<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, 1997                                            0-20706

                                DATA RACE, INC.
             (Exact name of registrant as specified in its charter)
      Texas                                             74-2272363
(State of Incorporation)                  (I.R.S. Employer Identification No.)

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

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

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

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

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 30, 1997, the aggregate market price of the voting stock held by
non-affiliates of the Company was approximately $47,265,083. (For purposes
hereof, directors, executive officers and 10% or greater shareholders have been
deemed affiliates).

On September 30, 1997, there were 5,541,677 outstanding shares of Common Stock,
no par value.

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

                                                                      Page
                                                                     Number
PART I.
-------
Item 1.  Business.....................................................  3

Item 2.  Properties................................................... 23

Item 3.  Legal Proceedings............................................ 24

Item 4.  Submission of Matters to a Vote of Security Holders.......... 24


PART II.
--------
Item 5.  Market for Registrant's Common Stock and Related
          Stockholder Matters ........................................ 25

Item 6.  Selected Financial Data...................................... 26

Item 7.  Management's Discussion and Analysis of Financial
          Condition and Results of Operations......................... 27

Item 8.  Financial Statements and Supplementary Data.................. 30

Item 9.  Changes in and Disagreements with Accountants on
          Accounting and Financial Disclosure......................... 46

PART III.
---------
Item 10.  Directors and Executive Officers of the Registrant.......... 47

Item 11.  Executive Compensation...................................... 49

Item 12.  Security Ownership of Certain Beneficial Owners
           and Management............................................. 53

Item 13.  Certain Relationships and Related Transactions.............. 53


PART IV.
--------
Item 14.  Exhibits, Financial Statement Schedules, and
           Reports on Form 8-K........................................ 54



                                      -2-
<PAGE>
 
                                    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."  The Company's products enable knowledge workers who
work at home, in branch offices, or on the road from hotels or airport lounges
to access the various elements of the corporate communications infrastructure.
These products include the recently launched Be There! (TM) personal multiplexer
system, a unique client/server product which allows teleworkers to access the
corporate intranet, LAN and the Internet, while sending and receiving e-mail,
faxes and phone calls, simultaneously over a single phone line.  The Company
also designs and manufactures custom modems for manufacturers of notebook
computers, and a line of network multiplexers which carry data, LAN, voice, and
fax traffic between a company's branch and headquarters offices over a broad
range of communications speeds and services. The Company's ability to discern
emerging remote access market requirements and rapidly 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. With the advent of the laptop computer, predecessor to today's
notebook computers, the Company developed miniaturized versions of its modem
technology.  DATA RACE pioneered the laptop data/fax modem, allowing a mobile
user to send and receive faxes directly from the laptop when it was not being
used for a data connection.  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.

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 category
called a personal multiplexer, and in February 1997 introduced the Be There!
personal multiplexer system.  Such a device is intended to allow 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.

While the Company maintains a small direct sales force, its 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, a global technology
management and services company based in Omaha, Nebraska, announced the
completion of an agreement for distribution, sales and support.  The Company
continues to be in discussion with a small number of additional billion dollar-
class partners and marketing alliance candidates.  In addition, the Company
continues to be in discussion with, and in some cases has already signed
agreements with, a number of select regional distribution partners.

The Company seeks to capture a leadership position in the market for remote
access solutions by capitalizing on being first-to-market with the Be There!
system solution.

                                      -3-
<PAGE>
 
                               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, more time with family, and
the need 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 instantaneous access to all forms of information that they require
have created a multi-billion dollar market opportunity.

                                    STRATEGY

The Company's strategy is to provide innovative, early to market, high-value-
added solutions to meet the needs of knowledge workers working remotely 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 suppliers and 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 and
facilities, control manufacturing costs, and enable the Company to use the most
technologically advanced, cost-effective components 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, although the
Company anticipates the addition of a greater number of internal sales personnel
to support the marketing of its Be There! system than has been employed for its
custom modem and multiplexer products.  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! personal multiplexer system; custom modems for notebook computers; and
network multiplexers which connect data, phone, and fax systems of branch
offices to their headquarters.

BE THERE! PERSONAL MULTIPLEXER SYSTEM

The Be There! personal multiplexer 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 into 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 switchboard, enabling the user to work just as he or she would in
the office.

While telecommutting is a relatively recent phenomenon, several sources indicate
that there are already several million teleworkers in the United States alone.
FIND/VP, a market research and advisory company, estimates the number of
telecommutters has risen from 4 million in 1990 to 11 million in 1997.
Similarly, Computerworld estimates that there are already 11.1 million people
who work from home and these teleworkers average about 19 hours per week.  The
Olsten Corp. also estimates 42% of U.S. companies use 

                                      -4-
<PAGE>
 
telecommuting and a recently released survey by KPMG Peat Marwick LLP indicates
that almost one out of four Fortune 1000 companies already have employees who
regularly telecommute either full-time or part-time. 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
three to five years. In-Stat, a market research company estimates the Remote
Access Server market has already reached an annual rate of six million ports, or
$2 billion.

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 trends.  In these programs,
workers who are affiliated with a particular office 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, reports that facility savings alone amount to
about $6,750 per year for each teleworker.  More importantly, numerous studies
of telecommuting programs 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.  According to the Gartner Group, because the economic benefits
currently outweigh the incremental costs by such a large margin, for the
foreseeable future technology, not price, will remain one of the major selection
criteria for telecommuting products.

In addition to the economic forces, there are significant social forces driving
the increase in telecommuting.  Eliminating the commute each day 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 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 typically have three or more phone lines
installed in their homes.  This usually includes a personal line, a business
line, a data/modem line, and 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, fax, and data - over a single conventional line.

                                      -5-
<PAGE>
 
Road Warriors
-------------

Road warriors are traveling professionals who require efficient phone, fax, and
data 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.

Remote Call Center Workers
--------------------------

Call center workers are generally workers that deal with customers over the
telephone.  For example, in airline reservation centers, 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.

Construction and staffing of call centers is expensive.  Centers typically have
very uneven call loads through the work day.  While the center often must be
staffed on a 12- to 24-hour per day basis, the rate of incoming calls at the
peak hour, typically in the early- to mid-afternoon, can be several times higher
than the rate early in the morning.  Nonetheless, workers must typically be
hired to work 8-hour shifts.

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.  Finally, 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.

                                      -6-
<PAGE>
 
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.  These partial solutions 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! personal multiplexer system, all e-mail, file
servers, 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, 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 (depending on market
demands, a future release may also allow connection of a fax machine).  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.

                                      -7-
<PAGE>

"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.  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 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 an analogous way, faxes sent to the user's normal office fax number can be
redirected to be delivered to the PC on which the user is working remotely.

"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.

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 comprising earphone
and boom microphone, as typically used by telephone operators, allows hands-free
operation.  Faxes are displayed on the notebook screen, rather than connecting
to a physical fax machine.  This configuration is illustrated in Diagram 2.

                                      -8-
<PAGE>
 
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 (or higher in certain
applications) over ordinary telephone lines.  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 or fax traffic, the full data rate of 33.6
kbps (or whatever other rate is actually achieved over the telephone line) 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.  Similarly,
while a fax is being transmitted or received, the bandwidth available for other
data will be reduced.

"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 inter-leaves 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 with higher port density servers planned for future releases.  A four port
server is illustrated in Diagram 4.


                                      -9-
<PAGE>
 
"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 the 
speech compression digital signal processor, the speech data is output to the 
corporate PBX.

Since its recent introduction, the new Be There! personal multiplexer system has
received numerous accolades.  At its February 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, and in June, a Forbes
magazine article featured the benefits of Be There! for business users.  In
July, a cover page article in CTI magazine gave Be There! a Platinum Editor's
Choice award, stating they "would highly recommend it to anyone interested in a
telecommuting solution" and giving the product high ratings for installation,
documentation, features, interface, and security.  The product has also received
favorable coverage from Infoworld, Demo Letter, Computer Telephony, Mobile
Letter, Mobile Computing, Andrew Seybold's Outlook, and Telecommuting Review.

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, an increasing number of workers have foregone desktop machines for
their offices and are using notebook computers for use at their offices, homes
and while traveling.  As a result of these and other trends, the Company
believes that notebook computers represent one of the fastest growing segments
of the personal computer market.

Associated with this growth in the personal computer industry has been equally
dramatic growth in sales of modems and other interconnectivity devices.  A modem
is a device that modulates and demodulates signals on telephone lines in such a
way that digital data can be sent from one computing device to another over the
telephone network.  Modern modems also contain a great number of automatic
features to assist the computer user.  These include error controllers, data
compressors, line adapters, line equalizers, and fax capability.

The Company provides custom modems to a small number of notebook computer
manufacturers.  Such notebook computer manufacturers as Toshiba, Compaq and IBM
may incorporate internally-designed and manufactured modems; however a  number
of manufacturers have elected to rely upon third party sources for custom
modems.  While the market niche for these custom modems is very small compared
to the overall modem market, the Company believes that it is a leader in the
third party custom modem market niche.

                                      -10-
<PAGE>
 
Portable computer manufacturers are continually decreasing the size and weight
of their computers to make them more portable and usable.  Manufacturers of data
communication devices for the portable computer have had to keep pace by
miniaturizing their products into custom-designed packages.  In addition, high
performance options such as increased transmission speeds, error correction,
data compression, the ability to send and receive faxes, and wireless (cellular)
capability are sought by today's more sophisticated users.  Power management of
the data communications device is also increasingly important, since battery
life is very limited in portable computers.  Those manufacturers of data
communications devices that aid the computer manufacturer in extending battery
life and offering high performance options have an important competitive
advantage.

Notebook computer manufacturers have generally adopted the PCMCIA standard and
provide a socket into which the user can plug a standardized modem (or other
device), rather than bundling a custom modem inside the computer.  The Company's
products typically are based on custom form factors; however, the Company has
offered modems based upon the PCMCIA standard when it believes that it can offer
significant differentiating features.

The Company features high quality, innovative modems for mid-range and high-end
notebook computers.  The Company specializes in this niche of the modem industry
because it believes the combination of exacting form factor requirements and
desire for other advanced features in the notebook computer market afford it the
opportunity to offer a value-added product in a more competitive manner than is
the case with standardized modems. In the past, the Company has sold custom
modems to many of the world's leading notebook computer manufacturers, including
IBM, NEC, Texas Instruments, Dell, AT&T and Tandy. In addition to its reputation
and proven track record, the Company believes that it has a significant market
advantage in its engineering capabilities to produce full-featured, high-speed
custom modems.

A modem offered by the Company will typically be customized for a particular
model of notebook computer and may include one or more of the following
attributes:  high speed operation, customized connections to other notebook
components (e.g. microphones and speakers), customized form factor, and
customized power management features.

The Company develops reference designs that incorporate novel technologies and
demonstrates them to potential customers as a way to promote its capabilities
and technologies.  This approach typically results in the development of new
features and helps position the Company as an innovator which can bring low-risk
innovative solutions to OEM's.  For example, in March 1995, IBM introduced the
ThinkPad 701C notebook, which for the first time included a number of features
previously found only in desktop machines, including the full-duplex
speakerphone and telephone answering machine capabilities.  These capabilities
were supported and made possible by the modem which the Company designed and
manufactured under contract with IBM.  By the fall of 1996, Toshiba, Compaq,
NEC, IBM, and Texas Instruments were advertising notebook computers with similar
features.  Beginning in the fourth quarter of fiscal 1996, the Company provided
modems with these features to NEC and Texas Instruments, and subsequently to
AST.

The Company believes that a number of notebook computer manufacturers may
continue to require specialized modems for some of their notebook and smaller
computers.  Modem technology continues to advance quickly and is characterized
by a high level of innovation. Digital signal processing and other technologies
have made it possible to expand the communications bandwidth; it is now possible
to transmit up to 33.6 kbps full duplex over normal dial-up phone lines and in
certain cases, when connected to a digitally-connected server, at higher speeds
approaching 56 kbps.  New telephony features such as full-duplex speakerphone
and telephone answering machine capabilities are still being added to notebook
computers.  Over the coming years, the Company expects that the modem market for
notebook computers and other portable computers could be significantly affected
by one or more of the following trends:  increasing bandwidth, notably the
recently introduced, so called 56 kbps modem technologies; digital simultaneous
voice and data, enabling voice and data transmissions to be simultaneously
transmitted across the same phone connection; video phone capabilities; demand
for speakerphone and telephone answering machine functions in a standard PCMCIA
form-factor product; low power consumption; small size; and low cost modem
technology using the host process for signal processing functions.

                                      -11-
<PAGE>
 
In the past, rapid changes in modem technologies have presented the Company with
market opportunities.  As new technologies and capabilities proliferate, the
modem manufacturer that can most quickly integrate these new capabilities into
functioning modems may be able to offer the manufacturer of notebook computers
and other portable computers a significant competitive advantage.

NETWORK MULTIPLEXERS

Network multiplexers, allow a company to connect its various offices over a
single set of communications circuits which carry telephone conversations and
faxes while simultaneously providing access to electronic mail, corporate data
bases, the Internet, and other local and wide area network services.  Such a
network can often pay for itself in months, based on savings in telephone
service costs.  Some users justify the purchase of a network on the basis of the
strategic necessity to access data resources, while the savings in telephone and
fax costs are 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, and LAN bridging and routing, and has designed into its
multiplexers a greater degree of expansibility than most competitive products.

Because of rapid changes in the cost and availability of these services, the
buyer of a network for a small to medium sized business is faced with a dilemma.
A network purchased today might not support the services that are economically
advantageous in six to 24 months.  Many of the multiplexer products on the
market today are based on a single processor which provides all of the
processing capacity to support the circuits connected to the multiplexer.  If,
at some future date, the user wishes to connect more circuits, higher-speed
circuits, or more complex protocol services to the multiplexer, the user may
need to replace the multiplexer with one that has more processing power.

Through the use of an innovative multiprocessor architecture, the Company's
multiplexers alleviate the need to replace the multiplexer as additional
services become available.  In addition to the multiplexer's  powerful central
processor, each line function card that plugs into the multiplexer to connect to
external circuits contains its own processor, with compute power appropriate to
the speeds and protocol complexity of the circuits it is designed to support.
Thus, a user can add increasing numbers of circuits of increasingly high speeds
and complex protocols, simply by plugging the appropriate cards into the
existing system.  The Company refers to this concept as a Future-Proof(TM)
system.

Historically, multiplexers were used by small- to medium-sized businesses to
connect multiple remote workstations to a host computer over a single dial-up or
leased phone line.  For example, instead of eight users transmitting data over
eight long distance dial-up or leased lines, the users can employ statistical
multiplexers to send and receive traffic over one phone line, thus reducing
telephone long distance charges.  Because the traffic over the circuits from the
workstations to the multiplexer is intermittent in nature (rather than occupying
all circuits simultaneously), the multiplexer permits all users to operate their
workstations during the same period at or near full capacity, with little loss
in performance from the users' perspective.

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.  ISDN service is available in some
metropolitan areas with no per-minute fees, resulting in the availability of 128
kbps digital service for less than the cost of a 56 kbps leased circuit.
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 an increasingly attractive alternative. The Company has introduced products
that support T1 services and allow companies to take advantage of decreasing T1
price tariffs.  During fiscal 1997, the Company introduced its Local Area
Network ("LAN") Bridge-Router ("BRouter") product which allows the Company's
multiplexer products to be used in a wider variety of LAN applications.  Frame
relay service is also becoming increasingly available, and is currently a
popular alternative to traditional leased circuits due to its pricing and
circuit efficiency.

                                      -12-
<PAGE>
 
Effective network management is critical to minimize downtime and maximize
network productivity.  The Company's multiplexer products have built-in features
including dial-in password protected access to the multiplexer, remote
diagnostic and statistics and local and remote upload/downloading of network
configurations that ensure the user is able to cost effectively manage every
aspect of its network using a modem and dial-up telephone lines.

                      TECHNOLOGY AND PRODUCT DEVELOPMENT

The Company believes that its product development and design strategy, which
seeks to combine the latest industry standards and technologies with its own
technological advances, enables the Company to develop and introduce products
quickly in response to identified market trends.  The Company uses information
derived from participation in industry organizations, internal research, third-
party publications, customer participation and OEM relationships to identify
such trends and make design and product selection decisions.

Such resources are typically relied upon and assimilated by the Company's
engineering and technical staff.  The staff is assembled on a flexible basis
into technology teams divided along product lines to explore and develop new
product concepts and additional features and improvements to existing products.
The technology development teams work in association with teams of the Company's
marketing personnel in the same product lines.

The Company has successfully forged strategic relationships with a number of
suppliers, such as Lucent Technologies and Zilog Incorporated, that have allowed
it to remain in the forefront of interconnectivity technology advances.  In
developing these strategic relationships, these suppliers may present new
product ideas to the Company before they are generally released to the public,
and the Company may work with the suppliers in developing final product
proposals.  The Company also develops products based upon specific requirements
and specifications of its OEM customers in the custom modem business and to a
lesser extent in its other product lines develops new products or improvements
based upon customer recommendations and testing.

Company-sponsored research and development expenses were $4.9 million, $4.8
million, and $3.1 million for fiscal years 1997, 1996, and 1995, respectively.
The Company also capitalized software development costs of  $20,000 and $228,000
for fiscal years 1996 and 1995, 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.  Rather than incur the
higher fixed costs and investment required to be a vertically integrated
manufacturer, the Company elects to subcontract 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 cost, quality of work and
response time.

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

                                      -13-
<PAGE>
 
                  MARKETING, SALES, DISTRIBUTION AND SUPPORT

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. The Company's primary
distribution strategy is to focus on indirect sales channels through 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, 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, a global
technology management and services company based in Omaha, Nebraska, announced
the completion of an agreement for distribution, sales and support. The Company
continues to be in discussion with a small number of additional billion dollar-
class partners and marketing alliance candidates. The Company is also in
discussion with, and in some cases has already signed agreements with, a number
of select regional distribution partners, including certain of those
distribution partners from its current network multiplexer product line. In
addition, the Company is pursuing a number of potential customers on a direct
basis, with an internal direct sales and support organization. This internal
sales group is primarily targeting customers that can serve as credible
reference accounts and large organizations capable of purchasing large
quantities of the product.

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.  The Company and Mr.
Sarkissian, its Vice President for Sales and Marketing - OEM Products, are
generally well known and respected in the notebook computer industry.  The
Company also retains a small number of independent representatives that
represent the Company with respect to custom modem sales.  The Company's sales
and marketing efforts are currently focused in the U. S. and Japan.

With respect to its multi-media network multiplexer products, the Company
conducts its sales and marketing activities through a combination of
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 as well as the end user.

The Company provides nationwide service, installation, repair and technical
support for certain of its products.  In July 1997, the Company announced an
agreement with Telsource Corporation which expands the support services
available to prospective customers.  Telsource Corporation provides 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 the
excellent support is an essential part of developing long-term relationships
with its customers.

                                  COMPETITION

The Company is not currently aware of any product that offers capabilities
directly competitive with those of the Be There! system, particularly in the
areas of Telepresence 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, MCI, Shiva, Cisco, and Bay
Networks, offer products and services that are targeted at teleworkers.  Most,
if not all, of these companies have 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 custom modem products compete on the basis of features and
functions, time to market and delivery risk, technical support, price, inventory
risk and power consumption.  In the custom modem business, the Company faces
competition from three primary sources.  Several notebook computer 

                                      -14-
<PAGE>
 
manufacturers have internal development groups that are capable of delivering
custom modems, notably IBM, Compaq, Toshiba, and certain Asian manufacturers.
Other modem manufacturers such as 3Com/US Robotics, Hayes, and recently
Motorola, are also capable of offering both PCMCIA and custom modem solutions
for notebook computers. In addition, the Company has experienced competition
from Far East electronics manufacturers who are typically producing other
notebook computer parts. These competitors generally have substantially greater
financial resources than the Company.

The Company's multi-media network multiplexer products compete on the basis of
supplier credibility, recommendation of the systems integrator, modularity and
expansibility, reliability, service and support, and price.  In selling to
resellers and system integrators, additional competitive factors apply,
including channel conflict and ease of installation and support.  In the multi-
media network multiplexer business, the Company competes with Micom (now a
subsidiary of Nortel), RAD, Memotec, Nuera, ACT and others.  With the
introduction of its BRouter product, the Company also competes with certain
products offered by Cisco, 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.

                             INTELLECTUAL PROPERTY

The Company's success depends in part upon its proprietary technology,
consisting of 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 and subcontractors and OEMs that the Company works with
concerning 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.

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 against it.  If an
intellectual property claim 

                                      -15-
<PAGE>
 
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. See "Certain Business Risks --
Intellectual Property Rights."

                                    BACKLOG

The Company's backlog at June 30, 1997 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 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, 1997, the Company employed 133 employees, including 40 in
manufacturing, 52 in engineering, 21 in sales, marketing and customer support,
and 20 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 in the remote access
industry 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 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," "anticipates," "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

The Company's goal of returning to profitability and developing a more
dependable revenue base will depend to a large extent on the success of the Be
There! personal multiplexer system.  The recently introduced Be There! system
represents a new type of product for the Company which is significantly
different from the Company's custom modem and network multiplexer products, and
presents a unique set of risks and challenges for the Company.  Future growth is
dependent on the Company's ability to timely and successfully develop and
introduce new products, such as the Be There! system, establish new distribution
channels, develop affiliations with leading market participants which facilitate
product development and distribution, and market existing and new products with
service providers, resellers, channel partners 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 sales and
marketing infrastructure, as well as expand its operational systems.
Competition for qualified personnel is intense in the data communications
industry.  The Company is in the process of establishing new distribution
channels and developing marketing and competitive pricing strategies to
penetrate those channels which are substantially different from current
marketing strategies. The Company has little experience in marketing the  Be
There! system to potential customers or through sales channels for 

                                      -16-
<PAGE>
 
such products. The Company has little experience in providing customer support
and warranty service for the Be There! system and there can be no assurance that
the Company will be successful in providing adequate customer support and
warranty service. Furthermore, the costs associated with providing customer
support and warranty services cannot be accurately predicted and may have a
material adverse effect on the Company's results of operations or financial
condition. In addition, the Company may be required to enhance the features and
performance, including voice coding characteristics, of the teleworker products
in order to achieve wider 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.  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.

RECENT OPERATING LOSSES; ADEQUACY OF CAPITAL RESOURCES

The Company has suffered substantial recurring losses and, during fiscal 1997, 
incurred negative cash flows from operations. 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 ability to sustain operations, fund the development and marketing 
of new products, including the Be There! personal multiplexer, and make future 
capital expenditures, are highly dependent on existing cash and the ability to 
raise additional capital, and on some or all of the following:  demands on cash 
to support the custom modem business, final settlement of the shareholder 
lawsuit, and the Company's return to profitability.  The timing and amount of 
the Company's future capital requirements can not be accurately predicted.

The Company is currently seeking to raise additional capital.  There can be no 
assurance, however, that such efforts will be successful or, if successful, that
the amount received will adequately meet the Company's capital requirements 
until the Company achieves positive cash flow.  The Company believes that the 
failure to obtain adequate capital in the coming months would have a material 
adverse effect on the Company's operations.  See Management's Discussion and 
Analysis of Financial Condition and Results of Operations and note 1 to the 
Company's financial statements appearing elsewhere in this report.

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 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,
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.

                                      -17-
<PAGE>
 
UNPREDICTABILITY OF TELEWORKER MARKET

The teleworker market is rapidly changing. The growth and size 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 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, or financial condition may be adversely affected.

COMPETITION

The communications industry is intensely competitive. The Company currently
competes principally in the markets for high-speed custom data/fax modems and
network multiplexer products. Many of the Company's existing and potential
competitors (including certain of the Company's customers and suppliers) have
far more extensive financial, engineering, product development, manufacturing
and marketing resources than the Company.  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, in the case of the custom modem
business, time to market and delivery risk, price, quality, features and
functions, power consumption, and manufacturing rights, and, in the case of the
network multiplexer business, recommendations of the systems integrators,
features and functions, modularity and expansibility, reliability, service and
support, supplier credibility, and price.

In addition to many of the competitive factors inherent to both the custom modem
and the network multiplexer businesses, the Company's teleworker products will
compete in areas in which the Company may not have the experience or resources
to address. With the introduction of the Be There! personal multiplexer system,
the Company can be expected to compete with competitors with whom the Company
has had little or no experience. 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. 

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 to encounter an increased
number of well-established competitors, many of whom have far greater financial,
marketing, technical and other resources and experience, as it enters new areas
of the communications market. 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
competitors or alliances among competitors may emerge and rapidly acquire
significant market share. 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.

                                      -18-
<PAGE>
 
DEPENDENCE ON LIMITED NUMBER OF CUSTOMERS; FLUCTUATIONS IN PERIOD TO PERIOD
OPERATING RESULTS

Historically, custom modem shipments to a small number of customers that change
from year to year have represented a large portion of the Company's total
revenue.  For example, revenue from custom modem shipments to NEC and Texas
Instruments, the Company's two largest customers in fiscal 1997, accounted for
approximately 67% of the Company's total revenues for such fiscal year. However,
shipments under contracts with NEC and Texas Instruments were substantially
completed during fiscal 1997. The Company believes that its custom modem
business will, for the foreseeable future, continue to be characterized by a
small number of contracts, each typically with the bulk of volume deliveries
over a six month period or less. The Company has experienced gaps between the
expiration of one contract and the commencement of another. To the extent such
gaps continue, the Company anticipates large fluctuations in the Company's
revenue from custom modems. As long as the custom modem business continues to
dominate the Company's revenue, the Company anticipates continued fluctuations
between periods of profit and loss from custom modem products. Additionally,
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 fluctuations in
revenue similar to those experienced as a result of the custom modem business. 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
market, pricing and other competitive conditions, market acceptance of the
Company's products or its OEM customers' products, the timing of the
announcement and introduction of new products 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. Any of these factors could
materially adversely affect the Company's results of operations.

SHAREHOLDER LAWSUIT

On November 28, 1995, Guy and Carolyn Caspary and Tarik Hussain filed a class
action shareholder lawsuit 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, Vice President-Finance and Chief
Financial Officer, and Leven E. Staples, former Vice President and Chief
Technical Officer. The lawsuit was filed in the United States District Court in
San Antonio, Texas. The plaintiffs allege that the defendants violated certain
provisions of the federal securities laws, including Rule 10b-5 under the
Securities Exchange Act of 1934. The plaintiffs claim that during a class period
of January 26, 1995 through October 13, 1995, the Company issued misleading and
incomplete information to the investing public for the purpose of raising the
price of the Company's stock, thereby permitting some of the defendants to
profit from this rise by selling their stock at artificially inflated prices.
The plaintiffs claim that public statements made during the class period noting
the growth of the Company's backlog were misleading because the Company did not
also disclose that orders included in its backlog were subject to cancellation
and that revenues were likely to be short-lived due to the limited duration of
shipments under the contract. On December 15, 1995, a lawsuit was filed with
identical allegations by Sylvio L. Marcoccia, on behalf of himself and all
others similarly situated. On February 23, 1996, the Caspary and Marcoccia cases
were consolidated, and the style of the case was changed to In re Data Race,
Inc. Securities Litigation.

                                      -19-
<PAGE>
 
On July 29, 1997, the Company and the plaintiffs agreed to settle the In re Data
Race Securities Litigation. If the lawsuit were settled in accordance with this
agreement, the Company's insurance carrier would pay $800,000 in cash and the
Company would contribute 10,000 shares of Common Stock. The Company believes
that the case is absolutely without merit, and that neither the Company nor any
of the other defendants committed any of the alleged wrongdoings. The Company
decided to accept the settlement agreement based on the advice of counsel that
the costs to the Company of defending the lawsuit could exceed the costs to the
Company of the proposed settlement, and based on the unpredictable results of
jury trials. The settlement is contingent upon execution of a definitive
settlement agreement, U.S. District Court approval and certain other conditions.
There can be no assurance that all such conditions will be satisfied. In the
event final settlement is not reached, the Company intends to continue to
vigorously defend against the claims made in the lawsuit. The Company is unable,
however, to predict the costs to be incurred to resolve the lawsuit in the event
settlement is not reached on the terms set forth in the preliminary settlement
agreement. The Company is required under certain circumstances to indemnify the
named officers against losses incurred as a result of the lawsuit.

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 key technical personnel to
remain in the forefront of technological advances, its custom modem sales
executives to maintain close relationships with the Company's OEM customers and
on its teleworker products sales executives to develop and implement its sales
strategies for the teleworker products. Competition for qualified personnel is
intense in the data communications industry. All of the Company's senior
executives, including W. B. Barker, the Company's Chief Executive Officer, are
employed on an "at-will" basis. There can be no assurance that the Company will
retain its key managerial and technical employees or that it will attract and
assimilate such employees in the future. The loss of key management or technical
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 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.

                                      -20-
<PAGE>
 
SALES CHANNEL RISKS

The Company has derived a significant amount of its revenue from sales to its
national, regional and international distributors, resellers, and other
strategic marketing partners. In addition, 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.
Independent distributors, resellers, and other strategic marketing partners are
not typically 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 could have a significant
adverse effect on the Company's operating results. The Company has also derived
a significant amount of its revenue from sales to notebook computer
manufacturers. Such manufacturers have significantly different requirements from
independent distributors and resellers. Notebook computer manufacturers may also
require special distribution arrangements and product pricing. The Company's
relationships with notebook computer manufacturers exist on a contract-by-
contract basis. The loss of certain of the Company's key custom modem sales and
marketing employees could adversely affect the Company's ability to maintain
such relationships and enter into new contracts with notebook computer
manufacturers. There can be no assurance that the Company will be successful in
developing products for sales to notebook computer manufacturers or maintaining
or increasing sales to such manufacturers. Failure of the Company to
successfully develop, manufacture and market its products for any of these sales
channels could have a material adverse effect on the Company's results of
operations.

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 

                                      -21-
<PAGE>
 
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 represents 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. In the future, 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 of the rights of others, to resolve
disputes under technology license arrangements, and to determine the scope and
validity of the proprietary rights of others. 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 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.

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. In addition, each OEM
notebook computer that utilizes one of the Company's custom modems may also be
required to be certified for conformance to FCC regulations before any sale of
such product. 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, damage the Company's relationships with its OEMs, 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 CONVERTIBLE PREFERRED STOCK

As of September 30, 1997, 4,195 shares of the originally issued 5,000 shares of
the Convertible Preferred Stock had been converted into 570,839 shares of Common
Stock. 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 965,625 shares of Common Stock upon
conversion of the Convertible Preferred Stock and the exercise of the Common
Stock Purchase Warrants issued in connection therewith. The actual number of
shares of Common Stock to be issued upon conversion of the Convertible Preferred
Stock will depend on the average closing price of the Common Stock prior to
conversion. The Company is obligated to redeem any shares of Convertible
Preferred Stock which may not be converted and any Common Stock Purchase
Warrants which may not be exercised as a result of such regulatory limitation.
The cash demands to fund such a redemption may adversely affect the Company's
ability to make future capital expenditures

                                      -22-
<PAGE>
 
and fund the development and launch of new products, including the continued
development of the telecommuter business. There can be no assurance that the
Company will have cash available to fund such a redemption.

ANTI-TAKEOVER MEASURES

The Company recently adopted a shareholder rights plan in an effort to guard
against abusive tactics which could deprive shareholders from realizing 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 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 recently enacted
"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.

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, 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 notebook computers and other 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 Convertible 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. During the period from July
1, 1996 to June 30, 1997, the closing price of the Company's Common Stock as
reported on the Nasdaq National Market ranged from a low of $5.375 per share on
July 30, 1996 to a high of $24.375 per share on December 30, 1996. On October 2,
1997, the closing price of the Company's Common Stock as reported on the Nasdaq
National Market was $8.312 per share.


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 

                                      -23-
<PAGE>
 
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 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 personal multiplexer 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 November 28, 1995, Guy and Carolyn Caspary and Tarik Hussain filed a class
action shareholder lawsuit 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, Vice President-Finance and Chief
Financial Officer, and Leven E. Staples, former Vice President and Chief
Technical Officer. The lawsuit was filed in the United States District Court in
San Antonio, Texas. The plaintiffs allege that the defendants violated certain
provisions of the federal securities laws, including Rule 10b-5 under the
Securities Exchange Act of 1934. The plaintiffs claim that during a class period
of January 26, 1995 through October 13, 1995, the Company issued misleading and
incomplete information to the investing public for the purpose of raising the
price of the Company's stock, thereby permitting some of the defendants to
profit from this rise by selling their stock at artificially inflated prices.
The plaintiffs claim that public statements made during the class period touting
the growth of the Company's backlog were misleading because the Company did not
also disclose that orders included in its backlog were subject to cancellation
and that revenues were likely to be short lived due to the limited duration of
shipments under the contract. On December 15, 1995, a lawsuit was filed with
identical allegations by Sylvio L. Marcoccia, on behalf of himself and all
others similarly situated. On February 23, 1996, the Caspary and Marcoccia cases
were consolidated, and the style of the case was changed to In re Data Race,
Inc. Securities Litigation.

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

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

None.

                                      -24-

<PAGE>
 
                                    PART II

ITEM 5.  MARKET FOR THE 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, 1996 and June 30, 1997, 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.

<TABLE>
<CAPTION>
 
 
                                              High         Low
<S>                                          <C> <C>     <C> <C>
     July 1, 1995 to September 30, 1995      12           4   1/8
     October 1, 1995 to December 31, 1995     6  1/4      3   5/8
     January 1, 1996 to March 31, 1996        5  5/8      3   7/8
     April 1, 1996 to June 30, 1996           8  3/8      3   3/4
     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
 
</TABLE>

As of September 30, 1997, the last sale price of the Company's Common Stock as
reported on the Nasdaq National Market was $8.69. As of September 30, 1997 there
were 184 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.

                                      -25-
<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, 1997, 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,
                                                    ---------------------------------------------
                                                      1997     1996     1995      1994     1993
                                                    --------  -------  -------   -------  -------
                                                      (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                                 <C>        <C>      <C>      <C>      <C>
OPERATING STATEMENT DATA:
Total revenue....................................    $19,788  $17,232  $30,380  $ 23,124  $43,934
Cost of revenue..................................     14,561   13,839   21,959    26,638   27,286
                                                      ------   ------   ------    ------   ------      
   Gross profit (loss)...........................      5,227    3,393    8,421    (3,514)  16,648
                                                      ------   ------   ------    ------   ------        
Operating expenses:                                                                        
  Engineering and product development............      4,882    4,784    3,134     3,150    2,726
  Sales and marketing............................      4,156    4,081    3,540     6,418    4,623
  General and administrative.....................      2,682    3,233    1,983     3,215    1,884
                                                      ------   ------   ------    ------   ------      
   Total operating expenses......................     11,720   12,098    8,657    12,783    9,233
                                                      ------   ------   ------    ------   ------ 
    Operating income (loss)......................     (6,493)  (8,705)    (236)  (16,297)   7,415
                                                      ------   ------   ------    ------   ------      
Other income (expense), net......................        201      386      267        94      199
                                                      ------   ------   ------    ------   ------      
Income (loss) before income taxes and cumulative                                           
 effect of change in accounting for income taxes      (6,292)  (8,319)      31   (16,203)   7,614
Income tax expense (benefit).....................          -        -        -      (659)   2,698
                                                      ------   ------   ------    ------   ------        
Income (loss) before cumulative effect of change                                           
 in accounting for income taxes..................     (6,292)  (8,319)      31   (15,544)   4,916
Cumulative effect of change in accounting for                                              
 income taxes....................................          -        -        -        27        -
                                                      ------   ------   ------    ------   ------      
    Net income (loss)............................    $(6,292) $(8,319) $    31  $(15,517) $ 4,916
                                                      ------   ------   ------    ------   ------      
Earnings per share:                                                                        
  Net income (loss)..............................    $(6,292) $(8,319) $    31  $(15,517) $ 4,916
  Effect of beneficial conversion features of                                              
   convertible preferred stock...................     (2,063)       -        -         -        -
                                                      ------   ------   ------    ------   ------      
  Net income (loss) applicable to common stock...    $(8,355) $(8,319) $    31  $(15,517) $ 4,916
                                                      ------   ------   ------    ------   ------      
                                                                                           
  Income (loss) before cumulative effect of                                                
   change in accounting for income taxes per                                               
   common share..................................    $ (1.71) $ (1.77) $  0.01  $  (3.47) $  1.12
  Cumulative effect of change in accounting for                                            
   income taxes per common share.................          -        -        -      0.01        -
                                                      ------   ------   ------    ------   ------      
  Net income (loss) per common share.............    $ (1.71) $ (1.77) $  0.01  $  (3.46) $  1.12
                                                      ------   ------   ------    ------   ------      
Weighted average shares outstanding..............      4,873    4,688    4,773     4,481    4,409
                                                                                           
BALANCE SHEET DATA (AT YEAR END):                                                          
Working capital..................................    $ 4,888  $ 5,644  $13,692  $ 12,558  $25,404
Total assets.....................................      9,470   12,495   20,327    20,038   38,569
Current maturities of long-term debt.............          -        -        -        13       44
Earnout payable..................................          -        -        -        90      921
Long-term debt, net of current maturities........          -        -        -         -       13
Shareholders' equity.............................      6,863    7,956   16,164    15,728   31,075
</TABLE>

                                      -26-
<PAGE>
 
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
                                           -------------------------------------------------     ------------------------------
                                                 1997              1996              1995              1997             1996
                                           -------------     -------------     -------------     -------------    -------------
<S>                                          <C>               <C>               <C>               <C>              <C>
OPERATING STATEMENT DATA:
Total revenue...........................           100.0%            100.0%            100.0%             14.8%           (43.3%)
Cost of revenue.........................            73.6              80.3              72.3               5.2%           (37.0)
                                           -------------     -------------     -------------
    Gross profit (loss).................            26.4              19.7              27.7              54.1            (59.7)
                                           -------------     -------------     -------------
Operating expenses:
  Engineering and product development...            24.7              27.8              10.3               2.0             52.6
  Sales and marketing...................            21.0              23.7              11.7               1.9             15.3
  General and administrative............            13.5              18.7               6.5             (17.1)            63.0
                                           -------------     -------------     -------------
 
    Total operating expenses............            59.2              70.2              28.5              (3.1)            39.7
                                           -------------     -------------     -------------
 
Operating loss..........................           (32.8)            (50.5)             (0.8)                *                *
Other income (expense), net.............             1.0               2.2               0.9             (48.1)            44.6
                                           -------------     -------------     -------------
 
Income (loss) before income tax.........           (31.8)            (48.3)              0.1                 *                *
Income tax (expense) benefit............               -                 -                 -                 -                -
                                           -------------     -------------     -------------
     Net income (loss)..................           (31.8%)           (48.3%)             0.1%                *                *
                                           -------------     -------------     -------------
 
*     Not meaningful
</TABLE>

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.

Historically, sales of custom modem products to notebook computer manufacturers
have represented a large portion of the Company's total revenue. The number of
notebook computer manufacturers is relatively small, and the number of new
notebook computers introduced each year which utilize custom modems are limited.
Therefore, the Company's custom modem sales are characterized by a small number
of contracts, often with gaps between the expiration of one contract and the
commencement of another.  To the extent that such gaps continue, the Company
anticipates large fluctuations in the Company's revenue from custom modems.

Custom modem products generally yield lower gross margins than the Company has
historically achieved from its network multiplexer products.  The Company and
its competitors typically bid for jobs at prices which yield very low initial
margins, relying on rapid decreases in component costs to increase the margin to
acceptable levels over the life of the contract.  In contrast to the higher
gross margin network multiplexer products, the Company has historically incurred
lower sales and marketing expenses to support the custom modem products.

                                      -27-
<PAGE>
 
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! personal multiplexer system.  The Be There! system represents a new 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.

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

The Company believes that custom modem revenue, if any, will continue to be
characterized by a small number of large contracts, each typically with volume
deliveries over a short period.  The active market life of a notebook computer
has continued to shorten and is now typically six months or less.  To the extent
to which there continue to be gaps between the completion of one contract and
the commencement of another, the Company anticipates large fluctuations in
revenue from custom modems. As long as the custom modem business continues to
dominate the Company's revenue, the Company anticipates continued fluctuation
between periods of profit and loss from custom modem products.

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.


FISCAL 1996 COMPARED TO FISCAL 1995

Total revenue in fiscal 1996 decreased 43% to $17.2 million from $30.4 million
in fiscal 1995, primarily due to substantially reduced revenue from custom modem
products.  Revenue from custom modem products 

                                      -28-
<PAGE>
 
decreased to $10.6 million in fiscal 1996 from $22.1 million in fiscal 1995, a
decrease of 52%, which was primarily due to completion in the first half of
fiscal 1996 of a contract with IBM. Revenue from shipments to and cancellation
fees from IBM, the Company's largest customer in fiscal year 1996, represented
46% of total revenue.

Network product revenue decreased by 21% during fiscal 1996 to $6.6 million from
$8.3 million in fiscal 1995 primarily due to past product reliability problems
and increased competitive pressures.

The cost of revenue in fiscal 1996 was $13.8 million resulting in a gross profit
of $3.4 million compared to $8.4 million of gross profit in fiscal 1995.  Gross
profit margin declined to 20% in fiscal year 1996 from 28% for fiscal 1995
primarily due to manufacturing variances attributable to reduced production
volumes.

Engineering and product development expenses increased 53% to $4.8 million in
fiscal 1996 from $3.1 million in fiscal 1995.  The fiscal 1996 engineering and
product development expenses increased over the prior year in all three product
lines, primarily due to personnel-related costs.  However, during the fourth
quarter these expenses were reduced for multiplexer and custom modem products
and a greater percentage of engineering resources were allocated to the new
telecommuter product line.  Engineering and product development expenses were
28% of revenue in fiscal 1996 compared to 10% in fiscal 1995.  The increase in
spending as a percent of revenue was primarily caused by the increases in
engineering and product development expenditures described above and the
decrease in total revenue during fiscal 1996.

Sales and marketing expenses increased 15% during fiscal 1996 to $4.1 million
from $3.5 million in fiscal 1995.  This increase was primarily due to increased
trade show and advertising expenses, personnel-related costs, and travel
expenses.  Sales and marketing expenses in fiscal 1996 were 24% of revenue, up
from 12% of fiscal 1995 revenue primarily due to the reasons described above and
the decrease in fiscal 1996 revenue.

General and administrative expenses increased to $3.2 million in fiscal 1996
from $2.0 million in fiscal 1995.  The increase was primarily caused by costs in
fiscal 1996 for legal expenses associated with the shareholder lawsuit, the
reversal of bad debt provisions in fiscal 1995 and increased fiscal 1996
expenses from the addition of a new president and CEO.  General and
administrative expenses increased to 19% of revenue in fiscal 1996 from 7% in
fiscal 1995 primarily due to the reasons described above and the decrease in
revenue during fiscal 1996.

During the fourth quarter of fiscal 1996, the Company recorded non-cash charges
of approximately $1,006,000.  This amount comprises a provision of $246,000 for
costs associated with the shareholder litigation and charges of approximately
$760,000 reflecting impairments of fixed and technology assets.

LIQUIDITY AND CAPITAL RESOURCES
-------------------------------

Operating losses have had and continue to have a significant negative effect on 
the Company's cash balance.  At June 30, 1997, the Company had $4,536,000 in 
cash and cash equivalents, compared to $6,377,000 at March 31, 1997.

The Company's ability to sustain operations, fund the development and marketing
of new products, including the Be There! personal multiplexer, and make future
capital expenditures, are highly dependent on existing cash and the ability to
raise additional capital, and on some or all of the following: demands on cash
to support the custom modem business, final settlement of the shareholder
lawsuit, and the Company's return to profitability. The timing and amount of the
Company's future capital requirements cannot 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.

The Company is currently seeking to raise approximately $8 million in additional
capital. There can be no assurance, however, that such efforts will be
successful. The Company believes that the failure to obtain adequate capital in
the coming months would have a material adverse effect on the Company's
operations.

In January 1997, the Company received net proceeds of $4,619,00 from the 
issuance of convertible preferred stock and related warrants to purchase 45,800 
shares of common stock at an exercise price of $16 3/8.  The convertible 
preferred stock is redeemable under certain circumstances.  See note 6 to the 
Company's financial statements appearing elsewhere in this report and "Certain 
Business Risks - Potential Redemption of Convertible Preferred Stock".

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

                                      -29-
<PAGE>


ACCOUNTING FOR EARNINGS 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.  Earlier adoption is not
permitted. 

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
----------------------------------------------------

INDEX TO FINANCIAL STATEMENTS
                                                                            PAGE
Independent Auditors' Reports............................................... 31
Financial Statements
      Balance Sheets at June 30, 1997 and 1996.............................. 32
      Statements of Operations for the years ended
        June 30, 1997, 1996 and 1995........................................ 33
      Statements of Shareholders' Equity for the
        years ended June 30, 1997, 1996 and 1995............................ 34
      Statements of Cash Flows for the years ended 
        June 30, 1997, 1996, and 1995....................................... 35
Notes to Financial Statements............................................... 36


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

                                      -30-
<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, 1997 and 1996, and the related statements of operations, shareholders'
equity, and cash flows for each of the years in the three-year period ended June
30, 1997. 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,
1997 and 1996, and the results of its operations and its cash flows for each of
the years in the three-year period ended June 30, 1997, 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, during
fiscal 1997, incurred negative cash flows from operations. These conditions
along with other matters discussed in Note 1 to the financial statements, 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 30, 1997

                                      -31-
<PAGE>
 
                                DATA RACE, Inc.
                                BALANCE SHEETS


<TABLE>
<CAPTION>
                                                                               AS OF JUNE 30,
                                                                     ----------------------------------
                                                                         1997                  1996
                                                                     ------------          ------------
<S>                                                                  <C>                   <C> 
ASSETS
 
Current assets:
   Cash and cash equivalents..............................           $  4,535,768          $  3,990,435
   Accounts receivable, net...............................              1,879,656             2,034,874
   Inventory..............................................              1,056,999             4,111,209
   Prepaid expenses and deposits..........................                 22,889                46,906
                                                                     ------------          ------------
       Total current assets...............................              7,495,312            10,183,424
 
   Property and equipment, net............................              1,932,317             2,198,954
   Other assets net.......................................                 42,689               112,392
                                                                     ------------          ------------
       Total assets.......................................           $  9,470,318          $ 12,494,770
                                                                     ============          ============


 LIABILITIES AND SHAREHOLDERS' EQUITY
 
Current liabilities:
   Accounts payable.......................................           $    912,522          $  2,400,507
   Accrued expenses.......................................              1,693,265             1,652,641
   Other taxes payable....................................                      -               166,156
   Other current liabilities..............................                    932               319,923
                                                                     ------------          ------------
       Total current liabilities..........................              2,606,719             4,539,227
 
   Commitments and contingencies..........................
 
   Shareholders' equity:
     Preferred stock, no par value, 2,000,000 shares
      authorized, 5,000 shares issued, 3,280 shares 
      outstanding at June 30, 1997 and none issued 
      and outstanding at June 30, 1996....................              3,079,447                     -
     Common stock, no par value, 20,000,000 shares
      authorized, 5,137,741 and 4,746,192 shares 
      issued and outstanding at June 30, 1997 and  
      1996, respectively..................................             26,680,686            24,379,642
    Additional paid-in capital............................              1,882,303                     -
    Retained earnings (accumulated deficit)...............            (24,778,837)          (16,424,099)
                                                                     ------------          ------------
       Total shareholders' equity.........................              6,863,599             7,955,543
                                                                     ------------          ------------
         Total liabilities and shareholders' equity.......           $  9,470,318          $ 12,494,770
                                                                     ============          ============
</TABLE>

                See accompanying notes to financial statements

                                      -32-
<PAGE>
 
                                DATA RACE, INC.
                           STATEMENTS OF OPERATIONS


<TABLE>
<CAPTION>
                                                                      YEARS ENDED JUNE 30,
                                                    ---------------------------------------------------------
                                                       1997                   1996                   1995
                                                    -----------            -----------            -----------
 
<S>                                                 <C>                    <C>                    <C> 
   Total revenue...........................         $19,787,764            $17,231,640            $30,380,430
 
   Cost of revenue.........................          14,560,981             13,838,987             21,959,656
                                                    -----------            -----------            -----------
 
       Gross profit (loss).................           5,226,783              3,392,653              8,420,774
                                                    -----------            -----------            -----------
 
   Operating expenses:
     Engineering and product development...           4,881,461              4,784,232              3,133,661
     Sales and marketing...................           4,156,149              4,080,622              3,540,369
     General and administration............           2,681,992              3,233,349              1,982,991
                                                    -----------            -----------            -----------
       Total operating expenses............          11,719,602             12,098,203              8,657,021
                                                    -----------            -----------            -----------
 
       Operating loss......................          (6,492,819)            (8,705,550)              (236,247)
                                                    -----------            -----------            -----------
 
   Other income (expense):
     Interest income.......................             176,677                338,674                284,251
     Interest expense......................                   -                      -                (20,120)
     Other, net............................              24,048                 48,049                  2,942
                                                    -----------            -----------            -----------
       Total other income..................             200,725                386,723                267,073
                                                    -----------            -----------            -----------
 
   Income (loss) before income taxes.......          (6,292,094)            (8,318,827)                30,826
   Income tax benefit......................                   -                      -                      -
                                                    -----------            -----------            -----------
       Net income (loss)...................         $(6,292,094)           $(8,318,827)           $    30,826
                                                    ===========            ===========            ===========
 
 
   Per share data:
     Net income (loss).....................         $(6,292,094)           $(8,318,827)           $    30,826
     Effect of beneficial conversion
      feature of convertible preferred 
      stock................................          (2,062,644)                     -                      -
                                                    -----------            -----------            -----------
 
     Net income (loss) applicable to            
      common stock.........................         $(8,354,738)           $(8,318,827)           $    30,826
                                                    ===========            ===========            ===========
 
     Net income (loss) per share 
      applicable to common stock...........         $     (1.71)           $     (1.77)           $      0.01
                                                    ===========            ===========            ===========
 
   Weighted average shares outstanding....            4,873,000              4,688,000              4,773,000
                                                    ===========            ===========            ===========

</TABLE>

                See accompanying notes to financial statements

                                      -33-
<PAGE>
 
                                DATA RACE, INC.
                      STATEMENTS OF SHAREHOLDERS' EQUITY


<TABLE>
<CAPTION>

                               Series A Convertible                                       Retained              
                                 Preferred Stock        Common Stock        Additional    Earnings       Total 
                                ------------------  ----------------------    Paid-in   (Accumulated  Shareholders' 
                                Shares    Amount     Shares      Amount       Capital     Deficit)       Equity
                                ------  ----------  ---------  -----------  ----------  ------------  -------------
<S>                             <C>     <C>         <C>        <C>          <C>         <C>           <C>
Balances at June 30, 1994.....       -  $        -  4,514,157  $23,864,492  $        -  $ (8,136,098)  $15,728,394
                                                    
Net income....................       -           -          -            -           -        30,826        30,826
                                                    
Exercise of stock options.....       -           -    143,620      404,716           -             -       404,716
                                                    ---------  -----------              ------------   -----------
                                                    
Balances at June 30, 1995.....       -           -  4,657,777   24,269,208           -    (8,105,272)   16,163,936
                                                    
                                                    
Net loss......................       -           -          -            -           -    (8,318,827)   (8,318,827)
                                                    
Exercise of stock options.....       -           -     88,415      110,434           -             -       110,434
                                                    ---------  -----------              ------------   -----------
                                                    
Balance at June 30, 1996......       -           -  4,746,192   24,379,642           -   (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....   5,000   2,736,803          -            -   1,882,303             -     4,619,106
                                                    
Accretion of discount of                            
 beneficial conversion                              
 feature of convertible                             
 preferred stock..............       -   2,062,644          -            -           -    (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           -             -       581,044
                                ------  ----------  ---------  -----------  ----------  ------------   -----------
Balance at June 30, 1997......   3,280  $3,079,447  5,137,741  $26,680,686  $1,882,303  $(24,778,837)  $ 6,863,599
                                ======  ==========  =========  ===========  ==========  ============   ===========
 
</TABLE>

                See accompanying notes to financial statements

                                      -34-
<PAGE>
 
                                DATA RACE, INC.
                           STATEMENTS OF CASH FLOWS


<TABLE>
<CAPTION>
                                                                  YEARS ENDED JUNE 30,
                                                     -------------------------------------------
                                                          1997            1996           1995
                                                     ------------    ------------    -----------
<S>                                                  <C>             <C>             <C>
Cash flows from operating activities:
  Net income (loss)...............................   $(6,292,094)    $(8,318,827)    $    30,826
  Adjustments to reconcile net income (loss) to
   net cash provided by (used in) operating
   activities:
    Depreciation and amortization.................       591,091       2,321,443       1,845,830
    Decrease (increase) in accounts receivable....       155,218       5,302,659      (2,871,747)
    Decrease in inventory.........................     3,054,210         224,652         596,927
    Decrease (increase) in prepaid expenses,
     deposits and other assets....................        93,720          29,098        (124,607)
 
    Increase (decrease) in accounts payable.......    (1,487,985)       (245,342)        773,338
    Increase (decrease) in accrued expenses.......        40,624         336,572        (296,320)
    Increase (decrease) in other current                
     liabilities..................................      (318,991)        284,821         (75,535)
    Decrease (increase) in income taxes receivable             -               -       1,271,441
    Decrease in other taxes payable...............      (166,156)              -               -
                                                     -----------     -----------     -----------
      Net cash provided by (used in) operating          
       activities.................................    (4,330,363)        (64,924)      1,150,153 
                                                     -----------     -----------     -----------
 
Cash flows from investing activities:
  Maturities of short-term investments............             -               -       2,518,145
  Purchase of property and equipment..............      (367,798)     (2,127,457)       (419,134)
  Proceeds from sale of property and equipment....        43,344               -               -
  Expenditures for capitalized software...........             -         (20,000)       (227,583)
                                                     -----------     -----------     -----------
    Net cash provided by (used in) investing            
     activities...................................      (324,454)     (2,147,457)      1,871,428
                                                     -----------     -----------     -----------
 
Cash flows from financing activities:
  Earnout payments................................             -               -         (40,000)
  Net proceeds from issuance of preferred stock...     4,619,106               -               -
  Net proceeds from issuance of common stock......       581,044         110,434         404,716
                                                     -----------     -----------     -----------
    Net cash provided by financing activities.....     5,200,150         110,434         364,716
                                                     -----------     -----------     -----------
 
Net increase (decrease) in cash and cash                 
 equivalents......................................       545,333      (2,101,947)      3,386,297
                                                                   
Cash and cash equivalents at beginning of                          
 year.............................................     3,990,435       6,092,382       2,706,085
                                                     -----------     -----------     -----------
 
Cash and cash equivalents at end of year..........   $ 4,535,768     $ 3,990,435     $ 6,092,382
                                                     ===========     ===========     ===========
 
Supplementary Cash Flow Information:
Interest paid.....................................   $         -     $         -     $    20,120
Income taxes refunded.............................   $         -     $         -     $(1,200,438)

</TABLE>

                See accompanying notes to financial statements

                                      -35-
<PAGE>

                                DATA RACE, INC.
                         NOTES TO FINANCIAL STATEMENTS
                         JUNE 30, 1997, 1996, AND 1995


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."  The
Company's products enable knowledge workers who work at home, in branch offices,
or on the road from hotels or airport lounges to access the various elements of
the corporate communications infrastructure.  These products include the
recently launched Be There! personal multiplexer system, a unique client/server
product which allows teleworkers to access the corporate e-mail and other
network resources while sending and receiving faxes and phone calls
simultaneously over a single phone line.  The Company also designs and
manufactures custom modems for manufacturers of notebook computers, and a line
of network multiplexers which carry LAN, voice, and fax traffic between a
company's branch and headquarters offices, over a broad range of wide area
communications speeds and services.

Over three fourths of the Company's revenue in fiscal 1997 was derived from
sales of custom modem products.  The custom modem business is characterized by a
small number of large contracts, subjecting the Company to large fluctuations in
revenue.  The Company's modem business is also dependent in part on certain of
its suppliers.  Certain components for the Company's custom modems are available
only from a single source or a limited number of sources, and the Company could
experience difficulties in obtaining satisfactory alternate sources or changing
product designs to incorporate alternate components.

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! personal multiplexer system.  The Be There!(TM) system represents a new
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 1997,
the Company incurred an operating loss of $6.5 million and cash used in
operating activities was approximately $4.3 million. In January 1997, the
Company received net proceeds of $4.6 million from the issuance of convertible
preferred stock and related warrants.

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

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, and some or all of the following: demands on cash
to support the custom modem business, final settlement of the shareholder
lawsuit and the Company's return to profitability.

The Company is in the process of attempting to raise additional capital. No
assurances can be given that the Company will be successful in attracting new
capital required for future viability.

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

USE OF ESTIMATES

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.

SIGNIFICANT ACCOUNTING 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

                                      -36-
<PAGE>
 
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

Cash equivalents consist of highly liquid investments in interest bearing
accounts.

ACCOUNTS RECEIVABLE

Accounts Receivable as shown is net of allowance for doubtful accounts of
$156,152 and $92,206 at June 30, 1997 and June 30, 1996, respectively.

INVENTORY

Inventory is valued at the lower of cost (principally standard cost which
approximates current cost) 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, which approximated fair market value
at the date of acquisition.  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 on accelerated methods
for income tax purposes.

CAPITALIZED SOFTWARE

The Company did not have capitalized software at June 30, 1997 or June 30, 1996,
and did not capitalize or amortize software costs in fiscal 1997.  The Company
capitalized $20,000 and $227,583 in fiscal 1996 and 1995, respectively.
Amortization of such costs aggregated $464,336 and $639,520 in fiscal 1996 and
1995, respectively.

CONVERTIBLE PREFERRED SECURITIES

In accordance with the March 13, 1997 SEC staff announcement, the beneficial
conversion features of the Preferred Stock have been recognized by allocating a
portion of the proceeds to additional paid-in capital.  The amount allocated to
additional paid-in capital consists of the conversion discount on the Preferred
Stock and the value attributed to the Warrants.  The conversion discount is
calculated, at the date of issuance, as the difference between the conversion
price and the fair value of the common stock into which 

                                      -37-
<PAGE>
 
the security is convertible. Because the security provides for more than one
conversion rate, in conformity to the SEC announcement, the computation is made
using the conversion terms most beneficial to the investor, regardless of the
actual discount applied upon conversion. The value of the Warrants is calculated
using the Black-Scholes model and may not correspond to a market value.

The calculated intrinsic value of the beneficial conversion features of the
Preferred Stock, the offering costs and the premium will result in non-cash
charges of $2,285,000 to income (loss) available to common shareholders in the
computation of income (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 $2,285,000 in non-cash charges are reflected in the
income (loss) per common share as of June 30, 1997.  

As of September 30, 1997, 4,195 shares of the initial 5,000 shares of the 1997
Series A Convertible Preferred Stock had been converted into 570,839 shares of
common stock.

FAIR VALUE OF FINANCIAL INSTRUMENTS

The carrying amounts of cash and cash equivalents, receivables, and current
liabilities approximate their respective fair values because of 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, except capitalized software costs as applicable.
Research and development costs charged to operations aggregated approximately
$4,881,000 $4,784,000, and $3,134,000 in fiscal 1997, 1996, and 1995,
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 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 future net cash flows expected
to be generated by the asset.  If such assets are considered to be impaired, the
impairment to be recognized is measured by the amount by which the carrying
amount of the assets 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.

                                      -38-
<PAGE>
 
STOCK BASED COMPENSATION

Prior to July 1, 1996, the Company accounted for its stock option plan in
accordance with the provisions of Accounting Principles Board ("APB") Opinion
No. 25, Accounting for Stock Issued to Employees, and related interpretations.
As such, compensation expense would be recorded on the date of grant only if the
current market price of the underlying stock exceeded the exercise price.  On
July 1, 1996, the Company adopted SFAS No. 123, Accounting for Stock-Based
Compensation, which permits entities to recognize as expense over the vesting
period the fair value of all stock-based awards on the date of grant.
Alternatively, SFAS No. 123 also allows entities to continue to apply the
provisions of APB Opinion No. 25 and provide pro forma net income and pro forma
earnings per share disclosures for employee stock option grants made in fiscal
year 1996 and future years as if the fair-value-based method defined in SFAS No.
123 had been applied.  The Company has elected to continue to apply the
provisions of APB Opinion No. 25 and provide the pro forma disclosure provisions
of SFAS No. 123.

EARNINGS (LOSS) PER SHARE

Earnings (loss) per share are computed using the weighted average number of
common and common equivalent shares (when dilutive) outstanding during each
period.  Common equivalent shares include stock options, convertible preferred
shares and warrants.  The number of shares of common stock and common equivalent
shares outstanding for fiscal 1997 was computed on a basis consistent with APB
Opinion No. 15.  Common stock equivalents resulting from stock options,
convertible preferred shares, and warrants are excluded during loss periods when
their result is anti-dilutive.  Fully diluted earnings per share is not
significantly different than earnings per common and common equivalent 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.  Earlier adoption is not
permitted and upon adoption, all previously reported per share amounts will be 
restated to conform to the new presentation. Basic net income (loss) per share 
would be the same as Primary earnings (loss) per share for all periods 
presented.


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

Revenue from shipments to NEC and TI, the Company's largest and second largest
customers in fiscal 1997, represented 46% and 21% of total fiscal year 1997
revenue respectively.  Revenue from shipments to and fees from IBM represented
46% and 52% of total revenue in fiscal 1996 and 1995, respectively.

The Company has significant amounts of accounts receivable due from a variety of
domestic and international OEMs, resellers, and distributors under normal credit
terms.  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 3%,
8%, and 10% of total revenue for 1997, 1996, and 1995, respectively.

                                      -39-
<PAGE>
 
3) INVENTORY
------------

<TABLE>
<CAPTION>
Inventory consists of the following:

                                                June 30,     June 30,
                                                  1997         1996
                                               ----------   ---------- 
<S>                                            <C>          <C>
      Finished goods.......................... $  218,777   $  366,824
      Work in progress........................    440,005    2,778,064
      Raw materials...........................    398,217      966,321
                                               ----------   ----------
      Inventory............................... $1,056,999   $4,111,209
                                               ----------   ----------
</TABLE>

<TABLE>
<CAPTION>
4) PROPERTY AND EQUIPMENT
-------------------------
 
Property and equipment consists of the following:
                                                June 30,     June 30,    Useful
                                                  1997         1996       Lives
                                               ----------   ----------  --------
<S>                                            <C>          <C>         <C>
      Leasehold Improvements................   $1,582,563   $1,595,341         *
      Furniture, fixtures and equipment.....    2,570,899    3,924,378  2-5 yrs.
                                               ----------   ----------
                                                4,153,462    5,519,719
      Less accumulated depreciation.........    2,221,145    3,320,765
                                               ----------   ----------  
      Property and Equipment................   $1,932,317   $2,198,954
                                               ----------   ----------

</TABLE>

* remaining lease life, primarily 6 to 9 years.

5) INCOME TAXES
---------------

There was no income tax expense (benefit) for the fiscal years ended June 30,
1997, 1996 and 1995.

The tax effects of temporary differences that give rise to significant portions
of the deferred tax assets and liabilities at June 30, 1997 and 1996 are
presented below:

<TABLE>
<CAPTION>
                                                        June 30,
                                                 ------------------------
Deferred tax assets:                                1997          1996
                                                 ----------    ----------
<S>                                              <C>           <C>

    Accounts receivable due to allowances 
     for financial reporting purposes......... $     53,092   $    32,678
    Inventory, principally due to write-
     down for financial reporting purposes....      449,713       999,928
    Property and equipment, due to 
     difference in depreciation...............      135,259       354,400
    Accrued expenses..........................      234,207       181,755
    Net operating loss carryforwards..........    9,127,274     6,984,833
    Alternative minimum tax credit 
     carryforwards............................       71,003        71,003
    Research and experimentation credit 
     carryforwards............................      841,291       539,889
                                               ------------   -----------
      Total gross deferred tax assets.........   10,911,839     9,164,486
      Less valuation allowance................  (10,911,839)   (9,164,486)
                                               ------------   -----------
      Total gross deferred tax assets 
       less valuation allowances..............            -             -
 
  Deferred tax liabilities:
      Total gross deferred tax liabilities....            -             -
                                               ------------   -----------
      Net deferred tax asset.................. $          -   $         -
                                               ============   ===========

</TABLE>

The valuation allowance related to deferred tax assets increased by $1,747,353
and $3,197,843 during the years ended June 30, 1997, and 1996, respectively.

                                      -40-
<PAGE>
 
Reconciliation of the U.S. Federal statutory rate to the Company's effective tax
rate for each fiscal year is as follows:

<TABLE>
<CAPTION>
                                                        1997    1996    1995
                                                        -----   -----   -----
<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>

At June 30, 1997, the Company had net operating loss carryforwards for federal
income tax purposes of approximately $26,845,000 which expire beginning in 2009.
The Company also has research and experimentation credit carryforwards for
federal income tax purposes of approximately $841,000 which expire beginning in
2009 and alternative minimum tax credit carryforwards of approximately $71,000.

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

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

On January 10, 1997, the Company completed the first closing of a private
placement of its 1997 Series A Convertible Preferred Stock ("Preferred Stock")
and Stock Purchase Warrants ("Warrants") with Credit Suisse First Boston
Corporation, Capital Ventures International and Zanett Lombardier, Ltd. (the
"Investors"), at an aggregate price of $5,000,000.  At such time, the Investors
agreed to purchase at a second closing, on or before October 31, 1997,
additional shares of Preferred Stock and Warrants at an aggregate price of
$2,500,000, subject to reduction to the extent that the total number of shares
of Common Stock underlying the Preferred Stock and Warrants issued at the first
closing and issuable at the second closing exceeds 15% of the outstanding shares
of Common Stock on January 10, 1997 (i.e., 724,219 shares).  The second closing
is subject to certain conditions, including the collection by the Company of at
least $2 million in any three month period before October 15, 1997, on account
of revenues from its Be There! products.  The Company does not currently
anticipate satisfying such conditions.  The Company has used and intends to use
the proceeds from the sale of the Preferred Stock and Warrants for the
development and launch of new products, including the Company's Be There!
products, and for working capital.

The Preferred Stock bears no dividends, is non-voting except in limited
circumstances, has senior rights in liquidation, and is redeemable at the option
of the holders in limited circumstances upon the Company's breach of certain
covenants imposed by the Preferred Stock.  The Preferred Stock is convertible
into Common Stock at the option of each holder beginning April 10, 1997, at a
percentage of the then prevailing average market price (as defined in the
Statement of Designation establishing the Preferred Stock) of the Common Stock
equal initially to 85%, decreasing on July 9, 1997 to 80%, and decreasing on
January 5, 1998, to the lower of 75% or the average price (as defined in the
Statement of Designation) of the Common Stock on the first anniversary of the
first closing.  Upon conversions after the first anniversary, in certain
circumstances the holders will receive a premium on the 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.  Any
Preferred Stock outstanding on January 10, 1999, will convert automatically into
Common Stock.  Pursuant to regulations of the National Association of Securities
Dealers, in the absence of shareholder approval, the aggregate number of shares
of Common Stock issuable upon conversion of the Preferred Stock and exercise of
the Warrants may not exceed 19.99% of the outstanding shares of Common Stock on
January 10, 1997 (i.e., 965,925 shares); any Preferred Stock which may not be
converted because of such limitation must be redeemed by the Company in cash.

As of September 30, 1997, 4,195 shares of the initial 5,000 shares of the 1997
Series A Convertible Preferred Stock had been converted into 570,839 shares of
common stock.

The Warrants issued at the first closing are exercisable for an aggregate of
45,800 shares of Common Stock at a price of $16 3/8 per share through the third
anniversary of the date of issuance.  The Warrants to be issued at the second
closing are exercisable for an aggregate of 22,900 shares of Common Stock on
substantially the same terms.  The Warrants become exercisable in two equal
installments on July 10, 1997, and October 10, 

                                      -41-
<PAGE>
 
1997, but only in the same proportion which the number of shares of Preferred
Stock then outstanding bears to the number of shares of Preferred Stock
initially issued.

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

The Company has a 1985 Incentive Stock Option Plan, under which incentive stock
options were granted to full-time employees and 1988, 1994 and 1995 Stock Option
Plans, under which incentive stock options or non-qualified stock options may be
granted to employees, directors, consultants and advisors.  The exercise price
of options must be at least equal to the fair market value of the common shares
at the date of grant as determined by the Compensation Committee of the Board of
Directors.  As of June 30, 1997, total common shares reserved for issuance under
the 1985, 1988, 1994 and 1995 Plans were 13,507, 420,965, 240,000 and 489,000
respectively.  

In connection with the employment of a new corporate officer in April of 1995,
options to purchase 400,000 shares of common stock were granted at the market
price on the date of the grant ($9.625 per share).  All 400,000 options expire
on the tenth anniversary of employment with the Company.  The grant includes
150,000 and 50,000 options issued under the Company's 1994 Option Plan which
vest ratably over four and five years, respectively.  The remaining 200,000
shares were granted pursuant to a written compensation contract with the officer
by the Board of Directors and not pursuant to any of the Company's option plans.
These options vest on the ninth anniversary of the officer's employment.  The
agreement provides for accelerated vesting of the 200,000 options if the
Company's common stock price meets certain targeted prices ranging from $10.59
to $24.97 per share after the date of the grant.  During fiscal 1997, 190,000 of
these options vested.

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 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,
1997, June 30, 1996 and June 30, 1995, is as follows:

<TABLE>
<CAPTION>
                                     1997                  1996                   1995
                            --------------------   --------------------   --------------------
                                        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.................   1,066,716     $ 6.96   1,131,868      $7.58     701,761      $5.89
Granted..................     477,250      11.84     441,423       4.72     624,000       8.65
Exercised................     213,366       4.04     130,189       2.29     139,886       2.84
Expired..................      50,527       6.17     376,386       8.23      54,007       9.13
                            ---------   --------   ---------   --------   ---------   --------  
  Outstanding at                                                                          
      year-end...........   1,280,073     $ 9.23   1,066,716      $6.96   1,131,868      $7.58
                            =========   ========   =========   ========   =========   ======== 
                                                                                          
Options exercisable at                                                                    
 year end................     458,794     $ 8.46     311,832      $5.62     348,063      $4.76
Shares available for                                                                      
 future grant............      84,112          -     511,547          -      90,772          -
                                                              
</TABLE>                                                      

                                      -42-
<PAGE>
 
The following summarizes information regarding the Company's stock options
outstanding at June 30, 1997:

<TABLE>
<CAPTION>
                                                                 
       Range of                         Weighted Average      Weighted          Number          Weighted
       Exercise              Number         Remaining          Average      Exercisable at      Average
         Price            Outstanding   Contractual Life   Exercise Price    June 30 1997    Exercise Price
-----------------------   -----------   ----------------   --------------   --------------   --------------
                                                                                          
<S>                       <C>           <C>                <C>              <C>              <C>                 
$    4.00  -  $    5.50      293,321              6.8          $  4.53          101,606          $  4.56
     6.00  -       8.75      272,775              8.6             7.54           48,525             7.40
     9.25  -      13.00      495,477              7.9             9.99          308,663             9.91
    13.88  -      18.50      218,500              9.6            15.82                -                -
---------     ---------    ---------            -----          -------          -------          ------- 
$    4.00     $   18.50    1,280,073              8.1          $  9.21          458,794          $  8.46
=========     =========    =========            =====          =======          =======          ======= 
</TABLE>

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 income (loss) and
income (loss) per share would have been reduced to pro forma amounts indicated
below for the years ended June 30, 1997 and 1996:

<TABLE>
<CAPTION>
                                                      1997            1996
                                                  ------------    -------------
<S>                           <C>                 <C>              <C>
Net income (loss)             As Reported         $(8,354,738)     $(8,318,827)
                              Pro Forma            (9,340,744)      (8,561,423)
 
Net income (loss) per share   As Reported         $     (1.71)     $     (1.77)
                              Pro Forma                 (1.92)           (1.83)
</TABLE>

The per share weighted average value of stock options issued by the Company
during fiscal 1997 and 1996 was $7.27 and $3.09, respectively, on the date of
grant using the Black-Scholes option-pricing model. The Black-Scholes option
valuation model was developed for use in estimating the fair value of traded
options that have no vesting restrictions and are fully transferable. In
addition, option valuation models require the input of highly subjective
assumptions, including the expected stock price volatility. Because the
Company's options have characteristics significantly different from those of
traded options, and because changes in the subjective input assumptions can
materially affect the fair value estimate, in the opinion of management, the
existing models do not provide a reliable single measure of the fair value of
its options. The Company used the following weighted-average assumptions to
determine the fair value of stock options granted for the fiscal years ended
June 30, 1997 and 1996:

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

Pro forma net income (loss) reflects only options granted in 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 income
(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.

                                      -43-
<PAGE>
 
7) COMMITMENTS
--------------

In April 1996, the Company moved to its new facilities consisting 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 $303,378, $560,596, and
$544,025 in fiscal 1997, 1996 and 1995, respectively.

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

<TABLE>
<CAPTION>
        Fiscal Year               Amount
        ------------------      ----------
<S>                             <C>       
        1998                    $  298,936
        1999                       296,966
        2000                       283,006
        2001                       285,286
        2002                       294,093
        Thereafter                 565,059
                                ---------- 
                                $2,023,346
                                ========== 
</TABLE>

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

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

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

9) 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 $51,433 in fiscal 1997, $56,477 in
fiscal 1996, and $16,207 in fiscal 1995.  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,
60,722 shares have been purchased as of June 30, 1997.

The Company is self-insured for occupational injury and illness benefits 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 of $60,000 at June
30, 1997 is adequate to cover these claims.

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.

The Company provides Group Life Insurance and Accidental Death & Dismemberment
(AD&D) for full-time employees.  The life insurance benefit is equal to the
employee's annual salary up to $150,000 and the AD&D benefit is a variable
percentage of the employee's annual salary.

                                      -44-

<PAGE>
 
10) QUARTERLY RESULTS
--------------------

The following table presents unaudited quarterly operating results for the
Company for fiscal 1997 and 1996.  This information has been prepared by the
Company on a basis consistent with the Company's audited financial statements
and includes all adjustments that the Company considers necessary for a fair
presentation in accordance with generally accepted accounting principles. Such
quarterly results are not necessarily indicative of future results of
operations.

The quarterly operating results may vary significantly depending upon such
factors as the timing of new product releases by the Company and its
competitors, the volume of sales and the mix of products sold and the level of
the Company's operating expenses.

<TABLE>
<CAPTION>
                                                                   Quarters Ended (unaudited)
                                    ----------------------------------------------------------------------------------------
                                    June 30,   Mar. 31,   Dec. 31,   Sept. 30,   June 30,   Mar. 31,   Dec. 31,   Sept. 30,
                                      1997       1997       1996        1996       1996       1996       1995        1995
                                  -----------------------------------------------------------------------------------------
<S>                                 <C>        <C>        <C>        <C>         <C>        <C>        <C>        <C>
                                                             (in thousands, except per share data)
 
Total revenue.....................   $ 3,517    $ 3,903    $ 4,425     $ 7,943    $ 3,053    $ 2,026    $ 6,580     $ 5,573
Cost of revenue...................     2,159      2,713      3,174       6,516      3,313      1,301      4,865       4,360
                                     --------------------------------------------------------------------------------------
 
  Gross profit (loss).............     1,358      1,190      1,251       1,427       (260)       725      1,715       1,213
 
Operating expenses:
  Engineering and product
   development....................     1,259      1,198      1,210       1,215      1,403      1,255      1,260         866
 
  Sales and marketing.............     1,148      1,330        744         934      1,140      1,058        932         951
  General and administrative......       720        612        646         703      1,163        741        687         642
                                     --------------------------------------------------------------------------------------
 
    Total operating expenses......     3,127      3,140      2,600       2,852      3,706      3,054      2,879       2,459
                                     --------------------------------------------------------------------------------------
 
Operating income (loss)...........    (1,769)    (1,950)    (1,349)     (1,425)    (3,966)    (2,329)    (1,164)     (1,246)
Other income, net.................        61         68         28          44         83        124         80          99
                                     --------------------------------------------------------------------------------------
 
Net income (loss).................   $(1,708)   $(1,882)   $(1,321)    $(1,381)   $(3,883)   $(2,205)   $(1,084)    $(1,147)
                                     --------------------------------------------------------------------------------------
 
Per Share Data
Net Income (loss).................   $(1,708)   $(1,882)   $(1,321)    $(1,381)   $(3,883)   $(2,205)   $(1,084)    $(1,147)
Effect of Beneficial Conversion
 Feature of Convertible Preferred
 Stock............................      (608)    (1,455)         -           -          -          -          -           -
 
 
Net Income (loss) Applicable to
 Common Stock.....................   $(2,316)   $(3,337)   $(1,321)    $(1,381)   $(3,883)   $(2,205)   $(1,084)    $(1,147)
                                     -------------------------------------------------------------------------------------- 
 
Earnings (loss) per share.........   $ (0.46)   $ (0.68)   $ (0.27)    $ (0.29)   $ (0.82)   $ (0.47)   $ (0.23)    $ (0.25)
                                     --------------------------------------------------------------------------------------
 
Weighted average shares
 outstanding......................     5,040      4,893      4,806       4,754      4,724      4,698      4,671       4,661
                                     --------------------------------------------------------------------------------------
</TABLE>

                                      -45-
<PAGE>
 
ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
---------------------------------------------------------
         ACCOUNTING AND FINANCIAL DISCLOSURE
         -----------------------------------

Not applicable.

                                      -46-
<PAGE>
 
                                   PART III

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

The following table sets forth certain information concerning the directors and
executive officers of the Company:

NAME                    AGE  POSITION WITH COMPANY
----                    ---  ---------------------

W. B. Barker             50  President and Chief Executive Officer, Director
Walter D. Warren         61  Senior Vice President-Operations
Gregory T. Skalla        42  Vice President-Finance, Chief Financial Officer,
                             Treasurer and Secretary
Haig A. Sarkissian       36  Vice President-Sales and Marketing-OEM Products
Gregory A. Williamson    47  Vice President-Human Resources
Curtis C. Fisher         52  Vice President-Sales and Marketing
Paul Demko Jr.           53  Vice President-Development
Jeffrey P. Blanchard     44  Chairman of the Board of Directors
Matthew A. Kenny         63  Director
George R. Grumbles       64  Director
Marcelo A. Gumucio       60  Director
Dwight E. Lee            50  Director
Edward A. Masi           50  Director

W. B. Barker has served as President and Chief Executive Officer since April
1995 and as a Director since May 1995. Prior to joining DATA RACE, Dr. Barker
was employed for 26 years by Bolt Beranek and Newman Inc. ("BBN"). At BBN, he
served in a variety of technical and management capacities, including Senior
Vice President, Chief Technology Officer, founder and President of LightStream
Corporation, an ATM switch company, and was responsible for the acquisition of
regional Internet service providers. While employed by BBN, he held general
management positions and was President of several subsidiaries, where he was
directly responsible for product strategies, development, marketing and
manufacturing for many communications and multiprocessor products. He holds a
Ph.D., MS, and BA degrees from Harvard University.

Walter D. Warren has served as Senior Vice President-Operations since June 1993.
Prior to joining DATA RACE, Mr. Warren served as Senior Vice President of
Technical Operations at Kinetic Concepts, a San Antonio-based manufacturer and
distributor of therapeutic hospital beds.

Gregory T. Skalla has served as Vice President-Finance, Chief Financial Officer
of DATA RACE and corporate Secretary and Treasurer since February 1995. Mr.
Skalla has been employed by DATA RACE since 1992 when he joined the Company as
Controller. From 1987 to 1992, Mr. Skalla was Chief Financial Officer of Mil-Com
Electronics Corporation in San Antonio, Texas.

Haig A. Sarkissian has served as Vice President-Sales and Marketing-OEM Products
since August 1995. From 1990 until that time, Mr. Sarkissian was employed by
AT&T Microelectronics as Manager, World Wide Marketing, DSP Modem Products.
Prior to his tenure at AT&T, Mr. Sarkissian was the field applications manager
at Standard Microsystems Corporation.

Gregory A. Williamson was appointed Vice President-Human Resources in October
1996. Mr. Williamson has been employed by DATA RACE since September 1995 when he
joined the Company as Director-Human Resources. From 1978 to 1995, Mr.
Williamson served in a variety of technical, management and

                                      -47-
<PAGE>
 
administrative positions including Corporate Manager-Benefits with
SBC Communications Inc., a publicly held telecommunications company.

Curtis C. Fisher joined DATA RACE as Vice President-Sales and Marketing in
January 1997.  During 1996, Mr. Fisher was Vice President of the channels
management group at Access Graphics, Inc.  He also was Vice President of
worldwide partnership marketing at AT&T-Global Information Solutions from 1994
to 1996.  Prior to this, Mr. Fisher was the director of channels marketing at
Sun Microsystems from 1988 to 1994.

Dr. Paul Demko Jr. joined the Company as Vice President-Development.  During
1996, Dr. Demko served as Vice President-Product Development at Process Software
Corp.  Prior to this, Dr. Demko held executive management positions at
Centerline Software, Inc. (1995-1996), Proteon, Inc. (1992-1995), and Wang
Laboratories, Inc. (1982-1992)  He holds a Ph.D., M.S. and B.S. in electrical
engineering from the Massachusetts Institute of Technology where, in the mid-
1970s, he worked with the pioneers in voice coding developing linear predictive
and channel vocoders.

Jeffrey P. Blanchard has served as a Director of the Company since August 1985
and as Chairman of the Board of Directors since October 1996. Mr. Blanchard has
been the Managing General Partner of First Capital Group of Texas, Ltd. since
January 1984. Since September 1995, Mr. Blanchard has been the Managing General
Partner of First Capital Group of Texas II, L.P., an investment firm which
provides private equity to middle-market companies throughout the Southwest
United States. From January 1989 to December 1994, Mr. Blanchard served as Vice
President and Investment Manager of Victoria Capital Corporation, a venture
capital investment company.

Matthew A. Kenny was elected to the Board of Directors in February 1995. From
1984 until 1989, Mr. Kenny was  President and CEO of RACAL-MILGO, a company with
revenues in excess of $300 million.  Mr. Kenny joined Milgo in 1968. From 1989
to 1993, Mr. Kenny was Chairman of the Board and CEO of Physical Health Devices,
Inc.  From 1989 to the present he has been a managing partner in Venture
Solutions, and since 1994 he has been President and CEO of Core Technology
Development, Inc., Fort Lauderdale, Florida.

George R. Grumbles was appointed to the Board of Directors in February 1995.
From 1985 until his retirement in 1993, Mr. Grumbles served as a corporate Vice
President of Motorola and the President and CEO of Universal Data Systems which
he joined in 1972.

Marcelo A. Gumucio was elected to the Board of Directors in December 1995. From
April 1996 until recently, Mr. Gumucio served as Chief Executive Officer of
Micro Focus, Palo Alto, California. From November 1992 until joining Micro
Focus, Mr. Gumucio served as President and Chief Executive Officer of Memorex
Telex N.V., a publicly-held multinational computer company based in Amsterdam,
The Netherlands. Prior to joining Memorex Telex, Mr. Gumucio founded and led,
from August 1990 to November 1992, Gumucio, Burke and Associates, a private
investment firm in Minneapolis, Minnesota. From July 1983 to August 1990, Mr.
Gumucio held various positions, including President, Chief Executive Officer,
and Director, with Cray Research, Inc., a publicly-held manufacturer of
supercomputers.

Dwight E. Lee appointed to the Board of Directors in January 1997.  Since
October 1981, Mr. Lee has served as a managing partner of Barker, Lee & Company,
a New York City-based investment management firm.  Mr. Lee was nominated for
election because of his extensive background in the investment community, and
brings significant board experience with both public and private companies.

Edward Masi was appointed to the Board of Directors in May 1997. Mr. Masi is a
veteran of the computer industry and is well-known in the high performance
computing market. From 1992 until recently, Mr. Masi was a corporate Vice
President at Intel Corporation. Prior to joining Intel, Mr. Masi worked for Cray
Research from 1980 to 1992, ultimately holding the position of Executive Vice
President of Sales, Marketing and Service. Mr. Masi began his career in 1969 at
IBM, where he held various sales and marketing positions over the course of
eleven years.

                                      -48-
<PAGE>
 
All directors serve for a term of one year and until their successors are duly
elected, subject to earlier resignation or removal.  Outside directors are
entitled to receive automatic and other awards of options under the Company's
most recently adopted stock option plan.  Outside directors are also reimbursed
for their out-of-pocket expenses involved in connection with their service as
directors.  The Board of Directors met six times during fiscal 1997. Each
director attended a majority of the Board meetings held during the period for
which he was a director during fiscal year 1997.

Committees of the Board of Directors

The Board of Directors has two committees: The Audit Committee and the
Compensation Committee.  The Audit Committee, composed of Messrs. Blanchard,
Grumbles and Kenny, is responsible for reviewing the Company's financial
statements and overseeing the Company's accounting practices and audit
procedure.  The Compensation Committee, composed of Messrs. Blanchard
(Chairman), Gumucio, and Grumbles, reviews and makes recommendations to the
Board of Directors regarding executive compensation levels and administers the
Company's stock option and stock purchase plans.  The Audit Committee met once
during fiscal 1997, and the Compensation Committee met seven times in the same
period.


SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE

Section 16(a) of the Securities Exchange Act of 1934, as amended, requires
directors, executive officers, and beneficial owners of more than 10% of any
class of securities of the Company to file certain forms regarding such persons'
ownership of equity securities of the Company. Based on Company records and
other information, the Company believes that its executive officers and
directors complied with all these filing requirements with respect to the fiscal
year ended June 30, 1996, except that two reports covering two transactions were
filed late by Jeffrey P. Blanchard, one report covering two transactions was
filed late by Haig A. Sarkissian, and one initial report of ownership was filed
late by Curtis C. Fisher and Paul J. Demko, Jr.


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

Summary Compensation Table. The Summary Compensation Table shows certain
compensation information for the fiscal years ended June 30, 1997, 1996 and
1995, for the Chief Executive Officer and each of the other three most highly
compensated executive officers during fiscal year 1997 (hereinafter referred to
as the "named executive officers").

                                      -49-
<PAGE>
 
<TABLE>
<CAPTION>
                                                    SUMMARY COMPENSATION TABLE

                                             Annual Compensation           
                                             -------------------         Long-Term   
                                                                        Compensation 
                                                                           Awards
                                                                          
                                                                         Securities
                                                Base                     Underlying         All Other  
                                     Year     Salary ($)    Bonus ($)    Options (#)     Compensation ($)
                                   --------  -----------    ---------    -----------     ----------------
<S>                                <C>       <C>            <C>          <C>             <C>
W. B. Barker.....................      1997    $ 188,125          -         30,000            $3,822(1)
President and CEO                      1996      175,000    $39,712(2)           -             8,500(3)
                                       1995       31,859     11,192(2)     400,000                 -
                                                                                              
Walter D. Warren.................      1997      137,500          -         20,000             2,625(1)
Senior Vice President-Operations       1996      125,000          -         61,346(4)          1,250(1)
                                       1995      125,000     31,250         25,000             1,138(1)
                                                                                              
Gregory T. Skalla................      1997      112,500          -         25,000             2,063(1)
Vice President-Finance, Chief          1996       92,331          -              -             2,506(1)
 Financial Officer, Secretary          1995       69,350     10,000         34,000               722(1)
 and Treasurer
 
Haig A. Sarkissian...............      1997       75,000     91,989          25,000            1,553(1)
Vice President-OEM Sales and           1996       69,038     84,431(5)       50,000(6)         1,138(1)
 Marketing

</TABLE>

_____________

(1)  Represents contributions made by the Company under the Company's 401(k)
     plan.
(2)  Represents guaranteed bonus pursuant to Mr. Barker's employment agreement.
(3)  Represents reimbursement of relocation expenses.
(4)  Effective November 28, 1995, Mr. Warren elected to reprice 81,797 stock
     options pursuant to a repricing plan adopted by the Company's Board of
     Directors.  In connection with such repricing, 81,797 of Mr. Warren's
     existing stock options were canceled and 61,346 stock options were granted
     in their place.
(5)  Represents a $30,000 signing bonus and $54,431 in sales commissions earned
     during the year.
(6)  Represents 50,000 options granted as a signing bonus.

Director Compensation. Matthew Kenny, George Grumbles, Marcelo Gumucio, Dwight
E. Lee, and Edward A. Masi each receive compensation of $1,000 for each Board of
Directors meeting attended. Outside directors are entitled to receive options
under the Company's stock option plans and are automatically granted options
under the Company's latest stock option plan. Outside directors are reimbursed
for their out-of-pocket expenses involved in connection with their services as
directors. Outside directors also receive consulting fees for services rendered
from time to time to the Company. In fiscal year 1997, no such person received
in excess of $60,000 for such services.

Employment Agreements. Dr. W. B. Barker entered into an employment agreement
with the Company on April 25, 1995. Pursuant to such agreement, Dr. Barker
receives an annual base salary of not less than $175,000. Dr. Barker is eligible
to receive an incentive bonus, pursuant to the Company's management incentive
program, of up to 50% of his base salary. Pursuant to the agreement, if Dr.
Barker is terminated without cause he may elect to receive severance pay equal
to one year's base salary, paid in monthly installments. During the period in
which such severance payments are made, Dr. Barker is prohibited from competing
directly with the Company.

                                      -50-
<PAGE>
 
Stock Option Grant Table. The following table sets forth certain information
concerning options granted to the named executive officers during the Company's
fiscal year ended June 30, 1997:

<TABLE>
<CAPTION>
                                           OPTION GRANTS IN LAST FISCAL YEAR
                                                        
                                                                                                                       
                                   Percent of                                                                 
                      Number of       Total                                 Potential Realizable Value at  
                       Shares        Options                                Assumed Annual Rates of Stock  
                     Underlying    Granted to    Exercise or                Price Appreciation for Option  
                       Options    Employees in    Base Price   Expiration             Term(1)              
        Name           Granted    Fiscal Year      ($/Sh)         Date         5%($)             10%($) 
        ----         ----------   ------------   -----------   ----------   -----------------------------
<S>                  <C>          <C>            <C>            <C>         <C>                <C> 
W. B. Barker           30,000        8.4%          $7.625       09/26/06       $143,861        $364,559
                                                                            
Walter D. Warren       20,000        5.6%           7.625       09/26/06         95,907         243,039
                                                                            
Gregory T. Skalla      25,000        7.0%           7.625       09/26/06        119,884         303,799
                                                                            
Haig A. Sarkissian     25,000        7.0%           7.625       09/26/06        119,884         303,799

</TABLE>

_____________

(1)  As required by rules of the SEC, potential values stated are based on the
     assumption that the Company's Common Stock will appreciate in value from
     the date of the grant to the end of the option term (ten years from the
     date of grant) at annualized rates of 5% and 10% (total appreciation of
     approximately 63% and 159%), respectively, and therefore are not intended
     to forecast possible future appreciation, if any, in the price of the
     Common Stock.  The exercise price of each option equals the fair market
     value of the Common Stock on the grant date.

Stock Option Exercises and Holdings Table.  The following table shows stock
options exercised by the named executive officers during the fiscal year ended
June 30, 1997, including the aggregate value of gains on the date of exercise.
In addition, the table includes the number of shares covered by both exercisable
and non-exercisable stock options as of June 30, 1997.  Also reported are the
values of "in-the-money" options which represent the positive spread between the
exercise price of any such existing stock options and the Common Stock price as
of June 30, 1997.

                AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR
                       AND FISCAL YEAR END OPTION VALUES
                                        
<TABLE>
<CAPTION>
                                                           Number of                Value of Unexercised
                        Shares                        Unexercised Options      In-the-Money Options at Fiscal
                     Acquired  on      Value        at Fiscal Year-End (#)              Year-End ($)
      Name           Exercise (#)   Realized ($)   Exercisable/Unexercisable    Exercisable/Unexercisable(1)
      ----           ------------   ------------   -------------------------   ------------------------------
<S>                  <C>            <C>            <C>                          <C>
W. B. Barker              10,000       $ 30,000          265,000 / 145,000             $828,125 / $513,155
Walter D. Warren               -              -           61,696 / 46,915               371,164 / 270,379
Gregory T. Skalla              -              -           27,500 / 43,750               168,815 / 254,861
Haig A. Sarkissian        12,500        112,500                0 / 62,500                     0 / 451,563

</TABLE>
_____________

                                      -51-
<PAGE>
 
(1)  Values stated are based on the last sale price of $12.75 per share of the
     Company's Common Stock on June 30, 1997, the last trading day of the fiscal
     year, and equal the aggregate amount by which the market value of the
     option shares exceeds the exercise price of such options at the end of the
     fiscal year.

Compensation Committee Interlocks and Insider Participation. During the fiscal
year ended June 30, 1997, Messrs. Blanchard, Grumbles (since December 1996),
Kenny (until December 1996), and Gumucio served on the Company's Compensation
Committee.

                                      -52-
<PAGE>
 
ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
-------------------------------------------------------------------------


The following table sets forth certain information regarding the ownership of
Common Stock as of September 30, 1997, by (i) each person known by the Company
to be the beneficial owner of more than 5% of the outstanding Common Stock; (ii)
each director; (iii) each named executive officer and (iv) all executive
officers and directors as a group. Unless otherwise noted, each shareholder has
sole voting and investment power with respect to the shares beneficially owned.
Options included in the following table represent options currently exercisable
or exercisable within 60 days of September 30, 1997.

<TABLE>
<CAPTION>
 
 
 
                                                                           Number of     Percent of Stock
                                 Name                                       Shares         Outstanding
                                 ----                                      ---------     ----------------
<S>                                                                        <C>           <C>
W. B. Barker...........................................................   301,677(1)         5.20%
Jeffrey P. Blanchard...................................................    37,115(2)           *
George R. Grumbles.....................................................    13,000(3)           *
Marcelo A. Gumucio.....................................................     7,500(4)           *
Matthew A. Kenny.......................................................    13,000(5)           *
Dwight E. Lee..........................................................    18,500(6)           *
Edward A. Masi.........................................................         -              *
Walter D. Warren.......................................................    83,977(7)         1.49%
Gregory T. Skalla......................................................    35,400(8)           *
Haig A. Sarkissian.....................................................    28,298(9)           *
Charles D. Axelrod(10)(11).............................................   690,550           12.46%
All Directors and Executive Officers as a Group (13 persons)...........   548,588(12)        9.16%

</TABLE>

_____________

*Less than 1%.

(1)  Includes 265,000 shares subject to options held by Dr. Barker.
(2)  Includes 10,000 shares subject to options held by Mr. Blanchard.
(3)  Includes 13,000 shares subject to options held by Mr. Grumbles.
(4)  Includes 7,500 shares subject to options held by Mr. Gumucio.
(5)  Includes 13,000 shares subject to options held by Mr. Kenny.
(6)  Includes 10,000 shares subject to options held by Mr. Lee.
(7)  Includes 76,931 shares subject to options held by Mr. Warren.
(8)  Includes 29,250 shares subject to options held by Mr. Skalla.
(9)  Includes 12,500 shares subject to options held by Mr. Sarkissian.
(10) Mr. Axelrod owns shares solely in his capacity as trustee for the
     liquidation of the business of W.S. Clearing, Inc., a California
     corporation, pursuant to court orders under the Securities Investor
     Protection Act.
(11) Address: 500 North Brand Boulevard, Suite 1225, Glendale, California
     91203.
(12) Includes 445,931 shares subject to options held by such persons.

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

     None.

                                      -53-
<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, 1997 and 1996

          Statements of Operations for the fiscal years ended June 30, 1997,
          1996 and 1995

          Statements of Shareholders' Equity for the fiscal years ended June 30,
          1997, 1996 and 1995

          Statements of Cash Flows for the fiscal years ended June 30, 1997,
          1996 and 1995

          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     Statement of Establishment of Series A Convertible Preferred Stock of
          the Company, filed December 27, 1991. (a)

  3.3     Statement of Establishment of Series B Convertible Preferred Stock of
          the Company, filed December 31, 1991. (a)

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

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

  3.6     Bylaws of the Company. (a)

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

  3.8     Amendments to Bylaws of the Company. (b)

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

  4.1     Specimen Common Stock Certificate. (a)

 10.1*    Description of Executive Bonus Plan. (a)

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

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

                                      -54-
<PAGE>
 
 10.4*    401(k) Profit Sharing Plan, effective March 1, 1992. (a)

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

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

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

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

 10.9*    1994 Stock Option Plan. (e)

 10.10*   1995 Stock Option Plan. (f)

 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)

 10.13    Security and Loan Agreement, dated November 12, 1996, between the
          Company and Imperial Bank. (b)

 10.14    General Security Agreement, dated November 12, 1996, between the
          Company and Imperial Bank. (b)

 10.15    Credit Terms and Conditions, dated November 12, 1996, between the
          Company and Imperial Bank. (b)

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

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

 10.18    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 Lombardier, Ltd. (b)

 23.1     Consent of KPMG Peat Marwick LLP (g)

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

___________________

(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.

                                      -55-
<PAGE>
 
(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 herewith.

*   Management contract or compensatory plan, contract or arrangement

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

    No reports on Form 8-K were filed during the last quarter of the period
    covered by this report

                                      -56-
<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

                                        Date:  October 13, 1997

          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.

        NAME                          TITLE                          DATE
        ----                          -----                          ----

/s/ W. B. BARKER              President, Chief Executive       October 13, 1997
------------------------      Officer and Director
W. B. Barker

/s/ GREGORY T. SKALLA         Vice President-Finance,          October 13, 1997
------------------------      Chief Financial Officer,
Gregory T. Skalla             Treasurer and Secretary 
                              (Principal Financial and
                              Accounting Officer)
 
/s/ JEFFREY P. BLANCHARD      Chairman of the Board            October 13, 1997
------------------------      of Directors
Jeffrey P. Blanchard

/s/ GEORGE R. GRUMBLES        Director                         October 13, 1997
------------------------
George R. Grumbles

/s/ MARCELO A. GUMUCIO        Director                         October 13, 1997
------------------------
Marcelo A. Gumucio

/s/ MATTHEW A. KENNY          Director                         October 13, 1997
------------------------
Matthew A. Kenny

/s/ DWIGHT E. LEE             Director                         October 13, 1997
------------------------
Dwight E. Lee

/s/ EDWARD A. MASI            Director                         October 13, 1997
------------------------
Edward A. Masi

                              

                                      -57-