<PAGE>
 
                      SECURITIES AND EXCHANGE COMMISSION

                            Washington, D.C.  20549
                                _______________

                                   FORM 10-Q


[X]            QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
                      THE SECURITIES EXCHANGE ACT OF 1934
               FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1996

                                      OR


[-]            TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
                      THE SECURITIES EXCHANGE ACT OF 1934

                        Commission file number 0-24936


                                7TH LEVEL, INC.
            (Exact name of registrant as specified in its charter)

           DELAWARE                                       75-2480669
   (State of incorporation)                (I.R.S. Employer Identification No.)


      1110 EAST COLLINS BOULEVARD
             SUITE 122
         RICHARDSON, TEXAS                                      75081
(Address of principal executive offices)                      (Zip Code)

      REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (972) 498-8100

          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 and (2) has been subject to such filing requirements for the past 90
days.

                           Yes     X         No  ____
                                 ----                

          Indicate the number of shares outstanding of each of the issuer's
classes of common stock, as of the latest practicable date.

     COMMON STOCK, $0.01 PAR VALUE                        13,527,341
         (Title of Each Class)                (Number of Shares Outstanding at
                                                      November 8, 1996)
<PAGE>
 
                                7TH LEVEL, INC.
                                        
                                   Form 10-Q
               For the Quarterly Period Ended September 30, 1996

                                     Index
<TABLE>
<CAPTION>
 
PART I                                 FINANCIAL INFORMATION            Page No.
                                                                        --------
                                                                                        
<S>                          <C>                                        <C>             
Item 1                       Condensed Consolidated Balance Sheets at                   
                             September 30, 1996 and December 31, 1995          3        
                                                                                        
                                                                                        
                             Condensed Consolidated Statements of                       
                             Operations for the Three and Nine Months                   
                             Ended September 30, 1996 and 1995                 4        
                                                                                        
                                                                                        
                                                                                        
                             Condensed Consolidated Statements of                       
                             Cash Flows for the Nine Months Ended              5        
                             September 30, 1996 and 1995                                
                                                                                        
                                                                                        
                             Notes to Condensed Consolidated                   6        
                             Financial Statements                                       
                                                                                        
Item 2                       Management's Discussion and Analysis of                    
                             Financial Condition and  Results of               7        
                             Operations                                                 
                                                                                        
                                                                                        
PART II                      OTHER INFORMATION                                          
                                                                                        
Item 6                       Exhibits and Reports on Form 8-K                 12        
                                                                                        
                             SIGNATURES                                       13         
</TABLE>

                                       2
<PAGE>
Part I - FINANCIAL INFORMATION
Item 1.  Condensed Consolidated Financial Statements

                               7TH LEVEL, INC. 
                     CONDENSED CONSOLIDATED BALANCE SHEETS
                                  (Unaudited)


<TABLE> 
<CAPTION> 
                                                      September 30, 1996               December 31, 1995
                                                      ------------------               ------------------ 
                                    ASSETS
<S>                                                   <C>                              <C>    
Cash and cash equivalents                                    $11,089,244                   $  29,940,217
Short-term investments                                        10,478,649                       9,706,270
Accounts receivable, net                                       5,865,956                       6,917,280
Inventories                                                      604,771                         385,470
Other current assets                                           1,606,924                       1,210,085
                                                             -----------                   -------------- 
          Total current assets                                29,645,544                      48,159,322
Property and equipment, net                                   11,199,853                       5,156,058
Intangible assets, net                                         1,157,256                       1,100,492
Other assets                                                   1,452,206                         145,808
                                                             -----------                   --------------
          Total assets                                       $43,454,859                   $  54,561,680
                                                             ===========                   ============== 



                     LIABILITIES AND STOCKHOLDERS' EQUITY

Accounts payable                                            $  1,580,355                    $  1,263,392
Accrued expenses and other current liabilities                 4,950,056                       4,074,934
Current portion of long-term debt                              1,500,000                              -
                                                            ------------                    -------------
          Total current liabilities                            8,030,411                       5,338,326
Long-term debt                                                 4,539,179                         118,902
Long-term debt to related parties                                581,098                         581,098
Other                                                            371,872                         257,883
                                                            ------------                    -------------
          Total liabilities                                   13,522,560                       6,296,209
Commitments and contingencies
Stockholders' equity:
     Common Stock                                                135,273                         130,785
     Additional capital                                       70,099,016                      69,168,061
     Cumulative translation adjustment                            (6,489)                        (14,923)
     Unrealized gain (loss) on investments                        (5,472)                         21,791
     Accumulated deficit                                     (40,290,029)                    (21,040,243)
                                                            -------------                  --------------
          Total stockholders' equity                          29,932,299                      48,265,471
                                                            -------------                  --------------
          Total liabilities and stockholders' equity        $ 43,454,859                   $  54,561,680
                                                            =============                  ==============
</TABLE> 


                            See accompanying notes.

                                       3

<PAGE>
                                7TH LEVEL, INC.
                CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                                  (Unaudited)

<TABLE>
<CAPTION>
                                  Three Months Ended      Three Months Ended       Nine Months Ended           Nine Months Ended
                                  September 30, 1996      September 30, 1995       September 30, 1996          September 30, 1995
                                  ------------------      ------------------       ------------------          -------------------
<S>                               <C>                     <C>                     <C>                         <C> 
Net revenues                      $       4,807,418       $       2,638,095       $          14,206,389       $           5,373,709
Cost of revenues                          1,977,815                 355,668                   5,305,451                   1,033,690
                                  -----------------       -----------------       ---------------------       ---------------------
    Gross profit                          2,829,603               2,282,427                   8,900,938                   4,340,019
                                  -----------------       -----------------       ---------------------       ---------------------
                                                   
Operating expenses:                                
    Research and product                           
     development                          6,448,529               2,960,943                  16,444,911                   7,135,184
    Purchased in-process                           
     research and development                     -                       -                           -                   1,500,000
    Sales and marketing                   2,532,481               1,786,656                   8,470,944                   3,579,589
    General and administrative            1,235,995                 734,247                   3,575,047                   2,084,999
    Amortization of intangible                     
     assets                                  28,466                 563,799                      84,174                   1,694,311
                                  -----------------       -----------------       ---------------------       ---------------------
        Total operating expenses         10,245,471               6,045,645                  28,575,076                  15,994,083
                                  -----------------       -----------------       ---------------------       ---------------------
         Operating loss                  (7,415,868)             (3,763,218)                (19,674,138)                (11,654,064)
Interest and other, net                     234,965                  73,225                   1,007,275                     458,022
                                  -----------------       -----------------       ---------------------       ---------------------
         Net loss                 $      (7,180,903)      $      (3,689,993)      $         (18,666,863)      $         (11,196,042)
                                  =================       =================       =====================       =====================


Loss per common share             $           (0.53)      $           (0.35)      $               (1.39)      $               (1.08)
                                  =================       =================       =====================       =====================
Weighted average common stock 
    and common equivalent shares         13,523,500              10,464,660                  13,404,726                  10,373,114
                                  =================       =================       =====================       =====================
</TABLE> 

                            See accompanying notes.

                                       4
<PAGE>
 
                                7TH LEVEL, INC
                CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                  (Unaudited)

<TABLE> 
<CAPTION> 
                                                                           Nine Months Ended        Nine Months Ended    
                                                                           September 30, 1996       September 30, 1995   
                                                                           ------------------       ------------------
<S>                                                                        <C>                      <C>     
Cash flows from operating activities:                                                                                    
     Net Loss                                                                 ($18,666,863)             ($11,196,042)         
     Adjustments to reconcile net loss to net cash used in                                                          
      operating activities:                                                                                         
          Depreciation and amortization                                          1,781,972                 2,166,125
          Purchased in-process research and development                                  -                 1,500,000 
          Change in operating assets and liabilities                               156,515                  (937,817) 
                                                                           ------------------       ------------------ 
               Net cash used in operating activities                           (16,728,376)               (8,467,734)     
                                                                                                                    
Cash flows from investing activities:                                                                               
     Acquisitions, net of cash acquired (paid)                                       6,323                  (100,000)
     Acquisition of property and equipment                                      (7,455,382)               (2,617,847)
     Acquisition of intangible assets                                                    -                  (504,183)
     Equity investments                                                           (400,000)                        -
     Purchase of short-term investments                                           (799,642)               (1,741,727)
                                                                           ------------------       ------------------
               Net cash used in investing activities                            (8,648,701)               (4,963,757)
                                                                                                                    
Cash flows from financing activities:                                                                               
     Issuance of Common Stock under stock options                                                                   
                         and stock purchase plans                                  521,595                   258,818
     Borrowings under bank line of credit                                        6,000,000                         - 
     Repayment of long-term obligations                                                  -                (1,248,750)
                                                                           ------------------       ------------------
               Net cash provided by (used in) financing activities               6,521,595                  (989,932)
                                                                           ------------------       ------------------
               Effect of exchange rate changes on cash                               4,509                         -
                                                                           ------------------       ------------------
               Net decrease in cash                                            (18,850,973)              (14,421,423) 
Cash and cash equivalents, beginning of period                                  29,940,217                20,001,612
                                                                           ------------------       ------------------
Cash and cash equivalents, end of period                                     $  11,089,244               $ 5,580,189    
                                                                           ==================       ==================
</TABLE> 

                            See accompanying notes.

                                       5
<PAGE>
 
                                7TH LEVEL, INC.

              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (Unaudited)

1.   Basis of Presentation

          The condensed consolidated financial statements of 7th Level, Inc.
(the "Company") are unaudited and reflect all adjustments, consisting of normal
recurring adjustments, which are, in the opinion of management, necessary for a
fair presentation of the results for the interim periods.  These condensed
consolidated financial statements should be read in conjunction with the
financial statements and notes thereto included in the Company's Annual Report
on Form 10-K for the year ended December 31, 1995.  The results of operations
for the three and nine months ended September 30, 1996 are not necessarily
indicative of the results for the entire year ending December 31, 1996.

2.   Loss per Share

          Primary loss per share is computed by dividing the net loss by the
weighted average common stock and common stock equivalents outstanding. Warrants
and options to purchase common stock have been excluded from the loss per share
calculation because the effect would be anti-dilutive. Fully diluted loss per
share has not been presented because the result of the computation would be 
anti-dilutive.

3.   Acquisitions

          On March 1, 1996, the Company acquired all of the outstanding stock of
PyroTechnix, Inc. ("PyroTechnix") for 300,000 shares of the Company's common
stock. The acquisition was accounted for as a pooling-of-interests. The related
acquisition costs were charged to expense during the quarter ended March 31,
1996. PyroTechnix is a software development company which specializes in
realtime 3D rendering technology. The operating results for PyroTechnix were not
material to the combined results of the two companies for all periods prior to
the acquisition and therefore results for those periods have not been restated.
The operating results of PyroTechnix have been included in the condensed
consolidated financial statements from the date of the acquisition.

          During 1995, the Company acquired Distant Thunder Entertainment, Inc.
in February and Lanpro Corporation and Lanpro Localization Center, Inc. in
December. Pro forma results of operations have not been presented because the
effects of these acquisitions were not significant.

4.   Bank Line of Credit

          During the quarter ended September 30, 1996, the Company entered into
a fully-secured credit agreement providing for a $6 million term loan to provide
funding for fixed assets previously acquired by the Company and a revolving
credit facility of $5 million for general operating funds. At September 30,
1996, total borrowings under this credit agreement were $6 million. Monthly
interest payments under the $6 million term loan are scheduled at the bank's
prime rate plus 3/4% and quarterly principal payments of $375,000 commence
December 6, 1996. Essentially all of the Company's assets except for the land
and building currently being constructed are pledged in conjunction with these
debt instruments.

                                       6
<PAGE>
 
ITEM 2.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
          RESULTS OF OPERATIONS

     The following information should be read in conjunction with the financial
statements and the notes thereto and in conjunction with Management's Discussion
and Analysis of Financial Condition and Results of Operations in the Company's
Annual Report on Form 10-K for the year ended December 31, 1995.  This analysis
is provided pursuant to applicable Securities and Exchange Commission
regulations and is not intended to serve as a basis for projections of future
events.

OVERVIEW

     The Company's business activities include the development and acquisition
of technological and production processes to create interactive software titles
for use on multimedia PCs. The Company's efforts to date have resulted in the
development and production of eleven titles which include both educational and
entertainment content. The Company's most recent releases were Ace Ventura, a
graphic adventure title and Topsy Turvey, developed with Disney Interactive
("Disney"), based on the animated film The Hunchback of Notre Dame. These two
titles follow the successful release of Monty Python and the Quest for the Holy
Grail in June of 1996.

     While the Company plans to continue to make substantial expenditures to
develop its business in 1996, it has acted on a number of cost saving measures
in the third quarter of 1996. For example, the Company has rationalized its
marketing activities to identify those programs which provide the best
returns/1/. In addition, the Company has reduced production staffing in the
quarter but plans to maintain capacity through the implementation of optimized
production processes and technologies/1/. The Company expects that its operating
results will fluctuate as a result of a variety of factors, including changes in
the composition of the Company's revenues, the timing of new title releases and
the seasonal nature of the market for consumer software with peak demand in the
fourth calendar quarter or holiday selling season./1/

RESULTS OF OPERATIONS

Three Month Periods Ended September 30, 1996 and September 30, 1995

     Net revenues were derived from product sales and product development
agreements.  During the three months ended September 30, 1996, net revenues
totaled $4,807,418, which is 82% higher than the $2,638,095 revenue achieved in
the three months ended September 30, 1995.  Revenues for the three months ended
September 30, 1996 were primarily from continuing sales of Monty Python and the
Quest for the Holy Grail and royalty and development revenue from Topsy Turvy
and Timon & Pumbaa's Jungle Games, developed for Disney.  Revenues also included
development work for other third parties and sales of existing titles.  The
graphic adventure title Ace Ventura began shipping on the last day of the three
months ended September 30, 1996 in limited quantities.  Revenues for the three
months ended September 30, 1995 were from sales of four existing titles,
primarily Battle Beast, which was launched in August 1995.  More than 20% of the
revenues were from international sales in each of the three months ended
September 30, 1996 and 1995.

     Cost of revenues during the three months ended September 30, 1996 was
$1,977,815 or 41% of net revenue, including product development, manufacturing,
and royalty and licensing costs of $639,379, $609,160, and $729,276,
respectively.  For the three months ended September 30, 1995, cost of revenues
was $355,668 or 13% of net revenues, including manufacturing, and royalty and
licensing costs of $284,098 and $71,570, respectively.  The increase in cost of
revenues in 1996 as a percentage of net revenue is due to several factors,
including the lower margins associated with development revenue and higher
royalty rates.  The Company's royalty agreements generally provide for stepped
increases in royalty rates based on quantities sold and accordingly, such rates
have reached higher royalty tiers on certain of the more popular releases, such
as the Python titles.  Additionally, Ace Ventura, which is a product of a joint
venture between the Company and Morgan Creek Interactive, Inc. ("Morgan Creek")
has a low gross margin as the Company pays a high effective royalty rate to
Morgan Creek.  The agreement also calls for 

                                       7
<PAGE>
 
Morgan Creek to pay one-half of development, manufacturing and marketing
expenses. During the three months ended September 30, 1995 cost of revenues was
unusually low as most revenues were generated from non-royalty bearing titles.
The Company expects fluctuations in gross margin in the future as changes occur
in the composition of the revenue and the associated cost of revenues/1/.

     Research and product development expenses were $6,448,529 and $2,960,943
for the three months ended September 30, 1996 and 1995, respectively. Research
and product development costs have increased significantly as the Company has
more than doubled its capacity from the same period in the prior year. Research
and product development expenses for the three months ended September 30, 1996
included $3,482,090 of production expenses, $1,565,436 for software research and
development and $1,401,003 for expenses of the companies acquired in 1995 and
1996 (as described in Note 3) to provide expertise in the development of 3D
technology and graphics design and to provide the capabilities needed to expand
into the Asia Pacific market. During the three months ended September 30, 1995,
research and product development expenses included $2,053,975 of production
expenses and $906,968 for software research and development costs. Although the
Company significantly reduced head count in production during the three months
ended September 30, 1996, such staff reductions followed a heavy production mode
in various studio departments such as animation. The staffing cuts were effected
near the end of the period and severance related amounts were included as
expenses. The Company is focused on optimization of its production processes and
technology and expects these measures to allow more efficient title development
even with reduced staff resources/1/.

     Sales and marketing expenses were $2,532,481 and $1,786,656 for the three
months ended September 30, 1996 and 1995, respectively.  Sales and marketing
expenses for the three months ended September 30, 1996 included $1,228,525 of
expenses for advertising, marketing and public relations and $1,303,956 of
expenses related to internal staffing.  For the three months ended September 30,
1995 expenses of $1,037,861 for advertising, marketing and public relations and
$748,795 related to internal staffing were incurred.  As a percentage of net
revenues, sales and marketing expenses related to internal staffing remained
steady at 27% compared to 28%, for the three months ended September 30, 1996 and
1995, respectively. However, the advertising, marketing and public relations
expenses decreased to 26% from 39% as a percentage of net revenues in the three
months ended September 30, 1996 compared to the same period in 1995.  The 1996
quarter also included bad debt provisions for the bankruptcy of a U.S.
distributor, Neostar.  The Company has focused its efforts to judiciously review
and implement only marketing activities with the highest returns.

     General and administrative expenses for the three months ended September
30, 1996 were $1,235,995 compared with $734,247 in the three months ended
September 30, 1995. The increase of $501,748 is associated with the expansion of
the Company's operational and administrative support infrastructure. As a
percentage of net revenues, in the three months ended September 30, 1996,
general and administrative expenses have remained relatively unchanged at 26%
compared to 28% in the three months ended September 30, 1995.

     Amortization of intangible assets was $28,466 for the three months ended
September 30, 1996, and primarily represents amortization of intangible assets
acquired in the Lanpro Acquisition.  These assets were acquired on December 29,
1995 and are being amortized over periods up to seven years.  Amortization of
intangible assets during the three months ended September 30, 1995 was $563,799
and primarily related to intangible assets acquired in the MetroCel asset
acquisition in March of 1994 which were fully amortized by December 31, 1995.

     Net interest income was $234,965 for the three months ended September 30,
1996 compared with $73,225 in the three months ended September 30, 1995. This
change was due to higher average cash balances which were generated by a public
stock offering in late 1995.


                                       8
<PAGE>

Nine Month Periods Ended September 30, 1996 and September 30, 1995
 
     For the nine months ended September 30, 1996, net revenues totaled
$14,206,389 compared to $5,373,709 for the nine months ended September 30, 1995.
The revenues for the nine months ended September 30, 1996 have increased 164%
over the revenues for the nine months ended September 30, 1995 because of the
increase in the number of titles offered by the Company as well as higher OEM,
license and development revenues in the nine months ended September 30, 1996.

     Cost of revenues during the nine months ended September 30, 1996 was
$5,305,451 or 37% of revenue.  For the nine months ended September 30, 1995 cost
of revenues was $1,033,690 or 19% of sales.  The gross margin was negatively
impacted by changes in the revenue mix for the nine months ended September 30,
1996, through the inclusion of development revenue, which has a higher cost of
revenue than product sales or OEM licensing revenue.  For the nine months ended
September 30, 1995, revenues were derived from product sales and OEM licensing.

     Research and product development expenses were $16,444,911 for the nine
months ended September 30, 1996 compared to $8,635,184 for the nine months ended
September 30, 1995, which included a $1,500,000 write-off related to the
acquisition of in-process research and development costs in the purchase of
Distant Thunder. Excluding the write-off, research and product development
expenses increased 130% over the same period of the prior year. Research and
product development expenses have increased significantly in 1996 from 1995. The
Company has expanded production activity by having numerous 2D and 3D titles in
simultaneous production and is engaged in various language translation
activities in studio offices in Los Angeles, San Francisco, Dallas, Cincinnati
and Munich. In addition, the Company's development efforts support the higher
number of titles in production as well as the multimedia and internet authoring
and production tools under development. While the Company has aggressively
invested to increase its capacity to produce new titles for release, the Company
has experienced higher costs than expected and several titles which were
expected to ship in the second half of 1996 have been delayed. The Company has
introduced a number of technological efficiencies in the traditional animation
production processes, is planning additional improvements, and is currently
focusing on ways to reduce costs, to improve the financial performance and to
increase the competitive strength of the Company in this area/1/.

     Sales and marketing expenses were $8,470,944, or 60% of revenues, for the
nine months ended September 30, 1996, compared to $3,579,589, or 67% of
revenues, for the nine months ended September 30, 1995. The Company's expansion
into global distribution channels, the increased advertising, marketing and
public relations expenses to support revenue growth and growth of the Company's
sales and marketing organization all contributed to the 137% increase in
spending in sales and marketing.

     General and administrative expenses were $3,575,047 for the nine months
ended September 30, 1996, compared with $2,084,999 in the nine months ended
September 30, 1995. These increases were associated with the expansion of the
Company's operational and administrative support infrastructure. As a percentage
of revenues, general and administrative expenses declined to 25% from 39% for
the nine months ended September 30, 1996 and 1995, respectively.

     Amortization of intangibles assets was $84,174 for the nine months ended
September 30, 1996 and included the amortization of intangible assets acquired
in the Lanpro acquisition.  Amortization expense was $1,694,311 for the nine
months ended September 30, 1995, which represents amortization of intangible
assets acquired in the MetroCel asset acquisition which were fully amortized in
December 1995.
 
     Net interest income was $1,007,275 for the nine months ended September 30,
1996, which is more than twice the amount of $458,022 recognized in the nine
months ended September 30, 1995.  This improvement is attributable to higher
average cash balances and  repayment of certain outstanding debt from the
proceeds generated from a public stock offering in late 1995.  However, interest
income has declined each successive quarter of 1996 as cash balances have
declined.

                                       9
<PAGE>
 
LIQUIDITY AND CAPITAL RESOURCES

     Cash and short term investments decreased $18,078,594 to $21,567,893 at
September 30, 1996, from $39,646,487 at December 31, 1995.  The decrease is
primarily the result of the net loss of $18,666,863 incurred in the first nine
months of 1996.  The Company's cash position was also reduced by $4,274,431 to
cover asset additions for expanded computer and network capacity along with
$3,180,951 expended for land and construction-in-progress of the future site of
the Dallas operations.  This decrease in cash was offset by $6,000,000 in
proceeds generated from borrowings under a new bank line of credit for
equipment-based financing. Monthly interest payments under the $6 million term
loan are scheduled at the bank's prime rate plus  3/4% and quarterly principal
payments of $375,000 commence December 6, 1996. Additionally the Company has
$5,000,000 available under a second line for general working capital
requirements. Essentially all of the Company's assets except for the land and
building currently being constructed are pledged in conjunction with these debt
instruments. (See note 4.) The Company expects to continue to fund the
development of new titles and technologies and sales and marketing activities to
launch new products/1/. The Company plans to spend approximately $3.5 million
for completion of the construction of the corporate offices for Dallas
operations/1/. The Company also anticipates making additional capital
expenditures for expansion of its computer network to include connectivity
between all offices/1/. Outside funding alternatives are being examined to
finance the Dallas building costs.

     The Company anticipates that its capital resources, including the
anticipated borrowings for the Dallas building will be sufficient to satisfy its
capital requirements for the foreseeable future/1/. To date, however, the
Company continues to operate at a loss. The Company's ability to achieve
positive cash flow depends upon a variety of factors, including the timely
introduction and market success of its products, the costs of developing,
producing and marketing such products and various other factors, some of which
may be beyond the Company's control. In the future, the Company's capital
requirements will be affected by each of these factors as well as its
investments in technological and production process research/1/. If the Company
requires additional capital, it would seek such funding through additional
public or private financing, although there can be no assurance that the Company
will be able to obtain such financing/1/.

STRATEGIC RELATIONSHIP STATUS

     In June 1996, the Company signed an agreement with Future Endeavors
Incorporated ("Future Endeavors") to publish on a worldwide basis all
entertainment products that are developed by the Canadian company for an initial
three-year period. The Company made a $400,000 investment in Future Endeavors
and has made and expects to continue making royalty advances from time to time
to fund title development/1/. Additionally, the Company has provided its
development tools to Future Endeavors for use in producing titles. Future
Endeavors will receive royalty payments on revenues of each title published by
7th Level, including Tracer, the first title which was released in June 1996.

     In April 1996, the Company entered into an agreement with Disney to co-
develop a new PC game featuring the characters from Disney's animated film The
Hunchback of Notre Dame. The agreement calls for Disney to fund the development
expenses for the Hunchback title and for the Company to receive royalties based
on revenues generated by the game. The Hunchback title includes five single and
multiplayer games. In July 1996, the Company's development work was completed as
scheduled and the title was released to Disney for publishing. Disney began
shipping this title in August 1996. This is the second in Disney's GameBreak!
series and the second collaboration between Disney and the Company.

     In August 1995, the Company entered into an agreement with Morgan Creek
Interactive, Inc. ("Morgan Creek") for formation of a joint venture to develop
at least two computer software titles based on Morgan Creek's character, "Ace
Ventura."  The first title, a graphic adventure game was competed and released
in September 1996.  The Company has made and will continue to make capital
contributions to the venture to fund the costs of development of the titles and
will fund all marketing expenses and duplication costs for the titles.  All
revenues of the venture are to be shared equally by the parties after 

                                       10
<PAGE>
 
repayment of the Company's capital contributions to fund development expenses,
reimbursement of all amounts advanced by the Company to fund marketing expenses
and duplication costs and payment to the Company of a distribution fee. Morgan
Creek has been granted warrants to purchase 75,000 shares of the Company's
common stock at $20 per share and 100,000 shares of the Company's common stock
at $24 per share, which warrants expire in 1998.

     The Company anticipates forming a joint venture (the "QD7 Joint Venture")
for the development, production and distribution of multimedia products with
Quincy Jones--David Salzman Entertainment ("QDE") pursuant to the terms of a
letter agreement/1/. This letter agreement provides that the Company and QDE
shall initially contribute $750,000 and $250,000, respectively, to the QD7 Joint
Venture and contemplates that additional capital contributions shall be made
only with the unanimous consent of both parties. The first title to be developed
by the QD7 Joint Venture, scheduled for release after 1996, is in the design
phase, and is subject to further review based on expected returns/1/. To date,
no material expenditures or commitments have been incurred. All development,
manufacturing, testing, marketing and distribution costs will be advanced by the
Company and then recouped prior to any distribution of net receipts. Pursuant to
the letter agreement, net receipts, after the payment or reimbursement of all
costs, will be applied to the repayment to the Company and QDE of their capital
contributions, with all remaining net receipts to be shared equally by such
parties.
 
     In the normal course of business, the Company evaluates potential
acquisitions and joint ventures that may complement the Company's business.
While the Company has no present plans, commitments or agreements with respect
to any material potential acquisitions or joint ventures other than as disclosed
herein, the Company may in the future consummate acquisitions or enter into
joint ventures which may require the Company to make additional capital
expenditures, and such expenditures may be significant/1/. 

____________________________

     /1/ This statement is a forward looking statement that involves risks and
     uncertainties. Accordingly, no assurances can be given that the actual
     events and results will not be materially different than the anticipated
     results described in the forward looking statement. See the discussion of
     the Company's business and a description of the various factors that could
     materially affect the ability of the Company to achieve the anticipated
     results described in the forward looking statement which is included in
     Item 1 of the Company's Annual Report on Form 10-K for the year ended
     December 31, 1995.

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<PAGE>
 
                                7TH LEVEL, INC.

                          Part II.  Other Information


Item 6.   Exhibits and Reports on Form 8-K

     (a)  The following documents are filed as exhibits to this Report:

          10.35 - Imperial Bank - Credit Terms and Conditions; $6,000,000 Note;
                  $5,000,000 Note; General Security Agreement; Mortgage,
                  Assignment and Grant of Security Interest with Respect to
                  Trademarks; and Mortgage, Assignment and Grant of Security
                  Interest with Respect to Copyrights and Other Collateral, all
                  dated September 6, 1996.

     (b)  Reports on Form 8-K - none

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<PAGE>
 
                                7TH LEVEL, INC.

                                  Signatures

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

                                   7TH LEVEL, INC.



Date:  November 12, 1996           By /s/ David W. Craig
                                      ------------------
                                   David W. Craig
                                   Chief Financial Officer
                                   (Principal Financial Officer and
                                   Principal Accounting Officer)

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