<PAGE>
 
                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION

                            Washington, D.C.  20549
                                _______________

                                   FORM 10-Q

(Mark One)

[X]           QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
                      THE SECURITIES EXCHANGE ACT OF 1934
                 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 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 0-24936


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

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


        1201 RICHARDSON DRIVE
              SUITE 277
          RICHARDSON, TEXAS                          75080
    (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                  17,585,192
            (Title of Each Class)            Number of Shares Outstanding at
                                                      July 28, 1998
<PAGE>
 
                                7TH LEVEL, INC.

                                   Form 10-Q
                 For the Quarterly Period Ended June 30, 1998

                                     Index

<TABLE>
<CAPTION>
PART I                                      FINANCIAL INFORMATION                             Page No.
                                                                                          ----------------
<S>                       <C>                                                            <C>
Item 1                     Condensed Consolidated Balance Sheets at June 30, 1998 and
                           December 31, 1997                                                             3
 
 
                           Condensed Consolidated Statements of Operations for the
                           Three and Six Months Ended June 30, 1998 and 1997                             4
 
 
                           Condensed Consolidated Statements of Cash Flows for the Six
                           Months Ended June 30, 1998 and 1997                                           5
 
 
                           Notes to Condensed Consolidated Financial Statements                          6
 

Item 2                     Management's Discussion and Analysis of Financial Condition
                           and  Results of Operations                                                    8
 
 
PART II                    OTHER INFORMATION
 
Item 1                     Legal Proceedings                                                            14
 
Item 2                     Changes in Securities                                                        14
 
Item 4                     Submission of Matters to a Vote of Security Holders                          16
 
Item 6                     Exhibits and Reports on Form 8-K                                             16
 
                           SIGNATURE                                                                    17
</TABLE>
<PAGE>
 
Part I - FINANCIAL INFORMATION
Item 1.  Condensed Consolidated Financial Statements

                                7TH LEVEL, INC.
                    CONDENSED CONSOLIDATED BALANCE SHEETS 
                                  (Unaudited)
<TABLE> 
<CAPTION> 

                                                                       June 30, 1998           December 31, 1997
                                                                       -------------           -----------------
                                     ASSETS
<S>                                                                    <C>                     <C> 
Cash and cash equivalents                                                 $ 9,052,907              $ 2,465,079
Accounts receivable, net                                                       90,703                1,112,026
Inventories                                                                         -                   18,477
Other current assets                                                          599,435                  752,847
                                                                       ---------------          ---------------
                Total current assets                                        9,743,045                4,348,429
Fixed assets, net                                                           3,745,699                4,960,560
Intangible assets, net                                                         10,095                   13,132
Other assets                                                                  315,997                  532,605
                                                                       ===============          ===============
                Total assets                                             $ 13,814,836              $ 9,854,726
                                                                       ===============          ===============



                      LIABILITIES AND STOCKHOLDERS' EQUITY

Accounts payable                                                            $ 499,708              $ 1,111,732
Accrued expenses and other current liabilities                              4,502,044                5,352,874
Current portion of notes payable                                              564,453                   79,318
                                                                       ---------------          ---------------
                Total current liabilities                                   5,566,204                6,543,924
Notes payable                                                               4,266,431                  377,027
Notes payable to related parties                                                    -                  108,108
Other                                                                         256,268                  366,212
                                                                       ---------------          ---------------
                Total liabilities                                          10,088,904                7,395,271
Commitments and contingencies
Stockholders' equity:
        Series A preferred stock  ($5,500,000 liquidation value)            2,479,138                        -
        Common stock                                                          168,156                  137,837
        Additional capital                                                 76,964,315               70,642,628
        Accumulated deficit                                               (75,885,677)             (68,333,578)
        Cumulative other comprehensive income                                       -                   12,568
                                                                       ---------------          ---------------
                Total stockholders' equity                                  3,725,932                2,459,455
                                                                       ===============          ===============
                Total liabilities and stockholders' equity               $ 13,814,836              $ 9,854,726
                                                                       ===============          ===============
</TABLE> 

                            See accompanying notes.

                                       3
<PAGE>
 
                                7TH LEVEL, INC.
                CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                                  (Unaudited)

<TABLE>
<CAPTION>
                                         Three Months Ended Three Months Ended  Six Months Ended   Six Months Ended
                                            June 30, 1998      June 30, 1997      June 30, 1998      June 30, 1997
                                            -------------      -------------      -------------      -------------




<S>                                         <C>                <C>                <C>                <C>          
Net revenues                                $      72,388      $     963,736      $     534,141      $   5,161,572
Cost of revenues                                   38,423          1,037,013            123,343          3,703,148
                                            -------------      -------------      -------------      -------------
       Gross profit (loss)                         33,965            (73,277)           410,798          1,458,424
                                            -------------      -------------      -------------      -------------

Operating expenses:
       Research and product development         1,002,757          4,033,503          2,168,973          8,621,283
       Sales and marketing                        191,365          1,821,248            542,310          3,724,593
       General and administrative               2,584,269          1,392,811          3,828,587          2,993,745
                                            -------------      -------------      -------------      -------------
             Total operating expenses           3,778,391          7,247,562          6,539,870         15,339,621
                                            -------------      -------------      -------------      -------------
             Operating loss                    (3,744,426)        (7,320,839)        (6,129,072)       (13,881,197)
Interest and other, net                        (1,266,198)           181,681         (1,423,027)           280,793
                                            -------------      -------------      -------------      -------------
             Net loss                       $  (5,010,624)     $  (7,139,158)     $  (7,552,099)     $ (13,600,404)
                                            =============      =============      =============      =============

Basic and diluted loss per common share     $       (0.33)     $       (0.52)     $       (0.52)     $       (1.00)
                                            =============      =============      =============      =============

Weighted average basic and diluted
       shares outstanding                      15,022,132         13,628,742         14,406,355         13,612,820
                                            =============      =============      =============      =============
</TABLE>

                            See accompanying notes.

                                       4
<PAGE>
 
                                7TH LEVEL, INC.
                CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                  (Unaudited)
<TABLE> 
<CAPTION> 
                                                                                Six Months Ended        Six Months Ended
                                                                                  June 30, 1998           June 30, 1997
                                                                                  -------------           -------------
<S>                                                                             <C>                     <C> 
Cash flows from operating activities:
      Net loss                                                                     $(7,552,099)          $ (13,600,404)
      Adjustments to reconcile net loss to net cash used in
           operating activities:
                Non-cash compensation and interest                                   2,767,749                       -
                Depreciation and amortization                                        1,039,401               1,791,983
                (Gain) loss on sale of assets                                          161,207                 (94,802)
                Gain on early retirement of debt                                             -                 (10,142)
                Change in operating assets and liabilities                               6,941                ,991,113
                                                                                  -------------           -------------
                          Net cash used in operating activities                     (3,576,801)             (7,922,252)
                                                                                  -------------           -------------

Cash flows from investing activities:
      Capital expenditures                                                             (22,240)               (427,910)
      Proceeds from sale of assets                                                      39,528               5,594,010
      Sale of short-term investments                                                         -               2,992,458
                                                                                  -------------           -------------
                          Net cash provided by investing activities                     17,288               8,158,558
                                                                                  -------------           -------------

Cash flows from financing activities:
      Issuance of Common Stock under stock option
                and stock purchase plans                                               638,774                 216,167
      Net proceeds from issuance of preferred stock                                  5,268,876                       -
      Net proceeds from debt issuance                                                4,616,796                       -
      Proceeds from exercise of warrants                                                20,500                       -
      Issuance of Common Stock                                                           7,650                       -
      Repayment of long-term obligations                                               (99,359)             (5,750,000)
                                                                                  -------------           -------------
                         Net cash provided by (used in ) financing activities       10,453,237              (5,533,833)
                                                                                  -------------           -------------

                         Effect of exchange rate changes on cash                             -                 (17,357)
                                                                                  -------------           -------------
                         Net increase (decrease) in cash                             6,893,724              (5,314,884)
Cash and cash equivalents, beginning of period                                       2,465,079              10,798,372
                                                                                  -------------           -------------
Cash and cash equivalents, end of period                                           $ 9,358,803             $ 5,483,488
                                                                                  =============           =============
</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, 1997 [and the Company's Quarterly
Report on Form 10-Q for the quarterly period ended March 31, 1998].  The results
of operations for the three and six months June 30, 1998 are not necessarily
indicative of the results for the entire year ending December 31, 1998.

2.  Loss per Common Share

          The Company adopted the provisions of Statement of Financial
Accounting Standards No. 128 ("SFAS 128"), Earnings per Share, in the fourth
quarter of 1997, which required companies to present basic earnings per share
and diluted earnings per share.  Basic loss per share is computed by dividing
loss attributable to common stockholders by the weighted average number of
common shares outstanding during the period.  Diluted loss per share reflects
the potential dilution that could occur if securities or other contracts to
issue common stock were exercised or converted into common stock.  There is no
difference between basic and diluted loss per share in the accompanying
financial statements as the potential issuances of common stock had an
antidilutive effect.

3.  Private Placement

          In May 1998, the Company sold, pursuant to a private placement,
Secured Promissory Notes ("Notes") in the aggregate principal amount of
$4,500,000 and warrants for 675,000 shares of common stock, par value $0.01 per
share ("Common Stock"), of the Company at an exercise price of $0.01 per share.
The Company allocated approximately $1,200,000 of the proceeds from the Notes to
the warrants based on the relative fair values of the Notes and the warrants.
Accordingly, the Company is amortizing the related debt discount to interest
expense over the period from May 6, 1998 (date of issuance) to July 13, 1998
(date of exchange  see below).  All of such warrants were exercised in June
1998. On July 9, 1998, the Company obtained stockholder approval for, among
other things, an increase in its authorized Common Stock (the "Certificate of
Amendment") at its 1998 Annual Meeting of Stockholders.  The Certificate of
Amendment was filed on July 10, 1998.  On July 13, 1998, the holders of the
Notes exchanged the Notes for 4,500 shares of the Company's Series B Convertible
Preferred Stock, $0.01 par value per share ("Series B Convertible Preferred
Stock") and warrants to purchase 1,125,000 shares of Common Stock at an exercise
price of $0.01 per share.

          In May 1998, the Company also sold, pursuant to a private placement,
shares of Series A Preferred Stock in the aggregate amount of $5,500,000 and
warrants exercisable at any time or from time to time commencing from June 1,
1998 until March 30, 2005, unless there is a change in control of the Company,
at which time the warrants may be exercised immediately, for 1,375,000 shares of
Common Stock at an exercise price of $0.01 per share. The Company allocated
approximately $2,500,000 of the proceeds from the Series A Preferred Stock to
the warrants based on the relative fair values of the Series A Preferred Stock
and the warrants. All of such warrants were exercised in June 1998. On July 13,
1998, after the Certificate of Amendment was approved by the Company's
stockholders and was filed with the

                                       6
<PAGE>
 
Secretary of State of the State of Delaware, the exchange of 5,500 shares of
Series A Preferred Stock for 5,500 shares of Series B Convertible Preferred
Stock was effected.

          The Certificate of Designations, Preferences and Rights of Series B
Convertible Preferred Stock ("the Certificate of Designations") provides that on
the original issue date of the Series B Convertible Preferred Stock, the holders
of the Series B Convertible Preferred Stock will have the right to nominate two
members of the Board of Directors of the Company.  The Series B Convertible
Preferred Stock ranks senior and prior to the Common Stock and to all other
classes or series of stock issued by the Company.  Dividends accrue on the
shares of Series B Convertible Preferred Stock at the rate of 8% per annum;
provided, however, that in the event the Company fails to redeem the Series B
Convertible Preferred Stock on or before April 30, 2005, (the "Anniversary
Redemption Date") pursuant to the Certificate of Designations, the dividend rate
on the Series B Convertible Preferred Stock shall increase 2% per annum on each
anniversary of the Anniversary Redemption Date.  Annual dividends are cumulative
and are payable quarterly in arrears when and as declared by the Company's Board
of Directors.  These shares have a liquidation preference of $1,000 per share.
The Series B Convertible Preferred Stock is convertible immediately into Common
Stock, initially at a conversion price of $2.00 per share, subject to
adjustment.  The shares of Series B Convertible Preferred Stock may be redeemed,
at the option of the Company, at $1,000 per share on or after the Anniversary
Redemption Date.  Upon a change of control, the Company may offer to redeem such
shares at $2,000 per share or the Company may issue to each holder of Series B
Convertible Preferred Stock warrants exercisable for 250,000 shares of Common
Stock for each 1,000 shares of Series B Convertible Preferred Stock, at an
exercise price of $0.01 per share.  The Company also has optional redemption
rights at any time after i) completion of an underwritten public offering by the
Company with gross proceeds to the Company of at least $20,000,000 and a price
per share of Common Stock , initially in excess of $4.00 per share or ii) after
the Company's Common Stock shall have traded at an average price generally in
excess of $4.00 per share for 20 consecutive trading days and the aggregate
market value of the Common Stock held by non-Affiliates of the Company is at
least $35,000,000.  The holders of Series B Convertible Preferred Stock also are
entitled to certain preemptive rights, co-sale rights and registration rights.

                                       7
<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, 1997 [and
the Company's Quarterly Report on Form 10-Q for the quarterly period ended March
31, 1998].  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 continues to leverage its core animation software
technology on the Internet, other narrow and broadband networks and standalone
PC's.  The Company has developed a software technology, Agent 7, which can be
used to produce, lip synch and play back animated characters on Web pages and
from within all major PC software packages, such as Microsoft PowerPoint, Word
and Excel. Agent 7 1.0, which was first released for sale on the Company's
website on August 7, 1998, is the first commercial application of 7th Level's
core technology, which has been named Media Control 7, or "mc7". mc7 can be used
to control, manipulate, and publish multiple sources of media streaming over the
Internet and other networks or multiple sources resident on standalone PCs. 7th
Level plans to release additional applications this year and next, based on
mc7(1).

          On May 6, 1998, the Company closed a $10 million private placement to
finance the rollout of the Company's new line of Internet software products.
(See "Liquidity and Capital Resources.") Additionally, the Company announced
several new strategic distribution agreements and a new management team to lead
the Company's entry into the market for Internet applications, tools and
technology. Richard S. Merrick, the Company's Senior Vice President of
Technology and Chief Strategist, was named Chief Executive Officer; Curt W.
Marvis, Senior Vice President of Business Development, was named President; and
Timothy J. Cahill, formerly Vice President and General Manager of Pulse
Entertainment, Inc., was named Chief Operating Officer and Executive Vice
President. Robert Alan Ezrin, a founder of the Company, relinquished his
position as interim Chief Executive Officer and President to become Vice
Chairman of the Board of Directors.

          The Company is emerging from the development phase of its new Internet
technology and accordingly, the Company believes that significant revenues from
its new mc7 technology will not be realized until at least the second half of
1998.(1)  However, the Company has begun to realize the benefits of previous
actions reflecting a dramatically lower cost structure primarily due to staff
reductions.

RESULTS OF OPERATIONS

Three Month Periods Ended June 30, 1998 and June 30, 1997

          In the three months ended June 30, 1998, 7th Level net revenues
decreased to $72,388, which is significantly lower than the $963,736 achieved in
the three months ended June 30, 1997. Approximately $25,000 of revenues from
custom character work was recognized in the three months ended June 30, 1998
which amounted to 35% of total revenues. The remaining 65% of revenues was from
sales of CD-ROM products and licenses. The Company's minimal revenues in the
1998 period represent the transition from the previous business model and the
new strategy as discussed above. Gross revenues for the second quarter of 1997
were reduced approximately $800,000 for returns allowances and price reductions
on CD-ROM inventory already in the channel. The Company continued pricing
actions into the second quarter of 1997 to stimulate sales through the
distribution channel. The Company's returns allowance was higher in the 1997
period than previously experienced, as many of the titles in the back catalog
were not achieving sales expectations at the retail level and risked losing
shelf space. In the second three months of 1997, approximately 45% of net
revenues related to product sales and the remaining 55% was from licensing, OEM
and development contracts.

                                       8
<PAGE>
 
          Cost of revenues for the quarter ended June 30, 1998 was $38,423 or
53% of net revenue, including manufacturing cost of $7,288 and royalty and
licensing costs of $31,135. For the quarter ended June 30, 1997, cost of
revenues was $1,037,013 or 108% of net revenues. The significant cost of
revenues in the 1997 period as a percentage of net revenues is due to numerous
factors including the returns and price protection adjustments noted above as
well as asset valuation reductions, primarily inventory and prepaid royalties,
along with lower margins associated with development revenue. The Company
expects fluctuations in gross margin in the future as the Company's new business
strategy is implemented and as changes occur in the composition of the revenues
and the associated cost of revenues.(1)

          Research and product development expenses were $1,002,757 and
$4,033,503 for the three months ended June 30, 1998 and 1997, respectively.
Research and product development costs decreased 75% in the 1998 period due to
reductions in headcount and related expenditures in line with the new business
strategy. Results from the 1997 period included spending for five CD-ROM titles
in active production.

          Sales and marketing expenses were $191,365 and $1,821,248 for the
quarter ended June 30, 1998 and 1997, respectively. Sales and marketing expenses
included $94,257 and $782,061 of expenses for advertising, marketing and public
relations and $97,108 and $1,039,187 of expenses related to internal staffing
for the three months ended June 30, 1998 and 1997, respectively. Following its
departure from the CD-ROM games business, the Company has effected various cost
saving measures including staff reductions and lower advertising expenditures
which resulted in the significant decrease in sales and marketing expenses
between the two periods.

          General and administrative expenses for the three months ended June
30, 1998 were $2,584,269 compared with $1,392,811 for the three months ended
June 30, 1997. General and administrative expenses for the quarter ended June
30, 1998 included approximately $1,380,000 in non-cash compensation related to
stock granted to the Company's Chairman and Vice Chairman and approximately
$44,000 in charges for certain stock options and stock warrants granted to
consultants. Excluding the one-time expenses, general and administrative
expenses decreased approximately 17% between the two periods.

          The Company's interest income was more than offset by interest expense
in the three months ended June 30, 1998. Net interest expense was $1,266,198
recognized in the three months ended June 30, 1998 compared to $181,681 net
interest income for the three months ended June 30, 1997. Included in the amount
for 1998 was approximately $1,340,000 related to amortization of debt issuance
costs and accretion of debt discount following the financing transaction (see
"Liquidity and Capital Resources"). Included in the amount for 1997 was
approximately $95,000 for the gain recognized from the sale of an office
building, net of the interest capitalized as a cost of financing the acquisition
of land and office building construction.

Six Month Periods Ended June 30, 1998 and June 30, 1997

          For the six months ended June 30, 1998, net revenues totaled $534,141
compared to $5,161,572 for the six months ended June 30, 1997.  As previously
disclosed, the Company has transitioned from the CD-ROM games business and is
leveraging the underlying software technologies in the new business strategy.
The 90% decrease in net revenues reflects the shift in business strategy as the
new products on the mc7 platform have not yet been launched and accordingly, no
revenues have been realized.

          Cost of revenues during the six months ended June 30, 1998 was
$123,343 or 23% of net revenue.  For the six months ended June 30, 1997 cost of
revenues was $3,703,148 or 72% of net revenue.  The Company expects fluctuations
in gross margin in the future as the Company's new business strategy is
implemented.(1  The gross margin in the first half of 1997 was negatively
impacted by changes in the revenue mix, through the inclusion of substantial
returns and price protection adjustments and development revenue, which has a
higher cost of revenue than product sales or OEM licensing revenue.

                                       9
<PAGE>
 
          Research and product development expenses were $2,168,973 for the six
months ended June 30, 1998 compared to $8,621,283 for the six months ended June
30, 1997.  Research and product development expenses decreased 75% over the same
period of the prior year due to reductions in headcount and related expenditures
in line with the new business strategy.

          Sales and marketing expenses were $542,310 or 102% of revenues, for
the six months ended June 30, 1998, compared to $3,724,593, or 72% of revenues,
for the six months ended June 30, 1997.  Internal staffing expenses decreased
approximately 80% as a result of personnel reductions and closure of the
Company's international sales and marketing offices.  Costs for advertising,
marketing and public relations decreased by 91% in the first half of 1998
compared to the first half of 1997 as no products were launched in the first
half of 1998 and marketing activities were negligible.

          General and administrative expenses were $3,828,587 for the six months
ended June 30, 1998, compared with $2,993,745 for the six months ended June 30,
1997.  One time charges were recognized in the first half of 1998 totaling
$1,824,000 which included approximately (i)$1,380,000 in non-cash compensation
related to stock granted to the Company's Chairman and Vice Chairman, (ii)
$44,000 in charges for certain stock options and stock warrants granted to
consultants and (iii) $400,000 related to professional fees associated with the
terminated merger with Pulse.  Approximately $400,000 of the amount in the 1997
period was associated with expenses related to employee resignations in the
first quarter of 1997.  Excluding the one-time expenses, general and
administrative expenses decreased approximately 23% between the two periods.

          Net interest expense was $1,423,027 for the six months ended June 30,
1998 compared to $280,793 net interest income for the six months ended June 30,
1997. Included in the amount for 1998 was approximately $1,340,000 expense
related to amortization of debt issuance costs and accretion of debt discount
following the financing transaction (see "Liquidity and Capital Resources"). The
decrease is also because of lower cash balances available for investment along
with higher average debt outstanding. Included in the amount for 1997 was
approximately $95,000 for the gain recognized from the sale of an office
building, net of the interest capitalized as a cost of financing the acquisition
of land and office building construction.

LIQUIDITY AND CAPITAL RESOURCES

          Cash and short term investments increased $6,587,828 during the first
half of the year to $9,052,907 at June 30, 1998.  The increase is the result of
the $10,000,000 private placement funded in May 1998, offset by operating
activities during the first six months of 1998.  Net cash used in operating
activities was $3,729,749 which included a net loss of $7,552,099 for the six
months ended June 30, 1998, offset by non cash items such as charges for stock
grants and amortization of debt issuance costs and accretion of debt discount
described above, as well as the non-cash depreciation and amortization expenses.
Approximately $660,000 cash was provided in the six months ended June 30, 1998
from the issuance of Common Stock due to exercises of stock options, stock
purchase agreements and stock warrants.  The Company sold surplus equipment
resulting in a loss on disposition of $161,207, and has significantly curtailed
capital expenditures, with disbursements of $22,240, in the first six months of
1998 compared to $427,910 in the same period of 1997.  Capital expenditures for
the second half of 1998 are anticipated to be minimal (1), however, the Company
continues to use cash and operate at a loss.

          In May 1998, the Company sold, pursuant to a private placement, Notes
in the aggregate principal amount of $4,500,000 and warrants for 675,000 shares
of Common Stock at an exercise price of $0.01 per share. The Company allocated
approximately $1,200,000 of the proceeds from the Notes to the warrants based on
the relative fair values of the Notes and the warrants. Accordingly, the Company
is amortizing the related debt discount to interest expense over the period from
May 6, 1998 (date of issuance) to July 13, 1998 (date of exchange see below).
All of such warrants were exercised in June 1998. On July 9, 1998, the Company
obtained stockholder approval for, among other things, an increase in its
authorized

                                       10
<PAGE>
 
Common Stock and the Certificate of Amendment was filed on July 10, 1998. On
July 13, 1998, the holders of the Notes exchanged the Notes for 4,500 shares of
the Company's Series B Convertible Preferred Stock, $0.01 par value per share
("Series B Convertible Preferred Stock") and warrants to purchase 1,125,000
shares of Common Stock at an exercise price of $0.01 per share.

          In May 1998, the Company also sold, pursuant to a private placement,
shares of Series A Preferred Stock in the aggregate amount of $5,500,000 and
warrants exercisable at any time or from time to time commencing from June 1,
1998 until March 30, 2005, unless there is a change in control of the Company,
at which time the warrants may be exercised immediately, for 1,375,000 shares of
Common Stock at an exercise price of $0.01 per share.  The Company allocated
approximately $2,500,000 of the proceeds from the Series A Preferred Stock to
the warrants based on the relative fair values of the Series A Preferred Stock
and the warrants.  All of such warrants were exercised in June 1998. On July 13,
1998, after the Certificate of Amendment was approved by the Company's
stockholders and was filed with the Secretary of State of the State of Delaware,
the exchange of 5,500 shares of Series A Preferred Stock for 5,500 shares of
Series B Convertible Preferred Stock was effected.

          The Certificate of Designations, Preferences and Rights of Series B
Convertible Preferred Stock ("the Certificate of Designations") provides that on
the original issue date of the Series B Convertible Preferred Stock, the holders
of the Series B Convertible Preferred Stock will have the right to nominate two
members of the Board of Directors of the Company.  The Series B Convertible
Preferred Stock ranks senior and prior to the Common Stock and to all other
classes or series of stock issued by the Company.  Dividends accrue on the
shares of Series B Convertible Preferred Stock at the rate of 8% per annum;
provided, however, that in the event the Company fails to redeem the Series B
Convertible Preferred Stock on or before April 30, 2005, (the "Anniversary
Redemption Date") pursuant to the Certificate of Designations, the dividend rate
on the Series B Convertible Preferred Stock shall increase 2% per annum on each
anniversary of the Anniversary Redemption Date.  Annual dividends are cumulative
and are payable quarterly in arrears when and as declared by the Company's Board
of Directors.  These shares have a liquidation preference of $1,000 per share.
The Series B Convertible Preferred Stock is convertible immediately into Common
Stock, initially at a conversion price of $2.00 per share, subject to
adjustment.  The shares of Series B Convertible Preferred Stock may be redeemed,
at the option of the Company, at $1,000 per share on or after the Anniversary
Redemption Date.  Upon a change of control, the Company may offer to redeem such
shares at $2,000 per share or the Company may issue to each holder of Series B
Convertible Preferred Stock warrants exercisable for 250,000 shares of Common
Stock for each 1,000 shares of Series B Convertible Preferred Stock, at an
exercise price of $0.01 per share.  The Company also has optional redemption
rights at any time after i) completion of an underwritten public offering by the
Company with gross proceeds to the Company of at least $20,000,000 and a price
per share of Common Stock , initially in excess of $4.00 per share or ii) after
the Company's Common Stock shall have traded at an average price generally in
excess of $4.00 per share for 20 consecutive trading days and the aggregate
market value of the Common Stock held by non-Affiliates of the Company is at
least $35,000,000.  The holders of Series B Convertible Preferred Stock are also
entitled to certain preemptive rights, co-sale rights and registration rights.

           Subsequent to accepting commitments for the $10,000,000 financing, 
the Company was advised that it will be required to decrease the income 
(increase the loss) attributable to common shareholders for the quarter ending 
September 30, 1998, as a result of the increase in the market price of the 
Company's Common Stock from the date the Company entered into agreements with 
respect to the financing to the date of issuance of the Series B Convertible 
Preferred Stock (July 13, 1998). The reduction in income (increase in loss) 
attributable to common shareholders is based upon the difference between the 
market price of 5,000,000 shares of Common Stock into which the Series B 
Convertible Preferred Stock is convertible and the carrying value of the Series 
B Convertible Preferred Stock on the assumed date of conversion, or 
approximately $15,000,000.  The one-time occurrence would be accounted for 
similar to a non-cash dividend and would not affect the Company's net income 
(loss) nor aggregate stockholders' equity.  In the view of the Company's 
accountants, based on the SEC's current position and the recent discussions of 
the Financial Accounting Standards Board's Emerging Issues Task Force Topic 
D-60 (Accounting for the Issuance of Convertible Preferred Stock and Debt 
Securities with a Nondetachable Conversion Feature), the Series B Convertible 
Preferred Stock conversion feature should be recognized and measured on July 13,
1998. The underlying conversion rate was provided for when the terms of the
financing were agreed to and at a price above the then current market price of
the Company's Common Stock, i.e., "out-of-the-money". Subsequent to reaching
agreement on the financing transaction, the market price of the Company's Common
Stock increased such that the conversion rate (fixed at the time of the
financing commitment) was "in the money" at the time the securities were issued.

                                       11
<PAGE>
 
          To date, the Company continues to use cash and 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, adoption of the
Internet as a medium of commerce and communications and various other factors,
some of which may be beyond the Company's control.  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).

          The Company received a letter from Nasdaq setting forth conditions for
continued listing.  The Company satisfied all of Nasdaq's conditions.  The
Company subsequently received a memo entitled, "Update to Hearings Memorandum
from Nasdaq" regarding certain stock and option issuances to directors and
officers.  The Company believes it is in compliance with all of Nasdaq's
requirements and has so indicated in its response to Nasdaq.

                                       12
<PAGE>
 
RECENTLY ISSUED ACCOUNTING PRINCIPLES

          In June 1997, Statement of Financial Accounting Standards No. 131,
Disclosures about Segments of an Enterprise and Related Information ("SFAS No.
131") was issued.  This statement establishes standards for reporting
information about operating segments in annual and interim financial statements,
although this statement need not be applied to interim financial statement in
the initial year of its application.  This statement is effective for fiscal
years beginning after December 15, 1997.  The adoption of SFAS No. 131 is not
expected to have a material impact on the Company's financial statements and
related disclosures.

          In April, 1998, Statement of Position (SOP) 98-5, Reporting on the
Costs of Start-up Activities was issued.  This SOP provides guidance on the
financial reporting of start-up and organization costs and requires that these
costs be expensed as incurred.  The provisions of SOP 98-5 are effective for
financial statements for fiscal years beginning after December 15, 1998,
although early adoption is allowed.  Adoption of SOP 98-5 is not expected to
have a material impact on the Company's financial statements.  The Company will
adopt the provisions of this SOP on January 1, 1999.

_______________________________________________________________________________
     (1)  Certain statements contained herein including those indicated by (1)
          are forward looking statements that involve risks and uncertainties.
          Accordingly, no assurance can be given that the actual events and
          results will not be materially different than the anticipated results
          described in the forward looking statement. There are a number of
          important factors that could cause actual results to differ materially
          from those expressed in any forward looking statements made by the
          Company. These factors include among others, the Company's ability to
          complete new products at planned costs and on planned schedules, the
          Company's ability to attract and retain strategic partners, the
          Company's ability to leverage intangible assets in its technology, the
          success of the Company's cost reduction strategy and the Company's
          ability to maintain a sufficient level of financing for its new
          business strategy. Additional factors which are beyond the Company's
          control and could influence results include market acceptance of the
          Company's products and adoption of the Internet as a medium of
          commerce and communications. 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 Report on Form 10-K for the
          year ended December 31, 1997.


ITEM 3.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not applicable

                                       13
<PAGE>
 
                                7TH LEVEL, INC.

                          Part II.  Other Information


Item 1.   Legal Proceedings

               Technology Edutainment Network Laboratory Co., Ltd. v. 7th Level,
          Inc., United States District Court for the Central District of
          California, Case No. 98-3923 ADH (JGx).  On May 19, 1998, plaintiff
          Technology Endutainment Network Laboratory Co., Ltd. ("TEN") filed a
          suit against the Company for alleged breach of contract and related
          claims concerning a contract for development of CD-ROM software,
          seeking $246,000 in alleged damages (the "Action").  On June 26, 1998,
          the Court partially granted TEN's application for a writ of attachment
          in the amount of $144,000.  The writ of attachment has not yet been
          issued, and the Company intends to file an undertaking with the Court,
          or take other steps to secure against the attachment order so that no
          property is attached.  On June 29, 1998, TEN instituted arbitration
          proceedings before the American Arbitration Association ("AAA") on the
          same claims it brought in the Action.  On July 13, 1998, the Court
          issued an order staying the Action pending arbitration of the issues
          contained in the Action before the AAA.  The Company intends
          vigorously to defend itself against TEN's claims in the arbitration
          and is considering filing a counterclaim against TEN concerning its
          alleged non-performance under the software development contract.  The
          matter is still in its early stages and no arbitration proceedings
          have taken place.

Item 2.   Changes in Securities

               In April 1998, the Board of Directors approved the grant of
          options under a broad based plan to purchase approximately 2,967
          shares of Series C Preferred Stock, ("Series C Preferred Stock") or
          upon the filing of a Certificate of Amendment (the "Amendment")
          increasing the Company's authorized Common Stock, which occurred on
          July 10, 1998, approximately 2,967,000 shares of Common Stock to
          Directors, management, employees and consultants.

               In May 1998, the Board of Directors approved the potential grant
          of an option to purchase 350 shares of Series C Preferred Stock or,
          upon the filing of the Amendment, which occurred on July 10, 1998,
          350,000 shares of Common Stock to the new Chief Executive Officer
          conditioned upon a successful secondary offering and the attainment of
          a $15 per share stock price average for 60 days by the Company.

               In May 1998, the Board of Directors approved the grant of a
          warrant to purchase 200 shares of Series C Preferred Stock or, upon
          the filing of the Amendment, which occurred on July 10, 1998, 200,000
          shares of Common Stock to East West Capital Associates, Inc. in
          connection with a consulting agreement, of which 50 shares of Series C
          Preferred Stock will be issued at $2.00 per one one-thousandth of a
          share, 50 shares at $3.00 per one one-thousandth of a share, 50 shares
          at $4.00 per one one-thousandth of a share and 50 shares at $5.00 per
          one one-thousandth of a share, or 50,000 shares of Common Stock will
          be issued at $2.00 per share, 50,000 shares at $3.00 per share, 50,000
          shares at $4.00 per share and 50,000 shares at $5.00 per share.

                                       14
<PAGE>
 
               In May 1998, the Board of Directors approved the grant of a
          warrant to purchase 800 shares of Series C Preferred Stock or, upon
          the filing of the Amendment, which occurred on July 10, 1998, 800,000
          shares of Common Stock to Donaldson, Lufkin and Jenrette Securities
          Corporation in connection with an engagement letter executed in
          November 1997, with respect to the Company's private placement of debt
          or equity securities, of which 200 shares of Series C Preferred Stock
          will be issued at $2.00 per one one-thousandth of a share, 200 shares
          at $3.00 per one one-thousandth of a share, 200 shares at $4.00 per
          one one-thousandth of a share and 200 shares at $5.00 per one one-
          thousandth of a share, or 200,000 shares of Common Stock will be
          issued at $2.00 per share, 200,000 shares at $3.00 per share, 200,000
          shares at $4.00 per share and 200,000 shares at $5.00 per share.

               In April, 1998, as part of the broad based plan, the Board of
          Directors granted 655,000 and 110,000 shares of Common Stock to Donald
          Schupak and Robert Ezrin, respectively, in exchange for the payment of
          $0.01 per share and the surrender of options issued to Messrs. Schupak
          and Ezrin to purchase 655,000 and 60,000 shares of Common Stock,
          respectively.  In addition, Messrs. Schupak and Ezrin waived cash
          bonuses which they were entitled to upon completion of the Company's
          $10,000,000 financing.

               The information concerning the Notes, the Series A Preferred
          Stock, the Series B Convertible Preferred Stock and the warrants
          issued with respect to the Notes and the Series A Preferred Stock set
          forth in Part 1, Item 2, "Management's Discussion and Analysis of
          Financial Condition and Results of Operations" in the second and third
          paragraphs under "Liquidity and Capital Resources" on pages ten and
          eleven of this Report is incorporated herein by reference.

               The Company believes the sale of the Notes and the warrants
          issued in connection therewith qualifies as a transaction by an issuer
          not involving a public offering within the meaning of Section 4(2) of
          the Securities Act of 1933, as amended (the "Securities Act"), based
          on the manner of offering (a negotiated sale to two "accredited
          investors" (as defined in Rule 501 of Regulation D under the
          Securities Act) without general solicitation) and the purchasers'
          financial status, investment experience and investment intent, as
          represented to the Company.

               The Company believes the sale of the Series A Preferred Stock and
          the warrants issued in connection therewith qualifies as a transaction
          by an issuer not involving a public offering within the meaning of
          Section 4(2) of the Securities Act based on the manner of offering (a
          negotiated sale to "accredited investors" (as defined in Rule 501 of
          Regulation D under the Securities Act) and to two non-accredited
          investors without general solicitation) and the purchasers' financial
          status, investment experience and investment intent, as represented to
          the Company.

                                       15
<PAGE>
 
Item 4.   Submission of Matters to a Vote of Security Holders

          The Company's Annual Meeting of Stockholders was held on July 9, 1998.
          The results of the voting were as follows:

          Proposal 1:  Election of Directors of the Company

<TABLE>
<CAPTION>
                                                Votes          Votes          Votes
                                                -----          -----          -----
                 Nominee                         For          Against      Abstaining
                 -------                         ---          -------      ----------
<S>                                           <C>             <C>           <C>
          Donald Schupak                       16,388,144       7,855        129,878
          Robert Alan Ezrin                    16,380,052      16,214        129,878
          Merv Adelson                         16,383,416      12,850        129,878
          James A. Cannavino                   16,389,116       7,150        129,878
          Richard S. Merrick                   16,389,666       6,600        129,878
</TABLE>

          Proposal 2:  Approval of an amendment to the Restated Certificate of
          Incorporation of the Corporation (the "Certificate of Incorporation")
          to increase the number of authorized shares of Common Stock from
          20,000,000 to 100,000,000.

                              Votes For:                         15,986,641
                              Votes Against:                        469,448
                              Votes Abstaining:                      70,055

          Proposal 3:  Approval of an amendment to the Certificate of
          Incorporation to amend the terms of the Corporation's blank check
          preferred stock to provide that the Board of Directors of the
          Corporation may designate shares of preferred stock with voting rights
          other than one vote per share.

                              Votes For:                          9,402,803
                              Votes Against:                        474,057
                              Votes Abstaining:                     184,098

Item 6.   Exhibits and Reports on Form 8-K
 
(a)       Exhibits

          10.43 -  Employment Agreement, dated as of April 20, 1998 by and
                   between the Company and Richard S. Merrick

          27    -  Financial data schedule

(b)       Reports on Form 8-K

               Registrant filed a Current Report on Form 8-K, dated July 9,
          1998, in respect to the proposals approved at the annual stock holder
          meeting, the filing of the Certificate of Amendment, the automatic
          conversion of Series A Preferred Stock to Series B Convertible
          Preferred Stock and the exchange of the Notes for Series B Convertible
          Preferred Stock. (Item 5).

               Registrant filed a Current Report on Form 8-K, dated April 23,
          1998, in respect to the press release of registrant dated April 22,
          1998 announcing 7th Level & Pulse Cancel Merger Plans; 7th Level
          Announces Commitments and Terms for $4.5 Million Bridge Loan and $10
          Million Private Placement.  (Item 5.)

                                       16
<PAGE>
 
                                7TH LEVEL, INC.

                                   Signature

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.

                                    7/TH/ LEVEL, INC.


 

Date:      August 12, 1998                 By: /s/ DONALD SCHUPAK
                                              ----------------------------------
                                              Donald Schupak
                                              Chairman of the Board and Director
                                              (Principal Financial Officer)

                                       17