<PAGE>
 
                                 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 Exchange Act
of 1934
For the fiscal year ended March 31, 1998 or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from ______________________to______________________
Commission File Number:  72870

<TABLE>
<CAPTION>
                                             SONIC SOLUTIONS
                          (Exact name of registrant as specified in its charter)
<S>                                                                  <C>
                     CALIFORNIA                                                   93-0925818
(State or other jurisdiction of incorporation or organization)       (I.R.S. Employer Identification No.)

     101 ROWLAND WAY,  SUITE 110,  NOVATO,  CALIFORNIA                             94945
        (Address of principal executive offices)                                 (Zip Code)
</TABLE>

<TABLE>
<S>                                                                                 <C>
Registrant's telephone number, including area code:                              (415) 893-8000
Securities registered pursuant to Section 12(b) of the Act:                      NONE
Securities registered pursuant to Section 12(g) of the Act:                      COMMON STOCK, NO PAR VALUE
                                                                                 (Title of class)
</TABLE>
     Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.

                         Yes   X             No 
                             -----              -----
      
     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of 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 this
Form 10-K.  ____

     The aggregate market value of the voting stock held by non-affiliates of
the registrant on June 5, 1998, based upon the closing price of the Common Stock
on the NASDAQ National Market for such date, was approximately $16,163,067./1/

     The number of outstanding shares of the registrant's Common Stock on 
June 5, 1998 was 8,409,032.


                      DOCUMENTS INCORPORATED BY REFERENCE

(1)  Portions of the Proxy Statement to be filed with the Securities and
Exchange Commission on or prior to July 15, 1998 and to be used in connection
with the Annual Meeting of Shareholders expected to be held September 1, 1998
are incorporated by reference in Part III of this Form 10-K.

----------------------
/1/  Excludes 3,530,352 shares held by directors, officers and ten percent or
greater shareholders on June 5, 1998.  Exclusion of such shares should not be
construed to indicate that any such person possesses the power, direct or
indirect, to direct or cause the direction of the management or policies of the
registrant or that such person is controlled by or under common control with the
registrant.
                                        

                                       1
<PAGE>
 
                                    PART I


FORWARD LOOKING STATEMENTS

     To the extent that this report discusses future financial results,
information or expectations about products or markets, or otherwise makes
statements about future events, such statements are forward-looking and are
subject to a number of risks and uncertainties that could cause actual results
to differ materially from the statements made.  These risks and uncertainties
include, among others, the timely introduction and acceptance of new products,
costs associated with new product introductions, the transition of products to
new hardware configurations, and other factors.  In addition, such risks and
uncertainties also include the matters identified under Management's Discussion
and Analysis of Financial Condition and Results of Operations in Item 7 below.

ITEM 1.  BUSINESS

     Sonic Solutions ("Sonic" or "the Company") designs, develops, manufactures
and markets digital tools for professionals who manipulate media -- sound,
images, moving pictures and text -- in computer based settings. SonicStudio is a
line of digital audio random access editing and processing systems, commonly
known as Digital Audio Workstations ("DAWs"). SonicStudio systems are used by a
wide range of audio professionals to prepare recorded sound for release on
Digital Audio Compact Discs ("CDs"), for inclusion in film and video sound
tracks, and for broadcast on radio and television. The Company's Sonic MediaNet
and Sonic LightSpeed/2/ product line is a high-speed local area network and file
management system that is optimized for management of data intensive file
transfers typically required in digital video, digital audio, computer graphics
and desktop publishing. The Company's DVD Creator/3/ product line ("DVD
Creator") is a complete workgroup solution for DVD premastering. It includes
MPEG-2 video encoding, audio preparation and encoding, and disc authoring,
layout, and formatting.

     Sonic's products generally include application software and specialized
hardware installed on a personal computer.  Sonic's products are designed to
improve the productivity and effectiveness of media professionals, enabling them
to process and manipulate more material in a given amount of time and to achieve
results which would have been impossible using traditional linear analog or
digital technology.

INDUSTRY BACKGROUND

AUDIO MARKET; AUDIO MARKET SEGMENTS

     The market for Sonic's audio products consists primarily of professional
facilities which prepare sound for commercial release of finished audio and
video products.  The Company's audio products are

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

/2/ During the last quarter of the 1998 fiscal year, the Company began
    transitioning its networking products from its earlier MediaNet product line
    to the new LightSpeed product line.

/3/ At the National Association of Broadcasters convention held in Las Vegas in
    early April 1998, the Company introduced a new line of DVD products called
    "DesktopDVD" aimed at the needs of professionals preparing DVD discs for
    corporate and industrial applications, to be distinguished from DVD Creator
    which is aimed at those professionals who prepare DVD discs for publishing
    consumer entertainment software. In this discussion DVD Creator will be
    taken to include all of the Company's DVD products, unless the context
    specifically requires otherwise.

                                       2
<PAGE>
 
used both by professionals who primarily prepare sound, for example in the music
recording and radio broadcasting industries, as well as by professionals who
primarily prepare visual materials which incorporate sound, for example in the
film and broadcast video industries. Sonic's target customers include recording
studios, mastering houses (which balance, equalize and sequence recorded music
for final release), editing facilities (which edit production music,
particularly classical and jazz recordings), radio and television broadcast
studios, and film and video post-production facilities (which create sound
tracks for film and video releases). Sonic also markets to companies and other
organizations that produce professional quality video and audio products for in-
house use.

     Sonic divides the professional audio market into three segments: Music
Post-Production/CD Preparation, Sound for Picture and Broadcast.  The common
goal of audio professionals in each of these market segments is to produce the
highest quality finished audio product in the shortest period of time for the
lowest total cost.  The professionals in each segment must perform somewhat
different tasks, however, and may require different tools.  The Music Post-
Production/CD Preparation segment, which includes recording studios, mastering
houses and CD facilities, requires 2-channel, high-quality editing and filtering
to edit, mix, equalize and sequence sound recordings for release on CDs and
other media.  The Sound for Picture segment, which includes film studios, video
post-production facilities and television networks and stations, requires multi-
track editing, video machine control, time compression and expansion, networking
and sound storage to modify sound tracks and audio special effects incorporated
in film and video.  The Broadcast segment, which includes television and radio
networks, syndicators and independent stations, requires multi-track editing and
time code control to prepare and broadcast program material.


ADOPTION OF PROFESSIONAL DIGITAL AUDIO WORKSTATIONS; VIDEO WORKSTATION MARKET

     For the first 100 years of recorded sound, recording devices stored
representations or "maps" of sound waves on various analog media such as wax
cylinders, vinyl records and magnetic tapes.  Traditional professional audio
practice had been built around high precision analog recording (usually magnetic
tape) and processing devices which operated in a linear, serial fashion.  As
high fidelity analog recording technology developed in the 1950s, 1960s and
1970s, professional systems became larger, more elaborate and more cumbersome.

     As a result of developments in the electronics industry, the technology
required for economical real-time recording and playback of digital audio became
generally available in the early 1980s.  Digital recording significantly
improves the quality of sound and reduces noise and other forms of degradation
that can occur in analog recordings.  A digital recording carefully and rapidly
measures or "samples" the strength of a sound wave at discrete points in time.
From the samples the original sound wave can be reconstructed perfectly within
the relevant range of human hearing.  More importantly, the samples, which are
simply numbers, can be randomly accessed, processed, edited, corrected and
otherwise manipulated using digital signal processing software tools running on
general purpose and special purpose computer hardware.  Professional recording
engineers became interested in digital recording when the rapid acceptance of
the CD in the music recording industry began to require most recorded music to
be released in digital format.  In addition, although other audio formats such
as film sound tracks and radio and television broadcast channels remained
analog, recording engineers wished to gain the greater fidelity and reduced
degradation which digital recording offered and to perform certain kinds of
audio processing that were best performed or could only be performed using
digital technology.

     Audio professionals have adopted two digital technologies: digital audio
tape-based systems ("DATs") and digital audio workstations ("DAWs").  DATs
record audio signals as digital information on magnetic tape and are designed to
operate like analog tape recorders.  DATs gained early acceptance because they
reduced noise and distortion compared to analog systems, while preserving the
familiarity of the linear analog recording process.  However, DATs offer little
advantage over analog technology 

                                       3
<PAGE>
 
with respect to sound manipulation. In addition, an inefficient copying process
must be used to edit digital audio tape recordings because the physical "razor
blade" editing typically used with analog tape is generally impractical with
digital audio tape.

     DAWs allow professional audio engineers to manipulate and process sound
that has been recorded onto computer magnetic disk drives ("hard disks").  Early
DAWs gained only limited acceptance because they were based on proprietary
hardware, were usually more costly than tape-based systems, required significant
redesign of studio work flow and operations, and did not permit easy movement of
volumes of sound onto and off of the workstation.  However, DAWs offered
significant advantages over analog and DAT technologies through random access to
sound on the hard disks, and editing without altering the original recorded
sound.  In addition, certain kinds of operations, such as signal reconstruction,
could be performed effectively only by using DAWs.

     Currently available DAWs use digital signal processing and analog-to-
digital converter chip sets which are relatively inexpensive and are available
from a number of semiconductor manufacturers.  In addition, the workstations
utilize widely available personal computers, high performance graphics monitors
and economical hard disks.  The advantages of DAWs include:

        *  EFFICIENCY - DAWs enable professionals to perform audio processing
           and editing tasks in less time than analog and DAT technologies.
           These tasks may be processed concurrently and may be automated.

        *  COST SAVINGS - A single DAW typically replaces the traditional racks
           of individual audio processing devices, each of which is typically
           devoted to a single function such as filtering, compression or
           reverberation.

        *  UNIQUE CAPABILITIES - Certain functions such as noise elimination,
           declicking, pitch shifting and time compression and expansion are
           best performed on DAWs where digital sound can be stored on randomly
           accessible hard disks and re-accessed at various stages of analysis
           and processing.

     Although analog and linear digital technology remain significant recording
and processing formats for audio professionals, the substitution of DAWs for
traditional technologies is continuing due to the performance, efficiency, cost
and functionality benefits of DAWs.  In addition, the use of DAWs is being
driven by the shift in the recording industry's standard release format from
analog (LP records and analog cassettes) to digital (CDs, digital compact
cassettes and MiniDiscs) as well as increasing interest in digital release
formats in the video, film and broadcast industries.  Sonic believes that these
factors have created a market for the Company's products.

     Emerging alongside the market for DAWs is a market for professional digital
video workstations and related tools.  The Company believes that the
professional video post-production market is significantly larger than the
professional audio market. As networked DAWs become more widely adopted, teams
of special effects, animation, and other media specialists may be able to
combine the traditionally separate processes of video creation and audio
creation, leading to greater efficiency and a reduction in time to market for
finished products.

DVD MARKET

     The market for the Company's DVD products consists of those facilities and
end user organizations who prepare material for publication on versions of discs
which fall within the DVD standard.  Currently, the Company divides this market
into 3 segments:

        *  "Hollywood" Segment - This segment consists of facilities and
           organizations which prepare film and video material for mass
           publication on DVD-Video discs. It includes film and television
           studios and production companies and other content owners as well as
           top flight independent video post production facilities which provide
           services to such

                                       4
<PAGE>
 
           content holders. Customers in this segment tend to cluster in major
           film and video product centers including Hollywood/Los Angeles, New
           York City, Chicago, London, Paris, Tokyo, Taipei, etc. Customers in
           this segment demand the very highest quality in terms of processing
           output, strict adherence to standards, and are very concerned with
           the overall efficiency of production since projects are often
           produced on tight schedules. Parallel production techniques are often
           employed by customers in this segment to speed production. The
           Company estimates that there are a few thousand facilities and
           organizations in this segment, worldwide.

        *  "Corporate" Segment - Customers in this segment prepare DVD-Video
           discs for publishing a variety of kinds of information for sales,
           training, and other communications purposes, and include "in-house"
           departments of corporate, industrial, non-profit or educational
           organizations, or independent facilities who specialize in assisting
           such organizations in preparing such material. Customers in this
           segment, on average, are somewhat more budget constrained than
           customers in the "Hollywood" segment (though in certain instances
           production values and budgets equal or even exceed those typically
           encountered in the Hollywood segment). They tend to be geographically
           more dispersed. While efficiency of production is a key requirement
           of such customers, compatibility with other, existing recording and
           post-production equipment is a major concern of customers in this
           segment. This segment is only now beginning to adopt DVD, though
           given the spread of DVD-ROM in the Personal Computer industry, many
           industry observers predict rapid growth in the use of DVD in this
           segment. The Company estimates that there are potentially more than
           100,000 facilities and organizations in this segment on a worldwide
           basis.

        *  "Multimedia" Segment - This segment includes developers of multimedia
           entertainment and educational titles intended for a mass audience.
           Many of the organizations in this segment previously were involved in
           the production of CD-ROM, CD-I, and computer based titles. Customers
           in this segment tend to use DVD in conjunction with specialized
           computer software, and accordingly their needs are more variegated
           than those in the other segments. While relatively few organizations
           in this segment have moved to DVD, industry observers report a high
           level of interest. The Company estimates that there are approximately
           15,000 organizations that might ultimately become involved in DVD-
           based production in this segment.

       The market for DVD production tools is an emerging market and will grow
  depending on the acceptance of the DVD format worldwide. While the Company
  believes the DVD format will become widely adopted and create a significant
  market for the Company's products, broadscale acceptance of the DVD format is
  not certain at this time.

BUSINESS STRATEGY: SONICSTUDIO, DVD CREATOR, SONIC MEDIANET

SONICSTUDIO AND STRATEGY

     In 1989, the Company introduced the Sonic System/TM/, now called
SonicStudio/TM/, a family of digital audio workstations for professional audio
users. A wide range of audio professionals now use SonicStudio to prepare
recorded sound for release on CD, for inclusion in film and video sound tracks,
and for broadcast on radio and television. SonicStudio consists of extensive
applications software as well as specialized hardware installed in a personal
computer. Currently, SonicStudio is compatible with various models of Macintosh
personal computers. The Company plans to introduce versions of SonicStudio
compatible with other computer platforms. Because of the uncertain nature of
such development, there can be no assurance that problems or delays will not be
encountered which will delay or prevent such versions of the SonicStudio from
reaching market. In light of the substantial costs
                                       5
<PAGE>
 
associated with such development, the financial results of the Company would be
materially adversely affected if such introduction were delayed for a
significant period of time.

     SonicStudio is designed to improve the productivity and effectiveness of
audio professionals, enabling them to process and manipulate more audio material
in a given amount of time, and to achieve results which would have been
impossible using other audio technologies.  Versions of SonicStudio vary in
functionality from 4-channel systems for the editing and assembly of music and
other stereo material, to elaborate systems capable of input and output of 64
independent audio channels, playback of over 80 independent tracks from hard
disk storage, and performing a wide range of signal processing functions.  End
user prices of complete Sonic configurations (including host computer and hard
disk storage, neither of which are typically sold by the Company) range from
under $10,000 to over $45,000.

     The Company's SonicStudio strategy is to continue to offer products that
enhance professional productivity while meeting the specific needs of each
segment of its target market.  The Company believes that SonicStudio and related
peripheral products currently accomplish this strategy for the following
reasons:

        *  FOCUS ON THE APPLICATION - Each segment of the professional audio
           market targeted by Sonic has specialized needs. Sonic's product line
           spans a wide range of performance characteristics, hardware and
           software options, configurations and price points to address the
           specific needs of discriminating professionals in each market
           segment.

        *  PROFESSIONAL PERFORMANCE - Sonic's continuing focus has been on
           satisfying demanding professional performance requirements. The
           Company has accomplished this to date by basing the design of the
           SonicStudio on an architecture that utilizes specialized hardware and
           software to ensure a fast, professional level of system response, to
           avoid processing bottlenecks in handling bulky audio files and to
           support the audio quality requirements of professional users. This
           architecture also makes SonicStudio easily scaleable to a large
           number of inputs and outputs.

        *  EFFICIENCY FEATURES - Sonic has designed SonicStudio to increase
           operator efficiency. Every system allows background loading of sound
           to the hard disks while the audio professional works on other
           material already loaded on the hard disk. Most SonicStudio systems
           also allow the audio professional to off load sound from the hard
           disks while processing other material, to queue loading and unloading
           of audio material, and to automatically control source and
           destination external tape machines or other devices. In addition, the
           Company's Sonic MediaNet product enables customers to network their
           workstations and accelerate loading and unloading of audio material,
           thereby increasing the processing efficiency of professional work
           groups by allowing them to share work and resources.

        *  MODULAR SOFTWARE-BASED SOLUTIONS; UPGRADES - Sonic offers a modular
           set of software applications which provide important benefits in
           terms of cost effectiveness and the ability to adapt quickly to
           changing customer needs. Sonic provides its customers with optional
           integrated signal processing capabilities, including digital
           equalization, filtering, dynamics, processing, mixing, dithering,
           time compression, pitch shifting, varispeed and reverberation. Every
           SonicStudio sold can be upgraded easily by the addition of these and
           other software options. In addition, the Company has historically
           offered customers under the Company's SonicCare(TM) maintenance
           program relatively low priced hardware upgrades when hardware
           versions change. This economical upgrade path affords customers a
           degree of assurance that their investment in a SonicStudio will not
           be quickly outmoded.

        *  NETWORKING - The Company's networking system, Sonic
           MediaNet/LightSpeed, allows users to share digital audio material
           efficiently among multiple workers in a facility. SonicStudio is
           designed to be compatible with Sonic MediaNet/LightSpeed and includes
           software designed to take advantage of Sonic MediaNet/LightSpeed's
           high speed transaction protocols and bandwidth reservation
           capabilities.

                                       6
<PAGE>
 
        *  HIGH LEVELS OF CUSTOMER SUPPORT - To meet the customer support needs
           of audio professionals, Sonic employs personnel at its headquarters
           and at other locations who deal directly with customers and work
           closely with the Company's distributors and dealers to help them
           provide customer support. The Company offers the SonicCare(TM)
           maintenance program which provides for timely replacement of hardware
           components, free access to new versions of SonicStudio software and
           unlimited telephone technical support during specified hours.

        *  COST-EFFECTIVE INDUSTRY-STANDARD HARDWARE COMPONENTS - SonicStudio
           utilizes cost-effective personal computers, high performance SCSI
           disks and standard digital signal processing chips. This permits
           Sonic's customers to benefit from computer industry-driven cost
           reductions.

DVD CREATOR AND STRATEGY

     During the last quarter of fiscal year 1994, the Company introduced Sonic
Cinema (previously called "Disc Video"), an option to SonicStudio supporting
premastering of Video CDs.  Sonic Cinema consisted of third party software and
hardware and Sonic-developed software and hardware which supported real time
encoding of compressed digital video and audio according to the MPEG-1 standard,
and encoding and sequencing of the resultant data stream into the Video CD
format.

     At its introduction, Sonic Cinema was to be both an extension of the
Company's business in Compact Disc preparation, and a new business opportunity
incorporating elements of video, as well as audio and digital signal processing.

     The Company shipped a limited number of Sonic Cinema systems on a Beta site
basis in late March 1994.  During fiscal years 1995 and 1996, the Company
shipped a number of additional Sonic Cinema options for use by SonicStudio
customers.

     The Company encountered only limited demand for Sonic Cinema.  However, the
Company believed that Video CDs were a precursor to longer length, higher
quality video entertainment on a Compact Disc-like medium.  In 1996, such a
format was introduced as the DVD standard, proposed and supported by a
consortium of 10 companies including Toshiba Corporation, Pioneer Electronics
Corporation, Matsushita Electronics Company, Sony Corporation, Time-Warner, and
Philips, N.V., among others.  DVD discs are essentially the same physical shape
as conventional CDs but provide for storage of more information than CDs./4/ DVD
is intended to cover a range of applications including data storage (DVD-ROM),
video (DVD-Video), and audio (DVD-Audio), among others./5/

     In March, 1996 the Company publicly announced its intention to produce a
premastering system for DVD-Video discs incorporating the three capabilities
necessary to produce a finished DVD premaster/6/ image: (1) MPEG-2 video
compression,  (2) Dolby Digital and MPEG-2 audio compression, and (3) authoring.
The system began limited shipment in June, 1996.  This system, called "DVD
Creator," has a 

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

/4/  DVD discs are capable of storing 4.7 Gigabytes of data on a single layer of
a single disc side, compared to approximately 650 megaBytes of data on a
conventional CD-ROM disc.  DVD also makes provision for double-sided discs, and
for two layers of storage on each side of a disc, resulting in a total capacity
of 18.2 gigaBytes on a single disc.

/5/  Version 1.0 standards for the physical DVD disc, the logical DVD disc (DVD-
ROM), and the video DVD disc (DVD-Video) were published in August of 1996.
Standards for recordable and re-writable DVD discs (DVD-R and DVD-RAM,
respectively) were published in 1997.  Industry observers expect that a standard
for DVD-Audio will be published in 1998.

/6/  In Compact Disc and DVD disc manufacturing, a disc "master" refers to a
first generation physical disc from which molds are produced which are used to
manufacture stamped copies.  A disc "premaster" refers to the final data stream
to which final error encoding is applied prior to "cutting" the master disc.
Since the error encoding is a purely deterministic process, production of the
premaster marks the point after which no further judgmental or creative
decisions are possible.

                                       7
<PAGE>
 
number of technical elements.  For MPEG-2 video compression, the
Company has developed a set of plug-in boards with PCI host interfaces.  These
cards are capable of inputting and compressing high resolution digital video
into MPEG at real time rates, and of decoding an MPEG bit stream into a visible
image.  For audio compression, the Company has programmed its USP audio cards to
perform both the encoding and decoding of Dolby Digital and MPEG-2 bitstreams
and has developed a co-processor audio card to handle real time encoding of
surround 5.1 Dolby Digital audio.  For authoring, the Company previously
incorporated into DVD Creator a software package called Scenarist-DVD produced
by Daikin Industries Ltd. ("Daikin"). Sonic distributed Scenarist-DVD under an
agreement, concluded in March, 1996 with Daikin, which gave the Company
essentially exclusive distribution rights outside Japan.  Under this agreement
(as modified via subsequent amendments), Sonic had certain obligations,
including, among others, adequate promotion of Scenarist-DVD and minimum volume
commitments.  As of March 18, 1998, the Company's distributorship of the
Scenarist DVD-Video authoring package lapsed according to the terms of the
agreement between Daikin and Sonic.  In September 1997 Sonic introduced a new
Sonic-developed authoring package called DVD Producer which is now part of the
DVD Creator product line.

     As a result of the introduction of the Company's DVD Creator system, and
dwindling demand for the Sonic Cinema product line, the Company discontinued
Sonic Cinema in December, 1996.

     DVD Creator incorporates solutions for the major steps involved in
preparing a title for DVD and permits customers to integrate these individual
solutions into a complete DVD workgroups via the Company's Sonic MediaNet
networking system.  DVD Creator is sold both as a complete package and as
separable elements.  The main separate elements in a DVD Creator system include
(1) a video encoding station which incorporates specialized circuit cards
designed by the Company, based on an IBM chip set, and which compresses
professional format digital video into either the MPEG-1 or MPEG-2 format
required by the DVD-Video specification; (2) an audio prep and encoding station
which incorporates the Company's USP and co-processing audio cards, and permits
assembly of audio tracks into either the PCM, Dolby Digital, or MPEG-2 formats
supported by the DVD-Video specification, and (3) an authoring system.

     During June, 1996, the Company began shipping the first installation phase
of the DVD Creator system for DVD encoding and premastering including the audio
and authoring subsystems.  During the quarter ended September 30, 1996, the
Company began shipping the video subsystem of the DVD Creator system.  During
the remainder of the 1997 fiscal year, and throughout the 1998 fiscal year, the
Company continued to deliver updates of the DVD Creator Software.  The Company
expects to continue to deliver additional updates of DVD Creator software
throughout the 1999 fiscal year.  The entire DVD Creator system is complex, and
incorporates leading edge technologies.  While it is the Company's current
intention to continue development and enhancement of the DVD Creator system,
there can be no assurance that development and enhancement of the DVD Creator
system will be successfully continued (see further discussion of development
risk below).  There are a number of companies engaged in the development and
marketing of products which can perform some or all of the steps involved in
preparing titles for  release in the DVD-Video format.  Many of these companies
have long-standing involvement with technologies involved in DVD-Video
premastering, and many of them have technical and/or financial resources which
are greater than Sonic's.  Accordingly, there can be no assurance that the
Company's DVD Creator system, as developed and enhanced, will be preferred by
customers over competitive offerings.  Further, since the Company and its
customers have had only limited experience to date with the DVD Creator system
in actual production, there can be no assurance that design flaws, limitations,
"bugs", or other problems will not be discovered in the DVD Creator system which
may be difficult or impossible to repair or address, or to repair or address in
a timely fashion.  Under such circumstances, the Company would potentially incur
significant costs related to addressing such problems, and the Company's sales
of new systems would undoubtedly be adversely affected.

     While the Company believes that DVD Creator represents a significant
opportunity and it is the Company's current intention to further increase
expenditures for DVD development and marketing in the 

                                       8
<PAGE>
 
1999 fiscal year, there are a number of risks surrounding this initiative. These
risks include but are not limited to the following:

        *  DEVELOPMENT RISK -- The Company is new to the development of MPEG
           video processing hardware and is utilizing a newly developed chip set
           single sourced from IBM. Unanticipated development problems in the
           continued production of the IBM chip set, the boards designed by the
           Company incorporating the chip set, or the accompanying software
           could seriously delay future releases of DVD Creator. Newly developed
           technology of this kind is often subject to rapid changes in ways
           that may prove challenging to the Company. For example, the Company
           has been advised by IBM that IBM will introduce a new chip set in
           1998 to replace the currently shipping chip set. While the Company
           believes that the new chip set will be largely compatible with its
           existing software and designs, incorporation of the new chip set in
           the Company's video processing hardware will require a revision of
           its currently shipping circuit board set and some modification of its
           system software. In addition, the new chip set or board could
           encounter either design or production problems which would require
           another version of the chip or the card to be developed, a process
           which can consume several months. While the Company believes that
           there may be alternatives available to it from other OEM suppliers,
           there can be no assurance that such alternatives would be available
           on commercially reasonable terms and in the timeframe needed. Sonic
           is also delivering as part of DVD Creator, Dolby Digital and MPEG-2
           audio encoding and decoding capabilities by programming the Company's
           USP audio signal processing cards and by designing co-processing
           hardware. While Sonic has significant experience in signal processing
           of high quality digital audio, it has only limited experience with
           Dolby Digital and MPEG-2 audio encoding and decoding. Finally,
           authoring for DVD-Video is complex. Since the introduction of DVD
           Creator in 1996, the Company incorporated into the DVD Creator
           product line a format authoring system call Scenarist developed by
           Daikin Industries of Japan. The format authoring step is particularly
           complex and demanding for the DVD-Video format, and, accordingly,
           format authoring software is quite complicated. In September 1997,
           the Company announced the addition to DVD Creator of DVD Producer, a
           new DVD-Video format authoring system developed by Sonic. While the
           Company has commenced shipments of DVD Producer, there is continuing
           development associated with this product which is necessary to make
           the package a compelling alternative to Scenarist and other authoring
           packages . In addition, because of the complexity of development of
           tools of this kind, there can be no assurance that problems or "bugs"
           do not exist in the software which will be discovered only as
           customers attempt to replicate DVD-Video discs made with the product.
           In addition, there appears to be interest in the market in DVD
           premastering systems running on the Windows NT platform. While it is
           the Company's current intention to "port" DVD Creator to provide
           versions of DVD Creator running on the Windows NT platform, there can
           be no assurance that the porting process will proceed in a speedy and
           trouble-free way. At the National Association of Broadcasters
           convention in early April 1998 the Company announced its "DesktopDVD"
           System, an all-in-one premastering system positioned for corporate
           and industrial users. While many of the elements of DesktopDVD are
           included in the Company's DVD Creator product line, DesktopDVD relies
           on a new plug-in card and audio/video interface "box", which supports
           a number of video format types which are commonly encountered in
           corporate and industrial applications. While it is the Company's
           intention to commence shipments of the new hardware and the
           DesktopDVD System before the end of the first fiscal quarter of the
           1999 fiscal year (the quarter ending June 30, 1998), there are a
           number of factors which could delay completion of development and
           commencement of such shipments. In the event that shipments of
           DesktopDVD Systems are delayed past the end of the first fiscal
           quarter of the 1999 fiscal year, the impact on the Company's results
           of operations could be materially negative.

        *  MARKET RISK; COMPETITION -- The DVD-Video format has generated
           significant interest in the professional marketplace. Sonic
           anticipates that a number of companies will provide MPEG-2 video
           encoding capabilities, audio encoding capabilities and authoring
           systems for the

                                       9
<PAGE>
 
           professional user. Sonic is aware of a number of companies working in
           some or all of these areas, some of which have released or announced
           competitive products, including CagEnt Technologies/7/, C-Cube
           Microsystems, Digital Vision, Dolby Laboratories, FutureTel,
           Innovacom, Lucent, Matsushita, Minerva, Mitsubishi, Optibase,
           Philips, Spruce Technologies, 3DO, Toshiba, Pioneer, and Sony, among
           others. A number of these companies have financial or organizational
           resources significantly greater than those available to the Company
           and/or greater familiarity with certain technologies involved in DVD
           premastering solutions. While the Company believes that it can
           engineer a solution of acceptable or superior quality at a
           competitive price, there can be no assurance that competitive
           offerings will not be available in the market, and will not be better
           received than Sonic's offering. As of September 30, 1997, the
           Company's exclusive distributorship (outside Japan) of the Scenarist
           DVD-Video authoring package lapsed according to the terms of the
           agreement between Daikin Industries of Japan and Sonic and after that
           time the Company continued to distribute the Scenarist authoring
           package on a non-exclusive basis. As of March 18, 1998, the Company's
           non-exclusive distributorship of the Scenarist DVD-Video authoring
           package lapsed according to the terms of agreements between Daikin
           and Sonic. Daikin has made clear its impression that, with the
           introduction of DVD Producer, Sonic has become a competitor to
           Daikin. Accordingly, Daikin has taken a number of steps to develop
           relationships with other distribution partners, including Minerva,
           Digital Vision, Optibase, and Cagent, and has clearly signaled to the
           marketplace Daikin's intention to compete vigorously with Sonic.
           Specifically, Daikin has announced to the market the upcoming
           availability of Scenarist on the Windows NT platform. While the
           Company believes that it can compete effectively with Daikin and its
           distribution partners, and that customers will prefer DVD Producer on
           the Macintosh platform to Scenarist on the Windows NT platform, or
           that the Company will be able to provide Windows NT versions of DVD
           Producer and DVD Creator within a reasonable time frame, there can be
           no assurance that the Company's products will be preferred over those
           of competitors.

        *  MARKET RISK; CONSUMER MARKET FORMAT ADOPTION -- The DVD-Video format
           and players were introduced in Japan and some parts of Asia in late
           1996, in North America in early 1997, in Europe in March and April of
           1998. Many industry observers expect the format to be attractive to
           consumers since it combines high-quality video, six-channel surround
           sound, multiple language tracks, sub-titles, and interactive story
           branching, among other features and permits "feature length" movies
           and videos to be delivered on a "Compact Disc" sized disc. Although
           there has been significant interest in the DVD format among industry
           analysts and members of the press, there can be no assurance that the
           DVD-Video format will be readily accepted by consumers. There are a
           number of consumer entertainment formats that will compete with DVD-
           Video in the future, including broadcast TV, cable TV, high
           definition digital TV, VHS cassettes, direct broadcast satellite
           systems, and Internet distribution, among others. It is possible that
           the DVD format will fail to attain "critical mass" acceptance among
           consumers.

        *  MARKET RISK; CORPORATE MARKET -- The Company introduced to the market
           "DesktopDVD" - Sonic's first system aimed at the corporate DVD market
           at the National Association of Broadcasters convention ("NAB") in
           early April, 1998. It is the Company's intention to commence
           shipments of the first version of its DesktopDVD product before the
           end of June 1998. In addition to the development risks surrounding
           any new product introduction, the Company's DesktopDVD product
           introduction is dependent upon successful marketing, distribution,
           sales and customer support strategies and programs. The Company has
           only limited experience in selling to corporate customers and the
           required strategies and programs are likely to be significantly
           different from those the Company is familiar with in the professional
           audio and video markets. There can be no assurance that the Company
           has correctly identified the 

---------------------
/7/ On April 22, 1998, Spruce Technolgoies announced that it had acquired the 
MPEG-Video product lines which had been part of CagEnt Technologies.

                                       10
<PAGE>
 
           corporate opportunity or that the Company will be able to establish
           the necessary distribution channels to sell and support the DVD-
           Corporate products. The Company expects expenses to increase to
           support research and development and sales and marketing efforts
           related to the DVD-Corporate products in fiscal year 1999. The
           Company's results of operations will be materially adversely affected
           if these new products do not achieve market acceptance.

        *  FORMAT RISK; DELAYS AND CONFUSION -- There were a number of delays in
           reaching agreement on the final specification for DVD-Video,
           including disagreements within the DVD Consortium (now called the DVD
           Forum) and among various companies, industry associations and
           political organizations concerning issues involving copyright
           protection schemes and sharing of royalty revenues from patented
           technologies involved in the DVD format. The final specification of
           the DVD-Video format was published by the DVD Consortium in August,
           1996, and a final approach to the problem of encryption of data was
           announced in October, 1996. Other aspects of the DVD format have
           continued to be controversial. For example, while the DVD Forum has
           promulgated standards for DVD-R ("DVD-Recordable"), and for DVD-RAM
           ("DVD-Read/Write/Erase"), certain companies and groups of companies
           have indicated their intention to introduce into the market products
           which are intended to be alternatives to the official DVD-R and DVD-
           RAM standards. The DVD-Audio standard is now circulating in draft
           form among members of the DVD Forum and various trade associations
           representing the music recording industry. While a final standard is
           now expected in the summer of 1998, some companies - principally Sony
           Corporation and Philips - have indicated that they plan to introduce
           an alternative next generation audio format called "Super Audio CD".
           Continued controversy surrounding the DVD format in general has the
           potential to delay or halt the adoption of DVD by the consumer
           electronics and personal computer industries, and this could have a
           significant negative impact on the Company's business. Also, while
           the DVD-Video format is now standardized, Divx, a joint venture
           company funded in part by Circuit City Stores, has indicated its
           intention to introduce a specialized format built as an extension of
           the DVD-Video format, requiring a specialized player. Because of the
           support the Divx proposal has received from certain important content
           holders, some industry observers have expressed the opinion that
           consumer confusion regarding Divx, or consumer hesitation while
           waiting for the rollout of Divx players (projected to occur in the
           summer of 1998) will seriously retard the adoption of the DVD-Video
           format. This also could have a significant negative impact on the
           Company's business.

                  The Company expects that its DVD related business line will
constitute an increasing portion of Sonic's overall business in the future. The
Company's DVD strategy will continue to be based on the following elements:

        *  FOCUS ON PROFESSIONAL APPLICATIONS -- Sonic's DVD product and service
           offerings are focused on video and audio professionals whose primary
           concern is producing the highest quality DVD discs, in complete
           compliance with worldwide standards, with a high level of efficiency.
           Sonic plans to continue to evolve DVD-related premastering tools
           which are fully compatible with "industry-standard" input formats and
           typical professional video and audio equipment sets.

        *  HIGH PERFORMANCE TOOLS -- Sonic's DVD tools will offer professional
           users the highest levels of performance, both in terms of power and
           sophistication of processing, and in terms of maximizing facility
           efficiency.

        *  FLEXIBLE CONFIGURATIONS -- Because DVD premastering is relatively new
           and the application of DVD technology to the needs of content
           publishers is still evolving, the balance of capabilities in typical
           DVD premastering settings, and the typical workflow involved in
           generating a DVD title are still in flux. Sonic has engineered DVD
           Creator as a "workgroup" solution incorporating audio, video and
           authoring subsystems integrated on a high speed network to make it
           easy for facilities to re-arrange DVD workflow quickly, and to comply
           easily with changing demands in 

                                       11
<PAGE>
 
           the DVD universe. The Company plans to continue to implement this
           philosophy in future DVD offerings.

        *  RANGE OF PRODUCT OFFERINGS -- DVD has a number of potential uses,
           including applications in corporate and industrial settings, and in
           "prosumer" and consumer venues, as well as in delivery of mass
           entertainment such as feature films, videos, and recorded music.
           Sonic plans to evolve each element of its DVD premastering tool 
           set--video, audio and authoring -- to specifically address the
           specialized needs of such emerging segments.

SONIC MEDIANET AND STRATEGY

     In 1992 the Company introduced SonicNet/TM/, a 100 megabit per second
networking system which was designed to connect SonicStudio systems together.
Experience with SonicNet indicated that there might be demand for such a high
performance networking system beyond the population of SonicStudio customers.
Accordingly, in 1993, the Company undertook development to generalize its
networking system.  The result was introduced as Sonic MediaNet in the last
quarter of the 1994 fiscal year.

     Sonic MediaNet consists of specialized FDDI/CDDI adapter cards which are
installed in the NuBus or PCI Bus expansion slots of Macintosh computers.  Some
of the cards include SCSI controllers which permit control over hard disks and
other SCSI-interfaced devices.  Sonic MediaNet also includes a set of
specialized software running on the cards.  This software includes a real time
operating system, file management system, and a set of standard and optimized
transaction protocols.

     The aim of Sonic MediaNet is to provide an intelligent network/storage
subsystem, optimized to the needs of professionals who manipulate high bandwidth
"multimedia" data types such as digital audio, digital video, and high
resolution graphics.  Sonic MediaNet includes support for standard networking
protocols, such as TCP/IP and the Apple Filing Protocol  In addition to standard
protocols, Sonic MediaNet includes support for optimized movement of multimedia
data types from files, over the network, to calling applications.  Included in
this support is provision for bandwidth reservation which permits calling
applications to insure delivery of multimedia data types at real time rates.

     Since beginning shipments of Sonic MediaNet, the Company has encountered
demand for the product in applications involving manipulation of high resolution
graphics and images, primarily for pre-press applications, as well as with DAWs
provided by other companies, and with digital video workstations.  The Company
has established sales and marketing channels for Sonic MediaNet which are to
some extent separate from sales and marketing channels for SonicStudio.

EARLY SONIC MEDIANET TECHNOLOGY TRANSITION DIFFICULTIES

     In the last quarter of the 1996 fiscal year the Company became aware of
competitive announcements which involved the use of standard high speed network
adapter cards, in particular, those based on 100 megabit per second Ethernet
("Fast Ethernet"), with specialized software designed to circumvent bottlenecks
inherent in standard Macintosh networking protocols.  These products offered
quite significant improvements over standard Macintosh networking at price
points significantly lower than Sonic MediaNet's.  The Company believed that
these announcements would significantly reduce demand for Sonic MediaNet in the
prepress industry.

     Based on these announcements, the Company began preparing for transitioning
Sonic MediaNet to other, faster networking protocols earlier than it had
previously planned.  In connection with its decisions in these areas, the
Company reorganized its Sonic MediaNet sales and marketing group, accepted
certain returns of Sonic MediaNet product from dealers, and established
additional reserves against Sonic MediaNet receivables and inventory (see
discussion below "Products - Sonic MediaNet; Charges Related to Technology
Transition").

                                       12
<PAGE>
 
SONIC MEDIANET FUTURE DEVELOPMENTS

     It is the Company's intention to introduce a second generation Sonic
MediaNet product line in fiscal 1999, incorporating newer networking
technologies and increased performance levels.  In April 1997, the Company
announced its intention to base the second generation Sonic MediaNet product
line on FibreChannel technology.  FibreChannel is a 1 Gigabit per second network
which, practically, can deliver more than 40 Megabytes per second throughput,
allowing uncompressed, professional quality digital video and multiple tracks of
high-resolution audio to be transferred in real time.  In the last quarter of
the 1998 fiscal year, the Company substantially altered its approach to the new
MediaNet product line, by deciding significantly to de-emphasize the dependence
of the second generation product line on Sonic-designed plug-in FibreChannel
hardware, and by making the software components of the new product line more
broadly compatible with a number of networking technologies in addition to
FibreChannel, including 10BaseT and 100BaseT Ethernet.  The Company intends to
introduce the first components of the revised second generation product line,
now called "Sonic LightSpeed", in the 1999 fiscal year.  There can be no
assurance that the Company will be successful in developing such a product line,
or that, if successfully developed, such a second generation product line will
be attractive to customers when compared to other network product offerings.
Further, transition between the first generation and second generation product
lines may present a number of difficulties for the Company, including slow sell
through or returns of dealer stocks of the first generation product.  Such
difficulties could have an adverse affect on results of operations for future
periods.


COMPUTER PLATFORM DEPENDENCE

     All of the Company's current products operate on, and a significant portion
of the Company's planned future products will operate on Macintosh computers.
The Company's results of operations could be materially adversely affected if
the Company or its customers or dealers are unable to obtain sufficient
quantities of Macintosh computers.  There can be no assurance that the Macintosh
will be a preferred computer in the professional and corporate audio and DVD
markets in the future.  Any future changes to the operating system or
architecture of the Macintosh computer could require the Company to adapt its
products to those changes, and any inability to do so, or delays in doing so,
could render the Company's current and future products obsolete.  At the moment
it is unclear what the future operating system environment of Macintosh
computers will be, and, if Apple Computer discontinues support for the existing
Mac OS family and insists on Macintosh developers' migrating to the new
operating system, there can be no assurance that the Company will be able to
migrate the Company's products onto such a new operating system or will be able
to do so in a timely fashion.


PRODUCTS

SONICSTUDIO

     SonicStudio and related products constitute a significant part of the
Company's current product offerings.  All SonicStudio systems include a broad
array of integrated applications software and specialized hardware installed on
a personal computer.  The Company offers a wide range of options for
SonicStudio, including  additional applications software, hardware and
networking products, all of which are integrated with SonicStudio.

                                       13
<PAGE>
 
     The hardware components that support SonicStudio include proprietary
digital signal processing ("DSP") cards designed and manufactured by Sonic,
external interface devices, an Apple Macintosh personal computer and hard disk
storage.

SONICSTUDIO SOFTWARE

     All SonicStudio systems include a library of software tools that enable a
broad range of professional audio processing applications, including:

  *  RECORDING/LOADING - Professionals may record and load onto the
     SonicStudio's hard disks at any resolution from 16 to 24 bits, and at any
     of four standard professional sampling rates. The background loading
     feature allows professionals to process one segment of program material
     while other segments of program material are being prepared for processing.

  *  EDITING - Professionals are free to "cut and paste" sound on SonicStudio's
     hard disks into any sequence, leaving the originally recorded sound
     unchanged. Volume changes and cross fades from one sound segment to another
     are all performed in real-time. The operator has a high degree of control
     over cross fades with a virtually unlimited selection of fade durations,
     fade curves and fade relationships. Collectively, these editing features
     offer professionals highly refined control over the sound during
     preparation of music and dialog material.

  *  SOUND DISPLAY - Professionals can display up to 64 internal tracks either
     as waveforms which give a highly detailed, sample-level view of the sound,
     as lists of text names and time code data, or as bars indicating the
     presence or absence of sound. Fast display algorithms permit virtually
     instantaneous modification, redisplay and audition of edited material.

     In addition, all SonicStudio systems include software that provides audio
professionals with the ability to mix and equalize audio material, synchronize
material used and processed on SonicStudio with audio material used and
processed on external devices, and store and replay certain processing functions
such as equalization levels.  All SonicStudio systems also facilitate project
management by offering organization and flow control of project elements as they
are brought onto, off of and through the system.

SONICSTUDIO OPTIONS AND PERIPHERALS

     SonicStudio is offered with a wide range of options.  Most options involve
additional software and in some cases additional hardware.  Options available
for SonicStudio include:

  *  NONOISE(R) - The NoNOISE software option equips the SonicStudio with a set
     of DSP tools for removing hiss, buzz, rumble, clicks, crackles and other
     noises typically encountered in recording situations. NoNOISE software is
     typically sold with additional SSP cards. Sonic Solutions received an
     Emmy(R) award from the National Academy of Television Arts and Sciences in
     October, 1996, for development of NoNOISE.

  *  TIMETWIST - Certain situations require the ability to change the playing
     time of a particular sound. For example, it may be necessary to shorten a
     radio commercial to fit into a pre-assigned time slot. In other situations,
     it may be desirable to change the pitch of a piece of sound without
     changing the running time. The TimeTwist software option permits users to
     perform these audio functions with a high degree of fidelity to the
     original sound and with a wide operating range.

  *  MIXING DESK - The Mixing Desk software option adds enhanced equalization
     and dynamics functions to the SonicStudio. The Mixing Desk option includes
     more than fifteen different kinds of filters as well as advanced dynamics
     processing.

  *  ADDITIONAL CHANNELS AND TRACKS - The smallest SonicStudio systems include a
     single SSP-3 card capable of input and output of 2 or 4 channels of digital
     audio. Additional SSP-3 cards plus 

                                       14
<PAGE>
 
     associated interface hardware can be added to a SonicStudio system to
     permit input and output of additional channels in groups of 4. Since each
     SSP-3 card has direct control over external hard disks, additional cards
     add to the System's track playback ability. In USP based SonicStudio
     systems, each additional card enables input and output of up to 16
     channels, and playback of 24 or more tracks from hard disk. To date, the
     largest SonicStudio systems shipped include four USP cards used for audio
     input, output and playback. Such SonicStudio systems are capable of 64
     channels of input and output, and playback of up to 96 independent tracks
     from the hard disk.

  *  PQ EDITING/CD MASTERING PACKAGE - This software option is oriented toward
     the needs of facilities whose primary activity is preparation of music for
     release on CDs. It permits users to edit subcode information which permits
     the random accessing of tracks on CDs, and to input and output CD
     premasters in a variety of standard formats, including direct recording
     onto write-once CDs.

SONICSTUDIO CONFIGURATIONS

     The hardware elements of the SonicStudio are combined together with
SonicStudio applications software to create various configurations.  A great
number of combinations are possible.  Simple SonicStudio configurations
permitting only 4 channels of audio input and output, and a limited range of
processing functionality carry a list price/8/ of approximately $4,000, and when
combined with typical host computer and hard disk storage, represent a total
price to the customer of less than $10,000.  A larger SonicStudio system,
permitting 24 channels of audio input and output, and supporting a complete
range of processing capabilities, would carry a list price of approximately
$8,000, and when combined with typical host computer and hard disk storage,
would represent a total customer investment of $15,000.

     All of the Company's current products operate on, and a significant portion
of the Company's planned future products will operate on, Macintosh computers.
The Company's results of operations could be materially adversely affected if
the Company or its customers or dealers are unable to obtain sufficient
quantities of Macintosh computers.  There can be no assurance that the Macintosh
will be a preferred computer in the professional audio market in the future.
Any future changes to the operating system or architecture of the Macintosh
computer could require the Company to adapt its products to those changes, and
any inability to do so, or delays in doing so, could render the Company's
current and future products obsolete.

SONIC MEDIANET; CHARGES RELATED TO TECHNOLOGY TRANSITION

     Sonic MediaNet is a high performance, fully distributed networking system
designed specifically to handle digital audio, digital video, high resolution
graphics and other multimedia data types.  Sonic MediaNet allows users to share
digital audio and other "multimedia" data types efficiently among multiple
workers in a facility.  Sonic MediaNet combines FDDI or CDDI (fiber-based or
copper-based) technology with a special file system running on SCSI disks
attached directly to the network cards.  This file system, called the Digital
Media File System (DMFS), addresses the needs of multimedia applications.  In
addition to its use in digital audio applications, Sonic MediaNet has uses in
other areas of the computer industry whenever work groups wish to collaborate on
applications which require high, sustained rates of data transfer, a high degree
of compatibility with conventional computing systems and some degree of
guaranteed bandwidth. Sonic MediaNet is well-suited to the problems of data
sharing typically encountered by users of time sensitive and bandwidth intensive
applications such as digital video, computer graphics and desktop publishing.
The Company commenced commercial shipments of Sonic MediaNet in the first
calendar quarter of 1994.

---------------------
/8/   Prices are based on U.S. Domestic list prices in effect as of the date of
this report.

                                       15
<PAGE>
 
     During fiscal year 1996, the Company began preparing for transitioning
Sonic MediaNet to other, faster networking protocols earlier than it had
previously planned, based upon competitive announcements as discussed above in
"Early Sonic MediaNet Technology Transition Difficulties" beginning on page 12.
In connection with its decision, the Company incurred charges related to the
reorganization of its Sonic MediaNet sales and marketing group, accepted certain
returns of Sonic MediaNet product from dealers, and established additional
reserves against Sonic MediaNet receivables and inventory.

     The Company has announced its intention to introduce to the market a new
version of Sonic MediaNet in fiscal 1999 based on the Fibre-Channel standard.
This product, sometimes referred to as "Sonic MediaNet II" and now called "Sonic
LightSpeed", is intended to offer increased performance levels and to attract
new customers to the use of Sonic MediaNet products, particularly customers in
the professional digital video arena.  While the Company believes that it will
introduce Sonic LightSpeed in fiscal 1999, there can be no assurance that its
development efforts will be successful or that difficulties or problems will not
be encountered which delay or prevent introduction of the Sonic LightSpeed
product line as planned.  As noted above, the Company substantially changed its
approach to Sonic LightSpeed in the fourth quarter of the 1998 fiscal year by
deciding to de-emphasize the use of proprietary FibreChannel hardware in Sonic
LightSpeed and by making the software components of Sonic LightSpeed more
broadly compatible with other networking technologies including 10baseT and
100baseT Ethernet and there can be no assurance that other significant changes
will not be made in the Sonic LightSpeed introduction plans.  In addition, the
networking market is highly competitive, with purchase decisions influenced by a
variety of factors, including the cost of adoption, overall performance,
standards compliance and interoperability with other platforms and devices.  The
networking market is a far more diverse market than the professional audio
market the Company has historically addressed and requires a different
marketing, sales, distribution and customer support strategy.  The Company has
limited experience selling, distributing or supporting products such as Sonic
MediaNet and Sonic LightSpeed, and there can be no assurance that the Company
will be able to establish the necessary distribution channels to sell and
support Sonic MediaNet or Sonic LightSpeed or that the Company will be
successful in marketing and selling Sonic MediaNet or Sonic LightSpeed or any of
its other new products in new market segments.  The Company expects expenses to
increase to support research and development and sales and marketing efforts
related to the Sonic LightSpeed product in 1998 and 1999.

DVD CREATOR

     The Company announced the DVD Creator product line in March, 1996, and
commenced limited shipments of DVD Creator in the quarter ending June 30, 1996.
DVD Creator includes three separable subsystems capable together of performing
all the tasks necessary for producing a finished DVD-Video premaster -- the byte
stream "image" which is replicated on manufactured DVD discs.

     The DVD-Video format offers content publishers a wide range of features and
options.  Video is presented in the MPEG-1 or MPEG-2 compressed digital video
format.  A number of video streams may be presented in parallel so that,
responding to user  commands, the player may seamlessly jump from stream to
stream.  Audio is available in both compressed digital stereo and "surround"
formats, as well as uncompressed "PCM" digital audio. Up to eight audio streams
may be presented simultaneously (and may also be selected for playback based on
real-time user decisions) -- to support different language dialog tracks, or to
allow stereo and surround versions of the same audio program.   Chapter marks
may be specified for random access into the video program.  Subpictures (images
overlaid on background video or still images) may be included and can be used in
a number of ways, for example,  to create animated "buttons" to facilitate user
interaction, or to display language subtitles.  Still pictures may be presented
with audio and with subpictures.   Extensive navigation capabilities are
available to permit users to select from various program branches, to return to
previous branch points or menus, etc.

                                       16
<PAGE>
 
     DVD Creator incorporates solutions for the major  steps involved in
preparing a title for DVD and permits customers to integrate these individual
solutions into a complete DVD workgroup via the Company's MediaNet networking
system.

  *  DVD STUDIO - The DVD-Video standard specifies MPEG-2 and MPEG-1 compressed
     digital video as the video formats to be used on DVD-Video discs. While a
     number of choices within the standard are possible, the typically preferred
     format is variable bit rate MPEG-2 operating at an average bit rate of
     approximately 4 Megabits per second./9/ DVD Creator includes DVD Studio, a
     system enabling professional users to compress input professional video
     into the MPEG-2 format. DVD Studio consists of plug in circuit cards for
     the Macintosh incorporating an MPEG encoding/decoding chipset developed by
     IBM. Sonic has developed an extensive suite of applications software for
     DVD Studio to support user control of the encoding process, and facilitate
     the operation of DVD Studio with standard professional video tape recorders
     and other typical peripherals.

  *  DVD STUDIO AUDIO SYSTEMS - The current audio offering within DVD Creator
     bundles a standard USP-based SonicStudio system, running on the Macintosh,
     with special software to perform Dolby Digital and MPEG-2 audio compression
     and audition. At the current time, real time compression of stereo Dolby
     Digital and stereo MPEG-2 audio is supported; encoding of 5.1 Dolby
     Digital/10/,/11/ is supported with an out-of-real time process. It is the
     Company's intention to support real time encoding of 5.1 Dolby Digital in
     the summer of 1997, using additional plug-in hardware to enable the
     process. At the present time there is some confusion in the market
     regarding the acceptance of MPEG-2 audio surround formats. Sonic has
     accordingly advised customers that it is the Company's intention to support
     encoding of such formats within DVD Creator if there is significant demand
     for them in the marketplace. Conventional sample rate PCM audio (48 kHz) is
     supported within the standard SonicStudio system included in every DVD
     Creator Audio System. DVD Creator customers may purchase as an option a
     special interface box and software supporting high resolution PCM.

  *  AUTHORING - DVD Creator's authoring subsystem is currently DVD-Producer,
     which the Company began shipping (in early versions) in September, 1997. In
     the authoring step individual compressed video, audio (compressed and/or
     uncompressed), graphics, still picture and subpicture elements are
     assembled, organized, linked with instructions specifying interactivity
     (i.e., the response DVD players will make based on user manipulation of
     front panel buttons or remote control buttons), combined and assembled into
     the final disc image. Because of the large number of possible elements in a
     DVD title, and the wide degree of interaction supported, DVD-Producer is a
     complicated software package. The current version of DVD-Producer runs on
     the Macintosh computer.

  *  EMULATION - Because of the complexity of a DVD title, and the absence,
     currently, of desktop DVD disc recording systems, users of DVD Creator
     require the ability to preview the results of their decision making before
     the time consuming and expensive step of cutting a "glass master" at the
     replication plant. An optional (software and hardware) emulation station
     permits the user to interact with a DVD title stored as project elements on
     hard disk prior to final image generation.

---------------------
/9/  Encoding at this bit rate permits an average feature-length movie (135
     minutes) to be encoded on a single layer of a single sided DVD disc.

/10/ The Company is a licensee of Dolby Laboratories both with respect to the
     Dolby Digital patents and with respect to the encoding software.

/11/ In this context "5.1" refers to the number of surround channels supported.
     In Dolby Digital surround audio 6 speakers are utilized, 5 for the main
     program channels -- Left Front, Center Front, Right Front, Left Rear (or
     "Left Surround"), and Right Rear (or "Right Surround") -- and 1 for the 
     sub-woofer optimized for playback of low frequency sound.

                                       17
<PAGE>
 
     DVD Creator is sold both as a complete package and as separable elements.
Customers may purchase a complete DVD Creator Workgroup system for $150,000, not
including host computers or disk storage (which typically would add $50,000 or
more to the cost of the system).  The Company's new DesktopDVD System designed
for the corporate market includes all software and hardware necessary to produce
DVD premasters on a single Macintosh, and carries a list price of $40,000.  The
DVD Studio system is available in a variety of configurations, ranging in price
from $30,000 to  $70,000.

CUSTOMERS

     The SonicStudio product line has been adopted by many professional audio
facilities around the world, with more than 3,700 SonicStudio systems shipped to
customers, as of March 31, 1998.  In addition to sales of SonicStudio direct to
end users or to dealers for resale to end users,  Sonic Studio is also sold on
an OEM basis to customers  who incorporate SonicStudio into products of their
own.  During fiscal year 1998, Sonic's largest such OEM relationship was with
Discreet Logic, which incorporates SonicStudio technology into its Flame(TM) and
Fire(TM) digital video processing and editing systems.

     Sonic MediaNet is sold to SonicStudio and DVD Creator customers as well as
to customers who use Sonic MediaNet with other applications, principally in the
pre-press graphic arts industry.  As of March 31, 1998, the Company had shipped
approximately 4,400 Sonic MediaNet cards.  Of these, approximately 3,100 were
shipped for use with applications other than with SonicStudio or DVD Creator.

     DVD Creator is sold to professional audio and video facilities, production
studios, as well as CD/DVD plants and corporate customers.  As of March 31, 1998
Sonic had shipped approximately 170 DVD Creator systems to customers in various
locations around the world (not all customers purchased all three subsystems of
DVD Creator).

     The Company is not materially dependent on any one customer and no customer
accounted for more than 10% of the Company's sales revenue during the fiscal
years ended March 31, 1996 or 1997;  Discreet Logic accounted for 10% of the
Company's sales revenue during the fiscal year ended March 31, 1998.

SALES AND DISTRIBUTION

SONICSTUDIO SALES AND DISTRIBUTION

     The Company sells its SonicStudio products through a network of dealers and
distributors augmented with sales and technical support provided by the
Company's headquarters and regional sales and support staff.  Generally, dealers
and distributors are assigned a territory, sometimes on an exclusive basis, for
part or all of the SonicStudio product line.  Sales leads are generated by the
Company's dealers and distributors, by the Company's regional sales managers,
and by the Company's advertising and other direct marketing activities.  The
Company works with dealers, distributors and customers to provide technical and
sales support as required to facilitate the sales process.

     The complexities of SonicStudio applications and the length of the typical
sales cycle require the Company's dealers and distributors to possess a high
level of technical aptitude, as well as adequate financial resources.  Only a
limited number of dealers and distributors possess the required technical
expertise and financial resources, and the Company has experienced difficulties
in identifying and establishing relationships with such dealers and
distributors.  The Company's business and financial performance may be
materially adversely affected by any failure of the Company's distributors and
sales force to achieve sales levels consistent with the Company's expectations.
This is particularly true with international dealers and distributors which
experience additional difficulties such as fluctuations in exchange rates,
difficulties in managing accounts receivable, tariff regulations, foreign safety
and radio 

                                       18
<PAGE>
 
frequency emissions regulations and difficulties in obtaining export
licenses. In addition, certain of the Company's dealers and distributors sell
products which may compete directly or indirectly with the Company's products.
There can be no assurance that these dealers and distributors will not devote
greater resources to selling products from other companies.  Failure of the
Company's dealers or distributors to successfully market the Company's products
could have a material adverse effect on the Company's results of operations.

     Currently, the Company has 18 dealers in the United States and 46 dealers
and distributors outside the United States covering more than 40 countries.  The
Company employs 6 regional sales managers and 3 field sales engineers in North
America, Europe and the Pacific Rim supported by a headquarters sales and sales
administration staff.

     In the 1997 fiscal year the Company opened a sales and support office in
London. In April 1997 the Company opened a sales and support office in Tokyo.

SONIC MEDIANET SALES AND DISTRIBUTION

     The Company sells Sonic MediaNet for use with SonicStudio systems through
its SonicStudio sales and distribution channel described above.  Sales of Sonic
MediaNet for applications other than the SonicStudio, principally graphic arts
applications, are made via a network of specialized dealers and a dedicated
sales force.

DVD CREATOR & DESKTOPDVD SALES AND DISTRIBUTION

     Since the market for DVD premastering is still quite new, the market is
somewhat specialized and the function of generating DVD premasters is complex
and unfamiliar to many video and audio professionals, the Company has not yet
established an extensive distribution structure for DVD Creator and DesktopDVD.
In the Americas, many sales are currently made directly to end users without
dealer assistance (except to provide peripheral packages upon customer request).
In Europe, the Company had appointed, by March 31, 1998, 9 dealers covering
certain territories within Europe, although certain sales were still handled
directly by the Company.  In the Pacific Rim, the Company had appointed 6
dealers for DVD Creator and DesktopDVD by March 31, 1998, with some significant
portion of sales handled directly by the Company's sales staff.

     The Company anticipates that in the future it will recruit additional
dealers for selling DVD Creator and DesktopDVD systems.  Depending on the
evolution of the Company's DVD product line, it may be desirable to establish
different dealer structures for various parts of the Company's DVD business.

CUSTOMER SUPPORT

     The Company believes that active customer support is important to
professional users, and has therefore made customer support an important part of
its strategy.  The Company offers the SonicCare maintenance program to
SonicStudio, DVD Creator and DesktopDVD customers.  Under this program customers
purchase annual service contracts which provide for ongoing software upgrades,
telephone support, replacement hardware and preferential access to new products
and upgrades.  Customers typically add a SonicCare option to their initial
system purchase.

     Sonic maintains a staff of product support specialists at the Company's
headquarters and in the field, supplemented by a "front line" third party
support group.  Unlimited telephone support is provided during scheduled support
hours to all customers under maintenance contract or initial system warranty.
Customer support calls also provide the Company with another means of
understanding 

                                       19
<PAGE>
 
customer requirements for future product enhancements. In addition, the Company
also administers a customer calling program in which customers are contacted by
a Sonic customer support representative to assess their level of satisfaction
and to acquaint them with new product offerings.

RESEARCH AND DEVELOPMENT

     The Company's research and development strategy continues to be to develop
high quality digital media product solutions and related tools for its target
markets.  The key to this strategy will continue to be the quality and tenure of
the Company's research and development personnel and the Company's management.
The Company's research and development staff consists of twenty-nine hardware
and software engineers with technical backgrounds in digital audio signal
processing, digital video image processing, distributed networking, and computer
systems design.

     Sonic's research and development program emphasizes development of
additional products or product enhancements to serve existing market segments as
well as extension of existing products to new markets and applications.  The
Company's development team exhibits a number of technology capabilities
including the following which the Company believes are particularly important in
light of the Company's strategy:

  *  DIGITAL SIGNAL PROCESSING - Sonic's engineering team is experienced at
     providing DSP solutions which address the quality and performance
     requirements of audio and video professionals.

  *  MEDIA MANIPULATION ARCHITECTURES - The Company's engineers are experienced
     in dealing with the requirements of high bandwidth, time synchronous
     multimedia data types in computer-based settings. The Company believes that
     this has resulted in products which provide cost effective solutions to
     multimedia data manipulation for professional applications.

  *  CRAFT FAMILIARITY - The Company's engineers are experienced in the needs
     and work patterns of audio, film and video professionals. The Company
     believes that this has resulted in products which adapt the power of
     digital technologies to the work habits of creative professionals.

     The markets for the Company's products are characterized by rapidly
changing technology, evolving industry standards and frequent new product
introductions.  The Company's future success will depend in part on its ability
to enhance its existing products and to introduce new products and features to
meet changing customer requirements and evolving industry standards.  The
Company's research and development efforts are subject to a number of risks, and
there can be no assurance that the Company's research and development efforts
will be successful or completed in a timely manner.  In addition, future Company
products and enhancements may contain undetected or unresolved errors which
could adversely impact market acceptance.  There can be no assurance that the
Company will successfully complete the development of these enhancements and
products or that the Company's products will achieve market acceptance.  Any
delay or failure to complete development of the Company's products and any
failure of the Company's products to achieve market acceptance would have a
material adverse effect on the Company's results of operations.

GEOGRAPHIC EXPOSURE; PACIFIC RIM SITUATION

     The Company has traditionally, and intends in the future, to realize a
significant percentage of its revenues in areas outside the United States.  For
instance, in some quarters non-U.S. revenue has constituted as much as 52% of
total Company revenues and it is possible that in the future the Company will
experience demand for its products outside the Untied States exceeding these
levels.  The Company is accordingly, highly exposed to factors which might make
it difficult to realize revenues outside the United States including currency
movements in which the U.S. dollar becomes significantly stronger with respect
to foreign currencies, import and export restrictions and duties which inhibit
demand, and 

                                       20
<PAGE>
 
liquidity problems in various foreign markets. In particular, in the quarters
ended December 31, 1997 and March 31, 1998, the Company experienced significant
problems closing business in the Pacific Rim area, especially in Korea. To the
extent that the Pacific Rim economies do not improve, it is likely that the
Company's results of operations will be significantly adversely affected.

COMPETITION

     The market for professional audio systems is highly competitive. The
Company encounters competition from a large number of companies offering
traditional analog production tools, digital tape oriented tools and
workstation-based tools.  Sonic generally competes against companies on the
basis of features, cost effectiveness and product quality, customer support, and
marketing and sales efforts.  Sonic competes with companies on different bases
depending on the nature of the competitor's products.  For example, when selling
against companies offering a traditional analog solution, the Company competes
on the basis of editing capability, industry trends to substitute digital
technologies for analog and potential return on investment through productivity
and quality gains.  When selling against companies offering digital tape-based
systems, the Company competes on the basis of speed and ease of editing and
processing, and economic and processing efficiencies afforded by workstations.
When selling against companies offering digital workstation solutions, the
Company competes on the basis of the power and effectiveness of its software
applications, the cost and availability of expansion through optional upgrades
and the customer's ability to maintain an integrated system and achieve
networking capabilities.

     Many of the Company's competitors have greater financial, technical and
marketing resources than Sonic.  Traditional professional audio competitors,
such as Japan Victor Corporation (JVC), Otari Corp., Sony Corporation and Studer
AG (a division of Harmon), which have a major share of the analog and digital
tape professional audio market, continue to sell analog and digital-tape based
systems.  A number of these competitors have introduced, or may be developing,
digital audio workstations which will compete more directly with Sonic's
products.  Divisions of Siemens AG (Siemens Audio) and the Carlton Companies
(SSL), among others, market relatively high end professional disk-based digital
audio systems which compete with the upper end and mid-range of Sonic's product
line.  Some independent companies and some divisions of large musical instrument
companies offer hard disk-based digital audio systems which compete with various
parts of Sonic's product line, including Avid Technology, Digidesign (a division
of Avid Technology), Fairlight, Spectral Synthesis (acquired by Euphonix),
Studio Audio and Design, Ltd. (Sadie), Studer Editech (a division of Harmon
International), and TimeLine Vista Inc. (WaveFrame), among others.  Alesis
Corporation and Tascam, Inc.  have recently introduced low cost multi-track
digital tape systems which compete with the lower end of Sonic's product line.
In addition, other companies manufacture various kinds of single function
digital audio processing devices which compete with the Company's noise
reduction, time compression and reverberation software options, for example,
noise reduction modules from Cambridge Audio Research (CEDAR) and time
compression, pitch shift, and reverberation modules from Lexicon (a division of
Harmon).  In the networking area, many companies provide FDDI- and CDDI-
compliant solutions, as well as solutions based on alternate network
technologies such as Asynchronous Transfer Mode (ATM) and "Fast" Ethernet,
which may compete with Sonic MediaNet.   Please see discussion "Products - Early
Sonic MediaNet Technology Transition Difficulties" beginning on Page 12.

     While the market for DVD premastering systems is still quite new, the
Company has already encountered significant competition from a number of
different kinds of companies. For example, a number of companies specialize in
MPEG video encoding, and many of these have introduced systems compliant with
the DVD-Video specification.  Among these are CagEnt, C-Cube Microsystems,
Digital Vision, Futuretel, Lucent, Minerva, 3DO, Philips, Matsushita,
Optivision, Optibase,  Toshiba, Pioneer, Zapex, and Nuko.  In addition, the
Company believes that other companies, not currently offering DVD-Video MPEG-2
video compression systems are likely to enter the market for such systems in the
foreseeable future. In the DVD-Audio area, Dolby Laboratories, Zapex, Minerva,
and other companies 

                                       21
<PAGE>
 
already offer, or have announced systems which perform Dolby Digital and/or 
MPEG-2 audio compression. Authoring systems for DVD-Video are available from 
or have been announced by Philips, Matsushita, Pioneer, Spruce Technologies, and
Hyundai, among others. The Company anticipates that there will be additional
competitors offering solutions in some or all of these areas in the near future.

     Sonic's competitors may be able to develop products comparable or superior
to those offered by the Company, or to adapt more quickly than the Company to
rapidly evolving market requirements and technologies.  In addition, other
companies possessing competitive technologies or which are active in the
Company's markets may attempt to develop products that compete with the
Company's products.  There can be no assurance that Sonic will be able to
continue to compete effectively in its markets, that competition will not
intensify or that future competition will not have a material adverse effect on
the Company's results of operations.

PROPRIETARY RIGHTS

     The Company's future success will depend in large part on its proprietary
technology.  The Company relies on a combination of trade secret, copyright law,
and trademark law, contracts and technical measures to establish and protect its
proprietary rights in its products.  The Company's products are generally sold
pursuant to purchase and license agreements which contain terms and conditions
restricting unauthorized disclosure of the proprietary software embodied in its
products.  The Company has applied in the United States for patents covering
certain of its technology and may apply for additional patents in the future.
There can be no assurance that the patents applied for or any additional patents
applied for by the Company will issue, or that any patents that may issue will
be valid and enforceable.  In addition, even if any such patents were
enforceable, the Company anticipates that any attempt to enforce its patents
will be time consuming and costly.

     Although the Company relies to a great extent on trade secret protection
for much of its technology, and has obtained confidentiality agreements from
most of its employees, there can be no assurance that third parties will not
independently develop the same or similar technology, obtain unauthorized access
to the Company's proprietary technology or misuse the technology to which the
Company has granted access.

     The Company believes that, due to the rapid proliferation of new
technologies in the audio, video and general software industries, intellectual
property protection of the Company's proprietary technology will be less
influential on the Company's ability to compete in its target markets than the
ability of the Company's research and development staff to design products that
continue to address evolving customer requirements, and the ability of the
Company to enter new markets and to service its customers.  In addition, the
Company has substantial international sales, and the laws of foreign countries
treat the protection of proprietary rights differently from, and may not protect
the Company's proprietary rights to the same extent as do, laws in the United
States.

     The status of United States patent protection in the software industry is
not well defined and will evolve as the United States Patent and Trademark
Office grants additional patents.  Patents have been granted recently on
fundamental technologies in the multimedia area and patents may issue which
relate to fundamental technologies incorporated into the Company's products.
Since patent applications in the United States are not publicly disclosed until
the patent issues, applications may have been filed which, if issued as patents,
would relate to the Company's products.  In addition, the Company has never
conducted a comprehensive patent search relating to all of the technology used
in its products.  Accordingly, there may be issued patents which relate to the
Company's products. There can be no assurance that any infringement claims will
not be made or that they will not be successful.  The Company could incur
substantial costs in defending itself and its customers against any such claims,
or in prosecuting infringement claims against third parties.  Furthermore,
parties making such claims may be able to obtain injunctive or other equitable
relief which could effectively block the Company's ability to 

                                       22
<PAGE>
 
sell its products in the United States and abroad, as well as substantial
damages. Such equitable relief could materially adversely effect the Company's
results of operations. In the event of a claim of infringement, the Company and
its customers may be required to obtain one or more licenses from third parties.
There can be no assurance that the Company or its customers could obtain
necessary licenses from third parties at a reasonable cost or at all. Failure to
obtain any such required license would have a material adverse effect on the
Company's results of operations.

     In this regard, the Company has been advised by a patent holder that Sonic
MediaNet infringes patents covering basic token ring technology. The Company
believes that Sonic MediaNet does not infringe such patents, and that if its
does, a license will be available on terms which are reasonable from the
Company's point of view.  However, there can be no assurance that such a license
agreement will be available on terms which will not have a material adverse
effect on the Company's results of operations.

     The Company has also been advised that its use of the "MediaNet" trademark
infringes the rights of the owner of the trademark "MediaNet" registered for a
product line in an application unrelated to the Company's business. The Company
has negotiated a non-financial settlement regarding the usage of the MediaNet
name with the owner of the registered trademark and the Company believes that
the settlement was concluded on terms which are reasonable from the Company's
point of view.

MANUFACTURING AND SUPPLIERS

     Sonic's hardware products are either manufactured under contract by various
electronics manufacturing and assembly houses in the San Francisco Bay Area or
are purchased as completed sub-assemblies from manufacturers.  Final assembly,
integration and testing is performed at Sonic's Novato, California facility.
Generally, Sonic's dealers or third parties supply the Macintosh computer for
use with the SonicStudio.

     The Company is dependent on sole-source suppliers for certain key
components used in its products, including DSP, AES/EBU audio
receiver/transmitter and FDDI chips, all manufactured by Motorola, Inc., SCSI
controller chips manufactured by NCR Corp., field programmable logic arrays
manufactured by Xilinx, Inc. and Altera,  MPEG encoding/decoding chipset
manufactured by IBM, CDDI modules manufactured by Cisco Systems, Inc., and
specialized static RAM manufactured by Integrated Device Technologies ("IDT"),
among others.  The Company purchases these sole-source components pursuant to
purchase orders placed from time to time, does not carry significant inventories
of these components and has no guaranteed supply agreements.  In December 1994,
the Company experienced shortages in certain key components (IDT Static RAM and
Motorola AES Transceivers) for the USP card, the SSP-3 card, and their
peripherals.  The USP card, the SSP-3 card and their peripherals have several
sole-sourced components and the Company cannot guarantee that adequate supplies
of these components will be available in future quarters.  The Company
experienced a supply limitation of DSP chips from Motorola, Inc., in the fall of
1993, which the Company was able to remedy by purchasing DSP chips from other
sources at greater cost.  Any extended future interruption or limitation in the
supply of any of the components currently obtained from a single source could
have a material adverse effect on the Company's results of operations.  Also,
because of the Company's reliance on these sole-source components, the Company
may be subject to increases in component costs which could have an adverse
effect on the Company's results of operations.  In the past, the Company has
scheduled introduction of certain products based on the scheduled availability
of components from third parties and has experienced delays in the timely
availability of these components.  If such delays occur in the future, the
introduction of the Company's proposed new products would be delayed and could
have a material adverse effect on the Company's results of operations.

     Early in the 1997 fiscal year the Company began exploring various
"outsourcing" alternatives for further streamlining its manufacturing
operations.  In the summer of 1996, the Company began shifting various hardware
products into an outsourcing arrangement with Time Electronics.  Under this

                                       23
<PAGE>
 
arrangement, Time is responsible for purchasing components, assembly into
circuit cards, and testing of hardware products.  Time's responsibility is to
produce according to forecast schedules provided by Sonic.  During the quarter
ended March 31, 1998, approximately 75% of all product shipped by Sonic during
the quarter were procured through this outsourcing program.  It is the Company's
current intention to continue to shift its production into outsourcing until
only new or prototype products are manufactured directly by the Company.  Sonic
expects that this point will be reached within the 1999 fiscal year.

     While an outsourcing approach presents a number of advantages to Sonic,
there are various risks that are an inherent part of such a program.  Chief
among these is that the Company's production is significantly dependent on a
single source.  Financial, operational, or supply problems encountered by Time
could result in Sonic's inability to obtain timely delivery of finished product.
Any such difficulties would adversely effect the Company's financial results.

BACKLOG

     The Company schedules production based on firm customer commitments and
anticipated orders.  The Company generally ships its products within one week of
acceptance of a customer purchase order and, accordingly, operates with only a
little or no backlog.  All orders are subject to cancellation or delay by the
customer with limited or no penalty.  The Company does not believe that the
level of backlog is an indicator of the Company's future performance.

EMPLOYEES

     At March 31, 1998, the Company had 78 full-time equivalent employees,
including 28 in marketing, sales and customer support, 29 in software and
hardware engineering, 11 in manufacturing and 10 in administration and finance.
The success of the Company's future operations depends in large part on the
Company's ability to recruit and retain engineers, technicians and other
professionals who are in considerable demand and the process of locating
technical, marketing, sales and management personnel with the combination of
skills and attributes required to execute the Company's strategy is often
lengthy.  The Company believes that it will need to hire additional technical
personnel in order to enhance its existing products and to develop new products.
If the Company is unable to hire additional technical personnel, the development
of new products and enhancements would likely be delayed.  The loss of the
services of these and other key personnel, particularly Robert J. Doris, Mary C.
Sauer and James A. Moorer, or the inability to attract new personnel, could have
a material adverse effect upon the Company's results of operations and research
and development efforts.  None of the Company's employees is represented by a
labor union and the Company has never experienced a work stoppage, slowdown, or
strike.  The Company considers its employee relations to be good.

ITEM 2.  PROPERTIES

     Sonic's principal administrative, sales and marketing, research and
development and support facility is located at 101 Rowland Way in Novato,
California and consists of approximately 30,000 square feet under a lease which
expires in 2001.

     Sonic also has sales offices located in London and Tokyo.

ITEM 3.  LEGAL PROCEEDINGS

     None.

                                       24
<PAGE>
 
ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     During the fourth quarter of the fiscal year ended March 31, 1998, the
Company did not submit any matters to a vote of its security holders.

SUPPLEMENTAL ITEM.  EXECUTIVE OFFICERS OF THE REGISTRANT

     The executive officers of the Company and their ages as of May 31, 1998 are
as follows:


<TABLE>
<CAPTION>
----------------------------------------------------------------------------------------------------------------- 
NAME                                  AGE      POSITION
-----------------------------------------------------------------------------------------------------------------
<S>                                  <C>       <C>
Robert J. Doris                       45       President (Chief Executive Officer) and Director
James A. Moorer                       52       Senior Vice President of Audio Development and Director
Mary C. Sauer                         45       Senior Vice President of Business Development and Director
A. Clay Leighton                      41       Vice President of Finance (Chief Financial Officer)
-----------------------------------------------------------------------------------------------------------------
</TABLE>
 
     ROBERT J. DORIS.  Mr. Doris founded Sonic Solutions in 1986 and has served
as President and Director of the Company since that time.  Prior to 1986 he was
President of The Droid Works, a subsidiary of Lucasfilm Ltd., which produced
computer-based video and digital audio systems for the film and television post-
production and music recording industries.  Prior to founding The Droid Works,
Mr. Doris was a Vice President of Lucasfilm and General Manager of the Lucasfilm
Computer Division.    Mr. Doris received B.A., J.D. and M.B.A. degrees from
Harvard University.  Mr. Doris is married to Ms. Sauer.

     JAMES A. MOORER.  Dr. Moorer joined Sonic Solutions in 1987 and has served
as a Vice President and Director of the Company since that time.  Dr. Moorer
became Senior Vice President of Audio Development in February 1993.  Dr. Moorer
was the principal developer of the NoNOISE and SonicStudio products.  From 1986
to 1987, Dr. Moorer consulted for NeXT, Inc., on DSP software architecture for
audio processing.  From 1985 to 1986, he was the Chief Technical Officer at The
Droid Works.  From 1980 to 1985, he was the digital audio project leader at
Lucasfilm, Ltd. Dr. Moorer holds a Ph.D. in Computer Science from Stanford
University and S.B. degrees in Applied Mathematics and Electrical Engineering
from MIT.  In 1991, he won the Audio Engineering Society Bronze Award for
lifetime achievement.

     MARY C. SAUER.  Ms. Sauer founded Sonic Solutions in 1986 and has served as
a Vice President and Director of the Company since that time.  Ms. Sauer became
Senior Vice President of Marketing and Sales in February 1993.  Prior to 1986,
Ms. Sauer was Vice President of Marketing for The Droid Works and prior to
joining The Droid Works, Ms. Sauer was Director of Marketing for the Lucasfilm
Computer Division.  Ms. Sauer received an M.B.A. in Finance and Marketing from
the Wharton School of the University of Pennsylvania and a B.F.A. from
Washington University in St. Louis.  Ms. Sauer is married to Mr. Doris.

     A. CLAY LEIGHTON.  Mr. Leighton joined Sonic Solutions in February 1993 as
Vice President of Finance.  Prior to joining Sonic, from January 1990 to July
1992 he was Vice President, Finance and CFO for RESNA Industries Inc., an
environmental services firm, and from August 1988 to December 1989 he was Vice
President, Finance and CFO for Command Data Systems, a software company
specializing in software for the public safety market.  Mr. Leighton has also
worked as strategy consultant for the Boston Consulting Group.  Mr. Leighton
received a B.A. from Wesleyan University and an M.B.A. from the Amos Tuck School
of Business Administration at Dartmouth College.

                                       25
<PAGE>
 
PART II

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

     The Company's common stock is listed on the Nasdaq National Market. As of
March 31, 1998 there were approximately 110 registered holders of the Company's
common stock.  The Company believes, however, that many beneficial holders of
its common stock have registered their shares in nominee or street name, and
that there are substantially more than 110 beneficial owners.  The low price and
high price of the Company's common stock during the last eight quarters, are as
follows:

<TABLE>
<CAPTION>
                                                                             Low Price          High Price
                                                                         -----------------  -------------------
<S>                                                                      <C>                <C>
     Quarter ended June 30, 1996.......................................             $6.375              $12.250
     Quarter ended September 30, 1996..................................             $5.250              $ 9.750
     Quarter ended December 31, 1996...................................             $5.625              $ 9.125
     Quarter ended March 31, 1997......................................             $5.375              $ 8.250
     Quarter ended June 30, 1997.......................................             $5.000              $ 6.750
     Quarter ended September 30, 1997..................................             $5.000              $10.625
     Quarter ended December 31, 1997...................................             $4.375              $10.250
     Quarter ended March 31, 1998......................................             $2.250              $ 3.750
</TABLE>

     The Company has not paid any dividends on its Common Stock during the
periods set forth above.  It is presently the policy of the Board of Directors
to retain earnings for use in expanding and developing the Company's business.
Accordingly, the Company does not anticipate paying dividends on the Common
Stock in the foreseeable future.

     On March 31, 1998, the Company issued 461,538 shares of its Series C
Preferred Stock (the "Series C Preferred Stock") to Hambrecht & Quist Guaranty
Finance, LLC, for an aggregate purchase price of $1,500,000, paid for by the
cancellation of indebtedness.  In connection with the foregoing sale of
securities, the Company relied on (i) the exemption from securities registration
afforded by Rule 506 under Regulation D ("Regulation D") as promulgated under
the Securities Act of 1933, and (ii) the purchaser of such securities
representations that it is a sophisticated investor and accredited investor with
the meaning of Regulation D.  The Series C Preferred Stock is currently
convertible to shares of the Company's Common Stock on a share-to-share basis
(the "Initial Conversion Rate") subject to adjustment for stock splits, stock
dividends or other similar transactions.  Subject to certain limitations, the
Initial Conversion Rate may be reduced if the Company sells or issues dilutive
equity securities at an effective purchase price of less than $3.00 per share.

                                       26
<PAGE>
 
ITEM 6.  SELECTED FINANCIAL DATA

     The following table sets forth selected financial data of the Company for
each of the years in the five year period ended March 31, 1998.  The selected
financial data should be read in conjunction with the Financial Statements and
Notes thereto and "Management's Discussion and Analysis of Financial Condition
and Results of Operations" included elsewhere herein.  The financial statements
for the periods ended March 31, 1994, 1995, 1996, 1997 and 1998 have been
audited by KPMG Peat Marwick LLP, independent certified public accountants.

<TABLE>
<CAPTION>
                                                                          Years Ended March 31,
                                                      --------------------------------------------------------------
                                                        1994       1995         1996          1997          1998
                                                      ---------  ---------  ------------  ------------  ------------
<S>                                                   <C>        <C>        <C>           <C>           <C>
                                                                   (in thousands except share amounts)
STATEMENT OF OPERATIONS DATA:
Net revenue.........................................     15,278     20,154       13,944        15,911        19,881
Cost of revenue.....................................      5,576      7,676        7,344         7,432        10,209
                                                         ------     ------       ------        ------        ------
Gross profit........................................      9,702     12,478        6,600         8,479         9,672
Operating expenses:
 Marketing and sales................................      3,891      5,198        5,873         6,000         7,257
 Research and development...........................      1,598      2,417        2,961         5,737         6,037
 General and administrative.........................      1,234      1,627        2,668         1,837         1,603
                                                         ------     ------       ------        ------        ------
       Total operating expenses.....................      6,723      9,242       11,502        13,574        14,897
                                                         ------     ------       ------        ------        ------
Operating income (loss).............................      2,979      3,236       (4,902)       (5,095)       (5,225)
Other income (expense)..............................         19        298          176           (96)         (651)
Pro forma provision for income taxes(1).............      1,025          -            -             -             -
                                                         ------
Provision (benefit) for income taxes................          -      1,000       (1,169)            -             -
                                                                    ------       ------        ------        ------
Pro forma net income(1).............................      1,973          -            -             -             -
                                                         ======
Net income (loss)...................................          -      2,534       (3,557)       (5,191)       (5,876)
                                                                    ======       ======        ======        ======
Pro forma net income per share(1)...................       0.31          -            -             -             -
                                                         ======
Basic net income (loss) per share...................          -       0.33        (0.48)        (0.69)        (0.76)
                                                                    ======       ======        ======        ======
Shares used in computing per share amounts..........      6,379      7,726        7,447         7,542         7,761
 
BALANCE SHEET DATA:
Working capital.....................................     12,343     13,529        8,384         6,263         1,164
Total assets........................................     18,644     21,712       16,107        15,889        12,630
Shareholders' equity................................     13,724     16,332       12,912         8,430         5,418
</TABLE>

_______________
 
   (1) The Company elected to be treated as an S Corporation for federal income
tax purposes for the period January 1, 1989 through July 31, 1993.  As such, the
Company did not pay federal income taxes during that period; the Company's
taxable income was included in the personal tax returns of the shareholders of
the Company.  The Statement of Operations Data includes a pro forma provision
for income taxes, computed at the effective corporate rate on the net income of
the Company of 34.2% for the fiscal year ended March 31, 1994.

                                       27
<PAGE>
 
ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

OVERVIEW; CERTAIN FACTORS THAT MAY IMPACT FUTURE RESULTS

     The Company commenced shipments of its Digital Audio Workstation, the
SonicStudio, in the first calendar quarter of 1989.  Sales of the SonicStudio
product line including Sonic developed software and Sonic manufactured hardware,
third party developed software and hardware peripheral devices and associated
maintenance fees, together with sales of Sonic MediaNet accounted for virtually
all of the Company's net revenue during the three fiscal years ended March 31,
1996, approximately 50% of the Company's net revenue during the fiscal year
ended March 31, 1997 and approximately 40% of the Company's net revenue during
the fiscal year ended March 31, 1998.  The Company believes there is little
growth in the overall market for professional audio equipment.  Sales of
products by Sonic have depended upon the substitution of digital audio
workstations for other existing technologies, and Sonic's ability to maintain or
increase sales will continue to depend in large part on the continued
substitution of digital audio workstations for other technologies.  In June,
1996, the Company began shipments of its DVD Creator system.  The Company's
future success will  depend in large part on sales of the DVD Creator system and
related products which accounted for approximately 50% of the Company's net
revenue in the fiscal year ended March 31, 1997, and 60% of the Company's net
revenue in the fiscal year ended March 31, 1998.

     SonicStudio is an integrated assembly of software, signal processing cards
and other Sonic manufactured hardware, as well as peripheral devices such as
disk drives and CD printers which are purchased as complete or largely complete
devices from other manufacturers.   SonicStudio is integrated with a Macintosh
computer which is not typically provided by the Company.  For the fiscal years
ending March 31, 1996, 1997 and 1998, the percentage of net revenue of
peripheral devices has declined from approximately 20% to 2% to 0% as the
Company has de-emphasized the sale of OEM hardware.

     In February of 1994, the Company began shipments of Sonic MediaNet, a high
performance, fully distributed networking system designed specifically to handle
digital audio, digital video, high resolution graphics and other multimedia data
types, for use with applications other than SonicStudio.  In the fiscal years
ended March 31, 1996, 1997 and 1998, Sonic MediaNet net revenue constituted
approximately 16%, 9% and 4% of Company net revenue.

     Sonic MediaNet allows users to share digital audio and other "multimedia"
data types efficiently among multiple workers in a facility.  Sonic MediaNet
consists of specialized network adapter plug in cards installed in the NuBus or
PCI bus of an Apple Macintosh computer.  Sonic MediaNet combines FDDI or CDDI
(fiber-based or copper-based) technology with a special file system running on
SCSI disks attached directly to the network cards.  This file system, called the
Media Optimized File System, addresses the needs of multimedia applications.  In
addition to its use in digital audio applications, Sonic MediaNet has uses in
other areas of the computer industry whenever work groups wish to collaborate on
applications which require high, sustained rates of data transfer, a high degree
of compatibility with conventional computing systems and some degree of
guaranteed bandwidth.

     In the last quarter of fiscal 1996, the Company became aware of competitive
announcements which would significantly reduce demand for Sonic MediaNet in the
prepress industry.   Based on these announcements, the Company began preparing
for transitioning the current Sonic MediaNet product, which included various
charges to the 1996 fiscal year results of operations, as discussed in "Products
- Sonic MediaNet; Charges Related to Technology Transition" beginning on Page
15.

     It is the Company's intention to introduce in fiscal 1999 a second
generation Sonic MediaNet product line, incorporating newer networking
technologies and supporting increased performance levels.  There can be no
assurance that the Company will be successful in developing such a product line,
or that, 

                                       28
<PAGE>
 
if successfully developed, such a second generation product line will be
attractive to customers when compared to other network product offerings.
Further, transition between the first generation and second generation product
lines may present a number of difficulties for the Company including slow sales
or returns of dealer stocks of the first generation product. Such difficulties
could have an adverse affect on revenues in future periods.

     DVD Creator is a premastering system for DVD discs incorporating the three
functions necessary to produce a finished DVD premaster image: video encoding,
audio encoding and authoring.  DVD Creator is sold both as a single workstation
or as a workgroup with separate subsystems linked together via the Company's
Sonic MediaNet networking system.  During June, 1996, the Company began shipping
the first installation phase of the DVD Creator system.   For the fiscal year
ended March 31, 1998, DVD Creator systems constituted approximately 60% of the
Company's net revenue.

     Sonic has announced its intention to deliver DestopDVD, a workstation aimed
at the corporate DVD market, in the first quarter of fiscal year 1999.   The
introduction of DesktopDVD is subject to a number of risks related to hardware
and software development, marketing, distribution and sales programs, and
customer support.  There can be no assurance that the Company has correctly
identified the corporate opportunity or that the Company will be able to
establish the necessary distribution channels to sell and support DVD-Corporate
products.  If the Company has failed to correctly identify the corporate
opportunity, or fails to develop, market, sell or support the product, the
Company's results of operations could be materially adversely affected.

     The Company's quarterly operating results vary significantly depending on
the timing of new product introductions and enhancements by the Company and its
competitors and on the volume and timing of orders, which are difficult to
forecast.  Customers generally order on an as-needed basis, and the Company
normally ships products within one week after receipt of an order.  The results
of operations for any quarter are not necessarily indicative of the results to
be expected for any future period.  A disproportionate percentage of the
Company's quarterly net revenue is typically generated in the last few weeks of
the quarter.  A significant portion of the Company's operating expenses is
relatively fixed, and planned expenditures are based primarily on sales
forecasts.  As a result, if revenue generated in the last few weeks of a quarter
do not meet with the Company's forecast, operating results may be materially
adversely affected.

     The Company capitalizes a portion of its software development costs in
accordance with Statement of Financial Accounting Standard No. 86.  Such costs
are amortized to cost of revenue over the estimated economic life of the
product, which is generally three years.  See Note 4 to Notes to Financial
Statements.

                                       29
<PAGE>
 
RESULTS OF OPERATIONS

     The following table sets forth certain items from the Company's statements
of operations as a percentage of net revenue for fiscal years 1996 through 1998:

<TABLE>
<CAPTION>
                                                                                        Years ended March 31,
                                                               --------------------------------------------------------------------
                                                                       1996                      1997                    1998
                                                               --------------------     --------------------    ------------------- 

<S>                                                                 <C>                       <C>                      <C>    
Net revenue..................................................          100.0%                    100.0%                  100.0%
Cost of revenue..............................................           52.7                      46.7                    51.4
                                                                      ------                    ------                   -----
Gross profit.................................................           47.3                      53.3                    48.6
Operating expenses:
     Marketing and sales.....................................           42.1                      37.7                    36.5
     Research and development................................           21.2                      36.1                    30.4
     General and administrative..............................           19.2                      11.5                     8.0
                                                                      ------                    ------                   -----
Total operating expenses.....................................           82.5                      85.3                    74.9
                                                                      ------                    ------                   -----
Operating income (loss)......................................          (35.2)                    (32.0)                  (26.3)
Other income (expense).......................................            1.3                      (0.6)                   (3.3)
Provision (benefit) for income taxes.........................           (8.4)                        -                       -
                                                                      ------                    ------                   -----
Net loss.....................................................          (25.5)  %                 (32.6)  %               (29.6)  %
                                                                      ======                    ======                   =====
</TABLE>



COMPARISON OF FISCAL YEARS ENDED MARCH 31

     Net Revenue.  Net revenue increased from $13,944,000 in fiscal 1996 to
$15,911,000 in fiscal 1997 and to $19,811,000 in fiscal 1998, representing an
increase of 14.1% and 24.5%, respectively. The increase in net revenue in fiscal
1997 is primarily due to the introduction of the Company's DVD Creator systems,
which is partially offset by the decrease in SonicStudio sales (including the
decrease in peripheral devices sold with SonicStudio systems) due to a general
weakness in sales of professional audio workstations, and a decrease in Sonic
MediaNet sales.  The Company began shipping its DVD Creator systems during the
quarter ended June 30, 1996.  The increase in net revenue in fiscal 1998 is
primarily due to the increased sales of DVD Creator systems, offset partially by
the continued decline in Sonic MediaNet sales.

     International sales accounted for 53%, 45% and 52% of net revenue for the
fiscal years ended March 31, 1996, 1997 and 1998, respectively.  See Note 10 of
Notes to Financial Statements.  International sales as a percentage of net
revenue decreased in fiscal 1997 primarily due to higher initial sales of DVD
Creator in North America.  International sales as a percentage of net revenue
increased in fiscal 1998 primarily due to increased sales of DVD Creator
overseas.  The Company expects that international sales will continue to
represent a significant percentage of future revenue.

     Cost of Revenue.   Cost of revenue, as a percentage of net revenue,
decreased from 52.7% for fiscal 1996 to 46.7% for fiscal 1997 and increased to
51.4% for fiscal 1998. The decrease in cost of revenue for fiscal year 1997 is
primarily due to the reduction of peripheral devices sold with SonicStudio
systems.  The margin on software and Sonic manufactured hardware is generally
over 60%, and the margin on peripheral devices is generally less than 30%.  In
fiscal year 1996 net revenue from peripheral devices was approximately 20% of
total net revenue and in fiscal year 1997 it was approximately 2%.  Cost of
revenue for the fiscal year 1997 included a charge of approximately $281,000 for
inventory write-down related to the discontinuance of the Sonic Cinema product
line (Sonic Cinema was a system for Video CD premastering and the predecessor to
DVD Creator.  See discussion Sonic Cinema & DVD Creator).  The increase in cost
of revenue for fiscal year 1998 is primarily due to the additional charges of
approximately $981,000 which were recorded during the fourth quarter, based upon
board decisions 

                                       30
<PAGE>
 
made during the fourth quarter, related to inventory and capitalized software
write-downs for discontinued and slower selling product lines.

     Marketing and Sales.  Marketing and sales expenses increased from
$5,873,000 in fiscal 1996 to $6,000,000 in fiscal 1997 and to $7,257,000 in
fiscal 1998.  Marketing and sales represented 42.1%, 37.7% and 36.5% of net
revenue for fiscal 1996, 1997 and 1998, respectively.  The Company's marketing
and sales headcount increased from thirty-one at March 31, 1996 to thirty-four
at March 31, 1997 and decreased to twenty-eight at March 31, 1998.  In fiscal
1997, marketing and sales increased primarily due to the increase in headcount
and the enhanced advertising and marketing related to the DVD Creator product
line.  In fiscal 1998, marketing and sales increased primarily due to the
continued enhancement of advertising and marketing related to the DVD Creator
product line and increased commission expense.  Included in the marketing and
sales expense is dealer and employee commission expense, which as a percentage
of net revenue increased from 4.2% in fiscal 1997 to 5.2% in fiscal 1998. The
increase in the dealer and employee commission expense, as a percentage of net
revenue, is primarily due to a shift in sales mix away from dealer sales (where
no commission is payable to dealers) to direct sales (which generally involves a
commission payable to dealers).


     Research and Development.  Research and development expenses increased
from $2,961,000 in fiscal 1996 to $5,737,000 in fiscal 1997 to $6,037,000 in
fiscal 1998.  Research and development represented 21.2%, 36.1% and 30.4% of net
revenue in fiscal 1996, 1997 and 1998, respectively.  The Company capitalizes a
portion of its software development costs in accordance with statement of
Financial Accounting Standard No. 86.  Research and development expenses
increased in dollar amounts in fiscal year 1997  due to an increase in the
number of software and hardware engineers from twenty-six at March 31, 1996 to
thirty-three at March 31, 1997.  In fiscal 1997, research and development
expenses also increased due to the significant increase of consulting and
prototype expenses associated with the development of the DVD Creator system.
Prototype and consulting expenses can fluctuate significantly from period to
period depending upon the status of hardware and software development projects.
In fiscal 1997, research and development, as a percentage of net revenue,
increased significantly due to the investment made in the DVD Creator system.
In fiscal 1998, research and development expenses increased slightly in dollar
amounts primarily due to continued investment in the development of the DVD
Creator system.   Research and development as a percentage of net revenue
decreased due to the increase in net revenue.


     General and Administrative.  General and administrative expenses
decreased from $2,668,000 in fiscal 1996 to $1,837,000 in fiscal 1997 and to
$1,603,000 in fiscal 1998.  General and administrative expenses represented
19.2%, 11.5% and 8.0% of net revenue in fiscal 1996, 1997 and 1998,
respectively.  Included in the fiscal year 1996 amount is a charge of $570,000
related to the unexpectedly early technology transition in the Company's Sonic
MediaNet product line.  Please see discussion "Products - Sonic MediaNet;
Charges Related to Technology Transition" beginning on Page 15. The decrease in
general and administrative expense for fiscal year 1998 is primarily due to the
reduction in bad debt and other general expenses.  The Company anticipates that
general and administrative expenses will increase in the future as the Company's
operations expand.


     Other Income, Net.  Other income for fiscal year ended March 31, 1996
is primarily due to interest income received on investments which were purchased
with cash not immediately needed for operations.   Other expense for fiscal
years ended March 31, 1997 and 1998 is due to the interest expense associated
with the debt financing agreements with entities associated with Hambrecht &
Quist and with borrowings under the bank line of credit, which is partially
offset by the interest income received on investments.

                                       31
<PAGE>
 
     Provision for Income Taxes.  The Company has presented a provision
(benefit) for income taxes (for fiscal year 1996), computed at the combined
federal and state effective corporate rate in accordance with Statement of
Financial Accounting Standards No. 109.  The tax benefit for fiscal 1996 related
to the amount the Company expected to recover in a federal income tax refund.  A
valuation allowance has been provided for deferred tax assets for which recovery
would depend upon future taxable income.  During the fiscal year ended March 31,
1996, the Company exhausted it's loss carryback capabilities, therefore, no
benefit was recorded during fiscal year 1997 and 1998.


     The Company accrues quarterly for income taxes based upon its projection of
its full year tax liability.  This may result in adjustments based on the actual
full year results.

     Liquidity and Capital Resources. In fiscal 1994 the Company completed a
private sale of equity securities and an initial public offering of Common Stock
which generated net proceeds of approximately $10 million after all expenses and
a one time special distribution to the former subchapter S Corporation
shareholders.

     In December, 1996, the Company entered into a Loan and Security Agreement
with Silicon Valley Bank.  The current agreement provides for up to $1,500,000
in available borrowings based upon the Company's eligible accounts receivable
balances, and expires in May, 1999.  This Agreement provides for a variety of
covenants, including among other things, that the Company maintain certain
financial ratios and is collateralized by a security interest in substantially
all of the Company's assets.  Interest on borrowings under this agreement is
payable monthly at a rate between three-quarters percent and two and one half
percent  in excess of the prime rate.  On March 31, 1998 $500,000 was
outstanding.

     In December, 1996, the Company also obtained a $5,100,000 financing
facility with entities associated with Hambrecht & Quist.  The facility included
subordinated debt and equipment financing.  In December, 1996, the Company
received $3,000,000 from Hambrecht & Quist Transition Capital, LLC and
$1,100,000 from Hambrecht & Quist Guaranty Finance, LLC, pursuant to the above
facility.  The remaining $1,000,000 was a master lease line for financing of
future capital asset purchases.  The facility with the Hambrecht & Quist
entities is secured by an interest in the Company's fixed assets and
substantially all of the assets of the Company subordinate to the Silicon Valley
Bank Agreement.  In connection with the financing facility, the Company issued
warrants to purchase 260,200 common shares to entities associated with Hambrecht
& Quist.  The Hambrecht & Quist entities may exercise 130,100 shares at an
exercise price of $10.00 at any time on or before December 24, 2004, and 130,100
shares at an exercise price of $7.00 at any time on or after December 24, 1997
and before December 24, 2004.  In December, 1997, 130,100 of the $7.00 warrants
were exercised on a "net" basis, and the warrant holder received 40,266 shares
of Common Stock.  The Company recorded $549,000 of deferred interest, which will
be amortized to interest expense over the term of the financing facility,
attributable to the value of the warrants. The value of the warrants was 
estimated using the following assumptions for fiscal 1998 and 1997; volatility 
of .75, risk free interest rate of 6.3% and expected life equal to the 
contractual terms. 

     In December, 1997, the Company secured a $7,000,000 equity-based line of
credit.  Under this arrangement, the Company has the right to draw up to a total
of $7,000,000 in cash in exchange for the Company's common stock.  Pricing of
the common stock issued will be based on the market price of the Company's
common stock at the time of a draw.  The timing and amount of individual draws
are at the sole discretion of the Company, subject to a number of conditions.
The line will remain in place for a period of approximately 24 months.  The
Company filed a registration statement for the resale of shares issued under
this arrangement in January, 1998.  During the quarter ended March 31, 1998, the
Company drew down $1,450,000 on this equity-based line of credit and issued
606,130 shares of common stock.

     In March, 1998, the Company renegotiated its financing arrangement with
Hambrecht & Quist Guaranty Finance.  The agreements reached involve the
restructuring of $3,000,000 debt into $1,500,000 of convertible preferred stock
and $1,500,000 of lower interest debt due in October 1999.  The Company has

                                       32
<PAGE>
 
filed a Form S-3 Registration Statement under the Securities Act of 1933 to
register the 461,538 shares of the Company's Common Stock which underlie the
Series C Preferred Stock issued to Hambrecht & Quist Guaranty Finance.  In
connection with the agreement, the exercise price of 90,000 of the $10.00
warrants issued in connection with the original arrangement reached in December
1996 was changed to $3.25.

     The Company's operating activities have used cash of $2,591000, $34,000 and
$1,412,000 in fiscal 1996, 1997 and 1998, respectively.   During fiscal years
1996 and 1997, cash was used primarily to fund the operating loss.  During
fiscal year 1997 the cash used to fund the operating loss was substantially
offset by the improvement in collection of receivables and the receipt of an
income tax refund.  During fiscal year 1998 the cash used to fund the operating
loss was partially offset by the raising of $1,450,000 of equity through the
equity line of credit.  The management of the Company believes that existing
cash, cash equivalents and short term investments, available credit and cash
generated from operations will be sufficient to meet the Company's cash and
investment requirements through at least fiscal 1999.

     As of March 31, 1998, the Company had cash, cash equivalents and short term
investments of $2,479,000 and working capital of $1,164,000.

     Impact of Year 2000 Issue:  The year 2000 issue is the result of computer
programs being written using two digits rather than four to define the
applicable year.  Any of the Company's computer programs that have date-
sensitive software may recognize a date using "00" as the year 1900 rather than
the year 2000.  This could potentially result in a system failure or
miscalculations causing disruptions of operations, including, among other
things, a temporary inability to process transactions, send invoices, or engage
in other similar normal business activities.  The Company has ensured that its
software is already year 2000 compliant, as such this issue is not expected to
have a material effect on the operations of the Company.  Nevertheless, the
Company cannot predict the effect of the year 2000 problem on the vendors,
customers and other entities with which the Company transacts business, or with
whose products the Company's products interact and there can be no assurance
that the effect of the year 2000 issue on such entities will not adversely
effect the Company's operations.  The Company believes that all current versions
of its product lines are Year 2000 compliant.

     Forward Looking Statements.  Certain statements in this Form 10-K,
including statements contained herein under the caption "Management's Discussion
and Analysis of Financial Condition and Results of Operations", constitute
"forward-looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995.  Such forward looking statements involve known
and unknown risks, uncertainties and other factors which may cause the actual
results, performance or achievements of the Company to be materially different
from any future results, performance or achievements express or implied by such
forward-looking statements.  Such factors include, but are not limited to the
following:  general economic and business conditions; charges and costs related
to acquisitions; and the ability of the Company to develop and market products
for the markets in which it operates, to successfully integrate its acquired
products and services, to adjust to changes in technology, customer preferences,
enhanced competition and new competitors in the markets in which it operates.

                                       33
<PAGE>
 
ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA


          The Report of Independent Auditors, Financial Statements and Notes to
Financial Statements follow on pages 35 through 50.

                                       34
<PAGE>
 
                        INDEPENDENT AUDITORS' REPORT



The Board of Directors
Sonic Solutions:

We have audited the financial statements of Sonic Solutions as listed in the
accompanying index in Item 14(a)1. In connection with our audits of the
financial statements, we also have audited the financial statement schedule as
listed in accompanying index Item 14(a)2. These financial statements and
financial statement schedule are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements and
financial statement schedule based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Sonic Solutions as of March 31,
1997 and 1998 and the results of its operations and its cash flows for the each
of the years in the three-year period ended March 31, 1998, in conformity with
generally accepted accounting principles.  Also in our opinion, the related
financial statement schedule, when considered in relation to the basic financial
statements taken as a whole, presents fairly, in all material respects, the
information set forth therein.



                                  KPMG Peat Marwick LLP


Oakland, California
April 24, 1998


                 See accompanying Notes to Financial Statements

                                       35
<PAGE>
 
                               SONIC SOLUTIONS
                               

                                BALANCE SHEETS
              (in thousands, except share and per share amounts)

<TABLE>
<CAPTION>
                                                                                                     March 31,
                                                                                         -------------------------------
                                    ASSETS                                                     1997            1998
                                    ------                                               ----------------  -------------
<S>                                                                                      <C>               <C>
Current assets:
    Cash and cash equivalents..........................................................          $ 4,806          2,479
    Accounts receivable, net of allowance for returns and doubtful accounts of $588
     and $617 at March 31, 1997 and 1998, respectively.................................            3,105          3,198

   Inventory...........................................................................            1,275            634
   Refundable income taxes.............................................................              450            148
   Prepaid expenses and other current assets...........................................              719            317
                                                                                                 -------        -------
      Total current assets.............................................................           10,355          6,776
Fixed assets, net......................................................................            3,154          2,766
Purchased and internally developed software costs, net.................................            1,954          2,944
Other assets...........................................................................              426            144
                                                                                                 -------        -------

      Total assets.....................................................................           15,889         12,630
                                                                                                 =======        =======

                    LIABILITIES AND SHAREHOLDERS' EQUITY
                    ------------------------------------
Current Liabilities:
   Accounts payable and accrued liabilities............................................          $ 2,971          3,315
   Bank note payable...................................................................                -            500
   Deferred revenue and deposits.......................................................              705          1,036
   Subordinated debt, current portion..................................................              347            623
   Current portion of obligations under capital leases.................................               69            138
                                                                                                 -------        -------

      Total current liabilities........................................................            4,092          5,612

Subordinated debt, net of current portion..............................................            3,195          1,364
Obligations under capital leases, net of current portion...............................              172            236
                                                                                                 -------        -------
      Total liabilities................................................................            7,459          7,212
                                                                                                 -------        -------
Commitments and contingencies
Shareholders' Equity:
Preferred stock, no par value, 10,000,000 shares authorized: 0 and 461,538
  shares issued and outstanding at March 31, 1997, and 1998, respectively..............                -          1,500
Common stock, no par value, 30,000,000 shares authorized; 7,595,897
 and 8,302,230  shares issued and outstanding at March 31, 1997 and
 1998, respectively....................................................................           13,840         15,204
Accumulated deficit....................................................................           (5,410)       (11,286)
                                                                                                 -------        -------

   Total shareholders' equity..........................................................            8,430          5,418
                                                                                                 -------        -------

   Total liabilities and shareholders' equity..........................................          $15,889         12,630
                                                                                                 =======        =======
</TABLE>
                       See accompanying Notes to Financial Statements

                                       36
<PAGE>
 
                                SONIC SOLUTIONS

                           STATEMENTS OF OPERATIONS
                   (in thousands, except per share amounts)

<TABLE>
<CAPTION>
                                                                                     Years Ended March 31,
                                                                         --------------------------------------------
                                                                             1996           1997            1998
                                                                         -------------  -------------  --------------
<S>                                                                      <C>            <C>            <C>
Net revenue............................................................      $ 13,944         15,911          19,881

Cost of revenue........................................................      --------         ------          ------
                                                                                7,344          7,432          10,209
                                                                             --------         ------          ------

                                                                                6,600          8,479           9,672
Gross profit...........................................................      --------         ------          ------

Operating expenses:
 Marketing and sales...................................................         5,873          6,000           7,257
 Research and development..............................................         2,961          5,737           6,037
 General and administrative............................................         2,668          1,837           1,603
                                                                             --------         ------          ------

 Total operating expenses..............................................        11,502         13,574          14,897
                                                                             --------         ------          ------

 Operating loss........................................................        (4,902)        (5,095)         (5,225)

Other income (expense), net............................................           176            (96)           (651)
                                                                             --------         ------          ------

 Loss before income taxes..............................................        (4,726)        (5,191)         (5,876)

Provision (benefit) for income taxes...................................        (1,169)             -               -
                                                                             --------         ------          ------

 Net loss..............................................................       ($3,557)        (5,191)         (5,876)
                                                                             ========         ======          ======


 Basic and diluted loss per common share...............................        ($0.48)         (0.69)          (0.76)
                                                                             ========         ======          ======

 Shares used in computing per share amounts............................         7,447          7,542           7,761
                                                                             ========         ======          ======
</TABLE>

                        See accompanying Notes to Financial Statements

                                       37
<PAGE>
 
                              SONIC SOLUTIONS

                      STATEMENTS OF SHAREHOLDERS' EQUITY


                               (in thousands)


<TABLE>
<CAPTION>

                                                                                                 
                                                                                                  Unrealized       
                                            Preferred stock    Common stock                       Gain (Loss)        Total
                                           -----------------    ------------        Accumulated       on          Shareholders'
                                           Shares     Amount  Shares   Amount         deficit     Investments        Equity
                                           ------     ------  ------   ------         -------     -----------        ------
<S>                                     <C>       <C>        <C>         <C>        <C>         <C>                 <C>
Balances at March 31, 1995............       ---        ---    7,380   $12,990          3,338               4        16,332
  Exercise of common stock options....       ---        ---      114       143            ---             ---           143
  Unrealized loss on investments......       ---        ---      ---       ---            ---              (6)           (6)
  Net loss............................       ---        ---      ---       ---         (3,557)            ---        (3,557)
                                        --------  ---------    -----   -------        -------   -------------        ------

Balances at March 31, 1996............       ---        ---    7,494    13,133           (219)             (2)       12,912
  Exercise of common stock options....       ---        ---      102       158            ---             ---           158
  Unrealized gain on investments......       ---        ---      ---       ---            ---               2             2
  Issuance of warrants................       ---        ---      ---       549            ---             ---           549
  Net loss............................       ---        ---      ---       ---         (5,191)            ---        (5,191)
                                        --------  ---------    -----   -------        -------   -------------        ------

Balances at March 31, 1997............                         7,596    13,840         (5,410)            ---         8,430
  Exercise of common stock options....      ---        ---       50        84            ---             ---            84
  Issuance of preferred stock.........      462      1,500      ---       ---            ---             ---         1,500
  Equity line of credit issuances.....      ---        ---      618     1,253            ---             ---         1,253
  Issuance of warrants................      ---        ---      ---        27            ---             ---            27
  Exercise of warrants................      ---        ---       38       ---            ---             ---           ---
  Net loss............................      ---        ---      ---       ---         (5,876)            ---        (5,876)
                                        --------  ---------    -----   -------        -------   -------------        ------

Balances at March 31, 1998............       462      1,500    8,302   $15,204        (11,286)             --         5,418
                                        ========  =========    =====   =======        =======   =============        ======
</TABLE>

                  See accompanying Notes to Financial Statements

                                       38
<PAGE>
 
                                SONIC SOLUTIONS
                            STATEMENTS OF CASH FLOWS
                                 (in thousands)
<TABLE>
<CAPTION>
                                                                                           Years Ended March 31,
                                                                                 ----------------------------------------- 
                                                                                    1996          1997           1998
                                                                                 -----------  -------------  -------------
<S>                                                                              <C>          <C>            <C>
Cash flows from operating activities:
Net loss.......................................................................     ($3,557)        (5,191)        (5,876)
Adjustments to reconcile net loss  to net cash used in operating activities:
Depreciation and amortization..................................................         900          1,693          2,255
Provision for returns and doubtful accounts, net...............................         880            190             29
Changes in operating assets and liabilities:
  Accounts receivable..........................................................       1,625            806           (122)
  Inventory....................................................................         886            606            641
  Refundable income taxes......................................................      (1,600)         1,150            450
  Prepaid expenses and other current assets....................................         107           (243)           254
  Other assets.................................................................         (96)           181            282
  Accounts payable and accrued liabilities.....................................      (1,717)           218            344
  Deferred revenue and deposits................................................        (116)           263            331
  Income taxes payable.........................................................         (37)          ----           ----
  Deferred income taxes........................................................         134            293           ----
                                                                                   --------         ------         ------
    Net cash used in operating activities......................................      (2,591)           (34)        (1,412)
                                                                                   --------         ------         ------
Cash flows from investing activities:
  Purchase of fixed assets.....................................................      (1,673)        (1,462)          (787)
  Additions to purchased and internally developed software.....................        (577)        (1,112)        (1,849)
  Redemption/maturities of short-term investments..............................       5,103          2,108           ----
                                                                                   --------         ------         ------
    Net cash provided by (used in) investing activities........................       2,853           (466)        (2,636)
                                                                                   --------         ------         ------
Cash flows from financing activities:
  Proceeds from exercise of common stock options...............................         143            158             84
  Proceeds from issuances of subordinated debt.................................          --          3,542            ---
  Repayments of subordinated debt..............................................          --             --            (55)
  Proceeds from equity line financing..........................................          --             --          1,392
  Borrowings on line of credit.................................................       3,700            ---            500
  Repayments of line of credit.................................................      (3,700)           ---            ---
  Principal payments on capital leases.........................................          --            (29)           (88)
  Redemption of warrants.......................................................          --             --           (112)
  Proceeds from issuance of warrants...........................................          --            549             --
                                                                                   --------         ------         ------
    Net cash provided by financing activities..................................         143          4,220          1,721
                                                                                   --------         ------         ------
Net increase (decrease) in cash and cash equivalents...........................         405          3,720         (2,327)
Cash and cash equivalents, beginning of year...................................         681          1,086          4,806
                                                                                   --------         ------         ------
Cash and cash equivalents, end of year.........................................    $  1,086          4,806          2,479
                                                                                   ========         ======         ======
Supplemental disclosure of cash flow information:
  Interest paid during year....................................................    $     28            106            265
                                                                                   ========         ======         ======
  Income taxes paid during year................................................    $    345            ---             13
                                                                                   ========         ======         ======
  Noncash financing and investing activities:
    Assets acquired through capital lease......................................    $    ---            270            221
                                                                                   ========         ======         ======
</TABLE> 
                                       39
<PAGE>
<TABLE> 
<S>                                                                                <C>              <C>            <C>  
    Conversion of subordinated debt to preferred stock.........................    $    ---            ---          1,500
                                                                                   ========         ======         ======
</TABLE>






                 See accompanying Notes to Financial Statements

                                       40
<PAGE>
 
                                SONIC SOLUTIONS

                         NOTES TO FINANCIAL STATEMENTS
                         March 31, 1996, 1997 and 1998

(1)  SUMMARY OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES

  (a)  Operations

  Sonic Solutions (the Company) designs, develops, manufactures and markets
digital tools for professionals who manipulate media - sound, images, moving
pictures and text - in computer based settings. SonicStudio(TM) is a line of
digital audio random access editing and processing systems, commonly known as
Digital Audio Workstations.  SonicStudio systems are used by a wide range of
audio professionals to prepare recorded sound for release on Digital Audio
Compact Discs, for inclusion in film and video sound tracks, and for broadcast
on radio and television. The Company's Sonic MediaNet and Sonic LightSpeed
product is a high speed local area network and file management system that is
optimized for management of data intensive file transfers typically required in
digital video, digital audio, computer graphics and desktop publishing.  The
Company's DVD Creator product line is a complete workgroup solution for DVD
premastering.  It includes MPEG-2 video encoding, audio preparation and disc
authoring, layout, and formatting.  The Company's products generally include
application software and specialized hardware installed on a personal computer.
The Company's products are designed to improve the productivity and
effectiveness of media professionals, enabling them to process and manipulate
more material in a given amount of time and to achieve results which would have
been impossible using traditional linear analog or digital technology.

  A summary of significant accounting policies applied in the preparation of the
accompanying financial statements of the Company follows:

  (b)  Use of Estimates and Certain Concentrations

  The preparation of financial statements in accordance 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
reported amounts of revenues and expenses during the period.  Actual results
could differ from those estimates.

  The Company is dependent on sole-sourced suppliers for certain key components
used in its products.  The Company purchases these sole-source components
pursuant to purchase orders placed from time to time, does not carry significant
inventories of these components, and has no guaranteed supply agreements.  Any
extended future interruption or limitation in the supply of any of the
components obtained from a single source could have a material adverse effect on
the Company's results of operations.

  The Company's products are primarily compatible with Macintosh personal
computers.  Although the Company plans to introduce new products compatible with
other computer platforms in the future, the financial results of the Company
could be materially adversely affected should the industry no longer support the
Macintosh platform prior to the new products release.

                                       41
<PAGE>
 
  (c)  Revenue Recognition

  Revenue is derived from product sales and maintenance contracts.  Revenue from
product sales is recognized upon shipment of the products.  Revenue from
software maintenance, including maintenance bundled with the product sale, is
recognized on a straight-line basis over the term of the agreement, generally
one year.

  Revenue from sales to distributors and dealers may be subject to agreements
allowing limited rights of return and exchange.  Accordingly, the Company
provides reserves for estimated future returns and exchanges at the time of the
sale as a reduction of revenue.

  In the years ended March 31, 1996 and 1997 no single customer accounted for
more than 10% of revenue.  In the year ended March 31, 1998, one customer
accounted for 10% of revenue.

  Cost of revenue includes hardware product costs, third party hardware costs,
amortization of capitalized software and third party software royalties.

  (d)  Cash Equivalents

  Cash equivalents consist of short-term, highly-liquid investments with
remaining maturities of ninety days or less at the date of acquisition.  Cash
equivalents are generally invested in money market funds.

  (e)  Inventory

  Inventory is valued at the lower of cost, determined on a first-in, first-out
basis, or market.  Inventory consists of raw materials, work in process and
original equipment manufacturer's goods.

  (f)  Fixed Assets

  Fixed assets consist of furniture and equipment and are recorded at cost.
Equipment under capital leases is stated at the present value of minimum lease
payments at the inception of the lease.  Depreciation of furniture and equipment
is provided using the straight-line method over the estimated useful lives of
the respective assets which are generally three to five years.  Equipment held
under capital leases is amortized over the shorter of the lease term or the
estimated useful life of the asset.

  (g) Purchased and Internally Developed Software Costs

  Subsequent to attaining technological feasibility in accordance with Statement
of Financial Accounting Standards No. 86 Accounting for the Costs of Computer
Software to be Sold, Leased, or Otherwise Marketed, purchased software and
software product development costs are capitalized when a product's 
technological feasibility has been established and then is amortized over a
future period.  Amortization begins when a product is available for general 
release to customers. Amortization of capitalized software costs, for both
internally developed and purchased software products, is computed on a straight-
line basis over the estimated economic life of the product, which is generally
three years, or the ratio of current revenue to the total of current and
anticipated future revenue, whichever is greater. All other research and
development expenditures are charged to research and development expense in the
period incurred.

  (h)  Income Taxes

  The Company accounts for income taxes under the asset and liability method
of accounting.  Under the asset and liability method, deferred tax assets and
liabilities are recognized based on the future tax consequences attributable to
differences between the financial statement carrying amount of existing assets
and liabilities and their respective tax bases.

  (i)  Basic and diluted loss per share

                                       42
<PAGE>
 
  The Financial Accounting Standards Board (FASB) recently issued SFAS No. 128,
Earnings Per Share.  SFAS No. 128 requires the presentation of basic net income
per share, and for companies with complex capital structures, diluted net income
per share.  Prior periods should be restated to conform to SFAS No. 128,
however, as the Company had a net loss in the prior periods, basic and diluted
loss per share are the same as the previously presented primary loss per share.

  Excluded from the computation of diluted loss per share for 1998 are options 
to acquire 640,809 shares of common stock with a weighted average exercise price
$2.82 because their effects would be anti-dilutive. 

  The following tables set forth the computations of shares and net loss used
in the calculation of basic and diluted net loss per share for the years ended
March 31, 1996, 1997 and 1998 (in thousands, except per share data):



<TABLE>
<CAPTION>
                                                                               Year Ended March 31,
                                                       -------------------------------------------------------------------
                                                               1996                   1997                   1998
                                                       ---------------------  ---------------------  ---------------------
<S>                                                    <C>                    <C>                    <C>
Net loss.............................................               ($3,557)                (5,191)                (5,876)
                                                                    =======                 ======                 ======
Weighted average number of
 common shares outstanding...........................                 7,447                  7,542                  7,761
Number of common stock
 equivalents as a result of stock
 options outstanding using the
 treasury stock method...............................                    --                     --                     --
            Total....................................                 7,447                  7,542                  7,761
                                                                    =======                 ======                 ======
Primary and fully diluted net loss
 per share...........................................                ($0.48)                 (0.69)                 (0.76)
                                                                    =======                 ======                 ======
</TABLE>


  (j)  Concentrations of Credit Risk

  Financial instruments which potentially subject the Company to concentrations
of credit risk are trade receivables. The Company manufactures and sells its
products to customers who are primarily audio and video and graphic arts
professionals who prepare sound, video and graphics for use in the music
recording, video, film and broadcast and printing industries or for corporate 
in-house use and to dealers who support such customers. Management believes that
any risk of credit loss is significantly reduced due to the diversity of its end
users and their dispersion across many geographic sales areas. The Company
maintains an allowance for doubtful accounts to provide against potential credit
losses.

  (k)  Stock-Based Compensation

  The Company has various stock-based compensation plans, as discussed
in Note 7.  The Company has accounted for the effect of its stock based
compensation plans under Accounting Principles Board Opinion No. 25, Accounting
for Stock Issued to Employees.  The Company has elected to adopt only the
disclosure based requirements of Statement of Financial Accounting Standards No.
123 Accounting for Stock-Based Compensation and as such has disclosed the pro
forma effects on net income (loss) and net income (loss) per share data as if
the Company had elected to use the fair value approach to account for all its
employee stock-based compensation plans.

  (l) Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed Of

  The Company adopted the provisions of SFAS No. 121, "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of", in
fiscal 1997. SFAS No. 121 requires that long-lived assets and certain
identifiable intangibles be reviewed for impairment whenever events or changes
in circumstances indicate that the carrying amount of an asset may not be
recoverable. Recoverability of assets to be held and used is measured by
comparison of the carrying amount of an asset to future net cash flows expected
to be generated by the asset. If such assets are considered to be impaired, the
impairment to be recognized is measured by the amount by which the carrying
amount of the assets exceed the fair value of the assets. Assets to be disposed
of are reported at the lower of the carrying amount or fair value less costs to
sell. The adoption of SFAS No. 121 did not have a material impact on the
Company's financial position, results of operations, or liquidity.

                                       43
<PAGE>
 
  (m)  New Accounting Pronouncements

  SFAS 131 "Disclosures About Segments of an Enterprise and Related
Information", is effective for years beginning after December 15, 1997 and early
adoptions is encouraged. The Company will adopt this standard in the next fiscal
year.

  SFAS No. 130 establishes standards for the reporting and disclosure of
comprehensive income and its components which will be presented in association
with a company's financial statements.  Comprehensive income is defined as the
change in a business enterprise's equity during a period arising from
transactions, events or circumstances relating to nonowner sources, such as
foreign currency translation adjustments and unrealized gains or losses on
available-for-sale securities.  It includes all changes in equity during a
period except those resulting from investments by or distributions to owners.

  In October 1997, the American Institute of Certified Public Accountants issued
SOP 97-2, Software Revenue Recognition. The statement provides specific industry
guidance and stipulates that revenue recognized from software arrangements is to
be allocated to each element of the arrangement based on the relative fair
values of the elements, such as software products, upgrades, enhancements, post
contract customer support, installation, or training. Under SOP 97-2, the
determination of fair value is based on objective evidence which is specific to
the vendor. If such evidence of fair value for each element of the arrangement
does not exits, all revenue from the arrangement is deferred until such time
that evidence of fair value does exist or until all elements of the arrangement
are delivered. Revenue allocated to software products, specified upgrades and
enhancements is generally recognized upon delivery of the related products,
upgrades and enhancements. Revenue allocated to post contract customer support
is generally recognized ratably over the term of the support, and revenue
allocated to service elements is generally recognized as the services are
performed. SOP 97-2 will be adopted by the Company effective April 1, 1998 and
is not expected to have any material effect on revenue recognition.

  (n)  Impact of the Year 2000 Issue

  The Year 2000 issue is the result of the computer programs being written using
two digits rather than four to define the applicable year. Any of the Company's
computer programs that has date-sensitive software may recognize a date using
"00" as the year 1900 rather than the year 2000. This could potentially result
in a system failure or miscalculations causing disruptions of operations
including among other things, a temporary inability to process transactions,
send invoices, or engage in other similar normal business activities. The
Company has ensured that its software is already year 2000 compliant and that
the current versions of its product lines are year 2000 compliant, and as such
this issue is not expected to have a material effect of the operations of the
Company.

  (o)  Reclassification

  Certain amounts in the 1997 and 1996 financial statements have been
reclassified to conform to the 1998 presentation.

(2)  INVENTORY

     The components of inventory consist of (in thousands):

<TABLE>
<CAPTION>
                                                          March 31,
                                                  ---------------------
<S>                                               <C>         <C>
                                                      1997       1998
Raw materials...................................  ----------  ---------
Work-in-process.................................  $      700        468
Original equipment manufacturer's goods.........         500        130
                                                          75         36
                                                  ----------  ---------
                                                  $    1,275        634
                                                  ==========  =========
</TABLE>

                                       44


<PAGE>
 
 
(3)  FIXED ASSETS

     Fixed assets consist of (in thousands):
<TABLE>
<CAPTION>
                                                                                             March 31,
                                                                                       ---------------------
<S>                                                                                     <C>           <C>
                                                                                         1997          1998
                                                                                       -------        ------
Equipment, furniture and fixtures................................................      $ 3,509         4,206
Demonstration equipment..........................................................        1,375         1,505
Parts used in service, not held for sale.........................................        1,110         1,292
                                                                                       -------        ------
                                                                                         5,994         7,003
Less accumulated depreciation....................................................       (2,840)       (4,237)
                                                                                       -------        ------
                                                                                       $ 3,154         2,766
                                                                                       =======        ======
</TABLE>

          Depreciation expense was $675,000, $1,262,000 and $1,397,000 for the
years ended March 31, 1996, 1997, and 1998, respectively.  As of March 31, 1998,
fixed assets held under capital lease totaled $313,000 and accumulated
depreciation on those assets totaled $62,000.


(4)  PURCHASED AND INTERNALLY DEVELOPED SOFTWARE COSTS

     Capitalized software costs consist of (in thousands):
<TABLE>
<CAPTION>
                                                                                            March 31,
                                                                                   --------------------------
                                                                                       1997          1998
                                                                                   ------------  ------------
<S>                                                                                <C>           <C>
Purchased software...............................................................      $   290           332
Internally developed software....................................................        2,808         4,615
                                                                                       -------        ------
                                                                                         3,098         4,947
Accumulated amortization.........................................................       (1,144)       (2,003)
                                                                                       -------        ------
                                                                                       $ 1,954         2,944
                                                                                       =======        ======
</TABLE>

          Amortization of capitalized software costs was $225,000, $431,000 and
$859,000 for the years ended March 31, 1996, 1997 and 1998, respectively.

(5)  ACCOUNTS PAYABLE AND ACCRUED LIABILITIES

     Accounts payable and accrued liabilities consist of (in thousands):

<TABLE>
<CAPTION>
                                                                                           March 31,
                                                                                   ----------------------
                                                                                      1997        1998
                                                                                   -----------  ---------
<S>                                                                                <C>          <C>
Accounts payable.................................................................       $1,697      1,458
Commissions payable..............................................................          401        321
Accrued compensation and benefits................................................          445        605
Accrued expenses.................................................................          428        931
                                                                                        ------      -----
                                                                                        $2,971      3,315
                                                                                        ======      =====
</TABLE>

(6)  LONG-TERM DEBT AND CREDIT FACILITIES


                                       45
<PAGE>
          In December, 1996, the Company entered into a Loan and Security
Agreement with Silicon Valley Bank.  The current agreement provides for up to
$1,500,000 in available borrowings based upon the Company's eligible accounts
receivable balances, and expires in May, 1999.  This Agreement provides for a
variety of covenants, including among other things, that the Company maintain
certain financial ratios and is collateralized by a security interest in
substantially all of the Company's assets.  Interest on borrowings under this
Agreement is payable monthly at a rate between three-quarters percent and two
and one half percent in excess of the prime rate (9.25% at March 31, 1998).  The
Company was in technical default of certain financial covenants in connections
with its bank facility, which have been waived by the lender; on March 31, 1998,
there was $500,000  outstanding.

          In  December, 1996, the Company obtained a $5,100,000 financing
facility with entities associated with Hambrecht & Quist.  The facility included
subordinated debt and equipment financing.  During December, 1996, the Company
received $3,000,000 from Hambrecht & Quist Transition Capital, LLC and
$1,100,000 from Hambrecht & Quist Guaranty Finance, LLC, pursuant to the above
facility.  The remaining $1,000,000 was a master lease line for financing of
future capital asset purchases.  The facility with the Hambrecht & Quist
entities is secured by an interest in the Company's fixed assets and
substantially all the assets of the Company, subordinate to the Silicon Valley
Bank Agreement discussed above.  Interest on borrowings under these facilities
is payable monthly at a rate of 7.75% and 6.75%, respectively.  In connection
with the financing facility, the Company issued warrants to purchase 260,200
common shares.  The Hambrecht & Quist entities may exercise 130,100 shares at an
exercise price of $10.00 at any time on or before December 24, 2004, and 130,100
shares at an exercise price of $7.00 at any time on or after December 24, 1997
and before December 24, 2004.  In December 1997, 130,100 of the $7.00 warrants
were exercised on a "net" basis, and the warrant holder received 40,266 shares
of Common Stock.  The Company recorded $549,000 of debt discount, which is being
amortized to interest expense over the term of the financing facility,
attributable to the value of the warrants.  In March, 1998, the Company
renegotiated its financing arrangement with Hambrecht & Quist Guaranty Finance.
The agreements reached involve the restructuring of $3,000,000 of debt into
$1,500,000 of convertible preferred stock and $1,500,000 of lower interest debt
due in October 1999. The Company has filed a Form S-3 Registration Statement
under The Securities Act of 1933 to register the 461,538 shares of the Company's
Common Stock which underlie the Series C Preferred Stock issued to Hambrecht &
Quist Guaranty Finance.  In connection with the agreement, the exercise price of
90,000 of the $10 Warrants issued in connection with the original arrangement
reached in December 1996 was changed to $3.25.

          In December, 1997, the Company secured a $7,000,000 equity-based line
of credit.  Under this arrangement, the Company has the right to draw up to a
total of $7,000,000 in cash in exchange for the Company's common stock.  Pricing
of the common stock issued will be based on the market price of the Company's
common stock at the time of a draw.  The timing and amount of individual draws
are at the sole discretion of the Company, subject to a number of conditions.
The line will remain in place for a period of approximately 24 months.  The
Company filed a registration statement for the resale of shares issued under
this arrangement in January, 1998.  During the quarter ended March 31, 1998, the
Company drew down $1,450,000 on this equity-based line of credit and issued
606,130 shares of common stock at an average price per share of $2.39.


(7)  SHAREHOLDERS' EQUITY

     Stock Options

     Under the Company's September 1989 Stock Option Plan (the Plan), options to
purchase up to an aggregate of 2,090,000 shares of common stock may be granted
to key employees, directors and consultants. Grants of options to the directors
of the Company may not exceed 140,000 shares. The Plan provides for issuing both
incentive stock options, which must be granted at fair market value at the date
of grant, and nonqualified stock options, which must be granted at not less than
85% of fair market value of the stock. All options to date have been granted as
incentive stock options. Options under the Plan generally vest over four years
from the date of grant. The options generally expire ten years from the date of
grant and are canceled three months after termination of employment. The Board
of Directors and/or the President administer the Plan.

     During 1995, the Company adopted the 1994 NonEmployee Directors Stock
Option Plan which provides for the grant of stock options to the Company's
nonemployee directors.  Under this plan, stock options are granted annually at
the fair market value of the Company's common stock on the date of grant.  The
number of options so granted annually is fixed by the plan.  Such options
generally vest over four years from the grant date.  The total number of shares
to be issued under this plan may not exceed 100,000 shares. There were 24,000
options outstanding at March 31, 1998, at a price of $2.5625 per share, of which
7,416 were exercisable.

     In March 1998, the Board of Directors approved the repricing of options at
an exercise price of $2.5625. There were no changes made to the vesting
schedules in relation to the repricing.

                                      46
<PAGE>
 
     A summary of the Company's option plans is presented below:
<TABLE>
<CAPTION>

                                          1996                              1997                                1998
                                          ----                              ----                                ----
                                             Weighted-                            Weighted-                           Weighted-
                                              average                              average                             average
                                Options      Exercise price         Options     Exercise price       Options     Exercise price
                                -------      --------------         -------     --------------       -------     --------------
<S>                            <C>           <C>                    <C>         <C>                  <C>         <C>
Outstanding at beginning
of year....................        526,191       $3.29              820,398          $4.92            829,699         $5.53
Granted....................        522,500        6.19              310,400           6.31          1,925,150          3.76
Exercised..................       (114,071)       1.26             (102,269)          1.66            (50,062)         1.70
Forfeited..................       (114,222)       6.90             (198,830)          6.19         (1,044,609)         6.66
                                 ---------                        ---------                       -----------
Outstanding at end of year.        820,398       $4.92              829,699          $5.53          1,660,178         $2.89
                                 =========                        =========                       ===========

Options exercisable at
 year end..................        275,675       $2.76              308,723          $4.45            640,809         $2.82

Fair value of options granted
 during the year...........                      $3.62                               $3.73                            $2.22


</TABLE>


ACCOUNTING FOR STOCK-BASED COMPENSATION

          Had compensation cost for the Company's plans been determined
consistent with the fair value approach enumerated in SFAS No. 123, the
Company's net loss and net loss per share for the years ended March 31, 1997 and
1998 would have been increased as indicated below (in thousands, except per
share data):

<TABLE>
<CAPTION>

                                                March 31,
                                                ---------
                                       1996        1997         1998
                                   -----------  -----------  -----------
<S>                   <C>          <C>          <C>          <C>
Net loss              As Reported     $3,557      $5,191      $5,876
Pro Forma                             $3,636      $5,603      $6,572

Net loss per share    As Reported     $ 0.48      $ 0.69      $ 0.76
                      Pro Forma       $ 0.49      $ 0.74      $ 0.85
</TABLE>

          The fair value of options granted was estimated on the date of grant
using the Black-Scholes option-pricing model with the following weighted-average
assumptions used for grants in 1996, 1997 and 1998; risk-free interest rate of 
5.59%, 6.31% and 5.97%; expected life of 4 years; 73%, 73% and 91% expected
volatility; and no dividends.

          The effect of applying SFAS No. 123 for disclosing compensation costs
may not be representative of the effects on reported net income (loss) for
future years because pro forma net income (loss) reflects compensation costs
only for stock options granted in fiscal 1996 and 1997 and does not consider
compensation costs for stock options granted prior to April 1, 1995.

                                       47
<PAGE>
          The following table summarizes information about stock options
outstanding at March 31, 1998.

<TABLE> 
<CAPTION> 
                                   Options Outstanding           Options Exercisable  
                                   -------------------           -------------------
 
                                Number                               Weighted          Number          Average
                           Outstanding at       Remaining             Average      Outstanding at     Exercise
    Exercise Price         March 31, 1998    Contractual Life     Exercise Price   March 31, 1998       Price
    --------------         --------------    ----------------     --------------   --------------       -----
<S>                        <C>               <C>                   <C>             <C>                  <C>
From $0.86 to $1.00                5,167                 3.50              $0.91           5,167       $0.91
From $1.01 to $1.71               44,318                 4.82               1.43          44,318        1.43
From $1.72 to $2.86
                               1,437,084                 8.97               2.53         528,729        2.53
From $2.87 to $4.29
                                   3,821                 5.58               4.29           3,821        4.29
From $4.30 to $7.50
                                 154,538                 7.03               6.17          55,942        6.36
From $7.51 to $11.50
                               ---------                 ----              -----         -------       -----
                                  15,250                 6.82               8.88           2,832        9.88
                               ---------                 ----              -----         -------       -----
From $0.05 to $10.25
                               1,660,178                 8.64              $2.89         640,809       $2.82
                               =========                 ====              =====         =======       =====
</TABLE>

(8)    INCOME TAXES

            Income tax expense (benefit) consists of the following for the years
            ended March 31:

<TABLE>
<CAPTION>
                                        Current         Deferred          Total
                                    ---------------  --------------  ----------------
                                                     (in thousands)
1996:
<S>                                 <C>              <C>             <C>
   Federal........................         ($1,304)             83            (1,221)
   State..........................               2              50                52
                                           -------             ---            ------
                                           ($1,302)            133            (1,169)
                                           =======             ===            ======
1997:
   Federal........................           ($293)            293                 -
   State..........................               -               -                 -
                                           -------             ---            ------
                                             ($293)            293                 -
                                           =======             ===            ======

1998:
   Federal........................               -               -                 -
   State..........................               3               -                 3
                                           -------             ---            ------
                                                 3               -                 3
                                           =======             ===            ======
</TABLE>

      The differences between income taxes computed using the statutory federal
income tax rate and that shown in the statements of operations are summarized as
follows (in thousands):

<TABLE>
<CAPTION>
                                                                                      1997                1998
                                                                               ------------------  ------------------
<S>                                                                            <C>                 <C>
Computed tax at statutory rate...............................................             (1,765)             (1,998)
Tax credits utilized.........................................................               (201)                131
State taxes, net of federal benefit..........................................                 --                   3
Tax exempt interest income...................................................                (25)                (36)
Current year net operating losses, temporary differences and credits for
which no benefit was recognized..............................................              1,681               1,880
Change in beginning of year valuation allowance..............................                293                  --
Other........................................................................                 17                  23
                                                                                          ------              ------
                                                                                              --                   3
                                                                                          ======              ======
</TABLE>

                                       48
<PAGE>

The components of deferred taxes are as follows at March 31 (in thousands):

<TABLE>
<CAPTION>
    Deferred tax assets:                                                                           1997               1998
                                                                                           -----------------  -----------------
<S>                                                                                           <C>                <C>
             Accounts receivable........................................................               252                254
             Inventories................................................................               459                542
             Tax credit carryforwards...................................................             1,013              1,550
             Net operating losses.......................................................             1,843              4,103
             Accrued vacation pay.......................................................                50                 62
             Commissions................................................................                29                 40
             State income taxes.........................................................                --                  1
             Warranty and other.........................................................                22                 42
                                                                                           -----------------  -----------------

                     Gross deferred tax assets..........................................             3,668              6,594
                     Valuation allowance................................................            (2,784)            (5,343)
                     Total deferred tax assets, net of valuation allowance..............               884              1,251

Deferred tax liabilities:
             Fixed assets..............................................................               (172)              (174)
             Internally developed software.............................................               (712)            (1,077)
                                                                                           -----------------  -----------------
                     Total deferred tax liability......................................               (884)            (1,251)
                                                                                           -----------------  -----------------
                                                                                       
                               Net deferred taxes......................................                 -                  -
                                                                                           =================  =================
</TABLE>

     The net change in the valuation allowance for the year ended March 31, 1998
was an increase of approximately $2,559,000.  Management believes that
sufficient uncertainty exits regarding the future realization of certain
deferred tax assets and, that a valuation allowance is required.

     As of March 31, 1998, the Company has cumulative federal and California net
operating losses of approximately $10,800,000 and $6,000,000 which can be used
to offset future income subject to taxes.  The federal tax loss carryforwards
will expire beginning in the year 2012 through 2013.  The California tax loss
carryforwards will expire beginning in the year 2001 through 2003.

     As of March 31, 1998, the Company has cumulative unused research and
development tax credits of approximately $1,015,000 and $400,000 which can be
used to reduce future federal and California income taxes, respectively.
Federal credit carryforwards expire from 2009 through 2013; California credits
will carryforward indefinitely.

     As of March 31, 1998, the Company has federal minimum tax credit
carryforwards of approximately $135,000 which will carry forward indefinitely
until utilized.

(9)  COMMITMENTS AND CONTINGENCIES

     (a)  Leases

          In December, 1996, the Company entered into a leasing agreement to
finance the purchase of up to $1,000,000 in equipment, as discussed in Note 6.
Lease terms under the agreement are for 42 months and are secured by the leased
equipment. The Company also leases certain facilities and equipment under
noncancelable operating leases.  Future payments under capital and operating
leases that have initial remaining noncancelable lease terms in excess of one
year are as follows (in thousands):

                                       49
<PAGE>
 
<TABLE>
<CAPTION>
                                                                                        Capital        Operating
                               Year Ending March 31,                                     Leases           Leases
                               ---------------------                                    -------        ---------
<S>                                                                                     <C>          <C>
1999...............................................................................       $ 126              702
2000...............................................................................         168              705
2001...............................................................................         141              705
2002...............................................................................           -              705
2003...............................................................................           -              117
Thereafter.........................................................................           -                -
                                                                                        -------        ---------
Total minimum lease payments.......................................................         435            2,934
                                                                                                       =========
Less amount representing interest..................................................         (61)
Less current portion of obligations under capital lease............................        (138)
                                                                                        -------        
Long-term obligations under capital lease..........................................       $ 236
                                                                                        =======        
</TABLE>

     Rent expense under operating leases for the years ended March 31, 1996,
1997 and 1998 was approximately $447,000, $610,000 and $847,000, respectively.

     (b)  Benefit Plan

          The Company sponsors a 401(k) savings plan covering most salaried
employees.  To date, no contributions have been made to this plan by the
Company.

     (c)  Other

          The Company is from time to time subject to routine claims and
litigation incidental to it's business.  The Company believes that the results
of these matters will not have a material adverse effect on the Company's
financial condition.

(10) INDUSTRY AND GEOGRAPHIC INFORMATION

     The Company operates in a single industry segment and markets its products
in the United States and in foreign countries through its sales personnel,
dealers, and distributors.  Export sales account for a significant portion of
the Company's net revenue and are summarized by geographic area as follows (in
thousands):

<TABLE>
<CAPTION>
                                                                   Year Ended March 31,
                                                          ---------------------------------------
                                                             1996         1997          1998
                                                          -----------  -----------  -------------
<S>                                                       <C>          <C>          <C>
North America (substantially all United States).........      $ 6,565        8,780          9,612
Export:
     Europe.............................................        2,451        2,763          4,949
     Pacific Rim........................................        4,181        3,491          4,009
     Other international................................          747          877          1,311
                                                              -------       ------         ------
               Total net revenue                              $13,944       15,911         19,881
                                                              =======       ======         ======
</TABLE>
     Foreign based assets were insignificant as of March 31, 1997 and 1998.

                                       50
<PAGE>

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

         Not applicable.


                                   PART III

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

          The information required by this Item with respect to executive
officers is set forth in Part I of this Report and the information with respect
to directors is incorporated herein by reference to the information set forth
under the caption "Election of Directors" in the Proxy Statement.

ITEM 11.  EXECUTIVE COMPENSATION

          The information required by this Item is incorporated herein by
reference to the information set forth under the caption "Executive
Compensation" in the Proxy Statement.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

          The information required by this Item is incorporated herein by
reference to the information set forth under the caption "Security Ownership of
Certain Beneficial Owners and Management" in the Proxy Statement.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

          The information required by this Item is incorporated herein by
reference to the information set forth under the caption "Certain Relationships
and Related Transactions" in the Proxy Statement.
 

                                       51
<PAGE>
 
                                    PART IV

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

     (a)1.  FINANCIAL STATEMENTS.

            Included in Part II of this report:

            Report of Independent Auditors (page 35 of this Report).

            Balance Sheets as of March 31, 1997 and March 31, 1998.

            Statements of Operations for each of the three years in the period
            ended March 31, 1998.

            Statements of Shareholders' Equity for each of the three years in
            the period ended March 31, 1998.

            Statements of Cash Flows for each of the three years in the period
            ended March 31, 1998.

            Notes to Financial Statements (pages 41 through 50 of this Report).

      (a)2. FINANCIAL STATEMENTS SCHEDULES.

            Included in Part IV of this report:

            Schedule II   Valuation and Qualifying Accounts

            All other schedules are omitted because they are not required, or
            are not applicable, or the information is included in the financial
            statements.

      (a)3. EXHIBITS:
<TABLE>
<S>                            <C>          <C>
             3.1               (1)    Restated Articles of Incorporation

             3.2               (1)    Amended and Restated By-Laws

             4.1               (1)    Specimen Common Stock Certificate

             4.2               (1)    Investors' Rights Agreement dated August
                                      20, 1993 between the Investors listed on
                                      the Schedule of Investors thereto and the
                                      Company

             4.3               (1)    Right of Last Refusal, Co-Sale and
                                      Shareholders' Option Agreement dated
                                      August 20, 1993 between the Investors
                                      listed on the Schedule of Investors
                                      thereto and the Company

             10.1              (1)    Amended and Restated Stock Option Plan

             10.2              (1)    Lease Agreement dated December 16, 1991
                                      between Phoenix Leasing Incorporated and
                                      the Company

             10.3              (1)    Loan Agreement dated November 28, 1993
                                      between Bank of America and the Company

             10.4              (1)    Agreement dated September 28, 1993 between
                                      JL Cooper Electronics and the Company
</TABLE>


                                       52
<PAGE>
 
<TABLE> 
<CAPTION> 
<S>                            <C>     <C> 
             10.5              (1)    Form of Indemnity Agreement

             10.6              (2)    Lease Agreement dated January 26, 1995
                                      between Golden Gate Plaza and the Company

             10.7              (3)    Private Line of Credit Agreement dated
                                      December 31, 1997 between Kingsbridge
                                      Capital Limited and the Company

             10.8              (4)    Private Securities Subscription Agreement
                                      dated March 31, 1998 between Hambrecht &
                                      Quist Guaranty Finance, LLC and the
                                      Company

             24.1                     Power of Attorney (see pages 54 and 55)

             27                       Financial Data Schedule                
             </TABLE>

_______________

(1)  Incorporated by reference to exhibits to Registration Statement on Form S-1
     (No. 33-72870) effective February 10, 1994.

(2)  Incorporated by reference to exhibits to Annual Report on Form 10-K
            for the Fiscal Year Ended March 31, 1996 (No. 33-72870).

(3)  Incorporated by reference to exhibits to Registration Statement on
            Form S-3 (No. 333-44347) effective January 30, 1998.

(4)  Incorporated by reference to exhibits to Registration Statement on
            Form S-3 (No. 333-50697) effective April 29, 1998.

     (b)    REPORTS ON FORM 8-K:  None.

                                       53
<PAGE>
 
                                  SIGNATURES

          Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant, Sonic Solutions, a corporation organized
and existing under the laws of the State of California, has duly caused this
report to be signed on its behalf by the undersigned thereunto duly authorized,
in the City of Novato, State of California, on the 19th day of June, 1998.


                                      SONIC SOLUTIONS



                                      By /s/  Robert J. Doris
                                         --------------------
                                         Robert J. Doris
                                         President


                              POWERS OF ATTORNEY


          KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Robert J. Doris, Mary C. Sauer, and A.
Clay Leighton, jointly and severally, his attorneys-in-fact, each with the power
of substitution, for him in any and all capacities, to sign any amendments to
this Annual Report on Form 10-K and to file the 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 or her substitute or substitutes, may do or cause to be done by
virtue hereof.

          Pursuant to the requirements of the Securities Exchange Act of 1934,
this Annual Report on Form 10-K has been signed below by the following persons
on behalf of the Registrant and in the capacities and on the dates indicated.

<TABLE>
<CAPTION>
              SIGNATURE                            TITLE                                  DATE
              ---------                            -----                                  ----
<S>                                     <C>                                             <C>
         /s/  Robert J. Doris           President and Director (Principal Executive     June 19, 1998
--------------------------------------  Officer)
              Robert J. Doris

         /s/  James A. Moorer           Senior Vice President of Audio Development      June 19, 1998
--------------------------------------  and Director
              James A. Moorer

         /s/  Mary C. Sauer             Senior Vice President of Marketing and Sales    June 19, 1998
--------------------------------------  and Director
              Mary C. Sauer

</TABLE> 

                                       54
<PAGE>
<TABLE> 
<CAPTION> 
<S>                                     <C>                                           <C> 
 
         /s/  Michael C. Child          Director                                        June 19, 1998
----------------------------------
              Michael C. Child

         /s/  Robert M. Greber          Director                                        June 19, 1998
----------------------------------
              Robert M. Greber

         /s/  Peter J. Marguglio        Director                                        June 19, 1998
----------------------------------
              Peter J. Marguglio

         /s/ A. Clay Leighton           Vice President of Finance and Chief Financial   June 19, 1998
----------------------------------      Officer (Principal Financial Accounting
             A. Clay Leighton           Officer)

</TABLE>
 
                                       55
<PAGE>

                                                            SCHEDULE II
                                SONIC SOLUTIONS

                       VALUATION AND QUALIFYING ACCOUNTS

                   Years Ended March 31, 1996, 1997 and 1998
                                 (in thousands)


<TABLE>
<CAPTION>
                                              Balance at  Charged to  Charged                 Balance
                                              ----------  ----------  --------               ---------
                                              beginning   costs and   to other               at end of
                                              ----------  ----------  --------               ---------
                                              of period    expenses   accounts  Deductions    period
                                              ----------  ----------  --------  ----------   ---------
<S>                                           <C>         <C>         <C>       <C>          <C>
Year ended March 31, 1996
     Allowance for doubtful accounts........      $  512         593       ---         ---       1,105
     Allowance for returns..................         298         ---       287         ---         585
                                                  ------         ---       ---      ------       -----
                                                  $  810         593       287         ---       1,690
                                                  ======         ===       ===      ======       =====

Year ended March 31, 1997
     Allowance for doubtful accounts........      $1,105          90       ---        (974)        221
     Allowance for returns..................         585         ---       100        (318)        367
                                                  ------         ---       ---      ------       -----
                                                  $1,690          90       100      (1,292)        588
                                                  ======         ===       ===      ======       =====

Year ended March 31, 1998
     Allowance for doubtful accounts........      $  221          44       ---         (42)        223
     Allowance for returns..................         367         ---       190        (163)        394
                                                  ------         ---       ---      ------       -----
                                                  $  588          44       190        (205)        617
                                                  ======         ===       ===      ======       =====
</TABLE>
 
                                       56
<PAGE>
 
INDEX TO EXHIBITS

<TABLE>
<S>                      <C>         <C>
         3.1             1           Restated Articles of Incorporation
         3.2             1           Amended and Restated By-Laws
         4.1             1           Specimen Common Stock Certificate
         4.2             1           Investors' Rights Agreement dated August 20, 1993 between the Investors
                                     listed on the Schedule of Investors thereto and the Company
         4.3             1           Right of Last Refusal, Co-Sale and Shareholders' Option Agreement dated
                                     August 20, 1993 between the Investors listed on the Schedule of
                                     Investors thereto and the Company
         10.1            1           Amended and Restated Stock Option Plan
         10.2            1           Lease Agreement dated December 16, 1991 between Phoenix Leasing
                                     Incorporated and the Company
         10.3            1           Loan Agreement dated November 28, 1993 between Bank of America and the
                                     Company
         10.4            1           Agreement dated September 28, 1993 between JL Cooper Electronics and
                                     the Company
         10.5            1           Form of Indemnity Agreement
         10.6            2           Lease Agreement dated January 26, 1995 between Golden Gate Plaza and
                                     the Company
         10.7            3           Private Line of Credit Agreement dated December 31, 1997 between Kingsbridge 
                                     Capital Limited and the Company
         10.8            4           Private Securities Subscription Agreement dated March 31, 1998 between 
                                     Hambrecht & Quist Guaranty Finance, LLC and the Company. 
         24.1                        Power of Attorney (see pages 54 and 55)

         27                          Financial Data Schedule                
--------------------
/1/   Incorporated by reference to exhibits to Registration Statement on Form
      S-1 (No. 33-72870) effective February 10, 1994.
/2/   Incorporated by reference to exhibits to Annual Report on Form 10-K for the Fiscal Year Ended March 31, 1996.
/3/   Incorporated by reference to exhibits to Registration Statement on Form S-3 (No. 333-44347) effective January 30, 1998.
/4/   Incorporated by reference to exhibits to Registration Statement on Form S-3 (No. 333-50697) effective April 29, 1998.
</TABLE> 
                                       57