<PAGE>
 
                      SECURITIES AND EXCHANGE COMMISSION
                             Washington, DC 20549

                                   FORM 10-K
                                 ANNUAL REPORT

    Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

FOR THE FISCAL YEAR ENDED                                 COMMISSION FILE NUMBER
     June 30, 1998                                               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  
                                       -----  -----    

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. 
           -----

On September 2, 1998, the aggregate market price of the voting stock held by
non-affiliates of the Company was approximately $23,445,295. (For purposes
hereof, directors, executive officers and 10% or greater shareholders have been
deemed affiliates).

On September 2, 1998, there were 14,537,140 outstanding shares of Common Stock,
no par value.

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                      DOCUMENTS INCORPORATED BY REFERENCE
                      -----------------------------------

Portions of the Proxy Statement for the 1998 Annual Meeting of Shareholders,
expected to be filed within 120 days from the Company's fiscal year-end, are
incorporated by reference into Part III.

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                                DATA RACE, Inc.
                               INDEX TO FORM 10-K

                                                                            Page
                                                                          Number

PART I.
-------
Item 1.   Business.............................................................4
 
Item 2.   Properties..........................................................27
 
Item 3.   Legal Proceedings...................................................27
 
Item 4.   Submission of Matters to a Vote of Security Holders.................28
 

PART II.
--------
Item 5.   Market for Registrant's Common Stock and Related Stockholder 
          Matters.............................................................28
 
Item 6.   Selected Financial Data.............................................30
 
Item 7.   Management's Discussion and Analysis of Financial
          Condition and Results of Operations.................................31
 
Item 8.   Financial Statements and Supplementary Data.........................34
 
Item 9.   Changes in and Disagreements with Accountants on
          Accounting and Financial Disclosure.................................53
 

PART III.
---------
Item 10.  Directors and Executive Officers of the Registrant..................54
 
Item 11.  Executive Compensation..............................................54
 
Item 12.  Security Ownership of Certain Beneficial Owners and Management......54
 
Item 13.  Certain Relationships and Related Transactions......................54
 

PART IV.
--------
Item 14.  Exhibits, Financial Statement Schedules, and Reports on Form 8-K....55

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                                    PART I.

ITEM 1. 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. Its unique client/server product, the Be There!/(TM)/
Remote Access System, gives teleworkers access to all elements of corporate
communications networks, including the PBX, Intranet, and Internet. Through Be
There!, remote workers send and receive e-mail, faxes, and phone calls
simultaneously over a single phone line. The Company also designs and
manufactures advanced network multiplexers that carry data, network, voice, and
fax traffic among a company's multiple offices. The Company's ability to discern
emerging remote access market requirements and develop innovative technological
solutions, as well as its ability to rapidly take products into high-volume
production, are key elements of its competitive strategy.

Beginning in 1983 with its patented RACE modem, the first high-speed, error
correcting, dial-up modem, the Company has maintained a reputation for new and
innovative data communications products.  Subsequent innovations incorporated
multiplexing technology into these devices so that the user could print files at
the same time as receiving information on the screen.  Later product lines were
created to support multiple simultaneous users in a remote office, allowing them
all to be connected to the central computer facility at the same time over the
same line. In the early 1990s, the Company enhanced its multiplexer product line
with additional capabilities to carry voice and fax multiplexed over the same
communications circuit used to carry the data.  With the advent of the laptop
computer, predecessor to today's notebook computers, the Company also developed
miniaturized versions of its modem technology.  Among other things, DATA RACE
pioneered the laptop data/fax modem, and integration of voice capabilities into
modems for notebook computers.

In 1995, DATA RACE saw an opportunity to capitalize on the communications
requirements of the rapidly growing number of "teleworkers" who need convenient
simultaneous access to all of their corporate information assets  voice, data,
and fax  when working from home or on the road.  Based on discussions with
certain large potential corporate users of such a product, the Company undertook
to combine its modem and multiplexer technologies into a new product line, and
in February 1997 introduced the Be There! Remote Access System.  This system
allows teleworkers to work at home, in a hotel room, or airport lounge just as
they would work in their offices, simultaneously talking on the phone, sending
and receiving faxes, reading or writing e-mail, browsing the Internet, and
performing other data functions over a single conventional phone line.

The Company's primary distribution strategy is to focus on indirect sales
channels.  In June 1997, the Company and Data General, a world-wide supplier of
advanced server and storage systems based in Westboro, Massachusetts, announced
an agreement in which Data General will sell and provide pre-installation
support and installation services for the Be There! system.  In September 1997,
the Company and Inacom Communications, a global technology management and
services company based in Omaha, Nebraska, announced the completion of an
agreement for distribution, sales, and support.  In August 1998, the Company
announced that it had entered into a marketing agreement with NEC America, an
affiliate of the NEC Corporation that develops, manufactures, and markets a
complete line of advanced communications products and software for public and
private networks.  In addition, the Company has signed agreements with a number
of select regional distribution partners.

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The Company seeks to capture a leadership position in the market for remote
access solutions by capitalizing on its unique advanced technology, its patents
and other intellectual property, its relationships with existing distribution
partners, and on developing relationships with leading technology companies.

                               INDUSTRY OVERVIEW

The Company operates within the remote access segment of the digital
communication products industry.  This industry has been characterized by high
rates of growth and change.  As the basis for value within the global economy
shifts from goods to information, global instantaneous access to all forms of
information, by phone, fax, or data link, is transitioning from a luxury to a
necessity for businesses.  The recent progress in the deployment of intranet and
Internet solutions is accelerating this trend.  As the workforce shifts from
production worker to knowledge worker, the need for companies to physically
cluster their workers is also diminishing in many industries.  New initiatives
for reduced automobile traffic congestion, cleaner air, accommodations made for
workers unable to commute to a corporate facility, seeking to spend more time
with family, or  needing to be physically closer to customers have all aligned
to produce a workforce far more geographically dispersed than at any previous
time.  These trends, and the resulting need to give these dispersed and mobile
knowledge workers the required instantaneous access to all forms of information,
have created a multi-billion dollar market opportunity.

                                    STRATEGY

The Company's strategy is to provide innovative, first-to-market, high-value-
added solutions to meet the needs of knowledge workers while away from their
headquarters office, whether working at home, in branch offices, or on the road
in hotels or airport lounges.  In devising product solutions, the Company
obtains input from prospective customers throughout the development process.
The Company applies substantial engineering and technical capabilities to
incorporate current remote access technologies, as well as the Company's own
technological innovations and advances, to the design of products intended to
meet such market needs.  The Company outsources most of its manufacturing
operations in an effort to minimize its investment in plants, facilities, and
inventory, control manufacturing costs, maximize flexibility and ability to
support growth, and enable the Company to use the most technologically advanced,
cost-effective production methods available at the time.  In similar fashion,
the Company's strategy is to minimize and control sales expenses by outsourcing
a significant portion of its sales and distribution efforts to distributors and
other strategic marketing partners.  The Company believes that by controlling
its manufacturing and marketing overhead, it is better able to deliver
technologically innovative products to its customers at competitive prices.

                                    PRODUCTS

The Company offers three product lines serving the remote access market: the Be
There! Remote Access System; network multiplexers, which connect data, phone,
and fax systems of branch offices to their headquarters; and custom modems.

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BE THERE! REMOTE ACCESS SYSTEM

The Be There! Remote Access System enables teleworkers to access all elements of
the corporate communications network simultaneously over a single phone line.
The Be There! system consists of a card which plugs into the user's PC, software
which is loaded onto the PC, and a server unit which is installed at the
corporate office to which the user connects through the public telephone
network.  Once connected to the corporate office via the Be There! system, the
user will have simultaneous access to the corporate computer network, fax
server, and telephone system, enabling remote users to work just as they would
in the office.

While telecommuting is a relatively recent phenomenon, several sources indicate
that there are already several million teleworkers in the United States alone.
FIND/SVP, a market research and advisory company, estimates the number of
telecommuters has risen from 4 million in 1990 to 13 million in 1998. Decisive
Technology states that there are 12 million telecommuters averaging 2.78 days
per week telecommuting.  The Olsten Corp. estimates 42% of U.S. companies use
telecommuting.  As a result of these trends, Infoworld, Link Resources, and
Gartner Group forecast that as many as 30 to 55 million people will work outside
the traditional office setting within the next two to four years, and as many as
75 million people in five years.  Gartner Group estimates that the remote access
concentrator market has already reached an annual rate of 9 million ports.

The Be There! system is intended to serve three segments of the teleworker
market: telecommuters, road warriors, and remote call center workers.  The
Company has initially focused its efforts on United States market opportunities
where the teleworker phenomena is most evident.

Telecommuters

Over the past several years, an increasing number of companies have adopted
telecommuting programs, either on a trial basis or as permanent programs, due to
a variety of economic, social, and legislative pressures.  In these programs,
employees work from home rather than physically commuting to the office.

Studies in the last few years have shown that there are substantial economic
benefits to corporations with telecommuting programs.  The Gartner Group, a
leading market research firm, reported that facility savings alone amount to
about $6,750 per year for each teleworker.  More importantly, numerous studies
of telecommuting programs done in recent years have documented productivity
improvements among telecommuters, typically in the range of 10% to 30%.
Contributing to this improvement is the reduction in non-business discussions
with colleagues and the longer hours worked after dinner or at other periods
outside the traditional working day by someone whose office is in the home.
Because a commute is not required, many companies will also be able to tap into
labor resources for short peak-hour periods during the day in ways that were
impractical before telecommuting.  The economic benefits currently outweigh the
incremental costs by such a large margin that, for the foreseeable future,
technology, not price, will remain one of the major selection criteria for
telecommuting products, according to the Gartner Group.

In addition to the economic forces, there are significant social forces driving
the increase in telecommuting.  Eliminating the daily commute has clear benefits
for the environment and for traffic.  Telecommuting also improves workers'
lifestyles as the time lost to commuting is recovered for more rewarding
activities.  In addition, the ability to spend the day at home with the 

                                       6
<PAGE>
 
family is attractive to many workers. For these and other reasons, studies
report that telecommuting improves employee morale.

There are also a variety of legislative forces behind the increases in
telecommuting.  The Clean Air Act of 1990 encourages cities in non-attainment
zones to implement plans to reduce automobile emissions.  Telecommuting may
prove to be a convenient method of reducing such emissions.  The Family and
Medical Leave Act and the Americans with Disabilities Act both require companies
to offer accommodations to workers who may not be able to work daily in the
corporate office, but who may be able to work from home, or work part of a day.

Without Be There!, telecommuters often have four or more phone lines installed
in their homes.  This might include a personal line, a business line, a
data/modem line, and/or a fax line.  The number of phone lines needed by the
typical telecommuter can make telecommuting cumbersome and expensive for large
employers, particularly when the cost of additional corresponding lines at the
corporate office is considered.

The Be There! system allows the telecommuter to connect to a compatible server
at the corporate office, and combine the three business communication lines
voice, data, and fax  over a single conventional line.

Road Warriors

Road warriors are traveling professionals who require efficient phone, data, and
fax connectivity to their offices.  Because road warriors are often highly
compensated, any increase in their productivity may be worth a great deal to
their employers.  When working from a hotel room or airport lounge, a road
warrior often needs to retrieve and reply to e-mail, voice mail, and fax
traffic, all within a very limited time.  At other times, the road warrior may
need to work collaboratively with a colleague on a document while discussing it
on the phone.  Such needs are currently partially met by notebook computer
modems,  which may provide some or all of such functions, but not
simultaneously.

The Company believes that the needs of the road warrior are uniquely met by the
Be There! system, which can increase a road warrior's productivity by providing
simultaneous phone, fax, and data connectivity to the office.  When working from
a hotel room or airport lounge, a road warrior can use the Be There! system to
quickly retrieve and reply to e-mail, voice mail, and fax traffic at the same
time.  The Be There! system can also provide the road warrior the ability to
work collaboratively with a colleague on a document while discussing it on the
phone, using only a single telephone line.  In addition to productivity
improvements, Be There! can yield substantial hard-dollar savings from reduced
cellular phone costs and hotel telephone surcharges.

Remote Call Center Workers

Call center workers are generally workers that deal with customers over the
telephone.  Airline reservation centers are such an example, in which workers
are connected by phone to the customers, and by computer to a database
containing flight and space availability information.  In certain applications,
workers must also send and receive faxes.  Incoming phone calls are typically
routed through specialized computer systems to the next available worker.
Computers allow the monitoring of individual and overall performance.

                                       7
<PAGE>
 
Hiring and employee scheduling are two of the most challenging and costly
aspects of call center management.  Many call centers operate on a 24 hour-a-
day, 7 day-a-week basis, with peak call hours varying by industry, and by
whether the call center is inbound, outbound or both.  It is often more
economical to staff the call center, at least partially, with part-time
employees working from home.  Such remote call center workers, often parents of
young children who cannot afford to be away from home, can nevertheless work
productively for a limited number of hours while their children are napping, at
school, or otherwise occupied.  Such part-time employees typically receive
reduced benefits, making them less costly to their employers.  Very  substantial
capital savings may also be realized because facilities do not need to be built
to house these workers.

Without Be There!, connecting remote workers to call centers is problematic.
Such workers need a telephone connection to the customer and a simultaneous data
connection to the database, and often the ability to send and receive faxes.  To
enable a remote call center worker to operate in this mode would generally
require the installation of multiple additional telephone or ISDN lines to the
worker's home.  In addition to the expense of these connections, it may take
several months to get the service installed, connected, and operating properly.
With the high turnover rates common among call center employees, it may not be
feasible to have these services installed during the employee's tenure, and is
typically economically impractical.

With the Be There! system, the worker's normal phone line is all that is
required to provide simultaneous telephone, data, and fax connection to the call
center, enabling the worker to be connected as if he or she were physically in
the call center.  Furthermore, a unique feature of the Be There! system allows
any calls placed to the worker's home phone to be re-routed through the call
center and back to the worker.  In this way, an emergency call from the school
nurse, for example, will not be blocked because the worker's phone line is tied
up with the connection to the call center.

Existing Approaches

The needs of teleworkers are currently being met by a variety of partial
solutions, including computer modems and remote access servers to provide data
connectivity; telephones (including cellular phones), PBXs, and a variety of
software products and communications services providing some degree of phone
access; and fax servers, fax modems, and software, as well as remote physical
fax machines, to support remote fax access.  Although technology is advancing
rapidly, the partial solutions currently available typically require multiple
phone lines or ISDN lines, which are often unavailable and are generally
expensive where they are available.  These solutions also generally require that
the user act as systems integrator to cause all of these disparate systems and
services to function in unison.  Such partial solutions fail to accomplish the
fundamental objective of a remote access system, namely to allow teleworkers to
perform their jobs at remote locations just as effectively as they would in
their offices.

The Be There! Solution

To address the teleworker market needs, the Company has developed the Be There!
system.  With the Be There! Remote Access System, e-mail, file server, intranet,
Internet, and other data connections are supported as they would be in the
office.  An image of the worker's office telephone appears on the worker's
computer screen and has the same functions it would have in the office.  The
teleworker can dial colleagues or place local or long-distance calls through the
company's WATS lines, as if present in the office.  Colleagues who dial a
teleworker's extension, 

                                       8
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or outsiders who call in on the teleworker's corporate office direct line, will
automatically and immediately be connected to the teleworker in the remote
location, all without disturbing the data connections on which the teleworker is
reading e-mail or browsing the Web. At the same time, the teleworker can send
and receive faxes over the company's fax server, again without interrupting the
phone and data connections. The Company refers to this transparent combination
of data, fax, and voice features which enable a remote worker to operate just as
he or she would in the office as Telepresence/(TM)/.

The Be There! system comprises a card which plugs into each user's desktop or
notebook PC, software which is loaded into the PC, and a server which is
installed at the corporate office to which the user connects over a single
conventional telephone line.  This server is connected to the corporate data
network and also to the PBX or telephone system.  This configuration is outlined
in Diagram 1.  In a desktop configuration, the user connects a conventional
telephone to the personal multiplexer card in the PC, or to an external Be
There! client box.  On the PC's screen there is an icon labeled Be There!.  When
the user double clicks this icon, the system automatically dials the Be There!
server and commences an authentication dialog.  This dialog includes verifying
the user's name and password.  The server also queries the user's personal
multiplexer to ascertain its identity in the form of a unique identifier built
into each such personal multiplexer.  If the server cannot determine that the
user is authorized to use the particular hardware, the system will not allow the
user to connect.  In addition to this unique authentication system, the Be
There! system is capable of supporting a variety of authentication systems
available in the market to verify the identity of the user.

                            [GRAPHIC APPEARS HERE]

"Diagram 1 - The Be There! System" has been replaced by the following narrative 
description: The diagram shows a graphic depiction of how a Be There! user (the 
"Be There! client") connects to the Be There! server through the telephone 
system and shows how the Be There! server is connected to a customer's PBX or 
telephone system or LAN or other corporate data network.

Once the user is authenticated, the system establishes the user's PC as a remote
node on the corporate data network, giving the user the same access to corporate
data resources, including e-mail, file servers, and Internet access (through the
corporate fire wall) as the user would have in the corporate office.  The system
also instructs the PBX or other telephone system to forward any calls  whether
internal or dial-in  for that user to a particular connection to the Be There!
server.  

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Thereafter, when the server detects an incoming call on that connection, it
causes the telephone connected to the user's PC to ring, and a normal
conversation is established.

Once the connection is established, an image is presented on the PC screen of
the physical phone in the user's office.  This phone will typically have a
variety of buttons to perform special functions, such as one-touch dialing to
the user's secretary or other commonly called numbers, conferencing with
multiple people, and call transfers to third parties.  These buttons will behave
on the user's PC in substantially the same way that the same button behaves on
the user's office phone.  The user does not need to learn to use a new phone to
take advantage of the telephony systems that are available in the office.  In
addition, the image will typically contain enhanced functions of computer
telephony systems, including computerized phone books and call logs.

In the notebook computer implementation, operation is essentially the same, with
the exception that there is no provision for the external connection of a
physical telephone or fax machine.  The telephone is handled by connecting a
conventional telephone handset to the PCMCIA form-factor personal multiplexer
plugged into the user's notebook.  Alternatively, a headset, as typically used
by telephone operators, allows hands-free operation. This configuration is
illustrated in Diagram 2.

                            [GRAPHIC APPEARS HERE]

"Diagram 2 - Notebook Computer Configuration" has been replaced by the following
narrative description: The diagram shows an image of a typical notebook computer
equipped with a Be There! personal multiplexer card and software to allow the 
user to use the notebook computer as an office telephone and a fax machine.

The Be There! system is made possible by recent advances in digital signal
processing ("DSP") technology.  These powerful processors make possible the
transmission of data at rates as high as 33.6 kbps over a single ordinary
telephone line.  This same technology makes practicable digital speech
compression, which can transmit speech at low data rates with clarity and
quality such that many users do not distinguish it from normal telephone speech.
The Be There! system uses a coding scheme that transmits the speech at a rate of
8.5 kbps.

In the absence of active telephone traffic, the full data rate of 33.6 kbps is
available to the data stream.  When a phone call is active, up to 8.5 kbps is
taken from the data stream to support the compressed speech frames.

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                            [GRAPHIC APPEARS HERE]

"Diagram 3 - Personal Multiplexer Block Diagram" has been replaced by the 
following narrative description: The diagram shows a graphic depiction of the 
operation and function of the modem, multiplexer, and speech compression 
components that make up the Be There! personal multiplexer. Speech data, 
symbolized by small circles, are fed through a speech compression digital signal
processor and then into a multiplexer where it is mixed with incoming data 
packets and fax frames, symbolized by small triangles and squares, respectively.
The stream of intermixed speech data, data packets, and fax frames are sent from
the multiplexer to a modem connected to a telephone line for transmission to the
Be There! server.

Internally, the personal multiplexer hardware comprises a speech compressor /
decompressor, which converts the signals to and from the handset to a series of
data frames; a multiplexer, which interleaves these compressed speech frames
with frames of fax information and frames from the data stream; and a modem,
which then converts these frames to an appropriate analog signal for
transmission over the telephone line.  This configuration is represented in
Diagram 3.  In performing this multiplexing, careful attention is paid to
controlling the size of the voice, data and fax frames, and to ensuring that
priority is given to the speech frames, in order to minimize the latency issues
which render unacceptable the speech characteristics of many other systems which
intermix speech and data.

At the Be There! server, corresponding elements perform the inverse functions
simultaneously for multiple users to present the appearance of locally connected
telephony and data devices to the appropriate data network and PBX connections.
The Company currently offers a variety of configurations supporting up to 24
ports per server.  A four port server is illustrated in Diagram 4.


                            [GRAPHIC APPEARS HERE]

"Diagram 4 - Four Port Be There! Server" has been replaced by the following 
narrative description: The diagram shows a graphic depiction of the operation 
and function of the modem, multiplexer, and speech compression components of a 
four port Be There! server attached to four incoming telephone lines, each 
receiving separate streams of intermixed speech data, fax frames, and data 
packets transmitted from a Be There! personal multiplexer such as the one shown 
in Diagram 3 above. Each intermixed stream of speech data, fax frames, and data 
packets is processed by an individual multiplexer component which separates the 
speech data for output to a speech compression digital signal processor and the 
data packets and fax frames for output to the corporate LAN. After leaving 
speech compression digital signal processor, the speech data is output to the 
corporate PBX.
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In May 1998, DATA RACE announced the addition of a Windows NT compatible Be
There! client to the Be There! product offerings, in addition to the previously
offered Windows 95 compatible client.  In August 1998, the Company introduced
the Be There! External Client.  The External Client allows remote workers to use
Be There! on their desktop without having to internally install the client card,
thereby simplifying the set-up process.

Since its introduction, the Be There! Remote Access System has received numerous
accolades.  At its February 1997 announcement, Be There! was honored as a
"Premier" product at Demo '97, a show which focuses on emerging technologies.
Shortly thereafter, Be There! received the prestigious "Best of Computer
Telephony 97" award from Call Center Magazine.  In February 1998, CTI Magazine
named Be There! as one of its choices for Best Remote Access Product of 1997.
Be There! has also received favorable coverage from  Forbes, Infoworld, Demo
Letter, Computer Telephony, Mobile Letter, Mobile Computing, Andrew Seybold's
Outlook, and Telecommuting Review.

Since the introduction of the Be There! system in February 1997, the Company has
been disappointed with the results of its direct sales effort.  The Company
believes that the lack of direct sales has been attributable, in part, to a lack
of credibility, lack of name brand recognition, and the creation of a new
product category with the Be There! system.  As a result, the internal direct
sales effort is now focused on establishing relationships with, training, and
supporting channel partners.  In fiscal 1998, the Company entered into
agreements with Inacom Communications and Data General Corporation, and has
signed agreements with a number of regional distribution partners.  Although the
time to record significant indirect sales is generally longer than the time
required for direct sales, the Company is pleased with the response from the
indirect channel partners of the new product line.  In addition to the Company's
existing channel partners, the Company is currently pursuing a number of
strategic alliance possibilities including additional distribution agreements,
financial assistance opportunities, joint development programs, bundling
opportunities, OEM agreements, and technology licensing.  Although there can be
no assurance that such efforts will be successful, the Company believes that
successful implementation of such strategic alliances would increase the
Company's credibility and enhance market presence.

NETWORK MULTIPLEXERS

Network multiplexers allow a company to electronically connect to its remote
branch offices over single or multiple communications circuits. Network
multiplexers provide branch offices with needed access to electronic mail,
corporate data bases, the Internet, and other local and wide area network
services. The Company's Free Speech/(TM)/ Voice/FAX system integrates compressed
voice/fax channels to these networks extending PBX and phone system services to
the branch offices for toll-free intra-network calling. Such a network can often
pay for itself in months, based on savings from reduced inter-office telephone
service costs. Some users justify the purchase of a network based on the
strategic necessity to access data resources, while the cost-savings in
telephone and fax costs alone are generally sufficient to cover the cost of the
network.

The Company's network multiplexer products primarily address the needs of small-
to-medium sized businesses.  Over the past several years, the Company has added
significant capabilities to its network multiplexer products, including
compressed speech, fax, LAN routing, T1 connectivity, and firmware with enhanced
frame relay support, and has designed into its multiplexers a greater degree of
expansion capabilities than most competitive products.

                                       12
<PAGE>
 
Through the use of an innovative modular architecture, the Company's
multiplexers alleviate the need to replace a multiplexer as additional network
needs arise, or new services become available.  In addition to the multiplexer's
powerful central processor, the system supports add-on feature modules and
controller cards that provide optional features and capabilities.  These add-on
cards can provide additional user ports, WAN ports, LAN and voice/fax features.
As new services or technologies are developed, and market needs warrant, the
Company can provide existing networks an upgrade path for these new
technologies.  Thus, a network administrator can add increasing numbers of
users, WAN circuits, and as yet undeveloped services simply by plugging the
appropriate cards into the existing system.  The Company refers to this concept
as a Future-Proof/(TM)/ systems architecture.

Today, many multiplexer networks for small- to medium-sized businesses are
interconnected with 56 kbps leased digital circuits.  New services are rapidly
becoming available and cost-effective. Tariffs for T1 (a digital service
offering 1.544 megabits per second, equivalent to twenty-four 64 kbps circuits)
are declining rapidly in certain areas, making this medium an increasingly
attractive alternative.  The Company has products that support T1 services and
allow companies to take advantage of attractive T1 price tariffs.  DATA RACE
offers the LAN bridge-router ("BRouter") product, which allows the Company's
multiplexer products to operate in a wide variety of LAN applications.  Frame
relay service is currently a popular alternative to traditional leased circuits
due to its pricing and circuit efficiency.  In fiscal 1998, the Company
introduced release 3.0 multiplexer firmware with enhanced frame relay support
for its MACH DS Plus, NetEscort, and ROADrunner multiplexers.  The firmware has
an option that can be enabled to support a direct frame relay connection for any
particular device, on either T1 or standard 56/64K lines.

Effective network management is critical to minimizing downtime and maximizing
network productivity.  The Company's multiplexer products have built-in features
facilitating local and remote configuration, control, diagnostics, and
upload/downloading of network configurations. All multiplexers include a built-
in modem for dial-in access to local or remote multiplexers.  The network
management feature set was developed to ensure that the user is able to cost-
effectively manage every aspect of their network using a modem and dial-up
telephone lines.  The network multiplexer line is evolving into a mature,
declining business as customers shift to low-end routers and competitive
telephone offerings.  Although the network multiplexer business did see an
upswing at the end of fiscal 1998 with the introduction of the T1 frame relay,
there is no evidence that it will be sustained.

CUSTOM MODEM PRODUCTS

During the 1980s, the personal computer dramatically improved the productivity
of office workers, and in the 1990s, the portable computer is similarly
improving the productivity of the worker away from the office.  As a result of
the increasing equivalence in power and function of notebook computers and
desktop computers, a growing number of workers have foregone desktop machines
for their offices, and are instead using a single notebook computer at their
office, home, and while traveling.  The Company has, in the past, provided
custom modems to a number of leading notebook computer manufacturers, such as
IBM, NEC, and Texas Instruments.  Revenue from the custom modem business
represented approximately 27%, 79%, and 62% of total revenues for fiscal years
1998, 1997, and 1996, respectively.

Many notebook computer manufacturers today rely on standard commodity PCMCIA
modems.  Others have internal modem design groups which have designed modem
functions directly onto the 

                                       13
<PAGE>
 
computer motherboard. As a result, the market for OEM custom form factor modems,
in which the Company has excelled, has largely been eliminated.

While the Company believes that it possesses important differentiating
technology applicable to notebook modem designs, and continues to make modest
investments in the technology and in marketing in this area, the Company
believes that the market for custom modems is in a state of transition.  Future
opportunities in this market are expected to increasingly shift from high-volume
manufacturing to alternatives such as custom design contracts and royalties. The
Company has taken steps to better align its spending related to custom modems to
the expected reduced revenue levels.  During January 1998, the Company reduced
its total workforce by approximately one-fourth, primarily in areas related to
volume modem manufacturing.


                       TECHNOLOGY AND PRODUCT DEVELOPMENT


The Company believes that the extension and enhancement of the existing Be
There! product line and the development of new products that leverage state-of-
the-art local and wide-area connectivity technologies to provide remote access
to both corporate data and telephony facilities are critical to its future
success.  The Company seeks to implement its innovative products using the
latest industry standards and technologies, thus enabling the Company to develop
and introduce products quickly in response to customer requirements and
identified market trends.

When appropriate industry standards are not available, the Company may, from
time to time, introduce and promote the required new standards in the various
industry fora and standards organizations.

The Company regularly uses information derived from interaction with key
customers, its distribution channel partners, participation in industry
standards organizations, and market and technical research to set its
development directions and make design and product decisions.

Users of the Company's products for telephone communication expect a standard of
quality closer to that for normal telephony than that for normal data
communications software and other software applications.  As a result, the
Company's development priorities include significant testing, quality assurance,
and focus on a development and planning methodology and processes.

Company-sponsored research and development expenses were $3.6 million, $4.9
million, and $4.8 million for fiscal years 1998, 1997, and 1996, respectively.


                          MANUFACTURING AND SUPPLIERS

The Company purchases key components used in the manufacture of its products
from third party suppliers.  The Company ordinarily avoids fixed long-term
commitments for components.  This allows the Company to better coordinate
component inventory build-up and to select suppliers who have the most
technologically advanced, cost-effective components available at the time.

The Company's manufacturing operation primarily consists of final assembly,
test, and quality control of subassemblies and systems.  As is typical in the
industry, rather than incur the higher fixed costs and investment required to be
a vertically integrated manufacturer, the Company elects 

                                       14
<PAGE>
 
to subcontract major portions of the purchasing, circuit board manufacturing,
and assembly to others. Once the Company receives shipments of components, it
packages and sends them to various domestic third party circuit board assembly
houses for automatic placement, soldering and functional testing. This approach
allows the Company to more easily adjust its production schedule to match
demand, and results in improved cost control and time-to-market responsiveness.
Third party circuit board assembly houses are typically chosen by the Company
based upon their quality of work, response time, and cost.

After the subassemblies are returned to the Company from the assembly houses,
they may be loaded with the Company's latest proprietary firmware, burned in,
placed in the appropriate final system assembly, tested, inspected and prepared
for shipment.  This procedure allows the Company to maintain control over the
cost and integrity of its products.


                   MARKETING, SALES, DISTRIBUTION AND SUPPORT

In order to successfully penetrate the emerging teleworker market, the Company
believes that it will need to expand the sales and marketing infrastructure.
The Company's primary distribution strategy is to focus on indirect sales
channels, relying on large distribution partners that have the distribution
power and credibility which the Company believes are needed to effect rapid
growth.  In June 1997, the Company and Data General, a world-wide supplier of
advanced server and storage systems based in Westboro, Massachusetts, entered
into an agreement in which Data General sells and provides pre-installation
support and installation services for the Be There! system.  In September 1997,
the Company and Inacom Communications, a global technology management and
services company based in Omaha, Nebraska, entered into an agreement for
distribution, sales and support.  In August 1998, the Company announced that it
had entered into a marketing agreement with NEC America, an affiliate of NEC
Corporation that develops, manufactures, and markets a complete line of advanced
communications products and software for public and private networks. NEC
America's Corporate Networks Group awarded "FUSION Certification" to the Be
There! system, as part of the FUSION Strategic Alliance Program.  The Company
has signed agreements with a number of select regional distribution partners,
including certain of those distribution partners from its current network
multiplexer product line.  The Company is also signing up an increasing number
of regional resellers who are focused on the Computer Telephony marketplace. In
addition, the Company has an internal sales and support organization.  This
internal sales group is primarily focused upon signing up, training, and
supporting channel partners.  With these channel partners, the internal sales
organization focuses upon targeting customers that can serve as credible
reference accounts, and large organizations capable of purchasing large
quantities of the product.

With respect to its network multiplexer products, the Company conducts its sales
and marketing activities through distributors, resellers, and systems
integrators.  In many cases, the communications equipment is sold in conjunction
with the sale of a computer system or PBX.  In these cases, the end user will
often accept the recommendation of the systems integrator as to which network
equipment to buy.  As a result, the Company has focused marketing activities on
the resellers and systems integrators.

With respect to its custom modem products, the Company generally conducts its
sales and marketing activities through direct personal contact with executive or
senior technical staff personnel of OEM customers, and through agents.  The
Company's sales and marketing efforts are currently focused on a small number of
prospects in the United States and Japan.

                                       15
<PAGE>
 
The Company provides nationwide service, installation, repair, and technical
support for certain of its products.  In July 1997, the Company entered into an
agreement with Telsource Corporation which expands the support services
available to prospective customers.  Telsource Corporation can provide both
remote and on-site Be There! support contracts where customers may contact the
24-hour service center for remote diagnostics and repair, requests for
assistance, and spare parts.  The Company also provides a technical support
hotline to support its service and sales channels.  The Company's commitment to
providing excellent support is an essential part of developing long-term
relationships with its customers.


                                  COMPETITION

The Company is not aware of any product currently available that offers
capabilities directly competitive with those of the Be There! system,
particularly in the areas of Telepresence/(TM)/ transparent access and low-delay
multiplexing of voice, data, and fax over ordinary phone lines.  Recently, a
number of products have been discussed or released that have certain
characteristics in common with the Be There! system, and may represent
competitive alternatives to prospective Be There! customers.  Several of these
products have yet to be introduced to the market, and the information that the
Company has on them is limited.

Numerous companies, including 3Com/US Robotics, AT&T, Lucent, MCI, Sprint,
Shiva, Cisco, and Bay Networks offer products and services that are targeted at
teleworkers.  Most, if not all, of these companies have much greater resources
than the Company.  One or more of these or other companies might offer in the
future an integrated data/voice/fax teleworker solution with capabilities
substantially similar to those of the Be There! system, which could have a
material adverse effect upon the Company's prospective opportunity in this
product line.

The Company's network multiplexer products compete on the basis of supplier
credibility, recommendation of the systems integrator, feature set,
expandability, reliability, service and support, and price.  In the network
multiplexer business, the Company competes with Micom (a subsidiary of NorTel),
RAD, Memotec, Nuera, ACT, MultiTech, and others.  With the introduction of its
BRouter product, the Company also competes with certain products offered by
Cisco, Ascend, Bay Networks, 3Com, and similar companies.  These companies have
substantially greater resources than the Company.  Higher levels of spending
have often permitted these competitors to release new products well in advance
of the Company's.  In certain cases, such as Micom's introduction of T1 frame
relay support well in advance of the Company's product, these lead times of the
Company's competitors have significantly impaired the Company's competitive
position in the market.

Although the Company believes its products are competitive in each of above
described areas, there can be no assurance that competitors will not introduce
comparable or superior products incorporating more advanced technology at lower
prices.  See "Certain Business Risks - Competition."


                             INTELLECTUAL PROPERTY

The Company's success depends in part upon its proprietary technology, including
both its software programs and its hardware designs.  The Company relies upon
patent, copyright, trademark and trade secret laws to protect its proprietary
technology.  The Company generally also enters into nondisclosure agreements
with persons to whom it reveals its proprietary information, such as component
suppliers, subcontractors, and OEMs that the Company works with concerning

                                       16
<PAGE>
 
future products.  Although it is unusual in the industry for patents to be of
substantial strategic value, the Company has ongoing programs seeking patent and
other intellectual property protection for its technologies and products, and it
sometimes grants licenses of its technology to other companies.There can be no
assurance that the Company's present protective measures will be adequate to
prevent misappropriation of its technology or independent third party
development of the same or similar technology.  Many foreign jurisdictions offer
less protection of intellectual property rights than the United States, and
there can be no assurance that the protection provided to the Company's
proprietary technology by the laws of the United States or foreign jurisdictions
will be sufficient to protect the Company's technology.

While the Company's competitive position may be affected by its ability to
protect its proprietary information, the Company believes that the rapid pace of
technological change in the remote access products industry will cause other
factors to be more significant in maintaining the Company's competitive
position.  These factors include the technical expertise, knowledge and
innovative skill of the Company's management and technical personnel, name
recognition, the timeliness and quality of support services provided by the
Company and its ability to rapidly develop, produce, enhance, and market
innovative products.

In the current market, in which voice and data communications are converging
rapidly, the Company believes that the intellectual property of its "virtual
presence to an office" product innovations may be of significant strategic
value.  Therefore, the Company protects its new ideas by regularly filing patent
applications on new product concepts and implementation methods.  In June 1998,
the United States Patent and Trademark Office issued patent number 5,764,639
entitled "System and Method for Providing a Remote User with a Virtual Presence
to an Office".  The patented system and method provide remote users with the
ability to work outside of the office just as if they were physically located in
the corporate office.  The Company also has other patents applications pending
related to the Be There! product technology.  The Company is currently
investigating a number of recently-announced products and services from various
vendors which may infringe upon its patents.  The Company intends to
aggressively protect its rights under its patents.  See "Certain Business Risks
- Intellectual Property Rights."

DATA RACE believes that Lucent Technologies' Virtual Telephone System and
Internet Telephony Server products infringe U.S. patent number 5,764,639.
Accordingly, on August 18, 1998, the Company filed a lawsuit in United States
District Court in San Antonio, Texas, against Lucent Technologies, Inc., citing
patent infringement and other related issues.  The Company seeks unspecified
damages and a permanent injunction prohibiting Lucent Technologies from
violating the Company's intellectual property rights.  The Company is also
asking the Court to issue a preliminary injunction prohibiting Lucent from
marketing and selling its Virtual Telephone system.   See "Certain Business
Risks - Patent Infringement Lawsuit " and "Item 3. Legal Proceedings."

The Company commonly enters into licensing agreements with suppliers of
components that the Company desires to incorporate into its products.  The
Company may choose to obtain additional licenses in the future, but believes
that any necessary licenses could be obtained on terms that would not have a
material adverse effect on the Company.

It is common in the computer industry for companies to assert intellectual
property infringement claims against other companies.  As a consequence, the
Company indemnifies some OEM customers in certain respects against intellectual
property claims relating to the Company's products.  The Company presently is
unaware of any material intellectual property claims pending 

                                       17
<PAGE>
 
against it. If an intellectual property claim were brought against the Company
and one of the Company's products were found to be infringing upon the rights of
others, the Company could be required to pay infringement damages, pay licensing
fees, modify its products so that they are not infringing or discontinue
offering products that were found to be infringing, any of which could
materially adversely affect the Company and its results of operations. In
addition, the assertion of such claims against one or more of the Company's
vendors could adversely affect the availability from those vendors of components
used by the Company.

                                    BACKLOG

The Company's backlog at June 30, 1998 was not significant.  The Company does
not believe that its backlog as of any particular date is necessarily indicative
of future sales because, as is customary in the industry, the Company often
allows changes in delivery schedules or certain cancellation of orders without
significant penalty, and because the time between order placement and shipment
is short.

                                   EMPLOYEES

As of June 30, 1998, the Company employed 86 employees, including 31 in
manufacturing, 23 in engineering, 19 in sales, marketing and customer support,
and 13 in general and administration.  None of the Company's employees are
represented by a labor union.  The Company believes its relations with its
employees are good.  Competition for qualified personnel is intense, especially
for talented engineers and senior marketing personnel, and the Company believes
that its prospects for future growth and success will depend, in a significant
part, on its ability to retain and continue to attract highly skilled and
capable personnel in all areas of operations.

                             CERTAIN BUSINESS RISKS

This Report contains certain "forward-looking statements" within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. Such forward-looking statements, which are often
identified by words such as "believes", "anticpates", "expects", "estimates",
"should", "may", "will" and similar expressions, represent the Company's
expectations or beliefs concerning future events. Numerous assumptions, risks
and uncertainties, including the factors set forth below, could cause actual
results to differ materially from the results discussed in the forward-looking
statements.

DEPENDENCE ON SUCCESS OF THE BE THERE! SYSTEM

Historically, the Company has derived the majority of its revenue from custom
modem and network multiplexer product sales.  The market for custom modems has
shifted away from high volume manufacturing and is moving toward standardized
modem products where the Company does not compete, and the network multiplexer
business has been declining.  The Company's goal of returning to profitability
and developing a more reliable revenue base will depend on the success of the Be
There! Remote Access System.  Revenue to date from the Company's Be There!
products has not been significant.  The Be There! system represents a new type
of product for the Company which is significantly different from the Company's
network multiplexer products and prior custom modem products, and presents a
unique set of risks and challenges for the Company.  Since its release in early
1997, the Be There! product 

                                       18
<PAGE>
 
line has had very limited success. Future growth is dependent on the Company's
ability to penetrate its target markets and increase sales of Be There!, to
timely and successfully develop and introduce new or follow-on products and
enhancements, establish new distribution channels, develop affiliations with
leading market participants which facilitate product development and
distribution, and market existing and new products through distributors,
resellers and others.

In addition to the potential obstacles associated with the introduction of any
new product, in order for the Company to successfully penetrate the emerging
teleworker market, the Company must make significant additions to its
distribution capabilities.  Competition for qualified personnel is intense in
the data communications industry.  The Company is continuing its efforts to
establish additional distribution channels and to develop marketing strategies
which are substantially different from prior marketing strategies.  The Company
has had limited success in marketing the Be There! system to potential customers
or through sales channels for such products, and there can be no assurance that
the Company will be successful in establishing a market for Be There! or in
establishing the Company's credibility in such market.  In addition, the Company
may be required to enhance the features and performance, including voice
quality, of the teleworker products in order to achieve broad market acceptance
of the products.

The Company's success may also be affected by competition from much larger, more
experienced companies, or by the introduction of alternative product solutions
or services.  For example, Sprint recently announced its ION service, and Lucent
Technologies has also announced a relevant product known as the Virtual
Telephone, both of which purport to provide many of the Be There! features.
Technologies such as ISDN and the more recently announced DSL products also
provide a more limited set of features similar to those offered by Be There!.
Rapidly changing technology, emerging industry standards, and the broad array of
competing remote access solutions may adversely affect the market acceptance of
the Be There! system or cause it to become obsolete.  There can be no assurance
that the Company will overcome such obstacles, and the failure to do so could
have a material adverse effect on the Company's business, results of operations,
or financial condition.  See "Competition" below.

In order to pursue its objective of capturing a leadership position in the
remote access solutions market, the Company has developed and continues to seek
relationships with strategic partners able to assist the Company with marketing,
distribution and further development of the Be There! product line, to provide
needed capital, and otherwise to enhance value of the Company's business and
assets.  There can be no assurance that existing relationships will be
maintained or that new relationships will be developed.  The loss of these
relationships or the inability to forge a key relationship could have a material
adverse effect on the Company.

RECENT OPERATING LOSSES; ADEQUACY OF CAPITAL RESOURCES

The Company has suffered substantial recurring losses, and revenue to date from
the Company's Be There! products has not been significant.  There can be no
assurance that the Company will return to profitability or will generate future
revenue levels sufficient to support operations.  The Company's independent
auditors have included an explanatory paragraph in their report covering the
June 30, 1998 financial statements which expresses 

                                       19
<PAGE>
 
substantial doubt about the Company's ability to continue as a going concern.
The explanatory paragraph notes that the Company has suffered recurring losses
and incurred negative cash flow from operations during fiscal 1998 and fiscal
1997.

The Company's ability to sustain operations, make future capital expenditures,
and fund the development and marketing of new products, including the Be There!
remote access system, are highly dependent upon limited existing cash, the
ability to raise additional capital, the cash requirements to fund redemption
(if required) of the Company's Series D, E, and F Convertible Preferred Stock
("Preferred Stock") and to pay the premium on the Preferred Stock (in the event
the Company does not or cannot issue shares of Common Stock in lieu thereof),
and the Company's return to profitability.  See "Potential Redemption of
Preferred Stock" below.  There can be no assurance that the Company's limited
existing cash will adequately meet the Company's capital requirements until the
Company achieves positive cash flow. The Company does not anticipate a return to
profitability as long as its expenditures on the Be There! system remain
disproportionate to attendant Be There! revenues.  As a result, in the future,
the Company will likely require additional financing.  The timing and amount of
the Company's future capital requirements can not be accurately predicted.
There can be no assurance that additional financing can be obtained or that, if
obtained, the Company will be able to satisfy conditions restricting the
Company's ability to utilize such financing sources.  In particular, there can
be no assurance that the Company will be able to satisfy the conditions
precedent to the second closing for the Preferred Stock pursuant to the Purchase
Agreement entered into in July 1998 (the "Purchase Agreement").  Accordingly,
there can be no assurance that the Company will have cash available in the
amounts and at the times needed.  The inability to obtain additional capital
when needed would have a material adverse effect on the Company's business.

RISK OF LOSING NASDAQ NATIONAL MARKET LISTING

Companies with securities listed on the Nasdaq National Market must satisfy
certain maintenance criteria, including minimum net tangible asset and stock
price requirements in order to remain so listed.  The Company's recurring losses
have had a negative effect on the Company's shareholders' equity, and the
Company does not currently meet the Nasdaq National Market net tangible assets
requirement.  In addition, the Company's stock price, as quoted on the Nasdaq
National Market, is volatile and, during a six week period earlier this year,
closed below the Nasdaq National Market minimum requirement of $1.00 per share.
There can be no assurance that the Company will be able to comply with the
maintenance criteria of the Nasdaq National Market, the failure of which could
result in the delisting of the Common Stock from such market.  Termination of
listing of the Company's Common Stock on the Nasdaq National Market could have a
material adverse effect on the market price and liquidity of the Common Stock,
and on the Company's ability to raise additional capital.  Delisting could also
jeopardize certain secondary trading exemptions from state "blue sky" laws,
further affecting liquidity of the Common Stock.  In addition, the Company would
be liable for certain substantial monetary penalties to the holders of the
Preferred Stock in the event of such a termination of listing.

RAPID TECHNOLOGICAL CHANGE

The market for the Company's products is characterized by rapidly changing
technology, emerging industry standards, product proliferation, and short
product life cycles. The 

                                       20
<PAGE>
 
Company believes that its future success will depend upon its ability to enhance
its existing products and to develop and introduce new products, which conform
to or support emerging data communications standards and influence the
development of these standards, meet a wide range of evolving user needs, and
achieve market acceptance. The introduction of new or enhanced products requires
the Company to manage the transition from older products in order to minimize
disruption in customer ordering patterns, avoid excessive levels of older
product inventories, and ensure that adequate supplies of new products can be
delivered to meet customer demand. There can be no assurance that the Company
will succeed in developing and marketing such products, or that the Company will
be able to respond effectively to technological changes, emerging industry
standards, or new product introductions by others. Furthermore, there can be no
assurance that competitors will not introduce products or services incorporating
technology as advanced or more advanced than the Company's, thereby rendering
the Company's products or technologies uncompetitive or obsolete. In addition,
as the technical complexity of new products increases, it may become
increasingly difficult to introduce new products quickly and according to
schedule. Delays in developing or shipping new or enhanced products, which the
Company has experienced in the past, could adversely affect the Company's
operating results. Conversely, the growth of the market for communications
products has been driven in part by the rapid technological change experienced
by that market. There can be no assurance that such rapid technological change
will continue or that the telecommunications infrastructure will have the
capacity to support such products. Any of these factors could adversely affect
the market for the Company's products and its operating results.

UNPREDICTABILITY OF TELEWORKER MARKET

The teleworker market is rapidly changing.  The size and growth of the
teleworker market may be affected by various factors, including changes in
market trends and market needs and changes in technology.  There can be no
assurance that the actual rate of growth and size will reach expected levels.
In addition, the Company's teleworker products have not yet achieved substantial
market acceptance.  There can be no assurance that the product concept will be
accepted by the market or, if accepted, to what extent it will be accepted, or
that the feature sets and performance of the Company's products are sufficient
to meet customers' needs.  The Company's products will compete with a broad
array of remote access solutions and there can be no assurance that the Company
will be able to compete successfully.  If the teleworker market does not develop
as expected, or if the Company's strategies for this market are unsuccessful,
the Company's business, results of operations, and financial condition may be
adversely affected.

COMPETITION

The communications industry is intensely competitive. The Company currently
competes principally in the remote access markets.  The Company's existing and
potential competitors have far more extensive financial, engineering, product
development, manufacturing and marketing resources than the Company.  As a
result, these competitors may be able to respond more quickly to new or emerging
technologies and changes in customer requirements, or to devote greater
resources to the development, promotion, and sale of their products and services
than the Company.  In addition, current and potential competitors have
established or may establish cooperative relationships among themselves or with
third parties to address the needs of the Company's prospective customers.
Accordingly, it is possible that new 

                                       21
<PAGE>
 
competitors or alliances among competitors may emerge and rapidly acquire
significant market share. Many of these competitors have greater brand
recognition, thereby placing the Company at a competitive disadvantage. In
addition, some competitors, including many foreign competitors, have a lower
cost structure that will allow them a competitive advantage on the basis of
price. The Company's products and services compete on the basis of a number of
factors, including features and functions, modularity and expansibility,
reliability, service and support, supplier credibility, recommendations of the
systems integrators, perceived cost savings, and price.

The Company's teleworker products compete in areas in which the Company may not
have the experience or resources to address.  There can be no assurance that
competitors will not introduce products or services incorporating technology as
advanced or more advanced than the Company's or that changes in the
communications environment will not render competitors' product solutions more
attractive to the customer than the Company's solutions. For example, Sprint
recently announced its ION service, and Lucent Technologies has also announced a
relevant product known as the Virtual Telephone, both of which purport to
provide many of the Be There! features.  Technologies such as ISDN and the more
recently announced DSL products also provide a more limited set of features
similar to those offered by Be There!

Competitive pressures often necessitate price reductions which the Company may
not be able to achieve or which could adversely affect profit margins and
operating results. In addition, the Company expects new competition to arise as
new technologies develop, such as Computer Telephony Integration, Voice over IP,
and others.  There can be no assurance that the Company will be able to compete
successfully with existing or new competitors or that competitive pressures
faced by the Company will not materially and adversely affect its business,
results of operations, or financial condition.

SALES CHANNEL RISKS

The Company anticipates that the success of the Be There! products will depend,
in large part, on its ability to market through distributors, resellers, and
other strategic marketing partners where the Company has little experience.
Independent distributors, resellers, and other strategic marketing partners,
including Inacom Communications and Data General Corp., are not contractually
committed to future purchases of the Company's products and therefore could
discontinue carrying the Company's products at any time in favor of a
competitor's products or for any other reason.  The loss of any of the Company's
major distributors or resellers, including Inacom Communications and Data
General Corp., could have a significant adverse effect on the Company's
operating results.  Failure of the Company to successfully develop, manufacture,
and market products appropriate for such channels could have a material adverse
effect on the Company's results of operations.

DEPENDENCE ON LIMITED NUMBER OF CUSTOMERS; FLUCTUATIONS IN PERIOD TO PERIOD
OPERATING RESULTS

Although the Company has not yet recorded significant revenue from its
teleworker products, the Company is currently targeting large corporations as
potential users of its teleworker products in addition to smaller potential
users.  If the Company is successful in attracting such large customers (as to
which there can be no assurance), the Company could experience 

                                       22
<PAGE>
 
significant fluctuations in revenue. A reduction or delay in orders or a delay
or default in payment by a major customer, or the loss of such a customer, could
have a material adverse effect on the Company's results of operations.

In addition to the factors set forth above, the results for a particular quarter
or other period may vary due to the overall state of the communications products
and services market, pricing and other competitive conditions, market acceptance
of the Company's products, the timing of the announcement and introduction of
new products and services by the Company and its competitors, variations in the
Company's product mix and component costs (which may vary substantially between
the Company's product lines), the financial stability of the Company's
customers, the timing of expenditures in anticipation of future sales, the
timing of product development costs, and economic conditions generally.  The
Company expects that its operating results will continue to fluctuate from
period to period in the future as a result of the factors described herein and
other factors, particularly until such time (if ever) that the Company's revenue
from Be There! sales increase substantially.  Any of these factors could
materially adversely affect the Company's results of operations.

DEPENDENCE ON KEY EMPLOYEES

The Company's ability to implement its strategies depends upon its ability to
retain and continue to attract highly talented managerial and technical
personnel. The Company is especially dependent on its President, Dr. W.B.
Barker, its teleworker products sales executives to generate substantial revenue
from Be There! products, and on its key technical personnel to introduce new
products and to remain in the forefront of technological advances. Competition
for qualified personnel is intense in the data communications industry.  All of
the Company's senior executives and other employees are employed on an "at-will"
basis.  There can be no assurance that the Company will retain its key employees
or that it will attract and assimilate such employees in the future.  The loss
of key personnel could materially and adversely affect the Company's business,
results of operations, and financial condition.

DEPENDENCE ON SUPPLIERS

The Company manufactures its products using components or subassemblies procured
from third party suppliers.  Certain of these components, including certain
critical microchips, are available only from a single source, and others are
available only from a limited number of sources.  A substantial majority of the
Company's sales have been from products containing one or more components which
are available from single supply sources.  The Company has no guaranteed supply
arrangements.  In addition, the Company is dependent on worldwide conditions in
the semiconductor market.  If the Company were unable to obtain a sufficient
supply of such components from its current sources, it could experience
difficulties in obtaining alternative sources or in altering product designs to
use alternative components.  In the past, the Company has experienced supply
shortages that have delayed product shipments.  From time to time, the Company
is subject to allocation arrangements with certain of its suppliers by which it
receives a portion of its orders for components which are in short supply.  In
addition, due to the Company's dependence on third party suppliers, the Company
is not always able to control the quality and reliability of the components it
uses to manufacture its products.  Supply shortages or deficiencies in the
quality or reliability of components may result in delays or reductions in
product shipments.  Such delays or reductions could adversely affect the
Company's operating results and damage customer 

                                       23
<PAGE>
 
relationships. Further, a significant increase in the price of one or more of
these components could adversely affect the Company's operating results.

DEPENDENCE ON MANUFACTURERS

The Company utilizes the services of third party manufacturers in the assembly
of certain of its products.  Due to this reliance on third party manufacturers,
the Company is not always able to exercise direct control over quality and
manufacturing costs.  In addition, from time to time, the Company may experience
difficulties in scheduling production of its products due to other demands
placed upon the third party manufacturers.  Delays in scheduling production or
deficiencies in quality may adversely affect the Company's operating results and
damage customer relationships.  Furthermore, a significant increase in
manufacturing costs attributable to the foregoing factors could adversely affect
the Company's operating results.

INVENTORY MANAGEMENT

From time to time, the Company has experienced significant increases in its
levels of inventory, in order to meet production requirements of existing or
anticipated orders, or as the result of delays in receiving certain components,
such as critical chipsets, from suppliers and the concurrent accumulation of
other inventory.  Increased levels of inventory could adversely affect the
Company's liquidity, increase the risk of inventory obsolescence (from
cancellation of orders, failure to receive anticipated orders or otherwise), or
increase the risk of a decline in market value of such inventory or losses from
theft, fire, or other similar occurrences.  The failure of the Company to
effectively manage its purchasing activities and inventory levels could have a
material adverse effect on the Company's financial condition and results of
operations.

INTELLECTUAL PROPERTY RIGHTS

The Company's success depends in part upon its technological expertise and
proprietary product designs.  The Company relies upon its trade secret
protection efforts and, to a lesser extent, upon patents and copyrights to
protect its proprietary technologies.  There can be no assurance that these
steps will be adequate to deter misappropriation or infringement of its
proprietary technologies or that the Company's competitors will not
independently develop technologies that are substantially equivalent or superior
to the Company's technology.  In addition, the laws of some foreign countries do
not protect the Company's proprietary rights to the same extent as do the laws
of the United States, and there can be no assurance that United States or
foreign laws will be adequate to protect such proprietary rights.

The Company expects that remote access technologies and know-how in general will
become increasingly valuable intellectual properties as competition intensifies.
The Company believes this increasing value may produce a competitive environment
where intellectual property disputes are likely to arise.  Intellectual property
disputes may be initiated against the Company for tactical purposes to gain
competitive advantage or overcome competitive disadvantage, even if the merits
of a specific dispute are doubtful.  In certain cases, the Company grants, or
may grant, certain licenses of its intellectual property rights.  The Company
may be required to bring or defend against litigation to enforce any patents
issued or assigned to the Company, to protect trademarks, trade secrets, and
other intellectual property rights owned by the Company, to defend the Company
against claimed infringement 

                                       24
<PAGE>
 
of the rights of others, to resolve disputes under technology license
arrangements, and to determine the scope and validity of the proprietary rights
of the Company or others. See "Patent Infringement Lawsuit" below. Any
litigation could be costly and a diversion of management's attention, which
could have a material adverse effect on the Company's business, financial
condition, and results of operations. The Company's limited resources may limit
its ability to bring or defend against any such litigation. Adverse
determinations in litigation, including litigation initiated by the Company,
could result in the loss of the Company's proprietary rights, subject the
Company to significant liabilities, require the Company to seek licenses from
third parties or prevent the Company from manufacturing or selling its products,
any of which could have a material adverse effect on the Company's business,
financial condition and results of operations.

The Company is currently required to obtain licenses for various technologies
used in many of the Company's products.  There can be no assurance that the
Company will continue to be able to obtain such licenses on commercially
reasonable terms.  Finally, the Company's ability to purchase components could
be adversely affected in the event infringement claims are brought against the
Company's suppliers.

PATENT INFRINGEMENT LAWSUIT

On August 19, 1998, the Company filed a lawsuit in United States District Court
in San Antonio, Texas, against Lucent Technologies Inc.  The suit alleges that
Lucent is infringing upon a patent held by the Company entitled "System and
Method for Providing a Remote User with a Virtual Presence to an Office".  There
can be no assurance that the Company will be able to fully pursue such suit due
to limited resources, uncertainty as to the source of funding to pay the total
amount of legal expenses, the court's interpretations and decisions regarding
the Company's allegation in the lawsuit (including their effect on the validity
or enforceability of the Company's patents), and the risk of costly
counterclaims.  Litigation by its very nature is unpredictable, and there can be
no assurance that the Company will prevail in the lawsuit.  Should the Company
fail to prevail in a significant manner, such failure may have a material
adverse effect on the Company's financial condition and operations.  For
additional risks associated with such litigation, see "Intellectual Property
Rights" above.

REGULATORY STANDARDS

The Company's products are subject to regulation by the Federal Communications
Commission (the "FCC"), and each of the Company's products must typically be
tested before it can be introduced into the market.  The inability of the
Company's products to conform to FCC regulations or the failure of the Company's
products to meet FCC testing requirements could delay the introduction of the
Company's products into the market, and otherwise adversely affect the Company.
Foreign authorities often establish telecommunications standards different from
those in the United States, making it difficult and more time consuming to
obtain the required regulatory approvals.  A significant delay in obtaining such
regulatory approvals could have an adverse effect on the Company's operating
results. Furthermore, changes in such laws, regulations, policies, or
requirements could affect the demand for the Company's products or result in the
need to modify products, which might involve substantial costs or delays in
sales and could have an adverse effect on the Company's future operating
results.

POTENTIAL REDEMPTION OF PREFERRED STOCK

                                       25
<PAGE>
 
As of September 2, 1998, 1,500 shares of Series D Preferred Stock, 750 shares of
Series E Preferred Stock and Common Stock Purchase Warrants ("Warrants") to
purchase 819,871 shares of Common Stock ("Warrant Shares") were issued and
outstanding, all of which were issued in the first closing pursuant to the
Purchase Agreement.  Subject to the satisfaction of certain conditions (as to
which there can be no assurance), the Company may also issue in a second closing
an additional 1,000 shares of Series D Preferred Stock, 750 shares of Series F
Preferred Stock and Warrants to purchase 480,248 Warrant Shares.  Pursuant to
regulations of the National Association of Securities Dealers, Inc., in the
absence of shareholder approval, the Company may not issue in the aggregate more
than 2,905,782 shares of Common Stock ("Conversion Shares") upon conversion of
the Preferred Stock and exercise of the Warrants.  The Company is obligated to
redeem any shares of Preferred Stock which may not be converted and any Warrants
which may not be exercised as a result of such regulatory limitation or as a
result of an insufficient number of authorized shares of Common Stock pursuant
to the Company's articles of incorporation.  In addition, the Preferred Stock is
redeemable upon certain major corporate events and other triggering events, and
upon the failure to pay penalties arising from the delisting of the Common Stock
on the Nasdaq National Market.  Because the Company may issue Common Stock upon
conversion of the Preferred Stock in lieu of paying a cash premium accrued
thereon, and because the conversion price of the Series D Preferred Stock
depends upon the average closing bid price of the Common Stock prior to
conversion (subject to maximum and minimum conversion prices), the actual number
of Conversion Shares that are issuable upon conversion of the Preferred Stock
(including the shares of Common Stock issued in payment of the accrued premium
thereon) will depend on the average closing bid price of the Common Stock prior
to conversion.  As of September 2, 1998, assuming conversion of the outstanding
Series D Preferred Stock at an assumed conversion price of $1.1701 per share
(equal to 80% of the trailing five-day average closing bid price of the Common
Stock prior to such date), the conversion of the outstanding Series E Preferred
Stock and the exercise of the outstanding Warrants (excluding any payment in
Common Stock of the accrued premium on the Preferred Stock), the Company would
be required to issue an aggregate of 2,851,835 shares of Common Stock; assuming
the issuance on such date of all such Conversion Shares and Warrant Shares,
there would have been approximately 19,486,050 shares of Common Stock
outstanding and reserved for issuance pursuant to employee benefit plans and
other arrangements.  Although the Company intends to seek shareholder approval
of the issuance of in excess of 2,905,782 Conversion Shares and Warrant Shares
and of an increase of in its currently authorized 20,000,000 shares of Common
Stock, there can be no assurance that such approvals will be obtained.  The cash
requirements to fund such a redemption of the Preferred Stock and Warrants could
adversely affect the Company's ability to sustain operations, fund the continued
development and marketing of products, including the Be There! Remote Access
System, and make future capital expenditures.

ANTI-TAKEOVER MEASURES

The Company has adopted a shareholder rights plan in an effort to guard against
abusive tactics which could deprive shareholders of the opportunity to realize
the long-term value of their investment in the Company. In addition, certain
provisions of the Company's Articles of Incorporation may have the effect of
discouraging unsolicited proposals for acquisition of control of the Company.
The Company's Board of Directors can, without obtaining shareholder approval,
issue shares of no par value preferred stock of the Company having rights that
could adversely affect the voting power of holders of the Common Stock,
including 

                                       26
<PAGE>
 
the right to vote as a class on any proposed change of control. Such an issuance
could have the effect of delaying, deferring, or preventing a change of control
of the Company and might make it difficult to replace incumbent management.

Certain provisions of Texas corporate law, including the Texas "Business
Combination Law," could also have the effect of hindering or delaying a takeover
bid for the Company. Such provisions may inhibit takeover bids and decrease the
chance of shareholders realizing a premium to the then market price of the
Common Stock as a result of a takeover bid.  In general, the Business
Combination Law prohibits a Texas "issuing public corporation" from engaging in
a "business combination" with an "affiliated shareholder," or an affiliate or
associate thereof, for a period of three years after the date of the transaction
in which the person became an affiliate shareholder, unless the business
combination is approved in a prescribed manner.  "Business Combinations" include
mergers, asset sales and other transactions resulting in a financial benefit to
the affiliated shareholder.  An "affiliated shareholder" is a person who,
together with affiliates and associates, owns (or within three years, did own)
20% or more of the corporation's voting stock.

PRICE VOLATILITY

The market price of the Company's Common Stock has been, and may continue to be,
highly volatile.  The Company believes that factors such as quarterly
fluctuations in results of operations, changes in distributor or reseller
relationships, adverse circumstances affecting the introduction or market
acceptance of new products offered by the Company, changes in or cancellations
under existing contracts, changes in the market success of products which
utilize or incorporate the Company's products, announcements of new products by
competitors, changes in earnings estimates by analysts, changes in accounting
principles, sales by existing shareholders (including sales from time to time of
Common Stock issued upon conversion of the Preferred Stock), short selling, loss
of key personnel, and other factors will continue to cause the market price of
the Company's Common Stock to fluctuate substantially.  In addition, stock
prices for many technology companies, including the Company, fluctuate widely
for other reasons (such as market perception of high technology industries)
unrelated to operating results or the Company.  These fluctuations, as well as
general economic, political and market conditions, such as recessions or
military conflicts, may adversely affect the market price of the Company's
Common Stock. Changes in the price of the Company's Common Stock could affect
the Company's ability to successfully attract and retain qualified personnel or
complete other transactions in the future.  In the past, following periods of
volatility in the market price of a company's securities, securities class
action litigation has often been instituted against companies with fluctuating
stock prices.  Such litigation could result in substantial costs and a diversion
of management's attention and resources, which could have a material adverse
effect on the Company's operating results and financial condition.

ITEM 2. PROPERTIES
------------------

The Company's corporate headquarters and facilities for manufacturing,
distribution, engineering, product development, sales, and sales support are
currently located in two buildings totaling approximately 50,000 square feet of
leased space in San Antonio, Texas.  The buildings, consisting of approximately
21,000 and 29,000 square feet, are subject to ten- and seven-year leases,
respectively, which commenced in April 1996.  The Company has also leased a
third 

                                       27
<PAGE>
 
adjacent parcel of property upon which an additional building could be
constructed if necessary. The Company has a purchase option, exercisable through
November 1998, to acquire all leased parcels at an escalating purchase price.

The Company believes that its existing facilities are adequate to meet current
requirements, including foreseeable short-term requirements to support the
growth of its Be There! remote access business, and believes that suitable
additional space will be available as needed to accommodate any future expansion
of its operations.

ITEM 3.  LEGAL PROCEEDINGS
--------------------------

On August 18, 1998, the Company filed a lawsuit against Lucent Technologies,
Inc. ("Lucent").  The lawsuit was filed in the United States District Court in
San Antonio, Texas.  In the lawsuit, the Company alleges that Lucent is
infringing upon the Company's patent entitled "System and Method for Providing a
Remote User with a Virtual Presence to an Office."  The Company further alleges
that Lucent misappropriated certain of the Company's confidential and
proprietary information in violation of a nondisclosure agreement between Lucent
and the Company and has engaged in anti-competitive conduct.  The Company is
seeking injunctive relief to prevent Lucent from continuing its infringing
activities and further violation of the nondisclosure agreement and is also
seeking to recover attorneys' fees, actual damages resulting from Lucent's
alleged breach of the nondisclosure agreement, treble damages incurred by the
Company as a result of Lucent's alleged anti-competitive conduct, and certain
punitive damages. The Company places a high value on its intellectual property
and intends to aggressively protect its patent and other property rights from
infringement and other misappropriation.  The Company is unable to predict the
costs to be incurred in prosecuting this lawsuit or the ultimate outcome of such
lawsuit.  See "Business  Certain Business Risks  Patent Infringement Lawsuit."

On May 22, 1998, the United States District Court in San Antonio, Texas approved
the settlement and dismissal of the shareholder class action lawsuit titled In
re Data Race, Inc. Securities Litigation originally filed on November 28, 1995,
against the Company and certain of its officers  Herbert T. Hensley, former
Chairman of the Board, W. B. Barker, President and Chief Executive Officer,
Gregory T. Skalla, Senior Vice President-Finance and Chief Financial Officer,
and Leven E. Staples, former Vice President and Chief Technical Officer.  The
plaintiffs had alleged that the defendants violated certain provisions of the
federal securities laws, including Rule 10b-5 under the Securities Exchange Act
of 1934. The settlement and dismissal of the lawsuit was the result of the
successful mediation of the dispute. Pursuant to the terms of the settlement
agreement, the Company's insurance carrier paid approximately $800,000 in cash
and the Company paid $5,940 in cash. In the final judgment and order of
dismissal, the plaintiffs acknowledged that, after investigation, they found no
provable wrongdoing on the part of the defendants. Although the Company believed
that the case was absolutely without merit, and that neither the Company nor any
of the other defendants committed any of the alleged wrongdoings, the Company
ultimately decided to accept the settlement agreement based on the advise 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.

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
------------------------------------------------------------

None.

                                       28
<PAGE>
 
                                    PART II

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

The Company's Common Stock has been traded on the Nasdaq National Market under
the symbol RACE since the Company's initial public offering on October 7, 1992.
The following table sets forth, for the two most recent fiscal years, ended June
30, 1997 and June 30, 1998, on a per share basis, the range of high and low last
reported sale prices for the Company's Common Stock as quoted on the Nasdaq
National Market.  These price quotations reflect interdealer prices, without
adjustment for retail mark-ups, mark-downs or commissions and may not
necessarily represent actual transactions.

 
                                                    High       Low
 
     July 1, 1996 to September 30, 1996             7 3/4     5 3/8
     October 1, 1996 to December 31, 1996          24 3/8     7 7/16
     January 1, 1997 to March 31, 1997             22 3/4    12 1/8
     April 1, 1997 to June 30, 1997                16 1/8     8 7/8
     July 1, 1997 to September 30, 1997            12 3/4     6 1/2
     October 1, 1997 to December 31, 1997           9 3/8     3
     January 1, 1998 to March 31, 1998              4 1/2     1 11/16
     April 1, 1998 to June 30, 1998                 2           1/2
 
As of September 2, 1998, the last sale price of the Company's Common Stock as
reported on the Nasdaq National Market was $1.625.  As of September 2, 1998,
there were 257 shareholders of record, although the Company believes that the
number of beneficial owners is significantly greater.

The Company has never declared or paid cash dividends on the Common Stock.  The
Company presently intends to retain earnings, if any, for the operation and
development of its business and does not anticipate paying any cash dividends on
the Common Stock in the foreseeable future.  Any future determination as to the
payment of cash dividends will depend on a number of factors, including future
earnings, capital requirements, the financial condition and prospects of the
Company and any restrictions under credit agreements existing from time to time,
as well as such other factors as the Board of Directors may deem relevant.
There can be no assurance that the Company will pay any dividends in the future.

                                       29
<PAGE>
 
ITEM 6.  SELECTED FINANCIAL DATA
--------------------------------

The selected data presented below for, and as of the end of, each of the fiscal
years in the five-year period ended June 30, 1998, are derived from the audited
financial statements of DATA RACE, Inc.  The selected financial data should be
read in conjunction with the Company's financial statements and notes thereto
appearing elsewhere in this report and "Management's Discussion and Analysis of
Financial Condition and Results of Operations".

<TABLE>
<CAPTION>
                                                                            FISCAL YEARS ENDED JUNE 30,
                                                   ------------------------------------------------------------------------------
                                                       1998           1997            1996             1995             1994
                                                   ----------     -----------     ------------     ------------     -------------
<S>                                               <C>             <C>             <C>              <C>              <C>
                                                                        (IN THOUSANDS, EXCEPT PER SHARE DATA)
OPERATING STATEMENT DATA:
Total revenue................................     $     4,507     $    19,788     $     17,232     $     30,380     $      23,124
Cost of revenue..............................           3,677          14,561           13,839           21,959            26,638
                                                   ----------     -----------     ------------     ------------     -------------
   Gross profit (loss).......................             830           5,227            3,393            8,421            (3,514)
                                                   ----------     -----------     ------------     ------------     -------------
Operating expenses:                                               
  Engineering and product development........           3,648           4,882            4,784            3,134             3,150
  Sales and marketing  .                                4,006           4,156            4,081            3,540             6,418
  General and administrative.................           2,341           2,682            3,233            1,983             3,215
                                                   ----------     -----------     ------------     ------------     -------------
   Total operating expenses..................           9,995          11,720           12,098            8,657            12,783
                                                   ----------     -----------     ------------     ------------     -------------
    Operating loss...........................          (9,165)         (6,493)          (8,705)            (236)          (16,297)
                                                   ----------     -----------     ------------     ------------     -------------
Other income, net............................             136             201              386              267                94
                                                   ----------     -----------     ------------     ------------     -------------
Income (loss) before income taxes and              
 cumulative effect of change in accounting         
 for income taxes............................          (9,029)         (6,292)          (8,319)              31           (16,203)
Income tax expense (benefit).................                               -                -                -              (659)
                                                   ----------     -----------     ------------     ------------     -------------
Income (loss) before cumulative effect of                                                                                 
 change in accounting for income taxes.......          (9,029)         (6,292)          (8,319)              31           (15,544)
Cumulative effect of change in accounting                                                                                        
 for income taxes............................               -               -                -                -                27
                                                   ----------     -----------     ------------     ------------     -------------
    Net income (loss)........................      $   (9,029)    $    (6,292)    $     (8,319)    $         31     $     (15,517)
                                                   ==========     ===========     ============     ============     =============
Earnings per share:
  Net income (loss)..........................      $   (9,029)    $    (6,292)    $     (8,319)    $         31     $     (15,517)
  Effect of beneficial conversion features                                                                                       
   of convertible preferred stock............            (458)         (2,063)               -                -                 -
                                                   ----------     -----------     ------------     ------------     -------------
  Net income (loss) applicable to common
   stock.....................................      $   (9,487)    $    (8,355)    $     (8,319)    $         31     $     (15,517)
                                                   ==========     ===========     ============     ============     =============
  Income (loss) before cumulative effect of
   change in accounting for income taxes per
   common share - basic and diluted..........      $    (1.60)    $     (1.71)    $      (1.77)    $       0.01     $       (3.47)
  Cumulative effect of change in accounting
   for income taxes per common share - basic
   and diluted...............................               -               -                -                -              0.01
                                                   ----------     -----------     ------------     ------------     -------------
  Net income (loss) per common share - basic        
   and diluted...............................      $    (1.60)    $     (1.71)    $      (1.77)    $       0.01     $       (3.46)
                                                   ==========     ===========     ============     ============     =============
</TABLE> 

                                       30
<PAGE>
 
<TABLE> 

<S>                                               <C>             <C>             <C>              <C>              <C>
Weighted average shares outstanding..........           5,937           4,873            4,688            4,773             4,481

BALANCE SHEET DATA (AT YEAR END):
Working capital..............................      $    1,056     $     4,888     $      5,644     $     13,692     $      12,558
Total assets.................................           4,009           9,470           12,495           20,327            20,038
Current maturities of long-term debt.........               -               -                -                -                13
Earnout payable..............................               -               -                -                -                90
Shareholders' equity.........................           2,557           6,863            7,956           16,164            15,728
</TABLE>

ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
--------------------------------------------------------------------------------
OF OPERATIONS
-------------

RESULTS OF OPERATIONS


The following table sets forth for the fiscal years indicated the percentage of
total revenue represented by items reflected in the Company's statements of
operations.

<TABLE>
<CAPTION>
                                                         PERCENTAGE OF TOTAL                           PERCENTAGE
                                                       REVENUE FOR FISCAL YEARS                   INCREASE (DECREASE)
                                                            ENDED JUNE 30,                          FROM PRIOR YEAR
                                          ----------------------------------------------     ---------------------------
                                                1998             1997             1996            1998           1997
                                          ------------     ------------     ------------     -----------    ------------
<S>                                       <C>              <C>              <C>              <C>            <C>
OPERATING STATEMENT DATA:
Total revenue..........................          100.0%           100.0%           100.0%         (77.2)%           14.8%
Cost of revenue........................           81.6             73.6             80.3           (74.7)            5.2
                                          ------------     ------------     ------------
    Gross profit.......................           18.4             26.4             19.7           (84.1)           54.1
                                          ------------     ------------     ------------
Operating expenses:
  Engineering and product development..           80.9             24.7             27.8           (25.3)            2.0
  Sales and marketing..................           88.9             21.0             23.7            (3.6)            1.9
  General and administrative...........           51.9             13.5             18.7           (12.7)          (17.1)
                                          ------------     ------------     ------------
 
    Total operating expenses...........          221.7             59.2             70.2           (14.7)           (3.1)
                                          ------------     ------------     ------------
 
Operating loss.........................         (203.3)           (32.8)           (50.5)            *               *
Other income, net......................            3.0              1.0              2.2           (32.4)          (48.1)
                                          ------------     ------------     ------------
 
     Net loss..........................         (200.3%)          (31.8%)          (48.3%)           *               *
                                          ------------     ------------     ------------
</TABLE> 
 
*     Not meaningful

From its inception in 1983, the Company has designed, manufactured, and marketed
advanced technology communication products.  The Company's strategy is to
provide innovative, early to market, high-value-added solutions to meet the
needs of knowledge workers remote from their headquarters office.

The Company's goal of returning to profitability and developing a more
dependable revenue base depends on the success of the Be There! Remote Access
System.  The Be There! system represents 

                                       31
<PAGE>
 
a type of product which is significantly different from the Company's custom
modem and network multiplexer products. Although the Company has not recorded
significant revenue from sales of the Be There! system, the Company has expended
substantial resources on its development and introduction. In order to
successfully penetrate the emerging teleworker market, the Company expects that
significant additional resources will need to be expended in order to expand its
sales and marketing infrastructure and operational systems, and to finance
inventory and receivables.

FISCAL 1998 COMPARED TO FISCAL 1997

Total revenue in fiscal 1998 decreased 77% to $4.5 million from $19.8 million in
fiscal 1997.   The decrease was primarily due to the completion during fiscal
1997 of substantially all shipments under existing custom modem contracts and
the decline in revenue from network multiplexers.  Revenue from custom modem
products decreased to $1.2 million in fiscal 1998 from $15.6 million in fiscal
1997.  Revenue to date from the Company's Be There! products has not been
significant.  Revenue from shipments to NEC, the Company's largest customer in
fiscal 1998 represented 15% of total fiscal 1998 revenue.  The Company believes
that the market for custom modems is in a state of transition, and future
opportunities in this market are expected to increasingly shift from high-volume
manufacturing to alternatives such as custom design contracts and royalities.
The Company has taken steps to better align its spending related to custom
modems to the expected lower revenue levels.

Gross profit margin was 18% for fiscal 1998, down from 26% for fiscal 1997. This
decrease was primarily due to unabsorbed manufacturing variances attributable to
reduced production volumes.

Engineering and product development expenses decreased to $3.6 million in fiscal
1998 from $4.9 million in fiscal 1997.  This decrease was primarily due to
significant workforce reductions in custom modem development in January 1998,
and reductions in outside product development contracts.

Sales and marketing expenses decreased during fiscal 1998 to $4.0 million from
$4.2 million in fiscal 1997.  This decrease was primarily due to the Company's
suspension of most outside advertising, offset in part by additional sales and
marketing personnel additions for the Company's Be There! Remote Access System.

General and administrative expenses decreased during fiscal 1998 to $2.3 million
from $2.7 million in fiscal 1997.  This decrease was primarily due to workforce
reductions.

Income tax benefits related to the losses for fiscal year 1998 were not
recognized because the utilization of such benefits is not assured.  As of June
30, 1998, the Company had federal and state tax net operating loss carry
forwards of approximately $35,246,000 million which expire beginning in 2010.
The value of these net operating loss carryforwards is dependent on future
events and complex tax code provisions, and cannot be stated with certainty.

FISCAL 1997 COMPARED TO FISCAL 1996

Total revenue in fiscal 1997 increased 15% to $19.8 million from $17.2 million
in fiscal 1996, primarily due to increased revenue from custom modem revenue.
Revenue from custom modem products increased to $15.6 million in fiscal 1997
from $10.6 million in fiscal 1996, an increase of 46%, which was primarily due
to shipments to NEC Technologies, Inc. (NEC), Texas Instruments (TI), and AST
Research, Inc. (AST) under contracts which were substantially completed in
fiscal 

                                       32
<PAGE>
 
1997. Revenue from shipments to NEC and TI, the Company's largest customer and
second largest customers in fiscal 1997, represented 46% and 21%, respectively,
of total fiscal 1997 revenue.

Network product revenue decreased by 38% during fiscal 1997 to $4.1 million from
$6.6 million in fiscal 1996 primarily due to continued competitive pressures
with regard to feature sets.

The cost of revenue in fiscal 1997 was $14.6 million, resulting in a gross
profit of $5.2 million compared to $3.4 million of gross profit in fiscal 1996.
Gross profit margin increased to 26% in fiscal year 1997 from 20% for fiscal
1996, primarily due to improved manufacturing variances attributable to
increased production volumes.

Engineering and product development expenses increased to $4.9 million in fiscal
1997 from $4.8 million in fiscal 1996.  Engineering and product development
expenses were 25% of revenue in fiscal 1997 compared to 28% in fiscal 1996.  The
decrease in spending as a percent of revenue was primarily caused by the
increase in total revenue during fiscal 1997.

Sales and marketing expenses increased during fiscal 1997 to $4.2 million from
$4.1 million in fiscal 1996.  Sales and marketing expenses in fiscal 1997 were
21% of revenue, down from 24% of fiscal 1996 revenue, primarily due to the
increase in fiscal 1997 revenue.

General and administrative expenses decreased by 17% to $2.7 million in fiscal
1997 from $3.2 million in fiscal 1996.  The decrease was primarily caused by
reduced costs for legal expenses associated with the shareholder lawsuit.
General and administrative expenses decreased to 13% of revenue in fiscal 1997
from 19% in fiscal 1996 primarily due to the reasons described above and the
increase in revenue during fiscal 1997.

LIQUIDITY AND CAPITAL RESOURCES

Operating losses have had and continue to have a substantial negative effect on
the Company's cash balance.  At June 30, 1998, the Company had approximately
$1,644,000 in cash and cash equivalents, compared to $3,149,000 at March 31,
1998.

In November 1997, the Company received net proceeds of approximately $4,617,000
from the issuance of Series C Convertible Participating Preferred Stock and
related warrants.

In July 1998, the Company received net proceeds of approximately $2,135,000 from
the issuance of Preferred Stock and Warrants to purchase 339,623 and 140,625
shares of Common Stock.  In addition, the purchasers of the Preferred Stock and
Warrants have agreed to purchase, subject to the Company's satisfaction of
certain conditions (as to which there can be no assurance), an additional
$1,750,000 of Preferred Stock and Warrants at a second closing on or before
January 31, 1999.  The Preferred Stock is redeemable under certain
circumstances.  See note 11 to the Company's financial statements appearing
elsewhere in this report and "Certain Business Risks - Potential Redemption of
Convertible Preferred Stock."

The Company's ability to sustain operations, make future capital expenditures
and fund the development and marketing of new products, including the Be There!
Remote Access System, are highly dependent on existing cash, the ability to
close on the second funding of the Preferred Stock, and the Company's return to
profitability.  The timing and amount of the Company's future capital

                                       33
<PAGE>
 
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 will
likely require additional financing in the future; the failure to obtain such
financing when needed would have a substantial adverse effect on the Company.
If the Company's plans to improve operations and fund the second closing of the
Preferred Stock are not successful, management will consider, strategic and/or
financial alliances with third parties.  See "Business - Certain Business Risks
- Recent Operating Losses; Adaquacy of Capital Resources."

YEAR 2000 COMPLIANCE


The Company has been evaluating and adjusting all known date-sensitive systems
and equipment for Year 2000 compliance. The assessment phase of the Year 2000
project is substantially complete. Virtually all of the compliance was performed
or is expected to be performed by Company personnel. The total estimated cost of
the Year 2000 conversion is not deemed material to the Company and is being
expensed as incurred.

In addition to internal Year 2000 implementation activities, the Company is in
communication with third party suppliers and vendors with whom which the
Company's systems communicate and interact to determine the extent to which
those companies are addressing their Year 2000 compliance problems.  There can
be no assurance that there will not be an adverse effect on the Company if third
parties, such as suppliers or service providers, do not bring their systems into
compliance in a timely manner.  However, management believes that ongoing
communication with, assessment of, and coordination with these parties will
minimize these risks.

Although the Company anticipates minimal business disruption will occur as a
result of Year 2000 issues, possible consequences include, but are not limited
to, disruption of voice mail communications, purchase order processing, and
other normal business activities.

To date, the Company has not established a contingency plan for possible Year
2000 issues.  Where needed, the Company will establish contingency plans based
on its actual testing experience and assessment of outside risks.  The Company
anticipates contingency plans to be in place by June 30, 1999.

The cost of and the completion dates are based on management's best estimates
and may be updated as additional information becomes available.


ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
----------------------------------------------------
 
INDEX TO FINANCIAL STATEMENTS 
                                                                           PAGE
Independent Auditors' Report..............................................  35
Financial Statements

                                       34
<PAGE>
 
    Balance Sheets at June 30, 1998 and 1997...............................  36
    Statements of Operations for the years ended June 30, 1998, 1997
     and 1996..............................................................  37
    Statements of Shareholders' Equity for the years ended June 30, 1998,
     1997 and 1996.........................................................  38
    Statements of Cash Flows for the years ended June 30, 1998, 1997,
     and 1996..............................................................  39
    Notes to Financial Statements..........................................  40

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

                                       35
<PAGE>
 
INDEPENDENT AUDITORS' REPORT

Board of Directors and Shareholders

DATA RACE, Inc.:

We have audited the accompanying balance sheets of Data Race, Inc. as of June
30, 1998 and 1997, and the related statements of operations, shareholders'
equity, and cash flows for each of the years in the three-year period ended June
30, 1998. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Data Race, Inc. as of June 30,
1998 and 1997, and the results of its operations and its cash flows for each of
the years in the three-year period ended June 30, 1998, in conformity with
generally accepted accounting principles.

The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern.  As discussed in Note 1 to the
financial statements, the Company has suffered recurring losses and negative
cash flows from operations that raise substantial doubt about the Company's
ability to continue as a going concern.  Management's plans in regard to these
matters are also described in Note 1.  The financial statements do not include
any adjustments that might result from the outcome of this uncertainty.



                                                           KPMG PEAT MARWICK LLP
SAN ANTONIO, TEXAS
SEPTEMBER 2, 1998

                                       36
<PAGE>
 
                                 DATA RACE, INC.
                                 BALANCE SHEETS


<TABLE>
<CAPTION>
                                                                         AS OF JUNE 30,
                                                              ------------------------------------
                                                                    1998                  1997
                                                              ---------------      ---------------
<S>                                                           <C>                  <C>
ASSETS                                                     
                                                              
Current assets:                                            
   Cash and cash equivalents..............................    $     1,644,294      $     4,535,768
   Accounts receivable, net...............................            321,103            1,879,656
   Inventory..............................................            542,963            1,056,999
   Prepaid expenses and deposits..........................                  -               22,889
                                                              ---------------      ---------------
     Total current assets.................................          2,508,360            7,495,312
                                                              
Property and equipment, net...............................          1,475,132            1,932,317
Other assets..............................................             25,389               42,689
     Total assets.........................................    $     4,008,881      $     9,470,318
                                                              ---------------      ---------------
                                                              
LIABILITIES AND SHAREHOLDERS' EQUITY                       
                                                              
Current liabilities:                                       
   Accounts payable.......................................    $       346,973      $       912,522
   Accrued expenses.......................................          1,104,910            1,693,265
   Other current liabilities..............................                  -                  932
                                                              ---------------      ---------------
     Total current liabilities............................          1,451,883            2,606,719
                                                              
Commitments and contingencies.............................    
                                                              
Shareholders' equity:                                      
   Redeemable convertible preferred stock, no par value,      
2,000,000 shares authorized:                               
    Series A (aggregate liquidation preference $232,750)       
     5,000 shares issued, 175 shares outstanding at June 
     30, 1998 and 3,280 outstanding at June 30, 1997......            224,970            3,079,447     
    Series C (aggregate liquidation preference $1,765,809)     
     5,000 shares issued, 1,681 shares outstanding at June      
     30, 1998; none issued outstanding at June 30, 1997...          1,380,001                    -
                                                              
   Common stock, no par value, 20,000,000 shares              
    authorized 9,126,406 and 5,137,741 shares issued and       
    outstanding at June 30, 1998 and 1997, respectively...         33,334,779           26,680,686

   Additional paid-in capital.............................          1,882,303            1,882,303
   Accumulated deficit....................................        (34,265,055)         (24,778,837)
                                                              ---------------      ---------------
     Total shareholders' equity...........................          2,556,998            6,863,599
                                                              ---------------      ---------------
   Total liabilities and shareholders' equity.............    $     4,008,881      $     9,470,318
                                                              ===============      ===============
</TABLE>

                 See accompanying notes to financial statements

                                       37
<PAGE>
 
                                DATA RACE, INC.
                           STATEMENTS OF OPERATIONS


<TABLE>
<CAPTION>
                                                                      YEARS ENDED JUNE 30,
                                               --------------------------------------------------------------
                                                     1998                  1997                   1996
                                               ----------------      -----------------      -----------------
 
<S>                                            <C>                   <C>                    <C> 
   Total revenue...........................    $      4,507,461      $      19,787,764      $      17,231,640
 
   Cost of revenue.........................           3,677,390             14,560,981             13,838,987
                                               ----------------      -----------------      -----------------
 
       Gross profit........................             830,071              5,226,783              3,392,653
                                               ----------------      -----------------      -----------------
 
   Operating expenses:
     Engineering and product development...           3,647,647              4,881,461              4,784,232
     Sales and marketing...................           4,006,537              4,156,149              4,080,622
     General and administration............           2,340,642              2,681,992              3,233,349
                                               ----------------      -----------------      -----------------
       Total operating expenses............           9,994,826             11,719,602             12,098,203
                                               ----------------      -----------------      -----------------
 
       Operating loss......................          (9,164,755)            (6,492,819)            (8,705,550)
                                               ----------------      -----------------      -----------------
 
   Other income (expense):
     Interest income.......................             122,813                176,677                338,674
     Other, net............................              12,953                 24,048                 48,049
                                               ----------------      -----------------      -----------------
       Total other income..................             135,766                200,725                386,723
                                               ----------------      -----------------      -----------------
 
       Net loss............................    $     (9,028,989)     $      (6,292,094)     $      (8,318,827)
                                               ================      =================      =================
 
 
   Per share data:
     Net loss..............................    $     (9,028,989)     $      (6,292,094)     $      (8,318,827)
     Effect of beneficial conversion
       feature of convertible preferred 
       stock...............................            (457,229)            (2,062,644)                     -
                                               ----------------      -----------------      -----------------
 
     Net loss applicable to common
       stock...............................    $     (9,486,218)     $      (8,354,738)     $      (8,318,827)
                                               ================      =================      =================
 
     Net basic and diluted loss per share
       applicable to common stock..........    $          (1.60)     $           (1.71)     $           (1.77)
                                               ================      =================      =================
 
   Weighted average shares outstanding.....           5,937,000              4,873,000              4,688,000
                                               ================      =================      =================
</TABLE>


                See accompanying notes to financial statements

                                       39
<PAGE>
                                                  DATA RACE, INC.
                                        STATEMENTS OF SHAREHOLDERS' EQUITY

<TABLE> 
<CAPTION> 
                                          Series A Convertible    Series C Convertible                               
                                            Preferred Stock         Preferred Stock             Common Stock         
                                        ----------------------------------------------- ----------------------------
                                          Shares     Amount      Shares      Amount        Shares         Amount     
                                        --------- ------------- --------- ------------- ------------  --------------
<S>                                     <C>       <C>           <C>       <C>           <C>           <C> 
Balances at June 30, 1995                   -       $                     $                4,657,777  $   24,269,208 
                                                                                                             
Net loss                                    -                                                                       
                                                                                                             
Exercise of stock options                   -                                                 88,415         110,434 
                                                                                        ------------  --------------
                                                                                                             
Balances at June 30, 1996                   -                                                 88,415      24,379,642 
                                                                                                             
Net loss                                    -                                                                       
                                                                                                             
Issuance of convertible preferred                                                                            
stock, net of offering cost of                                                                               
    $380,894                                5,000     2,736,803                                                      
                                                                                                             
Accretion of discount due to                                                                                 
beneficial conversion feature                                                                                
of convertible preferred stock                        2,062,644                                                      
                                                                                                             
Conversion of convertible                                                                                    
preferred stock to common stock            (1,720)   (1,720,000)                             177,159       1,720,000 
                                                                                                             
Exercise of stock options                                                                    214,390         581,044 
                                        --------- -------------                         ------------  --------------
                                                                                                             
Balances at June 30, 1997                   3,280     3,079,447                            5,137,741      26,680,686 
                                                                                                             
Net loss                                                                                                     
                                                                                                             
Issuance of convertible preferred                                                                            
stock, net of offering cost of                                                                               
    $385,808                                                        5,000     4,614,192 
                                                                                                             
Accretion of discount due to beneficial
conversion feature of convertible                                                                            
preferred stock                                         250,523                  84,809                      121,897 
                                                                                                             
Conversion of convertible                                                                                    
preferred stock to common stock            (3,105)   (3,105,000)   (3,319)   (3,319,000)   3,969,256       6,424,000 
                                                                                                             
Exercise of stock options                                                                        337           1,517 
                                                                                                             
Employee stock purchase plan                                                                  19,072         106,679 
                                                                                                             
                                        --------- ------------- --------- ------------- ------------  --------------
Balances at June 30, 1998                     175 $     224,970     1,681 $   1,380,001    9,126,406  $   33,334,779 
                                        ========= ============= ========= ============= ============  ==============
<CAPTION> 
                                          Additional                        Total
                                          Paid - in      Accumulated    Shareholder's
                                           Capital         Deficit         Equity
                                        -------------  ---------------  -------------   
<S>                                     <C>            <C>              <C>
Balances at June 30, 1995               $                 ($8,105,272)  $16,163,936
                                                                 
Net loss                                                   (8,318,827)   (8,318,827)
                                                                
Exercise of stock options                                                   110,434
                                        -------------  ---------------  -----------
                                                               
Balances at June 30, 1996                                 (16,424,099)    7,955,543  
                                                                
Net loss                                                   (6,292,094)   (6,292,094) 
                                                                
Issuance of convertible preferred                               
stock, net of offering cost of                                  
    $380,894                                1,882,303                     4,619,106
                                                                
Accretion of discount due to                                    
beneficial conversion feature                                   
of convertible preferred stock                             (2,062,644)           --
                                                                
Conversion of convertible                                       
preferred stock to common stock                                 
                                                                
Exercise of stock options                                                   581,044
                                        -------------  ---------------  -----------
                                                                
Balances at June 30, 1997                   1,882,303     (24,778,837)    6,863,599
                                                                
Net loss                                                   (9,028,989)   (9,028,989)
                                                                
Issuance of convertible preferred                               
stock, net of offering cost of                                  
    $385,808                                                              4,614,192 
                                                                
Accretion of discount due to beneficial
conversion feature of convertible                               
preferred stock                                              (457,229)           --
                                                                
Conversion of convertible                                       
preferred stock to common stock                                
                                                                
Exercise of stock options                                                     1,517
                                                                
Employee stock purchase plan                                                106,679
                                                                
                                        -------------  ---------------  ----------- 
Balances at June 30, 1998               $   1,882,303  $  (34,265,055)  $ 2,556,998
                                        =============  ===============  ===========
</TABLE> 

                See accompanying notes to financial statements 


                                      40
<PAGE>
 
                                DATA RACE, INC.
                            STATEMENTS OF CASH FLOWS


<TABLE>
<CAPTION>
                                                                                       Years Ended June 30,                     
                                                                    ------------------------------------------------------------
                                                                          1998                  1997                  1996      
                                                                    ----------------    ------------------    ------------------
<S>                                                                 <C>                   <C>                   <C>             
  Cash flows from operating activities:                                                                                         
    Net loss..................................................      $     (9,028,989)      $    (6,292,094)      $    (8,318,827)
    Adjustments to reconcile net loss to net cash                                                                               
     provided by (used in) operating activities:                                                                                 
      Depreciation and amortization...........................               530,667               591,091             2,321,443
      Loss on sales of property and equipment.................                 2,155                     -                     -
      Decrease in accounts receivable.........................             1,558,553               155,218             5,302,659
      Decrease in inventory...................................               514,036             3,054,210               224,652
      Decrease in prepaid expenses, deposits and                                                                                
       other assets...........................................                40,189                93,720                29,098
      Decrease in accounts payable............................              (565,549)           (1,487,985)             (245,342)
      Increase (decrease) in accrued expenses.................              (589,287)               40,624               336,572
      Increase (decrease) in other current                                         -              (318,991)              284,821
       liabilities............................................                                                                  
      Decrease in other taxes payable.........................                     -              (166,156)                    -
                                                                    ----------------    ------------------    ------------------
        Net cash used in operating activities.................            (7,538,225)           (4,330,363)              (64,924)
                                                                    ----------------    ------------------    ------------------
                                                                                                                                
  Cash flows from investing activities:                                                                                         
    Purchase of property and equipment........................               (78,057)             (367,798)           (2,147,457)
    Proceeds from sale of property and equipment..............                 2,420                43,344                     -
                                                                    ----------------    ------------------    ------------------
       Net cash used in investing activities..................               (75,637)             (324,454)           (2,147,457)
                                                                    ----------------    ------------------    ------------------
                                                                                                                                
  Cash flows from financing activities:                                                                                         
    Net proceeds from issuance of preferred stock.............             4,614,192             4,619,106                     -
    Net proceeds from issuance of common stock................               108,196               581,044               110,434
                                                                    ----------------    ------------------    ------------------
       Net cash provided by financing activities..............             4,722,388             5,200,150               110,434
                                                                    ----------------    ------------------    ------------------
                                                                                                                                
  Net increase (decrease) in cash and cash equivalents........                                                                    
                                                                          (2,891,474)              545,333            (2,101,947) 
                                                                                                                                
  Cash and cash equivalents at beginning of year..............             4,535,768             3,990,435             6,092,382
                                                                    ----------------    ------------------    ------------------
                                                                                                                                
  Cash and cash equivalents at end of year....................      $      1,644,294       $     4,535,768       $     3,990,435
                                                                    ================    ==================    ==================
                                                                                                                                
  Supplementary Cash Flow Information:                                                                                          
  Interest paid...............................................      $              -       $             -       $             -
  Income taxes paid...........................................      $              -       $             -       $             - 
</TABLE>

                 See accompanying notes to financial statements

                                       41
<PAGE>
 
                                DATA RACE, INC.
                         NOTES TO FINANCIAL STATEMENTS
                         JUNE 30, 1998, 1997, AND 1996


1) DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
-------------------------------------------------------------------------

DESCRIPTION OF BUSINESS
-----------------------

The Company designs, manufactures and markets a line of communication products
that meet the need for remote access to the corporate environment.  Its unique
client/server product, the Be There!(TM) Remote Access System, gives teleworkers
access to all elements of corporate communications networks, including the PBX,
Intranet, and Internet.  The Company also designs and manufactures advanced
network multiplexers which carry data, network, voice and fax traffic between a
company's multiple offices.

The Company's goal of returning to profitability and developing a more
dependable revenue base depends to a large extent on the success of the Be
There! Remote Access System.  The Be There! system represents a type of product
for the Company which is significantly different from the Company's custom modem
and network multiplexer products.  Although the Company has not recorded
significant revenue from sales of the Be There! system, the Company has expended
substantial resources on its development and introduction.  In order to
successfully penetrate the emerging teleworker market, the Company expects that
significant additional resources will need to be expended in order to expand its
sales and marketing infrastructure and operational systems, and to finance
inventory and receivables.

LIQUIDITY AND GOING CONCERN
---------------------------

The accompanying financial statements have been prepared on a going concern
basis which assumes continuity of operations and realization of assets and
liquidation of liabilities in the ordinary course of business.  In fiscal 1998
and 1997, the Company incurred operating losses of $9.2 million and $6.5
million, respectively, and negative cash flows from operations were
approximately $7.5 million and $4.3 million, respectively.

The Company's ability to sustain operations, fund the development and marketing
of new products, including the Be There! line, and make future capital
expenditures, are dependent on the Company's ability to attract new capital and
maintain adequate liquidity.

The Company closed a private placement in July 1998 for initial proceeds of
approximately $2.1 million, and, as part of such private placement, the
investors agreed to purchase approximately $1.75 million in additional
securities, on or before January 31, 1999, subject to certain conditions.  There
can be no assurance that the Company will be able to satisfy such conditions to
the second funding.  The Company will likely require additional financing in the
future.

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
------------------------------------------

USE OF ESTIMATES

                                       42
<PAGE>
 
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amount of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.

The Company's estimate for lower of cost or market for inventory is based on the
Company's best estimates of product sales prices and customer demand patterns
and/or its plans to transition its product mix.  However, the Company
participates in a highly competitive industry that is characterized by
aggressive pricing practices, downward pressures on gross margins, rapid
technological advances, continual improvement in product price-performance
characteristics, and price sensitivity and changing demand patterns on the part
of customers.  As a result of the industry's ever-changing and dynamic nature,
it is at least reasonably possible that the estimates used by the Company to
determine lower of cost or market for inventory amounts will be materially
different from any actual amounts realized on sale.  These differences could
result in materially higher or lower than expected inventory costs, which could
have a material effect on the Company's results of operations and financial
condition in the near term.

CASH AND CASH EQUIVALENTS

The Company considers all highly liquid investments purchased with a remaining
maturity of three months or less to be cash equivalents.

ACCOUNTS RECEIVABLE

Accounts receivable as shown is net of allowance for doubtful accounts of
$154,080 and $156,152 at June 30, 1998 and June 30, 1997, respectively.

INVENTORY

Inventory is valued at the lower of cost (principally standard cost which
approximates first-in, first-out) or market (net realizable value).  Costs
include materials, labor, overhead, and subcontract charges as applicable.

PROPERTY AND EQUIPMENT

Property and equipment are stated at cost.  Major renewals and betterments are
charged to the property accounts while replacements, maintenance, and repairs
which do not improve or extend the lives of the respective assets are expensed
currently.  Depreciation of property and equipment is provided at amounts
calculated to amortize the cost of the assets over their useful economic lives
using the straight-line method for financial reporting purposes and accelerated
methods for income tax purposes.

CONVERTIBLE PREFERRED SECURITIES

In accordance with the March 13, 1997 SEC staff announcement, the beneficial
conversion features of the Series A Convertible Preferred Stock ("Series A
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 on the Preferred Stock and the value
attributed to the Warrants.  The conversion discount is calculated, at the date
of 

                                       43
<PAGE>
 
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 with 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 the Black-Scholes option pricing model
and may not correspond to a market value.

The calculated intrinsic value of the beneficial conversion features of the
Series A Preferred Stock, the offering costs and the premium resulted in
non-cash charges of approximately $2,313,000 to loss available to common
shareholders in the computation of loss per common share over the conversion
period, January 1997 through December 1997, as required by the SEC guidelines.
As a result, $2,062,644 of the $2,313,000 in non-cash charges are reflected in
the loss per common share for the year ended June 30, 1997 and the remainder in
the year ended June 30, 1998.

The Series C Convertible Participating Preferred Stock ("Series C Preferred
Stock") contains an 8% annual premium upon conversion which the Company may
elect to pay in common stock.  For the year ended June 30, 1998, the 8%
conversion premium on the Series C Preferred Stock was $206,706 and is reflected
in the accompanying financial statements as a reduction of earnings available to
common stockholders.

FAIR VALUE OF FINANCIAL INSTRUMENTS

The Company's financial instruments consist primarily of cash and cash
equivalents, accounts receivable and accounts payable.  The book value of cash
and cash equivalents, accounts receivable and accounts payable are
representative of their respective fair values due to the short-term maturity of
those instruments.

REVENUE RECOGNITION

Revenue is generally recognized upon shipment of products to customers or when
contractual services have been provided to customers.  The Company recognizes
revenue and gross profit from trial units only upon receipt of payment or
receipt of a purchase order without significant contingencies.

WARRANTY EXPENSE

The Company generally offers one or two year warranty coverage on the majority
of its products.  Warranty costs are accrued and expensed when revenue is
recognized based upon the Company's experience with such costs.

RESEARCH AND DEVELOPMENT

All engineering and product research and development expenditures are charged
against operations as incurred.  Research and development costs charged to
operations aggregated approximately $3,648,000, $4,881,000 and $4,784,000 in
fiscal 1998, 1997, and 1996, respectively.

IMPAIRMENT OF LONG-LIVED ASSETS AND LONG-LIVED ASSETS TO BE DISPOSED OF

The Company adopted the provisions of SFAS No. 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of, on
July 1, 1996.  This Statement 

                                       44
<PAGE>
 
requires that long-lived assets and certain identifiable intangibles be reviewed
for impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. Recoverability of assets to
be held and used is measured by a comparison of the carrying amount of an asset
to undiscounted future net cash flows expected to be generated by the asset. If
such assets are considered to be impaired on this basis, the impairment loss to
be recognized is measured by the amount by which the carrying amount of the
assets exceeds the fair value of the assets. Assets to be disposed of are
reported at the lower of the carrying amount or fair value less costs to sell.
Adoption of this Statement did not have a material impact on the Company's
financial position, results of operations, or liquidity.

STOCK BASED COMPENSATION

The Company accounts for stock-based compensation using the intrinsic value
method described in Accounting Principles Board Opinion No. 25, "Accounting for
Stock Issued to Employees" ("APB No. 25") and related interpretations.
Accordingly, compensation cost for stock options is measured as the excess, if
any, of the quoted market price of the Company's Common Stock at the date of the
grant over the amount an employee must pay to acquire the stock.  The Company
has adopted the disclosure requirements of SFAS No. 123, "Accounting for Stock
Based Compensation."

EARNINGS (LOSS) PER SHARE

In February 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 128, "Earnings Per Share".  FASB
Statement No. 128 supersedes APB Opinion No. 15, "Earnings Per Share", and
specifies the computation, presentation, and disclosure requirements for
earnings per share ("EPS").  It replaces Primary EPS and Fully Diluted EPS with
Basic EPS and Diluted EPS, respectively.  Basic EPS, unlike Primary EPS,
excludes all dilution while Diluted EPS, like Fully Diluted EPS, reflects the
potential dilution that could occur if securities or other contracts to issue
common stock were exercised or converted into common stock or resulted in the
issuance of common stock that then shared in the earnings of the entity.
Statement No. 128 is effective for financial statements for both interim and
annual periods ending after December 15, 1997.  Diluted loss per share
approximates basic loss per share as no potential common shares are to be
included in the computation when a loss from continuing operations available to
common shareholders exists.  The Company had approximately 1,494,898 and
1,280,073 options outstanding as of June 30, 1998 and 1997, respectively.  The
Company had 175 and 3,280 shares of Series A Preferred Stock outstanding as of
June 30, 1998 and 1997, respectively, and 1,681 and no shares of Series C
Preferred Stock outstanding as of June 30, 1998 and 1997, respectively.  Also
outstanding at June 30, 1998, were warrants to purchase 25,274 shares of common
stock at $16.375 and 53,977 shares of common stock at $6.435.  No warrants were
outstanding at June 30, 1997.  All previously reported per share amounts have
been restated to conform to the new presentation.

NEW ACCOUNTING PRONOUNCEMENTS

In June 1997, the FASB issued Statement of Financial Accounting Standards No.
130, Reporting Comprehensive Income ("Statement 130").  Statement 130
establishes standards for reporting and display of comprehensive income and its
components in a full set of general purpose financial statements.  Statement 130
requires all items that are required to be recognized under accounting standards
as components of comprehensive income be reported in a financial statement that
is 

                                       45
<PAGE>
 
displayed in equal prominence with the other financial statements. Statement 130
is effective for both interim and annual periods beginning after December 15,
1997. While the Company has not performed a detailed analysis of Statement 131,
the adoption of Statement 130 is not expected to have a material adverse effect
on the financial statements of the Company.

In June 1997, the FASB also issued Statement of Financial Accounting Standards
No. 131, Disclosures about Segments of an Enterprise and Related Information
("Statement 131").  Statement 131 establishes standards for the way public
business enterprises are to report information about operating segments in
annual financial statements and requires those enterprises to report selected
information about operating segments in interim financial reports issued to
shareholders.  It also establishes standards for related disclosures about
products and services, geographic areas, and major customers.  Statement 131
replaces the "industry segment" concept of Statement 14 with a "management
approach" concept as the basis for identifying reportable segments.  The
management approach is based on the way that management organizes the segments
within the enterprise for making operating decisions and assessing performance.
Statement 131 is effective for financial statements for periods beginning after
December 15, 1997.  While the Company has not performed a detailed analysis of
Statement 131, the adoption of Statement 131 is not expected to have a material
adverse effect on the financial statements of the Company.

2) ACCOUNTS RECEIVABLE AND MAJOR CUSTOMERS
------------------------------------------

Revenue from shipments to NEC, the Company's largest customer in fiscal 1998 and
1997, represented 15% and 46%, respectively, of total revenue. Revenue from
shipments to and fees from IBM represented 46% of total revenue in fiscal 1996.

Credit limits, ongoing credit evaluation, and account monitoring procedures are
used by the Company to minimize the risk of loss on accounts receivable.
Generally, collateral is not required.  Export revenues were 7%, 3%, and 8% of
total revenue for 1998, 1997, and 1996, respectively.

3) INVENTORY
------------

Inventory consists of the following:
                                                  June 30,         June 30,
                                                   1998              1997
                                              ---------------   ---------------
                                                               
   Finished goods..........................   $        13,859   $       218,777
   Work in progress........................           256,285           440,005
   Raw materials...........................           272,819           398,217
                                              ---------------   ---------------
   Inventory...............................   $       542,963   $     1,056,999
                                              ---------------   ---------------

4) PROPERTY AND EQUIPMENT
-------------------------
Property and equipment consists of the following:
                                             June 30,      June 30,     Useful
                                               1998          1997       Lives
                                          ------------- ------------- ---------
  Leasehold Improvements................. $   1,560,385 $   1,582,563         *
  Furniture, fixtures and equipment......     2,535,387     2,570,899  2-5 yrs.
                                          ------------- -------------
                                              4,095,772     4,153,462
  Less accumulated depreciation..........     2,620,640     2,221,145
                                          ------------- -------------
  Property and Equipment................. $   1,475,132 $   1,932,317
                                          ------------- -------------

* remaining lease life, primarily 6 to 9 years.


                                       46
<PAGE>
 
5) INCOME TAXES
---------------

There was no income tax expense (benefit) for the fiscal years ended June 30,
1998, 1997, and 1996.

The tax effects of temporary differences that give rise to significant portions
of the deferred tax assets and liabilities at June 30, 1998, and 1997 are
presented below:

<TABLE>
<CAPTION>
                                                                                         June 30,
                                                                       -----------------------------------------
                                                                              1998                   1997
                                                                       -------------------    ------------------
<S>                                                                    <C>                    <C>
Deferred tax assets:
  Accounts receivable due to allowances for financial reporting                                                  
   purposes.........................................................     $          75,422       $        53,092 
  Inventory, principally due to write-down for financial reporting
   purposes.........................................................               682,549               449,713
  Property and equipment, due to difference in depreciation.........               260,500               135,259
  Accrued expenses..................................................               285,942               234,207
  Net operating loss carryforwards..................................            12,517,863             9,127,274
  Alternative minimum tax credit carryforwards......................                83,645                71,003
  Research and experimentation credit carryforwards.................               539,889               841,291
  Other, net........................................................                10,256                     -
                                                                       -------------------    ------------------
     Total gross deferred tax assets................................            14,456,066            10,911,839
     Less valuation allowance.......................................           (14,456,066)          (10,911,839)
                                                                       -------------------    ------------------
     Net deferred tax asset.........................................     $               -       $             -
                                                                       ===================    ==================
</TABLE>

The valuation allowance related to deferred tax assets increased by $3,544,227
and $1,747,353 during the years ended June 30, 1998, and 1997, respectively.

In assessing the realization of deferred tax assets, management considers
whether it is more likely than not that some portion or all of the deferred tax
assets will not be realized.  The ultimate realization of deferred tax assets is
dependent upon the generation of future taxable income during the periods in
which those temporary differences become deductible.  Based upon the level of
historical taxable income, management has a 100% valuation allowance for the
Company's deferred tax assets at June 30, 1998.  The amount of the deferred tax
asset considered realizable, however, could fluctuate in the near term if
estimates of future taxable income during the carryforward period are adjusted.

Reconciliation of the U.S. Federal statutory rate to the Company's effective tax
rate for each fiscal year is as follows:

<TABLE>
<CAPTION>
                                                          1998               1997               1996
                                                     -------------      -------------       ------------
<S>                                                  <C>                <C>                 <C>
  U. S. Federal statutory rate..................              34.0%              34.0%              34.0%
  Increase (reduction) in income taxes
   resulting from:
  Net operating losses..........................             (34.0)             (34.0)             (34.0)
                                                     -------------      -------------       ------------
  Net effective tax rate........................                 -                  -                  -
                                                     =============      =============       ============
</TABLE>

                                       47
<PAGE>

At June 30, 1998, the Company had net operating loss ("NOL") carryforwards for
federal and state income tax purposes of approximately $42,834,000 which expire
beginning in 2009.  The Company also has research and experimentation credit
carryforwards for federal income tax purposes of approximately $540,000 which
expire beginning in 2009 and alternative minimum tax credit carryforwards of
approximately $71,000.  The Internal Revenue Code section 382 limits  NOL and
tax credit carryforwards when an ownership change of more than fifty percent of
the value of stock in a loss corporation occurs within a three year period.  In
fiscal 1998 and 1997 the Company issued preferred stock which coverts into
common stock.  Accordingly, the ability to utilize remaining NOL and tax credit
carryforwards may be significantly restricted.

6)   SHAREHOLDERS' EQUITY
-------------------------

SERIES C CONVERTIBLE PARTICIPATING PREFERRED STOCK
--------------------------------------------------

On November 12, 1997, the Company completed a private placement of its Series C
Preferred Stock and Stock Purchase Warrants with four investment firms, at an
aggregate price of $5,000,000.  The Series C Preferred Stock has a stated value
of $1,000 per share and a liquidation preference of $1,000 per share plus an 8%
annual premium payable upon conversion or redemption or in liquidation (in the
case of conversion the Company may elect to pay such premium in common stock);
is non-voting except in limited circumstances; ranks senior to the Company's
common stock in liquidation; and is redeemable at a premium at the option of
each holder under certain circumstances, including the occurrence of certain
major corporate transactions and the failure of the Company to register the
conversion shares within prescribed time periods.

As of September 2, 1998, the initial 5,000 shares of the Series C Preferred
Stock had been converted into 6,573,515 shares of common stock.  As of September
2, 1998, the Company had warrants outstanding to purchase 53,977 shares of
common stock at $6.435 through November 12, 2000, which were issued in
connection with the Series C Preferred Stock.

SERIES A CONVERTIBLE PREFERRED STOCK
------------------------------------

On January 10, 1997, the Company completed a private placement of its Series A
Preferred Stock and Stock Purchase Warrants with three investment firms at an
aggregate price of $5,000,000.  The Series A Preferred Stock  bears no
dividends, is non-voting except in limited circumstances, has senior rights in
liquidation, with a preference of 133% of the stated value of $1,000, and is
redeemable at the option of the holders in limited circumstances upon the
Company's breach of certain covenants imposed by the related purchase agreement.
The Series A Preferred Stock is convertible into common stock at the option of
each holder at a percentage of the then prevailing average market price (as
defined in the Statement of Designation establishing the Series A Preferred
Stock) of the Common Stock equal initially to 85% and decreasing to the lower of
75% or the average price (as defined in the Statement of Designation) of the
common stock on the January 10, 1998.  Upon conversions after the first
anniversary, in certain circumstances the holders will receive a premium on the
Series A Preferred Stock converted, payable in cash or stock at the Company's
option, equal to 1% per annum based on the number of days elapsed since the
first closing.

As of September 2, 1998, the initial 5,000 shares of the Series A Preferred
Stock had been converted into 950,145 shares of common stock.  As of September
2, 1998, the Company had warrants outstanding to purchase 25,274 shares of
common stock at $16.375 through January 10, 2000, which were issued in
connection with the Series A Preferred Stock.


                                       48
<PAGE>

STOCK OPTION PLANS
------------------

Under the Company's existing stock option plans (the "Plans"), stock options to
purchase up to 2,637,500 shares of common stock were originally authorized to be
granted to employees, directors, and certain other persons.  As of June 30,
1998, stock options covering 1,494,898 shares of common stock were outstanding
under the Plans and  410,950 shares were available for issuance upon exercise of
options which may be granted in the future under the Plans.

Options under the Plans may either be incentive stock options or non-qualified
stock options (except in the case of the Company's non-qualified stock option
plan which permits only the issuance of non-qualified stock options). Options
under the Plans may be granted for a term not to exceed ten years (five years
with respect to incentive stock options granted to any person having 10% or more
voting power of the Company) and are not transferable other than by will or the
laws of descent and distribution. Incentive stock options may be exercised
within 90 days after the optionee's termination of employment (to the extent
exercisable prior to such termination), and one year after the optionee's
disability. The exercise price of the options under the Plans must be at least
equal to the fair market value of the common stock on the date of grant, or 110%
of such value for incentive stock options granted to any person having 10% or
more of the voting power of the Company. The aggregate fair market value of the
common stock for which any employee may be granted incentive stock options which
first become exercisable in any one calendar year may not exceed $100,000.
Options may be exercised by payment of cash or by tender of shares of common
stock (valued at their then current market value). The Plans are administered by
the Compensation Committee of the Board of Directors.

On April 21, 1998, the Board of Directors authorized and granted the non-officer
employees of the Company, the right to exchange up to 100% of their outstanding
options, both vested and unvested, for replacement options at a rate of one
replacement option for each option surrendered.  These replacement options are
exercisable at a price of $1.7813 per share (the fair market value at the date
of repricing).  A total of 341,604 options was exchanged.  Officers, other than
the Chief Executive Officer, were authorized and granted the right to exchange
up to 100% of their outstanding options, both vested and unvested, for
replacement options at a rate of two replacement options for every three options
surrendered.  These replacement options are exercisable at a price of $1.7813
per share (the fair market value at the date of repricing).  A total of 294,750
options were exchanged for 196,499 replacement options.  The replacement options
vest in two equal installments on October 21, 1998 and April 21, 1999.

On August 19, 1998, the Company's Board of Directors adopted the 1998 Stock
Option Plan, authorizing the grant of incentive stock options and non-qualified
stock options to employees, directors and certain other persons.  No options
have been granted under the 1998 Stock Option Plan.  Shareholder approval of the
1998 Stock Option Plan is being sought.

Included in fiscal 1997 options exercised under the 1988 and 1994 Option Plans
are 105,000 options exercised by directors of the Company.  The exercise of
these options was effected by the exchange of 45,148 shares previously owned by
these directors.

On November 28, 1995, the Board of Directors authorized and granted the
employees of the Company, other than the CEO, the right to exchange up to 75% of
their outstanding options, both vested and unvested, for replacement options at
a rate of three replacement options for every four options surrendered.  These
replacement options are exercisable at a price of $4.50 per share (the 

                                       49

<PAGE>

fair market value at the date of repricing), subject to certain restrictions. A
total of 116,464 options were exchanged for 87,375 replacement options.



A summary of option activity under the Plans for the fiscal years ended June 30,
1998, June 30, 1997 and June 30, 1996, is as follows:

<TABLE>
<CAPTION>
                                        1998                             1997                             1996
                          ------------------------------   ------------------------------   ------------------------------
                                               Weighted                         Weighted                         Weighted
                                               Average                          Average                          Average
                                               Exercise                         Exercise                         Exercise
                              Shares            Price          Shares            Price          Shares            Price
                          ------------   ---------------   ------------   ---------------   ------------   ---------------
 
<S>                         <C>            <C>               <C>            <C>               <C>            <C>   
Outstanding at                                          
 beginning of year.....      1,280,073     $        9.23      1,066,716     $        6.96      1,131,868     $        7.58
Granted................      1,257,373              3.04        477,250             11.84        441,423              4.72
Exercised..............            337              4.50        213,366              4.04        130,189              2.29
Expired................      1,042,211              6.43         50,527              6.17        376,386              8.23
                          ------------   ---------------   ------------   ---------------   ------------   ---------------
Outstanding at year                                                                                                        
 end...................      1,494,898     $        5.00      1,280,073     $        9.23      1,066,716     $        6.96 
                          ============   ===============   ============   ===============   ============   ===============
Options exercisable at                                  
 year end..............        458,925     $        9.24        458,794     $        8.46        311,832     $        5.62
Shares available for                                     
 future grant..........        410,950                 -         84,112                 -        511,547                 -
</TABLE>

The following summarizes information regarding the Company's stock options
outstanding at June 30, 1998:

<TABLE>
<CAPTION>
                                                  Weighted
       Range of                                    Average               Weighted            Number               Weighted
       Exercise                 Number            Remaining              Average          Exercisable             Average
         Price               Outstanding         Contractual          Exercise Price      at June 30,          Exercise Price
                                                    Life                                      1998
-----------------------   ----------------   -----------------   -------------------   ----------------   -------------------
<S>                       <C>                <C>                 <C>                   <C>                <C>
$    1.78  -  $    1.78            797,473                 9.8     $            1.78                  -     $               -
     3.31  -       4.88             80,300                 8.5                  3.87             20,300                  4.73
     6.31  -       8.88            126,250                 7.9                  7.52             45,250                  6.76
     9.63  -      10.19            490,875                 7.2                  9.76            393,375                  9.76
-----------------------   ----------------   -----------------   -------------------   ----------------   -------------------
$    1.78     $   10.19          1,494,898                 8.7     $            5.00            458,925     $            9.24
=========   ===========   ================   =================   ===================   ================   ===================
</TABLE>

                                       50

<PAGE>
 
The Company applies APB Opinion No. 25 and related interpretations in accounting
for its stock option and stock purchase plans.  Had compensation cost been
recognized consistent with SFAS No. 123, the Company's net loss and loss per
share would have been reduced to pro forma amounts indicated below for the years
ended June 30, 1998, 1997, and 1996:

<TABLE>
<CAPTION>
                                               1998                       1997                    1996
                                      ----------------------     ---------------------    --------------------
<S>                  <C>              <C>                        <C>                      <C> 
Net loss             As Reported        $     (9,486,217)          $     (8,354,738)        $    (8,318,827)
 applicable to                                                                                
 common stock                                                                                 
                     Pro Forma               (10,451,918)                (9,340,744)             (8,561,423)
                                                                                              
Net loss per share   As Reported        $          (1.60)          $          (1.71)        $         (1.77)
                     Pro Forma                     (1.76)                     (1.92)                  (1.83)
</TABLE>

The per share weighted average value of stock options issued by the Company
during fiscal 1998, 1997 and 1996 was $2.04, $7.27 and $3.09 respectively, on
the date of grant using the Black-Scholes option-pricing model.  The Company
used the following weighted-average assumptions to determine the fair value of
stock options granted for the fiscal years ended June 30, 1998, 1997, and 1996:

<TABLE>
<CAPTION>
                                                Stock                                          Employee Stock
                                             Option Plans                                       Purchase Plan
 
                                 1998            1997           1996                1998            1997            1996
                          ----------------------------------------------      ----------------------------------------------
<S>                       <C>                   <C>            <C>            <C>                   <C>            <C>
Dividend yield                         0.0%           0.0%           0.0%                0.0%            0.0%            0.0%
Expected volatility                   95.7%          83.7%          75.6%               92.3%           83.7%           75.6%
Risk-free rate of return               5.4%           6.4%           5.8%                6.0%            6.4%            5.2%
Average expected option              3.6yrs         3.6yrs         3.6yrs              0.5yrs          0.5yrs          1.0yrs
 life

</TABLE>

Pro forma net loss reflects only options granted in fiscal 1998, fiscal 1997,
and fiscal 1996.  Therefore, the full impact of calculating compensation cost
for stock options under SFAS No. 123 is not reflected in the pro forma net loss
amounts presented above because compensation cost is reflected over the options'
vesting period and compensation cost for options granted prior to July 1, 1995
is not considered.


7) COMMITMENTS
--------------

The Company's facilities consists of two buildings of approximately 21,000 and
29,000 square feet, which are subject to ten and seven-year operating leases,
respectively.  The Company has also leased a third adjacent parcel of property
upon which an additional building could be constructed if necessary.  The
Company has a purchase option, exercisable through November 1998, to acquire all
leased parcels at an escalating purchase price.  Total rent expense charged to
operations was $302,493, $303,378, and $560,596 in fiscal 1998, 1997, and 1996,
respectively.

The minimum annual rental payments on all operating leases for the fiscal years
ending June 30 are as follows:


                                       51
<PAGE>
 
                              Fiscal Year            Amount
                            ----------------    ----------------
                                  1999            $      297,159
                                  2000                   287,852
                                  2001                   304,193
                                  2002                   294,092
                                  2003                   144,271
                                  Thereafter             402,758
                                                  --------------
                                                  $    1,730,325
                                                  ==============

8)   LEGAL PROCEEDINGS
----------------------

On August 18, 1998, the Company filed a lawsuit against Lucent Technologies,
Inc. ("Lucent").  The lawsuit was filed in the United States District Court in
San Antonio, Texas.  In the lawsuit, the Company alleges that Lucent is
infringing upon the Company's patent entitled "System and Method for Providing a
Remote User with a Virtual Presence to an Office."  The Company further alleges
that Lucent misappropriated certain of the Company's confidential and
proprietary information in violation of a nondisclosure agreement between Lucent
and the Company and has engaged in anti-competitve conduct.  The Company is
seeking injunctive relief to prevent Lucent from continuing its infringing
activities and further violation of the nondisclosure agreement and is also
seeking to recover attorneys' fees, actual damages resulting from Lucent's
alleged breach of the nondisclosure agreement, treble damages incurred by the
Company as a result of Lucent's alleged anti-competitive conduct, and certain
punitive damages. The Company places a high value on its intellectual property
and intends to aggressively protect its patent and other property rights from
infringement and other misappropriation.  The Company is unable to predict the
costs to be incurred in prosecuting this lawsuit or the ultimate outcome of such
lawsuit.

On May 22, 1998, the United States District Court in San Antonio, Texas approved
the settlement and dismissal of the shareholder class action lawsuit titled In
re Data Race, Inc. Securities Litigation originally filed on November 28, 1995,
against the Company and certain of its officers Herbert T. Hensley, former
Chairman of the Board, W. B. Barker, President and Chief Executive Officer,
Gregory T. Skalla, Senior Vice President-Finance and Chief Financial Officer,
and Leven E. Staples, former Vice President and Chief Technical Officer. The
plaintiffs had alleged that the defendants violated certain provisions of the
federal securities laws, including Rule 10b-5 under the Securities Exchange Act
of 1934. The settlement and dismissal of the lawsuit was the result of the
successful mediation of the dispute. Pursuant to the terms of the settlement
agreement, the Company's insurance carrier paid approximately $800,000 in cash
and the Company paid $5,940 in cash. In the final judgment and order of
dismissal, the plaintiffs acknowledged that, after investigation, they found no
provable wrongdoing on the part of the defendants. Although the Company believed
that the case was absolutely without merit, and that neither the Company nor any
of the other defendants committed any of the alleged wrongdoings, the Company
ultimately decided to accept the settlement agreement based on the advise 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.

9)   RELATED PARTY TRANSACTIONS
-------------------------------

Certain outside directors also receive consulting fees for services rendered
from time to time to the Company.  In fiscal 1998, 1997, and 1996, no such
person received in excess of $60,000 for such services.

                                       52
<PAGE>
 
On July 24, 1998, the Company completed the first closing of a Private Placement
( as defined in Footnote 11 below) involving, among other things, the sale of
its Series E Convertible Preferred Stock and related Common Stock Purchase
Warrants to First Capital Group of Texas II, L.P., an investment firm managed by
Jeffery P. Blanchard, the Company's Chairman of the Board, at an aggregate of
$750,000.  At such time, First Capital Group of Texas II, L.P., agreed to
purchase at a second closing shares of Series F Convertible Preferred Stock and
additional related Common Stock Purchase Warrants at an aggregate price of
$750,000.  The second closing is scheduled to occur on or before January 31,
1999, and is subject to the Company's satisfaction of certain conditions.
Additional information regarding the Private Placement is set forth in Footnote
11 below.

10)  EMPLOYEE BENEFIT PLANS
--------------------------

Effective March 1, 1992, the Company adopted the DATA RACE, Inc. 401(k) Plan
under section 401(k) of the Internal Revenue Code of 1986, as amended.  Under
the Plan, substantially all employees eligible to participate may elect to
contribute up to the lesser of 15% of their salary or the maximum allowed under
the Code.  All full time employees with at least one year of continuous service
and who have completed 1,000 work hours are eligible for the Plan.  The Company
may elect to make contributions to the Plan at the discretion of the Board of
Directors.  The Company made contributions of $45,048 in fiscal 1998, $51,433 in
fiscal 1997, and $56,477  in fiscal 1996.  The Company has no other post-
retirement benefit plans.

In December 1993, the Company adopted the DATA RACE, Inc. Employee Stock
Purchase Plan ("ESPP") pursuant to which eligible employees may purchase up to
an aggregate of 200,000 shares of the Company's common stock at 85% of the fair
market value of the common stock through payroll deductions.  In 1997, the ESPP
was amended to offer two consecutive six-month plan periods, beginning February
1 and August 1, respectively.  Of the 200,000 shares available in this Plan,
79,794 shares have been purchased as of June 30, 1998.

The Company was self-insured for occupational injury and illness benefits until
August 1998 whereby it is liable for individual claims up to $100,000 and in
excess of $1,000,000 per occurrence.  Liabilities over $100,000 and up to
$1,000,000 per occurrence are the responsibility of a co-insurer.  The amounts
charged to expense for occupational injury and illness are based upon benefits
paid and expected liabilities.  While the ultimate outcome of these claims
cannot presently be determined, management believes that the accrued liability
at June 30, 1998 is adequate to cover these claims.  Effective August 1998, the
Company became fully insured for occupational injury and illness benefits
through an insurance company.

The Company was self-insured for employee medical and dental insurance until
February 1996, whereby it was liable for claims up to $50,000 per employee per
year.  Claims in excess of $50,000 were covered by a stop-loss policy to an
aggregate of $1,000,000 per employee. Self-insurance costs were accrued based
upon historical claim experience and expected liabilities. Effective March 1996,
the Company became fully insured for employee medical and dental insurance
coverage through an insurance company.

11)  SUBSEQUENT EVENT
---------------------

On July 13, 1998, the Company entered into a consulting agreement with Liviakis
Financial Communications, Inc. ("LFC").  LFC will advise and assist the Company
in developing and 

                                       53
<PAGE>
 
implementing appropriate plans and materials for presenting the Company and its
business plans, strategy and personnel to the financial community, establishing
an image for the Company in the financial community, and creating the foundation
for subsequent financial public relations efforts. The Company issued to LFC
1,406,475 shares of Common Stock and 468,825 shares of Common Stock to Robert P.
Prag, an officer of LFC. The consulting agreement terminates on March 15, 1999.

On July 24, 1998, the Company completed the first closing of a private placement
(the "Private Placement") of its Series D Convertible Preferred Stock ("Series D
Preferred Stock") and related Common Stock Purchase Warrants ("Class A
Warrants") to Sovereign Partners L.P. and Dominion Capital Fund, Ltd. (the
"Class A Investors"), at an aggregate price of $1,500,000 and its Series E
Convertible Preferred Stock ("Series E Preferred Stock") and related Common
Stock Purchase Warrants ("Class B Warrants") to First Capital Group of Texas
L.P. (the "Class B Investor"), an investment firm managed by the Company's
Chairman of the Board, at an aggregate price of $750,000.  At such time, the
Class A Investors agreed to purchase at a second closing additional shares of
Series D Preferred Stock and Class A Warrants at an aggregate price of
$1,000,000, and the Class B Investor agreed to purchase at a second closing
shares of Series F Convertible Preferred Stock (the "Series F Preferred Stock")
and Class B Warrants at an aggregate price of $750,000.  The second closing is
scheduled to occur on or before January 31, 1999, and is subject to the
Company's satisfaction of certain conditions, including, among others, the
following:  the approval of the securities issuances by the shareholders; the
average closing bid price of the Company's Common Stock during the five trading
days prior to the closing is at least $1.50; in the case of the closing with
respect to the Class B Investor, the Company has a minimum of $750,000 in
revenue for the quarter ending September 30, 1998 or December 31, 1998; the
shares of the Company's Common Stock issuable upon conversion of the Preferred
Stock ("Conversion Shares") and upon exercise of the Warrants ("Warrant Shares")
are registered for resale pursuant to the Securities Act of 1933, as amended;
the Company is in compliance with Nasdaq listing requirements; and there is no
material adverse change in the Company's financial condition, business or
prospects.

Each of the Series D Preferred Stock, Series E Preferred Stock, and Series F
Preferred Stock (the "Preferred Stock") issued in the Private Placement has a
stated value of $1,000 per share and a liquidation preference of $1,000 per
share plus an 8% annual premium payable upon conversion or redemption or in
liquidation (in the case of conversion the Company may elect to pay such premium
in Common Stock); is non-voting except in limited circumstances; ranks senior to
the Company's Common Stock in liquidation; and is redeemable at a premium at the
option of each holder under certain circumstances, including the occurrence of
certain major corporate transactions, the failure of the Company to register the
Conversion Shares or Warrant Shares within prescribed time periods, or the
Company's failure to pay certain monetary penalties arising from a delisting of
the Common Stock from the Nasdaq National Market.

The Series D Preferred Stock is convertible into Common Stock of the Company at
the option of each holder beginning 90 days after the issuance date (subject to
acceleration in certain events), at a conversion price equal to 80% of the
trailing five-day average closing bid price of the Common Stock on the
conversion date, subject to a minimum conversion price equal to the trailing 15-
day average closing bid price of the Common Stock 90 days after the issuance
date and subject to a maximum conversion price equal to the lesser of $3.00 or
the trailing five-day average closing bid price of the common Stock 90 days
after the issuance date.  The Series E Preferred Stock is convertible into
Common Stock at the option of the holder beginning one year after the issuance

                                       54
<PAGE>
 
date (subject to acceleration in certain events), at a conversion price equal to
$1.00 (which represents a premium to the Common Stock closing price of $0.5938
on July 8, 1998, the date the Company reached an agreement in principle with the
Investors regarding the terms of the Private Placement).  The Series F Preferred
Stock will be convertible into Common Stock at the option of the holder
beginning one year after the second closing (subject to acceleration in certain
events), at a conversion price equal to the trailing five-day average closing
bid price of the Common Stock on the date of the second closing.  Subject to
certain limitations, all Preferred Stock outstanding five years after the
issuance date will convert automatically into Common Stock at the applicable
conversion price.  In each case, the number of shares of Common Stock issuable
upon conversion of one share of Preferred Stock is computed by dividing the
share's stated value of $1,000 by the applicable conversion price, plus any
shares of Common Stock which the Company elects to issue in payment of the
accrued premium on the Preferred Stock.

The Class A Warrants are exercisable on the earlier of 90 days after issuance on
the first closing or second closing (as applicable), or the effective date of
the Registration Statement filed on August 24, 1998 with the Securities and
Exchange Commission (subject to acceleration in certain events), at an exercise
price equal to 120% of the average of the three lowest closing bid prices during
the 22 trading days prior to first closing, up to a maximum price of $.80 per
share (the "Class A Warrant Exercise Price"), to purchase that number of shares
of Common Stock equal to 15% of the stated value of the Series D Preferred Stock
issued at each closing, divided by the Class A Warrant Exercise Price.  Based on
such formula, the Company issued at the first closing Class A Warrants to
purchase an aggregate of 339,623 shares of Common Stock at an exercise price of
$.6625 per share and is obligated to issue at the second closing Class A
Warrants to purchase 226,415 shares of Common Stock at an exercise price of
$.6625 per share.  The Class B Warrants are exercisable one year after issuance
(subject to acceleration in certain events), at an exercise price of $.80 per
share, to purchase that number of shares of Common Stock equal to 15% of the
stated value of the Series E Preferred Stock and Series F Preferred Stock issued
at each closing, divided by the Class B Warrant Exercise Price.  Based on such
formula, the Company issued at the first closing and is obligated to issue at
the second closing, Class B Warrants to purchase an aggregate of 140,625 shares
of Common Stock at an exercise price of $.80 per share.

Additionally, in consideration for their services to the Company in connection
with the Private Placement, the Company issued at the first closing to two
persons Class A Warrants to purchase 339,623 shares of Common Stock at an
exercise price of $.6625 per share and agreed to issue to such persons at the
second closing Class A Warrants to purchase 113,208 shares of Common Stock at an
exercise price of $.6625 per share.



ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
---------------------------------------------------------

ACCOUNTING AND FINANCIAL DISCLOSURE
-----------------------------------

None.

                                       55
<PAGE>
 
                                   PART III*

ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
------------------------------------------------------------

ITEM 11.  EXECUTIVE COMPENSATION
--------------------------------

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
------------------------------------------------------------------------

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
--------------------------------------------------------

* The information required by Part III of this Annual Report on Form 10-K is
incorporated by reference from the Registrant's Definitive Proxy Statement to be
filed pursuant to Regulation 14A not later than 120 day after the Registrant's
fiscal year end.

                                       56
<PAGE>
 
                                    PART IV

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


(a) 1.  Financial Statements
----------------------------

           Independent Auditors' Report

           Balance Sheets as of June 30, 1998 and 1997

           Statements of Operations for the fiscal years ended June 30, 1998,
           1997, and 1996

           Statements of Shareholders' Equity for the fiscal years ended June
           30, 1998, 1997, and 1996

           Statements of Cash Flows for the fiscal years ended June 30, 1998,
           1997, and 1996

           Notes to Financial Statements

  2.  Financial Statement Schedules
  ---------------------------------

           Schedules are either not required or the necessary information is
           included in the financial statements or notes thereto.

  3.  Exhibits
  ------------

  3.1      Articles of Amendment to and Restatement of the Articles of
           Incorporation of the Company, filed December 27, 1991. (a)

  3.2      Articles of Correction to Articles of Amendment to and Restatement of
           the Articles of Incorporation of the Company, filed August 13, 1992.
           (a)

  3.3      Articles of Amendment to the Articles of Incorporation of the
           Company, filed August 21, 1992. (a)

  3.4      Bylaws of the Company and amendment to Bylaws. (a)(b)

  3.5      Statement of Designations, Preferences and Rights of 1997 Series A
           Convertible Preferred Stock, filed January 10, 1997. (b)

  3.6      Statement of Resolution Establishing Series B Participating
           Cumulative Preferred Stock. (g)

  3.7      Statement of Designations, Preferences and Rights of Series C
           Convertible Participating Preferred Stock, filed November 10, 1997.
           (h)

                                       57
<PAGE>
 
  3.8      Statement of Designations, Preferences and Rights of Series D
           Convertible Preferred Stock, filed July 24, 1998. (j)

  3.9      Statement of Designations, Preferences and Rights of Series E
           Convertible Preferred Stock, filed July 24, 1998. (j)

  4.1      Specimen Common Stock Certificate. (a)

  4.2      Form of Stock Purchase Warrant issued on January 10, 1997,
           representing a series of warrants issued by the Company to Capital
           Ventures International, Credit Suisse First Boston Corporation, and
           Zanett Lobardier. (b)

  4.3      Form of Stock Purchase Warrants issued on November 7, 1997,
           representing a series of warrants issued by the Company to Capital
           Ventures International, Nelson Partners, Olympus Securities, Ltd. and
           CC Investments, LDC. (h)

 4.4       Form of Class A Stock Purchase Warrants representing a series of
           warrants issued by the Company pursuant to the Purchase Agreement
           dated July 24, 1998. (j)

 4.5       Form of Class B Stock Purchase Warrant representing a series of
           warrants issued by the Company pursuant to the Purchase Agreement
           dated July 24, 1998. (j)

 10.1*     Incentive Stock Option Plan, adopted May 3, 1985, as amended. (a)

 10.2*     Amended and Restated Stock Option Plan, adopted August 29, 1988, as
           amended. (a)

 10.3*     401(k) Profit Sharing Plan, effective March 1, 1992. (a)

 10.4*     Employment Agreement, dated April 25, 1995, between the Company and
           W.B. Barker. (e)

 10.5      Master Agreement for Hardware Support Services between the Company
           and Data General Corporation. (a)

 10.6      Form of Indemnification Agreement between the Company and each
           director. (c)

 10.7*     Amended and Restated Employee Stock Purchase Plan adopted in February
           1996. (f)

 10.8*     1994 Stock Option Plan. (e)

 10.9*     1995 Stock Option Plan. (f)

 10.10*    1997 Stock Option Plan. (i)

 10.11     Lease Agreement between the Company and Lee Partners, Ltd., dated
           June 20, 1995. (e)

 10.12     First through fifth amendments to Lease Agreement between the Company
           and Lee Partners, Ltd. (f)

                                       58
<PAGE>
 
 10.13  Securities Purchase Agreement, dated January 10, 1997, between the
        Company, Capital Ventures International, Credit Suisse First Boston
        Corporation, and Zanett Lombardier, Ltd. (b)

 10.14  Registration Rights Agreement, dated January 10, 1997, between the
        Company, Capital Ventures International, Credit Suisse First Boston
        Corporation, and Zanett Lombardier, Ltd. (b)

 10.15  Securities Purchase Agreement, dated effective November 7, 1997,
        between the Company, Capital Ventures International, Nelson Partners,
        Olympus Securities, Ltd. and CC Investments, LDC.(h)

 10.16  Registration Rights Agreement, dated effective November 7, 1997,
        between the Company, Capital Ventures International, Nelson Partners,
        Olympus Securities, Ltd. and CC Investments, LDC.(h)

 10.17  Securities Purchase Agreement, dated July 24, 1998, between the Company,
        Sovereign Partners L.P., Dominion Capital Fund Ltd., and First Capital
        Group of Texas II, L.P.(j)

 10.18  Registration Rights Agreement, dated July 24, 1998, between the
        Company, Sovereign Partners L.P., Dominion Capital Fund Ltd., and First
        Capital Group of Texas II, L.P.(j)

 10.19  Consulting Agreement between the Company and Liviakis Financial
        Communications, Inc.(k)

 23.1   Consent of KPMG Peat Marwick LLP (k)

 24     Powers of Attorney to sign amendments to this report.  Reference is made
        to the signature page of this report.

 27     Financial Data Schedule (k)

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

(a)  Filed as an exhibit to Form S-1 Registration Statement No. 33-51170,
     effective October 7, 1992.

(b)  Filed as an exhibit to Form 10-Q for the quarter ended December 31, 1996.

(c)  Filed as an exhibit to Form 10-K Annual Report for fiscal year ended June
     30, 1993.

(d)  Filed as an exhibit to Form S-8 Registration Statement, No. 33-75800,
     effective February 25, 1994.

(e)  Filed as an exhibit to Form 10-K Annual Report for fiscal year ended June
     30, 1995.

(f)  Filed as an exhibit to Form 10-K Annual Report for fiscal year ended June
     30, 1996.

(g)  Filed as an exhibit to Form 10-K Annual Report for fiscal year ended June
     30, 1997.

                                       59
<PAGE>
 
(h)  Filed as an exhibit to Form 8-K filed on November 19, 1997.

(i)  Incorporated by reference to appendix A of the Company's Definitive Proxy
     Statement dated December 12, 1997.

(j)  Filed as an exhibit to Form 8-K filed on August 4, 1998.

(k)  Filed herewith.


*    Management contract or compensatory plan, contract or arrangement

(b) Reports on Form 8-K
-----------------------

     A report on Form 8-K was filed on April 15, 1998, to report Amendment No. 2
to the Securities Purchase Agreement dated November 7, 1997.

     A report on Form 8-K was filed on June 2, 1998, to report an amendment to
the Securities Purchase Agreement dated November 7, 1997.

     A report on Form 8-K was filed on June 12, 1998, to report that the Company
does not expect the second funding of the Securities Purchase Agreement dated
November 7, 1997 to occur.

                                       60
<PAGE>
 
                                   SIGNATURES
                                        
      Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended the Registrant has duly caused this report to
be signed on behalf of the undersigned, thereunto duly authorized.

                                  DATA RACE, INC.

                                  By:  /s/ W. B. BARKER
                                       -------------------------------------
                                       W. B. Barker,
                                       President and Chief Executive Officer

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

                                  Date:  September 17, 1998

      Each person whose signature appears below authorizes W. B. Barker and
Gregory T. Skalla, or either of them, each of whom may action without joinder of
the other, to execute in the name of each such person who is then an officer or
director of the Registrant and to file any amendments to this annual report on
Form 10-K necessary or advisable to enable the Registrant to comply with the
Securities Exchange Act of 1934, as amended, and any rules, regulations and
requirements of the Securities and Exchange Commission in respect thereof, which
amendments may make such changes in such report as such attorney-in-fact may
deem appropriate.

      Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, this report has been signed by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.

<TABLE>
<CAPTION>
              NAME                                    TITLE                                DATE
              ----                                    -----                                ----
<S>                               <C>                                             <C>
/s/ W. B. BARKER                  President, Chief Executive Officer and          September 17, 1998
--------------------------        Director
 W. B. Barker

/s/ GREGORY T. SKALLA             Senior Vice President-Finance, Chief            September 17 , 1998
--------------------------        Financial Officer, Treasurer and Secretary
 Gregory T. Skalla
</TABLE> 

                                       61
<PAGE>

<TABLE> 
<S>                               <C>                                            <C> 
/s/ JEFFREY P. BLANCHARD          Chairman of the Board of Directors              September 17, 1998
-------------------------
 Jeffrey P. Blanchard
 
/s/ GEORGE R. GRUMBLES            Director                                        September 17, 1998
-------------------------
 George R. Grumbles

/s/ MARCELO A. GUMUCIO            Director                                        September 17, 1998
-------------------------
 Marcelo A. Gumucio

/s/ MATTHEW A. KENNY              Director                                        September 17, 1998
-------------------------
 Matthew A. Kenny

/s/ DWIGHT E. LEE                 Director                                        September 17, 1998
-------------------------
 Dwight E. Lee

/s/ EDWARD A. MASI                Director                                        September 17, 1998
-------------------------
Edward A. Masi

</TABLE>

                                       62