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                                 UNITED STATES
                       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 AND EXCHANGE ACT OF 1934
 
                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
 
                                       OR
 
     [ ]   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
        SECURITIES AND EXCHANGE ACT OF 1934
 
         FOR THE TRANSITION PERIOD FROM ____________ TO ____________ .
 
                         COMMISSION FILE NUMBER 0-27168
 
                           METACREATIONS CORPORATION
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
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                DELAWARE                                  95-4102687
        (STATE OF INCORPORATION)            (I.R.S. EMPLOYER IDENTIFICATION NUMBER)
</TABLE>
 
                 6303 CARPINTERIA AVENUE, CARPINTERIA, CA 93013
                    (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
 
                                 (805) 566-6200
              (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
 
        SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: COMMON STOCK, $0.001
                                   PAR VALUE
 
     Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file reports), and (2) has been subject to such
filing requirements for the past 90 days.  Yes [X]  No [ ]
 
     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to the
Form 10-K.  [X]
 
     As of March 10, 1999, there were outstanding 24,410,038 shares of the
registrant's Common Stock, $0.001 par value, which is the only outstanding class
of common or voting stock of the registrant. As of that date, the aggregate
market value of the shares of Common Stock held by non-affiliates, based upon
the last sale price of the shares as reported on the NASDAQ National Market
System on such date, was approximately $115,828,322.
 
                      DOCUMENTS INCORPORATED BY REFERENCE:
 
     Portions of the registrant's definitive proxy statement relating to its
1999 Annual Meeting of Stockholders to be held in May 1999 are incorporated by
reference into Part III.
 
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                           METACREATIONS CORPORATION
 
                                   FORM 10-K
 
                               TABLE OF CONTENTS
 
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          PART I
Item 1.   Business....................................................    1
Item 2.   Properties..................................................   16
Item 3.   Legal Proceedings...........................................   16
Item 4.   Submission of Matters to a Vote of Security Holders.........   16
 
          PART II
Item 5.   Market for Registrant's Common Equity and Related
          Stockholder Matters.........................................   18
Item 6.   Selected Financial Data.....................................   19
Item 7.   Management's Discussion and Analysis of Financial Condition
          and Results of Operations...................................   20
Item 8.   Financial Statements and Supplementary Data.................   29
Item 9.   Changes in and Disagreements with Accountants on Accounting
          and Financial Disclosure....................................   58
 
          PART III
Item 10.  Directors and Executive Officers of the Registrant..........   58
Item 11.  Executive Compensation......................................   58
Item 12.  Security Ownership of Certain Beneficial Owners and
          Management..................................................   58
Item 13.  Certain Relationships and Related Transactions..............   58
 
          PART IV
Item 14.  Exhibits, Financial Statement Schedules, and Reports on Form
          8-K.........................................................   59
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                                     PART I
 
     This Annual Report on Form 10-K contains forward-looking statements within
the meaning of Section 27A of the Securities Act and Section 21E of the Exchange
Act. Words such as "anticipates," "expects," "intends," "plans," "believes,"
"seeks," "estimates," variations of such words and similar expressions are
intended to identify such forward-looking statements. These statements are not
guarantees of future performance and are subject to certain risks, uncertainties
and assumptions that are difficult to predict. Therefore, actual results could
differ materially from those expressed or forecasted in any such forward-
looking statements as a result of certain factors, including those set forth in
"Additional Factors Affecting Future Results." In connection with
forward-looking statements which appear in these disclosures, investors should
carefully review the factors set forth in this Form 10-K under "Additional
Factors Affecting Future Results."
 
ITEM 1.  BUSINESS
 
     MetaCreations Corporation ("MetaCreations" or the "Company") is a leading
provider of graphics software for use in print, the World Wide Web (the "Web" or
the "Internet") and computer graphics applications. The Company develops and
markets 2D and 3D visualization software and technologies for use by
professionals and consumers. MetaCreations offers a broad product line of
award-winning graphics desktop software for both Windows and Macintosh
platforms, and its products are available in more than 50 countries.
 
     In 1998, MetaCreations introduced its "Creative Web" strategy, designed to
leverage the Company's 2D and 3D visualization technologies for use in a variety
of applications on the Web. The Creative Web strategy is centered on the
Company's new MetaStream and MetaFlash technologies, and employs an array of
MetaCreations' software development tools to accelerate the creation of 2D and
3D graphics for online applications, and to make fast, interactive use of
photo-realistic 3D on the Web practical, viable and easy.
 
     In connection with the Company's new business focus, on June 30, 1998,
MetaCreations announced a restructuring plan aimed at reducing costs and
improving competitiveness and efficiency, which was implemented during the third
quarter of 1998. In connection with the restructuring, management determined
that a restructuring charge of approximately $5 million was required to cover
the costs of reducing certain sectors of its workforce and facilities.
 
INDUSTRY BACKGROUND
 
     Computer graphic imaging and visual computing tools are standard tools for
desktop publishers, Web site designers, production artists, multimedia
developers, creative directors, digital imagers and photographers (collectively,
"Creative Professionals") to develop and present their materials. Creative
Professionals may use digital painting, illustration, composition, page layout
and design, special effects, digitally captured images and video, animation,
text, photographs, music and other audio to produce a wide variety of end
products. Creative Professionals also use computer modeling tools to design 3D
objects, landscapes and environments. The images and content generated by these
Creative Professionals increasingly must be deliverable through a wide variety
of media, including print, the Web, intranets, video, and film. Business
professionals and consumers are also increasingly using graphical and digital
creative productivity software tools at work and in the home.
 
     Factors influencing the use of computer graphic imaging and Internet/online
design tools include:
 
     - The Rapid Expansion of the Internet and Electronic Commerce
       Environments. The rapid expansion of the Internet and electronic commerce
       environments is driving demand for tools to create enhanced digital
       graphic and multimedia content for use in Web sites. Examples of these
       uses include the electronic merchandising of products, electronic
       catalogs, virtual shopping malls, the 3D inspection of real estate,
       travel destinations and entertainment venues, electronic magazines and
       newspapers, financial analysis, online games, educational materials and
       other forms of online visual communication and data analysis.
 
     - The Enhancement of Visual Media for Communications, Commerce,
       Entertainment and Education. Computer graphic imaging tools are changing
       the way information is communicated. Increasingly,
 
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       producers of magazines, annual reports, marketing brochures, product
       packaging, advertising and newsletters are using software graphic arts
       tools to create sophisticated illustrations and graphic designs for
       desktop published material. Similarly, Internet/online design tools
       provide Web developers the ability to create high impact Web sites, sales
       presentations, catalogs, advertising, product demonstrations, data
       analysis, videos, educational materials, and game environments.
 
     - The Growing Availability of Digital Content. There is a growing body of
       professionally produced digital images and electronically produced media.
       The digital nature of this content enables Creative Professionals to
       enhance and manipulate this 2D and 3D content in a variety of media,
       including print, the Web, video and film. Information that has been
       digitized includes photographs, 3D objects, illustrations, video,
       animations, voice and music.
 
     - The Proliferation of Powerful Computers and Peripherals and Expanding
       Bandwidth on the Web. The increased performance, affordability and
       availability of powerful personal computers and graphics accelerator
       chips, and related high performance peripheral devices such as digital
       cameras, digital capture devices, scanners, Jazz and Zip drives,
       high-capacity hard drives, and high resolution color printers, have led
       to a proliferation of graphics and multimedia-capable computers in
       business and the home. In addition, continued increases in bandwidth for
       online environments is expected to increase demand for enhanced graphics
       and digital content for the Web.
 
     In response to these trends, Creative Professionals, including Web site
developers and those providing e-commerce on the Web, are continually seeking
new tools and technology to enhance their productivity to create and capture
digital content. As a result, the Company believes that there is a demand for
fast, powerful and easy to use tools and technologies that go beyond the
capabilities of existing applications.
 
     Businesses are also looking for productivity tools to creatively
manipulate, analyze and display their business data and digital imaging at work,
at home, and on the Web. Further, the Company believes that high resolution,
photo-realistic 3D is critical for the future of visual computing on the
Internet, particularly related to the merchandising of products and services for
e-commerce.
 
STRATEGY
 
     The Company is a leading provider of computer graphics and design tools.
The Company's Creative Web strategy is targeted at leveraging its powerful 2D
and 3D graphics products and technologies into new markets on the Web with a
focus on e-commerce applications. The Company's strategies include the following
key elements.
 
     - Enhance Professional Software Products and Enable Web
       Capabilities. MetaCreations' priority for 1999 is to revitalize growth
       from its core professional graphics software products, by enhancing its
       leading products, Painter, Kai's Power Tools, Bryce, Poser, Infini-D, and
       Ray Dream Studio. To achieve this goal, the Company plans to introduce
       new versions of these products in 1999, which will include increased Web
       functionality and interactivity.
 
     - Leverage MetaStream and MetaFlash Technologies to Extend 3D Visualization
       to the Web. MetaStream is a 3D file format jointly developed by
       MetaCreations and Intel that enables the delivery of high-quality 3D
       graphics over the Web. MetaStream content progressively streams over the
       Internet, and scales to the performance of a user's particular computer
       system, maximizing the user's graphical experience. MetaFlash is the
       combination of a flash attachment for standard digital cameras and
       powerful software that reconstructs digital pictures into high-quality,
       texture-mapped 3D wire frame models. The MetaFlash technology reduces the
       time and cost involved in producing and capturing photo-realistic 3D
       images. MetaFlash outputs to the MetaStream 3D file format, which can
       then be streamed over the Web and viewed with the MetaStream client-side
       engine. The combination of MetaStream and MetaFlash, along with
       MetaCreations' 3D modeling and editing tools, are planned to give the
       Internet community an integrated, end-to-end solution for the capture,
       transmission, viewing and manipulation of 3D content for a variety of
       applications, including electronic merchandising.
 
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     - Use Strategic Acquisitions to Develop Complementary Technologies. In
       December 1997, the Company acquired Real Time Geometry Corp. ("RTG")
       whose proprietary technology has been further developed into MetaStream
       and the recently announced MetaFlash. In December 1998, the Company
       acquired Canoma, Inc., and anticipates the further development of its
       in-process technology which will enable the creation of photorealistic 3D
       models from 2D digital photographs or scanned images. This technology
       will be incorporated into a product expected to be released by the
       Company in the first half of 1999. In the future, the Company may make
       similar acquisitions that complement the Company's existing product line
       and the Creative Web strategy.
 
     - Introduce Dynamic 2D Products for the Web. MetaCreations' new 2D product,
       Headline Studio, features an easily accessible tool set to quickly create
       high quality animated banners for advertising on the Web. Late in 1998
       the Company released Painter 5.5 Web Edition, which allows for the
       creation and output of sophisticated natural media content for Web
       design. Headline Studio, which was released during the first quarter of
       1999, and Painter 5.5 Web Edition are expected to be part of a future
       suite of powerful MetaCreations 2D products for Web developers,
       e-commerce site designers, and hosting sites.
 
     - Leverage Strategic Alliances. During 1998, the Company entered into a
       series of strategic licensing and co-marketing agreements for the
       MetaStream and MetaFlash technologies with third party hardware and
       software companies. In May 1998, the Company announced its partnership
       with Intel Corporation ("Intel") for the joint development of the
       MetaStream 3-D file format designed for Intel Architecture. In June 1998,
       Microsoft Corporation ("Microsoft") licensed the MetaStream 3D graphics
       file format and related run-time engine and in November 1998 announced
       plans to distribute MetaStream with the Windows 98 and Windows 2000
       operating systems. In January 1999, the Company announced that Intel will
       co-develop and acquire a license for the MetaFlash technology and assist
       the Company in efforts to support swift market adoption of MetaFlash.
       During January and February 1999, the Company announced separate
       agreements with Eastman Kodak Company ("Kodak") and Minolta Co., Ltd.
       ("Minolta") for the production and distribution of 3D digital cameras
       using the MetaFlash technology. These new strategic licensing and
       co-marketing arrangements offer MetaCreations the opportunity to
       establish wide market penetration and acceptance of these products and
       technologies.
 
     - Distribute Software Via the Web. While sustaining its strong relationship
       with its traditional distributors, MetaCreations plans to extend its
       direct distribution, employing the Web for direct-to-customer marketing
       and sales, with delivery of products via electronic software download or
       mail. In addition to increasing direct sales, this move will demonstrate
       the effectiveness of the Company's e-merchandising technology by making
       MetaCreations.com a model of online commerce and communications.
 
     - Expand Sales in International Markets. The Company is investing in its
       sales efforts globally to capitalize on and drive geographic expansion.
       Recently, MetaCreations hired a Munich-based Vice President, European
       Sales and Marketing, and a Tokyo-based Director of Sales for Japan. In
       addition, the number of international sales and marketing personnel is
       being increased, and as conditions warrant MetaCreations will continue to
       invest and expand the Company's international visibility and presence.
 
PRODUCTS
 
     MetaCreations focuses its product development efforts on creating
affordable, high performance, high quality and easy to learn and use software
tools. Key features of the Company's products include the following:
 
     - Innovative User Interface Design. MetaCreations' products are designed
       with innovative user interfaces to facilitate ease of learning and use
       while providing access to advanced algorithmic-based graphics design and
       special effects techniques. The Company's products are designed to allow
       customers to control the creative process and explore new areas of
       graphic design without requiring a detailed understanding of the enabling
       technology.
 
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     - Portability. The Company develops its products in the C and C++
       programming languages, facilitating portability to alternative operating
       systems, and focuses on the Windows and Macintosh platforms. The Company
       will continue to evaluate available hardware and software platforms and
       consider adapting its products for use on such platforms as technological
       advancements and market demands dictate.
 
     - Resolution Independent Imaging Technology. Many of the Company's tools
       create and manipulate images through the application of sophisticated
       proprietary mathematical algorithms, rather than by generating new
       bit-mapped graphics at each stage of the design process, enabling real
       time manipulation and rapid prototyping of creative alternatives.
 
     MetaCreations classifies it products within two categories: professional
and consumer. The Company's professional product line includes both 2D products,
consisting of Painter 5.5 Web Edition, Kai's Power Tools 5 and Headline Studio,
and 3D products, consisting of Bryce 3D, Poser 3, Ray Dream Studio 5, Infini-D
4.5, MetaStream, and MetaFlash. The leading consumer products include Kai's
Super GOO, Kai's Photo Soap 2, and Kai's Power Show.
 
  2D PROFESSIONAL PRODUCTS
 
     Painter. Painter is an advanced paint and image-editing platform which
empowers digital designers and graphics artists with more than one hundred
Natural-Media brushes that simulate the look of traditional art tools and
techniques, Dynamic Plug-in Floaters which perform image processing effects such
as buring and tearing to the selected item in real time, and customizable
palettes and tear-off tools which allow artists and designers the option to
optimize their environment. The latest version, Painter 5.5 Web Edition,
incorporates image slicing, dynamic text, JavaScript rollover support, easy
custom button creation, and a built-in content library of more than 1,000
Web-ready images for stunning Web site graphics. Painter 5.5 Web Edition, which
was released in the third quarter of 1998 and is available on the Windows and
Macintosh platforms in English, Japanese, German, French, and Chinese, has a
suggested retail price of $299.
 
     Kai's Power Tools ("KPT"). Kai's Power Tools is a set of creative and
production extensions to graphics products that support the Adobe plug-in
architecture, including Adobe's PhotoShop, Micrografx Inc.'s Picture Publisher,
Corel Corporation's PhotoPaint, MetaCreation's Painter and other leading
application platforms. KPT allows the creation of new graphic forms through an
advanced user interface design and, in certain cases, integration of
multiple-step image processing functions into a single step. The most recent
version, KPT 5, which is available on the Windows and Macintosh platforms in
English, Japanese, German and French, was released in the fourth quarter of
1998. The suggested retail price of KPT 5 is $199.
 
     Headline Studio is a dynamic new software for Web design professionals who
want to create animated, broadcast-quality Web advertising banners. Headline
Studio contains all the necessary tools in an easily accessible format to
quickly create animated GIF banner ads for the Web that can be viewed on any
browser at multiple bandwidths. Headline Studio, which was released in the first
quarter of 1999, is available on both the Windows and Macintosh platforms via
e-commerce and electronic distribution. Headline Studio is available in English,
Japanese, German, and French at a suggested retail price of $199.
 
  3D PROFESSIONAL PRODUCTS
 
     Bryce. Bryce, first released in the third quarter of 1994, is an
application platform that provides Creative Professionals with the ability to
generate natural and supernatural 3D landscapes and terrains. Bryce provides
Creative Professionals with powerful functions, including materials and texture
creation and editing capabilities, and provides non-graphic arts professionals
and consumers unfamiliar with 3D graphics design an entry point into the
development of photo-realistic 3D worlds. Bryce enables advanced,
photo-realistic creation of skies with natural cloud formations, humidity, fog
and light diffraction, as well as rivers, snowy peaks, deserts, or ocean floors,
supplemented by an array of special effects including complex textures and
reflective surfaces. The most recent version, Bryce 3D, which allows any
property such as atmospheres, terrains, or objects to be animated, was released
on both the Windows and Macintosh platforms in the fourth quarter of 1997. Bryce
3D
 
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is available in English, Japanese, German and French. The suggested retail price
of Bryce 3D is $199. The Company plans to release a new version of Bryce, Bryce
4, in the first half of 1999.
 
     Poser. Poser, introduced in the second quarter of 1995, is a modeling
application that allows users to create and animate images of human figures and
animals which can be posed, rendered with surface textures and multiple lights,
and easily incorporated into artwork and designs. Model images created with
Poser can be exported for use in graphics design, illustration, multimedia and
3D software. Poser is designed to work with 2D and 3D design application such as
Painter, Adobe's PhotoShop, Macromedia's Director, and several other products.
Poser 3, the most recent version, was released in the second quarter of 1998 on
both the Windows and Macintosh platforms. Poser 3 is available in English,
Japanese, German, and French. The suggested retail price of Poser 3 is $199.
 
     Ray Dream Studio ("Studio"). Studio is an application platform that
provides Creative Professionals the ability to create lifelike 3D illustrations
and animations. Studio incorporates a Mesh Form Modeler which provides
exceptional control over individual polygons, lines, or vertex points on the
model; a Free-Form Modeler which allows the generation of models by extruding,
lathing, lofting, and sweeping; a Natural-Media renderer which allows the
creation of 3D graphics that resemble cartoons, paintings, or sketches; and a
set of volumetric and particle-based primitives, including fire, fog, clouds,
and fountains, which allow the creation and animation of incredible natural
effects. Studio 5, the most recent version, was released on the Windows and
Macintosh platforms in the third quarter of 1997. Studio 5 is available in
English, Japanese, German and French at a suggested retail price of $449.
 
     Infini-D. Infini-D is an application platform that gives video
professionals and animation and multimedia artists in both the broadcast and
corporate arenas the tight integration and fast feedback needed to create
high-quality 3D animations in a production environment. Infini-D incorporates a
comprehensive list of powerful special effects, including sophisticated particle
systems, volumetric lighting effects, and deformation tools. Additionally, the
most recent version, Infini-D 4.5, incorporates the Company's MetaStream
multiresolution technology which allows artists to interactively change the
resolution of any 3D model and customize the number of polygons a model uses
while maintaining structural integrity. Infini-D 4.5 was released in the second
quarter of 1998 on both the Windows and Macintosh platforms. The suggested
retail price of Infini-D 4.5 is $899.
 
     MetaStream. MetaStream enables developers to author content to deliver
high-quality 3D graphics over the Web. MetaStream content progressively streams
and scales over the Internet and in PC games, adjusting to the performance of a
user's particular computer system. MetaStream-enabled content also takes
advantage of Direct-X-based high-performance graphics software services for
multimedia and game developers. The Company has entered into licensing
agreements for the MetaStream technology with Intel and Microsoft. The Company
has also incorporated the MetaStream technology into a number of products
released during 1997 and 1998, including Infini-D 4.5 and Ray Dream Studio 5,
and plans to continue incorporating the technology into future software
products. The MetaStream client-side engine, which plugs into Microsoft Internet
Explorer and Netscape Navigator, is available for download on the Windows
platform at www.metastream.com.
 
     MetaFlash. MetaFlash is the combination of a flash attachment for standard
digital cameras and powerful software that reconstructs digital pictures into
high-quality, texture-mapped 3D wire frame models. The MetaFlash technology
reduces the time and cost involved in producing photo-realistic 3D Web images.
MetaFlash outputs to the MetaStream 3D file format, which can then be streamed
over the Web and viewed with the MetaStream client-side engine. The MetaFlash
technology has been licensed by Intel, Kodak and Minolta. Cameras equipped with
the MetaFlash technology are expected to be released by Kodak and Minolta in the
second half of 1999.
 
  CONSUMER PRODUCTS
 
     Kai's Super GOO ("GOO"). GOO, the first consumer product offered by the
Company, allows users to turn pictures into images and then stretch, grow,
animate, fuse, mutate, or apply a host of other special effects to the images in
real time. A library of images is included, or users can import images from a
variety of
 
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sources, including images from 35 mm film transferred to CD-ROM or diskette,
digital cameras, scanners, capture devices, video cameras, or the Web. Images
can be printed out or saved for use on personalized items such as t-shirts,
mugs, or screen savers, or can be easily dropped into a real-time animation that
instantly transforms the original still image into a movie-like sequence which
can be uploaded to Quicktime and AVI movies. GOO, which is available on both the
Windows and Macintosh platforms in English, Japanese, German, French, Spanish,
and Italian, was released in the second quarter of 1998. The suggested retail
price of GOO is $49.95.
 
     Kai's Photo Soap ("Soap"). Soap, the second of the Company's home photo
digital imaging software programs, provides consumers the ability to clean,
edit, and manipulate personal photographs and other images in real time,
producing digital content such as slide shows that can be e-mailed, posted on a
Web page, printed on a color printer, or output to imaging software and hardware
for further manipulation or integration into desktop publishing applications.
Soap 2, the most recent version, allows users to convert digital images to
instantly viewable HTML formats or 3D picture cubes utilizing the MetaStream
format for posting on the Web. Soap 2 was released in the fourth quarter of 1998
on both the Windows and Macintosh platforms in English, Japanese, German, and
French, at a suggested retail price of $49.95.
 
     Kai's Power Show ("Show"). Show, which was released in the first quarter of
1998, is a home photo and business presentation software player which offers
consumers a simple way to create a dynamic photo show or enhance a business
presentation. Show allows consumers to import and organize digital media such as
digital photos, artwork, and video clips; sequence these elements; and add real
time TV-like transitions and animated placement of digital photos, text,
artwork, and video clips. The completed show can then be shared with family,
friends, or business associates via a computer display, projector, stand-alone
player, printer, or videotape. Show, which is available on both the Windows and
Macintosh platforms in English, Japanese, German, and French, has a suggested
retail sales price of $49.95.
 
MARKETING, SALES AND DISTRIBUTION
 
     MetaCreations develops awareness and demand for its products through public
relations activities, advertising, product reviews, tradeshows, the Company's
Web site, seminars, keynote speeches and lectures at major digital design,
multimedia and online conferences throughout the world. The Company also
utilizes direct mail and e-mail to introduce, educate and sell to customers new
products and upgrades in conjunction with activities of the Company's
distributors, dealers and in-house telemarketing operations. In addition, the
Company has begun advertising through the use of banner ads, e-mail, and links
from Web sites on the Internet. The Company also focuses on building a user
community through a number of initiatives, including producing and co-sponsoring
events at major tradeshows, at which the press, distributors and complementary
hardware and software manufacturers can gather to demonstrate technology, make
contacts and exchange ideas regarding digital graphic arts, multimedia and
Internet/online communications.
 
     MetaCreations sells its products worldwide through multiple distribution
channels, including traditional software distributors, hardware and software
Original Equipment Manufacturers ("OEMs"), international distributors,
educational distributors, value-added resellers ("VARs"), computer superstores,
retail dealers, mail order and direct sales. The Company's primary sales channel
is through large software distributors such as Ingram Micro, Inc. and Tech Data,
which in turn distribute the Company's products through large retail chains,
catalogs, and smaller retail dealers. In 1998, 1997, and 1996, Ingram Micro,
Inc., the Company's largest domestic distributor, accounted for approximately
8%, 17%, and 20% of net revenues, respectively. The Company supports this
channel by referring retail dealer sales, educational distributor sales and mail
order sales to these major distributors. The Company receives inventory and
sales reports from its distributors and certain major retailers to help monitor
sales through this channel. As is typical in the personal computer software
industry, the Company grants its distributors limited rights under a stock
balancing policy to return unsold inventories of the Company's products in
exchange for new purchases. In addition, the Company provides price protection
to its distributors in certain instances when it reduces the price of its
products.
 
     The Company offers product sales and upgrades directly to qualified
third-party resellers and end users. By selling to repeat customers in the
Company's installed base of registered customers, the Company
 
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complements its primary distribution channels. MetaCreations also sells its
products directly to end users over the Web through its online store and has
recently begun to deliver certain of its products via electronic software
download from its Web site.
 
     The Company currently distributes its products through over 70
international distributors in over 50 countries worldwide, with approximately
29%, 38%, and 41% of the Company's net revenues coming from international
markets in 1998, 1997, and 1996, respectively. In some cases, the distributor
has exclusive distribution rights to certain products in its country. Effective
February 1996, MetaCreations entered into a distribution agreement with Marubeni
Corporation, a leading software distributor in Japan, for the exclusive
distribution rights of certain of its products in Japan. In 1998, 1997, and
1996, Marubeni Corporation accounted for approximately 15%, 12%, and 2% of net
revenues, respectively. During the fourth quarter of 1996, MetaCreations entered
into a similar agreement with Prisma Express Distributionsgesellschaft GmbH, a
leading software distributor in Germany, for the exclusive distribution rights
of certain of its products in Germany, Austria, and Switzerland. In addition,
the Company established its international operations headquarters in Dublin,
Ireland in September 1996, where the Company localizes, manufactures and
distributes international versions of its products. In August 1998, the Company
hired a Vice President, European Sales and Marketing, and in February 1999, the
Company hired a Director of Sales for Japan. The Company intends to continue to
make strategic investments in additional markets throughout Europe, Asia and
Latin America.
 
     MetaCreations sells its products to educational institutions primarily
through a distributor which specializes in the education market, including
campus resellers, bookstores and educational mail order houses. The Company
views the education market as a strategic opportunity to establish product and
brand preferences early in the careers of future graphic arts and business
professionals. Accordingly, the Company offers substantial educational
discounts.
 
     MetaCreations actively maintains OEM relationships with many hardware and
software vendors that bundle MetaCreations products with their own complementary
hardware or software products and pay the Company royalties. The Company
believes that OEM sales increase the brand recognition of its products and
expand its customer and revenue base. In addition, these relationships give the
Company early access to computer graphic imaging, multimedia and Internet/online
technologies, which assist MetaCreations in quickly adapting its products for
compatibility with, or in releasing new products based on, such technologies.
Some of the Company's OEM customers include 3Com Corporation; Acer Peripherals,
Inc.; Apple Computer, Inc.; Bayer Corporation (AGFA division); Digital Equipment
Corporation; Epson America, Inc.; Matrox Graphics, Inc.; Play, Inc.; Ricoh
Corporation; UMAX Technologies, Inc.; and Wacom Computer Systems.
 
     The Company has also pursued and entered into marketing, distribution and
licensing agreements related to certain of its technologies, including
MetaStream and MetaFlash. The Company believes that such agreements allow it to
more effectively create market demand and acceptance for new technologies. Some
of the companies who have entered into such agreements include Eastman Kodak
Company; Intel Corporation; Microsoft Corporation; and Minolta Co., Ltd.
 
PRODUCT DEVELOPMENT
 
     The Company's principal current product development efforts are focused on
utilizing its core enabling technologies to develop enhanced digital graphic and
content creation tools for Creative Professionals and the Internet and
commercial online environments. From time to time, the Company may also acquire
basic software technologies that it considers critical to building computer
graphic imaging and Internet/online design tools.
 
     The Company has supplemented its internal product development efforts by
licensing on an exclusive basis products developed by or co-developed with third
parties. MetaCreations believes that outsourcing certain of its product
development activities enables it to capitalize on the latest technological
innovations.
 
                                        7
<PAGE>   10
 
     The Company's growth will be dependent upon the introduction of new
products and new versions of existing products. There can be no assurance that
any such new products or versions will achieve market acceptance. In addition,
the Company has in the past experienced delays in the development of new
products and the enhancement of existing products, and such delays may occur in
the future. If the Company were unable, due to resource constraints or
technological or other reasons, to develop and introduce such products in a
timely manner, this inability could have a material adverse effect on the
Company's business, operating results, financial condition, and cash flows. In
particular, the introductions of new products or enhanced versions of existing
products, are subject to the risk of development delays. Any delay in the
availability of new products could have a material adverse effect on the
Company's business, operating results, financial condition, and cash flows.
 
     The Company's research and development expenses were approximately $15.8
million, $14.1 million, and $8.2 million for 1998, 1997, and 1996, respectively.
 
CUSTOMER AND TECHNICAL SUPPORT
 
     The Company has built a customer education and technical support
organization focused on providing value to the Company's customers beyond the
purchase of the Company's products. MetaCreations provides customer and
technical support to customers via e-mail on the Internet and through online
services, fax and telephonic communication. In addition, the Company supports an
online community through its presence on the Web, where technical support, tips
and tricks and an entire electronic book on advanced imaging techniques can be
found. The Company also conducts seminars regularly for prospective and current
customers at leading tradeshows and conferences throughout the world, providing
education and insight into the uses of the Company's technology.
 
COMPETITION
 
     The Company faces competition from a number of sources, including other
vendors of personal computer graphic imaging and Internet/online design
application tools and other personal computer software industry participants,
including: Adobe Systems Incorporated; Autodesk, Inc.; Corel Corporation;
Macromedia, Inc.; and Microsoft Corporation.
 
     Many of the Company's competitors or potential competitors have longer
operating histories and significantly greater financial, management, technology,
development, sales, marketing and other resources than the Company. As the
Company competes with larger competitors across a broader range of product
lines, the Company may face increasing competition from such companies. If these
or other competitors develop products, technologies or solutions that offer
significant performance, price or other advantages over those of the Company,
the Company's business, operating results, financial condition, and cash flows
would be materially adversely affected.
 
     A variety of other possible actions by the Company's competitors could also
have a material adverse effect on the Company's business, operating results,
financial condition, and cash flows, including increased promotion, the bundling
of competitive products with other third-party products such as application
platforms or operating systems, and the introduction of new or enhanced
products. Moreover, in the event that price competition significantly increases,
competitive pressures could cause the Company to reduce the prices of its
products, which would result in reduced margins. Furthermore, new personal
computer platforms and operating systems, or new software distribution and
delivery systems, such as the Internet and commercial online services, may
provide new entrants with opportunities to obtain a substantial market share in
the Company's markets.
 
     The Company may also face competition from general personal computer market
participants who decide to offer graphic arts or multimedia design products.
Such new market entrants could have a significant, disruptive effect on the
markets in which the Company participates. In particular, Microsoft Corporation
currently holds a dominant position in the personal computer software market in
general, allowing it to exert considerable influence throughout the market. The
Company's products also compete with graphic design and multimedia solutions
based on other hardware platforms.
 
                                        8
<PAGE>   11
 
MANUFACTURING AND SHIPPING
 
     The manufacture of the Company's products consists of the duplicating of
diskettes and/or the pressing of CD-ROMs, the printing of manuals and the
packaging and assembling of final products, all of which are performed in
accordance with the Company's specifications and forecasts. While the Company's
current manufacturer, Modus Media International, maintains multiple site
facilities, there can be no assurance that their services could not become
subject to undue delays. Such delays, if they occur, may have a material adverse
effect on the Company's business, operating results, financial condition, and
cash flows. To date, the Company has not experienced any material difficulties
or delays in the manufacture or assembly of its products or material returns due
to product defects.
 
ADDITIONAL FACTORS AFFECTING FUTURE RESULTS
 
     This Annual Report on Form 10-K contains forward-looking statements within
the meaning of Section 27A of the Securities Act and Section 21E of the Exchange
Act. Words such as "anticipates," "expects," "intends," "plans," "believes,"
"seeks," "estimates," variations of such words and similar expressions are
intended to identify such forward-looking statements. These statements are not
guarantees of future performance and are subject to certain risks, uncertainties
and assumptions that are difficult to predict. Therefore, actual results could
differ materially from those expressed or forecasted in any such forward-
looking statements as a result of certain factors, including those listed below.
 
     Shares of MetaCreations' Common Stock are speculative in nature and involve
a high degree of risk. The following risk factors should be considered
carefully. The risks described below are not the only ones facing MetaCreations.
Many factors could cause our results to be different, including the following
risk factors and other risks described in this document. If any of the following
risks occur, our business would likely be adversely affected and the trading
price of our Common Stock could decline. This could result in a loss of all or
part of your investment.
 
  FLUCTUATIONS IN QUARTERLY RESULTS
 
     Our quarterly operating results depend on a number of factors that are
difficult to forecast. If our future quarterly operating results fall below the
expectations of securities analysts or investors, the trading price of our
common stock will likely drop. Our quarterly operating results have fluctuated
significantly in the past and may continue to fluctuate in the future as a
result of many factors, including:
 
     -  Introduction or enhancement of new products or technologies by us or our
        competitors;
 
     -  Market acceptance of our products;
 
     -  Industry press reviews of our products;
 
     -  Changes in our prices or our competitors' prices;
 
     -  The mix of distribution channels for our products;
 
     -  The mix of products we sell;
 
     -  Distributors' returns of our products; and
 
     -  General economic conditions.
 
                                        9
<PAGE>   12
 
     In addition, we ship our products as we receive orders. As a result, we
have little or no backlog. A large portion of our revenues occurs in the third
month of each quarter. In addition, demand for our products tends to increase at
the end of the calendar year due to year-end holiday buying trends. Revenues may
also be affected by the volume and timing of the orders we receive, our ability
to fulfill these orders, and our ability to close distribution and licensing
agreements during a particular quarter. Any delays in the receipt and shipment
of orders, the failure of our suppliers and manufacturers to produce and ship
products that we have requested or our inability to close distribution and
licensing agreements would adversely affect our revenues.
 
     Our staffing and other operating expenses are based in large part on
anticipated revenues. It would be difficult for us to adjust our spending to
compensate for any unexpected shortfall. If we are unable to reduce our spending
following any such shortfall, our results of operations would be adversely
affected.
 
     The Company has had operating losses the last four quarters. We have
recently restructured and have focused on reducing our operating expenses to
levels more consistent with expected revenues. We cannot guarantee that such
reductions in operating expenses will be enough to restore our profitability.
 
  POSSIBLE VOLATILITY OF STOCK PRICE
 
     The market price of our common stock has fluctuated significantly in the
past. The price at which our common stock will trade in the future will depend
on a number of factors including:
 
     -  Our historical and anticipated operating results;
 
     -  General market and economic conditions;
 
     -  Our announcement of new products or technologies;
 
     -  Actual or anticipated fluctuations in our operating results; and
 
     -  Developments regarding our products, or our competitors' products.
 
     In addition, the stock market has experienced extreme price and volume
fluctuations in recent months. This volatility has had a substantial effect on
our stock price, as well as the stock prices of other software companies,
particularly graphics software companies. These broad market and industry
fluctuations may continue to adversely affect the market price of our common
stock. As a result, the market price of our common stock may continue to
fluctuate.
 
  RISKS ASSOCIATED WITH PRODUCT TRANSITIONS AND PRODUCT RETURNS
 
     We may announce new products, product versions or technologies that may
replace or shorten the life cycles of our existing products. Our competitors may
also make similar announcements about their products which may replace or
shorten the life cycles of our products.
 
     During the second quarter of 1998, we increased our reserves for returns
because of lower than expected revenues in our domestic retail channels and
decreased demand in Japan. Although we provide allowances for anticipated
returns, actual product returns may exceed these allowances. This would
adversely affect our business.
 
     In certain cases we sell our new products and product versions at a
discounted price to achieve market acceptance. These price discounts could
adversely affect our revenues. In addition, when we announce plans for new
products or new releases, or when our competitors make similar announcements,
customers may delay purchasing our current products. This would also adversely
affect our business.
 
  DEPENDENCE ON DISTRIBUTORS AND ON OTHER THIRD PARTIES
 
     Although we make some direct sales to customers, we generate most of our
revenues from sales through third party distributors. We use many different
distribution channels to sell our products worldwide. Examples of distribution
channels include international distributors, educational distributors,
resellers, hardware superstores, retail dealers, direct marketers, and hardware
and software OEM's. Our future financial results depend in large part on our
relationship with third party distributors and their continued financial
stability. Any
 
                                       10
<PAGE>   13
 
termination or significant disruption of our relationship with any major
distributor or retailer, or any significant reduction in sales volume
attributable to a major distributor or retailer, would adversely affect our
business.
 
     The distribution channels are subject to rapid change, significant margin
pressures, consolidation and other financial difficulties. For example, if one
of our distributors experienced financial difficulties such as a bankruptcy, we
might not be able to collect on accounts receivable from that distributor. It is
also possible that new channels of distribution will develop which compete with
existing channels. For example, the Internet is currently evolving as a new
distribution channel for computer software. If we are unable to adapt our
products for distribution through the Internet, to the extent they need
adapting, our business could be adversely affected.
 
     We depend in part on our third party distributors to promote our products
to retailers. These retailers typically have a limited amount of shelf space
subject to high demand. We cannot be sure that our distributors and retailers
will continue to purchase our products or provide our products with adequate
shelf space and promotional support. Their failure to continue to do so would
adversely affect our business.
 
     An important part of our strategy is to enhance and diversify our domestic
and international distribution channels. We are currently restructuring our
domestic and international sales and marketing force. We are also continuing to
develop relationships with new third-party distributors and resellers. Our
ability to increase our sales and market share will depend in large part on our
success in recruiting and training sales personnel, distributors and resellers.
 
  NEED TO EXPAND INTERNATIONAL OPERATIONS
 
     We sell a large percentage of our products outside of the United States.
International sales accounted for approximately 29%, 38%, and 41% of net
revenues for the years ended December 31, 1998, 1997 and 1996, respectively. The
decrease in international sales resulted primarily from a decrease in
international OEM and licenses revenues and the economic weakness in Japan.
 
     An important element of our business strategy is to continue to expand our
sales in international markets, primarily Japan, Western Europe and Asia
Pacific. Our ability to expand our international presence depends on our success
in retaining effective international distributors and our ability to hire and
retain qualified employees abroad.
 
     There are risks inherent in expanding and doing business internationally
such as:
 
     -  Difficulties in staffing and managing foreign operations;
 
     -  Problems and delays in collecting accounts receivable;
 
     -  Fluctuations in currency exchange rates;
 
     -  Unexpected changes in regulatory requirements;
 
     -  Tariffs and other trade barriers;
 
     -  Political instability; and
 
     -  Potentially adverse tax consequences.
 
     Currently we sell our products in U.S. dollars. Any increase in the value
of the U.S. dollar as compared to currencies in our principal overseas markets
would increase the cost of our products in these markets. This may adversely
affect our sales in those markets. To date, we have not engaged in currency
hedging transactions to reduce the effect of fluctuations in currency exchange
rates.
 
     In addition, effective copyright and trade secret protection may be limited
or unavailable under the laws of certain foreign jurisdictions. The occurrence
of any of these risks would adversely affect the success of our international
operations and our business.
 
     A significant portion of our net revenues stem from the Asia Pacific
region, primarily Japan. Japan has recently experienced weaknesses in their
currency, banking and equity markets. We cannot guarantee that the financial
condition in Japan and in the Asia Pacific region will improve in the near
future. If the current
 
                                       11
<PAGE>   14
 
financial crisis in the Asia Pacific region continues or worsens, our business
will be adversely affected. For example, during 1998, our net revenues from
Japan and the Asia Pacific region decreased as a result of depressed demand for
our products due to the current Asian financial crisis.
 
  HIGHLY COMPETITIVE GRAPHICS SOFTWARE MARKETS
 
     We face intense competition in the market for graphics software products.
The market for our products can change rapidly, and customers constantly demand
new product features, accelerated releases of new products, product enhancements
and lower price points.
 
     Many of our competitors or potential competitors are larger than we are and
have significantly greater financial, managerial, technical and marketing
resources than we have. Our business would be adversely affected if any of our
competitors cut prices, increased promotions of their products, announced or
accelerated introduction of new products or enhanced product features or
acquired additional applications or technologies from third parties.
 
     Our present or future competitors may be able to develop products
comparable or superior to ours or may be able to develop new products faster
than we can. We also face competition from developers of personal computer
operating systems, such as Microsoft, Apple Computer and Linux. These companies
may incorporate functions into their operating systems which could be superior
to or incompatible with our products. Such competition would also adversely
affect our business.
 
     We are currently developing additional product enhancements that we believe
will address customer requirements. However, we cannot be sure that we will
complete our development and introduction of these products on a timely basis.
In addition, we cannot be sure that these product enhancements will achieve
market acceptance. If we are unable to compete effectively in our markets, or if
competition becomes increasingly intense, our business would be adversely
affected.
 
  DEPENDENCE ON KEY PERSONNEL
 
     We depend on the continued employment of our senior executive officers and
other key management personnel. If any of our senior officers or other key
employees leave our company and are not adequately replaced, our business would
be adversely affected.
 
     During February 1998, our previous Chief Executive Officer, John Wilczak,
resigned. Gary Lauer, who had most recently served as President of Silicon
Graphics, Inc.'s ("SGI") World Trade Group and Executive Vice President of SGI's
Worldwide Field Operations, succeeded Mr. Wilczak as our Chief Executive
Officer. In addition, in connection with our recent restructuring, our Senior
Vice President, Sales and Marketing; Vice President, Marketing; Vice President,
Product Management and Design; and Vice President, Corporate Communications left
our Company. We have recently hired a Senior Vice President, Marketing; a Senior
Vice President, Product Development; and a Vice President, European Sales and
Marketing. We are also seeking to hire a Senior Vice President, Sales and
Marketing. If we do not succeed in attracting and retaining new officers, our
business would be adversely affected.
 
  DIFFICULTY OF IDENTIFYING AND HIRING CERTAIN PERSONNEL
 
     Our future success depends on our continuing ability to identify, hire,
train and retain other highly qualified technical and managerial employees. The
competition for such employees is intense, and we have experienced difficulty in
identifying and hiring qualified engineering personnel. If we do not succeed in
attracting and retaining necessary technical and managerial employees in the
future, our business would be adversely affected.
 
  RAPID TECHNOLOGICAL CHANGE AND DEPENDENCE ON NEW PRODUCTS AND PRODUCT VERSIONS
 
     The market for graphics software products is characterized by rapidly
changing technology. Product life cycles are short and downward pricing
pressures are strong. As a result, our success depends substantially upon
 
                                       12
<PAGE>   15
 
our ability to continue to enhance our products and to develop new products that
meet customers' increasing expectations and that incorporate the latest
technology.
 
     We may not be successful in developing and marketing enhancements to our
existing products or introducing new products on a timely basis. Our new or
enhanced products may not succeed in the marketplace. If our new products or
product versions receive bad reviews in industry publications, this would likely
decrease their potential market acceptance, and our business would be adversely
affected.
 
     We expect our research and development expenditures will increase in the
future. If our increased research and development spending is not accompanied by
increased revenues, our business would be adversely affected. We have
supplemented our research and development efforts by exclusively licensing
products developed by or co-developed with third parties. We may not be able to
continue to obtain such outside product development capabilities on terms
favorable to us or at all. If we cannot maintain existing development
arrangements or fail to attract new product development partners, then we would
have to further increase our research and development spending. This would
adversely affect our business.
 
  POTENTIAL DELAYS IN PRODUCT RELEASES
 
     We also depend upon internal efforts for the development of new products
and product enhancements. In the past, we have had delays in the development of
new products and product versions. We may experience similar delays in the
future.
 
  RISK OF UNDETECTED ERRORS
 
     We offer complex software products which may contain undetected errors. In
the past, we discovered software errors in certain new products and enhancements
after these products were introduced to the marketplace. If errors are found in
our products after we have commercially shipped them, we would likely experience
bad product reviews and a loss or delay of market acceptance. This would
adversely affect our business.
 
  EVOLVING MARKETS FOR OUR COMPUTER GRAPHIC IMAGING AND INTERNET/ONLINE DESIGN
TOOLS
 
     The markets for computer graphic imaging and Internet/online design tools
are still emerging. Digital graphic and Internet/online content developers may
not adopt our products. We also may not have sufficient distribution resources
to market our products successfully or these products may not achieve market
acceptance.
 
     The demand for computer graphic imaging and Internet/online design tools
depends on many factors including:
 
     -  Installed base of digital graphic and multimedia capable personal
        computers;
 
     -  Widespread availability of digital media; and
 
     -  Number and expertise of skilled content producers.
 
     If the markets for these tools fail to grow or grow more slowly than we
currently anticipate, then our business would be adversely affected.
 
  RISKS OF INFRINGEMENT AND PROPRIETARY RIGHTS
 
     We rely on a combination of copyright, trademark, patent, trade secret
laws, employee and third-party nondisclosure agreements and exclusive contracts
to protect our intellectual and proprietary rights, products, and technology,
such as MetaStream and MetaFlash. We distribute our software under shrinkwrap
license agreements. We generally do not obtain signed license agreements from
the end users of our software.
 
     As is typical in the software industry, we do not copy-protect our
software. As a result, unauthorized third parties may be able to copy or reverse
engineer our products. We may not be able to police unauthorized uses of our
products, and we expect that software piracy could be a chronic problem. We also
distribute or plan to
 
                                       13
<PAGE>   16
 
distribute our products in other countries which do not protect the intellectual
property of our products to the same extent as laws in the United States.
 
     We also believe that the growing number of software products available and
the increasing overlap of products may lead to a greater number of infringement
claims. Our products may be the subject of infringement claims in the future.
This could result in costly litigation and could require us to obtain a license
to the intellectual property of third parties. We may be unable to obtain
licenses from these third parties on favorable terms, if at all. Even if a
license is available, we may have to pay substantial royalties to obtain it. If
we cannot obtain necessary licenses on reasonable terms, our business would be
adversely affected.
 
  YEAR 2000 RISKS
 
     Background
 
     Many currently installed computer systems and software products are coded
to accept only two digit entries for the year in the date code field. Beginning
in the year 2000, these date code fields will need to accept four digit entries
to distinguish 21st century dates from 20th century dates. As a result, over the
next year, computer systems and software used by many companies may need to be
upgraded to comply with such "Year 2000" requirements. The Year 2000 problem
could affect computers, software and other equipment used, operated, or
maintained by us, our business partners, our suppliers and our customers.
 
     Project
 
     We have identified potential Year 2000 risks in five categories:
 
        (1) Internal business software and systems;
 
        (2) Systems other than information technology systems ("Non-IT
            systems");
 
        (3) Software products we sell to customers;
 
        (4) Third party distributors of our products; and
 
        (5) Third party suppliers of products and services to us.
 
     Our Year 2000 project includes the following phases for the first three
categories above:
 
        (1) Inventorying Year 2000 items;
 
        (2) Assessing Year 2000 compliance for items determined to be material;
 
        (3) Assigning priorities to identified items;
 
        (4) Implementing remediation plans for items determined to be material
            and not Year 2000 compliant;
 
        (5) Re-testing items for which corrections have been implemented; and
 
        (6) Developing contingency plans.
 
     With respect to the our third-party distributors and suppliers, our Year
2000 project consists of the following phases:
 
        (1) Contacting distributors and suppliers for information concerning
            their Year 2000 readiness;
 
        (2) Prioritizing distributors and suppliers as to relative importance;
 
        (3) Validating distributor and supplier responses regarding Year 2000
            compliance; and
 
        (4) Developing contingency plans in the event one or more distributors
            or suppliers fails to achieve Year 2000 compliance.
 
     Assessment
 
     Internal business software and systems consist primarily of our business
information system which is based in the United States and services our
worldwide operations. During 1997, we completed implementation of a Year 2000
compliant enterprise-wide information system. Additionally, we have completed
the first three
 
                                       14
<PAGE>   17
 
phases of the Year 2000 project related to our business systems, and have
substantially completed the fourth phase. We currently expect completion of the
remediation and re-testing phases of our business systems, in addition to the
development of applicable contingency plans, by June 30, 1999. We presently
believe that with the implementation of our new information system and
modification to existing software, Year 2000 compliance will not adversely
affect our business. However, there can be no assurance that our internal
business software and systems will contain all date code changes necessary to
prevent processing errors potentially arising from calculations using the Year
2000 date. If our business systems are not compliant, we could experience
interruptions to our development programs and general business operations.
 
     We have been advised by our suppliers of non-IT systems, which primarily
consist of environmental systems such as fire suppression, air conditioning and
heating, and security systems at various buildings we occupy, that either such
systems are currently Year 2000 compliant or that such systems will be replaced
by June 30, 1999.
 
     The computer graphics software products that we sell to customers are not
date-sensitive. As a result, we believe that the current versions of our
products are Year 2000 compliant. However, there can be no assurance that our
current products do not contain undetected errors or defects associated with
Year 2000 that may result in costs which adversely affect our business.
 
     We contract with third parties for the manufacture and distribution of our
products. As a result, we have initiated communications with our key suppliers
and distributors and plan to monitor the status of their Year 2000 readiness. We
expect to complete the first three phases of our Year 2000 project related to
our key distributors by April 30, 1999. We have reviewed the Year 2000 project
plan implemented by our key supplier and have held quarterly meetings with them
since the middle of 1998 in order to monitor their progress. Based on these
meetings, we expect completion of their Year 2000 remediation and testing
phases, by June 30, 1999. If any of our principal suppliers and distributors
fail to demonstrate Year 2000 readiness, then we will evaluate alternatives that
could include the identification of alternate suppliers or distributors which
have demonstrated Year 2000 readiness and/or the accumulation of inventory to
assure production capability where feasible or warranted. These activities are
intended to provide a means of managing our risk, but cannot eliminate the
potential for disruption due to third party failure to achieve Year 2000
compliance. We expect the development of contingency plans, if necessary, to be
completed by August 31, 1999. Should any of our key suppliers or distributors
not achieve Year 2000 readiness, we may be unable to effectively manufacture our
products or distribute our products to our customers.
 
     Costs
 
     The balance of the effort for our Year 2000 project has been by employees
whose costs for this project are not tracked separately. We believe that costs
for the remainder of the project will not be material to our business, financial
position, results of operations, or cash flows.
 
     Risks
 
     Our business, financial position, results of operations, and cash flows
could be materially adversely affected if we or our key suppliers, distributors,
or customers do not achieve Year 2000 compliance. Although our Year 2000 project
is expected to minimize our risks of experiencing a Year 2000 problem, inherent
risks and uncertainties exist despite our efforts. As a result, we are unable to
determine at this time whether the consequences of Year 2000 failures resulting
from these inherent risks and uncertainties will have a material effect on our
business, financial position, results of operations, or cash flows.
 
  CONCENTRATION OF STOCK OWNERSHIP
 
     As of March 10, 1999, the directors and executive officers of the Company
and their respective affiliates beneficially own approximately 17% of the
Company's outstanding Common Stock. As a result, these stockholders will be able
to exercise significant influence over all matters requiring stockholder
approval, including the election of directors and approval of significant
corporate transactions.
 
                                       15
<PAGE>   18
 
EMPLOYEES
 
     As of March 10, 1999, the Company had 218 full time employees, including 72
in sales and marketing, 90 in development, quality assurance and documentation,
12 in customer service and technical support, and 44 in finance, administration
and operations. The employees and the Company are not parties to any collective
bargaining agreements, and the Company believes that its relationships with its
employees are good.
 
ITEM 2. PROPERTIES
 
     The Company's corporate offices consists of approximately 42,000 square
feet of leased space in two one-story buildings in Carpinteria, Santa Barbara
County, California. This space houses substantially all of the Company's general
and administrative personnel as well as a portion of its sales and marketing and
research and development personnel. The lease agreement expires in September
2008, if not renewed. The Company believes that the current facilities are
adequate for current and near term needs and that additional space is available
to provide for anticipated growth.
 
     The Company also leases approximately 30,000 square feet of office space in
Scotts Valley, California, pursuant to a lease agreement which expires in
September 2003. This space houses a significant portion of the Company's sales
and marketing and research and development personnel. The lease provides for two
options to extend the term of the lease for three years each.
 
     The facilities for RTG consists of approximately 13,000 square feet of
leased office space in Princeton and Short Hills, New Jersey, pursuant to lease
agreements which expire in December 1999 and May 2000, respectively. The Company
believes that this office space is adequate for the current needs of RTG and
that additional space is available to provide for anticipated growth.
 
     The Company's Irish facility consists of approximately 4,000 square feet of
leased space in an office building in Dublin, Ireland, pursuant to a lease
agreement which expires in August 1999. The Company believes that this office
space is adequate for current and near term needs and that additional space is
available to provide for anticipated growth.
 
ITEM 3. LEGAL PROCEEDINGS
 
     The Company is engaged in certain legal actions arising in the ordinary
course of business. The Company believes it has adequate legal defenses and
believes that the ultimate outcome of these actions will not have a material
effect on the Company's consolidated financial position, results of operations,
or cash flows.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
     None.
 
EXECUTIVE OFFICERS OF THE REGISTRANT
 
     The following table sets forth certain information regarding the Company's
current executive officers as of March 10, 1999:
 
<TABLE>
<CAPTION>
               NAME                  AGE                POSITION
               ----                  ---                --------
<S>                                  <C>   <C>
Gary Lauer.........................  46    Director, President and Chief
                                           Executive Officer
Kai Krause.........................  42    Director and Chief Design Officer
Mark Zimmer........................  42    Director and Chief Technology
                                           Officer
Terance Kinninger..................  43    Senior Vice President, Finance and
                                           Operations and Chief Financial
                                           Officer
Robert Rice........................  44    Vice President, Business
                                           Development and General Counsel
John Dearborn......................  43    Senior Vice President, Marketing
John Leddy.........................  40    Senior Vice President, Product
                                           Development
</TABLE>
 
                                       16
<PAGE>   19
 
     Mr. Lauer joined the Company as director, President and Chief Executive
Office in February 1998. From 1988 to 1997, Mr. Lauer served in various
capacities at Silicon Graphics, Inc. ("SGI"), including Vice President, North
American Marketing; Vice President and subsequently Senior Vice President, North
American Field Operations; and most recently as President of SGI's World Trade
Group and Executive Vice President of Worldwide Field Operations. Prior to
joining SGI, Mr. Lauer was with International Business Machines Corporation
("IBM") for eleven years where he held a variety of senior management positions,
the last of which included responsibility for field operations for IBM's U.S.
Marketing and Services Group in the Silicon Valley. Mr. Lauer holds a B.S. from
the University of Southern California Business School.
 
     Mr. Krause co-founded MetaTools and has been a director since 1992. For
more than eleven years prior to joining the Company on a full-time basis in
1993, Mr. Krause designed and developed advanced graphics, audio and systems
software as an independent consultant. Mr. Krause attended college in Essen,
West Germany, where he majored in foreign languages, math and philosophy. He
also attended the Music Conservatory, where he studied classical piano.
 
     Mr. Zimmer became a director and Chief Technology Officer of the Company in
May 1997 in connection with the merger with Fractal. In addition to co-founding
Fractal in April 1991, Mr. Zimmer was its Chief Executive Officer and director
since its inception. Mr. Zimmer also served as Fractal's President from March
1993 until May 1996, and resumed the position in February 1997 until the merger
with MetaCreations in May 1997. In 1985, Mr. Zimmer co-founded Fractal Software,
a predecessor of Fractal, and was a partner in Fractal Software from 1985 to
1990. At Fractal Software, Mr. Zimmer co-developed two graphics software
programs, ImageStudio and ColorStudio, as well as the initial version of
Painter. Mr. Zimmer attended California Institute of Technology.
 
     Mr. Kinninger joined the Company as Senior Vice President, Finance and
Operations and Chief Financial Officer in July 1995. Mr. Kinninger was employed
by Delphi Information Systems, Inc. ("Delphi") from October 1990 to June 1995,
initially as Chief Financial Officer and, from December 1993 to November 1994 as
Senior Vice President of Corporate Development. He then served as Senior Vice
President and General Manager of Delphi's SMART Division from December 1994 to
June 1995. Prior to working at Delphi, he served as Chief Financial Officer of
Integral Systems, Inc. from June 1983 to September 1990. Before his tenure at
Integral Systems, Inc., Mr. Kinninger was employed at Coopers & Lybrand. Mr.
Kinninger holds a B.S. from Miami University.
 
     Mr. Rice joined the Company as Vice President, Business Development and
General Counsel in connection with the Company's acquisition of RTG in December
1996. In addition to co-founding RTG in 1996, Mr. Rice served as its Chairman.
From 1983 to 1996, Mr. Rice was a partner at the international law firm of
Milbank, Tweed, Hadley and McCloy. Mr. Rice holds a B.S. and a J.D. from Florida
State University.
 
     Mr. Dearborn joined the Company as Senior Vice President, Marketing in
December 1998. Mr. Dearborn comes to MetaCreations from Micrografx, Inc.
("Micrografx"), where he most recently served as Executive Vice President of
Worldwide Sales and Marketing. Mr. Dearborn was also responsible for business
development and general management of the US subsidiary. Prior to Micrografx,
Mr. Dearborn was a co-founder and Vice President of Astral Development
Corporation, a privately held start-up that developed Picture Publisher, the
first image-editing application for Microsoft Windows. Astral Development
Corporation merged with Micrografx in 1991. Mr. Dearborn, who began his sales
and marketing career at Xerox Corporation, holds a B.S. from the University of
New Hampshire.
 
     Mr. Leddy joined the Company as Vice President and General Manager,
Professional Products Group in August 1998 and was subsequently promoted to
Senior Vice President, Product Development in December 1998. Prior to joining
the Company, Mr. Leddy was employed by Adobe Systems Inc. ("Adobe"), where he
most recently served as group product manager for imaging products. For five
years, he was responsible for overseeing Adobe's flagship product, Photoshop,
and for helping to develop new graphics tools. Prior to Adobe, Mr. Leddy held
product management positions at Macromedia Inc., where he managed the Authorware
professional product line, and Symantec Corporation. Mr. Leddy holds a B.A. from
the University of California at Berkeley.
 
                                       17
<PAGE>   20
 
                                    PART II
 
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
MARKET INFORMATION FOR COMMON STOCK
 
     The Company's common stock, $0.001 par value, began trading over the
counter in December 1995, and is quoted on the Nasdaq National Market tier of
the Nasdaq Stock Market under the symbol "MCRE." The following table sets forth,
for the periods indicated, the range of high and low closing sale prices per
share as reported on the Nasdaq National Market System:
 
<TABLE>
<CAPTION>
                                                  HIGH          LOW
                                                 ------        ------
<S>                                              <C>           <C>
1998
4th Quarter....................................  $ 8.06        $ 3.06
3rd Quarter....................................    5.63          3.03
2nd Quarter....................................   12.19          4.63
1st Quarter....................................   10.75          6.38
 
1997
4th Quarter....................................  $19.50        $ 8.25
3rd Quarter....................................   16.00          9.88
2nd Quarter....................................   13.38          6.50
1st Quarter....................................   19.00         10.00
</TABLE>
 
HOLDERS
 
     As of March 10, 1999, there were approximately 583 holders of record of the
Company's common stock.
 
DIVIDENDS
 
     The Company has not paid any cash dividends on its capital stock to date.
The Company currently anticipates that it will retain all future earnings, if
any, for use in its business and does not anticipate paying any cash dividends
on its capital stock in the foreseeable future.
 
RECENT SALES OF UNREGISTERED SECURITIES
 
     In December 1998, in connection with the Company's acquisition of Canoma,
Inc., the Company issued to the former stockholders of Canoma, Inc. an aggregate
of 300,000 shares of the Company's common stock valued at approximately
$1,305,000. The transaction was exempt from the registration requirements of
Section 5 of the Securities Act of 1933, as amended, pursuant to Section 4127.
 
                                       18
<PAGE>   21
 
ITEM 6. SELECTED FINANCIAL DATA
 
     The following selected condensed financial data should be read in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and the Financial Statements and related notes
thereto appearing elsewhere in this Annual Report on Form 10-K.
 
<TABLE>
<CAPTION>
                                                       YEARS ENDED DECEMBER 31,
                                         -----------------------------------------------------
                                           1998        1997       1996       1995       1994
                                         --------    --------    -------    -------    -------
                                                 (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                      <C>         <C>         <C>        <C>        <C>
STATEMENT OF OPERATIONS DATA
Net revenues...........................  $ 42,843    $ 69,074    $62,936    $46,260    $28,308
Cost of revenues.......................     7,007      11,859     11,677     10,081      6,627
                                         --------    --------    -------    -------    -------
  Gross profit.........................    35,836      57,215     51,259     36,179     21,681

Operating expenses:
  Sales and marketing..................    28,680      32,043     28,936     22,331     14,378
  Research and development.............    15,791      14,122      8,224      5,639      3,559
  General and administrative...........     6,862       6,410      5,883      4,590      3,735
  Costs associated with mergers,
     acquisitions and restructurings,
     including the related write-off of
     acquired in-process technology....     7,305      16,185     17,047         --         --
                                         --------    --------    -------    -------    -------
          Total operating expenses.....    58,638      68,760     60,090     32,560     21,672
                                         --------    --------    -------    -------    -------
Income (loss) from operations..........   (22,802)    (11,545)    (8,831)     3,619          9
Interest and investment income
  (expense), net.......................     2,618       3,157      3,397        634         11
                                         --------    --------    -------    -------    -------
Income (loss) before provision
  (benefit) for income taxes...........   (20,184)     (8,388)    (5,434)     4,253         20
Provision (benefit) for income taxes...      (353)       (210)     2,216      1,827        473
                                         --------    --------    -------    -------    -------
Net income (loss)......................  $(19,831)   $ (8,178)   $(7,650)   $ 2,426    $  (453)
                                         ========    ========    =======    =======    =======
Net income (loss) applicable to common
  stockholders.........................  $(19,831)   $ (8,178)   $(7,650)   $ 2,337    $  (692)
                                         ========    ========    =======    =======    =======
Net income (loss) per common share
  (diluted)............................  $  (0.83)   $  (0.36)   $ (0.37)   $  0.15    $ (0.06)
                                         ========    ========    =======    =======    =======
Weighted average number of shares
  outstanding (diluted)................    23,779      22,965     20,590     15,267     11,584
                                         ========    ========    =======    =======    =======
 
BALANCE SHEET DATA
Cash, cash equivalents and short-term
  investments..........................  $ 46,335    $ 50,002    $66,293    $77,721    $ 9,307
Working capital........................    60,201      77,677     79,254     80,135      9,086
Total assets...........................    77,965      97,257     97,935     95,017     18,488
Series B redeemable convertible
  preferred stock......................        --          --         --      8,359         --
Stockholders' equity (deficit).........    69,030      87,242     86,112     82,916        (49)
</TABLE>
 
                                       19
<PAGE>   22
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
 
     The discussion and analysis below contains trend analysis and other
forward-looking statements within the meaning of Section 27A of the Securities
Act and Section 21E of the Exchange Act. Words such as "anticipates," "expects,"
"intends," "plans," "believes," "seeks," "estimates," variations of such words
and similar expressions are intended to identify such forward-looking
statements. These statements are not guarantees of future performance and are
subject to certain risks, uncertainties and assumptions that are difficult to
predict. Therefore, actual results could differ materially from those expressed
or forecasted in any such forward-looking statements as a result of certain
factors, including those set forth in "Additional Factors Affecting Future
Results." In connection with forward-looking statements which appear in these
disclosures, investors should carefully review the factors set forth in this
Form 10-K under "Additional Factors Affecting Future Results."
 
OVERVIEW
 
     MetaCreations was formed in May 1997, as a result of the merger of
MetaTools, Inc. and Fractal Design Corporation, and included the acquisitions of
Real Time Geometry Corp. in December 1996 and Specular International. Ltd. in
April 1997, as well as the previous merger of Fractal and Ray Dream, Inc. in May
1996. The financial results for 1994 through 1996 include the pooled financial
statements of MetaTools, Inc., Fractal Design Corporation, and Ray Dream, Inc.
 
     Revenue growth for MetaCreations from 1994 to 1997 was substantially
achieved through the Company's continued introduction of new products and the
release of enhanced versions of its existing products, as well as significant
investment in the expansion of its sales and marketing activities to address
broader distribution channels. However, revenues declined during 1998 due to
lower than expected demand in the retail channel and lower OEM and licensing
revenues. On June 30, 1998, the Company announced a restructuring plan aimed at
reducing costs and improving competitiveness, which was implemented during the
quarter ended September 30, 1998. In connection with the restructuring, the
Company recorded a one-time charge to earnings of approximately $5.0 million to
cover the costs of reducing certain sectors of its workforce and facilities to
levels more appropriate to current business requirements. As a result of the
restructuring programs, the Company reduced operating expenses in the third
quarter of 1998 by approximately $3.5 million, or 24%, compared to the second
quarter of 1998.
 
     The Company's future revenues continue to be substantially dependent upon
the continued market acceptance of the Company's existing leading products and
technologies: Bryce, Infini-D, Kai's Photo Soap, Kai's Super GOO, Kai's Power
Show, Kai's Power Tools, MetaFlash, MetaStream, Painter, Poser, and Ray Dream
Studio. In this regard, revenue from the sale of these products and licensing of
the technologies represented a substantial majority of net revenues during 1998.
The Company also has a number of new product development efforts under way, and
a significant portion of future revenues is dependent upon the timely
introduction and ultimate success of these activities.
 
     In 1998, MetaCreations introduced its Creative Web strategy designed to
leverage the Company's 2D and 3D technologies for use on the Internet through
both new and existing products. The Company's future revenues will also be
dependent upon the Company's ability to successfully develop and market new
products based on this strategy.
 
     The Company develops substantially all of its products either internally or
occasionally through co-development arrangements with third parties. These
co-development arrangements generally provide the Company with certain exclusive
proprietary, copyright or marketing rights for developed products in exchange
for the payment of one-time and/or ongoing royalties. The Company expects to
continue fostering arrangements with external developers as part of its strategy
of expanding its product portfolio. There can be no assurance, however, that the
Company will be able to continue to supplement its product development efforts
in the future through such relationships.
 
     The Company sells its products primarily to domestic and international
distributors, including mail order resellers and retail outlets. The Company
also sells its products to OEMs for bundling with their hardware or
 
                                       20
<PAGE>   23
 
software products and directly to end users, generally through telesales, direct
mail campaigns, and the Internet from the Company's online store. Fluctuations
in distributor purchases can cause significant volatility in the Company's
revenues. Distributors generally stock the Company's products at levels which
may fluctuate significantly for a variety of reasons, including the
distributors' ability to finance the purchase of products and to devote shelf
space, catalog space or attention to the products. Distributor purchases may
also be affected by the Company's introduction of a new product or new version
of a product, the Company's end user promotions programs, anticipated product
price increases, the Company's purchases of display space at retail outlets and
other factors. Further, OEM and licensing agreements, which generally provide
for minimum guaranteed non-refundable payments to the Company, typically
coincide with the planned introduction of OEM bundled products and are often
entered into at the end of the quarter. The timing of the execution of such
agreements can fluctuate substantially throughout the year, causing volatility
in the Company's revenues, operating results, and cash flows.
 
     Since its inception, the Company has focused on building its product
portfolio and establishing brandname awareness of its products. These activities
have resulted in significant increases in all expense categories. The Company's
recent product development efforts to focus on the Creative Web strategy have
also entailed significant research and development expenditures. These higher
expense levels combined with costs associated with periodic mergers and
acquisitions, including the related write-off of acquired in-process technology,
and quarterly fluctuations in net revenues have contributed to the Company's
recent annual and quarterly losses, as well as fluctuations in its operating
results. The Company intends to continue to invest significant amounts both in
expanding its product portfolio and in maintaining and enhancing brand awareness
of its products, and accordingly may continue to experience losses and
volatility of net revenues and operating results in future periods.
 
OPERATING RESULTS
 
     The following table sets forth certain selected financial information
expressed as a percentage of net revenues for the periods indicated:
 
<TABLE>
<CAPTION>
                                                               YEARS ENDED DECEMBER 31,
                                                              --------------------------
                                                               1998      1997      1996
                                                              ------    ------    ------
<S>                                                           <C>       <C>       <C>
Net revenues................................................  100.0%    100.0%    100.0%
Cost of revenues............................................   16.4      17.2      18.6
                                                              -----     -----     -----
     Gross margin...........................................   83.6      82.8      81.4

Operating expenses:
  Sales and marketing.......................................   66.9      46.4      46.0
  Research and development..................................   36.8      20.4      13.0
  General and administrative................................   16.0       9.3       9.3
  Costs associated with mergers, acquisitions and
     restructurings, including the related write-off of
     acquired in-process technology.........................   17.1      23.4      27.1
                                                              -----     -----     -----
          Total operating expenses..........................  136.8      99.5      95.4
                                                              -----     -----     -----
Loss from operations........................................  (53.2)    (16.7)    (14.0)
Interest and investment income, net.........................    6.1       4.6       5.4
                                                              -----     -----     -----
Loss before provision (benefit) for income taxes............  (47.1)    (12.1)     (8.6)
Provision (benefit) for income taxes........................   (0.8)     (0.3)      3.5
                                                              -----     -----     -----
Net loss....................................................  (46.3)%   (11.8)%   (12.1)%
                                                              =====     =====     =====
</TABLE>
 
                                       21
<PAGE>   24
 
  NET REVENUES
 
     Net revenues totaled $42.8 million in 1998, which represented a 38%
decrease compared to 1997 net revenues of $69.1 million. The decrease in net
revenues was attributed to lower than expected demand in the retail channel and
lower OEM and licensing revenues. New products and new versions of existing
products released during 1998 included Dance Studio, Infini-D 4.5, Kai's Photo
Soap 2, Kai's Power Tools 5, Kai's Power Show, Kai's Super GOO, Painter 3D,
Painter 5.5 Web Edition, Painter Classic, and Poser 3. The number of new
products released by the Company increased in 1998 compared to previous years,
and as a result, the Company experienced a higher return rate in 1998 compared
to the Company's historical return rate, particularly related to its consumer
products. As a result, the Company increased its return reserve as a percentage
of gross revenues in 1998. International sales comprised 29% of net revenues in
1998, compared to 38% of net revenues in 1997.
 
     Net revenues totaled $69.1 million in 1997, compared to $62.9 million in
1996, an increase of 10%. Net revenues increased in 1997 as a result of volume
increases from the Company's release of new products and new versions of its
existing products during 1997 and the second half of 1996, along with increased
revenues from OEM and licensing agreements. New products and new versions of
existing products released during 1997 include Bryce 3D, Infini-D 4, Kai's Photo
Soap, Painter 5, Ray Dream 3D, and Studio 5. International sales comprised 38%
of net revenues in 1997, compared to 41% of net revenues in 1996. The decrease
was primarily due to flat revenues in Japan attributed to the consolidation of
the Company's Japanese distributors.
 
     During the year ended December 31, 1998, the Company adopted Statement of
Position ("SOP") 97-2, "Software Revenue Recognition," as amended by SOP 98-4,
"Deferral of the Effective Date of Certain Provisions of SOP 97-2." SOP 97-2 and
SOP 98-4, which supercede SOP 91-1, generally require revenue earned on software
arrangements involving multiple elements (e.g., software products,
upgrades/enhancements, postcontract customer support, etc.) to be allocated to
each element based on the relative fair value of the elements. The fair value of
an element must be based on evidence which is specific to the Company. The
Company recognizes product revenues upon shipment to the customer, satisfaction
of Company obligations, if any, and reasonable assurance regarding the
collectability of the corresponding receivable. Revenue allocated to
postcontract customer support is recognized ratably over the term of the
support. If the Company does not have evidence of the fair value for all
elements in a multiple-element arrangement, all revenue from the arrangement is
deferred until such evidence exists or until all elements are delivered. The
impact of adopting SOP 97-2 and SOP 98-4 was not material to the Company's
financial position, results of operations or cash flows.
 
     The Company provides an allowance for estimated returns at the time of
product shipments and adjusts this allowance as needed based on actual return
history. Such reserves as a percentage of gross revenues have varied over recent
years, reflecting the Company's experience in product returns as it has
significantly expanded the proportion of its sales through third-party
distribution channels and increased its product portfolio. The Company expects
reserves will continue to vary in the future. The Company's agreements with its
distributors generally provide the distributors with limited rights to return
unsold inventories under a stock balancing program. The Company monitors the
activities of its distributors in an effort to minimize excessive returns and
establishes its reserves based on its estimates of expected returns. While
historically the Company's returns have been within management's expectations,
the establishment of reserves requires judgments regarding such factors as
future competitive conditions and product life cycles, which can be difficult to
predict. As a result, there can be no assurance that established reserves will
be adequate to cover actual future returns.
 
     The Company has entered into agreements whereby it licenses products to
original equipment manufacturers ("OEM's") and foreign publishers which provide
such customers the right to produce and distribute multiple copies of its
software. Nonrefundable fixed fees are recognized as revenue at delivery of the
product master to the customer, satisfaction of Company obligations, if any, and
reasonable assurance regarding the collectability of the corresponding
receivable. Per copy royalties in excess of fixed amounts are recognized as
revenue when such amounts exceed fixed minimum royalties. Revenues under OEM
contracts without nonrefundable fixed fees are recognized as earned over the
term of the contract.
 
                                       22
<PAGE>   25
 
  COST OF REVENUES
 
     Cost of revenues includes the costs of goods sold, royalties due to
external developers, inventory management costs, freight and handling costs and
reserves for inventory obsolescence.
 
     Cost of revenues totaled $7.0 million, or 16% of net revenues, in 1998,
down from cost of revenues of $11.9 million, or 17% of net revenues, in 1997.
The changing mix of product sales toward lower royalty products contributed to
the decrease in cost of revenues as a percentage of net revenues. Royalties
represented 3% and 4% of net revenues for 1998 and 1997, respectively.
 
     Cost of revenues totaled $11.9 million, or 17% of net revenues in 1997,
compared to $11.7 million, or 19% of net revenues, in 1996. The decrease in cost
of revenues as a percentage of net revenues was due to a higher percentage of
revenues from OEM and licensing agreements and improved management of production
and inventories. Royalties represented 4% of net revenues for both 1997 and
1996.
 
     The Company expects that cost of revenues will increase in the future
commensurate with the increase in net revenues, but may vary as a percentage of
net revenues.
 
  SALES AND MARKETING
 
     Sales and marketing expenses include advertising, promotional materials,
mail campaigns, trade shows and the compensation costs of sales, marketing,
customer service and public relations personnel who promote the Company's
products, including related facilities costs.
 
     Sales and marketing expenses totaled $28.7 million in 1998, down from $32.0
million in 1997. The decrease in sales and marketing expenses primarily resulted
from the restructuring programs implemented during the third quarter of 1998,
which included reductions in sales and marketing personnel and promotional
activities. However, as a percentage of net revenues, sales and marketing
expenses increased from 46% in 1997 to 67% in 1998. The increase in sales and
marketing as a percentage of net revenues resulted from the decrease in net
revenues for the respective periods.
 
     Sales and marketing expenses totaled $32.0 million in 1997, compared to
$28.9 million in 1996, but remained flat at 46% of net revenues for both
periods. The increase in sales and marketing expenses in 1997 reflected the
Company's efforts to expand its sales and marketing presence and distribution
channels, both domestically and internationally, through the hiring of
additional personnel and increased marketing programs.
 
     The Company expects sales and marketing expenses will increase in future
periods, but such expenses may vary as a percentage of net revenues.
 
  RESEARCH AND DEVELOPMENT
 
     Research and development expenses consist primarily of personnel costs,
consultant fees, and required equipment and facilities costs related to the
Company's product development efforts. The Company expenses as incurred research
and development costs necessary to establish the technological feasibility of
its internally-developed software products. To date, the establishment of
technological feasibility of the Company's products and general release have
substantially coincided. As a result, the Company has not capitalized any
internal software development costs since costs qualifying for such
capitalization have not been significant.
 
     Research and development expenses totaled $15.8 million in 1998, up from
$14.1 million in 1997. The increase in research and development expenses
resulted from costs related to additional engineers obtained via the acquisition
of Specular in April 1997 and the increased number of products translated to
foreign languages. As a percentage of net revenues, research and development
expenses increased from 20% in 1997 to 37% in 1998. The significant increase in
research and development expense as a percentage of net revenues is attributed
to the decrease in net revenues for the respective periods.
 
     Research and development expenses totaled $14.1 million in 1997, up from
$8.2 million in 1996. Research and development expenses represented 20% and 13%
of net revenues in 1997 and 1996, respectively. The increase in research and
development expenses was attributed to increased personnel resulting from the
 
                                       23
<PAGE>   26
 
acquisitions of RTG in December 1996 and Specular in April 1997, in addition to
increased personnel associated with the expansion of the Company's product
portfolio.
 
     The Company expects research and development expenses will continue to
increase in future periods, but such expenses may vary as a percentage of net
revenues.
 
  GENERAL AND ADMINISTRATIVE
 
     General and administrative expenses include compensation costs related to
finance and administration personnel of the Company along with other
administrative costs including legal and accounting fees, insurance, and bad
debt expenses.
 
     General and administrative expenses totaled $6.9 million in 1998, compared
to $6.4 million in 1997. The increase in general and administrative expenses in
1998 was attributed to recruiting and relocation costs related to the hiring of
a new chief executive officer in February 1998, as well as to consulting costs
related to the preparation of the Company's new strategic plan. As a percentage
of net revenues, general and administrative expenses increased from 9% in 1997
to 16% in 1998. The increase general and administrative as a percentage of net
revenues resulted from the decrease in net revenues for the respective periods.
 
     General and administrative expenses totaled $6.4 million in 1997, up from
$5.9 million in 1996, but remained flat at 9% of net revenues for both periods.
The increase in general and administrative dollars in 1997 was due to increased
administrative expenses related to increased headcount and general corporate
expenses associated with the 1997 growth of the Company.
 
     The Company expects that its general and administrative expenses will
continue to increase in the future, but such expenses may vary as a percentage
of net revenues.
 
  RESTRUCTURING
 
     On June 30, 1998, the Company announced a restructuring plan aimed at
reducing costs and improving competitiveness and efficiency, which was
implemented during the third quarter of 1998. In connection with the
restructuring, management considered the Company's future operating costs and
levels of revenue in 1998 and beyond, and determined that a restructuring charge
of approximately $5.0 million was required to cover the costs of reducing
certain sectors of its workforce and facilities. The restructuring charge
included an accrual of approximately $2.2 million related to severance and
benefits associated with the reduction of approximately 75 positions during July
1998, as well as the related reduction of certain of the Company's facilities.
Non-cash restructuring costs, which totaled approximately $2.8 million,
primarily related to the write-down of non-strategic business assets made
redundant or obsolete due to the streamlining of the Company's product lines
and/or reduction of facilities. The Company expects completion of the
restructuring plan during the first quarter of 1999.
 
 COSTS ASSOCIATED WITH MERGERS AND ACQUISITIONS, INCLUDING THE RELATED WRITE-OFF
 OF ACQUIRED IN-PROCESS TECHNOLOGY
 
     On December 31, 1998, the Company completed the acquisition of Canoma, Inc.
("Canoma"), a privately held development-stage software company based in
Northern California, that was developing software technology that creates 3-D
digital images and content from 2-D digital images. The acquisition was
accounted for by the Company under the purchase method of accounting. Under the
terms of the Purchase Agreement, the stockholders of Canoma received 300,000
shares of the Company's common stock valued at approximately $1.3 million at
December 31, 1998, the closing date, and cash consideration totaling
approximately $1.8 million. As of December 31, 1998, neither technological
feasibility nor commercial viability had been reached with regard to Canoma's
technology or potential products. Based upon projected future cash flows,
risk-adjusted using a 33% discount rate, Canoma's in-process technology was
valued at approximately $2.3 million, which, including acquisition costs
totaling approximately $100,000, resulted in a one time charge to earnings of
approximately $2.4 million for the year ended December 31, 1998. The remaining
purchase price of approximately $805,000 was capitalized by the Company as
goodwill and will be
 
                                       24
<PAGE>   27
 
amortized over 5 years. As of the date of acquisition, Canoma's two research and
development engineers joined the Company's research and development team in
Scotts Valley, California.
 
     On April 15, 1997, the Company completed the acquisition of Specular
International, Ltd., a privately held software development company based in
Amherst, Massachusetts, that developed and marketed 3-D animation and graphic
design tools for professionals and pro-sumers. Under the terms of the Purchase
Agreement, the stockholders of Specular received approximately 547,000 shares of
the Company's common stock, valued at approximately $4.1 million, and $1.0
million in cash in exchange for all of the outstanding shares of Specular. The
Company also issued 450,000 non-qualified stock options to purchase shares of
the Company's common stock to Specular employees at an exercise price of $7 per
share, the fair market value of the Company's common stock on April 16, 1997. In
addition, the Company assumed the net liabilities of Specular, which totaled
$1.6 million at April 15, 1997. The Company charged approximately $6.4 million
against earnings during the year ended December 31, 1997, comprised of the
write-off of acquired in-process technology of $5.6 million, transaction costs
of $300,000, and relocation and severance costs of $555,000. In addition, the
Company recognized a deferred income tax asset of $900,000 relating to Federal
net operating losses and tax credits of Specular. In accordance with SFAS No.
109, the tax benefits were first applied to reduce to zero goodwill totaling
$280,000, with the remainder applied against current technology acquired from
Specular. After recognition of the deferred tax asset, acquired current
technology totaled $280,000. In connection with the acquisition, 14 of
Specular's research and development and product management personnel were
relocated to the Company's RTG facilities in Princeton, New Jersey.
 
     On December 31, 1996, the Company completed the acquisition of Real Time
Geometry Corp., a privately held development stage company based in Princeton,
New Jersey, that developed real time 3D graphics and visualization technologies.
The acquisition was accounted for by the Company under the purchase method of
accounting. Under the terms of the Purchase Agreement, the stockholders and
optionholders of RTG received a combination of shares of the Company's common
stock and options to purchase shares of the Company's common stock valued at
approximately $11.2 million and $607,000, respectively, at December 31, 1996,
the closing date. In addition, the Company assumed the net liabilities of RTG,
which totaled $1.4 million at December 31, 1996. As of December 31, 1996,
neither technological feasibility nor commercial viability had been reached with
regard to RTG's core technology, comprised of advanced geometry-based algorithms
which transform images in real-time to a series of triangles to produce
three-dimensional images. Based upon projected future cash flows, risk-adjusted
using a 40% discount rate, RTG's core in-process technology was valued in excess
of the amount written-off as acquired in-process technology of $13.3 million,
which combined with acquisition costs totaling $1.2 million, resulted in a one
time charge to earnings of $14.4 million for the year ended December 31, 1996.
As of the date of acquisition, RTG's 21 research and development personnel
remained in Princeton, New Jersey, continuing visual computing research and
development activities.
 
     On August 31, 1996, the Company acquired Dive Laboratories, Inc., a
privately held company based in Santa Cruz, California, that developed 3D
modeling and rendering environments for high-end applications and the
visualization of streaming online data. In connection with the acquisition,
which was accounted for under the purchase method of accounting, the Company
recorded a one-time charge to earnings of approximately $733,000 for the year
ended December 31, 1996, comprised of relocation expenses of $215,000,
acquisition costs of $155,000, and in-process research and development expenses
of $363,000. The Company paid $509,000 in cash and assumed $224,000 of net
liabilities of Dive. The four Dive research and development personnel relocated
to Santa Barbara.
 
  LOSS FROM OPERATIONS
 
     The loss from operations for the year ended December 31, 1998 was $22.8
million. Excluding costs related to the Company's acquisition of Canoma in
December 1998, proforma operating income for 1998 was $20.4 million or 48% of
net revenues. The loss from operations for the year ended December 31, 1997 was
$11.6 million and included $16.2 million in costs related to the merger of
MetaTools, Inc. and Fractal Design Corporation and the acquisition of Specular
International, Ltd. Excluding these costs, proforma operating income for 1997
was $4.6 million or 7% of net revenues. The proforma operating loss in 1998
primarily
                                       25
<PAGE>   28
 
resulted from the 38% reduction in net revenues from 1997 to 1998, $5.0 million
of restructuring costs, and increased research and development expenses.
 
     The loss from operations for the year ended December 31, 1996, totaled $8.8
million and included $17.0 million in costs related to the acquisitions of Real
Time Geometry Corp. and Dive Laboratories, Inc., in addition to the merger of
Ray Dream, Inc. into Fractal Design Corporation. Excluding these costs, proforma
operating income for 1996 was $8.2 million, or 13% of revenues. The decline in
proforma operating income in 1997 over 1996 is primarily attributed to higher
spending on research and development as a percentage of revenues as a result of
increased personnel resulting from the acquisitions of RTG in December 1996 and
Specular in April 1997, in addition to increased personnel associated with the
expansion of the Company's product portfolio.
 
  PROVISION (BENEFIT) FOR INCOME TAXES
 
     The Company records income taxes in accordance with Statement of Financial
Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." During
1998, the Company recorded a tax benefit of $353,000, relating to the net loss
incurred by the Company in the first quarter of 1998. The valuation allowance
for deferred taxes was increased by approximately $5.2 million during 1998 based
on management's assessment of the recoverability of the deferred tax assets.
Management's assessment included an evaluation of the Company's deferred income
tax assets; available tax carrybacks; cumulative net income, excluding costs
related to mergers and acquisitions; available tax planning strategies; and
future financial statement projections. Based on this assessment and
interpretation of the provisions of SFAS No. 109, management has concluded that
additional net operating losses and other tax benefits generated during 1998
require a valuation allowance. Management's assessment with respect to the
amount of deferred tax assets considered realizable may be revised over the near
term based on actual operating results and revised financial statement
projections.
 
     The effective tax rates of 3% and (41)% for the years ended December 31,
1997 and 1996, respectively, differed from the respective United States
statutory tax rates primarily due to changes in the valuation allowance against
the deferred income tax assets and the non-deductibility of certain costs
associated with mergers and acquisitions.
 
  NET LOSS
 
     Net loss totaled $(19.8) million, or $(0.83) per common share, in 1998,
compared to net loss of $(8.2) million, or $(0.36) per common share, in 1997,
and net loss of $(7.7) million, or $(0.37) per common share, in 1996.
 
YEAR 2000 RISKS
 
  BACKGROUND
 
     Many currently installed computer systems and software products are coded
to accept only two digit entries for the year in the date code field. Beginning
in the year 2000, these date code fields will need to accept four digit entries
to distinguish 21st century dates from 20th century dates. As a result, over the
next year, computer systems and software used by many companies may need to be
upgraded to comply with such "Year 2000" requirements. The Year 2000 problem
could affect computers, software and other equipment used, operated, or
maintained by us, our business partners, our suppliers and our customers.
 
  PROJECT
 
     We have identified potential Year 2000 risks in five categories:
 
        (1) Internal business software and systems;
 
        (2) Systems other than information technology systems ("Non-IT
            systems");
 
                                       26
<PAGE>   29
 
        (3) Software products we sell to customers;
 
        (4) Third party distributors of our products; and
 
        (5) Third party suppliers of products and services to us.
 
     Our Year 2000 project includes the following phases for the first three
categories above:
 
        (1) Inventorying Year 2000 items;
 
        (2) Assessing Year 2000 compliance for items determined to be material;
 
        (3) Assigning priorities to identified items;
 
        (4) Implementing remediation plans for items determined to be material
            and not Year 2000 compliant;
 
        (5) Re-testing items for which corrections have been implemented; and
 
        (6) Developing contingency plans.
 
     With respect to the our third-party distributors and suppliers, our Year
2000 project consists of the following phases:
 
        (1) Contacting distributors and suppliers for information concerning
            their Year 2000 readiness;
 
        (2) Prioritizing distributors and suppliers as to relative importance;
 
        (3) Validating distributor and supplier responses regarding Year 2000
            compliance; and
 
        (4) Developing contingency plans in the event one or more distributors
            or suppliers fails to achieve Year 2000 compliance.
 
  ASSESSMENT
 
     Internal business software and systems consist primarily of our business
information system which is based in the United States and services our
worldwide operations. During 1997, we completed implementation of a Year 2000
compliant enterprise-wide information system. Additionally, we have completed
the first three phases of the Year 2000 project related to our business systems,
and have substantially completed the fourth phase. We currently expect
completion of the remediation and re-testing phases of our business systems, in
addition to the development of applicable contingency plans, by June 30, 1999.
We presently believe that with the implementation of our new information system
and modification to existing software, Year 2000 compliance will not adversely
affect our business. However, there can be no assurance that our internal
business software and systems will contain all date code changes necessary to
prevent processing errors potentially arising from calculations using the Year
2000 date. If our business systems are not compliant, we could experience
interruptions to our development programs and general business operations.
 
     We have been advised by our suppliers of non-IT systems, which primarily
consist of environmental systems such as fire suppression, air conditioning and
heating, and security systems at various buildings we occupy, that either such
systems are currently Year 2000 compliant or that such systems will be replaced
by June 30, 1999.
 
     The computer graphics software products that we sell to customers are not
date-sensitive. As a result, we believe that the current versions of our
products are Year 2000 compliant. However, there can be no assurance that our
current products do not contain undetected errors or defects associated with
Year 2000 that may result in costs which adversely affect our business.
 
     We contract with third parties for the manufacture and distribution of our
products. As a result, we have initiated communications with our key suppliers
and distributors and plan to monitor the status of their Year 2000 readiness. We
expect to complete the first three phases of our Year 2000 project related to
our key distributors by April 30, 1999. We have reviewed the Year 2000 project
plan implemented by our key supplier and have held quarterly meetings with them
since the middle of 1998 in order to monitor their progress. Based
                                       27
<PAGE>   30
 
on these meetings, we expect completion of their Year 2000 remediation and
testing phases, by June 30, 1999. If any of our principal suppliers and
distributors fail to demonstrate Year 2000 readiness, then we will evaluate
alternatives that could include the identification of alternate suppliers or
distributors which have demonstrated Year 2000 readiness and/or the accumulation
of inventory to assure production capability where feasible or warranted. These
activities are intended to provide a means of managing our risk, but cannot
eliminate the potential for disruption due to third party failure to achieve
Year 2000 compliance. We expect the development of contingency plans, if
necessary, to be completed by August 31, 1999. Should any of our key suppliers
or distributors not achieve Year 2000 readiness, we may be unable to effectively
manufacture our products or distribute our products to our customers.
 
  COSTS
 
     The balance of the effort for our Year 2000 project has been by employees
whose costs for this project are not tracked separately. We believe that costs
for the remainder of the project will not be material to our business, financial
position, results of operations, or cash flows.
 
  RISKS
 
     Our business, financial position, results of operations, and cash flows
could be materially adversely affected if we or our key suppliers, distributors,
or customers do not achieve Year 2000 compliance. Although our Year 2000 project
is expected to minimize our risks of experiencing a Year 2000 problem, inherent
risks and uncertainties exist despite our efforts. As a result, we are unable to
determine at this time whether the consequences of Year 2000 failures resulting
from these inherent risks and uncertainties will have a material effect on our
business, financial position, results of operations, or cash flows.
 
LIQUIDITY AND CAPITAL RESOURCES
 
     Cash and investments totaled $46.3 million at December 31, 1998, down from
$50.0 million at December 31, 1997 and $66.3 million at December 31, 1996. Net
cash provided by operating activities of the Company totaled $498,000 for 1998,
compared to net cash used in operating activities of $12.0 million and $3.1
million for 1997 and 1996, respectively. The 1998 change primarily resulted from
significant reductions in both accounts receivable and inventory, primarily due
to the decrease in net revenues in 1998 compared to 1997, and to increased
reserves for returns resulting from a higher return rate in 1998 compared to the
Company's historical return rate. The increase in cash used in operating
activities in 1997 is primarily attributed to the approximately $11 million paid
in connection with the merger with Fractal and the acquisition of Specular, and
the increase in accounts receivable resulting from growth in revenues, in
particular, growth in OEM revenues which include guaranteed fixed minimum
royalties that may have extended payment terms up to 12 months from the contract
date. Net cash provided by (used in) investing activities totaled $6.4 million,
$(1.5) million, and $(25.2) million for 1998, 1997 and 1996, respectively. The
1998 and 1997 changes resulted primarily from increasing net proceeds from
maturities of short-term investments and decreasing purchases of property and
equipment. Net cash (used in) provided by financing activities totaled
$(310,000), $1.6 million, and $(4.0) million for 1998, 1997 and 1996,
respectively. Cash used in financing activities in 1998 resulted from $1.2
million in notes payable issued to stockholders, net of proceeds from the
exercise of stock options by the Company's employees. Cash provided by financing
activities in 1997 primarily resulted from proceeds from the exercise of stock
options by the Company's employees, while cash used in financing activities in
1996 primarily related to the repayment of notes payable to stockholders and the
issuance of notes receivable from stockholders during the year.
 
     The Company has a $3.0 million revolving line of credit with a bank which
expires during March 2000, if not renewed. Borrowings under the credit facility
are limited to a percentage of eligible accounts receivable, as defined in the
credit agreement. As of December 31, 1998, the Company had no outstanding
borrowings under the line of credit.
 
     The Company expects that its working capital requirements will continue to
increase to the extent the Company continues to grow. The Company believes that
its current cash and investment balances, cash
 
                                       28
<PAGE>   31
 
provided by future operations, if any, and available borrowings under the
Company's line of credit are sufficient to meet its working capital needs and
anticipated capital expenditure requirements through at least the next twelve
months.
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
     1. Index to Financial Statements
 
     The following financial statements are filed as part of this Report:
 
<TABLE>
<CAPTION>
                                                              PAGE NO.
                                                              --------
<S>                                                           <C>
AUDITED FINANCIAL STATEMENTS
Report of Independent Accountants...........................     30
Consolidated Balance Sheets as of December 31, 1998 and
  1997......................................................     31
Consolidated Statements of Operations for each of the three
  years in the period ended December 31, 1998...............     32
Consolidated Statements of Stockholders' Equity for each of
  the three
  years in the period ended December 31, 1998...............     33
Consolidated Statements of Cash Flows for each of the three
  years in the period ended December 31, 1998...............     34
Notes to Consolidated Financial Statements..................     36
</TABLE>
 
     2. Index to Financial Statement Schedules
 
     The following financial statement schedule of the Company is filed as part
of this Report and should be read in conjunction with the financial statements
and notes thereto:
 
<TABLE>
<CAPTION>
                                                              PAGE NO.
                                                              --------
<S>                                                           <C>
SCHEDULES
Report of Independent Accountants on Financial Statement
  Schedule..................................................     56
Schedule II -- Valuation and Qualifying Accounts............     57
</TABLE>
 
     All other schedules are omitted because they are not applicable, or not
required, or because the required information is included in the financial
statements or notes thereto.
 
                                       29
<PAGE>   32
 
                       REPORT OF INDEPENDENT ACCOUNTANTS
 
Board of Directors and Stockholders
MetaCreations Corporation
 
     In our opinion, the accompanying consolidated balance sheets and the
related consolidated statements of operations, stockholders' equity and cash
flows present fairly, in all material respects, the financial position of
MetaCreations Corporation and its subsidiaries (the "Company") as of December
31, 1998 and 1997, and the results of their operations and their cash flows for
each of the three years in the period ended December 31, 1998, in conformity
with generally accepted accounting principles. These financial statements are
the responsibility of the Company's management; our responsibility is to express
an opinion on these financial statements based on our audits. We conducted our
audits of these statements in accordance with generally accepted auditing
standards which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for the opinion expressed above.
 
PricewaterhouseCoopers LLP
 
Woodland Hills, California
January 28, 1999
 
                                       30
<PAGE>   33
 
                           METACREATIONS CORPORATION
 
                          CONSOLIDATED BALANCE SHEETS
                                 (IN THOUSANDS)
 
                                     ASSETS
 
<TABLE>
<CAPTION>
                                                                  DECEMBER 31,
                                                              --------------------
                                                                1998        1997
                                                              --------    --------
<S>                                                           <C>         <C>
Current assets:
  Cash and cash equivalents.................................  $ 16,297    $  9,653
  Short-term investments....................................    30,038      40,349
  Accounts receivable, net of allowance for returns and
     doubtful accounts of $2,725 and $3,250 at December 31,
     1998 and 1997, respectively............................    12,375      26,604
  Inventories...............................................       526       1,667
  Income taxes receivable...................................       220         772
  Deferred income taxes.....................................     5,913       5,153
  Prepaid expenses..........................................     3,767       3,494
                                                              --------    --------
          Total current assets..............................    69,136      87,692
 
Property and equipment, net.................................     6,829       7,577
Other assets................................................     2,000       1,988
                                                              --------    --------
          Total assets......................................  $ 77,965    $ 97,257
                                                              ========    ========
 
                       LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Accounts payable..........................................  $  3,777    $  4,860
  Accrued expenses..........................................     4,200       3,938
  Royalties payable.........................................       958       1,217
                                                              --------    --------
          Total current liabilities.........................     8,935      10,015
 
Commitments and contingencies
 
Stockholders' equity:
  Preferred stock, $.001 par value; 5,000,000 shares
     authorized -- none issued and outstanding at December
     31, 1998 and 1997......................................        --          --
  Common stock, $.001 par value; 75,000,000 shares
     authorized -- 24,242,784 and 23,605,645 shares issued
     and outstanding at December 31, 1998 and 1997,
     respectively...........................................        24          24
  Paid-in capital...........................................   112,829     109,896
  Cumulative translation adjustment.........................      (128)       (135)
  Notes receivable from stockholders........................    (4,491)     (3,170)
  Accumulated deficit.......................................   (39,204)    (19,373)
                                                              --------    --------
          Total stockholders' equity........................    69,030      87,242
                                                              --------    --------
          Total liabilities and stockholders' equity........  $ 77,965    $ 97,257
                                                              ========    ========
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       31
<PAGE>   34
 
                           METACREATIONS CORPORATION
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
<TABLE>
<CAPTION>
                                                             YEARS ENDED DECEMBER 31,
                                                      ---------------------------------------
                                                        1998            1997           1996
                                                      --------        --------        -------
<S>                                                   <C>             <C>             <C>
Net revenues........................................  $ 42,843        $ 69,074        $62,936
Cost of revenues....................................     7,007          11,859         11,677
                                                      --------        --------        -------
  Gross profit......................................    35,836          57,215         51,259
 
Operating expenses:
  Sales and marketing...............................    28,680          32,043         28,936
  Research and development..........................    15,791          14,122          8,224
  General and administrative........................     6,862           6,410          5,883
  Costs associated with mergers, acquisitions and
     restructurings, including the related write-off
     of acquired in-process technology..............     7,305          16,185         17,047
                                                      --------        --------        -------
          Total operating expenses..................    58,638          68,760         60,090
                                                      --------        --------        -------
 
Loss from operations................................   (22,802)        (11,545)        (8,831)
Interest and investment income, net.................     2,618           3,157          3,397
                                                      --------        --------        -------
 
Loss before provision (benefit) for income taxes....   (20,184)         (8,388)        (5,434)
Provision (benefit) for income taxes................      (353)           (210)         2,216
                                                      --------        --------        -------
 
Net loss............................................  $(19,831)       $ (8,178)       $(7,650)
                                                      ========        ========        =======
 
Net loss per common share:
  Basic and diluted.................................  $  (0.83)       $  (0.36)       $ (0.37)
                                                      ========        ========        =======
 
Weighted average number of shares outstanding:
  Basic and diluted.................................    23,779          22,965         20,590
                                                      ========        ========        =======
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       32
<PAGE>   35
 
                           METACREATIONS CORPORATION
 
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
             FOR THE YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
                                 (IN THOUSANDS)
<TABLE>
<CAPTION>
                                           SERIES A                                                     NOTES
                                        PREFERRED STOCK    COMMON STOCK                CUMULATIVE     RECEIVABLE
                                        ---------------   ---------------   PAID-IN    TRANSLATION       FROM       ACCUMULATED
                                        SHARES   AMOUNT   SHARES   AMOUNT   CAPITAL    ADJUSTMENT    STOCKHOLDERS    (DEFICIT)
                                        ------   ------   ------   ------   --------   -----------   ------------   -----------
<S>                                     <C>      <C>      <C>      <C>      <C>        <C>           <C>            <C>
Balances at December 31, 1995.........   --        $--    20,346    $21     $ 87,003      $ (50)       $    --       $ (4,058)

Issuance of common stock upon the
  exercise of stock options and
  warrants............................   --        --        561     --        1,288         --             --             --
Issuance of common stock in connection
  with the employee stock purchase
  plan and 401k plan..................   --        --         15     --          214         --             --             --
Issuance of common stock..............   --        --         20     --          138         --             --             --
Issuance of common stock in connection
  with the acquisition of Real Time
  Geometry Corp.......................   --        --      1,332      1       11,241         --             --             --
Tax benefit related to stock
  options.............................   --        --         --     --        1,072         --             --             --
Translation adjustment................   --        --         --     --           --       (108)            --             --
Notes receivable from stockholders....   --        --         --     --           --         --         (3,000)            --
Net loss..............................   --        --         --     --           --         --             --         (7,650)
                                          --       --     ------    ---     --------      -----        -------       --------
Balances at December 31, 1996.........   --        --     22,274     22      100,956       (158)        (3,000)       (11,708)

Issuance of common stock upon the
  exercise of stock options...........   --        --        756      1        1,851         --             --             --
Issuance of common stock in connection
  with the employee stock purchase
  plan................................   --        --         29     --          245         --             --             --
Issuance of common stock in connection
  with the acquisition of Specular
  International, Ltd..................   --        --        547      1        4,087         --             --             --
Tax benefit related to stock
  options.............................   --        --         --     --        2,396         --             --             --
Conversion of accrued compensation to
  equity upon exercise of certain
  options.............................   --        --         --     --          361         --             --             --
Translation adjustment................   --        --         --     --           --         23             --             --
Interest on notes receivable from
  stockholders........................   --        --         --     --           --         --           (170)            --
Adjustment to retained earnings as a
  result of business combination (Note
  1)..................................   --        --         --     --           --         --             --            513
Net loss..............................   --        --         --     --           --         --             --         (8,178)
                                          --       --     ------    ---     --------      -----        -------       --------
Balances at December 31, 1997.........   --        --     23,606     24      109,896       (135)        (3,170)       (19,373)

Issuance of common stock upon the
  exercise of stock options...........   --        --        231     --          840         --             --             --
Issuance of common stock in connection
  with the employee stock purchase
  plan................................   --        --        106     --          404         --             --             --
Issuance of common stock in connection
  with the acquisition of Canoma,
  Inc.................................   --        --        300     --        1,305         --             --             --
Tax benefit related to stock
  options.............................   --        --         --     --          376         --             --             --
Conversion of accrued compensation to
  equity upon exercise of certain
  options.............................   --        --         --     --            8         --             --             --
Translation adjustment................   --        --         --     --           --          7             --             --
Notes receivable from stockholders....   --        --         --     --           --         --         (1,150)            --
Interest on notes receivable from
  stockholders........................   --        --         --     --           --         --           (171)            --
Net loss..............................   --        --         --     --           --         --             --        (19,831)
                                          --       --     ------    ---     --------      -----        -------       --------
Balances at December 31, 1998.........   --        $--    24,243    $24     $112,829      $(128)       $(4,491)      $(39,204)
                                          ==       ==     ======    ===     ========      =====        =======       ========
 
<CAPTION>
 
                                            TOTAL
                                        STOCKHOLDERS'
                                           EQUITY
                                        -------------
<S>                                     <C>
Balances at December 31, 1995.........    $ 82,916
Issuance of common stock upon the
  exercise of stock options and
  warrants............................       1,288
Issuance of common stock in connection
  with the employee stock purchase
  plan and 401k plan..................         214
Issuance of common stock..............         138
Issuance of common stock in connection
  with the acquisition of Real Time
  Geometry Corp.......................      11,242
Tax benefit related to stock
  options.............................       1,072
Translation adjustment................        (108)
Notes receivable from stockholders....      (3,000)
Net loss..............................      (7,650)
                                          --------
Balances at December 31, 1996.........      86,112
Issuance of common stock upon the
  exercise of stock options...........       1,852
Issuance of common stock in connection
  with the employee stock purchase
  plan................................         245
Issuance of common stock in connection
  with the acquisition of Specular
  International, Ltd..................       4,088
Tax benefit related to stock
  options.............................       2,396
Conversion of accrued compensation to
  equity upon exercise of certain
  options.............................         361
Translation adjustment................          23
Interest on notes receivable from
  stockholders........................        (170)
Adjustment to retained earnings as a
  result of business combination (Note
  1)..................................         513
Net loss..............................      (8,178)
                                          --------
Balances at December 31, 1997.........      87,242
Issuance of common stock upon the
  exercise of stock options...........         840
Issuance of common stock in connection
  with the employee stock purchase
  plan................................         404
Issuance of common stock in connection
  with the acquisition of Canoma,
  Inc.................................       1,305
Tax benefit related to stock
  options.............................         376
Conversion of accrued compensation to
  equity upon exercise of certain
  options.............................           8
Translation adjustment................           7
Notes receivable from stockholders....      (1,150)
Interest on notes receivable from
  stockholders........................        (171)
Net loss..............................     (19,831)
                                          --------
Balances at December 31, 1998.........    $ 69,030
                                          ========
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       33
<PAGE>   36
 
                           METACREATIONS CORPORATION
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                                YEARS ENDED DECEMBER 31,
                                                            ---------------------------------
                                                              1998        1997        1996
                                                            --------    --------    ---------
<S>                                                         <C>         <C>         <C>
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss..................................................  $(19,831)   $ (8,178)   $  (7,650)
Adjustment to retained earnings as a result of business
  combination (Notes 1 and 3).............................        --         513           --
Adjustments to reconcile net loss to net cash provided by
  (used in) operating activities:
     Write-off of acquired in-process technology..........     2,250       5,575       13,623
     Non-cash restructuring costs.........................     2,747          --           --
     Deferred income taxes................................      (760)     (1,446)      (1,381)
     Depreciation and amortization........................     3,956       2,666        1,574
     Provision for losses on receivables and returns......    12,637       5,201        6,467
     Provision for losses on inventory....................       442         860          724
     Accrued interest income..............................      (171)       (170)          --
     Changes in operating assets and liabilities:
       Accounts receivable................................       704     (15,146)     (15,548)
       Inventories........................................       264        (972)        (104)
       Income taxes receivable............................       928       1,474          327
       Prepaid expenses and other assets..................    (1,000)        (30)         (88)
       Accounts payable and accrued expenses..............    (1,409)     (2,830)        (922)
       Royalties payable..................................      (259)        461          (76)
                                                            --------    --------    ---------
          Net cash provided by (used in) operating
            activities....................................       498     (12,022)      (3,054)
 
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property and equipment.......................    (2,368)     (3,944)      (3,960)
Purchases of software technology and product rights.......      (744)       (693)        (125)
Purchases of short-term investments.......................   (63,549)    (55,339)    (104,373)
Proceeds from maturities of short-term investments........    73,860      59,678       83,368
Payment in connection with acquisition....................      (750)     (1,233)        (139)
                                                            --------    --------    ---------
          Net cash provided by (used in) investing
            activities....................................     6,449      (1,531)     (25,229)
 
CASH FLOWS FROM FINANCING ACTIVITIES
Increase in notes receivable from stockholders............    (1,150)         --       (3,000)
Repayment of notes payable to stockholders................        --          --       (1,477)
Repayment of notes payable................................        --        (274)        (417)
Proceeds from exercise of warrants and stock options......       840       1,852          852
                                                            --------    --------    ---------
          Net cash (used in) provided by financing
            activities....................................      (310)      1,578       (4,042)

Effect of exchange rates on cash..........................         7          23         (108)
                                                            --------    --------    ---------

Net increase (decrease) in cash and cash equivalents......     6,644     (11,952)     (32,433)
Cash and cash equivalents at beginning of period..........     9,653      21,605       54,038
                                                            --------    --------    ---------
Cash and cash equivalents at end of period................  $ 16,297    $  9,653    $  21,605
                                                            ========    ========    =========
</TABLE>
 
(Table continued on next page)
 
                                       34
<PAGE>   37
 
                           METACREATIONS CORPORATION
 
               CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                                YEARS ENDED DECEMBER 31,
                                                            ---------------------------------
                                                              1998        1997        1996
                                                            --------    --------    ---------
<S>                                                         <C>         <C>         <C>
SUPPLEMENTAL DISCLOSURE OF CASH FLOW ACTIVITIES
Cash paid during the year for interest....................  $     --    $     --    $      18
Cash paid during the year for income taxes................       147         294        2,162
 
SUPPLEMENTAL DISCLOSURES OF NON-CASH ACTIVITIES
Issuance of common stock in connection with acquisition of
  Canoma, Inc.............................................     1,305          --           --
Issuance of common stock and stock options in connection
  with acquisition of Specular International, Ltd.........        --       4,088           --
Issuance of common stock and stock options in connection
  with acquisition of Real Time Geometry Corp.............        --          --       11,849
Net liabilities acquired in connection with acquisition of
  Specular International, Ltd.:
     Accounts receivable, net.............................        --          40           --
     Inventories, net.....................................        --          43           --
     Property and equipment...............................        --          43           --
     Deferred income taxes................................        --         900           --
     Prepaid expenses and other assets....................        --         331           --
     Accounts payable and accrued expenses................        --       1,337           --
     Notes payable........................................        --         274           --
Net liabilities acquired in connection with acquisitions
  of Dive Laboratories, Inc. and Real Time Geometry Corp.:
     Property and equipment...............................        --          --          498
     Prepaid expenses and other assets....................        --          --           33
     Accounts payable and accrued expenses................        --          --          689
     Notes payable to stockholder.........................        --          --        1,477
Tax benefit related to stock options......................       376       2,396        1,072
Conversion of accrued compensation to equity upon exercise
  of certain options and warrants.........................         8         361          524
Issuance of common stock in connection with employee stock
  purchase plan...........................................       404         245          126
Covenant not-to-compete with an officer of the Company....        --          --          600
Issuance of common stock in exchange for software
  technology and product rights...........................        --          --          138
</TABLE>
 
  The accompanying notes are an integral part of these consolidated financial
                                  statements.
 
                                       35
<PAGE>   38
 
                           METACREATIONS CORPORATION
 
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
 1. BUSINESS AND ORGANIZATION
 
     MetaCreations Corporation ("MetaCreations" or the "Company") is focused on
developing and marketing 2D and 3D visualization software for graphic artists,
and the World Wide Web. The consolidated financial statements include the
accounts of MetaCreations and its wholly-owned subsidiaries. All significant
intercompany accounts and transactions have been eliminated in consolidation.
 
     In May 1997, the stockholders of MetaTools, Inc. ("MetaTools") approved the
Amendment to Restated Articles of Incorporation, changing the name of the
Company to MetaCreations Corporation. Accordingly, the term "Company," as used
herein, refers to either MetaTools or MetaCreations, depending on the context of
the discussion.
 
     The computer graphics imaging and visual computing markets, and the
personal computer industry in general, are characterized by rapidly changing
technology, resulting in short product life cycles and price declines. The
Company must continuously update its existing products to keep them current with
changing technology and must develop new products to take advantage of new
technologies that could render the Company's existing products obsolete. The
Company's future prospects are highly dependent on its ability to keep pace with
its competitors' innovations, to adapt to new operating systems, hardware
platforms, and emerging industry standards, and to provide additional
functionality to the Company's existing products. The inability of the Company
to develop and introduce such products in a timely manner would have a material
adverse effect on the Company's future business, operating results, financial
condition, and cash flows.
 
     In May 1997, the stockholders of MetaCreations and Fractal Design
Corporation ("Fractal") approved the merger of the two companies. As a result of
the merger, the Company issued approximately 9,055,000 shares of MetaCreations
common stock for all of the outstanding shares of Fractal and assumed
approximately 1,653,000 options to purchase Fractal common stock. The merger was
accounted for as a pooling of interests and, accordingly, the consolidated
financial statements were restated to include the accounts of Fractal for all
periods presented.
 
     The Company reports its financial results on a December 31 fiscal year-end
basis, whereas Fractal reported its financial results on a March 31 fiscal
year-end basis. For the purposes of pooling-of-interests accounting, the balance
sheet of the Company as of December 31, 1996 has been combined with that of
Fractal as of March 31, 1997. The statements of operations of the Company for
the year ended December 31, 1996 has been combined with that of Fractal for the
year ended March 31, 1997. Accordingly, Fractal's net loss of $513,000 for the
three months ended March 31, 1997 has been reflected as an adjustment to
retained earnings. The results of operations of Fractal for such three month
period include net revenues of $7,004,000.
 
     Separate results of operations for the period presented is as follows (in
thousands):
 
<TABLE>
<CAPTION>
                                                           YEAR ENDED
                                                          DECEMBER 31,
                                                              1996
                                                          ------------
<S>                                                       <C>
Net revenues:
  MetaCreations.........................................    $28,035
  Fractal...............................................     34,901
                                                            -------
                                                            $62,936
                                                            =======
Net income (loss):
  MetaCreations.........................................    $(9,239)
  Fractal...............................................      1,589
                                                            -------
                                                            $(7,650)
                                                            =======
</TABLE>
 
                                       36
<PAGE>   39
                           METACREATIONS CORPORATION
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
  Revenue Recognition
 
     During the year ended December 31, 1998, the Company adopted Statement of
Position ("SOP") 97-2, "Software Revenue Recognition," as amended by SOP 98-4,
"Deferral of the Effective Date of Certain Provisions of SOP 97-2." SOP 97-2 and
SOP 98-4, which supercede SOP 91-1, generally require revenue earned on software
arrangements involving multiple elements (e.g., software products,
upgrades/enhancements, postcontract customer support, etc.) to be allocated to
each element based on the relative fair value of the elements. The fair value of
an element must be based on evidence which is specific to the Company. The
Company recognizes product revenues upon shipment to the customer, satisfaction
of Company obligations, if any, and reasonable assurance regarding the
collectability of the corresponding receivable. Revenue allocated to
postcontract customer support is recognized ratably over the term of the
support. If the Company does not have evidence of the fair value for all
elements in a multiple-element arrangement, all revenue from the arrangement is
deferred until such evidence exists or until all elements are delivered. The
impact of adopting SOP 97-2 and SOP 98-4 was not material to the Company's
financial position, results of operations or cash flows.
 
     The Company provides an allowance for estimated returns at the time of
product shipments and adjusts this allowance as needed based on actual return
history. Such reserves as a percentage of net revenues have varied over recent
years, reflecting the Company's experience in product returns as it has
significantly expanded the proportion of its sales through third-party
distribution channels and increased its product portfolio. The Company expects
reserves will continue to vary in the future. The Company's agreements with its
distributors generally provide the distributors with limited rights to return
unsold inventories under a stock balancing program. The Company monitors the
activities of its distributors in an effort to minimize excessive returns and
establishes its reserves based on its estimates of expected returns. At December
31, 1998 and 1997, the Company had an allowance for potential returns of
approximately $1,720,000 and $2,034,000, respectively.
 
     The Company has entered into agreements whereby it licenses products to
original equipment manufacturers ("OEM's") and foreign publishers which provide
such customers the right to produce and distribute multiple copies of its
software. Nonrefundable fixed fees are recognized as revenue at delivery of the
product master to the customer, satisfaction of Company obligations, if any, and
reasonable assurance regarding the collectability of the corresponding
receivable. Per copy royalties in excess of fixed amounts are recognized as
revenue when such amounts exceed fixed minimum royalties. Revenues under OEM
contracts without nonrefundable fixed fees are recognized as earned over the
term of the contract.
 
  Use of Estimates
 
     The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. The Company monitors the activities of its distributors in an
effort to minimize excessive returns and establishes its reserves based on its
estimates of expected returns. While historically the Company's returns have
been within management's expectations, the establishing of reserves requires
judgments regarding such factors as future competitive conditions and product
life cycles, which can be difficult to predict. Actual results could differ from
those estimates.
 
  Inventories
 
     Inventories consist of finished products and software components, primarily
instruction manuals, diskettes, CD ROMs and packaging ready for assembly. The
Company periodically evaluates the carrying
 
                                       37
<PAGE>   40
                           METACREATIONS CORPORATION
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
value of its inventories, including a review for potentially excess or obsolete
products, and adjusts these as necessary. At December 31, 1998 and 1997, the
Company had reserves of approximately $418,000 and $719,000, respectively, for
potentially excess or obsolete inventory items. Inventories are stated at the
lower of cost or market, with cost determined using the first-in, first-out
method.
 
  Property and Equipment
 
     Property and equipment are stated at cost. Assets are depreciated on the
straight-line method over their estimated useful lives, which range from 3 to 7
years. Leasehold improvements are amortized over the shorter of the life of the
lease or the life of the asset. Upon sale, any gain or loss is included in the
consolidated statement of operations. Maintenance and minor replacements are
expensed as incurred.
 
  Long-Term Assets
 
     The carrying value of long-term assets, primarily consisting of property
and equipment, goodwill, and other intangible assets, is periodically reviewed
by management. Impairment losses, if any, are recognized when the expected
nondiscounted future operating cash flows derived from such assets are less than
their carrying value.
 
  Research and Development
 
     Research and development costs are expensed as incurred.
 
  Software Development Costs
 
     The Company provides for capitalization of certain software development
costs once technological feasibility is established. The costs so capitalized
are then amortized on a straight-line basis over the estimated product life
(generally eighteen months to three years), or on the ratio of current revenue
to total projected product revenues, whichever is greater. To date, the
establishment of technological feasibility of the Company's products and general
release have substantially coincided. As a result, the Company has not
capitalized any internal software development costs since costs qualifying for
such capitalization have not been significant.
 
  Advertising
 
     The Company reports the costs of all advertising as expenses in the periods
in which those costs are incurred. The Company shares portions of certain
distributors' advertising expenses through co-op advertising arrangements.
 
     Advertising expense, primarily consisting of co-op advertising, catalog
advertising, direct mailings, and placements in business and consumer
publications, was approximately $11,816,000, $12,060,000, and $10,315,000 for
the years ended December 31, 1998, 1997, and 1996 respectively.
 
  Cash Equivalents and Short-term Investments
 
     The Company considers all highly liquid investments purchased with an
original maturity of three months or less to be cash equivalents.
 
     The Company considers its investment portfolio available-for-sale as
defined in Statement of Financial Accounting Standard ("SFAS") No. 115. These
available-for-sale securities are accounted for at their fair value, and
unrealized gains and losses on these securities are reported as a separate
component of stockholders' equity. At December 31, 1998 and 1997, net unrealized
gains or losses on available-for-sale securities were not significant.
 
                                       38
<PAGE>   41
                           METACREATIONS CORPORATION
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
     The Company invests its cash in accordance with a policy that seeks to
maximize returns while ensuring both liquidity and minimal risk of principal
loss. The policy limits investments to certain types of instruments issued by
institutions with investment grade credit ratings, and places restrictions on
maturities and concentration by type and issuer. The majority of the Company's
portfolio is composed of fixed income investments which are subject to the risk
of market interest rate fluctuations, and all of the Company's investments are
subject to risks associated with the ability of the issuers to perform their
obligations under the instruments.
 
  Royalty Expense
 
     The Company licenses certain third-party software and code for inclusion in
its products. Royalties are payable to developers of the software or code at
various rates and amounts, generally based on net unit sales or net revenues.
These agreements may include royalty advances against future expected sales,
which advances are recorded as prepaid expenses until such royalties are earned.
Royalty expense, which is included as a component of cost of revenues, amounted
to approximately $1,302,000, $2,563,000, and $2,487,000 for the years ended
December 31, 1998, 1997, and 1996, respectively.
 
  Credit Risk
 
     The Company sells its retail products domestically through unaffiliated
distributors and OEM's, as well as directly to end-users. International sales
are generally made through distributors in each of the foreign countries in
which the Company markets its products. Credit is extended based on an
evaluation of each customer's financial condition, and generally collateral is
not required. Estimated credit losses and returns, if any, have been provided
for in the financial statements and have generally been within management's
expectations. At December 31, 1998 and 1997, the Company has an allowance for
doubtful accounts of approximately $1,005,000 and $1,216,000, respectively.
 
     At December 31, 1998, and periodically throughout 1996 to December 31,
1998, the Company has maintained balances with various financial institutions in
excess of the federally insured limits.
 
  Foreign Currency Translation
 
     The functional currency of each of the Company's foreign subsidiaries is
its local currency. Financial statements of these foreign subsidiaries are
translated to U.S. dollars for consolidation purposes using current rates of
exchange for assets and liabilities and average rates of exchange for revenues
and expenses. The effects of currency translation adjustments are included as a
component of stockholders' equity. Gains and losses on foreign currency
translations for 1998, 1997, and 1996 were insignificant.
 
  Income Taxes
 
     The Company accounts for income taxes using the liability method as
required by SFAS No. 109, "Accounting for Income Taxes." Under SFAS No. 109,
deferred income taxes are determined based on the differences between the
financial statement and tax bases of assets and liabilities, using enacted tax
rates in effect for the year in which the differences are expected to reverse.
Valuation allowances are established when necessary to reduce deferred tax
assets to the amounts expected to be realized.
 
  Stock-Based Compensation
 
     The Company grants stock options for a fixed number of shares to employees
with an exercise price equal to the fair value of the shares at the date of
grant. The Company accounts for stock option grants in accordance with APB
Opinion No. 25, "Accounting for Stock Issued to Employees."
 
                                       39
<PAGE>   42
                           METACREATIONS CORPORATION
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
  Net Income (Loss) Per Common Share
 
     Basic net income (loss) per common share is computed using the weighted
average number of shares of common stock and diluted net income (loss) per
common share is computed using the weighted average number of shares of common
stock and common equivalent shares outstanding. Common equivalent shares related
to stock options, warrants and preferred stock are excluded from the computation
when their effect is antidilutive.
 
  Comprehensive Income
 
     During the year ended December 31, 1998, the Company adopted Statement of
Financial Accounting Standard ("SFAS") No. 130, "Reporting Comprehensive
Income." SFAS No. 130 establishes standards for the reporting and display of
comprehensive income and its components in a full set of general purpose
financial statements. Comprehensive income is defined as the change in equity of
a business enterprise during a period from transactions and other events and
circumstances from nonowner sources. Differences between comprehensive income
and net income were not material to the Company's financial position, results of
operations or cash flows for the years ended December 31, 1998, 1997, and 1996.
 
  Segment Information and Enterprise-Wide Disclosures
 
     During the year ended December 31, 1998, the Company adopted SFAS No. 131,
"Disclosures about Segments of an Enterprise and Related Information." SFAS No.
131 supercedes SFAS No. 14, "Financial Reporting for Segments of a Business
Enterprise," replacing the "industry segment" approach with the "management"
approach. The management approach designates the internal organization that is
used by management for making operating decisions and assessing performance as
the source of the Company's reportable segments. Specific information to be
reported for individual segments includes profit or loss, certain revenue and
expense items and total assets. SFAS No. 131 also requires disclosures about
products and services, geographic areas, and major customers. The adoption of
SFAS No. 131 did not have a material impact on the Company's financial position,
results of operations or cash flows for the years ended December 31, 1998, 1997,
and 1996, but did affect enterprise-wide disclosures for the respective periods
(Note 17).
 
  Reclassifications
 
     Certain reclassifications have been made to the 1997 consolidated financial
statements to conform to the 1998 presentation.
 
 3. RESTRUCTURING
 
     On June 30, 1998, the Company announced a restructuring plan aimed at
reducing costs and improving competitiveness and efficiency, which was
implemented during the third quarter of 1998. In connection with the
restructuring, management considered the Company's future operating costs and
levels of revenue in 1998 and beyond, and determined that a restructuring charge
of approximately $4,955,000 was required to cover the costs of reducing certain
sectors of its workforce and facilities. The restructuring charge included an
accrual of approximately $2,208,000 related to severance and benefits associated
with the reduction of approximately 75 positions during July 1998, as well as
the related reduction of certain of the Company's facilities. Non-cash
restructuring costs, which totaled approximately $2,747,000, primarily related
to the write-down of non-strategic business assets made redundant or obsolete
due to the streamlining of the Company's product lines and/or reduction of
facilities. The Company expects completion of the restructuring plan during the
first quarter of 1999.
 
                                       40
<PAGE>   43
                           METACREATIONS CORPORATION
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
     The following table depicts the restructuring activity through December 31,
1998 (in thousands):
 
<TABLE>
<CAPTION>
                                             TOTAL                      BALANCE AT
                                         RESTRUCTURING    SPENDING/    DECEMBER 31,
                                            CHARGES        CHARGES         1998
                                         -------------    ---------    ------------
<S>                                      <C>              <C>          <C>
Write-down of operating assets.........     $2,747         $2,747          $ --
Severance and benefits.................      1,801          1,684           117
Vacated facilities.....................        116            116            --
Other..................................        291            291            --
                                            ------         ------          ----
                                            $4,955         $4,838          $117
                                            ======         ======          ====
</TABLE>
 
 4. MERGERS AND ACQUISITIONS
 
  Ray Dream, Inc.
 
     On May 24, 1996, the Company acquired Ray Dream, Inc. ("Ray Dream"), a
California corporation which designed, developed and marketed graphics software
application tools emphasizing three-dimensional effects for the personal
computer market. As a result of the acquisition, Ray Dream became a wholly-owned
subsidiary of Fractal. As consideration for 100% of the outstanding shares of
Ray Dream capital stock, the Company issued an aggregate of approximately
2,371,000 shares of common stock and reserved approximately 164,000 shares of
common stock for issuance upon the exercise of outstanding options to purchase
Ray Dream common stock. The Company also assumed an outstanding warrant, held by
a third party software developer, to purchase Ray Dream common stock. This
warrant vested during the third quarter of 1996 upon completion of certain
development milestones, and was fully exercised, on a net basis, for
approximately 134,000 shares of common stock. The acquisition of Ray Dream was
accounted for as a pooling-of-interests and accordingly, the Company's
consolidated financial statements have been restated for all periods prior to
the acquisition to include the financial statements of Ray Dream. Transaction
fees of approximately $1,865,000 were recorded during the year ended December
31, 1996.
 
  Dive Laboratories
 
     On August 31, 1996, the Company acquired Dive Laboratories, Inc. ("Dive"),
a privately held company based in Santa Cruz, California, that developed 3D
modeling and rendering environments for high-end applications and the
visualization of streaming online data. In connection with the acquisition,
which was accounted for under the purchase method of accounting, the Company
recorded a one-time charge to earnings of approximately $733,000 for the year
ended December 31, 1996, comprised of relocation expenses of $215,000,
acquisition costs of $155,000, and in-process research and development expenses
of $363,000. The Company paid $509,000 in cash and assumed $224,000 of net
liabilities of Dive. The operating results of Dive have been included in the
accompanying consolidated financial statements from the date of acquisition.
 
  Real Time Geometry
 
     On December 31, 1996, the Company completed the acquisition of Real Time
Geometry Corp. ("RTG"), a privately held development stage company based in
Princeton, New Jersey, that developed real time 3D graphics and visualization
technologies. The acquisition was accounted for by the Company under the
purchase method of accounting. Under the terms of the Purchase Agreement, the
stockholders and optionholders of RTG received a combination of shares of the
Company's common stock and options to purchase shares of the Company's common
stock valued at approximately $11,242,000 and $607,000, respectively, at
December 31, 1996, the closing date. In addition, the Company assumed the net
liabilities of RTG, which totaled $1,411,000 at December 31, 1996. As of
December 31, 1996, neither technological feasibility nor commercial viability
had been reached with regard to RTG's core technology, comprised of
 
                                       41
<PAGE>   44
                           METACREATIONS CORPORATION
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
advanced geometry-based algorithms to accelerate the display of
three-dimensional images. Based upon projected future cash flows, risk-adjusted
using a 40% discount rate, RTG's core in-process technology was valued in excess
of the amount written-off as acquired in-process technology of $13,260,000,
which combined with acquisition costs totaling $1,189,000, resulted in a one
time charge to earnings of $14,449,000 for the year ended December 31, 1996.
 
     The operating results of RTG have been included in the accompanying
consolidated financial statements from the date of acquisition. The following
unaudited pro forma information presents a summary of the consolidated results
of operations of the Company and RTG as if the acquisition had taken place on
February 1, 1996 (date of inception of RTG). In management's opinion, the
following unaudited pro forma consolidated information is not indicative of the
actual results that would have occurred had the acquisition been consummated on
February 1, 1996 or of future operations of the consolidated entities under the
ownership and management of the Company (in thousands, except per share
amounts):
 
<TABLE>
<CAPTION>
                                                           YEAR ENDED
                                                          DECEMBER 31,
                                                              1996
                                                          ------------
                                                          (UNAUDITED)
<S>                                                       <C>
Net revenues............................................    $62,936
Net income..............................................      4,739
Net income per common share.............................       0.20
</TABLE>
 
  Specular International, Ltd.
 
     On April 15, 1997, the Company completed the acquisition of Specular
International, Ltd. ("Specular"), a privately held software development company
based in Amherst, Massachusetts, that developed and marketed 3-D animation and
graphic design tools for professionals and pro-sumers. Under the terms of the
Purchase Agreement, the stockholders of Specular received approximately 547,000
shares of the Company's common stock, valued at approximately $4,088,000, and
$1,000,000 in cash in exchange for all of the outstanding shares of Specular.
The Company also issued 450,000 non-qualified stock options to purchase shares
of the Company's common stock to Specular employees at an exercise price of $7
per share, the fair market value of the Company's common stock on April 16,
1997. In addition, the Company assumed the net liabilities of Specular, which
totaled $1,601,000 at April 15, 1997. The Company charged approximately
$6,430,000 against earnings during the year ended December 31, 1997, comprised
of the write-off of acquired in-process technology of $5,575,000, transaction
costs of $300,000, and relocation and severance costs of $555,000. In addition,
the Company recognized a deferred income tax asset of $900,000 relating to
Federal net operating losses and tax credits of Specular. In accordance with
SFAS No. 109, the tax benefits were first applied to reduce to zero goodwill
totaling $280,000, with the remainder applied against current technology
acquired from Specular. After recognition of the deferred tax asset, acquired
current technology totaled $280,000. The operating results of Specular have been
included in the accompanying consolidated financial statements from the date of
acquisition.
 
  Canoma, Inc.
 
     On December 31, 1998, the Company completed the acquisition of Canoma, Inc.
("Canoma"), a privately held development-stage software company based in
Northern California, that was developing software technology that creates 3-D
digital images and content from 2-D digital images for use primarily over the
Internet, and in other applications. The acquisition was accounted for by the
Company under the purchase method of accounting. Under the terms of the Purchase
Agreement, the stockholders of Canoma received 300,000 shares of the Company's
common stock valued at approximately $1,305,000 at December 31, 1998, the
closing date, and cash consideration totaling $1,750,000. As of December 31,
1998, neither technological feasibility nor commercial viability had been
reached with regard to Canoma's technology or potential
 
                                       42
<PAGE>   45
                           METACREATIONS CORPORATION
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
products. Based upon projected future cash flows, risk-adjusted using a 33%
discount rate, Canoma's in-process technology was valued at approximately
$2,250,000, which, including acquisition costs totaling approximately $100,000,
resulted in a one time charge to earnings of approximately $2,350,000 for the
year ended December 31, 1998. The remaining purchase price of approximately
$805,000 was capitalized by the Company as goodwill and will be amortized over 5
years. The operating results of Canoma have been included in the accompanying
consolidated financial statements from the date of acquisition.
 
 5. INVESTMENTS
 
     The Company considers its investment portfolio available-for-sale as
defined in SFAS No. 115. There were no material gross realized or unrealized
gains or losses nor any material differences between the estimated fair values
and costs of securities in the investment portfolio at December 31, 1998. The
cost of the investment portfolio by type of security, contractual maturity, and
its classification in the balance sheet, is as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                              DECEMBER 31,
                                                           ------------------
                                                            1998       1997
                                                           -------    -------
<S>                                                        <C>        <C>
Type of security:
  Corporate debt securities..............................  $32,954    $37,393
  Government agencies....................................    8,978      1,980
  Money market funds.....................................      880        688
  U.S. Treasury securities...............................       --      5,465
                                                           -------    -------
                                                           $42,812    $45,526
                                                           =======    =======
Contractual maturity:
  Due in one year or less................................  $34,125    $43,413
  Due in one to three years..............................    8,687      2,113
                                                           -------    -------
                                                           $42,812    $45,526
                                                           =======    =======
Classification in balance sheet:
  Cash and cash equivalents..............................  $16,297    $ 9,653
  Marketable securities..................................   30,038     40,349
                                                           -------    -------
                                                            46,335     50,002
  Less cash..............................................    3,523      4,476
                                                           -------    -------
                                                           $42,812    $45,526
                                                           =======    =======
</TABLE>
 
 6. INVENTORIES
 
     Inventories consist of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                               DECEMBER 31,
                                                              --------------
                                                              1998     1997
                                                              ----    ------
<S>                                                           <C>     <C>
Finished goods..............................................  $434    $1,465
Materials and supplies......................................    92       202
                                                              ----    ------
                                                              $526    $1,667
                                                              ====    ======
</TABLE>
 
                                       43
<PAGE>   46
                           METACREATIONS CORPORATION
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
 7. PROPERTY AND EQUIPMENT
 
     Property and equipment consist of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                              DECEMBER 31,
                                                           ------------------
                                                            1998       1997
                                                           -------    -------
<S>                                                        <C>        <C>
Computer equipment.......................................  $ 7,256    $ 7,687
Office furniture and equipment...........................    3,599      3,633
Leasehold improvements...................................    1,301      1,028
                                                           -------    -------
                                                            12,156     12,348
Less accumulated depreciation and amortization...........   (5,327)    (4,771)
                                                           -------    -------
                                                           $ 6,829    $ 7,577
                                                           =======    =======
</TABLE>
 
 8. ACCRUED EXPENSES
 
     Accrued expenses consist of the following (in thousands):
 
<TABLE>
<CAPTION>
                                                               DECEMBER 31,
                                                             ----------------
                                                              1998      1997
                                                             ------    ------
<S>                                                          <C>       <C>
Accrued compensation.......................................  $2,043    $2,520
Accrued acquisition costs..................................   1,100        --
Covenant-not-to-compete....................................     150       300
Accrued restructuring costs................................     117        --
Accrued advertising........................................      53       688
Other accrued expenses.....................................     737       430
                                                             ------    ------
                                                             $4,200    $3,938
                                                             ======    ======
</TABLE>
 
 9. RELATED PARTY TRANSACTIONS
 
     A director of the Company rendered services to the Company for which he
received $59,000, $47,000, and $44,000, in each of 1998, 1997, and 1996. Another
director of the Company rendered services to the Company for which he received
$48,000 and $44,000 in each of 1998 and 1997. The Company believes that the
terms of the agreements for these services are no less favorable than could be
obtained from third-party suppliers.
 
     During 1996, the Company leased space for development activities at the
residence of an officer and director of the Company at a rental rate of $2,500
per month.
 
     In connection with the acquisition of RTG on December 31, 1996 (Note 4),
the Company entered into a noncompetition agreement with one of RTG's founders
who is now an executive of the Company. The agreement, which carries a term of
four years, provided for payments to the executive in the amount of $300,000 in
1997 and $150,000 in each of 1998 and 1999. In addition, the Company loaned
$2,000,000 to the executive. The loan, which accrues interest semi-annually at
5.67% and is payable on December 31, 1999, is collateralized by shares of common
stock of the Company owned by the executive. The Company also loaned $1,000,000
to another of RTG's founders who is now an officer of the Company. The loan,
which accrues interest semi-annually at 5.67% and is payable on December 31,
2002, is collateralized by certain options to purchase shares of common stock of
the Company owned by the officer. The loans are classified as a component of
stockholders' equity.
 
     During 1998, the Company loaned $1,000,000 to an officer and director of
the Company. The loan, which is non-interest bearing, is payable on February 20,
2002. The loan is collateralized by a first deed trust on the
 
                                       44
<PAGE>   47
                           METACREATIONS CORPORATION
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
officer's residence. The Company also loaned $150,000 to another officer and
director of the Company. The loan, which bears interest semi-annually at 4.47%,
is payable on May 18, 2000. The loan is collateralized by certain shares of
common stock of the Company owned by the officer as well as options to purchase
shares of the common stock of the Company. The loans are classified as a
component of stockholders' equity.
 
10. NOTES PAYABLE TO BANK
 
     The Company has a credit facility (the "Facility") with its principal
lending institution (the "Bank") which provides a Line of Credit (the "Line")
under which borrowings can be made based upon eligible accounts receivable (as
defined), up to aggregate amount of $3.0 million. The Line accrues interest at
the Bank's prevailing prime interest rate (7.75% at December 31, 1998). The
Facility also provides for letter of credit and foreign exchange contracts
subfacilities up to the $3.0 million credit limit. The Facility expires in March
2000, if not renewed. There were no borrowings against the Line during the years
ended December 31, 1998, 1997 and 1996. In addition, there were no outstanding
letters of credit or foreign exchange contracts at December 31, 1998.
 
     The Facility contains certain covenants which provide, among other things,
a restriction on dividend payments and the requirement for the maintenance of
certain measures of liquidity and equity.
 
11. STOCKHOLDERS' EQUITY
 
  Warrants
 
     In June 1995, the Company entered into a Software Development and
Purchasing Agreement (the "Agreement") with a software development company (the
"Contractor") pursuant to which the Contractor would develop a software product
defined in the Agreement. The Company pays a royalty for product purchases at a
rate of 14% of net revenues (as defined) subject to adjustments for certain
events. The Company paid a total of $400,000 in advances against such product
purchases. Royalty payments were offset against the advances at a rate of 50%.
At December 31, 1997, advances totaling $147,000 were included in prepaid
expenses. No advances were outstanding at December 31, 1998. In addition, The
Company granted a warrant with a fair market value of $348,000 to the Contractor
to purchase approximately 328,000 shares of common stock at $9.45 per share. The
exercise of the warrants was subject to the Contractor meeting certain
milestones in the Agreement and provided for reductions in the royalty payments
to the Contractor as the warrants were exercised. This warrant was exercised
during the year ended December 31, 1996, on a net basis, for approximately
134,000 shares of common stock (see Note 4). Of the total value of these
warrants, $185,000 was recognized as research and development expense during the
year ended December 31, 1996.
 
12. EMPLOYEE BENEFIT PLANS
 
  Employee Stock Purchase Plan
 
     The Company's 1995 Employee Stock Purchase Plan (the "1995 Purchase Plan"),
which is qualified under Section 423 of the Internal Revenue Code of 1986, as
amended, permits eligible employees of the Company, via payroll deductions, to
purchase shares of the Company's common stock semi-annually at 85 percent of the
market price, on either the purchase date or the offering date, whichever is
lower. As of December 31, 1998, approximately 138,000 shares of common stock
have been issued under the 1995 Purchase Plan. At December 31, 1998, an
aggregate of approximately 287,000 shares of common stock were reserved for
future issuance under the 1995 Purchase Plan.
 
  401(k) Plan
 
     In September 1995, the Company adopted a Defined Contribution Plan (the
"401(k) Plan"). Participation in the 401(k) Plan is available to substantially
all employees. Employees can contribute up to 15% of their
 
                                       45
<PAGE>   48
                           METACREATIONS CORPORATION
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
salary, up to the Federal maximum allowable limit, on a before tax basis to the
401(k) Plan. Company contributions to the 401(k) Plan are discretionary. The
Company made contributions totaling $161,000 and $139,000 to the 401(k) Plan
during the years ended December 31, 1998 and 1997. No contributions were made
during the year ended December 31, 1996.
 
     In March 1995, the Company adopted a Defined Contribution Plan (the
"Fractal 401(k) Plan"). Participation in the Fractal 401(k) Plan was available
to substantially all Fractal employees. Employees could contribute up to 15% of
their salary, up to the Federal maximum allowable limit, on a before tax basis
to the 401(k) Plan. Effective August 1996, the Company began making matching
contributions in the form of common stock. During the year ended December 31,
1996, the Company contributed approximately 7,000 shares of common stock with an
aggregate fair market value of $88,000. Upon consummation of the merger, the
Fractal 401(k) Plan was merged with and into the 401(k) Plan.
 
  Stock Option Plans (the "Plans")
 
     1992 Incentive Stock Option Plan
 
     The Company's 1992 Incentive Stock Option Plan (the "1992 Plan") provides
for the grant to employees of incentive stock options and nonstatutory stock
options and for the sale or award of restricted common stock to employees and
consultants of the Company. As of December 31, 1998, options to purchase an
aggregate of 584,000 shares of common stock were outstanding under the 1992
Plan, with vesting provisions ranging up to five years. Options granted under
the 1992 Plan are exercisable for a period of ten years. At December 31, 1998,
no shares of common stock were reserved for additional grants of options or
awards of restricted stock under the 1992 Plan.
 
     1994 Incentive Stock Option, Non-Qualified Stock Option and Restricted
Stock Purchase Plan
 
     The Company's 1994 Incentive Stock Option, Non-Qualified Stock Option and
Restricted Stock Purchase Plan (the "1994 Plan") provides for the grant to
employees of incentive stock options and nonstatutory stock options and for the
sale of restricted common stock to employees and consultants of the Company,
with vesting provisions ranging up to five years. Options granted under the 1994
Plan are exercisable for a period of ten years. As of December 31, 1998, options
to purchase an aggregate of 344,000 shares of common stock were outstanding
under the 1994 Plan. At December 31, 1998, no shares of common stock were
reserved for additional grants of options or awards of restricted stock under
the 1994 Plan.
 
     1995 Stock Plan
 
     The Company's 1995 Stock Plan (the "1995 Plan") provides for the grant to
employees (including officers and employee directors) of incentive stock options
and for the grant to employees (including officers and employee directors) and
consultants of nonstatutory stock options and stock purchase rights. As of
December 31, 1998, options to purchase an aggregate of 3,333,000 shares of
common stock were outstanding under the 1995 Plan, with vesting provisions
ranging up to four years. Options granted under the 1995 Plan are exercisable
for a period of ten years. At December 31, 1998, an aggregate of 156,000 shares
of common stock were reserved for future issuance under the 1995 Plan.
 
     1995 Director Option Plan
 
     The Company's 1995 Director Option Plan (the "Director Plan") provides for
an automatic grant of options to purchase shares of common stock to each
non-employee director of the Company. Options granted under the 1995 Director
Plan vest over four years and are exercisable for a period of ten years. As of
December 31, 1998, 55,000 options were outstanding under the 1995 Director Plan.
At December 31, 1998, an aggregate of 95,000 shares of common stock were
reserved for future issuance under the 1995 Director Plan.
 
                                       46
<PAGE>   49
                           METACREATIONS CORPORATION
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
     1996 Dive Option Plan
 
     In connection with the acquisition of Dive in August 1996 (Note 4), the
Company issued options to purchase an aggregate of 211,000 shares of common
stock to the previous stockholders and employees of Dive (the "Dive Plan"). The
non-statutory stock options vest over four years and are exercisable for a
period of ten years. As of December 31, 1998, 129,000 options were outstanding
under the Dive Plan. At December 31, 1998, no shares of common stock were
reserved for future issuance under the Dive Plan.
 
     1996 Nonstatutory Stock Option Plan
 
     The Company's 1996 Nonstatutory Stock Option Plan (the "1996 Nonstatutory
Plan") provides for the grant to employees (including officers and employee
directors) and consultants of nonstatutory stock options and stock purchase
rights. As of December 31, 1998, options to purchase an aggregate of 2,341,000
shares of common stock were outstanding under the 1996 Nonstatutory Plan, with
vesting provisions ranging up to four years. Options granted under the 1996
Nonstatutory Plan are exercisable for a period of ten years. At December 31,
1998, an aggregate of 673,000 shares of common stock were reserved for future
issuance under the 1996 Nonstatutory Plan.
 
     Fractal Stock Option Plan
 
     In connection with the Company's merger with Fractal, which became
effective on May 30, 1997, the Company assumed all of the options outstanding
under the Ray Dream 1992 Stock Option Plan, the Fractal 1993 Stock Option Plan,
the Fractal 1995 Stock Option Plan, the Fractal Director Plan and the Fractal
Outside Plan (collectively, the "Fractal Plans"). All such options were
converted into options to purchase 0.749 shares of MetaCreations common stock at
an exercise price equal to the exercise price of the converted option divided by
0.749. Options granted under the Fractal Plans generally vest over a four year
period and are exercisable for a period of ten years. As of December 31, 1998,
options to purchase an aggregate of 289,000 shares of common stock were
outstanding under the Fractal Plans. At December 31, 1998, no shares of common
stock were reserved for future issuance under the Fractal Plans.
 
                                       47
<PAGE>   50
                           METACREATIONS CORPORATION
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
     Options Issued Under Plans
 
     The following summarizes activity in the Plans for the years ended December
31, 1996, 1997, and 1998 (in thousands, except per share data):
 
<TABLE>
<CAPTION>
                                                             OPTIONS OUTSTANDING
                                                            ---------------------
                                                OPTIONS                  WEIGHTED
                                               AVAILABLE                 AVERAGE
                                                  FOR       NUMBER OF    EXERCISE
                                                 GRANT       SHARES       PRICE
                                               ---------    ---------    --------
<S>                                            <C>          <C>          <C>
Options outstanding at December 31, 1995.....    1,299        2,980       $3.66
 
  Shares reserved under new plans............    1,511           --          --
  Reduction in shares reserved under plans...     (187)          --          --
  Granted -- exercise price equal to fair
     value...................................   (1,409)       1,409       16.35
  Granted -- exercise price greater than fair
     value...................................     (854)         854       13.06
  Exercised..................................       --         (428)       1.79
  Canceled...................................      329         (329)      11.30
                                                ------       ------       -----
 
Options outstanding at December 31, 1996.....      689        4,486        8.83
 
  Shares reserved under new plans............    2,140           --          --
  Reduction in shares reserved under plans...     (592)          --          --
  Granted -- exercise price equal to fair
     value...................................   (3,258)       3,258        9.77
  Granted -- exercise price greater than fair
     value...................................      (35)          35        7.16
  Exercised..................................       --         (756)       2.45
  Canceled...................................    1,520       (1,520)      14.57
                                                ------       ------       -----
 
Options outstanding at December 31, 1997.....      464        5,503       $8.66
 
  Shares reserved under new plans............    2,700           --          --
  Reduction in shares reserved under plans...     (426)          --          --
  Granted -- exercise price equal to fair
     value...................................   (5,412)       5,412        6.07
  Granted -- exercise price greater than fair
     value...................................   (1,577)       1,577        5.09
  Exercised..................................       --         (233)       3.66
  Canceled...................................    5,176       (5,176)       9.38
                                                ------       ------       -----
 
Options outstanding at December 31, 1998.....      925        7,083       $5.53
                                                ======       ======       =====
</TABLE>
 
     The following summarizes options exercisable at December 31, 1998, 1997,
and 1996 (in thousands):
 
<TABLE>
<CAPTION>
                                                           DECEMBER 31,
                                                      -----------------------
                                                      1998     1997     1996
                                                      -----    -----    -----
<S>                                                   <C>      <C>      <C>
Options exercisable.................................  1,847    1,642    1,036
</TABLE>
 
                                       48
<PAGE>   51
                           METACREATIONS CORPORATION
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
     The following summarizes information about stock options outstanding at
December 31, 1998 (in thousands, except per share data and lives):
 
<TABLE>
<CAPTION>
                                         OUTSTANDING                EXERCISABLE
                                -----------------------------    ------------------
                                                     WEIGHTED              WEIGHTED
                                                     AVERAGE               AVERAGE
                                          AVERAGE    EXERCISE              EXERCISE
     EXERCISE PRICE RANGE       SHARES    LIFE(A)     PRICE      SHARES     PRICE
     --------------------       ------    -------    --------    ------    --------
<S>                             <C>       <C>        <C>         <C>       <C>
$0.08 - $ 3.31................    779      6.09       $ 1.21       729      $ 1.07
$3.38 - $ 5.03................    806      7.17         4.03       312        4.23
$5.09 - $ 5.09................  3,752      8.60         5.09       172        5.09
$5.25 - $ 7.94................    976      9.05         6.72       127        7.25
$8.00 - $25.13................    770      7.26        12.09       507       12.10
                                -----      ----       ------     -----      ------
          Total...............  7,083      8.08       $ 5.53     1,847      $ 5.43
                                =====      ====       ======     =====      ======
</TABLE>
 
---------------
        (a) Average contractual life remaining in years.
 
     The Company accrued compensation expense of $607,000 for the difference
between the grant price and the deemed fair value of the common stock underlying
options, which are fully vested, issued in connection with the RTG acquisition
(Note 4) in December 1996. At December 31, 1998, accrued compensation related to
the options totaled $568,000.
 
     During the year ended December 31, 1995, the Company granted to employees
stock options for the purchase of shares of common stock at exercise prices less
than the fair market value of the Company's common stock on the grant date.
During the year ended December 31, 1996, the Company recognized approximately
$190,000 of compensation expense relating to these options.
 
     Pro Forma Information
 
     Pro forma information regarding net income and earnings per share is
required by SFAS No. 123, and has been determined as if the Company has
accounted for the Plans under the fair value method of SFAS No. 123. The fair
value of options issued under the Plans was estimated at the date of grant using
a Black-Scholes option pricing model with the following weighted average
assumptions:
 
<TABLE>
<CAPTION>
                                                     YEARS ENDED DECEMBER 31,
                                                     -------------------------
                                                     1998       1997      1996
                                                     -----      ----      ----
<S>                                                  <C>        <C>       <C>
Risk-free interest rate............................    5.6%     5.6%      6.0%
Dividend yield.....................................     --       --        --
Volatility factor..................................   1.00      .80       .70
Weighted average expected life in years............    4.3      4.5       4.3
</TABLE>
 
     The following summarizes the weighted average fair value of options granted
during the years ended December 31, 1998, 1997, and 1996:
 
<TABLE>
<CAPTION>
                                                     YEARS ENDED DECEMBER 31,
                                                     ------------------------
                                                     1998     1997      1996
                                                     -----    -----    ------
<S>                                                  <C>      <C>      <C>
Exercise price equal to fair value.................  $4.46    $6.40    $10.19
Exercise price greater than fair value.............   2.23     4.13      7.71
Exercise price less than fair value................     --       --        --
</TABLE>
 
                                       49
<PAGE>   52
                           METACREATIONS CORPORATION
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
     For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period. The Company's
pro forma net loss and net loss per common share would approximate the following
(in thousands, except per share amounts):
 
<TABLE>
<CAPTION>
                                                        AS REPORTED    PRO FORMA
                                                        -----------    ---------
<S>                                                     <C>            <C>
Year Ended December 31, 1998:
  Net loss............................................   $(19,831)     $(21,732)
  Net loss per common share (diluted).................      (0.83)        (0.91)
 
Year Ended December 31, 1997:
  Net loss............................................   $ (8,178)     $(10,499)
  Net loss per common share (diluted).................      (0.36)        (0.46)
 
Year Ended December 31, 1996:
  Net loss............................................   $ (7,650)     $ (9,938)
  Net loss per common share (diluted).................      (0.37)        (0.48)
</TABLE>
 
     The effects of applying SFAS No. 123 in this proforma disclosure are not
indicative of future amounts. The Company anticipates grants of additional
awards in future years.
 
13. INCOME TAXES
 
     The components of the provision (benefit) for income taxes for the years
ended December 31, 1998, 1997, and 1996 are as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                   YEARS ENDED DECEMBER 31,
                                                 ----------------------------
                                                  1998      1997       1996
                                                 ------    -------    -------
<S>                                              <C>       <C>        <C>
Current:
  Federal......................................  $  190    $ 1,210    $ 2,593
  State........................................       1          2        984
  Foreign......................................     216         24         --
                                                 ------    -------    -------
          Total current........................     407      1,236      3,577
Deferred:
  Federal......................................      67       (712)    (1,233)
  State........................................    (394)      (408)      (128)
  Foreign......................................    (433)      (326)        --
                                                 ------    -------    -------
          Total deferred.......................    (760)    (1,446)    (1,361)
                                                 ------    -------    -------
                                                 $ (353)   $  (210)   $ 2,216
                                                 ======    =======    =======
</TABLE>
 
                                       50
<PAGE>   53
                           METACREATIONS CORPORATION
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
     The differences between the Company's effective income tax rate and the
United States statutory rate are as follows:
 
<TABLE>
<CAPTION>
                                                   YEARS ENDED DECEMBER 31,
                                                 ----------------------------
                                                  1998      1997       1996
                                                 ------    -------    -------
<S>                                              <C>       <C>        <C>
Federal tax benefit at the statutory rate......   (34.0)%    (35.0)%    (34.0)%
State income taxes, net of Federal income
  tax benefit..................................    (5.1)      (4.3)      (5.3)
Nondeductible acquisition costs................     3.9       42.0       94.3
Other..........................................     7.7       (1.0)      10.6
Change in valuation reserve....................    25.7       (4.2)     (24.8)
                                                 ------    -------    -------
                                                   (1.8)%     (2.5)%     40.8%
                                                 ======    =======    =======
</TABLE>
 
     Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes, together with net
operating loss and tax credit carryforwards. Significant components of the
Company's deferred tax assets and liabilities are as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                              DECEMBER 31,
                                                            -----------------
                                                             1998       1997
                                                            -------    ------
<S>                                                         <C>        <C>
Deferred tax assets:
  Balance sheet reserves..................................  $   268    $  747
  Accrued expenses........................................      502       617
  Tax credit carryforwards................................    2,260        --
  Net operating loss carryforwards........................    9,019     4,733
                                                            -------    ------
                                                             12,049     6,097
  Valuation allowance.....................................   (6,102)     (911)
                                                            -------    ------
     Net deferred tax assets..............................    5,947     5,186
Deferred tax liabilities:
  Depreciation and amortization...........................      (34)      (33)
                                                            -------    ------
     Net deferred tax liabilities.........................      (34)      (33)
                                                            -------    ------
     Net deferred taxes...................................  $ 5,913    $5,153
                                                            =======    ======
</TABLE>
 
     The valuation allowance for deferred taxes was increased approximately
$5,191,000 during 1998 based on management's assessment of the recoverability of
the deferred tax assets. Management's assessment included an evaluation of the
Company's deferred income tax assets; available tax carrybacks; cumulative net
income, excluding costs related to mergers and acquisitions; available tax
planning strategies; and future financial statement projections. Based on this
assessment and interpretation of the provisions of SFAS No. 109, management has
concluded that additional net operating losses and other tax benefits generated
during 1998 require a valuation allowance. Management's assessment with respect
to the amount of deferred tax assets considered realizable may be revised over
the near term based on actual operating results and revised financial statement
projections.
 
     For 1997, the valuation allowance for deferred taxes decreased
approximately $353,000, primarily as a result of the recognition of a state
deferred tax asset. At December 31, 1997, a valuation allowance was placed
against the net operating losses of RTG due to potential limitations on the
Company's ability to utilize the loss carryforwards in light of RTG's earnings
history and pursuant to the ownership rule changes of the Internal Revenue Code,
Section 382.
 
                                       51
<PAGE>   54
                           METACREATIONS CORPORATION
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
     At December 31, 1998, the Company has net operating loss and tax credit
carryforwards of approximately $23,027,000 and $1,565,000, respectively, for
federal income tax purposes, which begin expiring in 2011. The Company's Federal
net operating loss carryforward relates to the Company's acquisitions of RTG and
Specular, its merger with Ray Dream, and the net loss incurred by the Company
during the year ended December 31, 1998. The Company also has net operating loss
and tax credit carryforwards of approximately $10,678,000 and $503,000,
respectively, for state income tax purposes, which begin expiring in 2001. The
Company's state net operating loss carryforward primarily relates to the net
loss incurred by the Company during the year ended December 31, 1998.
Additionally, the Company has net operating loss and tax credit carryforwards of
approximately $5,667,000 and $192,000, respectively, for foreign income tax
purposes, which do not expire. The Company's foreign net operating loss
carryforward relates to net losses incurred by the Company's Irish subsidiary
during the years ended December 31, 1998 and 1997. The net operating loss
carryforwards may be used to offset any future taxable income, subject to
potential limitations on the Company's ability to utilize such carryforwards
pursuant to the ownership rule changes of the Internal Revenue Code, Section
382.
 
14. EARNINGS PER SHARE
 
     The following table provides a reconciliation of the numerators and
denominators of the basic and diluted per-share computations for the years ended
December 31, 1998, 1997, and 1996 (in thousands, except per share amounts):
 
<TABLE>
<CAPTION>
                                                    LOSS           SHARES        PER-SHARE
                                                 (NUMERATOR)    (DENOMINATOR)     AMOUNT
                                                 -----------    -------------    ---------
<S>                                              <C>            <C>              <C>
Year Ended December 31, 1998:
  Basic EPS....................................   $(19,831)        23,779         $(0.83)
  Effect of dilutive securities -- stock
     options...................................         --             --
                                                  --------         ------
  Diluted EPS..................................   $(19,831)        23,779         $(0.83)
                                                  ========         ======
Year Ended December 31, 1997:
  Basic EPS....................................   $ (8,178)        22,965         $(0.36)
  Effect of dilutive securities -- stock
     options...................................         --             --
                                                  --------         ------
  Diluted EPS..................................   $ (8,178)        22,965         $(0.36)
                                                  ========         ======
Year Ended December 31, 1996:
  Basic EPS....................................   $ (7,650)        20,590         $(0.37)
  Effect of dilutive securities -- stock
     options...................................         --             --
                                                  --------         ------
  Diluted EPS..................................   $ (7,650)        20,590         $(0.37)
                                                  ========         ======
</TABLE>
 
     The computation of the diluted number of shares excludes unexercised stock
options which are anti-dilutive. Stock options to purchase 7,083,000, 5,503,000,
and 4,486,000 shares of common stock were outstanding as of December 31, 1998,
1997, and 1996, respectively, and excluded from the computation.
 
15. COMMITMENTS
 
     The Company leases office space in Carpinteria under a lease agreement
which expires in September 2008. The lease agreement provides the Company with
three options to extend the term of the lease through September 2018, in
addition to granting the Company the first right of purchase in the event the
lessor decides to sell the related property. The Company also leases office
space for its facility in Scotts Valley, California, its research facility in
Princeton, New Jersey, its international headquarters in Dublin, Ireland, and
its various international sales offices pursuant to non-cancelable lease
agreements with terms through 2003. The lease
 
                                       52
<PAGE>   55
                           METACREATIONS CORPORATION
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
agreement for the Scotts Valley facility, which expires in 2003, provides for
two options to extend the term of the lease for three years each.
 
     The Company also leases certain equipment and four vehicles for officers
and executives of the Company with lease terms of three years. Rent expense for
office space, equipment, and vehicles amounted to approximately $1,552,000,
$1,480,000, and $972,000 for the years ended December 31, 1998, 1997, and 1996,
respectively.
 
     Future minimum lease payments under non-cancelable operating leases for
each twelve-month period subsequent to December 31, 1998 are as follows (in
thousands):
 
<TABLE>
<S>                                  <C>
1999...............................  $ 1,875
2000...............................    1,704
2001...............................    1,647
2002...............................    1,573
2003...............................    1,379
Thereafter.........................    4,250
                                     -------
                                     $12,428
                                     =======
</TABLE>
 
16. CONTINGENCIES
 
     The Company is engaged in certain legal actions arising in the ordinary
course of business. On advice of counsel, the Company believes it has adequate
legal defenses and believes that the ultimate outcome of these actions will not
have a material adverse effect on the Company's consolidated financial position,
results of operations, or cash flows.
 
17. SEGMENT INFORMATION AND ENTERPRISE-WIDE DISCLOSURES
 
     MetaCreations is focused on developing and marketing 2D and 3D
visualization software for graphic artists, and the World Wide Web. The Company
is organized into a single reporting segment which is evaluated by management
for making operating decisions and assessing performance.
 
  Product and Services
 
     Net revenues by product group for the years ended December 31, 1998, 1997,
and 1996 are as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                  YEARS ENDED DECEMBER 31,
                                                -----------------------------
                                                 1998       1997       1996
                                                -------    -------    -------
<S>                                             <C>        <C>        <C>
Professional..................................  $33,175    $50,938    $51,124
Consumer......................................    9,668     18,136     11,812
                                                -------    -------    -------
                                                $42,843    $69,074    $62,936
                                                =======    =======    =======
</TABLE>
 
                                       53
<PAGE>   56
                           METACREATIONS CORPORATION
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
  Geographic Areas
 
     Net revenues by geographic location of external customers for the years
ended December 31, 1998, 1997, and 1996 are as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                  YEARS ENDED DECEMBER 31,
                                                -----------------------------
                                                 1998       1997       1996
                                                -------    -------    -------
<S>                                             <C>        <C>        <C>
North America.................................  $30,495    $42,494    $37,377
Japan.........................................    5,877     12,291     12,096
Europe........................................    4,480     12,126     10,689
Rest of World.................................    1,991      2,163      2,774
                                                -------    -------    -------
                                                $42,843    $69,074    $62,936
                                                =======    =======    =======
</TABLE>
 
     Long-lived assets by geographic area where the Company held assets at
December 31, 1998 and 1997 are as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                              DECEMBER 31,
                                                            -----------------
                                                             1998      1997
                                                            ------    -------
<S>                                                         <C>       <C>
United States.............................................  $8,472    $ 9,238
Ireland...................................................     286        230
Rest of Europe............................................      71         97
                                                            ------    -------
                                                            $8,829    $ 9,565
                                                            ======    =======
</TABLE>
 
  Major Customers
 
     Customers whose net revenues represent greater than 10 percent of the
Company's consolidated net revenues for the years ended December 31, 1998, 1997,
and 1996 are as follows:
 
<TABLE>
<CAPTION>
                                                  YEARS ENDED DECEMBER 31,
                                                -----------------------------
                                                 1998       1997       1996
                                                -------    -------    -------
<S>                                             <C>        <C>        <C>
Customer A -- domestic........................      8%        17%        20%
Customer B -- international...................     15%        12%         2%
</TABLE>
 
     Customers whose accounts receivable represent greater than 10 percent of
the Company's consolidated net accounts receivable at December 31, 1998 and 1997
are as follows:
 
<TABLE>
<CAPTION>
                                                              DECEMBER 31,
                                                            -----------------
                                                             1998      1997
                                                            ------    -------
<S>                                                         <C>       <C>
Customer A -- domestic....................................    30%        24%
Customer C -- domestic....................................    13%         5%
Customer D -- international...............................     8%        12%
Customer B -- international...............................     7%        15%
</TABLE>
 
                                       54
<PAGE>   57
                           METACREATIONS CORPORATION
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 
18. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
 
     Summarized quarterly financial information for fiscal years 1998 and 1997,
are as follows (in thousands, except per share amounts):
 
<TABLE>
<CAPTION>
                                                          QUARTER ENDED
                                       ---------------------------------------------------
                                       MARCH 31    JUNE 30     SEPTEMBER 30    DECEMBER 31
                                       --------    --------    ------------    -----------
<S>                                    <C>         <C>         <C>             <C>
Fiscal year 1998:
  Net revenues.......................  $14,423     $  8,015      $ 9,053         $11,352
  Gross profit.......................   12,092        6,453        7,509           9,782
  Net loss...........................     (823)     (12,393)      (2,952)         (3,663)
  Net loss per share (diluted).......    (0.03)       (0.52)       (0.12)          (0.15)

Fiscal year 1997:
  Net revenues.......................  $13,252     $ 18,749      $21,008         $16,065
  Gross profit.......................   10,584       15,186       17,985          13,460
  Net income (loss)..................     (432)     (12,354)       3,605           1,003
  Net income (loss) per share
     (diluted).......................    (0.02)       (0.54)        0.15            0.04
</TABLE>
 
     The net loss incurred for the quarter ended June 30, 1998 included costs
associated with the restructuring of the Company (Note 3). The net loss incurred
for the quarter ended December 31, 1998 included costs associated with the
acquisition of Canoma (Note 4), including the related write-off of acquired
in-process technology.
 
     The net loss incurred for the quarter ended June 30, 1997 resulted from
cost associated with the merger with Fractal (Note 1) and the acquisition of
Specular (Note 4), including the related write-off of acquired in-process
technology.
 
                                       55
<PAGE>   58
 
       REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE
 
Board of Directors and Stockholders
MetaCreations Corporation
 
     Our report on the consolidated financial statements of MetaCreations
Corporation and its subsidiaries is included on page 30 of this Form 10-K. In
connection with our audits of such financial statements, we have audited the
related financial statement schedule at December 31, 1998, 1997 and 1996 and for
each of the three years in the period ended December 31, 1998, as listed on the
index on page 29 of this Form 10-K.
 
     In our opinion, the financial statement schedule referred to above, when
considered in relation to the basic financial statements taken as a whole,
presents fairly, in all material respects, the information required to be
included therein.
 
PricewaterhouseCoopers LLP
 
Woodland Hills, California
January 28, 1999
 
                                       56
<PAGE>   59
 
                           METACREATIONS CORPORATION
 
                SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
             FOR THE YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                             BALANCE AT                                          BALANCE AT
                                             BEGINNING    CHARGED TO     OTHER      COSTS AND      END OF
                DESCRIPTION                  OF PERIOD     EXPENSE     ADDITIONS    DEDUCTIONS     PERIOD
                -----------                  ----------   ----------   ---------    ----------   ----------
<S>                                          <C>          <C>          <C>          <C>          <C>
ALLOWANCE FOR DOUBTFUL ACCOUNTS:
  Year Ended December 31, 1998.............    $1,216      $   765       $316(1)     $ 1,292       $1,005
  Year Ended December 31, 1997.............       936          630          6(2)         356        1,216
  Year Ended December 31, 1996.............       745          597         --            406          936
ALLOWANCE FOR RETURNS:
  Year Ended December 31, 1998.............    $2,034      $11,872       $572(1)     $12,758       $1,720
  Year Ended December 31, 1997.............     3,618        4,571        113(2)       6,268        2,034
  Year Ended December 31, 1996.............     3,060        5,870         --          5,312        3,618
ALLOWANCE FOR INVENTORY OBSOLESCENCE:
  Year Ended December 31, 1998.............    $  719      $   442       $435(1)     $ 1,178       $  418
  Year Ended December 31, 1997.............       631          860         96(2)         868          719
  Year Ended December 31, 1996.............       871          724         --            964          631
VALUATION ALLOWANCE FOR DEFERRED TAX
  ASSETS:
  Year Ended December 31, 1998.............    $  911      $ 5,191       $ --        $    --       $6,102
  Year Ended December 31, 1997.............     1,264           --         --            353          911
  Year Ended December 31, 1996.............     2,612           --         --          1,348        1,264
</TABLE>
 
---------------
(1) Reserves established in connection with the restructuring on June 30, 1998.
 
(2) Reserves obtained in connection with the acquisition of Specular
    International, Ltd. on April 15, 1997.
 
                                       57
<PAGE>   60
 
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
 
     Not applicable.
 
                                    PART III
 
     Certain information required by Part III is omitted from this Report since
the Company plans to file with the Securities and Exchange Commission the
definitive proxy statement for its 1999 Annual Meeting of Stockholders (the
"Proxy Statement") not later than 120 days after the end of the fiscal year
covered by this Report, and certain information included therein is incorporated
herein by reference.
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
     The information concerning the Company's directors required by this item is
incorporated by reference to the section in the Company's Proxy Statement
entitled "Election of Directors."
 
     The information concerning the Company's executive officers required by
this item is incorporated by reference herein to Part I, Item 4, entitled
"Executive Officers of the Registrant," on page 16 of this Report.
 
ITEM 11. EXECUTIVE COMPENSATION
 
     The information required by this item, except for such information as need
not be incorporated herein by reference under rules promulgated by the
Securities and Exchange Commission, is incorporated by reference to the section
in the Company's Proxy Statement entitled "Executive Compensation."
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
     The information concerning the Company's directors required by this item is
incorporated by reference to the section in the Company's Proxy Statement
entitled "Security Ownership."
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
     The information concerning the Company's directors required by this item is
incorporated by reference to the section in the Company's Proxy Statement
entitled "Employment Arrangements."
 
                                       58
<PAGE>   61
 
                                    PART IV
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
 
     (a) The following documents are filed as part of this report:
 
     1. Financial Statements and Financial Statement Schedules. See Index to
Financial Statements at Item 8 on page 29 of this Report.
 
     2. Exhibits.
 
<TABLE>
<CAPTION>
        EXHIBIT
        NUMBER                            EXHIBIT TITLE
        -------                           -------------
        <S>        <C>
         2.1       Form of Agreement and Plan of Merger by and between the
                   Registrant and MetaTools, Inc., a California corporation(1)
         2.2       Stock Purchase Agreement between the Registrant and Real
                   Time Geometry Corp. dated December 23, 1996 (the exhibits
                   listed therein have been omitted and filed separately as
                   Exhibits 10.22, 10.23, 10.24, and 10.26)(5)
         2.3       Agreement and Plan of Reorganization, dated as of February
                   11, 1997, among MetaTools, Inc., a Delaware corporation,
                   Fractal Design Corporation, a Delaware corporation, and Rook
                   Acquisition Corp., a Delaware corporation and wholly-owned
                   subsidiary of MetaTools(8)
         2.4       Agreement and Plan of Merger among Fractal Design
                   Corporation, a California corporation, and Rook Acquisition
                   Corp., a Delaware corporation, dated as of May 29, 1997(9)
         3.4       Restated Certificate of Incorporation of Registrant(3)
         3.5       Certificate of Amendment of Restated Certificate of
                   Incorporation of Registrant(9)
         3.6       Bylaws of Registrant, as amended on July 24, 1998(12)
         4.1       Specimen of Common Stock Certificate of Registrant(9)
        10.1       Indemnification Agreement for Executive Officers and
                   Directors(1)
        10.2       Investors' Rights Agreement, as amended(1)
        10.3       1992 Incentive Stock Plan(1)
        10.4       1994 Incentive Stock Option, Non-Qualified Stock Option and
                   Restricted Stock Purchase Plan(1)
        10.5       1995 Stock Plan, as amended on May 6, 1998(12)
        10.6       1995 Employee Stock Purchase Plan, as amended on May 6,
                   1998(11)
        10.7       1995 Director Option Plan(2)
        10.8       Employment Agreement between the Registrant and John J.
                   Wilczak dated April 15, 1992, as amended(1)
        10.9       Employment Agreement between the Registrant and Kai Krause
                   dated January 26, 1994(1)
        10.10      Employment Agreement between the Registrant and Terance A.
                   Kinninger dated September 27, 1995(1)
        10.15      Loan and Security Agreement between the Registrant and
                   Silicon Valley Bank dated September 25, 1994, as amended on
                   December 6, 1996 and March 12, 1998(1)(3)(10)
        10.16 *    Distribution Agreement between the Registrant and Ingram
                   Micro Inc. dated October 19, 1992, as amended on November
                   10, 1997(1)(10)
        10.19      Form of Employee Invention, Copyright, and Secrecy
                   Agreement(1)
</TABLE>
 
                                       59
<PAGE>   62
 
<TABLE>
<CAPTION>
        EXHIBIT
        NUMBER                            EXHIBIT TITLE
        -------                           -------------
        <S>        <C>
        10.20      Employment Agreement between the Registrant and Fred Brown
                   dated November 13, 1995(1)
        10.21 *    International Software Distribution Agreement between the
                   Registrant and Marubeni Corporation dated as of August 1,
                   1997(10)
        10.22 *    Turnkey/Inventory Agreement between the Registrant and Modus
                   Media International, Inc. dated as of June 1, 1997(10)
        10.23      Employment Agreement between the Registrant and Robert Rice
                   dated December 31, 1996(5)
        10.24      Noncompetition Agreement between the Registrant and
                   Alexander Migdal dated December 31, 1996(5)
        10.25      Amended and Restated Investors' Rights Agreement(5)
        10.26      Employment Agreement between the Registrant and Alexander
                   Migdal dated December 31, 1996(5)
        10.27      1996 Dive Option Plan(6)
        10.28      1996 Nonstatutory Stock Option Plan(10)
        10.29 *    Software Licensing Agreement between the Registrant and
                   Prisma Express Distributionsgesellschaft GmbH dated as of
                   December 30, 1996(7)
        10.30      Letter Agreement between the Registrant and Mark Zimmer
                   dated February 11, 1997(10)
        10.31 *    Software Licensing Agreement between the Registrant and
                   Prisma Express Distributionsgesellschaft GmbH dated as of
                   September 10, 1997(10)
        10.32      Severance Agreement between the Registrant and Terance A.
                   Kinninger dated October 31, 1997(10)
        10.33      Severance Agreement between the Registrant and Fred Brown
                   dated October 31, 1997(10)
        10.34      Lease Agreement between the Registrant and Bluffs Group III
                   dated December 8, 1998(10)
        10.35      Second Lease Agreement between the Registrant and Bluffs
                   Group III dated December 8, 1998(10)
        10.36      Lease Agreement between the Registrant and HKH Partners
                   dated December 8, 1998(10)
        10.37      Consulting and Release Agreement between the Registrant and
                   John J. Wilczak dated February 20, 1998(10)
        10.38      Employment Agreement between the Registrant and Gary L.
                   Lauer dated February 20, 1998(10)
        10.39      Amendment to Employment Agreement between the Registrant and
                   Gary L. Lauer dated July 16, 1998(12)
        10.40      Employment Agreement between the Registrant and John Leddy
                   dated August 24, 1998
        10.41      Offer Letter between the Registrant and John E. Dearborn
                   dated December 11, 1998
        21.1       Listing of Registrant's Subsidiaries
        23.1       Consent of PricewaterhouseCoopers LLP, Independent
                   Accountants
        24.1       Power of Attorney (included on the signature pages of this
                   Annual Report on Form 10-K)
</TABLE>
 
                                       60
<PAGE>   63
 
<TABLE>
<CAPTION>
        EXHIBIT
        NUMBER                            EXHIBIT TITLE
        -------                           -------------
        <S>        <C>
        27.1       Financial Data Schedule
</TABLE>
 
---------------
  *  Confidential treatment for this exhibit has been requested pursuant to Rule
     24b-2 under the Securities Exchange Act of 1934, as amended.
 
 (1) Incorporated by reference to the Company's Registration Statement on Form
     SB-2, filed December 11, 1995, as amended (File No. 33-98628LA).
 
 (2) Incorporated by reference to the Company's Registration Statement on Form
     S-8, filed on or about April 1, 1996 (File No. 333-3070).
 
 (3) Incorporated by reference to the Company's Annual Report on Form 10-K for
     the year ended December 31, 1995.
 
 (4) Incorporated by reference to the Company's Form 10-Q for the quarter ended
     June 30, 1996.
 
 (5) Incorporated by reference to the Company's Current Report on Form 8-K,
     filed on or about January 15, 1997.
 
 (6) Incorporated by reference to the Company's Registration Statement on Form
     S-8, filed on or about December 3, 1996 (File No. 333-17209).
 
 (7) Incorporated by reference to the Company's Form 10-K for the year ended
     December 31, 1996.
 
 (8) Incorporated by reference to the Company's Registration Statement on Form
     S-4, filed April 28, 1997 (File No. 333-25939).
 
 (9) Incorporated by reference to the Company's Form 8-K, filed June 13, 1997.
 
(10) Incorporated by reference to the Company's Annual Report on Form 10-K for
     the year ended December 31, 1997.
 
(11) Incorporated by reference to the Company's Form 10-Q for the quarter ended
     March 31, 1998.
 
(12) Incorporated by reference to the Company's Form 10-Q for the quarter ended
     June 30, 1998.
 
(b) Reports on Form 8-K
 
     No reports have been filed with the Securities and Exchange Commission
during the fourth quarter ended December 31, 1998.
 
(c) Exhibits
 
     See Item 14(a)(2) above.
 
(d) Financial Statement Schedules
 
     See Item 14(a)(1) above.
 
                                       61
<PAGE>   64
 
                                   SIGNATURES
 
     Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Report to be signed on
its behalf by the undersigned, thereunto duly authorized, in the City of
Carpinteria, State of California, on the 31st day of March 1999.
 
                                          METACREATIONS CORPORATION
 
                                          By:   /s/ TERANCE A. KINNINGER
 
                                            ------------------------------------
                                                    Terance A. Kinninger
                                                   Sr. Vice President and
                                                  Chief Financial Officer
 
                               POWER OF ATTORNEY
 
     KNOW ALL PERSON BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Terance A. Kinninger, his attorney-in-fact, with
the power of substitution, for him and any and all capacities, to sign any
amendments to this Report on Form 10-K, and to file same, with exhibits thereto
and other documents in connection therewith, with the Securities and Exchange
Commission, hereby ratifying and confirming all that each of said
attorneys-in-fact, or his substitutes, may do or cause to be done by virtue
hereof.
 
     Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed by the following persons on behalf of the registrant and
in the capacities indicated.
 
<TABLE>
<CAPTION>
                SIGNATURE                                     TITLE                         DATE
                ---------                                     -----                         ----
<C>                                           <C>                                      <S>
 
            /s/ GARY L. LAUER                     Director, President and Chief        March 26, 1999
------------------------------------------        Executive Officer (Principal
              Gary L. Lauer                            Executive Officer)
 
         /s/ TERANCE A. KINNINGER              Vice President and Chief Financial      March 26, 1999
------------------------------------------      Officer (Principal Financial and
           Terance A. Kinninger                        Accounting Officer)
 
              /s/ KAI KRAUSE                    Director and Chief Design Officer      March 26, 1999
------------------------------------------
                Kai Krause
 
             /s/ MARK ZIMMER                  Director and Chief Technology Officer    March 26, 1999
------------------------------------------
               Mark Zimmer
 
         /s/ SAMUEL H. JONES, JR.                           Director                   March 26, 1999
------------------------------------------
           Samuel H. Jones, Jr.
 
              /s/ BERT KOLDE                                Director                   March 26, 1999
------------------------------------------
                Bert Kolde
 
         /s/ WILLIAM H. LANE III                            Director                   March 26, 1999
------------------------------------------
           William H. Lane III
 
           /s/ HOWARD L. MORGAN                             Director                   March 26, 1999
------------------------------------------
             Howard L. Morgan
</TABLE>
 
                                       62