<PAGE>
 
                      SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, DC 20549
                                        
                                   FORM 10-Q
                               QUARTERLY REPORT
    Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Quarter Ended                       Commission File Number
  September 30, 1997                               0-20706


                                DATA RACE, INC.
            (Exact name of registrant as specified in its charter)


        Texas                                            74-2272363
(State of Incorporation)                     (I.R.S.Employer Identification No.)


                           12400 Network Boulevard
                           San Antonio, Texas 78249
                           Telephone (210) 263-2000
              (Address, including zip code, and telephone number,
       including area code, of registrant's principal executive offices)

       Securities registered pursuant to Section 12(b) of the Act:  None

   Securities registered pursuant to Section 12(g) of the Act:  Common Stock



Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.  YES  X   NO
                                        ---    ---


On November 7, 1997, there were 5,541,677 outstanding shares of Common Stock, no
par value.

                                       1
<PAGE>
 
                                DATA RACE, INC.
                              INDEX TO FORM 10-Q

 
                                                                           Page
                                                                          Number
                                                                          ------
PART I.  FINANCIAL INFORMATION
------------------------------

Item 1. Interim Condensed Financial Statements (Unaudited):
 

          Condensed Balance Sheets as of  September 30, 1997
           and June 30, 1997................................................   3
 
          Condensed Statements of Operations for the Three Months
          Ended September 30, 1997 and 1996.................................   4
 
          Condensed Statements of Cash Flows for the Three Months
          Ended September 30, 1997 and 1996.................................   5
 
          Notes to Interim Condensed Financial Statements...................   6
 
Item 2.  Management's Discussion and Analysis of Financial
          Condition and Results of Operations...............................   9
 
 
PART II.  OTHER INFORMATION
---------------------------
 
Item 1.  Legal Proceedings..................................................  12
 
Item 2.  Changes in Securities..............................................  12
 
Item 3.  Defaults Upon Senior Securities....................................  12
 
Item 4.  Submission of Matters to a Vote of Security Holders................  12
 
Item 5.  Other Information..................................................  12
 
Item 6.  Exhibits and Reports on Form 8-K...................................  12

 
SIGNATURES..................................................................  13
----------                                                   

                                       2
<PAGE>
 
                        PART I.  FINANCIAL INFORMATION
                        ------------------------------

ITEM 1.  INTERIM CONDENSED FINANCIAL STATEMENTS
-----------------------------------------------


                                DATA RACE, INC.
                           CONDENSED BALANCE SHEETS
                                   UNAUDITED

<TABLE>
<CAPTION>
                                                       AS OF
                                          -------------------------------
                                          SEPT. 30, 1997    JUNE 30, 1997
                                          --------------    -------------
<S>                                       <C>               <C>
ASSETS

Current assets:
  Cash and cash equivalents..............   $  2,509,892     $  4,535,768
  Accounts receivable, net...............        903,208        1,879,656
  Inventory..............................      1,038,293        1,056,999
  Prepaid expenses and deposits..........         22,889           22,889
                                            ------------     ------------
    Total current assets.................      4,474,282        7,495,312

Property and equipment, net..............      1,801,919        1,932,317
Other assets, net........................         42,689           42,689
                                            ------------     ------------
    Total assets.........................   $  6,318,890     $  9,470,318
                                            ============     ============


LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities:
  Accounts payable.......................   $    742,772     $    912,522
  Accrued expenses.......................      1,350,881        1,693,265
  Other current liabilities..............              -              932
                                            ------------     ------------
    Total current liabilities............      2,093,653        2,606,719

Commitments and contingencies

Shareholders' equity:
  Preferred stock........................        747,678        3,079,447
  Common stock...........................     29,241,514       26,680,686
  Additional paid-in capital.............      1,882,303        1,882,303
  Retained earnings (deficit)............    (27,646,258)     (24,778,837)
                                            ------------     ------------
    Total shareholders' equity...........      4,225,237        6,863,599
                                            ------------     ------------
     Total liabilities and
      shareholders' equity...............   $  6,318,890     $  9,470,318
                                            ============     ============
</TABLE>

  See accompanying notes to interim condensed financial statements unaudited

                                       3
<PAGE>
 
                                DATA RACE, INC.
                      CONDENSED STATEMENTS OF OPERATIONS
                                   UNAUDITED
<TABLE>
<CAPTION>
 
 
                                             THREE MONTHS ENDED SEPTEMBER 30,
                                             ---------------------------------
                                                  1997                 1996
                                             ---------------------------------
 
<S>                                          <C>                   <C>          
Total revenue...............................  $ 1,153,925          $ 7,943,204 
                                                                               
Cost of revenue.............................    1,004,604            6,515,809 
                                              -----------          ----------- 
                                                                               
    Gross profit............................      149,321            1,427,395 
                                              -----------          ----------- 
                                                                               
Operating expenses:                                                            
 Engineering and product development........    1,073,419            1,215,520 
 Sales and marketing........................    1,087,062              933,592 
 General and administration.................      759,538              703,297 
                                              -----------          ----------- 
    Total operating expenses................    2,920,019            2,852,409 
                                              -----------          ----------- 
                                                                               
    Operating loss..........................   (2,770,698)          (1,425,014)
                                              -----------          ----------- 
                                                                               
Other income:                                      46,509               43,717 
                                                                               
Loss before income taxes....................   (2,724,189)          (1,381,297)
Income tax benefit..........................            -                    - 
                                              -----------          ----------- 
                                                                               
    Net loss................................  $(2,724,189)         $(1,381,297)
                                              ===========          =========== 
                                                                               
Per share data:                                                                
    Net loss................................   (2,724,189)          (1,381,297)
    Effect of beneficial conversion feature                                    
    of convertible preferred stock..........     (143,231)                   - 
    Net loss applicable to common stock.....   (2,867,420)          (1,381,297)
                                              ===========          =========== 
    Net loss per share applicable to common                                    
    stock...................................  $     (0.54)         $     (0.29)
                                              ===========          =========== 
                                                                               
Weighted average shares outstanding.........    5,264,000            4,754,000 
                                              ===========          ===========  
 
</TABLE>

  See accompanying notes to interim condensed financial statements unaudited

                                       4
<PAGE>
 
                                DATA RACE, INC.
                      CONDENSED STATEMENTS OF CASH FLOWS
                                   UNAUDITED
<TABLE>
<CAPTION>
 
                                          THREE MONTHS ENDED SEPTEMBER 30,
                                          --------------------------------
                                                  1997            1996
                                          ----------------    ------------
<S>                                          <C>              <C>
Cash flows from operating activities:
 Net income (loss).........................  $ (2,724,189)    $(1,381,297)
 Adjustments to reconcile net income
  (loss) to net cash provided by (used
  in) operating activities:
  Depreciation and amortization............       155,020         219,879
  Gain on sale of property and equipment...        (2,320)              -
  Changes in assets and liabilitiies:
  Accounts receivable......................       976,448        (604,630)
  Inventory................................        18,706       1,446,921
  Prepaid expenses, deposits and other
   assets..................................             -          20,246
  Accounts payable.........................      (169,750)       (330,099)
  Accrued expenses.........................      (342,384)          2,630
  Other current liabilities................          (932)        (13,562)
                                             ------------     -----------
    Net cash used in operating activities..    (2,089,401)       (639,912)
                                             ------------     -----------

Cash flows from investing activities:
 Purchase of property and equipment........       (24,622)        (74,705)
 Proceeds from sale of property and
  equipment................................         2,320          31,707
                                             ------------     -----------
    Net cash used in investing activities..       (22,302)        (42,998)
                                             ------------     -----------

Cash flows from financing activities:
 Stock option transactions.................        85,827        (107,324)
                                             ------------     -----------
    Net cash provided by (used in)
     financing activities..................        85,827        (107,324)
                                             ------------     -----------

Net decrease in cash and cash
 equivalents...............................    (2,025,876)       (790,234)

Cash and cash equivalents at beginning
 of period.................................     4,535,768       3,990,435
                                             ------------     -----------

Cash and cash equivalents at end of
 period....................................  $  2,509,892     $ 3,200,201
                                             ============     ===========
 
 
</TABLE>

  See accompanying notes to interim condensed financial statements unaudited

                                       5
<PAGE>
 
                                DATA RACE, INC.
                NOTES TO INTERIM CONDENSED FINANCIAL STATEMENTS
                                   UNAUDITED


1)  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
----------------------------------------------

DESCRIPTION OF BUSINESS

DATA RACE, Inc. ("DATA RACE" or the "Company") designs, manufactures, and
markets a line of communication products that meet the need for "Remote Access
to the Corporate Environment." The Company's products enable knowledge workers
who work at home, in branch offices, or on the road from hotels or airport
lounges to access the various elements of the corporate communications
infrastructure. These products include the Be There! personal
multiplexer system, a unique client/server product that enables teleworkers to
access all elements of the corporate communications network. With Be There!,
teleworkers access the corporate intranet, LAN and the Internet, while sending
and receiving e-mail, faxes and phone calls--simultaneously--over a single phone
line. The Company also designs and manufactures advanced communications
subsystems for manufacturers of notebook computers, as well as a line of network
multiplexers which carry data, LAN, voice, and fax traffic between a company's
branch and headquarters offices, over a broad range of wide area communications
speeds and services.

BASIS OF PRESENTATION

The unaudited interim financial statements reflect all adjustments (consisting
of normal recurring accruals) that in the opinion of management are necessary
for a fair presentation of the financial position, results of operations and
cash flows for such periods.  These financial statements should be read in
conjunction with the Company's financial statements and notes thereto included
in the June 30, 1997 Annual Report on Form 10-K.  The condensed balance sheet
data as of June 30, 1997 included herein has been derived from such audited
financial statements.  Interim period results are not necessarily indicative of
the results to be expected for any future periods or the full year.

Earnings (loss) per share are computed using the weighted average number of
common and common equivalent shares (when dilutive) outstanding during each
period.  Common equivalent shares include stock options and warrants.  As
discussed in Note 4 to the Company's condensed financial statements, Net Income
applicable to Common Stock has been reduced to reflect the effect of the
beneficial conversion features of the Convertible Preferred Stock and related
Warrants.

                                       6
<PAGE>
 
2)  INVENTORY
-------------

Inventory is valued at the lower of cost (principally standard cost which
approximates current cost) or market (net realizable value).  Inventory consists
of the following:

<TABLE>
<CAPTION>
 
                            September 30,       June 30,
                               1997               1997
                           --------------   -------------
    <S>                    <C>              <C>          
    Finished goods            $  113,628       $  218,777
    Work in process              589,395          440,005
    Raw materials                335,270          398,217
                           -------------    -------------
    Total inventory           $1,038,293       $1,056,999
                           =============    ============= 
</TABLE>

3)  LITIGATION
--------------

On November 28, 1995, a class action shareholder lawsuit was filed against the
Company and certain of its officers.  On December 15, 1995, an additional
shareholder lawsuit was filed with identical allegations.  On February 23, 1996,
the cases were consolidated, and the style of the case was changed to In re Data
                                                                      ----------
Race Securities Litigation.
-------------------------- 

On July 29, 1997, the Company and the plaintiffs agreed to settle the In re Data
                                                                      ----------
Race Securities Litigation.  If the lawsuit were settled in accordance with
---------------------------                                                 
this agreement, the Company's insurance carrier would pay $800,000 in cash and
the Company would contribute 10,000 shares of Common Stock.  The Company
believes that the case is absolutely without merit, and that neither the Company
nor any of the other defendants committed any of the alleged wrongdoings.  The
Company decided to accept the settlement agreement based on the advice of
counsel that the costs to the Company of defending the lawsuit could exceed the
cost to the Company of the proposed settlement, and based on the unpredictable
results of jury trails.  The settlement is contingent upon execution of a
definitive settlement agreement, U.S. District Court approval and certain other
conditions.  There can be no assurance that all such conditions will be
satisfied.  In the event final settlement is not reached, the Company intends to
continue to vigorously defend against the claims made in the lawsuit.  The
Company is unable, however, to predict the costs to be incurred to resolve the
lawsuit in the event settlement is not reached on the terms set forth in the
preliminary settlement agreement.  The Company is required under certain
circumstances to indemnify the named officers against losses incurred as a
result of the lawsuit.

4)  ACCOUNTING TREATMENT FOR CONVERTIBLE PREFERRED SECURITIES
-------------------------------------------------------------

On March 13, 1997, the SEC staff announced its position on the accounting
treatment for the issuance of convertible preferred stock and debt securities
with beneficial conversion features such as those contained in the Preferred
Stock issued in January 1997.

                                       7
<PAGE>
 
In accordance with the SEC staff's announcement, the beneficial conversion
features of the Preferred Stock have been recognized by allocating a portion of
the proceeds to additional paid-in capital.  The amount allocated to additional
paid-in capital consists of the conversion discount of the Preferred Stock and
the value attributed to the Warrants.  The conversion discount is calculated, at
the date of issuance, as the difference between the conversion price and the
fair value of the common stock into which the security is convertible.  Because
the security provides for more than one conversion rate, in conformity to the
SEC announcement, the computation is made using the conversion terms most
beneficial to the investor, regardless of the actual discount applied upon
conversion.  The value of the Warrants is calculated using a Black-Scholes model
and may or may not correspond to a market value.

The calculated intrinsic value of the beneficial conversion features of the
Preferred Stock, the offering costs and the premium will result in non-cash
charges of $2,285,000 to earnings (loss) available to common shareholders in the
computation of earnings (loss) per common share over the conversion period as
required by the SEC guidelines. As of September 30, 1997 approximately
$2,178,000 has been charged, with approximately $107,000 to be charged in the
next fiscal quarter. As a result, the Company will show these non-cash charges
to earnings (loss) available to common shareholders in the computation of
earnings (loss) per common share over the period from January 1997 through
December 1997. As of September 30, 1997, 4,195 shares of the initial 5,000
shares of the 1997 Series A Convertible Preferred Stock had been converted into
570,839 shares of common stock.

5) SUBSEQUENT EVENTS
--------------------

Subsequent to September 30, 1997, the Company completed an $8,000,000 private 
placement of which $5,000,000 has been received and $3,000,000 is committed for 
purchase by January 29, 1998, subject to certain conditions.

                                       8
<PAGE>
 
ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
--------------------------------------------------------------------------------
OF OPERATIONS
-------------

OVERVIEW

DATA RACE believes that the indirect sales channels are critically important to
reaching its revenue objectives. As a result, the Company has focused a large
amount of its resources in establishing relationships with a variety of
distribution partnership, especially the billion-dollar class partners. While
the time to record revenue from indirect sales partners is somewhat longer than
direct sales, due to the need for joint generation of a marketing plan and
training of salespeople at multiple locations, the Company believes that this
strategy is in the shareholders' best interest. The Company has made progress in
establishing these important indirect sales partnerships. During recent months,
DATA RACE has signed national agreements with Inacom Communications and Data
General, strengthened its service and support offerings, and signed a number of
agreements with regional resellers.

The Company has recorded revenue from shipments to about one dozen customers and
distribution partners to date. While Be There! sales have increased, they are 
not yet a significant part of the Company's revenue. In addition, the Company 
currently has numerous trials, ranging from recent installations to a number of 
trials on which the Company hopes to receive purchase decisions shortly. These 
trials are installed at companies from the financial services, 
telecommunications, food, chemical, and retail sales industries, and vary in 
size from small companies to among the nation's largest.

During the last few months, a third of Data General's U.S. sales offices and
over 50 salespeople have been trained to sell Be There! systems. In addition,
the Company has completed its first jointly-sponsored Data General customer
seminar and has presented the Be There! product at two internal Data General
U.S. and international annual sales events. While the Inacom Communications
national distribution agreement was only recently signed, DATA RACE has already
trained three sales offices, representing over 25 salespeople. Inacom also
recently selected DATA RACE as its first external vendor for its interactive
video service designed to update, educate and communicate interactively with
Inacom employees across the country.

RESULTS OF OPERATIONS

Total revenue for the three months ended September 30, 1997 decreased 85% to
$1,153,925 from $7,943,204 in the same period of the prior fiscal year. This
decrease was primarily due to the completion during the quarter ended June 30,
1997 of substantially all shipments of existing custom modem contracts.

Gross profit margin was 13% for the three months ended September 30, 1997. This
gross profit margin is down from 18% for the comparable quarter of the prior
fiscal year primarily due to manufacturing variances attributable to reduced
production volumes.

Operating expenses of $2,920,019 for the three months ended September 30, 1997
were comparable to the same period of the prior fiscal year.

                                       9
<PAGE>
 
LIQUIDITY AND CAPITAL RESOURCES

Operating losses have had and continue to have a significant negative effect on 
the Company's cash balance. At September 30, 1997, the Company had $2,509,892 in
cash and cash equivalents.

In November 1997, the Company received proceeds of $5,000,000 from the issuance
of convertible preferred stock and warrants.  The convertible preferred stock is
redeemable under certain circumstances.  See note 5 to the Company's condensed
financial statements.

The Company's ability to sustain operations, make future capital expenditures
and fund the development and marketing of new products, including the Be There!
personal multiplexer, are highly dependent on existing cash and some or all of
the following: demands on cash to support the custom modem business, final
settlement of the shareholder lawsuit, and the Company's return to
profitability.  The timing and amount of the Company's future capital
requirements can not be accurately predicted. The Company does not anticipate a
return to profitability as long as its expenditures on the Be There! system
remain disproportionate to attendant revenue. As a result, the Company may in 
the future require additional financing; the failure to obtain such financing 
when needed would have a material adverse effect on the Company.

The Company maintains a $1,500,000 revolving line of credit from a financial
institution.  The line of credit has a term of one year and an interest rate of
prime plus 1%.  The Company must meet certain covenants, including profitability
covenants, to draw under the line of credit.  The line of credit is secured by a
first lien on the Company's assets.  The Company is prohibited from taking
certain actions, including paying dividends, without the lender's consent.  The
Company has not drawn on the line of credit and is not currently in compliance
with the profitability covenant necessary to ensure it could draw on the line in
the future. In addition, the Company is restricted from drawing on the line of 
credit until the Company obtains the lender's consent to the limited redemption 
rights of the convertible preferred stock.

NEW ACCOUNTING PRONOUNCEMENTS

In February 1997, the FASB issued Statement of Financial Accounting Standards
No. 128 (SFAS 128), "Earnings per Share," which specifies the computation,
presentation, and disclosure requirements for earnings per share (EPS).  SFAS
128 supersedes ABP Opinion No. 15, and is effective for financial statements for
both interim and annual periods ending after December 15, 1997.  The Statement
replaces Primary EPS and Fully Diluted EPS with Basic EPS and Diluted EPS,
respectively.  SFAS 128 does not permit early application and, when adopted, all
prior period EPS data presented must be restated to conform with the Statement.
The Company will implement the Statement in the required

                                       10
<PAGE>
 
period and does not expect it to have a material effect on the Company's
reported income (loss) per share.

RISKS REGARDING FORWARD LOOKING STATEMENTS

Except for the historical information, this report contains various "forward-
looking statements" which represent the Company's expectations or beliefs
concerning future events, including the timing and levels of revenues from the
Company's teleworker products, the timing of purchase decisions, the
Company's success in developing distribution partnerships, customer acceptance
of the teleworker products.  The Company cautions that these forward-looking 
statements involve a number of risks and uncertainties and are qualified by
important factors that could cause actual results to differ materially from
those in the forward-looking statements. Such factors include lack of adequate
capital; changing market trends and market needs; uncertainty regarding the
breadth of market acceptance of the teleworker products' performance;
uncertainty regarding the length of the sales process: rapid or unexpected
technological changes; new or increased competition from companies with greater
resources than the Company; inability to resolve technical issues or overcome
other development obstacles; and certain other factors set forth in the
Company's SEC filings, including the Form 10-K for fiscal 1997. The Company's
failure to succeed in its efforts, including its sales efforts with respect to
the teleworker products, could have a material adverse effect on the Company's
financial condition and operations.

                                       11
<PAGE>
 
                                DATA RACE, INC.

ITEM 1.  LEGAL PROCEEDINGS
--------------------------

On November 28, 1995, a class action shareholder lawsuit was filed against the 
Company and certain of its officers. On December 15, 1995, an additional 
shareholder lawsuit was filed with identical allegations. On February 23, 1996, 
the cases were consolidated, and the style of the case was changed to In re Data
                                                                      ----------
Race, Inc. Securities Litigation.
--------------------------------

On July 29, 1997, the Company and the plaintiffs agreed to settle the In re Data
                                                                      ----------
Race, Inc. Securities Litigation. If the lawsuit were settled in accordance 
--------------------------------
with this agreement, the Company's insurance carrier would pay $800,000 in cash 
and the Company would contribute 10,000 shares of Common Stock. The Company 
believes that the case is absolutely without merit, and that neither the Company
nor any of the other defendants committed any of the alleged wrongdoings. The 
Company decided to accept the settlement agreement based on the advice of
counsel that the costs to the Company of defending the lawsuit could exceed the
cost to the Company of the proposed settlement, and based on the unpredictable
results of jury trials. The settlement is contingent upon execution of a
definitive settlement agreement, U.S. District Court approval and certain other
conditions. There can be no assurance that all such conditions will be
satisfied. In the event final settlement is not reached, the Company intends to
continue to vigorously defend against the claims made in the lawsuit. The
Company is unable, however, to predict the costs to be incurred to resolve the
lawsuit in the event settlement is not reached on the terms set forth in the
preliminary settlement agreement. The Company is required under certain
circumstances to indemnify the named officers against losses incurred as a
result of the lawsuit.

ITEM 2.  CHANGES IN SECURITIES
------------------------------
None.

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES
----------------------------------------
None.

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
------------------------------------------------------------
None.

ITEM 5.  OTHER INFORMATION
--------------------------
None.

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K
-----------------------------------------
(a)  Exhibits.

--------------
27*  Financial Data Schedule.
*    Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the
     quarter ended September 30, 1997.
(b)  Reports on Form 8-K.
-------------------------
No reports on Form 8-K were filed during the quarter.

                                       12
<PAGE>
 
                                DATA RACE, 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.

                    DATA RACE, INC.

                    By:  /s/ Gregory T. Skalla
                         ---------------------
                         Gregory T. Skalla, Vice President-Finance
                         Chief Financial Officer, Treasurer and Secretary
                         (Principal Financial and Accounting Officer)

                         Date:  November 14, 1997

                                       13