (filed as Exhibit 10.3 of the Company's Form S-4
                 Registration Statement filed with the Commission on January 23, 1998 and
                 incorporated herein by reference).
 10.4     --     Agreement between Rentrak Corporation and the Company (filed as Exhibit 10.4 of
                 the Company's Form S-4 Registration Statement filed with the Commission on
                 January 23, 1998 and incorporated herein by reference).
 10.5     --     Form of Employment Agreement between the Company and Daniel C. Howard (filed as
                 Exhibit 10.6 of the Company's Form S-4 Registration Statement filed with the
                 Commission on January 23, 1998 and incorporated herein by reference).
 10.6     --     Credit Agreement entered into as of March 6, 1998, among the Company, Video
                 Update Canada Inc., various lending institutions and Banque Paribas, as agent
                 (the "Credit Agreement") (filed as Exhibit 10.1 to the Company's Current Report
                 on Form 8-K filed with the Commission on March 11, 1998 and incorporated herein
                 by reference).
 10.7     --     U.S. Pledge Agreement in favor of Banque Paribas, as Collateral Agent, dated as
                 of March 6, 1998 (filed as Exhibit 10.2 to the Company's Current Report on Form
                 8-K filed with the Commission on March 11, 1998 and incorporated herein by
                 reference).
</TABLE>
<PAGE>
 
<TABLE>
<CAPTION>
 EXHIBIT
 NUMBER                                           DESCRIPTION
 -------                                          -----------
 <C>     <S>    <C>
 10.8     --     U.S. Security Agreement among the Company, Various U.S. Subsidiaries of the
                 Company, and Banque Paribas, as Collateral Agent, dated as of March 6, 1998
                 (filed as Exhibit 10.3 to the Company's Current Report on Form 8-K filed with
                 the Commission on March 11, 1998 and incorporated herein by reference).
 10.9     --     Subsidiaries Guarantee Agreement among Various Subsidiaries of the Company, and
                 Banque Paribas, as Collateral Agent and as Pledgee, dated as of March 6, 1998
                 (filed as Exhibit 10.4 to the Company's Current Report on Form 8-K filed with
                 the Commission on March 11, 1998 and incorporated herein by reference).
 10.10    --     Warrant Purchase Agreement between the Company, and Banque Paribas, Grand
                 Cayman Branch, dated as of March 6, 1998 (filed as Exhibit 10.5 to the
                 Company's Current Report on Form 8-K filed with the Commission on March 11,
                 1998 and incorporated herein by reference).
 10.11    --     Warrant Agreement between the Company and Banque Paribas, Grand Cayman Branch,
                 dated as of March 6, 1998 (filed as Exhibit 10.6 to the Company's Current
                 Report on Form 8-K filed with the Commission on March 11, 1998 and incorporated
                 herein by reference).
 10.12    --     Registration Rights Agreement between the Company and Banque Paribas, Grand
                 Cayman Branch, dated as of March 6, 1998 (filed as Exhibit 10.7 to the
                 Company's Current Report on Form 8-K filed with the Commission on March 11,
                 1998 and incorporated herein by reference).
 10.13    --     1996 Stock Option Plan (filed as Exhibit 10a to the Company's Quarterly Report
                 on Form 10-QSB for the fiscal quarter ended July 31, 1996 and incorporated
                 herein by reference).
 10.14    --     Form of Franchise Offering Circular (filed as Exhibit 10b to the Company's
                 Quarterly Report on Form 10-QSB for the fiscal quarter ended July 31, 1996 and
                 incorporated herein by reference).
 10.15    --     Restated Employment Agreement between the Company and Daniel A. Potter,
                 effective as of April 30, 1998.
 10.16    --     Restated Employment Agreement between the Company and John M. Bedard, effective
                 as of April 30, 1998.
 10.17    --     Form of Merger and Acquisition Agreement between the Company and D.H. Blair
                 Investment Banking Corp. (filed as Exhibit 10a to the Company's Pre-Effective
                 Amendment No. 1 to its Form SB-2 Registration Statement (No. 33-89018)
                 originally filed with the Commission on March 31, 1995 and incorporated herein
                 by reference).
 10.18    --     Form of Amendment to Warrant Agreement dated July 20, 1994 between the Company,
                 American Stock Transfer & Trust Company and D.H. Blair Investment Banking Corp.
                 (filed as Exhibit 10b to the Company's Pre-Effective Amendment No. 1 to its
                 Form SB-2 Registration Statement (No. 33-89018) originally filed with the
                 Commission on March 31, 1995 and incorporated herein by reference).
 10.19    --     Stock Exchange Agreement by and between the Company and certain stockholders of
                 Tinseltown Video, Inc. (filed as Exhibit 10a to the Company's Current Report on
                 Form 8-K filed with the Commission on February 16, 1995 and incorporated herein
                 by reference).
 10.20    --     Formula Stock Option Plan (filed as Exhibit 10a to the Company's Form SB-2
                 Registration Statement (No. 33-89018) filed with the Commission on January 31,
                 1995 and incorporated herein by reference).
 10.21    --     Form of Franchise Agreement between the Company and Franchisees (filed as
                 Exhibit 10d to the Company's Form SB-2 Registration Statement (No. 33-79292-C)
                 declared effective by the Commission on July 20, 1994 and incorporated herein
                 by reference).
</TABLE>
<PAGE>
 
<TABLE>
<CAPTION>
 EXHIBIT
 NUMBER                                           DESCRIPTION
 -------                                          -----------
 <S>     <C>    <C>
 10.22    --     Form of Consulting Agreement between the Company and D.H. Blair Investment
                 Banking Corp. (filed as Exhibit 10f to the Company's Form SB-2 Registration
                 Statement (No. 33-79292-C) declared effective by the Commission on July 20,
                 1994 and incorporated herein by reference).
 10.23    --     Form of Agency Agreement between the Company and D.H. Blair Investment Banking
                 Corp. (filed as Exhibit 10aa to the Company's Form SB-2 Registration Statement
                 (No. 33-79292-C) declared effective by the Commission on July 20, 1994 and
                 incorporated herein by reference).
 10.24    --     1994 Stock Option Plan (filed as Exhibit 10bb to the Company's Form SB-2
                 Registration Statement (No. 33-79292-C) declared effective by the Commission on
                 July 20, 1994 and incorporated herein by reference).
 10.25    --     Form of Second Amendment and Waiver to the Credit Agreement, dated as of August
                 12, 1998.
 10.26    --     Form of First Amendment to Warrant Agreement.
 18       --     Letter on Change in Accounting Principles (filed as Exhibit 18 to the Company's
                 Annual Report on Form 10-KSB for the fiscal year ended April 30, 1996 and
                 incorporated herein by reference).
 21       --     List of the Company's Subsidiaries.
 23       --     Consent of Ernst & Young LLP.
 27       --     Financial Data Schedule.
 27.1     --     Financial Data Schedule--Restated 1996
 27.2     --     Financial Data Schedule--Restated 1997
</TABLE>