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                                   UNITED STATES
                         SECURITIES AND EXCHANGE COMMISSION
                               WASHINGTON, D.C. 20549
   
                                 ----------------
   
                                      FORM 8-K
   
                                   CURRENT REPORT
   
       Pursuant to Section 13 or 15(d) of The Securities Exchange Act of 1934
   
           Date of Report (Date of earliest event reported) July 27, 1998
   
                               SOFTNET SYSTEMS, INC.
               (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
   
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          NEW YORK                     1-5270                  11-1817252
       (STATE OR OTHER        (COMMISSION FILE NUMBER)        (IRS EMPLOYER
       JURISDICTION OF                                    IDENTIFICATION  NO.)
       INCORPORATION)
   
  520 LOGUE AVENUE, MOUNTAIN VIEW, CA                             94043
   (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)                    (ZIP CODE)
   
                                 ----------------
   
         Registrant's telephone number, including area code (650) 962-7470
   
           (Former name or former address, if changed since last report.)
  <PAGE>
   
  ITEM 5: OTHER EVENTS.
   
    SoftNet Systems, Inc. (the "Company") has announced the adoption of a Cable
  Affiliates Incentive Program to provide incentives to the Company's cable
  affiliates to launch the Company's ISP Channel Internet service. Under this
  program, the Company will offer to pay incentive bonuses to cable affiliates
  in cash or shares of its Common Stock based on the number of cable subscribers
  covered by cable systems that enter into exclusive arrangements with the ISP
  Channel. The amount of these incentive bonuses will depend on a variety of
  factors, including the size of the covered systems and the length of
  exclusivity of the contract. The Company has reserved up to 19.9% of its
  outstanding shares of Common Stock, totaling approximately 1.6 millions
  shares, for issuance under this program.
   
    The Company has also determined to account for its Telecommunications
  Division as a discontinued operation. The Company expects to dispose of this
  division within the next 12 months, though no assurance can be made that it
  will be able to do so. The Company's management does not anticipate a loss on
  the sale and intends to use the sales proceeds to reduce outstanding
  indebtedness and provide additional working capital for its other businesses.
  Included with this Current Report on Form 8-K are revised versions of the
  Company's Summary Consolidated Financial Data, Selected Consolidated
  Historical Financial Data, Consolidated Financial Statements, and Management's
  Discussion and Analysis of Financial Condition and Results of Operations,
  reflecting the accounting impact of treating the Telecommunications Division
  and as a discontinued operation.
   
    In addition, as the Company has decided to focus its efforts on its other
  businesses, particularly the expansion of its Internet Services Division, the
  Company has restated its Risk Factors disclosure to reflect this revised
  focus. A copy of this revised disclosure is attached to this report.
   
  ITEM 7: EXHIBITS
   
      23 Consent of PricewaterhouseCoopers L.L.P.
   
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                                   RISK FACTORS
   
    These risk factors include "forward-looking" statements within the meaning
  of Section 27A of the Securities Act and Section 21E of the Exchange Act.
  Although the Company believes that its plans, intentions, and expectations
  reflected in such forward-looking statements are reasonable, it can give no
  assurance that such plans, intentions or expectations will be achieved. Actual
  results will differ from such plans, intentions and expectations, and such
  differences may be material. Important factors that could cause actual results
  to differ materially from the Company's forward-looking statements are set
  forth below. All forward-looking statements attributable to the Company or
  persons acting on its behalf are expressly qualified in their entirety by the
  cautionary statements set forth herein. The Company disclaims any obligation
  to update information contained in any forward-looking statement.
   
  LIMITED OPERATING HISTORY OF THE INTERNET SERVICES DIVISION; UNPROVEN
  BUSINESS; HISTORICAL LOSSES; NO ASSURANCE OF PROFITABILITY
   
    The Company currently operates two continuing businesses: Micrographic
  Technology Corporation ("MTC") and the Internet Services Division. The Company
  is seeking a buyer for the Telecommunications Division, which is accounted for
  as a discontinued operation. The Company's current strategy for growth is to
  focus on substantially expanding the business of its Internet Services
  Division, which was acquired in June 1996. The Company has very limited
  operating history and experience in the Internet services business, and the
  successful expansion of the Company's Internet Services Division will require
  strategies and operations that are different from those historically employed
  by the Company in connection with its two other businesses. There can be no
  assurance that the Company will be able to develop or maintain strategies and
  business operations that are necessary to increase the revenues of the
  Company's Internet Services Division sufficiently to enable it to achieve
  positive cash flow and profitability.
   
    To be successful, the Company must, among other things, develop and market
  products and services that are widely accepted by consumers and businesses at
  prices that will yield cash flow sufficient to meet the Company's debt
  service, capital expenditure and working capital requirements. The provision
  of Internet services over cable infrastructure has only recently become
  feasible on a broad scale. There are only a very limited number of companies
  offering such services, none of which is currently profitable. The Company's
  ISP Channel service has only recently been launched in seven cable franchise
  areas (all of which have revenue-paying subscribers) in the United States, and
  there can be no assurance that it will achieve broad consumer or commercial
  acceptance. The success of the Company's ISP Channel service will depend upon
  the willingness of subscribers to pay the monthly fees and installation costs
  as well as to purchase or lease the equipment necessary to access the
  Internet. Currently, the Company has only approximately 500 subscribers to its
  ISP Channel service in these areas. Accordingly, it is difficult to predict
  whether the Company's pricing model will prove to be viable, whether demand
  for the Company's services will materialize at the prices it expects to charge
  or whether current or future pricing levels will be sustainable. If such
  pricing levels are not achieved or sustained or if the Company's services do
  not achieve or sustain broad market acceptance, the Company's business,
  financial condition, prospects and ability to repay its indebtedness will be
  materially adversely affected.
   
    The Company has sustained substantial losses over the last five fiscal
  years. For the six months ended March 31, 1998 and the fiscal year ended
  September 31, 1997, the Company had net losses of $3.7 million and $2.6
  million, respectively, and as of March 31, 1998, the Company had an
  accumulated stockholders' deficit of approximately $36 million. The Company
  expects to incur substantial losses and experience substantial negative cash
  flows as it expands its Internet Services Division. The costs of expansion
  will include expenses in connection with: (i) the deployment of infrastructure
  necessary to enable its cable affiliates to offer its services; (ii) research
  and development of new product and service offerings; (iii) the continued
  development of its direct and indirect selling and marketing efforts; and (iv)
  any charges related to acquisitions, divestitures, business alliances or
  changing technologies. The Company's prospects should also be considered in
  light of the risks, expenses and difficulties encountered by companies
  competing in new and rapidly evolving markets. There can be no assurance that
  the Company will ever achieve favorable operating results or profitability.
   
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  FLUCTUATIONS IN QUARTERLY RESULTS
   
    The Company's results of operations have fluctuated and will likely continue
  to fluctuate significantly from quarter to quarter, especially as the Company
  implements a new strategic focus that will emphasize its Internet Services
  Division. In addition, the Company is seeking a buyer for its
  Telecommunications Division. As a result, the Company believes that period-to-
  period comparisons of its revenues and results of operations are not
  necessarily meaningful and should not be relied upon as indicators of future
  performance. The Company's quarterly operating results may fluctuate
  significantly in the future as a result of a variety of factors, many of which
  are beyond the Company's control. Factors that may affect the Company's
  quarterly operating results attributable to its Internet Services Division
  include, among others, the rate at which the Company can enter into agreements
  with cable operators, the exclusivity and term of such agreements, the rate of
  subscription to the Company's Internet services, the prices subscribers pay
  for such services, subscriber churn rates, changes in the revenue sharing
  arrangements between the Company and its affiliated cable operators, the
  ability of the Company and its cable affiliates to coordinate timely and
  effective marketing, the success of the Company and its cable affiliates in
  marketing the ISP Channel service to subscribers in such affiliates' local
  cable areas, the quality of cable affiliates' cable infrastructure, the
  quality of customer and technical support, and the rate at which the cable
  affiliates can complete the installations required to initiate service for new
  subscribers. Additional factors that may affect the Company's quarterly
  operating results generally include the amount and timing of capital
  expenditures and other costs relating to the expansion of the Company's
  Internet Services Division, the introduction of new Internet services by the
  Company or its competitors, customer acceptance of such services, price
  competition or pricing changes in the Internet or cable industries, general
  economic conditions and economic conditions specific to the Internet and cable
  industries, and changes in law and regulation. See "Management's Discussion
  and Analysis of Financial Condition and Results of Operations."
   
    Factors that may affect the Company's quarterly operating results
  attributable to MTC include, among other things, the size and timing of
  customer orders and subsequent shipments, customer order deferrals in
  anticipation of new products and services, timing of product introductions or
  enhancements by the Company or its competitors, market acceptance of new
  products and services, technological changes in the industry, competitive
  pricing pressures, accuracy of customer forecasts of end-user demand, changes
  in the Company's operating expenses, personnel changes, changes in the mix of
  products sold, quality control of products sold, disruption in sources of
  supply, capital spending, delays of payments by customers and general economic
  conditions.
   
    The Company expects to continue to engage in extensive research and
  development activities and to evaluate new product and service opportunities.
  This will require the Company to continue to invest in research and
  development and sales and marketing, which could adversely affect short-term
  results of operations. The Company believes that its future revenue growth and
  profitability will depend in part on its success in developing new products
  and services. Failure to increase revenues from new products and services,
  whether due to lack of market acceptance, competition, technological change or
  otherwise, would have a material adverse effect on the Company's business,
  financial condition, prospects and ability to repay its indebtedness,
  including the Notes.
   
  SUBSTANTIAL LEVERAGE; ABILITY TO SERVICE INDEBTEDNESS
   
    The Company is in the process of placing an offering (the "Debt Offering")
  of approximately $150,000,000, or more, in Senior Notes ("Senior Notes"),
  although there can be no assurance that the Company will be able to complete
  such Debt Offering. In the event the Company is able to complete the Debt
  Offering, the Company would be highly leveraged. In addition, the indenture
  governing the Senior Notes would permit the Company and its subsidiaries to
  incur substantial additional indebtedness subject to certain restrictions. The
  degree to which the Company is leveraged could have important consequences to
  the Company and its securityholders, including, but not limited to, the
  following: (i) the Company's ability to obtain additional financing or
  refinancing in the future for working capital, capital expenditures, service
  development and enhancement, acquisitions, general corporate purposes or other
  purposes may be materially limited or impaired; (ii) the Company's cash flow,
  if any, may be unavailable for the Company's business as a substantial
   
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  portion of the Company's cash flow must be dedicated to the payment of
  principal and interest on its indebtedness; and (iii) the Company's high
  degree of leverage may make it more vulnerable to economic downturns, may
  limit its ability to withstand competitive pressures and may reduce its
  flexibility in responding to changing business and economic conditions.
   
    The Company expects that it will continue to generate substantial operating
  losses and negative cash flow for the next several years. No assurance can be
  given that the Company will be successful in developing and maintaining a
  level of cash flow from operations sufficient to permit it to pay the
  principal, premium, if any, and interest on its indebtedness. The ability of
  the Company to make scheduled payments with respect to indebtedness will
  depend upon, among other things: (i) the Company's ability to achieve
  significant and sustained growth in cash flow; (ii) the rate of successful
  commercial deployment of its Internet products and services; (iii) the market
  acceptance, customer demand, rate of utilization and pricing for the Company's
  products and services; (iv) future operating performance problems; (v) cable
  affiliates' ability to complete development, upgrades and enhancements of
  their cable infrastructure successfully; and (vi) economic, financial,
  competitive, regulatory, and other factors, many of which are beyond the
  Company's control. If the Company is unable to generate sufficient cash flow
  to service its indebtedness it may have to reduce or delay entering into
  affiliations with cable operators, deploying infrastructure and delivering its
  services to existing cable affiliates. Additionally, in such circumstances,
  the Company may have to restructure or refinance its indebtedness or seek
  additional equity capital. There can be no assurance that any of these
  strategies could be effected on satisfactory terms, if at all, in light of the
  Company's high leverage, or that any such strategy would yield sufficient
  proceeds to service and repay the Company's indebtedness. In the event of
  default under such indebtedness, certain holders of such indebtedness would
  have enforcement rights, including the right to accelerate such debt and the
  right to commence an involuntary bankruptcy proceeding against the Company.
   
  DEPENDENCE ON LOCAL CABLE OPERATORS AND THEIR CABLE INFRASTRUCTURE
   
    Certain ISP Channel services are dependent on the quality of the cable
  infrastructure. Cable system operators have announced and begun to implement
  major infrastructure investments in order to increase the capacity of their
  networks and deploy two-way capability. However, cable system operators have
  limited experience with implementing such upgrades, and these investments have
  placed a significant strain on the financial, managerial, operating and other
  resources of cable system operators, most of which are already significantly
  leveraged. Further, cable operators must periodically renew their franchises
  with city, county, or state governments and, as a condition of obtaining such
  renewal, may have to meet certain conditions imposed by the issuing
  jurisdiction, which may have the effect of causing the cable operator to delay
  such upgrades. The Company's contracts with its cable affiliates typically
  have terms ranging from three to five years, and there can be no assurance
  that the Company will be able to renew any such contracts. Moreover, even if
  cable affiliates renew such contracts, there can be no assurance that such
  renewal will be on terms satisfactory to the Company. In addition, cable
  operators are primarily concerned with increasing television programming
  capacity to compete with other modes of multichannel entertainment delivery
  systems such as direct broadcast satellite ("DBS") and may consequently choose
  to roll-out incompatible set-top boxes that do not support high-speed Internet
  access services, rather than to upgrade their network infrastructures as
  described above. Such upgrades thus have been, and the Company expects will
  continue to be, subject to change, delay or cancellation. The failure of cable
  operators to complete these upgrades in a timely and satisfactory manner, or
  at all, would adversely affect the market for the Company's products in any
  such operator's franchise area and, if repeated on a broad scale, could have a
  material adverse effect on the Company's business, financial condition,
  prospects and ability to repay its indebtedness.
   
    The Company provides Internet services to cable systems irrespective of
  their two-way capabilities. To the extent the Company provides Internet
  services over cable systems to the home with a telephone line return path for
  data from the home (under a "one-way" cable system), the Company's services
  may not provide the high speed, quality of experience and availability of
  certain applications, such as video conferencing, necessary to
   
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  attract and retain subscribers to the ISP Channel service. Subscribers using a
  telephone line return path will experience the upstream data transmission
  speeds provided by their analog modems (typically 28.8 Kbps). It is not clear
  what impact the lack of two-way capability will have on penetration levels for
  the ISP Channel.
   
    Because subscribers to the ISP Channel will subscribe through a cable
  affiliate, the cable affiliate (and not the Company) will substantially control
  the customer relationship with the subscriber. For example, under the Company's
  existing contracts, cable affiliates are responsible for important functions,
  such as billing for and collecting ISP Channel subscription fees and providing
  the labor and costs associated with the distribution of local marketing
  materials. Therefore, in addition to the Company's business being subject to
  general economic and market conditions and factors relating to Internet service
  providers and on-line services specifically, the success and future growth of
  the Company's business will also be subject to economic and other factors
  affecting its cable affiliates generally.
   
  DEPENDENCE ON EXCLUSIVE ACCESS TO CABLE SUBSCRIBERS; NEED FOR AGGRESSIVE
  IMPLEMENTATION AND DEPLOYMENT
   
    The success of the Company's Internet Services Division is dependent, in
  part, on its ability to gain exclusive access to cable consumers. This
  exclusivity is a function of cable operators' dominance within their geographic
  markets and the Company's exclusive relationship with such cable operators.
  There can be no assurance that cable operators affiliated with the Company will
  not face competition in the future or that the Company will be able to
  establish and maintain exclusive relationships with cable operators. Currently,
  a number of the Company's contracts with cable operators do not contain
  exclusivity provisions. Even if the Company is able to establish and maintain
  exclusive relationships with cable operators, there can be no assurance that
  the Company will be able to do so on terms favorable to the Company or in
  quantities to be profitable. In addition, the Company seeks to affiliate with a
  large number of cable operators as quickly as possible because it will be
  excluded from providing Internet over cable in those areas served by cable
  operators with exclusive arrangements with other Internet service providers. If
  the exclusive relationship between either the Company and its cable affiliates
  or its cable affiliates and their cable subscribers is impaired, or if the
  Company does not become affiliated with a sufficient number of cable operators,
  the Company's business, financial condition, prospects and ability to repay its
  indebtedness could be materially adversely affected.
   
  SUBSTANTIAL FUTURE CAPITAL REQUIREMENTS
   
    The development of the Company's business will require substantial capital
  infusions as a result of (i) the Company's need to enhance and expand its
  product and service offerings in order to maintain its competitive position and
  increase its market share and (ii) the substantial investment in equipment and
  corporate infrastructure required by the continued national deployment of the
  ISP Channel. In addition, the Company anticipates that the majority of cable
  affiliates with one-way cable systems will eventually upgrade their cable
  infrastructure to two-way cable systems, at which time the Company will have to
  upgrade its equipment on any affected cable system to handle two-way
  transmissions. Even with the proceeds of the Debt Offering, if completed,
  whether or when the Company ultimately can achieve cash flow levels sufficient
  to support its operations, development of new products and services, and
  expansion of its Internet Services Division, cannot be predicted accurately.
  Unless such cash flow levels are achieved, the Company will require additional
  borrowings, the sale of debt or equity securities, the sale of assets or
  businesses, or some combination thereof, to provide funding for its operations.
  In the event that the Company cannot generate sufficient cash flow from its
  operations, or is unable to borrow or otherwise obtain additional funds to
  finance its operations on desirable terms when needed, the Company's business,
  financial condition, prospects and ability to repay its indebtedness would be
  materially adversely affected.
   
  MANAGEMENT OF GROWTH
   
    To fully exploit the market for its products and services, the Company must
  rapidly execute its sales strategy while managing anticipated growth by
  implementing effective planning and operating processes. To manage its
   
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  anticipated growth, the Company must, among other things, continue to
  implement and improve its operational, financial and management information
  systems, hire and train additional qualified personnel, continue to expand and
  upgrade core technologies and effectively manage multiple relationships with
  various customers, suppliers and other third parties. Consequently, such
  expansion could place a significant strain on the Company's services and
  support operations, sales and administrative personnel and other resources.
  The Company may in the future also experience difficulties meeting the demand
  for its products and services. Additionally, if the Company is unable to
  provide training and support for its products, the implementation process will
  be longer and customer satisfaction may be lower. There can be no assurance
  that the Company's systems, procedures or controls will be adequate to support
  the Company's operations or that the Company's management will be capable of
  exploiting fully the market for the Company's products and services. Any
  failure of the Company to manage its growth effectively could have a material
  adverse effect on the Company's business, financial condition, prospects and
  ability to repay its indebtedness.
   
  NON-EXCLUSIVITY OF CABLE FRANCHISES; NON-RENEWAL OR TERMINATION OF FRANCHISES
   
    Cable television companies operate under non-exclusive franchises granted by
  local or state authorities that are subject to renewal and renegotiation from
  time to time. A franchise is generally granted for a fixed term ranging from
  five to 15 years but in many cases is terminable if the franchisee fails to
  comply with the material provisions thereof. The Cable Television Consumer
  Protection and Competition Act of 1992 prohibits franchising authorities from
  granting exclusive cable television franchises and from unreasonably refusing
  to award additional competitive franchises; it also permits municipal
  authorities to operate cable television systems in their communities without
  franchises. No assurance can be given that the cable television companies that
  have contracts with the Company will be able to retain or renew their
  franchises. The non-renewal or termination of any such franchises would result
  in the termination of the Company's contract with the applicable cable
  operator. Were an affiliated cable operator to lose its franchise, the Company
  would seek to affiliate with the successor to the franchisee. No assurance can
  be given that the Company would be able to achieve such replacement
  affiliation or that to do so would not result in additional costs to the
  Company. If the Company cannot affiliate with replacement cable operators in
  sufficient numbers, the Company's business, financial condition, prospects and
  ability to repay its indebtedness could be materially adversely affected.
   
  RISK OF ACQUISITION OF CABLE AFFILIATE BY UNAFFILIATED CABLE OPERATOR
   
    The Company believes that it is highly unlikely that a cable operator will
  find it desirable, economically or otherwise, to devote the channel capacity
  to offer Internet services to its subscribers over its infrastructure through
  more than one provider. However, under many of the Company's initial
  contracts, in the event a cable affiliate is acquired by an unaffiliated cable
  operator that already has a relationship with one of the Company's competitors
  or that does not enter into a contract with the Company, the Company may lose
  its ability to offer its Internet services in the area served by such former
  cable affiliate, which could have a material adverse effect on the Company's
  business, financial condition, prospects and ability to repay its
  indebtedness.
   
  DEPENDENCE ON THIRD PARTY TECHNOLOGY AND SUPPLIERS
   
    Many of the Company's products and service offerings incorporate technology
  developed and owned by third parties. The markets for all of the products and
  services used by the Company are characterized by intense competition, rapid
  technological advances, evolving industry standards, changes in subscriber
  requirements, frequent new product introductions and enhancements, and rapidly
  evolving, alternative service offerings. Consequently, the Company must rely
  upon third parties to develop and introduce technologies that enhance the
  Company's current product and service offerings and enable the Company, in
  turn, to develop its own products and services on a timely and cost-effective
  basis to meet changing customer needs and technological trends in its
  industries. Any impairment or termination of the Company's relationship with
  any licensers of third party technology would force the Company to find other
  developers on a timely basis or develop its own technology. There can be no
  assurance that the Company will be able to obtain the third party technology
  necessary to
   
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  continue to develop and introduce new and enhanced products and services, that
  the Company will obtain third party technology on commercially reasonable
  terms or that the Company will be able to replace third party technology in
  the event such technology becomes unavailable, obsolete or incompatible with
  future versions of the Company's products or services. The absence of or any
  significant delay in the replacement of third party technology would have a
  material adverse effect on the Company's business, financial condition,
  prospects and ability to service its indebtedness.
   
    In addition, the Internet Services Division and MTC currently depend on a
  limited number of suppliers for certain key products and services. In
  particular, the Internet Services Division depends on Excite, Inc. ("Excite")
  for national content aggregation, 3Com Corporation ("3Com") and Com21, Inc.
  ("Com21") for headend and cable modem equipment, Cisco Systems, Inc. ("Cisco")
  for specific network routing and switching equipment, and, among others, MCI
  Communications Corporation ("MCI") for national Internet backbone services.
  Certain of the Company's cable modem and headend equipment suppliers are in
  litigation over their patents. The Company could experience disruptions in the
  delivery or increases in the prices of products and services purchased from
  such vendors as a result of intellectual property litigation involving such
  vendors. There can be no assurance that delays in key components or product
  deliveries will not occur in the future due to shortages resulting from the
  limited number of suppliers, the financial or other difficulties of such
  suppliers or the possible limited availability in the suppliers' underlying
  raw materials. In addition, the Company may not have adequate remedies against
  such third parties as a result of breaches of their agreement with the
  Company. The inability to obtain sufficient key components or to develop
  alternative sources for such components, if and as required in the future,
  could result in delays or reductions in product shipments, which in turn could
  have a material adverse effect on the Company's customer relationships,
  business, financial condition, prospects and ability to repay its
  indebtedness.
   
    Certain key products resold by the Company are currently contracted
  exclusively for distribution in certain of the Company's markets. For
  instance, the Company's Telecommunications Division currently maintains an
  exclusive contract with Executone Information Systems, Inc. ("Executone") for
  the resale of Executone's products in certain specified markets. For the
  fiscal year ended September 30, 1997, such products accounted for
  approximately 30% of the Telecommunications Division's revenues and 13% of the
  Company's total revenues. Any change in the exclusivity provisions of these
  types of contracts, or loss thereof, could have a materially adverse effect on
  the Company's business, financial condition, prospects and ability to repay
  its indebtedness.
   
  COMPETITION
   
    The markets for the Company's products and services are intensely
  competitive, and the Company expects competition to increase in the future.
  Many of the Company's competitors and potential competitors have substantially
  greater financial, technical and marketing resources, larger subscriber bases,
  longer operating histories, greater name recognition and more established
  relationships with advertisers and content and application providers than the
  Company. Such competitors may be able to undertake more extensive marketing
  campaigns, adopt more aggressive pricing policies and devote substantially
  more resources to developing Internet services or on-line content than the
  Company. There can be no assurance that the Company will be able to compete
  successfully against current or future competitors or that competitive
  pressures faced by the Company will not materially adversely affect the
  Company's business, financial condition, prospects or ability to repay its
  indebtedness. Any increase in competition could reduce the Company's gross
  margins, require increased spending by the Company on research and development
  and sales and marketing, and otherwise materially adversely affect the
  Company's business, financial condition, prospects and ability to repay its
  indebtedness.
   
    Internet Services. The markets for the Company's Internet products and
  services are extremely competitive, and the Company expects this competition
  to intensify in the future. In the cable-based segment of the Internet access
  industry, the Company also competes with other cable-based data services that
  are seeking to contract with cable system operators to bring their services
  into geographic areas that are not covered by an agreement
   
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  between the Company and its cable affiliates. These competitors include
  systems integrators such as Convergence.com, Online System Services, HSAnet
  and Frontier Communications' Global Center business, as well as ISPs such as
  Earthlink Network, Inc. ("Earthlink"), MindSpring Enterprises, Inc.
  ("MindSpring"), and IDT Corporation. Several cable system operators, including
  CableVision Systems Corporation ("Cablevision"), Comcast Corporation
  ("Comcast"), Cox Enterprise, Inc. ("Cox"), MediaOne Group, Inc. ("MediaOne"),
  Tele-Communications, Inc. ("TCI") and Time Warner Inc. ("Time Warner") have
  deployed high-speed Internet access services over their existing local hybrid
  fiber and coaxial cable networks. TCI, Cox and Comcast market through At Home
  Corporation ("@Home") while Time Warner plans to market the RoadRunner service
  through Time Warner's own cable systems as well as to other cable system
  operators nationwide.
   
    Some of the Company's most direct competitors in the access markets are
  telephony-based access providers, including incumbent local exchange carriers
  ("ILECs"), national interexchange or long distance carriers ("IXCs"), fiber-
  based competitive local exchange carriers ("CLECs"), Internet service
  providers ("ISPs"), on-line service providers ("OSPs"), wireless and satellite
  data service providers, and DSL-focused CLECs. Competitors in the Internet
  services industry include AT&T Corp. ("AT&T"), BBN Corporation, Earthlink,
  Netcom Online Communications Services, Inc., Concentric Network, PSInet Inc.,
  and WorldCom, Inc., which provide basic Internet access to residential
  consumers and businesses, generally using the existing telephone network
  infrastructure. This method is widely available and inexpensive, and barriers
  to entry are low, resulting in a highly competitive and fragmented market.
   
    Some of the Company's competitors are offering diversified packages of
  telecommunications services, including Internet access service, to residential
  customers and could bundle such services, which could place the Company at a
  competitive disadvantage. Many of these competitors are offering (or may soon
  offer) technologies that will attempt to compete with some or all of the
  Company's high-speed data service offerings. The bases of competition in these
  markets include transmission speed, reliability of service, ease of access,
  ratio of price to performance, ease of use, content quality, quality of
  presentation, timeliness of content, customer support, brand recognition,
  operating experience and revenue sharing.
   
    In addition, the market for high-speed data transmission services is
  characterized by several competing technologies that offer alternative
  solutions. Competitive technologies include telecom-related wireline
  technologies that utilize telephone copper twisted-pair wiring, such as ISDN
  and DSL implementations, as well as wireless technologies such as local
  multipoint distribution service ("LMDS"), multichannel multipoint distribution
  service ("MMDS") and DBS. The Company's prospects may be further compromised
  by Federal Communications Commission ("FCC") rules and regulations, which are
  designed, at least in part, to increase competition in video and related
  services, for example, new multi-channel video technologies and services known
  as Open Video Systems ("OVS") and LMDS. While both are in nascent stages of
  development, OVS and LMDS offer the potential for providing competition to
  traditional cable television and other multi-channel video services. One form
  of OVS involves delivery of signals over existing telephone lines. LMDS is a
  broadband, wireless, digital service, and offers the potential for providing
  Internet access along with a variety of other services, including traditional
  multi-channel video entertainment. The FCC has also created a General Wireless
  Communications Service ("GWCS") in which licensees are afforded broad latitude
  in defining the nature and service area of the communications services they
  offer. The full impact of the GWCS remains to be seen. Nevertheless, all of
  these new technologies pose potential competition to the Company and its
  business. Significant market acceptance of alternative solutions for high-
  speed data transmission could decrease the demand for the Company's services
  if such alternatives are viewed as providing faster access, greater
  reliability, increased cost-effectiveness or other advantages over cable
  solutions. Competition from telecom-related solutions is expected to be
  intense.
   
    There can be no assurance that technological developments will not have a
  material adverse effect on the competitive position of the Company. The rapid
  development of new competing technologies and standards increases the risk
  that current or new competitors could develop products and services that would
  reduce the competitiveness of the Company's products and services, which could
  have a material adverse effect on the Company's business, financial condition,
  prospects and ability to repay its indebtedness.
   
                                         9
  <PAGE>
   
    Document Management. In the document management industry, the Company
  competes on the basis of breadth of offering, cost, flexibility and customer
  service. The Company has two direct competitors to its hardware products: Agfa
  AG in Europe and Anacomp, Inc. worldwide. Indirect competitors include
  International Business Machines Corp., Fuji Photo Film Co., Ltd., Mobius
  Management Systems, Inc., Storage Technology and others. In most cases, the
  Company's competitors have longer operating histories, greater name
  recognition, and significantly greater financial, technical and marketing
  resources. While the Company is not aware of any direct competitors to its
  software product offerings, the industry is rapidly evolving and the Company
  may face significant competition in the future.
   
  UNPROVEN NETWORK SCALABILITY AND SPEED
   
    Due to the limited deployment of the Company's ISP Channel service, the
  ability of the Company to connect and manage a substantial number of on-line
  subscribers at high transmission speeds is as yet unknown, and the Company
  faces risks related to its ability to scale up to its expected subscriber
  levels while maintaining superior performance. While peak downstream data
  transmission speeds across cable infrastructure approaches 3 megabits per
  second ("Mbps") in each 6 MHz channel, the actual downstream data transmission
  speeds are likely to be significantly slower and will depend on a variety of
  factors, including type and location of content, Internet traffic, the number
  of active subscribers on a given cable network node, the number of 6 MHz
  channels allocated by the cable affiliate (in its discretion) to carry the
  Company's service, the capability of cable modems used and the service quality
  of the cable affiliates' cable infrastructures. As subscriber penetration
  increases, it may be necessary for the cable affiliates to add additional 6
  MHz channels in order to maintain adequate downstream data transmission
  speeds, which would render such additional channels unavailable to such cable
  affiliates for video or other programming. There can be no assurance that
  cable affiliates will provide additional capacity for this purpose. On two-way
  cable systems, the upstream transmission data channel is located in a range
  not used for broadcast by traditional cable infrastructures and is more
  susceptible to interference than the downstream channel, resulting in a slower
  peak upstream transmission speed. In addition to the factors affecting
  downstream data transmission speeds, the level of interference in the cable
  affiliates' upstream data broadcast range can materially affect actual
  upstream data transmission speeds. The actual data delivery speeds that can be
  realized by subscribers will be significantly lower than peak data
  transmission speeds and will vary depending on the subscriber's hardware,
  operating system and software configurations. There can be no assurance that
  the Company will be able to achieve or maintain a speed of data transmission
  sufficiently high to enable the Company to attract and retain its planned
  numbers of subscribers, especially as the number of the subscribers to the
  Company's services grows, and a perceived or actual failure by the Company to
  achieve or maintain sufficiently high speed data transmission could
  significantly reduce consumer demand for its services and have a material
  adverse effect on its business, financial condition, prospects and ability to
  repay its indebtedness.
   
  DEPENDENCE ON NETWORK
   
    The Company's success will depend upon the capacity, reliability and
  security of the infrastructure used to carry data between its subscribers and
  the Internet. A significant portion of such infrastructure is owned by third
  parties, and accordingly the Company has no control over its quality and
  maintenance. The Company relies on cable operators to maintain their cable
  infrastructure. In addition, the Company relies on other third parties to
  provide a connection from the cable infrastructure to the Internet. Currently,
  the Company has transit agreements with MCI, MFS, Sprint Communications
  Company ("Sprint"), and others to support the exchange of traffic between the
  Company's network operations center ("NOC"), cable infrastructure and the
  Internet. The failure of the Internet backbone, or the NOC, or any other link
  in the delivery chain resulting in an interruption in the Company's operations
  would have a material adverse effect on the Company's business, financial
  condition, prospects and ability to repay its indebtedness.
   
  RISK OF SYSTEM FAILURE
   
    The Company's operations are dependent upon its ability to support its
  highly complex infrastructure and avoid damages from fires, earthquakes,
  floods, power losses, telecommunications failures, network software
   
                                        10
  <PAGE>
   
  flaws, transmission cable cuts and similar events. The occurrence of one of
  these events could cause interruptions in the services provided by the
  Company. In addition, failure of an ILEC or other service provider to provide
  communications capacity required by the Company, as a result of a natural
  disaster, operational disruption or any other reason, could cause
  interruptions in the services provided by the Company. Any damage or failure
  that causes interruptions in the Company's operations could have a material
  adverse effect on the Company's business, financial condition, prospects and
  ability to repay its indebtedness.
   
  SECURITY RISKS
   
    Despite the implementation of security measures, the Company's or its cable
  affiliates' networks may be vulnerable to unauthorized access, computer
  viruses and other disruptive problems. ISPs and OSPs have in the past
  experienced, and may in the future experience, interruptions in service as a
  result of the accidental or intentional actions of Internet users.
  Unauthorized access by current and former employees or others could also
  potentially jeopardize the security of confidential information stored in the
  computer systems of the Company and its subscribers. Such events may result in
  liability of the Company to its subscribers and also may deter potential
  subscribers. Although the Company intends to continue to implement industry-
  standard security measures, such measures have been circumvented in the past,
  and there can be no assurance that measures implemented by the Company will
  not be circumvented in the future. Moreover, the Company has no control over
  the security measures that the Company's cable affiliates adopt. Eliminating
  computer viruses and alleviating other security problems may require
  interruptions, delays or cessation of service to the Company's subscribers,
  which could have a material adverse effect on the Company's business,
  financial condition, prospects and ability to repay its indebtedness. In
  addition, the threat of these and other security risks may deter potential ISP
  channel subscribers from purchasing the ISP Channel service, which could have
  a material adverse effect on the Company's business, financial condition,
  prospects and ability to repay its indebtedness.
   
  DEPENDENCE ON HIGH-QUALITY CONTENT PROVISION AND ACCEPTANCE; DEVELOPING MARKET
  FOR HIGH-QUALITY CONTENT
   
    A key component of the Company's strategy is to provide a more compelling
  interactive experience to Internet users than the experience currently
  available to customers of dial-up ISPs and OSPs. The Company believes that, in
  addition to providing high-speed, high-performance Internet access, it must
  also develop and aggregate high-quality multimedia content. The Company's
  success in providing and aggregating such content will depend in part on the
  Company's ability to develop a customer base sufficiently large to justify
  investments in the development of such content as well as (i) the ability of
  content providers to create and support high-quality multimedia content; and
  (ii) the Company's ability to aggregate content offerings in a manner that
  subscribers find attractive. There can be no assurance that the Company will
  be successful in these endeavors. In addition, the market for high-quality
  multimedia Internet content has only recently begun to develop and is rapidly
  evolving, and there is significant competition among ISPs and OSPs for
  aggregating such content. If the market were to fail to develop, or were to
  develop more slowly than expected, or if competition were to increase, or if
  the Company's content offerings did not achieve or sustain market acceptance,
  the Company's business, financial condition, prospects and ability to repay
  its indebtedness would be materially adversely affected.
   
  DEPENDENCE ON ADVERTISING REVENUES
   
    The success of the Company's Internet Services Division depends in part on
  the ability of the Company to entice advertisers to advertise through the ISP
  Channel. The Company expects to derive significant revenues from
  advertisements placed on co-branded and ISP Channel web pages and "click
  through" revenues from products and services purchased through links from the
  ISP Channel to vendors. While the Company believes that it can leverage the
  ISP Channel to provide information to advertisers to help them better target
  prospective customers, there can be no assurance that advertisers will find
  such information useful or choose to advertise through the ISP Channel. There
  can be no assurance that the Company will be able to attract advertising
  revenues in quantities and at rates that are satisfactory to the Company. The
  failure to do so could have a material adverse effect on the Company's
  business, financial condition, prospects and ability to repay its
  indebtedness.
   
                                        11
  <PAGE>
   
  UNCERTAIN ACCEPTANCE AND MAINTENANCE OF THE ISP CHANNEL BRAND
   
    The Company believes that establishing and maintaining the ISP Channel brand
  are critical to attracting and expanding its subscriber base. Promotion of the
  ISP Channel brand will depend, among other things, on the Company's success in
  providing high-speed, high-quality consumer and business Internet products,
  services and content, the marketing efforts of the cable affiliates, and the
  reliability of the cable affiliates' networks and services, none of which can
  be assured. The Company has little control over the cable affiliates'
  marketing efforts or the reliability of their networks and services. If
  consumers and businesses do not perceive the Company's existing products and
  services to be of high quality or if the Company introduces new products or
  services or enters into new business ventures that are not favorably received
  by consumers and businesses, the Company will be unsuccessful in promoting and
  maintaining its brand. To the extent the Company expands the focus of its
  marketing efforts to geographic areas where the ISP Channel service is not
  available, the Company risks frustrating potential subscribers who are not
  able to access the Company's products and services. Furthermore, in order to
  attract and retain subscribers, and to promote and maintain the ISP Channel
  brand in response to competitive pressures, the Company may find it necessary
  to increase substantially its financial commitment to creating and maintaining
  a distinct brand loyalty among customers. If the Company were unable to
  establish or maintain the ISP Channel brand successfully or if the Company
  were to incur excessive expense in an attempt to improve its offerings or
  promote and maintain its brand, the Company's business, financial condition,
  prospects and ability to repay its indebtedness would be materially adversely
  affected.
   
  BILLING AND COLLECTIONS RISKS
   
    The Company has recently commenced the process of designing and implementing
  its billing and collections system for its Internet Services Division. It is
  the Company's intention to bill for the services provided by this business
  over the Internet and, in most cases, to collect these invoices through
  payments received via the Internet. Such invoices and payments have security
  risks. Given the complexities of such a system, there can be no assurance that
  the Company will be successful in developing and implementing the system in a
  timely manner or that it will be able to scale the system quickly and
  efficiently if necessary to accommodate potential growth in the number of
  subscribers requiring such a billing format. In some circumstances, the
  Company's cable affiliates are responsible for billing and collection for the
  Company's Internet access services. In any such instance, the Company has
  little or no control over the accuracy and timeliness of its invoices or over
  collection efforts. Given its relatively limited history with billing and
  collection for Internet services, the Company cannot predict the extent to
  which it may experience bad debts or the extent to which it will be able to
  minimize such bad debts. If the Company encounters significant problems with
  its billing and collections process, the Company's business, financial
  condition, prospects and ability to repay its indebtedness could be materially
  adversely affected.
   
  DEPENDENCE ON THE GROWTH AND EVOLUTION OF THE INTERNET
   
    Market acceptance of the Company's Internet services is substantially
  dependent upon the growth and evolution of the Internet in ways that are best
  suited for the Company's products and services. High-speed cable-based
  Internet access is of greatest value to consumers of multimedia and other
  bandwidth-intensive content. The nature of the content available over the
  Internet, and the technologies available to access that content, are evolving
  rapidly, and there can be no assurance that those applications that most favor
  the Company's services and technology will be widely accepted by the
  marketplace. In addition, to the extent that the Internet continues to
  experience significant growth in the number of users and level of use, there
  can be no assurance that the Internet infrastructure will continue to be able
  to support the demands placed on it by such potential growth or that the
  performance or reliability of the Internet will not be adversely affected. The
  Internet could lose its commercial viability due to delays in the development
  or adoption of new standards and protocols to handle increased levels of
  Internet activity. There can be no assurance that the infrastructure or
  complementary services necessary to make the Internet a viable commercial
  marketplace will be developed. In particular, the Internet has only recently
  become a medium for advertising and electronic commerce. If the necessary
  infrastructure or
   
                                        12
  <PAGE>
   
  complementary services or facilities are not developed, or if the Internet
  does not become a viable commercial marketplace or platform for advertising
  and electronic commerce, the Company's business, financial condition,
  prospects and ability to repay its indebtedness could be materially adversely
  affected.
   
  POTENTIAL LIABILITY FOR DEFAMATORY OR INDECENT CONTENT
   
    The law relating to liability of ISPs and OSPs for information carried on or
  disseminated through their networks is currently unsettled. A number of
  lawsuits have sought to impose such liability for defamatory speech and
  indecent materials. A recent federal statute seeks to impose such liability,
  in some circumstances, for transmission of obscene or indecent materials. In
  one case, a court has held that an OSP could be found liable for defamatory
  matter provided through its service, on the ground that the service provider
  exercised active editorial control over postings to its service. The
  imposition upon ISPs or OSPs of potential liability for materials carried on
  or disseminated through their systems could require the Company to implement
  measures to reduce its exposure to such liability, which may require the
  expenditure of substantial resources or the discontinuation of certain
  products or service offerings. In addition, the imposition of liability on the
  Company for information carried on the Internet could have a material adverse
  effect on the Company's business, financial condition, prospects and ability
  to repay its indebtedness.
   
  POTENTIAL LIABILITY FOR INFORMATION RETRIEVED AND REPLICATED
   
    Because materials will be downloaded and redistributed by subscribers and
  cached or replicated by the Company in connection with the Company's offering
  of its services, there is a possibility that claims may be made against the
  Company or its cable affiliates under both U.S. and foreign law for
  defamation, negligence, copyright or trademark infringement, or other theories
  based on the nature and content of such materials. Such types of claims have
  been successfully brought against OSPs. In particular, copyright and trademark
  laws are evolving both domestically and internationally, and there is
  uncertainty concerning how broadly the rights afforded under these laws will
  be applied to on-line environments. It is impossible for the Company to
  determine who the potential rights holders may be with respect to all
  materials available through the Company's services. In addition, a number of
  third party owners of patents have claimed to hold patents that cover various
  forms of on-line transactions or on-line technology. As with other OSPs,
  patent claims could be asserted against the Company based upon its services or
  technologies. The Company's liability insurance may not cover potential claims
  of the foregoing types or may not be adequate to indemnify the Company for all
  liability that may be imposed. Any imposition of liability that is not covered
  by insurance or is in excess of insurance coverage could have a material
  adverse effect on the Company's business, financial condition, prospects and
  ability to repay its indebtedness.
   
  RAPID TECHNOLOGICAL CHANGE; DEPENDENCE ON NEW PRODUCTS AND SERVICES
   
    There can be no assurance that the Company's future development efforts will
  result in commercially successful products or that the Company's products and
  services will not be rendered obsolete by changing technology, new industry
  standards or new product announcements by competitors. The markets for all of
  the Company's products and services are characterized by intense competition,
  rapid technological advances, evolving industry standards, changes in
  subscriber requirements, frequent new product introductions and enhancements,
  and rapidly evolving, alternative service offerings. For example, the Company
  expects digital set-top boxes capable of supporting high-speed Internet access
  services to be commercially available in the next 18 months. Although the
  widespread availability of set-top boxes could increase the demand for the
  Company's Internet Service, there is no assurance that the demand for set-top
  boxes will ever reach the level estimated by the Company and industry experts
  or, if set-top boxes reach this level of popularity, that the Company will be
  able to capitalize on such demand. If this scenario occurs or if other
  technologies or standards applicable to the Company's products or service
  offerings become obsolete or fail to gain widespread commercial acceptance,
  then the Company's business, financial condition, prospects and ability to
  repay its indebtedness will be materially adversely affected.
   
   
                                        13
  <PAGE>
   
    The introduction of products or services embodying, or purporting to embody,
  new technology or the emergence of new industry standards could also render
  the Company's existing products and services, as well as products or services
  under development, obsolete and unmarketable. Internet, telecommunications and
  cable technologies are evolving rapidly. Many large corporations, including
  large telecommunications providers, Regional Bell Operating Companies
  ("RBOCs") and telecommunications equipment providers, as well as large cable
  system operators, regularly announce new and planned technologies and service
  offerings that could impact the market for the Company's services. These
  announcements can have the effect of delaying purchasing decisions by the
  Company's customers and confusing the marketplace regarding available
  alternatives. Such announcements could in the future adversely impact the
  Company's business, financial condition, prospects and ability to repay its
  indebtedness.
   
    The Company's ability to adapt to changes in technology and industry
  standards, and to develop and introduce new and enhanced products and service
  offerings will be significant factors in maintaining or improving its
  competitive position and its prospects for growth. Due to rapid technological
  changes in the Internet and telecommunications industries, the lengthy product
  approval and purchase processes of the Company's customers and the Company's
  reliance on third party technology for the development of new products and
  service offerings, there can be no assurance that the Company will
  successfully introduce new products and services on a timely basis or achieve
  sales of new products and services in the future, or, if sales are achieved,
  that latent defects will not exist in the Company's products or equipment
  purchased by the Company from third parties. In addition, there can be no
  assurance that the Company will have the financial and manufacturing resources
  necessary to continue to successfully develop new products or services based
  on emerging technologies or to otherwise successfully respond to changing
  technology and/or industry standards. Moreover, due to intense competition,
  there may be a time-limited market opportunity for the Company's cable-based
  consumer and business Internet services. There can be no assurance that the
  Company will be successful in achieving widespread acceptance of its services
  before competitors offer products and services with speed and performance
  similar to the Company's current offerings. In addition, the widespread
  adoption of new Internet or telecommuting technologies or standards, cable-
  based or otherwise, could require substantial expenditures by the Company to
  modify or adapt its equipment, products and services and could fundamentally
  alter the character, viability and frequency of Internet-based advertising,
  either of which could have a material adverse effect on the Company's
  business, financial condition, prospects and ability to repay its
  indebtedness.
   
    The technology underlying capital equipment used by the Company such as
  headends and cable modems is continuing to evolve and, accordingly, it is
  possible that the equipment acquired by the Company could become out-of-date
  or obsolete prior to the time the Company would otherwise intend to replace
  such equipment. In any such circumstance, the Company may need to acquire
  substantial amounts of new capital equipment, which could have a material
  adverse effect on the Company's business, financial condition, prospects and
  ability to repay its indebtedness.
   
  ADVERSE EFFECT ON MTC OF GROWTH OF ALTERNATE TECHNOLOGIES
   
    Revenues for MTC's products and services have been adversely affected in
  recent years, and could in the future be substantially adversely affected by,
  among other things, the increasing use of digital technology. MTC's revenues,
  after giving effect to the discontinuation of the Telecommunications Division,
  have represented substantially all of the Company's revenues for the past
  several years.
   
    The effect of digital and other technologies on the demand for MTC's
  products and services depends, in part, on the extent of technological
  advances and cost decreases in such technologies. The recent trend of
  technological advances and attendant price declines in digital systems and
  products is expected to continue. As a result, in certain instances, potential
  MTC customers have deferred, and may continue to defer, investments in MTC
  systems while evaluating the abilities of digital and other technologies.
   
    The continuing development of local area computer networks and similar
  systems based on digital technologies has resulted and will continue to result
  in many MTC customers changing their use of MTC
   
                                        14
  <PAGE>
   
  products from data storage and retrieval to primarily archival use. The
  rapidly changing data storage and management industry also has resulted in
  intense price competition in certain of MTC's markets.
   
    Therefore, the Company has been and expects to continue to be impacted
  adversely by the decline in the market for COM services, the high fixed costs
  and declining market for COM systems and the attendant reduction in equipment
  and supplies. The Company's revenues for maintenance of COM systems have
  declined in part because of efficiencies associated with the Company's systems
  and could decline further in the event of lesser use and fewer sales of COM
  systems. The growth of alternate technologies has created consolidation in the
  micrographics industry. To the extent consolidation in the micrographics
  industry has the effect of causing major providers of micrographics services
  and products to cease providing such services and products, the negative
  trends in the industry, such as competition from alternate technologies
  described above, may accelerate.
   
  MTC PROPRIETARY TECHNOLOGY; RISK OF THIRD PARTY CLAIMS OF INFRINGEMENT
   
    The industry in which MTC operates may be affected by an increasing number
  of patents and frequent litigation based on allegations of patent and other
  intellectual property infringement. To develop and maintain its competitive
  position, MTC relies primarily upon the technical expertise and creative
  skills of its personnel, confidentiality agreements and, to some degree,
  patents and copyrights that it owns or, with respect to patents held by third
  parties, has license rights to use. There can be no assurance that such
  confidentiality or licensing agreements will not be breached, that others may
  not infringe upon such patents or licenses, or that the Company would have
  adequate remedies for any such breach for infringement. There can be no
  assurance that patents issued to or licensed by the Company will not be
  challenged or circumvented by competitors or be found to be sufficiently broad
  to protect the Company's technology or to provide it with any competitive
  advantage. Moreover, the Company may be materially adversely affected by
  competitors who independently develop substantially equivalent technology.
  Further, any litigation, either on behalf of or against the Company, relating
  to such confidentiality or licensing agreements, patents or copyrights,
  regardless of outcome, could result in substantial costs to the Company and
  diversion of effort by management. Any infringement claim or other litigation
  against or by the Company could have a material adverse effect on the
  Company's business, financial condition, prospects and ability to repay its
  indebtedness.
   
  ACQUISITION-RELATED RISKS
   
    The Company may from time to time acquire other businesses that the Company
  believes will complement its existing business. The Company is unable to
  predict whether or when any prospective acquisitions will occur or the
  likelihood of a material transaction being completed on favorable terms and
  conditions, if at all. The Company's ability to finance acquisitions may be
  constrained by, among other things, its high degree of leverage following the
  Debt Offering, if completed. The indenture that would govern the Senior Notes
  may significantly limit the Company's ability to make desired acquisitions and
  to incur indebtedness in connection with acquisitions. Such transactions, if
  effected, are likely to involve certain risks, including, among other things:
  the difficulty of assimilating the acquired operations and personnel; the
  potential disruption of the Company's ongoing business and diversion of
  resources and management time; the possible inability of management to
  maintain uniform standards, controls, procedures and policies; the risks of
  entering markets in which the Company has little or no direct prior
  experience; and the potential impairment of relationships with employees or
  customers as a result of changes in management. There can be no assurance that
  any acquisition will be so made, that the Company will be able to obtain
  additional financing needed to finance such acquisitions and, if any
  acquisitions are so made, that the acquired business will be successfully
  integrated into the Company's operations or that the acquired business will
  perform as expected.
   
  DEPENDENCE ON KEY PERSONNEL
   
    The success of the Company is dependent, in part, on its ability to attract
  and retain qualified technical, marketing, sales and management personnel.
  Competition for such personnel is intense and the Company's
   
                                        15
  <PAGE>
   
  inability to attract and retain additional key employees or the loss of one or
  more of its current key employees could materially adversely affect the
  Company's business, financial condition, prospects and ability to repay its
  indebtedness. The Company has recently assembled a new management team to
  implement its strategy for launching its ISP Channel concept on a large-scale
  basis, most of whom have been with the Company for less than six months. The
  Company is currently seeking new employees in connection with the expansion of
  its Internet Services Division. The loss of any member of the new team, or
  failure to attract such personnel, could also have a material adverse effect
  on the Company's business, financial condition, prospects and ability to repay
  its indebtedness. There can be no assurance that the Company will be
  successful in hiring or retaining key personnel.
   
  GOVERNMENT REGULATION
   
    Although the Company's services are not currently subject to direct
  regulation by the FCC or any other federal or state communications regulatory
  agency, changes in law or regulation relating to Internet connectivity and the
  telecommunications markets, including changes that, directly or indirectly,
  affect costs, limit usage of subscriber-related information or increase the
  likelihood or scope of competition from the RBOCs or other telecommunications
  companies, could affect the nature, scope and prices of the Company's
  services. For example, proceedings are pending at the FCC to determine
  whether, and to what extent, ISPs should be considered "telecommunications
  carriers" and, if so, whether they should be required to contribute to the
  Universal Service Fund. Although the FCC has decided for the moment that ISPs
  are not telecommunications carriers, that decision is not yet final and is
  being challenged by various parties, including the RBOCs. Some members of
  Congress have also challenged the FCC's conclusion. Congressional
  dissatisfaction with the FCC's conclusions could result in further changes to
  the FCC's governing law. The Company cannot predict the impact, if any, that
  future legal or regulatory changes might have on its business. In addition,
  regulation of cable television may affect the speed at which the Company's
  cable affiliates upgrade their cable infrastructures to two-way hybrid fiber
  coaxial cable. Currently, the Company's cable affiliates have generally
  elected to classify the distribution of the Company's services as "additional
  cable services" under their respective franchise agreements, and to pay
  franchise fees in accordance therewith. However, the election by cable
  operators to classify Internet access as an additional cable service may be
  challenged before the FCC, the courts or Congress, and any alteration in the
  classification of service could potentially have an adverse impact on the
  Company and its business.
   
    Another risk lies in the possibility that local franchise authorities may
  attempt to subject the cable affiliates to higher or other franchise fees or
  taxes or otherwise require them to obtain additional franchises in connection
  with their distribution of the Company's services. There are thousands of
  franchise authorities in the United States alone, and thus it will be
  difficult or impossible for the Company or its cable affiliates to operate
  under a unified set of franchise requirements. In the event that the FCC or
  another governmental agency were to classify the cable system operators as
  "common carriers" or "telecommunications carriers" because of their provision
  of Internet services, or if cable system operators were to seek such
  classification as a means of limiting their liability, the Company's rights as
  the exclusive ISP over the systems of certain of the cable affiliates could be
  lost. In addition, if the Company or its cable affiliates were classified as
  common carriers, they could be subject to government-regulated tariff
  schedules for the amounts they charge for their services. To the extent the
  Company increases the number of foreign jurisdictions in which it offers its
  services, the Company will be subject to additional governmental regulation.
  Any future implementation of any changes in law or regulation including those
  discussed herein, could have a material adverse effect on the Company's
  business, financial condition, prospects and ability to repay its
  indebtedness.
   
    In addition, the Company's business, financial condition, prospects and
  ability to repay its indebtedness may also be adversely affected by the
  imposition of certain tariffs, duties and other import restrictions on
  components that the Company obtains from non-domestic suppliers. Changes in
  law or regulation, in the United States or elsewhere, could materially
  adversely affect the Company's business, financial condition, prospects and
  ability to repay its indebtedness.
   
   
                                        16
  <PAGE>
   
  PRODUCT LIABILITY
   
    Some of the Company's products, such as those sold by MTC, are used to
  provide information that relates to the customer's enterprise operations and
  information that may be used in other critical applications. Any failure by
  the Company's products to provide accurate and timely information could result
  in claims against the Company. There can be no assurance that the Company's
  insurance coverage would adequately cover any claim asserted against the
  Company. A successful claim brought against the Company in excess of its
  insurance coverage could have a material adverse effect on the Company's
  business, financial condition, prospects and ability to repay its
  indebtedness. Even unsuccessful claims could result in the Company's
  expenditure of funds in litigation and management time and resources. There
  can be no assurance that the Company will not be subject to product liability
  claims, that such claims will not result in liability in excess of its
  insurance coverage or that the Company's insurance will cover such claims or
  that appropriate insurance will continue to be available to the Company in the
  future at commercially reasonable rates.
   
  RISKS RELATING TO MTC'S INTERNATIONAL OPERATIONS
   
    After giving effect to discontinued operations, sales outside of the United
  States accounted for approximately 22% and 27% of the Company's total revenues
  for Fiscal 1997 and 1996, respectively, which are attributable solely to MTC.
  Further development of foreign distribution channels for MTC's products and
  services could require a significant investment, which could adversely affect
  short-term results of operations. The Company believes that its future revenue
  growth and profitability in the foreign markets will principally depend on its
  success in developing these new distribution channels. Failure to increase
  revenues from the introduction of new products and services to these markets
  could have a material adverse effect on the Company's business, financial
  condition, prospects and ability to repay its indebtedness. Because of its
  export sales, MTC is subject to the risks of conducting business
  internationally, including unexpected changes in regulatory requirements
  (including the regulation of Internet access), uncertainty regarding liability
  for information retrieved and replicated in foreign institutions, foreign
  currency fluctuations which could result in reduced revenues or increased
  operating expenses, tariffs and trade barriers, potentially longer payment
  cycles, difficulty in accounts receivable collection, foreign taxes, and the
  burdens of complying with a variety of foreign laws and trade standards. MTC
  is also subject to general geopolitical risks, such as political and economic
  instability and changes in diplomatic and trade relationships, in connection
  with its international operations. In addition, the laws of certain foreign
  countries may not protect MTC's proprietary technology to the same extent as
  do the laws of the United States. There can be no assurance that the risks
  associated with MTC's international operations will not materially adversely
  affect the Company's business, financial condition, prospects and ability to
  repay its indebtedness or require MTC to modify significantly its current
  business practices.
   
  SHARES ELIGIBLE FOR FUTURE SALE
   
    Future sales of shares of the Common Stock by its existing shareholders
  under Rule 144 of the Securities Act, or through the exercise of registration
  rights or the issuance of shares of the Common Stock upon the exercise of
  options or warrants, could materially adversely affect the market price of
  shares of the Common Stock and could materially impair the Company's future
  ability to raise capital through an offering of equity securities. No
  predictions can be made as to the effect, if any, of market sales of such
  shares or the availability of such shares for future sale will have on the
  market price of shares of the Common Stock prevailing from time to time. At
  June 30, 1998, the Company has reserved for issuance 2,886,493 shares of
  Common Stock for issuance pursuant to outstanding Convertible Subordinated
  Debentures, options and warrants. The Company also has reserved up to 19.9% of
  its outstanding Common Stock as of May 29, 1998 for issuance under its cable
  affiliate incentive program. The Company has issued Convertible Preferred
  Stock that has a conversion price that fluctuates in relation to the price of
  the Common Stock. At June 30, 1998, such Convertible Preferred Stock would be
  convertible into 1,127,442 shares of Common Stock.
   
   
                                        17
  <PAGE>
   
  HOLDING COMPANY STRUCTURE; RESTRICTIONS ON ACCESS TO SUBSIDIARY CASH FLOW
   
    The Company is a holding company, conducting all of its operations through
  its Subsidiaries. Because the Company conducts all of its operations through
  subsidiaries, the Company's cash flow and its ability to service its
  indebtedness will depend upon the cash flow of its subsidiaries and payments
  of funds by those subsidiaries to the Company in the form of repayment of
  loans, dividends or otherwise. In addition, these subsidiaries may incur
  indebtedness or become parties to financing arrangements, which may contain
  limitations on the ability of such subsidiaries to pay dividends or to make
  loans or advances to the Company. Further, any holders of indebtedness
  (including subordinated indebtedness and trade payables) of subsidiaries of
  the Company would be entitled to repayment of such indebtedness from the
  assets of the affected subsidiaries before such assets were made available for
  distribution to the Company.
   
    In the event that the Company is unable to generate sufficient cash flow or
  is otherwise unable to obtain funds necessary to meet required payments of
  principal, premium, if any, and interest on its indebtedness, the Company
  would be in default under the terms of the agreements governing such
  indebtedness. In the event of such default, the holders of such indebtedness
  could elect to declare all of the funds borrowed thereunder to be due and
  payable together with accrued and unpaid interest. If such an acceleration
  were effected and the Company did not have sufficient funds to pay the
  accelerated indebtedness, the holders could initiate foreclosure or other
  enforcement action against the Company.
   
  FAILURE TO SELL THE TELECOMMUNICATIONS DIVISION
   
    The Company has decided to discontinue its Telecommunications Division, and
  is currently seeking a buyer for this division. However, there can be no
  assurance these efforts will be successful. If the Company is unable to
  consummate a sale of the Telecommunications Division on terms it believes are
  satisfactory, it will not obtain the proceeds anticipated from such sale,
  which will correspondingly diminish the capital available to the Company to
  implement its Internet Service Division's strategy. In the absence of such a
  sale, management's attention could be substantially diverted to operate or
  otherwise dispose of the Telecommunications Division. If a sale of the
  Telecommunications Division is delayed, its value could be diminished.
  Moreover, the Telecommunications Division could incur losses and operate on a
  cash flow negative basis in the future. Any such event could have a material
  adverse effect on the Company's business, financial condition, prospects and
  ability to repay its indebtedness.
   
  ABSENCE OF DIVIDENDS
   
    The Company has not historically paid any cash dividends on its Common Stock
  and does not expect to declare any such dividends in the foreseeable future.
  Payment of any future dividends will depend upon earnings and capital
  requirements of the Company, the Company's debt facilities and other factors
  the Board of Directors deems relevant. The Company currently intends to retain
  its earnings, if any, to finance the development and expansion of the Internet
  Services Division, and therefore does not anticipate paying any cash dividends
  in the foreseeable future. The Company's Certificate of Incorporation
  prohibits the payment of cash dividends on the Common Stock, without the
  consent of the holders of the Convertible Preferred Stock, while shares of the
  Convertible Preferred Stock are outstanding and, upon liquidation of the
  Company, requires payment of the liquidation value of the Convertible
  Preferred Stock prior to any payments with respect to the Common Stock. The
  Company's ability to pay dividends on its Common Stock is also restricted by
  certain of the Company's financing agreements.
   
  VOLATILITY OF STOCK PRICE
   
    The market price for the Common Stock has been volatile and market
  fluctuations may adversely affect the market price of the Common Stock without
  regard to the operating performance of the Company. The Company believes that
  factors such as announcements of developments related to the Company's
  business, fluctuations in the Company's results of operations, sales of
  substantial amounts of securities of the Company into the
   
                                        18
  <PAGE>
   
  marketplace, general conditions in the Company's industries or the worldwide
  economy, an outbreak of hostilities, a shortfall in revenues or earnings
  compared to analysts' expectations, changes in analysts' recommendations or
  projections, announcements of new products or services by the Company or its
  competitors or developments in the Company's relationships with its suppliers
  or customers could cause the price of the Common Stock to fluctuate in the
  future, perhaps substantially. There can be no assurance that the market price
  of the Common Stock will not experience significant fluctuations in the
  future, including fluctuations that are unrelated to the Company's
  performance. General market price declines or market volatility in the future
  could adversely affect the market price of the Common Stock, and the current
  market price of the Common Stock may not be indicative of future market
  prices.
   
  PROSPECTIVE ANTI-TAKEOVER PROVISIONS
   
    The Company is a New York corporation. Following the Offering, it is the
  Company's intention to solicit shareholder approval to reincorporate in
  Delaware. Both the New York Business Corporation Law and the Delaware General
  Corporation Law contain certain provisions that may have the effect of
  discouraging, delaying or making more difficult a change in control of the
  Company or preventing the removal of incumbent directors. In addition, the
  Company is currently reviewing proposed changes to its Certificate of
  Incorporation and Bylaws that would have the same effect. The existence of
  these provisions may have a negative impact on the price of the Common Stock
  and may discourage third party bidders from making a bid for the Company or
  may reduce any premiums paid to shareholders for their Common Stock.
   
  YEAR 2000 ISSUES
   
    Many existing computer systems, related software applications and other
  control devices use only two digits to identify a year in a date field,
  without considering the impact of the upcoming change in the century. Such
  systems, applications and/or devices could fail or create erroneous results
  unless corrected so that they can process data related to the Year 2000. The
  Company relies on such computer systems, applications and devices in operating
  and monitoring all major aspects of its business, including, but not limited
  to, its financial systems (such as general ledger, accounts payable and
  payroll modules), customer services, internal networks and telecommunications
  equipment, and end products. The Company also relies, directly and indirectly,
  on the external systems of various independent business enterprises, such as
  its customers, suppliers, creditors, financial organizations, and of
  governments, both domestically and internationally, for the accurate exchange
  of data and related information.
   
    The Company is currently in the process of evaluating the potential impact
  of the Year 2000 issue on its business and the related expenses that could
  likely be incurred in attempting to remedy such impact (including testing and
  implementation of remedial action). Management's current estimate is that the
  costs associated with the Year 2000 issue should not have a material adverse
  affect on the results of operations or financial position of the Company in
  any given year. However, despite the Company's efforts to address the Year
  2000 impact on its internal systems, the Company is not sure that it has fully
  identified such impact or that it can resolve it without disruption of its
  business and without incurring significant expenses. In addition, even if the
  internal systems of the Company are not materially affected by the Year 2000
  issue, the Company could be affected as a result of any disruption in the
  operation of the various third party enterprises with which the Company
  interacts such as cable affiliates, vendors and suppliers.
   
                                        19
  <PAGE>
   
                        SUMMARY CONSOLIDATED FINANCIAL DATA
   
    The following summary consolidated financial data should be read in
  conjunction with the Company's Consolidated Financial Statements and the
  related Notes thereto and "Management's Discussion and Analysis of Financial
  Condition and Results of Operations" included herein. The consolidated
  statement of operations data for the three years ended September 30, 1995,
  1996 and 1997 and the consolidated balance sheet data at September 30, 1997
  are derived from, and are qualified by reference to, the audited Consolidated
  Financial Statements and the related Notes thereto included herein.
   
  <TABLE>
  <CAPTION>
                                                                         (UNAUDITED)
                                                                         SIX MONTHS
                                  YEAR ENDED SEPTEMBER 30,             ENDED MARCH 31,
                           ------------------------------------------  ----------------
                            1993    1994     1995     1996     1997     1997     1998
                           ------  -------  -------  -------  -------  -------  -------
                                     ($ IN THOUSANDS, EXCEPT PER SHARE)
  <S>                      <C>     <C>      <C>      <C>      <C>      <C>      <C>
  STATEMENT OF OPERATIONS
   DATA:
   Revenues:
   MTC:
    COM equipment and
     system software...... $   --  $    --  $   265  $ 6,014  $ 6,347  $ 3,761  $ 1,020
    All other.............     43      188      823   13,403   13,983    6,956    5,625
   Internet Services:
    Cable service.........      0        0        0        0       20        0      237
    Dial-up service.......      0        0        0      150      587      305      339
    Misc. one-time........      0        0        0       17      401      313        8
                           ------  -------  -------  -------  -------  -------  -------
     Total revenues....... $   43  $   188  $ 1,088  $19,584  $21,338  $11,335  $ 7,229
                           ======  =======  =======  =======  =======  =======  =======
   Cost of revenues.......     --      172      783   11,375   11,935    6,371    5,252
   Selling, engineering,
    general and
    administrative........    837    1,180    7,548   10,921   11,191    4,400    5,257
   Income (loss) from
    continuing operations.   (794)  (1,164)  (7,243)  (2,712)  (1,788)     564   (3,280)
   Interest expense.......    (37)    (601)    (456)  (1,220)  (1,145)    (533)    (596)
   Other income ..........      3        2        5    5,708       49       81      170
   Gain (loss) from
    discontinued
    operations............    348      335   (1,962)  (1,812)     739      426      115
   Loss from extraordinary
    items.................      0        0        0   (6,061)    (486)       0        0
                           ------  -------  -------  -------  -------  -------  -------
   Net income (loss)...... $ (480) $(1,428) $(9,656) $(6,097) $(2,631) $   538  $(3,591)
   Preferred dividends....      0        0        0        0        0        0      (63)
                           ------  -------  -------  -------  -------  -------  -------
   Net income (loss)
    applicable to common
    shares................ $ (480) $(1,428) $(9,656) $(6,097) $(2,631) $   538  $(3,654)
                           ======  =======  =======  =======  =======  =======  =======
   Net income (loss) per
    share:
   Diluted................ $(0.14) $ (0.38) $ (2.22) $ (1.05) $ (0.40) $  0.08  $ (0.52)
                           ======  =======  =======  =======  =======  =======  =======
   Shares used in per
    share calculations:
   Diluted................  3,555    3,802    4,353    5,819    6,627    6,864    6,966
                           ======  =======  =======  =======  =======  =======  =======
  OTHER FINANCIAL DATA:
   Depreciation and
    amortization..........    116       68      194    1,374    1,798      829      951
   Capital Expenditures...     12       75    1,418      973      626      530      319
   EBITDA (1).............   (678)  (1,096)  (2,049)     162    1,010    1,393   (2,329)
   Ratio of earnings to
    fixed charges (2)(3)..     --       --       --      2.2       --      1.2       --
  </TABLE>
   
  <TABLE>
  <CAPTION>
                                                              (UNAUDITED)
                                                          AS OF MARCH 31, 1998
                                                          --------------------
                                                              ($ IN THOUSANDS)
  <S>                                                     <C>                  <C>
  CONSOLIDATED BALANCE SHEET DATA:
   Cash and cash equivalents.............................        $   17
   Total assets..........................................        21,934
   Total debt............................................        13,168
   Total stockholders' equity............................         3,387
  </TABLE>
   
                                        20
  <PAGE>
   
  ---------------------
  (1) EBITDA consists of net income (loss) from operations excluding net
      interest, depreciation and amortization. EBITDA is presented to enhance an
      understanding of the Company's operating results and is not intended to
      represent cash flow or results of operations in accordance with generally
      accepted accounting principles for the periods indicated and may be
      calculated differently than EBITDA for other companies. EBITDA presented
      for Fiscal 1995 excludes a one-time write-off of $5.0 million for in
      process, unproven technology associated with the Company's acquisition of
      MTC on September 15, 1995. EBITDA presented for the fiscal year 1996
      excludes a charge of $1.5 million for the write-down of certain software
      inventory associated with the Company's decision to discontinue the
      distribution of certain imaging products in favor of others. EBITDA
      presented for the fiscal year 1997 excludes a charge of $1.0 million for
      the write-off of prepaid license fees associated with certain imaging
      products. See the Company's Consolidated Financial Statements and the
      related Notes thereto.
   
  (2) For purposes of these computations, earnings consist of income (loss) from
      continuing operations before income taxes and extraordinary item plus
      fixed charges. Fixed charges consist of interest expense (including
      capitalized interest), amortization of deferred financing costs and one-
      third of rental expense (the portion deemed representative of the interest
      factor).
   
  (3) Fixed charges did not exceed the Company's net losses for the fiscal years
      ended 1993, 1994, 1995 and 1997 and for the six months ended March 31,
      1998. Accordingly, the Company had a deficiency of earnings to fixed
      charges of $(790), $(1,129), $(7,144), $(1,463) and $(2,972) for the
      respective periods.
   
                                        21
  <PAGE>
   
                  SELECTED CONSOLIDATED HISTORICAL FINANCIAL DATA
   
    The selected consolidated historical financial data set forth below for and
  as of the three years ended September 30, 1995, 1996 and 1997 have been
  derived from the audited Consolidated Financial Statements of the Company. The
  following selected consolidated financial data should be read in conjunction
  with the Consolidated Financial Statements and the related notes thereto, and
  "Management's Discussion and Analysis of Financial Condition and Results of
  Operations."
   
    The following table sets forth for the periods selected consolidated
  financial and operating data for the Company. The statement of operations and
  balance sheet data have been derived from the Company's consolidated financial
  statements audited by PricewaterhouseCoopers L.L.P. The selected consolidated
  financial data should be read in conjunction with "Management's Discussions
  and Analysis of Financial Conditions and Results of Operations" and the
  consolidated financial statements and the notes thereto.
   
  <TABLE>
  <CAPTION>
                                                                          (UNAUDITED)
                                                                          SIX MONTHS
                                   YEAR ENDED SEPTEMBER 30,             ENDED MARCH 31,
                            ------------------------------------------  ----------------
                             1993    1994     1995     1996     1997     1997     1998
                            ------  -------  -------  -------  -------  -------  -------
                                      ($ IN THOUSANDS, EXCEPT PER SHARE)
  <S>                       <C>     <C>      <C>      <C>      <C>      <C>      <C>
  STATEMENT OF OPERATIONS
   DATA:
   Revenues:
   MTC:
    COM equipment and
     system software......  $   --  $    --  $   265  $ 6,014  $ 6,347  $ 3,761  $ 1,020
    All other.............      43      188      823   13,403   13,983    6,956    5,625
   Internet Services:
    Cable service.........       0        0        0        0       20        0      237
    Dial-up service.......       0        0        0      150      587      305      339
    Misc. one-time........       0        0        0       17      401      313        8
                            ------  -------  -------  -------  -------  -------  -------
    Total revenues........  $   43  $   188  $ 1,088  $19,584  $21,338  $11,335  $ 7,229
                            ======  =======  =======  =======  =======  =======  =======
   Cost of revenues.......      --      172      783   11,375   11,935    6,371    5,252
   Selling, engineering,
    general and
    administrative........     837    1,180    7,548   10,921   11,191    4,400    5,257
   Income (loss) from
    continuing operations.    (794)  (1,164)  (7,243)  (2,712)  (1,788)     564   (3,280)
   Interest expense.......     (37)    (601)    (456)  (1,220)  (1,145)    (533)    (596)
   Other income ..........       3        2        5    5,708       49       81      170
   Gain (loss) from
    discontinued
    operations............     348      335   (1,962)  (1,812)     739      426      115
   Loss from extraordinary
    items.................       0        0        0   (6,061)    (486)       0        0
                            ------  -------  -------  -------  -------  -------  -------
   Net income (loss)......  $ (480) $(1,428) $(9,656) $(6,097) $(2,631) $   538  $(3,591)
   Preferred dividends....       0        0        0        0        0        0      (63)
                            ------  -------  -------  -------  -------  -------  -------
   Net income (loss)
    applicable to common
    shares................  $ (480) $(1,428) $(9,656) $(6,097) $(2,631) $   538  $(3,654)
                            ======  =======  =======  =======  =======  =======  =======
   Net income (loss) per
    share:
   Diluted................  $(0.14) $ (0.38) $ (2.22) $ (1.05) $ (0.40) $  0.08  $ (0.52)
                            ======  =======  =======  =======  =======  =======  =======
   Shares used in per
    share calculations:
   Diluted................   3,555    3,802    4,353    5,819    6,627    6,864    6,966
                            ======  =======  =======  =======  =======  =======  =======
  OTHER FINANCIAL DATA:
   Depreciation and
    amortization..........     116       68      194    1,374    1,798      829      951
   Capital Expenditures...      12       75    1,418      973      626      530      319
   EBITDA (1).............    (678)  (1,096)  (2,049)     162    1,010    1,393   (2,329)
   Ratio of earnings to
    fixed charges (2)(3)..      --       --       --      2.2       --      1.2       --
  </TABLE>
   
  <TABLE>
  <CAPTION>
                                                                (UNAUDITED)
                                                                AS OF MARCH
                                                                  31, 1998
                                                                --------------
                                                                ($ IN THOUSANDS)
  <S>                                                           <C>          <C>
  CONSOLIDATED BALANCE SHEET DATA:
   Cash and cash equivalents...................................   $       17
   Total assets................................................       21,934
   Total debt..................................................       13,168
   Total stockholders' equity..................................        3,387
  </TABLE>
   
                                        22
  <PAGE>
   
  ---------------------
  (1) EBITDA consists of net income (loss) from operations excluding net
      interest, depreciation and amortization. EBITDA is presented to enhance an
      understanding of the Company's operating results and is not intended to
      represent cash flow or results of operations in accordance with generally
      accepted accounting principles for the periods indicated and may be
      calculated differently than EBITDA for other companies. EBITDA presented
      for Fiscal 1995 excludes a one-time write-off of $5.0 million for in
      process, unproven technology associated with the Company's acquisition of
      MTC on September 15, 1995. EBITDA presented for the Fiscal 1996 excludes a
      charge of $1.5 million for the write-down of certain software inventory
      associated with the Company's decision to discontinue the distribution of
      certain imaging products in favor of others. EBITDA presented for the
      Fiscal 1997 excludes a charge of $1.0 million for the write-off of prepaid
      license fees associated with certain imaging products. See the Company's
      Consolidated Financial Statements and the related Notes thereto.
   
  (2) For purposes of these computations, earnings consist of income (loss) from
      continuing operations before income taxes and extraordinary item plus
      fixed charges. Fixed charges consist of interest expense (including
      capitalized interest), amortization of deferred financing costs and one-
      third of rental expense (the portion deemed representative of the interest
      factor).
   
  (3) Fixed charges did not exceed the Company's net losses for the fiscal years
      ended 1993, 1994, 1995 and 1997 and for the six months ended March 31,
      1998. Accordingly, the Company had a deficiency of earnings to fixed
      charges of $(790), $(1,129), $(7,144), $(1,463) and $(2,972) for the
      respective periods.
   
                                        23
  <PAGE>
   
                      MANAGEMENT'S DISCUSSION AND ANALYSIS OF
                   FINANCIAL CONDITION AND RESULTS OF OPERATIONS
   
    The following discussion of the financial condition and results of
  operations of the Company should be read in conjunction with, and is qualified
  in its entirety by reference to, the Consolidated Financial Statements of the
  Company and the related Notes. The Company's fiscal year ends on September
  30th of each year. "Fiscal 1998" refers to the twelve months ended September
  30, 1998 with comparable references for other twelve month periods ending
  September 30th. This discussion contains forward-looking statements that
  involve risks and uncertainties. The Company's actual results could differ
  materially from those anticipated in the forward-looking statements as a
  result of certain factors including, but not limited to, those discussed in
  "Risk Factors." The Company disclaims any obligation to update information
  contained in any forward-looking statement.
   
  OVERVIEW
   
    The Company currently operates through two continuing divisions: the
  Internet Services Division and MTC. SoftNet is in the process of implementing
  a new strategic focus that involves emphasizing the Internet Services
  Division. As part of its new focus, the Company is currently seeking a buyer
  for its Telecommunications Division and is now accounting for this division as
  a discontinued operation.
   
    MTC. Through MTC, the Company develops and manufactures sophisticated,
  automated electronic document management and film-based imaging solutions for
  customers with large-scale, complex, document-intensive requirements. MTC's
  hardware and software products are based on an industry standard client-server
  architecture, providing flexibility to connect to a wide variety of
  information systems and produce output to various storage media, including
  optical disk, magnetic disk and tape, CD-ROM, and microfilm and microfiche,
  spanning the entire document lifecycle.
   
    MTC's electronic and film-based imaging hardware systems typically range in
  price between $200,000 and $1,000,000, and may represent a significant capital
  commitment by MTC's customers, leading to a lengthy sales cycle of up to 24
  months. Accordingly, MTC's operating results may fluctuate significantly from
  period to period.
   
    The Internet Services Division. The Company began providing Internet
  services following its acquisition of the Internet Services Division in June
  1996. The Company seeks to become the dominant provider of high-speed Internet
  access via the existing cable television infrastructure to homes and
  businesses in the franchise areas of small- and medium-sized cable television
  systems. In addition, the Company seeks to maintain and build its traditional
  dial-up Internet access business. The Company commenced marketing its cable
  modem-based service, the ISP Channel, to selected cable operators and
  potential subscribers in March 1998.
   
    Potential Market. The growth of the Internet has been significant. By 2002,
  Forrester estimates that 59% of U.S. households and 50% of U.S. businesses
  will be on-line, and that annual spending by residential and business end-
  users on U.S. Internet access and related services will increase from an
  estimated approximately $6 billion in 1997 to nearly $50 billion. For many
  users, the speed of such access will become an increasingly important factor
  in choosing among service providers.
   
    The Company's solution emphasizes the use of cable modems and, in the
  future, television set-top boxes, due to the fact that the existing cable
  infrastructure can be equipped to provide Internet access to over 90% of U.S.
  households at speeds significantly in excess of those readily available using
  the telecommunications infrastructure. Of the approximately 92.2 million U.S.
  homes passed by cable, approximately 65% are under
   
                                        24
  <PAGE>
   
  exclusive contract with competing cable-based Internet access services or, in
  the Company's judgment, are located in cable systems to which one of these
  competitors is likely to obtain exclusive rights for the provision of such
  services. Such competitors include @Home and RoadRunner, both of which are
  affiliated with large MSOs including, among others, Cablevision, Comcast, Cox,
  MediaOne, TCI and Time Warner.
   
    The Company believes that the above-mentioned competitive providers of
  cable-based Internet access services presently intend to target large,
  clustered systems in major DMAs, and that the remaining systems owned by the
  MSO affiliates of such competitors, particularly systems with under 50,000
  subscribers that have not been upgraded to carry two-way traffic, will in many
  cases not be offered high-speed Internet capability by such competitors in the
  next two to three years. In certain cases, the Company believes that such
  systems may be divested by such competitors' MSO affiliates or permitted to
  contract for high-speed Internet capability with non-affiliated providers such
  as the Company. The remaining U.S. homes passed by cable are located in a
  large number of small- and medium-sized cable systems as well as certain large
  Independent MSOs. In evaluating the potential of these systems for investment,
  the Company has targeted only those systems that are sufficiently large to
  provide an adequate return on the required invested capital. Based on this
  analysis, the Company believes that its addressable market is approximately 30
  million homes, located in approximately 2,000 cable systems. Set forth below
  is a summary of the total U.S. cable market, based on data compiled by
  Claritas, an independent industry research consultant, and a summary of the
  portion of this market that SoftNet intends to address, based on the
  parameters described above.
   
            ISP CHANNEL--POTENTIAL U.S. MARKET BASED ON SUBSCRIBERS(A)
   
  <TABLE>
  <CAPTION>
                                                           ISP CHANNEL ADDRESSABLE U.S.
                                 TOTAL U.S. MARKET                    MARKET
                           ------------------------------ ------------------------------
                              CABLE      HOMES               CABLE      HOMES
  SYSTEM SIZE              SUBSCRIBERS   PASSED   SYSTEMS SUBSCRIBERS   PASSED   SYSTEMS
  -----------              ----------- ---------- ------- ----------- ---------- -------
  <S>                      <C>         <C>        <C>     <C>         <C>        <C>
  Cable Subs over 50,000.. 27,870,684  41,316,994    287   2,583,314   3,775,979     30
  Cable Subs 5,000 to
   49,999................. 28,317,985  39,565,810  1,793  16,774,574  22,772,280  1,183
  Cable Subs 2,500 to
   4,999..................  3,100,040   4,156,319    891   2,558,862   3,396,048    741
  Cable Subs 1,000 to
   2,499..................  2,300,091   3,542,782  1,473          --          --     --
  Cable Subs less than
   1,000..................  2,039,717   3,623,699  6,957          --          --     --
                           ----------  ---------- ------  ----------  ----------  -----
                           63,628,517  92,205,604 11,401  21,916,750  29,944,307  1,954
                           ==========  ========== ======  ==========  ==========  =====
  </TABLE>
  ---------------------
  (a) Source: Claritas (Total U.S. Market only) and the Company.
   
    Market Penetration. As of July 14, 1998, the Company had contracts for its
  ISP Channel service with 19 cable operators, including Galaxy, Palo Alto Cable
  Co-op and Coral Springs Cable, representing over 100 cable systems and
  approximately 575,000 homes passed. Nine of these systems, representing
  approximately 175,000 homes passed, have been equipped and have begun offering
  the Company's services, in most cases during the past two months. In addition,
  the Company has non-binding letters of intent with three cable operators,
  including Northland, representing approximately 525,000 homes passed.
  Currently, the Company has approximately 500 residential and business
  subscribers to its ISP Channel service. The Company also provides dial-up and
  dedicated Internet access to approximately 1,100 residential and business
  subscribers. The Company's contract with Galaxy for its ISP Channel service
  represents 82% of its cable systems and 57% of its homes passed currently
  under contract. In addition, the Company believes that its agreement with
  Northland, if executed, will also constitute a significant percentage of its
  cable systems and homes passed to date. See "Risk Factors--Dependence on Local
  Cable Operators and their Cable Infrastructure" and "--Dependence on Exclusive
  Access to Cable Subscribers Need for Aggressive Implementation and
  Deployment."
   
    In order to expand its cable-based Internet subscriber base significantly,
  the Company expects to pursue aggressively affiliation agreements with cable
  operators which will provide it with the exclusive right to market cable-based
  Internet services to existing cable television subscribers in such cable
  operators' systems. The Company's objective is to enter into exclusive
  arrangements with cable operators representing approximately 7.5 million homes
  passed in the next three years.
   
   
                                        25
  <PAGE>
   
    It is the Company's objective to market its services aggressively and to
  install its systems in as many cable systems as possible in the next few
  years. The Company anticipates that this policy of rapid deployment will
  result in substantial capital expenditures, operating losses and negative cash
  flow in the near term. The Company believes it will need to raise substantial
  additional capital to achieve its market penetration objectives. There can be
  no assurance, however, that the Company will be able to raise sufficient
  capital on acceptable terms, or at all, or that it will be able to implement
  its strategy or achieve positive cash flow or profitability in a timely
  fashion, or at all.
   
    Revenue Sources. In providing its Internet services, the Company receives
  revenue from the provision of (i) cable modem-based Internet access services
  and (ii) traditional dial-up Internet access services. Currently, the Company
  typically charges new cable modem-based Internet access subscribers a one-time
  connection fee of $99, which fee includes modem installation and any required
  modification of the existing cable television connection. Thereafter, each
  subscriber pays an access fee, which is currently as low as $49 per month. The
  Company anticipates that it will purchase a majority of cable modems used by
  subscribers, who will be charged a nominal lease charge. The Company does not
  charge new dial-up subscribers a connection fee, but does charge a monthly
  access fee of approximately $20.
   
    In addition to connection fees and monthly access fees, the Company intends
  to pursue additional revenue opportunities from Internet advertising, e-
  commerce and IP telephony. The Company also intends to pursue long distance
  telephone services and telephony debit and credit cards.
   
    In the future, as digital set-top boxes become available and are introduced
  into the Company's affiliated cable systems, the Company expects to charge
  those subscribers monthly access fees comparable to those now charged
  traditional dial-up subscribers. The Company also expects to charge customers
  a set-top connection fee to help defray installation expenses.
   
    For cable-based Internet services, the Company typically shares 25% of total
  revenues with cable affiliates for the first 200 subscribers in each system
  and 50% thereafter. For other services, such as IP telephony, e-commerce and
  advertising, the Company expects to share between 25% and 50% of total
  revenues with the cable affiliates. The Company expects that no commissions
  will be paid on cable modem lease income. The Company expects that these
  commissions will be netted against revenues.
   
    Cost of Services. Costs to the Company include installation costs, network
  and cable operation costs and personnel and other costs. Operator commissions
  vary by type of connectivity and size of contract.
   
    Installation costs are expected to vary by type of connectivity and type of
  customer. The Company charges new subscribers a one time fee to defray the
  costs of installation, which includes labor and overhead. While currently the
  installation fee does not cover the entire cost incurred, the Company expects
  that over time installation costs will decline as cable modems become more
  commercially available and are eventually bundled as standard equipment in new
  PCs.
   
    Other network costs include the cost of connection to the public switch
  telephone network and the cost of leased fiber capacity.
   
    Sales, Marketing and Operating Expenses. Sales, marketing and operating
  expenses include the costs of the Company's cable affiliate program,
  maintenance of its infrastructure, customer care, content and new business
  development in addition to sales and marketing expenses.
   
    EBITDA. Over the next three years, the Company will seek to become the
  exclusive provider of Internet based high-speed data, video and telephony
  services over cable systems representing approximately 7.5 million homes
  passed, and to attract approximately 470,000 ISP Channel subscribers, or
  approximately 6.3% of such homes passed. If it is able to accomplish this
  objective, the Company expects the Internet Services Division to achieve
  positive EBITDA within this timeframe. The Company's ability to generate
  positive EBITDA will be
   
                                        26
  <PAGE>
   
  affected by the Company's ability to contract with cable operators, attract
  customers for its services, achieve anticipated pricing levels for its
  services and maintain costs at anticipated levels. No assurance can be given
  that the Company will be able to contract with sufficient cable operators,
  attract an adequate amount of subscribers, or achieve and sustain the pricing
  and cost levels that would be required for it to obtain such financial
  results.
   
    Capital Expenditures. In order to pursue its business plan, the Company
  expects to incur significant capital expenditures to provision its turnkey
  solution for cable operators, principally relating to the installation of
  headend equipment and the purchase of customer premise equipment such as cable
  modems. The cost of headend provisioning has averaged $45,000 for the nine
  systems in which the Company currently provides service. The costs of cable
  modems, currently approximately $179 to $349, is expected to decline. With
  respect to the costs of cable modems, the Company believes that it will be
  able to recoup a limited amount of such costs from its subscribers, either
  through subscriber purchases or monthly lease charges. However, the Company
  recognizes that, in line with experience in other subscription service
  industries, it will need to subsidize both installation and customer premises
  equipment (cable modems) costs. Such expenditures, however, are expected to be
  offset in part by the savings resulting from decreased prices for such
  equipment as production volumes increase.
   
  HISTORICAL RESULTS OF OPERATION
   
    The Company has changed significantly over the last several years as it has
  entered certain businesses and exited or prepared to exit, others. For
  example, on April 7, 1998, the Company announced its decision to divest its
  Telecommunications Division and is currently considering purchase offers. The
  discussion of the Company's results of operation below therefore treats the
  Telecommunication Division as a discontinued operation. In addition, the
  Company entered the Internet business in June 1996 with the purchase of the
  Internet Services Division and began offering cable-based Internet services in
  the first quarter of Fiscal 1998. Accordingly, year-to- year comparisons may
  not be meaningful.
   
  <TABLE>
  <CAPTION>
                                                                 (UNAUDITED)
                                          FISCAL              SIX MONTHS ENDED
                                  -------------------------  -------------------
                                                             MARCH 31, MARCH 31,
  SEGMENT INFO                     1995     1996     1997      1997      1998
  ------------                    -------  -------  -------  --------- ---------
                                               ($ IN THOUSANDS)
  <S>                             <C>      <C>      <C>      <C>       <C>
  Sales
    MTC.......................... $ 1,088  $19,417  $20,330   $10,717   $ 6,645
    Internet Services............      --      167    1,008       618       584
  Cost of Sales
    MTC..........................     783   11,375   11,050     5,863     4,571
    Internet Services............      --       --      885       508       681
  Gross Profit
    MTC..........................     305    8,042    9,280     4,854     2,074
    Internet Services............      --      167      123       110       (97)
  Operating Expenses
    MTC..........................   6,329    8,162    8,714     3,282     3,296
    Internet Services............      --      478    1,273       566     1,047
  Income (loss) from continuing
   operations
    MTC..........................  (6,024)    (120)     566     1,572    (1,222)
    Internet Services............      --     (311)  (1,150)     (456)   (1,144)
    Corporate Overhead...........  (1,219)  (2,281)  (1,204)     (552)     (914)
                                  -------  -------  -------   -------   -------
    Consolidated................. $(7,243) $(2,712) $(1,788)  $   564   $(3,280)
                                  =======  =======  =======   =======   =======
  </TABLE>
   
  SIX MONTHS ENDED MARCH 31, 1998 COMPARED TO SIX MONTHS ENDED MARCH 31, 1997
   
    Consolidated net sales decreased $4.1 million, or 36.2%, for the six months
  ended March 31, 1998, as compared to the six months ended March 31, 1997. The
  decrease in consolidated net sales was primarily the result of a decrease in
  net sales of MTC. Sales in this division decreased $4.1 million, or 38.0%, to
  $6.6 million
   
                                        27
  <PAGE>
   
  for the six months ended March 31, 1998, as compared to sales of $10.7 million
  for the six months ended March 31, 1997. The decrease in MTC sales was
  primarily the result of a decrease in the sale of COM equipment. COM equipment
  sales were affected in the first quarter of Fiscal 1998 by the fact that MTC
  entered the year with an order backlog of $1.4 million, as compared to an
  order backlog of $3.4 million in the prior period. Internet Services Division
  sales decreased $34,000, or 5.5%, to $584,000 for the six months ended March
  31, 1998, as compared to sales of $618,000 for the six months ended March 31,
  1997. Miscellaneous one-time sales decreased $305,000 to $8,000 for the six
  months ended March 31, 1998, as compared to $313,000 for the same period in
  1997. A miscellaneous one-time sales opportunity for the installation of an
  Internet access system in the country of Milawi accounted for $187,000 of
  these sales in the six months ended March 31, 1997. The decrease in
  miscellaneous one-time sales was partially offset by an increase in sales of
  $237,000 for the Division's cable services. The Internet Services Division had
  not yet introduced this service to the market during the six months ended
  March 31, 1997.
   
    Consolidated gross profit decreased $3.0 million, or 60.2%, to $2.0 million
  for the six months ended March 31, 1998, as compared to $5.0 million for the
  six months ended March 31, 1997, with profit margins decreasing to 27.3% from
  43.8% for the comparable period in 1997. The decrease in gross profit is
  primarily the result of a decrease in gross profits of $2.8 million, or 57.3%,
  of MTC. Gross profit margins in this division decreased to 31.2% from 45.3%
  for the comparable period in 1997, primarily as the result of the decrease in
  MTC's COM equipment sales, which contribute the highest product profit
  margins. Gross profit decreased $207,000 in the Internet Services Division for
  the six months ended March 31, 1998, primarily as a result of the
  reclassification of certain web development expenses and certain other
  expenses associated with the expansion of the division's technical support
  staff to cost of goods sold. Similar expenses in prior year presentations have
  not been reclassified, due to immateriality.
   
    Operating expenses (including selling, engineering, general and
  administrative expenses, less amortization) increased $874,000, or 23.3%, to
  $4.6 million for the six months ended March 31, 1998, as compared to
  $3.7 million for the six months ended March 31, 1997. The increase in
  operating expenses is partially the result of the consolidation and relocation
  of the Company's operations formerly based in Chicago to the Company's
  facilities in Mountain View, California. These activities included a one time
  write-off of leasehold improvements and moving expenses of $240,000. In
  addition, operating expenses increased in the Internet Services Division by
  $481,000, or 134.0%, to $840,000 for the six months ended March 31, 1998, as
  compared with $359,000 for the same period in 1997. This increase in operating
  expense is primarily the result of the increase in the Internet Services
  Division's administrative, sales and marketing efforts supporting the
  division's cable service offering.
   
    Amortization expense decreased $17,000, or 2.6%, to $643,000 for the six
  months ended March 31, 1998 from $660,000 for the six months ended March 31,
  1997.
   
    For the six months ended March 31, 1998, the Company had a net loss from
  continuing operations of $3.3 million, as compared to net income from
  continuing operations of $564,000 for the six months ended March 31, 1997.
   
    Interest expense increased $63,000, or 11.8%, to $596,000 for the six months
  ended March 31, 1998 from $533,000 for the six months ended March 31, 1997.
   
    The Company made no provisions for income taxes for the six months ended
  March 31, 1998 and the six months ended March 31, 1997 as a result of the
  Company's net operating loss carry-forward.
   
    The Company recognized a gain from operations with respect to its
  discontinued Telecommunications Division of $115,000 for the six months ended
  March 31, 1998, as compared to a gain from operations of $426,000 for the same
  period in 1997.
   
    For the six months ended March 31, 1998, the Company had a net loss
  applicable to common shareholders  of $3.7 million, as compared to net income
  of $538,000 for the six months ended March 31, 1997.
   
                                        28
  <PAGE>
   
  FISCAL 1997 COMPARED TO FISCAL 1996
   
    Consolidated net sales increased $1.8 million, or 9.2%, to $21.3 million for
  Fiscal 1997, as compared to $19.6 million for Fiscal 1996. MTC's sales
  increased $913,000, or 4.7%, to $20.3 million for Fiscal 1997 as compared to
  $19.4 million for Fiscal 1996. This increase in net sales is primarily the
  result of increased monthly rental streams associated with the Division's
  continued implementation of alternative customer leasing arrangements for its
  core COM products. Sales in the Internet Services Division increased $841,000
  to $1.0 million for Fiscal 1997 from $167,000 for Fiscal 1996. Sales in the
  Internet Services Division for Fiscal 1996 consist only of fourth quarter
  sales, as the Division was acquired in June 1996.
   
    Consolidated gross profit increased $1.2 million, or 14.6%, to $9.4 million
  for Fiscal 1997, as compared to $8.2 million for Fiscal 1996, with profit
  margins increasing to 44.1% from 41.9% for the same period in 1996. Gross
  profit increased $1.3 million, or 15.4%, in MTC to $9.3 million for Fiscal
  1997 from $8.0 million for Fiscal 1996, with gross profit margins increasing
  to 45.7% from 41.4% for the same period in 1996. The increase in gross profit
  margin was primarily the result of increased productivity efficiencies in the
  manufacturing operation, which in turn resulted from a strong backlog and
  steady, customer order driven, manufacturing schedules. The Internet Services
  Division recorded gross profits of $123,000 for Fiscal 1997, however year to
  year comparisons are not meaningful, given the fact that the Division operated
  for only one quarter in Fiscal 1996 and allocated no expense to cost of goods
  sold during this one quarter period.
   
    Operating expenses (including selling, engineering, general and
  administrative, less amortization) decreased $24,000, or 0.2%, to $9.9 million
  for Fiscal 1997 as compared to $9.9 million for Fiscal 1996. General and
  administrative expenses associated with MTC and Corporate Overhead decreased a
  combined $810,000, or 20.2%, to $3.2 million for Fiscal 1997, as compared to
  $4.0 million in the same period in 1996. The decrease in these combined
  general and administrative expenses is the result of certain overhead cost
  cutting measures implemented to achieve back office efficiencies throughout
  the Company. For MTC, engineering expenses increased $324,000, or 19.1%, to
  $2.0 million for Fiscal 1997, as compared to $1.7 million for Fiscal 1996, as
  a result of the Division's continued effort to expand and improve the products
  offered to its customers. Included in the consolidated operating expenses are
  two separate, one-time charges associated with changes in the Company's
  product lines, in the amounts of $2.1 million for Fiscal 1997 and $2.2 million
  for Fiscal 1996. Operating expenses in the Internet Services Division
  increased $483,000 to $858,000 for Fiscal 1997, however year to year
  comparisons are not meaningful given the fact that the Division operated for
  only one quarter in Fiscal 1996.
   
    Amortization expense increased $294,000, or 29.6%, to $1.3 million for
  Fiscal 1997 from $993,000 for Fiscal 1996. This increase in amortization
  expense is primarily the result of the additional amortization expense
  associated with the acquisition of the Internet Services Division in June
  1996.
   
    The Company had a net loss from continuing operations of $1.8 million for
  Fiscal 1997, as compared to a net loss from continuing operations of $2.7
  million for Fiscal 1996.
   
    Consolidated interest expense decreased $75,000, or 6.2%, to $1.1 million
  for Fiscal 1997 as compared to $1.2 million for Fiscal 1996, primarily as a
  result of the conversion of $4.5 million of convertible subordinated notes
  since June 1996.
   
    The Company recognized a gain on the sale of securities of $5.7 million in
  Fiscal 1996. This gain was the result of the sale of all shares of IMNET
  Systems, Inc. ("IMNET") held by the Company.
   
    The Company made no provisions for income taxes for Fiscal 1997 and Fiscal
  1996 as a result of the Company's net operating loss carry-forward.
   
    The Company recognized a gain from operations with respect to its
  discontinued Telecommunications Division of $739,000 for Fiscal 1997, as
  compared to a loss from operations of $1.8 million for the same period in
  1996. The loss incurred in Fiscal 1996 includes a loss from operations of $2.5
  million associated with the disposal of the Company's wholly-owned subsidiary,
  Communicate Direct, Inc.
   
                                        29
  <PAGE>
   
    The Company recognized a loss from extraordinary item of $486,000 for Fiscal
  1997, as compared to a loss from extraordinary item of $6.1 million for the
  same period in 1996. The losses are associated with the disposal of the
  Company's wholly-owned subsidiary, Communicate Direct, Inc.
   
    For Fiscal 1997, the Company had a net loss applicable to common
  shareholders of $2.6 million, as compared to a net loss of $6.1 million for
  Fiscal 1996.
   
  FISCAL 1996 COMPARED TO FISCAL 1995
   
    Consolidated net sales increased by $18.5 million to $19.6 million for
  Fiscal 1996 as compared to $1.1 million for Fiscal 1995. The increase in sales
  was primarily the result of the acquisition of MTC in September 1995.
   
    Consolidated gross profit increased $7.9 million to $8.2 million for Fiscal
  1996 as compared to $305,000 for Fiscal 1995, with gross profit margin
  increasing to 41.9% from 28.0% for the comparable period in 1995. The increase
  in gross profit relates primarily to the inclusion of MTC's results for Fiscal
  1996. During Fiscal 1996, in order to conform with industry practices, the
  Company classified certain expenses as cost of sales which under prior
  presentations would have been classified as general and administrative
  expenses. Consistent with this presentation, the Company has reclassified
  certain general and administrative expenses as cost of sales for Fiscal 1995.
   
    Operating expenses (including selling, engineering, general and
  administrative expenses, less amortization) increased $2.4 million to $9.9
  million for Fiscal 1996, as compared to $7.5 million for Fiscal 1995. Selling,
  engineering, general and administrative expenses increased a combined $6.1
  million to $7.8 million for Fiscal 1996, as compared to $1.7 million for
  Fiscal 1995, primarily from the inclusion of MTC's operations for the entire
  fiscal year ended September 30, 1996. Included in the operating expenses for
  Fiscal 1996 is a one-time charge of $2.2 million associated with changes in
  the Company's product lines. Included in the operating expenses for Fiscal
  1995 is a write-off of acquired in process, unproven technology of $5.0
  million and acquisition expenses of $846,000, both of which are associated
  with the acquisition of MTC in September 1995.
   
    Amortization expense increased $964,000 to $993,000 for Fiscal 1996 as
  compared to $29,000 for Fiscal 1995. This increase in amortization expense is
  primarily the result of the additional amortization expense associated with
  the acquisition of MTC in September 1995.
   
    The Company had a net loss from continuing operations of $2.7 million for
  Fiscal 1996, as compared to a net loss from continuing operations of $7.2
  million for Fiscal 1995.
   
    Consolidated interest expense increased $764,000 to $1.2 million for Fiscal
  1996 as compared to $456,000 for Fiscal 1995. Interest expense increased as a
  result of increased outstanding indebtedness during Fiscal 1996. The increase
  in outstanding indebtedness was principally a result of acquisition debt and
  borrowings to fund working capital.
   
    The Company recognized a gain on the sale of securities of $5.7 million in
  Fiscal 1996. This gain was the result of the sale of all shares of IMNET held
  by the Company.
   
    The Company recognized a loss from operations with respect to its
  discontinued Telecommunications Division of $1.8 million for Fiscal 1996. The
  Company recognized a loss from operations with respect to its discontinued
  Telecommunications Division of $898,000 for Fiscal 1995, in addition to a loss
  of $1.1 million associated with the discontinued operations and disposal of
  Utilization Management Associates, Inc.
   
    For Fiscal 1996, the Company had a net loss applicable to common
  shareholders of $6.1 million, as compared to a net loss of $9.7 million for
  Fiscal 1995.
   
                                        30
  <PAGE>
   
  LIQUIDITY AND CAPITAL RESOURCES
   
    For fiscal 1997, cash flows used in operating activities of continuing
  operations were $1.4 million, as compared to $3.3 million for fiscal 1996. The
  Company used $1.1 million in investing activities of continuing operations
  during fiscal 1997, as compared to cash flows of $5.2 million provided by
  investing activities of continuing operations in fiscal 1996. During fiscal
  1996, the Company realized net proceeds of $7.7 million on the sale of
  marketable securities. Cash flows provided by financing activities of
  continuing operations increased $4.5 million to $2.4 million for fiscal 1997,
  as compared to cash flows used in financing activities of continuing
  operations of $2.1 million for fiscal 1996. This increase in cash flows was
  primarily the result of the establishment of additional credit facilities
  associated with certain lease arrangements the Company entered into with its
  customers.
   
    For the six months ended March 31, 1998, cash flows used in operating
  activities of continuing operations were $2.5 million, as compared to $908,000
  for the six months ended March 31, 1997. The Company used $243,000 in
  investing activities of continuing operations during the six months ended
  March 31, 1998, as compared to $924,000 for the same period in 1997. Cash
  flows provided by financing activities of continuing operations increased
  $962,000 million to $2.7 million for the six months ended March 31, 1998, as
  compared to $1.8 million for the six months ended March 31, 1997. This
  increase in cash flows was primarily the result of the realization of $4.6
  million in net proceeds associated with the Company's private equity placement
  on December 31, 1997 and the repayment of long-term debt of $2.0 million, as
  compared to net borrowings of $1.9 million over the six months ended March 31,
  1997.
   
    On December 31, 1997, the Company sold 5,000 shares of Series A Preferred
  Stock and warrants to purchase 150,000 shares of Common Stock for $5,000,000.
  On January 2, 1998, $4.6 million in net proceeds from this sale were applied
  to the Company's Revolving Credit Facility. On May 28, 1998, the Company sold
  10,000 shares of Series B Preferred Stock and warrants to purchase 200,000
  shares of Common Stock for $10,000,000. The Company has extended the maturity
  of its Revolving Credit Facility, which has a maximum borrowing capacity of
  $9.5 million, through July 15, 1999. During fiscal 1997, the Company obtained
  an additional credit facility from the same lender, whereby MTC can borrow up
  to $1.5 million against qualified lease arrangements it enters into with its
  customers.
   
    The Company believes that it will need to raise substantial additional
  capital to fund the Company's aggregate capital expenditures and working
  capital requirements, including operating losses, associated with achieving
  its market penetration objectives. The Company's future cash requirements for
  its business plan expansion will depend on a number of factors including (i)
  the number of cable affiliate contracts, (ii) cable modem and associated costs
  of equipment, (iii) the rate at which subscribers purchase the Company's
  Internet service offering and (iv) the level of marketing required to acquire
  and retain subscribers and to attain a competitive position in the
  marketplace. In addition, the Company may wish to selectively pursue possible
  acquisitions of businesses, technologies, content or products complementary to
  those of the Company in the future in order to expand its Internet presence
  and achieve operating efficiencies. The Company may seek to obtain additional
  funding through the sale of public or private debt and/or equity securities or
  through a bank credit facility. There can be no assurance as to the
  availability or terms upon which such financing might be available.
   
   
  YEAR 2000 ISSUE
   
    Many existing computer systems and related software applications, and other
  control devices, use only two digits to identify a year in a date field,
  without considering the impact of the upcoming change in the century. Such
  systems, applications and/or devices could fail or create erroneous results
  unless corrected so that they can process data related to the Year 2000. The
  Company relies on such computer systems, applications and devices in operating
  and monitoring all major aspects of its business, including, but not limited
  to, its financial systems (such as general ledger, accounts payable and
  payroll modules), customer services, internal networks and telecommunications
  equipment, and end products. The Company also relies, directly and indirectly,
  on the
   
                                        31
  <PAGE>
   
  external systems of various independent business enterprises, such as its
  customers, suppliers, creditors, financial organizations, and of governments,
  both domestically and internationally, for the accurate exchange of data and
  related information.
   
    The Company is currently in the process of evaluating the potential impact
  of the Year 2000 issue on its business and the related expenses that could
  likely be incurred in attempting to remedy such impact (including testing and
  implementation of remedial action). Management's current estimate is that the
  costs associated with the Year 2000 issue should not have a material adverse
  affect on the results of operations or financial position of the Company in
  any given year. However, despite the Company's efforts to address the Year
  2000 impact on its internal systems, the Company is not sure that it has fully
  identified such impact or that it can resolve it without disruption of its
  business and without incurring significant expenses. In addition, even if the
  internal systems of the Company are not materially affected by the Year 2000
  issue, the Company could be affected as a result of any disruption in the
  operation of the various third party enterprises with which the Company
  interacts such as cable affiliates, vendors and suppliers.
   
                                        32
  <PAGE>
   
                     INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
   
  <TABLE>
  <CAPTION>
                                                                             PAGE
                                                                             ----
  <S>                                                                        <C>
  Report of Independent Auditors............................................  33
  Consolidated Statements of Operations for years ended September 30, 1997,
   1996 and 1995............................................................  34
  Consolidated Balance Sheets, September 30, 1997 and 1996..................  35
  Consolidated Statements of Shareholders' Equity for years ended September
   30, 1997, 1996 and 1995..................................................  36
  Consolidated Statements of Cash Flows for years ended September 30, 1997,
   1996 and 1995............................................................  37
  Notes to Consolidated Financial Statements................................  38
  Condensed Consolidated Statement of Operations for the Three Months and
   Six Months Ended March 31, 1998 and March 31, 1997 (unaudited)...........  55
  Condensed Consolidated Balance Sheets, March 31, 1998 and September 30,
   1997 (unaudited).........................................................  56
  Condensed Consolidated Statements of Cash Flows for the Six Months Ended
   March 31, 1998 and March 31, 1997 (unaudited)............................  57
  Notes to Condensed Consolidated Financial Statements......................  58
  </TABLE>
  <PAGE>
   
                         REPORT OF INDEPENDENT ACCOUNTANTS
   
  To the Board of Directors and Shareholders of SoftNet Systems, Inc.:
   
    We have audited the consolidated financial statements of SoftNet Systems,
  Inc. and Subsidiaries as listed in the preceding index to the consolidated
  financial statements. 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 audits 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 consolidated financial position of SoftNet
  Systems, Inc. and Subsidiaries as of September 30, 1997 and 1996 and the
  consolidated results of their operations and their cash flows for each of the
  three years in the period ended September 30, 1997 in conformity with
  generally accepted accounting principles.
   
    As discussed in Note 2 to the consolidated financial statements, the Company
  adopted Statement of Financial Accounting Standard No. 115, "Accounting for
  Certain Investments in Debt and Equity Securities" in 1995.
   
    The accompanying consolidated financial statements have been restated for
  the effects of the discontinued operations of the telecommunications segment
  as discussed in Note 17.
   
                                            COOPERS & LYBRAND L.L.P.
   
                                            /s/ PricewaterhouseCoopers L.L.P.
   
  Chicago, Illinois
  December 24, 1997 except for Note 17
  as to which the date is July 27, 1998
   
                                        33
  <PAGE>
   
                       SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
                       CONSOLIDATED STATEMENTS OF OPERATIONS
               FOR THE YEARS ENDED SEPTEMBER 30, 1997, 1996 AND 1995
                       (IN THOUSANDS, EXCEPT PER SHARE DATA)
   
  <TABLE>
  <CAPTION>
                                                        1997     1996     1995
                                                       -------  -------  -------
  <S>                                                  <C>      <C>      <C>
  Net sales........................................... $21,338  $19,584  $ 1,088
  Cost of sales.......................................  11,935   11,375      783
                                                       -------  -------  -------
      Gross profit....................................   9,403    8,209      305
                                                       -------  -------  -------
  Operating expenses:
    Selling...........................................   1,905    1,794      168
    Engineering.......................................   2,234    1,770       59
    General and administrative........................   3,628    4,200    1,446
    Amortization of goodwill and transaction costs....   1,287      993       29
    Costs associated with change in product line and
     other............................................   2,137    2,164       --
    Write off of acquired in process unproven
     technology.......................................      --       --    5,000
    Acquisition costs and other.......................      --       --      846
                                                       -------  -------  -------
      Total operating expenses........................  11,191   10,921    7,548
                                                       -------  -------  -------
  Loss from continuing operations.....................  (1,788)  (2,712)  (7,243)
    Interest expense..................................  (1,145)  (1,220)    (456)
    Gain on sale of available-for-sale securities.....      --    5,689       --
    Other income......................................      49       19        5
                                                       -------  -------  -------
  Income (loss) from continuing operations before
   income taxes and extraordinary item................  (2,884)   1,776   (7,694)
  Provision for income taxes..........................      --       --       --
                                                       -------  -------  -------
  Income (loss) before discontinued operations and
   extraordinary item.................................  (2,884)   1,776   (7,694)
  Discontinued operations:
    Income (loss) from operations.....................     739   (1,812)  (1,318)
    Loss on disposal..................................      --       --     (644)
                                                       -------  -------  -------
  Loss before extraordinary item......................  (2,145)     (36)  (9,656)
  Extraordinary item:
  Loss on sale of business............................    (486)  (6,061)      --
                                                       -------  -------  -------
  Net loss............................................ $(2,631) $(6,097) $(9,656)
                                                       =======  =======  =======
  Loss per share:
    Continuing operations............................. $ (0.44) $  0.30  $ (1.77)
    Discontinued operations...........................    0.11    (0.31)   (0.30)
    Loss on disposal..................................      --       --    (0.15)
    Extraordinary item................................   (0.07)   (1.04)      --
                                                       -------  -------  -------
    Net loss.......................................... $ (0.40) $ (1.05) $ (2.22)
                                                       =======  =======  =======
    Weighted average shares outstanding...............   6,627    5,819    4,353
                                                       -------  -------  -------
  </TABLE>
   
    The accompanying notes are an integral part of these consolidated financial
                                    statements.
   
                                         34
  <PAGE>
   
                       SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
                            CONSOLIDATED BALANCE SHEETS
                         AS OF SEPTEMBER 30, 1997 AND 1996
                         (IN THOUSANDS, EXCEPT SHARE DATA)
   
  <TABLE>
  <CAPTION>
                                                                1997      1996
                                                              --------  --------
  <S>                                                         <C>       <C>
                            ASSETS
  Current assets:
    Cash..................................................... $     37  $    426
    Accounts receivable, net.................................    5,135     3,837
    Inventories..............................................    1,326     2,793
    Prepaid expenses and other...............................      319       254
                                                              --------  --------
      Total current assets...................................    6,817     7,310
                                                              --------  --------
  Property & equipment, net..................................    1,108     1,336
  Costs in excess of fair value of net assets acquired, net..    5,141     6,255
  Other assets...............................................    3,820     2,312
  Net assets associated with discontinued operations.........    3,435     1,783
                                                              --------  --------
                                                              $ 20,321  $ 18,996
                                                              ========  ========
             LIABILITIES AND SHAREHOLDERS' EQUITY
  Current liabilities:
    Accounts payable and accrued expenses.................... $  4,969  $  4,039
    Current portion of long-term debt........................    1,384       603
    Current portion of capital leases........................       23        79
    Deferred revenue.........................................      143       159
                                                              --------  --------
      Total current liabilities..............................    6,519     4,880
                                                              --------  --------
  Long-term debt, net of current portion.....................   11,727    10,247
                                                              --------  --------
  Capital leases, net of current portion.....................       47        76
                                                              --------  --------
  Shareholders' equity
    Preferred Stock, $.10 par value, 4 million shares
     authorized, none outstanding............................       --        --
    Common stock, $.01 par value, 25 million shares
     authorized, 6,870,559 and 6,540,065 shares outstanding,
     respectively............................................       69        65
    Capital in excess of par.................................   34,379    33,517
    Accumulated deficit......................................  (32,420)  (29,789)
                                                              --------  --------
      Total shareholders' equity.............................    2,028     3,793
                                                              --------  --------
                                                              $ 20,321  $ 18,996
                                                              ========  ========
  </TABLE>
   
    The accompanying notes are an integral part of these consolidated financial
                                    statements.
   
                                         35
  <PAGE>
   
                      SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
                  CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
               FOR THE YEARS ENDED SEPTEMBER 30, 1997, 1996 AND 1995
                                  (IN THOUSANDS)
   
  <TABLE>
  <CAPTION>
                                             COMMON STOCK  CAPITAL IN
                                             ------------- EXCESS OF  ACCUMULATED
                                             SHARES AMOUNT PAR VALUE    DEFICIT
                                             ------ ------ ---------- -----------
  <S>                                        <C>    <C>    <C>        <C>
  Balance, October 1, 1994.................. 3,903   $39    $16,434    $(14,036)
    Sale of common stock, net of issuance
     costs..................................   200     2        708          --
    Value assigned to options and warrants
     issued with the extension of senior
     notes..................................    --    --         66          --
    Exercise of warrants....................   100     1        187          --
    Common stock issued in connection with
     acquisitions, net of issuance costs.... 1,143    11      7,533          --
    Conversion of convertible subordinated
     notes..................................   201     2      1,628          --
    Settlement of related party receivable..    --    --      1,028          --
    Net loss................................    --    --         --      (9,656)
                                             -----   ---    -------    --------
  Balance, September 30, 1995............... 5,547    55     27,584     (23,692)
    Exercise of warrants....................    12    --         21          --
    Settlements of related party receivable.    --    --        815          --
    Conversion of convertible subordinated
     notes..................................   781     8      4,077          --
    Common stock issued in connection with
     acquisitions, net of acquisition costs.   200     2      1,020          --
    Net loss................................    --    --         --      (6,097)
                                             -----   ---    -------    --------
  Balance, September 30, 1996............... 6,540    65     33,517     (29,789)
    Exercise of warrants....................   251     3        432          --
    Conversion of convertible subordinated
     notes..................................    70     1        386          --
    Common stock issued to pay acquisition
     costs..................................    10    --         44          --
    Net loss................................    --    --         --      (2,631)
                                             -----   ---    -------    --------
  Balance, September 30, 1997............... 6,871   $69    $34,379    $(32,420)
                                             =====   ===    =======    ========
  </TABLE>
   
    In fiscal 1995, the Company recorded $7,738,000 of unrealized appreciation
  of available-for-sale securities in a Shareholders' Equity account. In fiscal
  1996, this amount was eliminated upon the sale of the securities.
   
    The accompanying notes are an integral part of these consolidated financial
                                    statements.
   
                                        36
  <PAGE>
   
                       SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
                       CONSOLIDATED STATEMENTS OF CASH FLOWS
               FOR THE YEARS ENDED SEPTEMBER 30, 1997, 1996 AND 1995
                                   (IN THOUSANDS)
   
  <TABLE>
  <CAPTION>
                                                        1997     1996     1995
                                                       -------  -------  -------
  <S>                                                  <C>      <C>      <C>
  Cash flows from operating activities:
   Net loss........................................... $(2,631) $(6,097) $(9,656)
   Adjustments to reconcile net loss to net cash used
    in operating activities:
   (Income) loss from discontinued operations.........    (739)   1,812    1,318
   Write-off of acquired in-process unproven
    technology........................................      --       --    5,000
   Depreciation and amortization......................   1,798    1,374      194
   Write-off of prepaid software licenses.............   1,000       --       --
   Write-off of capitalized product design costs......   1,137       --       --
   Acquisition costs..................................      --       --      543
   Loss on the disposal of property and equipment.....      40       --       25
   Gain on sale of available-for-sale securities......      --   (5,689)      --
   Debt discount and deferred financing amortization..      19       95       87
   Provision for bad debts............................     174      101       --
   Loss on sale of business...........................      --    6,061       --
   Changes in operating assets and liabilities, net
    of effect of purchase transactions and disposal
    of discontinued operations:
    Accounts receivable...............................  (1,471)    (521)    (125)
    Non-current lease receivable......................  (3,054)      --       --
    Inventories.......................................   1,466   (1,076)    (464)
    Prepaid expenses..................................     (65)     (25)     (27)
    Accounts payable and accrued expenses.............     930      775      395
    Deferred revenue..................................      17      (81)      (8)
                                                       -------  -------  -------
     Net cash used in operating activities of
      continuing operations...........................  (1,379)  (3,271)  (2,718)
                                                       -------  -------  -------
     Net cash used in operating activities of
      discontinued operations.........................  (1,089)  (1,132)  (1,951)
                                                       -------  -------  -------
  Cash flows from investing activities:
   Net cash paid in connection with acquisitions......      --     (195)  (2,450)
   Purchase of prepaid software licenses..............      --   (1,000)      --
   Purchase of property and equipment.................    (510)    (732)    (415)
   Additions to capitalized product design............    (654)    (462)      --
   Settlement of remaining obligations to owners of
    discontinued operations...........................      --     (117)      --
   Proceeds from sale of investment securities........      --    7,678    1,027
   Proceeds from sale of property and equipment.......      15       --       31
   Other..............................................      15       --     (115)
                                                       -------  -------  -------
     Net cash provided by (used in) investing
      activities of continuing operations.............  (1,134)   5,172   (1,922)
                                                       -------  -------  -------
     Net cash used in investing activities of
      discontinued operations.........................     (46)  (2,073)  (1,134)
                                                       -------  -------  -------
  Cash flows from financing activities:
   Proceeds from issuance of long-term debt, net of
    deferred financing costs..........................   3,665       --    3,135
   Repayment of long-term debt........................    (753)     (48)    (475)
   Net borrowings (payments) under revolving credit
    note..............................................    (831)  (2,540)   1,659
   Proceeds from settlement of related party
    receivable........................................      --      815       --
   Repayment of prior revolving credit facility.......      --       --     (383)
   Proceeds from sale of available-for-sale
    securities........................................      --       --      720
   Payment of put obligation..........................      --     (200)      --
   Proceeds from exercise of warrants.................     435       22      169
   Capitalized lease obligations paid.................     (85)    (100)    (118)
                                                       -------  -------  -------
     Net cash provided by (used in) financing
      activities of continuing operations.............   2,431   (2,051)   4,707
                                                       -------  -------  -------
     Net cash provided by financing activities of
      discontinued operations.........................     828    3,208    3,144
                                                       -------  -------  -------
  Net increase (decrease) in cash.....................    (389)    (147)     126
  Cash, beginning of period...........................     426      573      447
                                                       -------  -------  -------
  Cash, end of period................................. $    37  $   426  $   573
                                                       =======  =======  =======
  </TABLE>
   
    The accompanying notes are an integral part of these consolidated financial
                                    statements.
   
                                         37
  <PAGE>
   
                      SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
   
  1. NATURE OF BUSINESS AND BASIS FOR PRESENTATION
   
    SoftNet Systems, Inc. and Subsidiaries (the "Company") is engaged in the
  business of developing, marketing, installing and servicing electronic
  information and document management systems that allow customers to
  electronically request and electronically receive information. The Company
  operates through three segments: document management, telecommunications, and
  Internet services. The document management segment designs, develops,
  manufactures and integrates comprehensive, non-paper based systems and
  components that enable the Company to deliver to its customers cost-effective
  solutions for the storage, indexing and/or distribution of high-volume
  computer generated or entered information. The telecommunications segment
  sells and services telephone and computer hardware manufactured by others to
  provide communications solutions through the design, implementation,
  maintenance and integration of voice, data and video communications equipment
  and services. Additionally, the telecommunications segment sells and installs
  local and long distance network services. The Internet services segment
  provides Internet access, World Wide Web and database development.
   
    On September 15, 1995, a wholly-owned subsidiary of the Company merged with
  Kansas Communications, Inc. ("KCI"), which was the surviving corporation in
  the merger, pursuant to an Agreement and Plan of Reorganization dated March
  24, 1995, by and between the Company and KCI (see Note 3). The transaction was
  accounted for as a pooling of interests for financial reporting purposes and,
  accordingly, the financial statements of the merged companies relating to all
  periods presented had previously been restated and presented on a combined
  basis. However, in July 1998, the Company's Board of Directors adopted a plan
  to discontinue operations of the telecommunications segment (see Note 17),
  which includes the operations of KCI. Accordingly, the operating results of
  the telecommunications segment have been segregated from continuing operations
  and reported as a separate line item on the statement of operations. The
  assets and liabilities of such operations have been reflected as a net asset.
   
    During 1995, the Company adopted a formal plan to dispose of Utilization
  Management Association, Inc., a medical cost containment business.
  Accordingly, the results of discontinued operations and the estimated loss on
  disposal thereof have been reported separately from the continuing operations
  of the Company for fiscal 1995 (see Note 5).
   
  2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
   
   Principles of Consolidation
   
    The consolidated financial statements include the accounts of SoftNet
  Systems, Inc. ("SoftNet") and its subsidiaries ("Company"). All significant
  intercompany accounts and transactions have been eliminated in preparation of
  the consolidated financial statements.
   
   Concentration of Credit Risk
   
    Financial instruments that potentially subject the Company to concentrations
  of credit risk consist primarily of trade receivables. Credit risk is
  minimized as a result of the large number and diverse nature of the Company's
  customers. As of September 30, 1997, the Company had no significant
  concentrations of credit risk.
   
   Significant Customer
   
    For the fiscal years ended September 30, 1997 and 1996, one customer
  (different customer each year) accounted for 20% and 27%, respectively, of the
  Company's consolidated revenue. No single customer of the Company accounted
  for more than 20% of the Company's consolidated revenue in fiscal 1995.
   
                                        38
  <PAGE>
   
                      SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
   
   Cash and Cash Equivalents
   
    The Company considers cash equivalents to include all highly liquid
  financial instruments purchased with a maturity of three months or less to be
  cash equivalents.
   
   Inventories
   
    Inventories are stated at the lower of cost or market. Cost is determined
  using the first-in, first-out method. The components of inventories as of
  September 30, 1997 and 1996 are as follows (in thousands):
   
  <TABLE>
  <CAPTION>
                                                                      1997   1996
                                                                     ------ ------
        <S>                                                          <C>    <C>
        Raw materials............................................... $  126 $  472
        Work-in-process.............................................    217    424
        Finished goods..............................................    983  1,897
                                                                     ------ ------
                                                                     $1,326 $2,793
                                                                     ====== ======
  </TABLE>
   
   Receivables
   
    The Company has recorded an allowance for uncollectible accounts of $320,000
  and $164,000 at September 30, 1997 and 1996, respectively.
   
   Property and Equipment
   
    Property and equipment are carried at cost less allowances for accumulated
  depreciation. The cost of property and equipment held under capital leases is
  equal to the lower of the net present value of the minimum lease payments or
  the fair value of the leased property at the inception of the lease. Repairs
  and maintenance are charged to expense as incurred.
   
    Depreciation is computed by the straight-line method over the useful lives
  of the related assets. The estimated useful lives range from three to five
  years for equipment to seven years for property, principally office furniture.
  Amortization of capital leases is included with depreciation expense.
   
   Capitalized Software Costs
   
    Certain costs of acquired software to be sold, leased, or otherwise marketed
  are capitalized and amortized over the economic useful life of the related
  software product, which is generally five years. Net unamortized capitalized
  software costs, which resulted from the acquisition of MTC, are included in
  other non-current assets and were $592,000, $792,000 and $991,000 at September
  30, 1997, 1996 and 1995, respectively.
   
   Investments in Equity Securities
   
    In 1995, the Company adopted Statement of Financial Accounting Standards
  (SFAS) No. 115 "Accounting for Certain Investments in Debt and Equity
  Securities." The adoption of SFAS No. 115 resulted in an increase to
  shareholders' equity in the fourth quarter of 1995 of $7.7 million upon the
  completion by IMNET Systems, Inc. of its initial public offering of common
  stock. Prior to this offering, there had been no public market for this common
  stock. At September 30, 1995, the Company's investment in marketable equity
  securities was classified as available-for-sale and, as a result, was stated
  at fair value. During fiscal 1996 the Company sold its entire holdings of
  IMNET Systems, Inc. and realized a gain of $5.7 million.
   
   Fair Value of Financial Instruments
   
    The fair value of the Company's debt, current and long-term, is estimated to
  approximate the carrying value of these liabilities based upon borrowing rates
  currently available to the Company for borrowings with similar terms.
   
                                        39
  <PAGE>
   
                      SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
   
   Costs in Excess of Fair Value of Net Assets Acquired
   
    The excess of costs of acquired companies over the fair value of net assets
  acquired (goodwill) are amortized on a straight-line basis over 10 to 20
  years. Amortization expense for fiscal 1997, 1996 and 1995 was $1.1 million,
  $813,000 and $29,000, respectively. During fiscal 1996 the Company wrote off
  $3.6 million of net goodwill resulting from the sale of the non-application
  oriented interconnect business in Chicago, IL (see Note 5). Accumulated
  amortization at September 30, 1997, 1996 and 1995 was $1.9 million, $870,000
  and $29,000, respectively.
   
    The Company assesses the recoverability of unamortized goodwill by reviewing
  the sufficiency of estimated future operating income and undiscounted cash
  flows of the related entities to cover the amortization during the remaining
  amortization period.
   
   Revenue Recognition
   
    Revenue from the document management segment is generated from four primary
  sources, including product sales, installations, royalty and on-going
  maintenance. Product sales and installation revenue are recognized upon
  shipment, installation, or final customer acceptance, depending on specific
  contract terms. Royalty revenue is recognized monthly based upon estimated
  maintenance fees and is subject to verification against actual fees on a semi-
  annual basis. Revenue from on-going maintenance is recognized as services are
  completed.
   
    Revenue from the Internet services segment is generated from initial and
  recurring monthly Internet access and Web and database development. Set-up
  fees for Internet access customers is recognized upon completion of the
  service. Monthly access fees are recognized in the month of service. World
  Wide Web and database development is recognized upon completion of the
  service.
   
   Leases to Customers
   
    The Company's equipment lease transactions with its customers primarily
  involve the leasing of Computer Output Microfiche ("COM") equipment. Lease
  terms are typically for periods of 3 to 5 years. The Company typically leases
  its COM equipment on a "price per fiche" basis, in which monthly rents are
  driven by actual monthly microfiche production by the lessee. Leases contain
  minimum monthly rents by establishing provisions for minimum production
  volumes per month.
   
    At September 30, 1997, the Company has entered into various sales-type
  leases with its customers. These leases provide for minimum future rents of
  $4.4 million and equipment residual values of $542,000. Unearned interest
  relating to these leases total $673,000. The present value of these leases
  ($4.3 million) is recorded in trade receivables and other assets in the
  accompanying consolidated balance sheet. Future minimum lease payments are as
  follows (in thousands):
   
  <TABLE>
               <S>                                <C>
               1998.............................. $1,491
               1999..............................  1,362
               2000..............................    892
               2001..............................    471
               2002..............................    168
                                                  ------
                   Total......................... $4,384
                                                  ======
  </TABLE>
   
                                        40
  <PAGE>
   
                      SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
   
   Research and Development
   
    Research and development is primarily incurred by the document management
  segment. During fiscal 1997 and 1996, the Company expended $1.8 million and
  $1.1 million, respectively, for research and development.
   
   Income Taxes
   
    The Company recognizes the amount of taxes payable or refundable for the
  current year and recognizes deferred tax liabilities and assets for the
  expected future tax consequences of events and transactions that have been
  recognized in the Company's financial statements or tax returns. The Company
  currently has substantial net operating loss carryforwards. The Company has
  recorded a 100% valuation allowance against net deferred tax assets due to
  uncertainty of their ultimate realization.
   
   Loss Per Share
   
    Loss per share is based on the weighted average number of common shares
  outstanding during the periods. Common stock equivalents (outstanding options
  warrants and convertible securities) are not included in the computations of
  loss per share since their effect is anti-dilutive.
   
   Recently Issued Accounting Pronouncements
   
    In February 1997, the Financial Accounting Standards Board (FASB) issued
  Statement of Financial Accounting Standards No. 128. Earnings per Share (FAS
  128), which specifies the computation, presentation and disclosure
  requirements for earnings per share in order to simplify the computation of
  earnings per share. FAS 128 is effective for financial statements ending after
  December 15, 1997 and earlier application is not permitted. After the
  effective date, all prior period earnings per share data shall be restated to
  conform with the provisions of FAS 128. The adoption of FAS 128 is not
  expected to have a material impact on the Company's earnings per share data.
   
    In June 1997, the FASB issued FAS 130, Reporting Comprehensive Income. This
  statement, effective for fiscal years beginning after December 15, 1997, would
  require the Company to report components of comprehensive income in a
  financial statement that is displayed with the same prominence as other
  financial statements. Comprehensive income is defined by Concepts Statement
  No. 6, Elements of Financial Statements, as the change in equity of a business
  enterprise during a period from transactions and other events and
  circumstances from nonowner sources. It includes all changes in equity during
  a period except those resulting from investments by owners and distributions
  to owners. The Company has not yet determined its comprehensive income.
   
    Also in June 1997, the FASB issued FAS 131, Disclosures about Segments of an
  Enterprise and Related Information. This statement, effective for financial
  statements for periods beginning after December 15, 1997, requires that a
  public business enterprise report financial and descriptive information about
  its reportable operating segments. Generally, financial information is
  required to be reported on the basis that it is used internally for evaluating
  segment performance and deciding how to allocate resources to segments. The
  adoption of FAS 131 is not expected to have a material impact on the Company's
  financial statements.
   
   Use of Estimates in the Preparation of Financial Statements
   
    The preparation of financial statements in conformity with generally
  accepted accounting principles requires management to make estimates and
  assumptions that affect the reported amounts of assets and liabilities and
  disclosure of contingent assets and liabilities at the date of the financial
  statements and the reported amounts of the revenues and expenses during the
  reporting period. Actual results could differ from those estimates.
   
                                        41
  <PAGE>
   
                      SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
   
   Reclassifications
   
    Certain reclassifications have been made in the 1995 financial statements to
  conform with the 1997 and 1996 presentations.
   
  3. MERGER
   
    On September 15, 1995, a wholly-owned subsidiary of the Company merged
  Kansas Communications, Inc. ("KCI") pursuant to an Agreement and Plan of
  Reorganization dated March 24, 1995, by and between the Company and KCI. The
  KCI shareholders received 1.3 million shares of the Company's common stock in
  exchange for all of the outstanding shares of KCI. The business combination
  was accounted for as a pooling of interests and, accordingly, the operations
  of KCI had been included with the results of the Company for all periods
  presented. However, in July 1998, the Company's Board of Directors adopted a
  plan to discontinue operations of the telecommunications segment (see Note
  17), which includes the operations of KCI. Accordingly, the operating results
  of the telecommunications segment have been segregated from continuing
  operations and reported as a separate line item on the statement of
  operations. The assets and liabilities of such operations have been reflected
  as a net asset.
   
    KCI is a Kansas City-based company which sells and services telephone
  systems, third-party computer hardware and application oriented peripheral
  products such as voice mail, automated attendant systems, interactive voice
  response (IVR) and video conferencing systems.
   
    The following are the net revenues from continuing operations and net income
  (loss) of the separate companies for the period preceding the acquisition (in
  thousands):
   
  <TABLE>
  <CAPTION>
                                                     SOFTNET
                                                  SYSTEMS, INC.  KCI   COMBINED
                                                  ------------- ------ --------
        <S>                                       <C>           <C>    <C>
        Nine months ended June 30, 1995
         (Unaudited):
          Net sales..............................    $8,285     $7,564 $15,849
          Net income (loss)......................    (1,777)       272  (1,505)
  </TABLE>
   
    In connection with the merger, the Company recorded transaction related
  charges of $648,000 in fiscal 1995. The merger costs relate to expenses
  incurred to consummate the transaction, including investment banking, legal
  and accounting fees.
   
  4. ACQUISITIONS
   
   Milwaukee Operation of Executone Management Systems, Inc.
   
    On December 29, 1995, the Company acquired the Milwaukee operations of
  Executone Information Systems, Inc. ("Executone-Milwaukee"), in a business
  combination accounted for as a purchase. Executone-Milwaukee sells and
  services proprietary voice processing systems. The purchase price of
  approximately $1.9 million consisted of $100,000 of cash and a note payable
  for $1.8 million. The note was paid in February, 1996. The operations of
  Executone-Milwaukee have been included in the results of the Company since
  December 29, 1995. However, in July 1998, the Company's Board of Directors
  adopted a plan to discontinue operations of the telecommunications segment
  (see Note 17), which includes these operations. Accordingly, the operating
  results of the telecommunications segment have been segregated from continuing
  operations and reported as a separate line item on the statement of
  operations. The assets and liabilities of such operations have been reflected
  as a net asset.
   
                                        42
  <PAGE>
   
                      SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
    As a result of the acquisition, the Company recorded costs in excess of fair
  value of net assets acquired of $1.8 million, an amount which is being
  amortized on a straight-line basis over twenty years.
   
   MediaCity World, Inc.
   
    On June 21, 1996, the Company acquired MediaCity World, Inc. ("MCW"), in a
  business combination accounted for as a purchase. MCW is an Internet Service
  Provider with operations in the San Francisco Bay Area and Reno, Nevada. The
  purchase price consisted of 200,000 shares of the Company's common stock
  valued at $5.11 per share. The operations of MCW have been included in the
  results of the Company since June 21, 1996. As a result of the acquisition of
  MCW, the Company recorded costs in excess of fair value of net assets acquired
  of $1.2 million, being amortized on a straight line basis over three years.
   
   Communicate Direct, Inc.
   
    On October 31, 1994, the Company acquired Communicate Direct, Inc. ("CDI")
  in a business combination accounted for as a purchase. CDI, a Chicago-based
  company, sold and serviced telephone systems, third-party computer hardware
  and application oriented peripheral products such as voice mail, automated
  attendant systems, interactive voice response ("IVR") and video conferencing
  systems. The operations of CDI have been included with the results of the
  Company from November 1, 1994 until they were subsequently sold. During fiscal
  1996, the Company sold a significant portion of the CDI business and, during
  fiscal 1997, all of the remaining operation was sold.
   
    The Company acquired all of the outstanding stock of CDI for $1.9 million,
  such consideration consisting of 290,858 shares of the Company's Series A
  Convertible Preferred Stock ("Preferred Shares") valued at $6.00 per share and
  cash. In April 1995, the Preferred Shares were converted into common shares on
  a one-to-one basis following the approval of the Company's shareholders. The
  acquisition price has been adjusted for settlement of an earn-out agreement
  and resolution of certain post-closing purchase adjustments. The cost in
  excess of fair value of net assets acquired incurred in connection with the
  acquisition of CDI of $4.2 million was originally to be amortized on a
  straight-line basis over ten years. As a result of the 1996 sale, the Company
  wrote off the unamortized balance of the goodwill which arose from the
  original acquisition (See Note 5).
   
   Micrographic Technology Corporation
   
    On September 15, 1995, the Company acquired Micrographic Technology
  Corporation ("MTC") pursuant to an Agreement and Plan of Reorganization dated
  March 24, 1995 in a business combination accounted for as a purchase
  transaction. MTC is a designer, developer, manufacturer and integrator of
  comprehensive, non-paper based systems and components that enable MTC to
  deliver to its customers cost-effective solutions for storage, indexing and/or
  distribution of high-volume output data streams. The MTC shareholders'
  received 778,000 shares of the Company's common stock valued at $6.95 per
  share, $1.1 million in cash and $2.8 million principal amount of the Company's
  debentures. The operations of MTC have been included with the results of the
  Company since September 16, 1995.
   
    The cost in excess of fair value of net assets acquired incurred in
  connection with the acquisition of MTC of $6.1 million is being amortized on a
  straight-line basis over ten years. Additionally, in connection with the
  acquisition of MTC, the Company incurred a one-time charge in fiscal 1995 of
  $5.0 million for the write-off of acquired in-process unproven technology.
   
    The following unaudited pro forma summary presents information as if the
  acquisitions accounted for as purchases had occurred at the beginning of each
  fiscal year. The pro forma information is provided for informational purposes
  only. It is based on historical information and does not necessarily reflect
  the actual
   
                                        43
  <PAGE>
   
                      SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
  results that would have occurred nor is it necessarily indicative of future
  results of operations of the combined enterprise (in thousands, except per
  share data):
   
  <TABLE>
  <CAPTION>
                                                                  YEARS ENDED
                                                                 SEPTEMBER 30,
                                                                ----------------
                                                                 1996     1995
                                                                -------  -------
                                                                  (UNAUDITED)
        <S>                                                     <C>      <C>
        Net sales from continuing operations................... $42,270  $40,020
        Net loss from continuing operations....................    (328)  (9,175)
        Net loss per share..................................... $ (0.05) $ (2.02)
  </TABLE>
   
  5. DIVESTITURES
   
   Utilization Management Associates, Inc.
   
    During September 1995, the Company's Board of Directors approved a plan to
  rescind its November 1993 acquisition of Utilization Management Associates,
  Inc. ("UMA"). The plan provided for the exchange of the Company's interest in
  UMA for all common shares of the Company held by the former shareholders of
  UMA, including related put options, and the cancellation of SoftNet stock
  options held by the former shareholders of UMA.
   
    Effective November 20, 1995, the plan was executed such that the Company
  paid the former shareholders of UMA $200,000 in satisfaction of it's common
  stock put obligation and received in exchange 29,630 shares of SoftNet common
  stock. In addition, the Company paid approximately $300,000 in cash and notes
  for the termination of non-compete, employment, and earn-out agreements and an
  irrevocable and unconditional release of the Company from any outstanding
  obligations and liabilities to UMA or the shareholders of UMA.
   
    In connection with the disposition, in fiscal 1995, the Company recorded a
  loss on disposal of discontinued operations of $644,000, along with a loss
  from discontinued operations of $420,000. Such amounts have not been adjusted
  for any income tax effect given the Company's net operating loss carryforward.
  For the year ended September 30, 1995, UMA contributed revenue of
  approximately $860,000 to the consolidated revenues of the Company.
   
   Communicate Direct, Inc.
   
    In June 1996, CDI sold its non-application oriented interconnect business
  located in the Chicago, IL metropolitan area to Next Call, Inc. ("Next Call")
  for a $600,000 ten year note receivable. In connection with the sale, CDI
  agreed to lend Next Call up to $1.0 million to fund operating losses, as
  defined, for the first twelve months of operations. The loan agreement
  required CDI to advance cash to Next Call on a monthly basis to cover
  operating cash short fall. Next Call was required to repay such advances when
  it became profitable on a cumulative basis. After the first twelve months, any
  amount still outstanding from Next Call was to be forgiven. As of September
  30, 1996, the Company had made $189,000 in advances pursuant to this
  agreement. Subsequent to September 30, 1996, Next Call ceased operations.
   
    As a result of the sale to Next Call and the uncertainty resulting from Next
  Call's subsequent shut down, the Company incurred an extraordinary charge of
  $6.0 million for the loss on the sale of this business, including the write-
  off of unamortized goodwill which resulted from the initial purchase of CDI in
  October 1994, deferred acquisition costs associated with the purchase of CDI,
  severance payments, inventory, leasehold improvements, the notes receivable
  from Next Call and all amounts loaned to the buyer. The loss resulting from
  the disposition of certain assets and the assumption of certain liabilities of
  CDI, within a two year period following a pooling of interests has been
  classified as an extraordinary item as required by generally accepted
  accounting principles.
   
                                        44
  <PAGE>
   
                      SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
  The disposition of CDI was not contemplated at the time of the pooling with
  KCI. During fiscal 1997, CDI sold its operations that support its Fujitsu
  maintenance base in the Chicago metropolitan area to a new company formed by
  John I. Jellinek, the Company's former president, chief executive officer and
  director and Philip Kenny, a former SoftNet director. The buyer acquired
  certain assets in exchange for a $209,000 promissory note and the assumption
  of current liabilities of approximately $750,000. In addition, at the closing
  the buyer paid off $438,000 of existing Company bank debt and entered into a
  sub-lease of CDI's facility in Buffalo Grove, Illinois. At the closing, the
  buyer merged with Telcom Midwest, LLC., and the two former directors and the
  other two shareholders of the merged company personally guaranteed obligations
  arising out of the promissory note, the sub-lease arrangement and the
  assumption of certain liabilities. The personal guarantees of the promissory
  note are several. The personal guarantees of the sub-lease are limited to
  $400,000 and are on a joint and several basis. The personal guarantees of
  assumed liabilities are on a joint and several basis but are limited to the
  two former directors. Concurrent with this transaction, Messrs. Jellinek and
  Kenny resigned from the Company's board.
   
  6. CHANGE IN PRODUCTS
   
    During fiscal 1996, the Company acquired from IMNET an exclusive worldwide
  manufacturing right to certain microfilm retrieval technology, partially in
  exchange for the prepayment of fees for 250 software licenses. Accordingly,
  the Company recorded a prepaid license fee of $1.0 million in other non-
  current assets in the accompanying consolidated balance sheets. As of
  September 30, 1997, the transfer to the Company of the technical and
  manufacturing know-how for this technology has continued to be delayed.
  Despite the ongoing negotiation and cooperation between the parties, the
  Company determined there was a potential material risk in completing the
  transfer and getting the product to market. As a result, the Company wrote-off
  the prepaid license fee of $1.0 million in the fourth quarter of fiscal 1997
  (see Note 14).
   
    Also, in the fourth quarter of 1997, the Company reevaluated the development
  and timely offering of its RAPID (Rapid Archiving Peripheral for Images and
  Documents) product. Market driven product enhancements, and the resulting
  technological setbacks, delayed the estimated product offering date at least
  one year to the second quarter of fiscal 1998. As a result, the Company has
  written-off $1.1 million of capitalized product design costs associated with
  this product.
   
    In June, 1996, the Company signed an agreement to distribute Lucent
  Technologies, Inc. products in the Chicago, Illinois metropolitan area. In
  connection with this distribution agreement and the repositioning of its
  Chicago operations, the Company incurred one-time charges of $1.3 million for
  severance payments, asset write-downs and other.
   
    Included in the fourth quarter 1996 results is a charge of $1.5 million for
  the write-down of certain software inventory resulting from the Company's
  decision to discontinue the distribution of certain imaging products in favor
  of others (see Note 14).
   
  7. SIGNIFICANT FOURTH QUARTER EVENTS
   
    Operating results in the fourth quarter of fiscal 1997 include the effects
  of the following:
   
    A. A charge of $1.0 million related to the write-off of prepaid license
       fees (see Notes 6 and 14).
   
    B. A charge of $1.1 million related to the write-off of capitalized product
       design costs (see Notes 6 and 14).
   
                                        45
  <PAGE>
   
                       SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
   
  8. PROPERTY AND EQUIPMENT
   
    Balances of major classes of fixed assets and allowances for depreciation at
  September 30, 1997 and 1996 are as follows: (in thousands)
   
  <TABLE>
  <CAPTION>
                                                                    1997    1996
                                                                   ------  ------
        <S>                                                        <C>     <C>
        Leasehold improvements.................................... $  155  $  118
        Furniture and fixtures....................................    276     605
        Equipment.................................................  1,566   1,214
                                                                   ------  ------
            Total.................................................  1,997   1,937
        Less allowance for depreciation and amortization..........   (889)   (601)
                                                                   ------  ------
        Property and equipment, net............................... $1,108  $1,336
                                                                   ======  ======
  </TABLE>
   
  9. DEBT
   
  <TABLE>
  <CAPTION>
                                                                 1997     1996
                                                                -------  -------
  <S>                                                           <C>      <C>
  Debt is summarized as follows: (in thousands)
    Revolving Credit Note with maximum borrowings of $9.5
     million bearing interest, payable monthly, at the bank's
     prime rate plus 1% (the bank's prime rate 8.5% at
     September 30, 1997). The note matures on January 15, 1999. $ 5,900  $ 6,099
    Equipment Financing Agreement with a maximum borrowing
     limit of $3.15 million, bearing interest at the bank's
     prime rate plus 1% (the bank's prime rate being 8.5% at
     September 30, 1997), principal and interest due in 60
     monthly payments with the final payment due May 2002......   2,398       --
    Draw Note with maximum borrowings for $1.5 million bearing
     interest, payable monthly, at the bank's prime rate plus
     1% (the bank's prime rate being 8.5% at September 30,
     1997).....................................................     675       --
    9% Convertible Debentures due September 2000, interest
     payable quarterly, convertible into the Company's common
     shares at $6.75 per share.................................   2,619    2,856
    9% Convertible Subordinated Notes due December 1998,
     interest payable quarterly, subordinated to all other
     liabilities of the Company, convertible into the Company's
     common shares at $5.00 per share..........................      25       75
    6% Convertible Subordinated Debentures, due February 2002
     with semi-annual interest payments, convertible into the
     Company's common stock at $8.10 per share (subject to
     adjustment for anti-dilution).............................     780      780
    10% Convertible Subordinated Notes due October 1999,
     bearing interest, payable quarterly, at 10% for the first
     two years only and no interest thereafter, subordinated to
     all other liabilities of the Company, convertible into the
     Company's common shares at $4.10 per share................     200      300
    Promissory note due June 1998, interest payable at maturity
     accruing at 5% (terms revised in 1997.....................     161      409
    Promissory notes due November 1997, interest payable in
     arrears on each principal due date accruing at 8.75%......      75      200
    Promissory note bearing interest at 12.25%, principal and
     interest due in 24 monthly payments with final payment due
     October 1999..............................................     278       --
    Bank loan dated August 25, 1995, bearing interest at prime
     plus 1%, principal and interest due in 36 monthly
     instalments with final payment due August 1998............      --       74
    Other......................................................      --       57
                                                                -------  -------
                                                                 13,111   10,850
    Less current portion debt..................................  (1,384)    (603)
                                                                -------  -------
      Total long-term debt..................................... $11,727  $10,247
                                                                =======  =======
  </TABLE>
   
   
                                         46
  <PAGE>
   
                      SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
    The availability under the revolving credit note is subject to revisions on
  a monthly basis based upon available assets (as defined). The revolving credit
  note and the bank term loan (issued from the same bank) are collateralized by
  substantially all of the assets of the Company.
   
    The equipment financing agreement and the draw note were obtained from the
  same bank as the revolving credit note and the assets collateralizing each
  financing facility are excluded from the collateral associated with the
  revolving credit note. The equipment financing agreement covers a specific
  lease agreement and the draw note covers certain bank approved leases. The
  leases are initiated by the Company acting as lessor through the ordinary
  course of business.
   
    In connection with the issuance of the 10% Convertible Subordinated Notes,
  the Company issued warrants to purchase 298,000 shares of the Company's common
  stock exercisable for five years expiring in 1999 at an exercise price of
  $6.875 per share.
   
    During fiscal 1997 and 1996, holders of the 6%, 9% and 10% convertible
  subordinated notes converted $386,000 and $4.1 million face amount of notes
  into 69,000 and 781,000 shares, respectively, of the Company's common stock.
  An additional $200,000 of notes were converted into 49,000 shares of the
  Company's common stock after year end.
   
    In connection with the acquisition of MTC, the Company issued $2.9 million
  of its 9% Convertible Subordinated Debentures (the "MTC 9% Debentures") due
  September 2000. The MTC 9% Debentures are subordinated to senior indebtedness
  of the Company and are convertible after September 15, 1996, into the
  Company's common shares at $6.75 per share. The MTC 9% Debentures may be
  prepaid by the Company in whole or in part at face value. During fiscal 1997,
  of the total $386,000 of notes converted, $236,000 of these 9% debentures were
  converted into 35,000 shares of the Company's common stock.
   
    Also in connection with the acquisition of MTC, the Company assumed $1.8
  million of 6% Convertible Subordinated Secured Debentures (the "Debentures")
  due February 2002. The Debentures are convertible into the Company's common
  stock at $8.10 per share. The Debentures are subject to redemption at the
  option of the Company at face value, provided, however, that the Company
  issues common share purchase warrants to purchase the same number of shares as
  would have been issuable if the Debentures were converted. During fiscal 1996,
  certain holders of the debentures converted $1.0 million face amount
  Debentures into 126,000 shares of the Company's common stock.
   
    During fiscal 1997, the Company sold certain assets of its
  telecommunications segment for cash, a note receivable and the assumption of
  certain liabilities. In addition, the buyer repaid certain bank loans of the
  Company in the principal amount of $438,000 plus accrued interest (see Note
  5).
   
    Aggregate maturities of long-term debt for each of the next five fiscal
  years are as follows (in thousands):
   
  <TABLE>
             <S>                                         <C>
             1998....................................... $1,384
             1999.......................................  6,985
             2000.......................................  3,521
             2001.......................................    315
             2002.......................................    906
  </TABLE>
   
  10. SALE OF COMMON STOCK
   
    On October 26, 1994, the Company sold 200,000 shares of its common stock in
  a Regulation S offering at $4.00 per share. In connection with the sale of
  common stock, the Company incurred fees of $90,000 and issued warrants to
  purchase 250,000 shares of its common stock exercisable for five years at an
  exercise price of $6.875 per share (fair market value at the date of grant).
   
                                        47
  <PAGE>
   
                      SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
   
  11. CAPITALIZED LEASE OBLIGATIONS AND OTHER LEASE COMMITMENTS
   
    The Company leases computer equipment and certain other office equipment
  under leases which are capital in nature. The Company has net assets of
  $314,000 and $520,000 under these capital leases as of September 30, 1997 and
  1996, respectively.
   
    The Company has entered into operating leases for office space and
  manufacturing facilities. These leases provide for minimum rents. These leases
  generally include options to renew for additional periods. The Company's rent
  expense for the years ended September 30, 1997, 1996 and 1995 was $828,000,
  $755,000 and $282,000, respectively.
   
    The aggregate amount of the lease payments under capital and operating
  leases for the Company's continuing operations for each of the five fiscal
  years ending September 30 is as follows (in thousands):
   
  <TABLE>
  <CAPTION>
                                                                 CAPITAL OPERATING
                                                                 LEASES   LEASES
                                                                 ------- ---------
        <S>                                                      <C>     <C>
        1998....................................................  $ 29    $  644
        1999....................................................    22       264
        2000....................................................    23       248
        2001....................................................     9       230
        2002....................................................    --        75
                                                                  ----    ------
        Total minimum lease payments............................  $ 83    $1,461
                                                                  ====    ======
          Amount representing interest..........................   (13)
                                                                  ----
        Present value of net minimum payments...................    70
          Less current portion..................................   (23)
                                                                  ----
        Capital lease obligation................................  $ 47
                                                                  ====
  </TABLE>
   
  12. INCOME TAXES
   
    The Company's provision for income taxes in fiscal 1995 relates exclusively
  to the operations of KCI, for tax liabilities incurred by KCI prior to the
  merger with the Company. These amounts are included in "Loss from operations"
  for discontinued operations in the accompanying statement of operations due to
  the Company's decision to discontinue the telecommunications segment (see Note
  17).
   
    The components of the provision for income taxes are as follows for the
  fiscal years ending September 30 (in thousands):
   
  <TABLE>
  <CAPTION>
                                                                   1997 1996 1995
                                                                   ---- ---- ----
        <S>                                                        <C>  <C>  <C>
        Current
          Federal................................................  $--  $--  $113
          State..................................................   --   --    23
                                                                   ---  ---  ----
            Total current........................................   --   --   136
        Deferred
          Federal................................................   --   --   (10)
          State..................................................   --   --    (2)
                                                                   ---  ---  ----
            Total deferred.......................................   --   --   (12)
                                                                   $--  $--  $124
                                                                   ===  ===  ====
  </TABLE>
   
                                        48
  <PAGE>
   
                      SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
   
    The types of temporary differences between the tax basis of assets and
  liabilities and their financial reporting amounts that give rise to deferred
  taxes at September 30 and the approximate tax effects are as follows (in
  thousands):
   
  <TABLE>
  <CAPTION>
                                              1997                  1996
                                      --------------------- ---------------------
                                      TEMPORARY             TEMPORARY
                                      DIFFERENCE TAX EFFECT DIFFERENCE TAX EFFECT
                                      ---------- ---------- ---------- ----------
  <S>                                 <C>        <C>        <C>        <C>
  Inventory and other operating
   reserves..........................   $  499    $   170     $1,240    $   422
  Allowance for doubtful accounts....      104         35        541        184
  Reserve for note receivable........       --         --        624        212
  Unpaid accruals....................      477        162        794        270
  Reserve for lease termination......       --         --         75         26
  Deferred revenue...................    1,479        503      1,369        465
  Other..............................      (17)        (6)        (9)        (3)
  Net operating loss carryforwards...    6,747      2,294      7,854      2,670
                                        ------    -------     ------    -------
  Total deferred tax asset...........               3,158                 4,246
  Valuation allowance................              (3,158)               (4,246)
                                                  -------               -------
  Net deferred tax asset.............             $    --               $    --
                                                  =======               =======
  </TABLE>
   
    A valuation allowance was recorded as a reduction to the deferred tax assets
  due to the uncertainty of the ultimate realization of future benefits from
  such deferred taxes.
   
    Net operating loss carryforwards of approximately $6.7 million are available
  as of September 30, 1997 to be applied against future taxable income. In
  addition, net operating loss carryforwards of approximately $750,000 acquired
  in connection with the acquisition of MTC are available to reduce recorded
  goodwill when utilized. The net operating loss carryforwards expire between
  1999 and 2010 and are subject to certain annual limitations as a result of the
  changes in equity ownership.
   
                                        49
  <PAGE>
   
                      SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
   
  13. STOCK OPTIONS AND WARRANTS
   
    During fiscal 1995 the Company adopted the 1995 Long Term Incentive Plan
  (the "1995 LTIP") whereby the Company, under the direction of the committee
  appointed by the Board of Directors, can grant a variety of stock-based
  compensation awards. The Company has reserved 1.5 million shares (including an
  increase of 900,000 shares approved by the shareholders during fiscal 1997)
  for issuance under the plan. Outstanding options and warrants to purchase
  shares of common stock at September 30, 1997, 1996 and 1995 were as follows
  (in thousands, except price per option data):
   
  <TABLE>
  <CAPTION>
                                                          SHARES  PRICE PER OPTION
                                                          ------  ----------------
        <S>                                               <C>     <C>
        Outstanding at October 1, 1994...................   730      1.75-6.125
          Granted........................................   924       1.75-8.50
          Canceled.......................................    (4)         4.0429
          Expired........................................    --              --
          Exercised......................................  (100)           1.75
                                                          -----
        Outstanding at September 30, 1995................ 1,550       1.75-8.50
          Granted........................................   574     8.125-10.00
          Canceled.......................................  (542)      6.50-8.25
          Expired........................................    --              --
          Exercised......................................   (13)           1.75
                                                          -----
        Outstanding at September 30, 1996................ 1,569      1.75-10.00
          Granted........................................   400     4.938-5.313
          Canceled.......................................  (283)     4.938-5.00
          Expired........................................    --              --
          Exercised......................................  (251)           1.75
        Outstanding at September 30, 1997................ 1,435      1.75-10.00
                                                          -----
  </TABLE>
   
    Shares available under the Plan were 1,058,000, 303,000 and 600,000 at
  September 30, 1997, 1996 and 1995, respectively. As of September 30, 1997,
  1996 and 1995, there were 1.0 million, 1.2 million and 1.3 million exercisable
  options and warrants, respectively.
   
    During fiscal 1997, the Board of Directors elected to reduce the exercise
  price on 297,000 options from $8.25 to $4.94 per share, the market price on
  the day the board took such action. In addition, during fiscal 1996, the Board
  of Directors elected to reduce the exercise price on 117,000 options from
  $12.75 to $8.25 per share, the market price on the day the board took such
  action.
   
    During fiscal 1997, the Company was required to adopt Statement of Financial
  Standards No. 123, Accounting for Stock-Based Compensation (FAS 123), which
  encourages entities to adopt a fair value based method of accounting for stock
  based compensation plans in place of the provisions of Accounting Principles
  Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), for
  all arrangements under which employees receive shares of stock or other equity
  instruments of the employer.
   
    As allowed by FAS 123, the Company will continue to apply the provisions of
  APB 25 in accounting for its stock based employee compensation arrangements,
  and will disclose the pro forma net loss and loss per share information in its
  footnotes as if the fair value method suggested in FAS 123 had been applied.
   
    Had compensation cost for the Company's LTIP been determined based on the
  fair value at grant date for awards in fiscal 1997 and 1996 consistent with
  the provisions of FAS 123, the Company's net loss and loss per share would
  have been increased to the pro forma amounts indicated below:
   
                                        50
  <PAGE>
   
                      SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
   
    (Dollar amounts in thousands, except per share data)
   
  <TABLE>
  <CAPTION>
                                                                 1997     1996
                                                                -------  -------
        <S>                                                     <C>      <C>
        Net loss, as reported.................................. $(2,631) $(6,097)
        Net loss, pro forma....................................  (3,207)  (6,348)
        Loss per common share, as reported..................... $  (.40) $ (1.05)
        Loss per common share, pro forma.......................    (.48)   (1.09)
  </TABLE>
   
    The fair value of each option grant is estimated on the date of grant using
  the Black-Scholes option pricing model with the following weighted average
  assumptions used for grants in 1997: dividend yield of 0.0%; expected
  volatility of 58%; risk free interest rate spread of 5.8%-6.4%; and expected
  life of 4 years. Options outstanding at September 30, 1997 had exercise prices
  ranging from $4.94 to $5.31. The weighted average exercise price of these
  outstanding options outstanding is $4.98 and the weighted average remaining
  contractual life of those options is 8.8 years.
   
  14. RELATED PARTY TRANSACTIONS
   
    As of September 30, 1994, the Company was owed $4.2 million plus accrued
  interest by Ozite Corporation (Ozite). A Director of the Company and the
  former Chairman of the Board held substantial interests in Ozite. Due to
  uncertainties about collecting these funds, the receivable from Ozite was
  written off and charged against earnings in 1991, and, accordingly no amount
  related to this receivable is recorded on the Company's consolidated financial
  statements.
   
    On July 26, 1995, Ozite shareholders approved a merger of Ozite with Pure
  Tech with Pure Tech being the surviving corporation. As a condition of the
  merger, Ozite was required to secure a general release from the Company and to
  surrender certain securities in satisfaction of the amount owed to the
  Company. As a result, the Company received 311,000 shares of Pure Tech common
  stock, 267,000 shares of Artra Group Incorporated (ARTRA) Common Stock and 932
  shares of Artra Preferred Stock. Subsequently, the Company sold all 311,025
  shares of Pure Tech for net proceeds of $1.0 million, which was recorded as a
  capital contribution during fiscal 1995. During fiscal 1996, the remaining
  securities were sold for net proceeds of $815,000, which was recorded as a
  capital contribution.
   
    During fiscal 1997, CDI sold its operations that support its Fujitsu
  maintenance base in the Chicago metropolitan area to a new company formed by
  John I. Jellinek, the Company's former president, chief executive officer, and
  director and Philip Kenny, a former SoftNet director. The buyer acquired
  certain assets in exchange for a $209,000 promissory note and the assumption
  of current liabilities of approximately $750,000. In addition, at the closing
  the buyer paid off $438,000 of Company bank debt and entered into a sub-lease
  of CDI's facility in Buffalo Grove, Illinois. At the closing, the buyer merged
  with Telcom Midwest, LLC., and the two former directors and the other two
  shareholders of the merged company personally guaranteed obligations arising
  out of the promissory note, the sub-lease arrangement and the assumption of
  certain liabilities. The personal guarantees of the promissory note are
  several. The personal guarantees of the sub-lease are limited to $400,000 and
  are on a joint and several basis. The personal guarantees of assumed
  liabilities are on a joint and several basis but are limited to the two former
  directors. Concurrent with this transaction, Messrs. Jellinek and Kenny
  resigned from the Company's board.
   
    In June 1996, the Company acquired the exclusive worldwide manufacturing
  rights to IMNET's MegaSAR Microfilm Jukebox and completed and amended its
  obligations under a previous agreement. The Company issued a $2.9 million note
  for prepaid license fees, software inventory, the manufacturing rights, and
  certain other
   
                                        51
  <PAGE>
   
                      SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
  payables. Approximately $2.5 million was paid on this note during the fourth
  quarter of fiscal 1996. Subsequently, in fiscal 1997, the outstanding $410,000
  promissory note was further reduced by $249,000, and a new promissory not in
  the face amount of $161,000 was executed.
   
    In July 1997, due to a delay in the transfer to the Company of the technical
  and manufacturing know-how for the MegaSAR product, the Company and IMNET
  further amended the June 1996 Agreement. In an attempt to facilitate the
  technology transfer, the Company accepted an order from IMNET for the first 14
  MegaSAR units to be manufactured by the Company. A portion of the payment for
  these initial units would be applied against the outstanding promissory note.
  The transfer of the technology and the parts needed for production was to have
  occurred no later than September 1, 1997.
   
    As of September 30, 1997, the transfer to the Company of the technical and
  manufacturing know-how for this product offering has continued to be delayed.
  Despite the ongoing negotiation and cooperation between the two parties, the
  Company determined there was a potential material risk in completing the
  technology transfer and getting the product to market. As a result, in the
  fourth quarter of fiscal 1997, the Company recorded a one-time charge of $1.0
  million to write-off the associated prepaid licenses. The Company is currently
  negotiating with IMNET to either complete the transfer or seek an alternative
  solution.
   
    During the fourth quarter of fiscal 1996, the Company decided to discontinue
  its plans for distributing the IMNET microfilm retrieval software in favor of
  another software developer's product. As a result, the Company recorded a one-
  time charge of $1.5 million to write-off software inventory which is included
  under the caption costs associated with change in product lines and other in
  the accompanying consolidate statements of operations.
   
    During fiscal 1996, the Company sold its entire holdings in IMNET for net
  proceeds of $7.7 million. Accordingly, the Company recorded a gain on sale of
  the securities of $5.7 million.
   
  15. SUPPLEMENTAL CASH FLOW INFORMATION
   
  <TABLE>
  <CAPTION>
                                                              1997   1996   1995
                                                             ------ ------ ------
                                                                (IN THOUSANDS)
  <S>                                                        <C>    <C>    <C>
  Cash paid during the year for:
    Interest................................................ $1,220 $1,730 $  465
    Income taxes............................................     --     --    194
  Non-cash investing and financing activities:
    Common stock issued for acquisitions....................     --  1,022  7,931
    Securities received in settlement of $4,150,000 related
     party receivable, at net realized value................     --     --  1,027
    Convertible subordinated debt issued for acquisitions...     --     --  2,856
    Common stock issued for the conversion of subordinated
     notes..................................................    387  4,077  1,630
    Conversion of Senior Notes and accrued interest to 9%
     Convertible Notes......................................     --     --    309
    Note received in sale of a portion of CDI's operations..    209     --     --
    Equipment acquired by capital lease.....................     83     89    332
    Common stock issued to pay acquisition costs............     44     --     --
  </TABLE>
   
                                        52
  <PAGE>
   
                      SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
   
  16. SEGMENT INFORMATION
   
    The Company operates principally in three industry segments: document
  management, telecommunications and Internet services. The Company's
  acquisition of MTC in September, 1995, significantly broadened its operations
  in the document management industry. Prior to the acquisition, the Company's
  document management operations were not material. Although the Company
  acquired MCW, an Internet service provider, in June of 1996, its revenue and
  results of operations in fiscal 1996 are immaterial. In July 1998, the Company
  decided to discontinue its telecommunications operations and therefore, the
  data relating to this segment is included as discontinued. Note 17 provides
  segment data for telecommunications.
   
  <TABLE>
  <CAPTION>
                                                 AS OF AND FOR THE YEARS ENDED
                                                          SEPTEMBER 30,
                                                 ----------------------------
                                                  1997       1996       1995
                                                 ------     ------     ------
                                                   (IN THOUSANDS OF DOLLARS)
  <S>                                            <C>        <C>        <C>
  Net Sales
    Document Management......................... 20,330     19,417      1,088
    Internet Services...........................  1,008         --         --
    Other.......................................     --        167         --
                                                 ------     ------     ------
                                                 21,338     19,584      1,088
                                                 ======     ======     ======
  Income (loss) from continuing operations
  Before income taxes
    Document Management.........................    572 (a)   (227)(b) (6,031)(c)
    Internet Services........................... (1,152)        --         --
    Other....................................... (2,304)     2,003 (d) (1,663)
                                                 ------     ------     ------
                                                 (2,884)     1,776     (7,694)
                                                 ======     ======     ======
  Identifiable Assets
    Document Management......................... 15,049     14,426     11,262
    Discontinued Business.......................  7,491      8,373     11,582
    Internet Services...........................  1,364         --         --
    Corporate...................................    473      1,467     12,552
    Other.......................................     --      1,320         --
                                                 ------     ------     ------
                                                 24,377     25,586     35,396
                                                 ======     ======     ======
  Depreciation and Amortization Expense
    Document Management.........................  1,263        958        139
    Internet Services...........................    458         --         --
    Corporate...................................     76        306         55
    Other.......................................      1        110         --
                                                 ------     ------     ------
                                                  1,798      1,374        194
                                                 ======     ======     ======
  Capital Expenditures
    Document Management.........................    137        614          2
    Internet Services...........................    361         --         --
    Corporate...................................     11        100        332
    Other.......................................      1         18         81
                                                 ------     ------     ------
                                                    510        732        415
                                                 ======     ======     ======
  </TABLE>
  ---------------------
  (a) Includes $2.1 million charge for costs associated with change in product
      line and other
  (b) Includes $1.5 million charge for costs associated with change in product
  (c) Includes $5.0 million charge for the write-off of acquired in-process
      unproven technology
  (d) Includes $5.7 million gain on sale of available-for-sale securities
   
                                        53
  <PAGE>
   
                      SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
   
  17. SUBSEQUENT EVENT
   
    On July 27, 1998, the Board of Directors of the Company approved a plan to
  offer for sale its telecommunications segment. Accordingly, operating results
  have been reclassified and reported in discontinued operations. The Company is
  in the process of negotiating the sale of these operations and expects that
  the sale will be completed within a twelve month period. Management does not
  anticipate a loss on the sale and intends to use sale proceeds to reduce
  outstanding indebtedness and provide additional working capital.
   
    Operating results of discontinued telecommunications segment are as follows
  (in thousands):
   
  <TABLE>
  <CAPTION>
                                                         1997    1996     1995
                                                        ------- -------  -------
        <S>                                             <C>     <C>      <C>
        Revenues....................................... $17,218 $21,803  $20,164
        Income (loss) before income taxes.............. $   739 $(1,812) $  (898)
        Provision for income taxes.....................      --      --  $  (124)
        Net income (loss).............................. $   739 $(1,812) $(1,022)
  </TABLE>
   
    Interest expense allocated to the discontinued telecommunications segment
  totaled $49,000, $377,000 and $194,000 in 1997, 1996 and 1995 respectively.
   
    Assets and liabilities of the discontinued telecommunications segment are as
  follows at September 30:
   
  <TABLE>
  <CAPTION>
                                                                     1997   1996
                                                                    ------ ------
        <S>                                                         <C>    <C>
        Current assets:
          Cash..................................................... $   -- $   --
          Accounts receivable, net.................................  1,848  2,237
          Inventories..............................................  2,984  3,111
          Prepaid expenses.........................................    154     86
                                                                    ------ ------
                                                                     4,986  5,434
                                                                    ------ ------
          Property, plant and equipment, net.......................    529 $  978
          Goodwill, net............................................  1,759  1,846
          Other noncurrent assets..................................    217    115
                                                                    ------ ------
                                                                    $7,491 $8,373
                                                                    ====== ======
        Current liabilities:
          Accounts payable......................................... $2,295 $4,633
          Current portion, long term debt..........................    328    141
          Current portion, capital lease obligation................     23    108
          Deferred revenue.........................................  1,336  1,269
                                                                    ------ ------
                                                                     3,982  6,151
                                                                    ------ ------
        Long-term debt, net of current portion.....................     20    351
        Capital lease obligation, net of current portion...........     54     88
                                                                    ------ ------
                                                                    $4,056 $6,590
                                                                    ====== ======
          Net assets associated with discontinued operations....... $3,435 $1,783
                                                                    ====== ======
  </TABLE>
   
    The financial statements have been restated for the effects of the
  discontinued operations of the telecommunications segment.
   
                                        54
  <PAGE>
   
                       SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
                  CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
         FOR THE THREE MONTHS AND SIX MONTHS ENDED MARCH 31, 1998 AND 1997
                       (IN THOUSANDS, EXCEPT PER SHARE DATA)
                                    (UNAUDITED)
   
  <TABLE>
  <CAPTION>
                                            THREE MONTHS ENDED     SIX MONTHS
                                                MARCH 31,        ENDED MARCH 31,
                                            -------------------- ----------------
                                              1998       1997     1998     1997
                                            ---------  --------- -------  -------
  <S>                                       <C>        <C>       <C>      <C>
  Net sales...............................  $   4,308  $  5,680  $ 7,229  $11,335
  Cost of sales...........................      2,957     3,214    5,252    6,371
                                            ---------  --------  -------  -------
      Gross profit........................      1,351     2,466    1,977    4,964
                                            ---------  --------  -------  -------
  Operating expenses:
    Selling...............................        547       476    1,104    1,058
    Engineering...........................        643       564    1,225    1,114
    General and administrative............      1,106       888    2,285    1,568
    Amortization of goodwill and
     transaction costs....................        322       321      643      660
                                            ---------  --------  -------  -------
      Total operating expenses............      2,618     2,249    5,257    4,400
                                            ---------  --------  -------  -------
  Income (loss) from continuing
   operations.............................     (1,267)      217   (3,280)     564
    Interest expense......................       (267)     (294)    (596)    (533)
    Other income..........................         99         6      170       81
                                            ---------  --------  -------  -------
  Income (loss) from continuing operations
   before income taxes and extraordinary
   item...................................     (1,435)      (71)  (3,706)     112
  Provision for income taxes..............         --        --       --       --
                                            ---------  --------  -------  -------
  Income (loss) before discontinued
   operations and extraordinary item......     (1,435)      (71)  (3,706)     112
  Discontinued operations:
    Income from operations................        222       354      115      426
                                            ---------  --------  -------  -------
  Net income (loss).......................  $  (1,213) $    283  $(3,591) $   538
                                            =========  ========  =======  =======
  Preferred dividends.....................        (63)       --      (63)      --
                                            ---------  --------  -------  -------
  Net income (loss) applicable to common
   shares.................................  $  (1,276) $    283  $(3,654) $   538
                                            =========  ========  =======  =======
  Earnings (loss) per common share:
    Basic.................................  $   (0.18) $   0.04  $ (0.52) $  0.08
                                            =========  ========  =======  =======
    Diluted...............................  $   (0.18) $   0.04  $ (0.52) $  0.08
                                            =========  ========  =======  =======
  </TABLE>
   
   
    The accompanying notes are an integral part of these condensed consolidated
                               financial statements.
   
                                         55
  <PAGE>
   
                       SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
                       CONDENSED CONSOLIDATED BALANCE SHEETS
                    AS OF MARCH 31, 1998 AND SEPTEMBER 30, 1997
                         (IN THOUSANDS, EXCEPT SHARE DATA)
   
  <TABLE>
  <CAPTION>
                                                              MARCH 31,  SEPT. 30,
                                                                1998       1997
                                                              ---------  ---------
  <S>                                                         <C>        <C>
                            ASSETS
  Current assets:
    Cash..................................................... $     17   $     37
    Accounts receivables, net................................    5,449      5,135
    Inventories..............................................    2,303      1,326
    Prepaid expenses and other...............................      436        319
                                                              --------   --------
      Total current assets...................................    8,205      6,817
                                                              --------   --------
  Property and equipment, net................................    1,089      1,108
  Costs in excess of fair value of net assets acquired, net..    4,598      5,141
  Other assets...............................................    3,856      3,820
  Net assets associated with discontinued operations.........    4,186      3,435
                                                              --------   --------
                                                              $ 21,934   $ 20,321
                                                              ========   ========
             LIABILITIES AND SHAREHOLDERS' EQUITY
  Current liabilities:
    Accounts payable and accrued expenses.................... $  5,022   $  4,969
    Current portion of long-term debt........................    1,230      1,384
    Current portion of capital leases........................       10         23
    Deferred revenue.........................................      357        143
                                                              --------   --------
      Total current liabilities..............................    6,619      6,519
                                                              --------   --------
  Long-term debt, net of current portion.....................   11,887     11,727
                                                              --------   --------
  Capital leases, net of current portion.....................       41         47
                                                              --------   --------
  Shareholders' equity:
    Preferred stock, $.10 par value, 4 million shares
     authorized, Series A Convertible, 5,062.5 shares
     outstanding at March 31, 1998...........................       --         --
    Common stock, $.01 par value, 25 million shares
     authorized, 7,014,673 and 6,870,559 shares outstanding,
     respectively............................................       70         69
    Capital in excess of par value...........................   39,391     34,379
    Accumulated deficit......................................  (36,074)   (32,420)
                                                              --------   --------
      Total shareholders' equity.............................    3,387      2,028
                                                              --------   --------
                                                              $ 21,934   $ 20,321
                                                              ========   ========
  </TABLE>
   
    The accompanying notes are an integral part of these condensed consolidated
                               financial statements.
   
                                         56
  <PAGE>
   
                       SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
                  CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                  FOR THE SIX MONTHS ENDED MARCH 31, 1998 AND 1997
                             (IN THOUSANDS) (UNAUDITED)
   
  <TABLE>
  <CAPTION>
                                                               MARCH 31, MARCH 31,
                                                                 1998      1997
                                                               --------- ---------
  <S>                                                          <C>       <C>
  Cash flows from operating activities:
   Net income (loss).........................................   $(3,591)  $   538
   Adjustments to reconcile net income (loss) to net cash
    used in operating activities:
    Income from discontinued operations......................      (115)     (426)
    Depreciation and amortization............................       951       829
    Provision for bad debts..................................       157         2
    Changes in operating assets and liabilities, net of
     effect of purchase transactions And disposal of
     discontinued operations:
     Receivables.............................................       409    (4,525)
     Inventories.............................................      (658)      683
     Prepaid expenses........................................       (52)      125
     Accounts payable and accrued expenses...................       178     1,614
     Deferred revenue........................................       215       252
                                                                -------   -------
      Net cash used in operating activities of continuing
       operations............................................    (2,506)     (908)
                                                                -------   -------
      Net cash used in operating activities of discontinued
       operations............................................      (382)     (725)
                                                                -------   -------
  Cash flows from investing activities:
    Purchase of property and equipment.......................      (259)     (422)
    Additions to capitalized product design..................        --      (502)
    Other....................................................        16        --
                                                                -------   -------
      Net cash used in investing activities of continuing
       operations............................................      (243)     (924)
                                                                -------   -------
      Net cash used in investing activities of discontinued
       operations............................................       (60)     (103)
                                                                -------   -------
  Cash flows from financing activities:
   Repayment of long-term debt...............................      (748)      (64)
   Net borrowings (repayments) under revolving credit note...    (1,235)    1,982
   Proceeds from sale of preferred stock.....................     4,600        --
   Proceeds from exercise of warrants........................       141        --
   Capitalized lease obligations paid........................       (21)     (143)
                                                                -------   -------
  Net cash provided by financing activities of continuing op-
   erations..................................................     2,737     1,775
                                                                -------   -------
  Net cash provided by financing activities of discontinued
   operations................................................       434       522
                                                                -------   -------
  Decrease in cash...........................................       (20)     (363)
  Cash, beginning of period..................................        37       426
                                                                -------   -------
  Cash, end of period........................................   $    17   $    63
                                                                =======   =======
  Cash paid during the period for:
  Interest...................................................   $   671   $   504
  Income taxes...............................................        --        --
  Supplemental non-cash transactions
   Convertible debt issued for acquisition of equipment
    leases...................................................   $ 1,444        --
   Common stock issued for the conversion of subordinated
    notes....................................................       210        --
   Note received in sale of net assets.......................       110        --
  </TABLE>
   
    The accompanying notes are an integral part of these condensed consolidated
                               financial statements.
   
                                         57
  <PAGE>
   
                      SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
               NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
   
  1. BASIS OF PRESENTATION
   
    The financial information, except for the balance sheet as of September 30,
  1997, included herein is unaudited; however, such information reflects all
  adjustments (consisting solely of normal recurring adjustments) which are, in
  the opinion of management, necessary for a fair presentation of the condensed
  consolidated statements of financial position, results of operations and cash
  flows as of and for the interim periods ended March 31, 1998 and 1997.
   
    The Company's annual report on Form 10-K for the fiscal year ended September
  30, 1997, as filed with the Securities and Exchange Commission, should be read
  in conjunction with the accompanying condensed consolidated financial
  statements. The condensed consolidated balance sheet as of September 30, 1997
  was derived from the Company's audited Consolidated Financial Statements.
   
    The results of operations for the three months and six months ended March
  31, 1998 are based in part on estimates that may be subject to year-end
  adjustments and are not necessarily indicative of the results to be expected
  for the full year.
   
  2. DEBT
   
    Long-term debt is summarized as follows (in thousands):
   
  <TABLE>
  <CAPTION>
                                                           MARCH 31, SEPTEMBER 30,
                                                             1998        1997
                                                           --------- -------------
        <S>                                                <C>       <C>
        Bank Debt (See Note 3)............................  $ 7,912     $ 8,973
        Convertible Subordinated Notes....................    4,858       3,624
        Other.............................................      347         514
                                                            -------     -------
                                                             13,117      13,111
        Less current portion..............................   (1,230)     (1,384)
                                                            -------     -------
                                                            $11,887     $11,727
                                                            =======     =======
  </TABLE>
   
    On January 2, 1998, the Company issued $1,443,750 principal amount of its 5%
  Convertible Subordinated Debentures due September 30, 2002 to a single
  investor in exchange for the assignment to the Company of certain equipment
  leases and other consideration. The debentures are convertible into Common
  Stock of the Company, at $8.25 per share, after December 31, 1998.
   
    Subsequent to March 31, 1998, the Company issued 120,000 shares of common
  stock pursuant to the conversion of $810,000 of convertible debt by a single
  holder of the Company's 9% convertible subordinated notes due September 15,
  2000. These 9% notes have a conversion price of $6.75 per share.
   
  3. PREFERRED STOCK
   
    On December 31, 1997, the Company sold 5,000 shares of Series A Convertible
  Preferred Stock, $0.01 par value per share ("Convertible Preferred"), for an
  aggregate purchase price of $5 million. The Convertible Preferred shares
  accrue dividends at a rate of 5% per annum, payable quarterly, at the
  Company's option, in cash or additional Convertible Preferred shares. In
  addition, the Company issued warrants to purchase 170,000 shares of the
  Company's common stock at prices at or above the market price (20,000 shares
  at $6.625 expiring on December 31, 2000 and 150,000 shares at $7.95 expiring
  on December 31, 2001). On January 2, 1998, the Company used the net proceeds
  of $4.6 million, after issuance costs of $400,000, to reduce the balance of
  the bank revolving credit note.
   
                                        58
  <PAGE>
   
    Each share of Convertible Preferred is convertible, at the option of the
  holder, into the number of shares of common stock as defined by the stated
  value of the Convertible Preferred multiplied by 5% per annum, less any
  dividends paid, divided by the conversion price. The stated value of the
  Convertible Preferred is $1,000 per share and the conversion price is the
  lower of $8.28 or a two day average market price within a 20 day trading
  period prior to the conversion. Pursuant to the Company's Articles of
  Incorporation, as amended, the holders of the Convertible Preferred stock may
  only convert their outstanding Convertible Preferred stock into an aggregate
  amount of common stock that does not exceed 19.99% of the outstanding common
  stock of the Company. Any excess shares of common stock that are issuable upon
  conversion of outstanding Convertible Preferred, that exceed this 19.99%
  limitation, are subject to mandatory redemption at the option of the holder of
  the Convertible Preferred stock, unless the Company either obtains stockholder
  approval for the additional conversions over 20%, or the Company receives
  permission to allow such an issuance from the American Stock Exchange. All
  outstanding shares of Convertible Preferred, subject to the aforementioned
  restrictions, automatically convert to common stock on December 31, 2000.
   
    Holders of Convertible Preferred do not have voting rights, except for
  certain protective provisions relating to changes in the rights of holders of
  Convertible Preferred. The Convertible Preferred ranks senior to the Company's
  common stock as to dividends, distributions and distribution of assets upon
  liquidation, dissolution or winding up of the Company. The Convertible
  Preferred is subject to mandatory redemption upon certain circumstances,
  including the Company's (i) failure to convert the Convertible Preferred when
  required (ii) bankruptcy, and (iii) suspension from trading on the American
  Stock Exchange. The Company shall have the right to redeem the Convertible
  Preferred on or after December 31, 1998 at a price equal to the greater of
  130% of the stated value or the market price multiplied by the number of
  shares of common stock into which the Convertible Preferred can be converted.
   
    On March 31, 1998, the Company issued an additional 62.5 shares of
  Convertible Preferred as payment for $62,500 of earned dividends on the
  outstanding Convertible Preferred stock.
   
    Subsequent to March 31, 1998, the Company issued a combined total of 299,946
  shares of common stock, pursuant to the conversion of 2,000 shares of the
  Company's outstanding Series A Convertible Preferred Stock. The Series A
  Convertible Preferred Stock, including accrued dividends, was converted into
  common shares at the conversion price of $6.69 per share.
   
  4. STOCK OPTIONS AND WARRANTS
   
    Outstanding options and warrants to purchase shares of common stock at March
  31, 1998 were as follows (in thousands, except price per option data):
   
  <TABLE>
        <S>                                                                <C>
        Outstanding at September 30, 1997................................. 1,435
          Granted at exercise prices ranging from $6.625 to $7.95 per
           share..........................................................   862
          Canceled........................................................   (18)
          Exercised at exercise prices ranging from $1.75 to $5.313 per
           share..........................................................  (103)
                                                                           -----
        Outstanding at March 31, 1998..................................... 2,176
                                                                           =====
  </TABLE>
   
  5. EARNINGS (LOSS) PER SHARE
   
    The Company adopted Statement of Financial Accounting Standard (SFAS) No.
  128, "Earnings Per Share," in the quarter ended December 31, 1997. SFAS 128
  requires the computation of basic and diluted earnings per share. Basic
  earnings (loss) per common share is computed using the weighted average number
  of common shares outstanding. Diluted earnings (loss) per common share is
  computed using the weighted average number of common shares outstanding and
  the dilutive common stock equivalents (using the treasury stock
   
                                        59
  <PAGE>
   
  method for warrants and options). Summarized below is the reconciliation of
  basic and diluted earnings (loss) per common share for the three months and
  the six months ended March 31, 1998 and 1997 (in thousands except per common
  share amounts):
   
  <TABLE>
  <CAPTION>
                           FOR THE THREE MONTHS ENDED   FOR THE SIX MONTHS ENDED
                           --------------------------- ---------------------------
                           NET INCOME        PER SHARE NET INCOME        PER SHARE
                             (LOSS)   SHARES  AMOUNT     (LOSS)   SHARES  AMOUNT
                           ---------- ------ --------- ---------- ------ ---------
  <S>                      <C>        <C>    <C>       <C>        <C>    <C>
  March 31, 1998:
    Basic earnings (loss).  $(1,276)  6,992   $(0.18)   $(3,654)  6,966   $(0.52)
     Effect of outstanding
      securities (a)--
      Warrants and
       options............       --      --                  --      --
      Convertible debt....       --      --                  --      --
      Convertible
       preferred stock....       --      --                  --      --
                            -------   -----             -------   -----
    Diluted earnings
     (loss)...............  $(1,276)  6,992   $(0.18)   $(3,654)  6,966   $(0.52)
                            -------   -----             -------   -----
  March 31, 1997:
    Basic earnings........  $   283   6,580   $ 0.04    $   538   6,567   $ 0.08
     Effect of outstanding
      securities (b)--
      Warrants and
       options............       --     351                  --     297
      Convertible debt....       --      --                  --      --
      Convertible
       preferred stock....       --      --                  --      --
                            -------   -----             -------   -----
    Diluted earnings......  $   283   6,931   $ 0.04    $   538   6,864   $ 0.08
                            -------   -----             -------   -----
  </TABLE>
  ---------------------
  (a) As the Company had a net loss, the outstanding securities were
      antidilutive.
  (b) The remaining outstanding securities were antidilutive.
   
  6. SUBSEQUENT EVENT
   
    On July 27, 1998, the Board of Directors of the Company approved a plan to
  offer for sale its telecommunications segment. Accordingly, operating results
  have been reclassified and reported in discontinued operations. The Company is
  in the process of negotiating the sale of these operations and expects that
  the sale will be completed within a twelve month period. Management does not
  anticipate a loss on the sale and intends to use sale proceeds to reduce
  outstanding indebtedness and provide additional working capital.
   
    Operating results of discontinued telecommunications segment are as follows
  (in thousands):
   
  <TABLE>
  <CAPTION>
                                                       THREE MONTHS   SIX MONTHS
                                                        ENDED MARCH      ENDED
                                                            31,        MARCH 31,
                                                       ------------- -------------
                                                        1998   1997   1998   1997
                                                       ------ ------ ------ ------
        <S>                                            <C>    <C>    <C>    <C>
        Revenues...................................... $4,443 $4,494 $8,392 $9,617
        Net income.................................... $  222 $  354 $  115 $  426
  </TABLE>
   
                                        60
  <PAGE>
   
    Assets and liabilities of the discontinued telecommunications segment are as
  follows:
   
  <TABLE>
  <CAPTION>
                                                          MARCH 31, SEPTEMBER 30,
                                                            1998        1997
                                                          --------- -------------
        <S>                                               <C>       <C>
        Current assets:
          Cash...........................................  $   --      $   --
          Accounts receivable, net.......................   2,142       1,848
          Inventories....................................   2,904       2,984
          Prepaid expenses...............................     204         154
                                                           ------      ------
                                                            5,250       4,986
                                                           ------      ------
          Property, plant and equipment, net.............     430         529
          Goodwill, net..................................   1,711       1,759
          Other noncurrent assets........................     132         217
                                                           ------      ------
                                                           $7,523      $7,491
                                                           ======      ======
        Current liabilities:
          Accounts payable...............................  $2,450      $2,295
          Current portion, long term debt................      38         328
          Current portion, capital lease obligation......      23          23
          Deferred revenue...............................     783       1,336
                                                           ------      ------
                                                            3,294       3,982
                                                           ------      ------
          Long-term debt, net of current portion.........      --          20
          Capital lease obligation, net of current
           portion.......................................      43          54
                                                           ------      ------
                                                           $3,337      $4,056
                                                           ======      ======
          Net assets associated with discontinued
           operations....................................  $4,186      $3,435
                                                           ======      ======
  </TABLE>
   
    The financial statements have been restated for the effects of the
  discontinued operations of the telecommunications segment.
   
                                         61
  <PAGE>
   
                                     SIGNATURES
   
    Pursuant to the requirements of the Securities Exchange Act of 1934, the
  Registrant has duly caused this report to be signed on its behalf by the
  undersigned hereto duly authorized.
   
  Dated: July 27, 1998
   
                                                    /s/ Mark A. Phillips
                                            By:__________________________________
                                                      MARK A. PHILLIPS,
                                                          Secretary
                                                  Chief Accounting Officer
   
                                         62
metadata_documents: [{"type": "8-K", "sequence": "1", "description": "FORM 8-K", "secsgml_size_bytes": 252019}]
metadata_filer: {"company-data": {"conformed-name": "SOFTNET SYSTEMS INC", "cik": "0000097196", "assigned-sic": "7385", "irs-number": "111817252", "state-of-incorporation": "NY", "fiscal-year-end": "0930"}, "filing-values": {"form-type": "8-K", "act": "34", "file-number": "001-05270", "film-number": "98672117"}, "business-address": {"street1": "520 LOGUE AVE", "city": "MOUNTIAN VIEW", "state": "CA", "zip": "94043", "phone": "6509653700"}, "mail-address": {"street1": "520 LOGUE AVE", "city": "MOUNTAIN VIEW", "state": "CA", "zip": "94043"}, "former-company": [{"former-conformed-name": "VADER GROUP INC", "date-changed": "19920703"}, {"former-conformed-name": "MAGICSILK INC", "date-changed": "19880308"}, {"former-conformed-name": "TENSOR CORP", "date-changed": "19860819"}]}
text: UNITED STATES
                         SECURITIES AND EXCHANGE COMMISSION
                               WASHINGTON, D.C. 20549
   
                                 ----------------
   
                                      FORM 8-K
   
                                   CURRENT REPORT
   
       Pursuant to Section 13 or 15(d) of The Securities Exchange Act of 1934
   
           Date of Report (Date of earliest event reported) July 27, 1998
   
                               SOFTNET SYSTEMS, INC.
               (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
   
                                 ----------------
   
          NEW YORK                     1-5270                  11-1817252
       (STATE OR OTHER        (COMMISSION FILE NUMBER)        (IRS EMPLOYER
       JURISDICTION OF                                    IDENTIFICATION  NO.)
       INCORPORATION)
   
  520 LOGUE AVENUE, MOUNTAIN VIEW, CA                             94043
   (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)                    (ZIP CODE)
   
                                 ----------------
   
         Registrant's telephone number, including area code (650) 962-7470
   
           (Former name or former address, if changed since last report.)
  ITEM 5: OTHER EVENTS.
   
    SoftNet Systems, Inc. (the "Company") has announced the adoption of a Cable
  Affiliates Incentive Program to provide incentives to the Company's cable
  affiliates to launch the Company's ISP Channel Internet service. Under this
  program, the Company will offer to pay incentive bonuses to cable affiliates
  in cash or shares of its Common Stock based on the number of cable subscribers
  covered by cable systems that enter into exclusive arrangements with the ISP
  Channel. The amount of these incentive bonuses will depend on a variety of
  factors, including the size of the covered systems and the length of
  exclusivity of the contract. The Company has reserved up to 19.9% of its
  outstanding shares of Common Stock, totaling approximately 1.6 millions
  shares, for issuance under this program.
   
    The Company has also determined to account for its Telecommunications
  Division as a discontinued operation. The Company expects to dispose of this
  division within the next 12 months, though no assurance can be made that it
  will be able to do so. The Company's management does not anticipate a loss on
  the sale and intends to use the sales proceeds to reduce outstanding
  indebtedness and provide additional working capital for its other businesses.
  Included with this Current Report on Form 8-K are revised versions of the
  Company's Summary Consolidated Financial Data, Selected Consolidated
  Historical Financial Data, Consolidated Financial Statements, and Management's
  Discussion and Analysis of Financial Condition and Results of Operations,
  reflecting the accounting impact of treating the Telecommunications Division
  and as a discontinued operation.
   
    In addition, as the Company has decided to focus its efforts on its other
  businesses, particularly the expansion of its Internet Services Division, the
  Company has restated its Risk Factors disclosure to reflect this revised
  focus. A copy of this revised disclosure is attached to this report.
   
  ITEM 7: EXHIBITS
   
      23 Consent of PricewaterhouseCoopers L.L.P.
   
                                         2
  RISK FACTORS
   
    These risk factors include "forward-looking" statements within the meaning
  of Section 27A of the Securities Act and Section 21E of the Exchange Act.
  Although the Company believes that its plans, intentions, and expectations
  reflected in such forward-looking statements are reasonable, it can give no
  assurance that such plans, intentions or expectations will be achieved. Actual
  results will differ from such plans, intentions and expectations, and such
  differences may be material. Important factors that could cause actual results
  to differ materially from the Company's forward-looking statements are set
  forth below. All forward-looking statements attributable to the Company or
  persons acting on its behalf are expressly qualified in their entirety by the
  cautionary statements set forth herein. The Company disclaims any obligation
  to update information contained in any forward-looking statement.
   
  LIMITED OPERATING HISTORY OF THE INTERNET SERVICES DIVISION; UNPROVEN
  BUSINESS; HISTORICAL LOSSES; NO ASSURANCE OF PROFITABILITY
   
    The Company currently operates two continuing businesses: Micrographic
  Technology Corporation ("MTC") and the Internet Services Division. The Company
  is seeking a buyer for the Telecommunications Division, which is accounted for
  as a discontinued operation. The Company's current strategy for growth is to
  focus on substantially expanding the business of its Internet Services
  Division, which was acquired in June 1996. The Company has very limited
  operating history and experience in the Internet services business, and the
  successful expansion of the Company's Internet Services Division will require
  strategies and operations that are different from those historically employed
  by the Company in connection with its two other businesses. There can be no
  assurance that the Company will be able to develop or maintain strategies and
  business operations that are necessary to increase the revenues of the
  Company's Internet Services Division sufficiently to enable it to achieve
  positive cash flow and profitability.
   
    To be successful, the Company must, among other things, develop and market
  products and services that are widely accepted by consumers and businesses at
  prices that will yield cash flow sufficient to meet the Company's debt
  service, capital expenditure and working capital requirements. The provision
  of Internet services over cable infrastructure has only recently become
  feasible on a broad scale. There are only a very limited number of companies
  offering such services, none of which is currently profitable. The Company's
  ISP Channel service has only recently been launched in seven cable franchise
  areas (all of which have revenue-paying subscribers) in the United States, and
  there can be no assurance that it will achieve broad consumer or commercial
  acceptance. The success of the Company's ISP Channel service will depend upon
  the willingness of subscribers to pay the monthly fees and installation costs
  as well as to purchase or lease the equipment necessary to access the
  Internet. Currently, the Company has only approximately 500 subscribers to its
  ISP Channel service in these areas. Accordingly, it is difficult to predict
  whether the Company's pricing model will prove to be viable, whether demand
  for the Company's services will materialize at the prices it expects to charge
  or whether current or future pricing levels will be sustainable. If such
  pricing levels are not achieved or sustained or if the Company's services do
  not achieve or sustain broad market acceptance, the Company's business,
  financial condition, prospects and ability to repay its indebtedness will be
  materially adversely affected.
   
    The Company has sustained substantial losses over the last five fiscal
  years. For the six months ended March 31, 1998 and the fiscal year ended
  September 31, 1997, the Company had net losses of $3.7 million and $2.6
  million, respectively, and as of March 31, 1998, the Company had an
  accumulated stockholders' deficit of approximately $36 million. The Company
  expects to incur substantial losses and experience substantial negative cash
  flows as it expands its Internet Services Division. The costs of expansion
  will include expenses in connection with: (i) the deployment of infrastructure
  necessary to enable its cable affiliates to offer its services; (ii) research
  and development of new product and service offerings; (iii) the continued
  development of its direct and indirect selling and marketing efforts; and (iv)
  any charges related to acquisitions, divestitures, business alliances or
  changing technologies. The Company's prospects should also be considered in
  light of the risks, expenses and difficulties encountered by companies
  competing in new and rapidly evolving markets. There can be no assurance that
  the Company will ever achieve favorable operating results or profitability.
   
                                         3
  FLUCTUATIONS IN QUARTERLY RESULTS
   
    The Company's results of operations have fluctuated and will likely continue
  to fluctuate significantly from quarter to quarter, especially as the Company
  implements a new strategic focus that will emphasize its Internet Services
  Division. In addition, the Company is seeking a buyer for its
  Telecommunications Division. As a result, the Company believes that period-to-
  period comparisons of its revenues and results of operations are not
  necessarily meaningful and should not be relied upon as indicators of future
  performance. The Company's quarterly operating results may fluctuate
  significantly in the future as a result of a variety of factors, many of which
  are beyond the Company's control. Factors that may affect the Company's
  quarterly operating results attributable to its Internet Services Division
  include, among others, the rate at which the Company can enter into agreements
  with cable operators, the exclusivity and term of such agreements, the rate of
  subscription to the Company's Internet services, the prices subscribers pay
  for such services, subscriber churn rates, changes in the revenue sharing
  arrangements between the Company and its affiliated cable operators, the
  ability of the Company and its cable affiliates to coordinate timely and
  effective marketing, the success of the Company and its cable affiliates in
  marketing the ISP Channel service to subscribers in such affiliates' local
  cable areas, the quality of cable affiliates' cable infrastructure, the
  quality of customer and technical support, and the rate at which the cable
  affiliates can complete the installations required to initiate service for new
  subscribers. Additional factors that may affect the Company's quarterly
  operating results generally include the amount and timing of capital
  expenditures and other costs relating to the expansion of the Company's
  Internet Services Division, the introduction of new Internet services by the
  Company or its competitors, customer acceptance of such services, price
  competition or pricing changes in the Internet or cable industries, general
  economic conditions and economic conditions specific to the Internet and cable
  industries, and changes in law and regulation. See "Management's Discussion
  and Analysis of Financial Condition and Results of Operations."
   
    Factors that may affect the Company's quarterly operating results
  attributable to MTC include, among other things, the size and timing of
  customer orders and subsequent shipments, customer order deferrals in
  anticipation of new products and services, timing of product introductions or
  enhancements by the Company or its competitors, market acceptance of new
  products and services, technological changes in the industry, competitive
  pricing pressures, accuracy of customer forecasts of end-user demand, changes
  in the Company's operating expenses, personnel changes, changes in the mix of
  products sold, quality control of products sold, disruption in sources of
  supply, capital spending, delays of payments by customers and general economic
  conditions.
   
    The Company expects to continue to engage in extensive research and
  development activities and to evaluate new product and service opportunities.
  This will require the Company to continue to invest in research and
  development and sales and marketing, which could adversely affect short-term
  results of operations. The Company believes that its future revenue growth and
  profitability will depend in part on its success in developing new products
  and services. Failure to increase revenues from new products and services,
  whether due to lack of market acceptance, competition, technological change or
  otherwise, would have a material adverse effect on the Company's business,
  financial condition, prospects and ability to repay its indebtedness,
  including the Notes.
   
  SUBSTANTIAL LEVERAGE; ABILITY TO SERVICE INDEBTEDNESS
   
    The Company is in the process of placing an offering (the "Debt Offering")
  of approximately $150,000,000, or more, in Senior Notes ("Senior Notes"),
  although there can be no assurance that the Company will be able to complete
  such Debt Offering. In the event the Company is able to complete the Debt
  Offering, the Company would be highly leveraged. In addition, the indenture
  governing the Senior Notes would permit the Company and its subsidiaries to
  incur substantial additional indebtedness subject to certain restrictions. The
  degree to which the Company is leveraged could have important consequences to
  the Company and its securityholders, including, but not limited to, the
  following: (i) the Company's ability to obtain additional financing or
  refinancing in the future for working capital, capital expenditures, service
  development and enhancement, acquisitions, general corporate purposes or other
  purposes may be materially limited or impaired; (ii) the Company's cash flow,
  if any, may be unavailable for the Company's business as a substantial
   
                                         4
  portion of the Company's cash flow must be dedicated to the payment of
  principal and interest on its indebtedness; and (iii) the Company's high
  degree of leverage may make it more vulnerable to economic downturns, may
  limit its ability to withstand competitive pressures and may reduce its
  flexibility in responding to changing business and economic conditions.
   
    The Company expects that it will continue to generate substantial operating
  losses and negative cash flow for the next several years. No assurance can be
  given that the Company will be successful in developing and maintaining a
  level of cash flow from operations sufficient to permit it to pay the
  principal, premium, if any, and interest on its indebtedness. The ability of
  the Company to make scheduled payments with respect to indebtedness will
  depend upon, among other things: (i) the Company's ability to achieve
  significant and sustained growth in cash flow; (ii) the rate of successful
  commercial deployment of its Internet products and services; (iii) the market
  acceptance, customer demand, rate of utilization and pricing for the Company's
  products and services; (iv) future operating performance problems; (v) cable
  affiliates' ability to complete development, upgrades and enhancements of
  their cable infrastructure successfully; and (vi) economic, financial,
  competitive, regulatory, and other factors, many of which are beyond the
  Company's control. If the Company is unable to generate sufficient cash flow
  to service its indebtedness it may have to reduce or delay entering into
  affiliations with cable operators, deploying infrastructure and delivering its
  services to existing cable affiliates. Additionally, in such circumstances,
  the Company may have to restructure or refinance its indebtedness or seek
  additional equity capital. There can be no assurance that any of these
  strategies could be effected on satisfactory terms, if at all, in light of the
  Company's high leverage, or that any such strategy would yield sufficient
  proceeds to service and repay the Company's indebtedness. In the event of
  default under such indebtedness, certain holders of such indebtedness would
  have enforcement rights, including the right to accelerate such debt and the
  right to commence an involuntary bankruptcy proceeding against the Company.
   
  DEPENDENCE ON LOCAL CABLE OPERATORS AND THEIR CABLE INFRASTRUCTURE
   
    Certain ISP Channel services are dependent on the quality of the cable
  infrastructure. Cable system operators have announced and begun to implement
  major infrastructure investments in order to increase the capacity of their
  networks and deploy two-way capability. However, cable system operators have
  limited experience with implementing such upgrades, and these investments have
  placed a significant strain on the financial, managerial, operating and other
  resources of cable system operators, most of which are already significantly
  leveraged. Further, cable operators must periodically renew their franchises
  with city, county, or state governments and, as a condition of obtaining such
  renewal, may have to meet certain conditions imposed by the issuing
  jurisdiction, which may have the effect of causing the cable operator to delay
  such upgrades. The Company's contracts with its cable affiliates typically
  have terms ranging from three to five years, and there can be no assurance
  that the Company will be able to renew any such contracts. Moreover, even if
  cable affiliates renew such contracts, there can be no assurance that such
  renewal will be on terms satisfactory to the Company. In addition, cable
  operators are primarily concerned with increasing television programming
  capacity to compete with other modes of multichannel entertainment delivery
  systems such as direct broadcast satellite ("DBS") and may consequently choose
  to roll-out incompatible set-top boxes that do not support high-speed Internet
  access services, rather than to upgrade their network infrastructures as
  described above. Such upgrades thus have been, and the Company expects will
  continue to be, subject to change, delay or cancellation. The failure of cable
  operators to complete these upgrades in a timely and satisfactory manner, or
  at all, would adversely affect the market for the Company's products in any
  such operator's franchise area and, if repeated on a broad scale, could have a
  material adverse effect on the Company's business, financial condition,
  prospects and ability to repay its indebtedness.
   
    The Company provides Internet services to cable systems irrespective of
  their two-way capabilities. To the extent the Company provides Internet
  services over cable systems to the home with a telephone line return path for
  data from the home (under a "one-way" cable system), the Company's services
  may not provide the high speed, quality of experience and availability of
  certain applications, such as video conferencing, necessary to
   
                                         5
  attract and retain subscribers to the ISP Channel service. Subscribers using a
  telephone line return path will experience the upstream data transmission
  speeds provided by their analog modems (typically 28.8 Kbps). It is not clear
  what impact the lack of two-way capability will have on penetration levels for
  the ISP Channel.
   
    Because subscribers to the ISP Channel will subscribe through a cable
  affiliate, the cable affiliate (and not the Company) will substantially control
  the customer relationship with the subscriber. For example, under the Company's
  existing contracts, cable affiliates are responsible for important functions,
  such as billing for and collecting ISP Channel subscription fees and providing
  the labor and costs associated with the distribution of local marketing
  materials. Therefore, in addition to the Company's business being subject to
  general economic and market conditions and factors relating to Internet service
  providers and on-line services specifically, the success and future growth of
  the Company's business will also be subject to economic and other factors
  affecting its cable affiliates generally.
   
  DEPENDENCE ON EXCLUSIVE ACCESS TO CABLE SUBSCRIBERS; NEED FOR AGGRESSIVE
  IMPLEMENTATION AND DEPLOYMENT
   
    The success of the Company's Internet Services Division is dependent, in
  part, on its ability to gain exclusive access to cable consumers. This
  exclusivity is a function of cable operators' dominance within their geographic
  markets and the Company's exclusive relationship with such cable operators.
  There can be no assurance that cable operators affiliated with the Company will
  not face competition in the future or that the Company will be able to
  establish and maintain exclusive relationships with cable operators. Currently,
  a number of the Company's contracts with cable operators do not contain
  exclusivity provisions. Even if the Company is able to establish and maintain
  exclusive relationships with cable operators, there can be no assurance that
  the Company will be able to do so on terms favorable to the Company or in
  quantities to be profitable. In addition, the Company seeks to affiliate with a
  large number of cable operators as quickly as possible because it will be
  excluded from providing Internet over cable in those areas served by cable
  operators with exclusive arrangements with other Internet service providers. If
  the exclusive relationship between either the Company and its cable affiliates
  or its cable affiliates and their cable subscribers is impaired, or if the
  Company does not become affiliated with a sufficient number of cable operators,
  the Company's business, financial condition, prospects and ability to repay its
  indebtedness could be materially adversely affected.
   
  SUBSTANTIAL FUTURE CAPITAL REQUIREMENTS
   
    The development of the Company's business will require substantial capital
  infusions as a result of (i) the Company's need to enhance and expand its
  product and service offerings in order to maintain its competitive position and
  increase its market share and (ii) the substantial investment in equipment and
  corporate infrastructure required by the continued national deployment of the
  ISP Channel. In addition, the Company anticipates that the majority of cable
  affiliates with one-way cable systems will eventually upgrade their cable
  infrastructure to two-way cable systems, at which time the Company will have to
  upgrade its equipment on any affected cable system to handle two-way
  transmissions. Even with the proceeds of the Debt Offering, if completed,
  whether or when the Company ultimately can achieve cash flow levels sufficient
  to support its operations, development of new products and services, and
  expansion of its Internet Services Division, cannot be predicted accurately.
  Unless such cash flow levels are achieved, the Company will require additional
  borrowings, the sale of debt or equity securities, the sale of assets or
  businesses, or some combination thereof, to provide funding for its operations.
  In the event that the Company cannot generate sufficient cash flow from its
  operations, or is unable to borrow or otherwise obtain additional funds to
  finance its operations on desirable terms when needed, the Company's business,
  financial condition, prospects and ability to repay its indebtedness would be
  materially adversely affected.
   
  MANAGEMENT OF GROWTH
   
    To fully exploit the market for its products and services, the Company must
  rapidly execute its sales strategy while managing anticipated growth by
  implementing effective planning and operating processes. To manage its
   
                                         6
  anticipated growth, the Company must, among other things, continue to
  implement and improve its operational, financial and management information
  systems, hire and train additional qualified personnel, continue to expand and
  upgrade core technologies and effectively manage multiple relationships with
  various customers, suppliers and other third parties. Consequently, such
  expansion could place a significant strain on the Company's services and
  support operations, sales and administrative personnel and other resources.
  The Company may in the future also experience difficulties meeting the demand
  for its products and services. Additionally, if the Company is unable to
  provide training and support for its products, the implementation process will
  be longer and customer satisfaction may be lower. There can be no assurance
  that the Company's systems, procedures or controls will be adequate to support
  the Company's operations or that the Company's management will be capable of
  exploiting fully the market for the Company's products and services. Any
  failure of the Company to manage its growth effectively could have a material
  adverse effect on the Company's business, financial condition, prospects and
  ability to repay its indebtedness.
   
  NON-EXCLUSIVITY OF CABLE FRANCHISES; NON-RENEWAL OR TERMINATION OF FRANCHISES
   
    Cable television companies operate under non-exclusive franchises granted by
  local or state authorities that are subject to renewal and renegotiation from
  time to time. A franchise is generally granted for a fixed term ranging from
  five to 15 years but in many cases is terminable if the franchisee fails to
  comply with the material provisions thereof. The Cable Television Consumer
  Protection and Competition Act of 1992 prohibits franchising authorities from
  granting exclusive cable television franchises and from unreasonably refusing
  to award additional competitive franchises; it also permits municipal
  authorities to operate cable television systems in their communities without
  franchises. No assurance can be given that the cable television companies that
  have contracts with the Company will be able to retain or renew their
  franchises. The non-renewal or termination of any such franchises would result
  in the termination of the Company's contract with the applicable cable
  operator. Were an affiliated cable operator to lose its franchise, the Company
  would seek to affiliate with the successor to the franchisee. No assurance can
  be given that the Company would be able to achieve such replacement
  affiliation or that to do so would not result in additional costs to the
  Company. If the Company cannot affiliate with replacement cable operators in
  sufficient numbers, the Company's business, financial condition, prospects and
  ability to repay its indebtedness could be materially adversely affected.
   
  RISK OF ACQUISITION OF CABLE AFFILIATE BY UNAFFILIATED CABLE OPERATOR
   
    The Company believes that it is highly unlikely that a cable operator will
  find it desirable, economically or otherwise, to devote the channel capacity
  to offer Internet services to its subscribers over its infrastructure through
  more than one provider. However, under many of the Company's initial
  contracts, in the event a cable affiliate is acquired by an unaffiliated cable
  operator that already has a relationship with one of the Company's competitors
  or that does not enter into a contract with the Company, the Company may lose
  its ability to offer its Internet services in the area served by such former
  cable affiliate, which could have a material adverse effect on the Company's
  business, financial condition, prospects and ability to repay its
  indebtedness.
   
  DEPENDENCE ON THIRD PARTY TECHNOLOGY AND SUPPLIERS
   
    Many of the Company's products and service offerings incorporate technology
  developed and owned by third parties. The markets for all of the products and
  services used by the Company are characterized by intense competition, rapid
  technological advances, evolving industry standards, changes in subscriber
  requirements, frequent new product introductions and enhancements, and rapidly
  evolving, alternative service offerings. Consequently, the Company must rely
  upon third parties to develop and introduce technologies that enhance the
  Company's current product and service offerings and enable the Company, in
  turn, to develop its own products and services on a timely and cost-effective
  basis to meet changing customer needs and technological trends in its
  industries. Any impairment or termination of the Company's relationship with
  any licensers of third party technology would force the Company to find other
  developers on a timely basis or develop its own technology. There can be no
  assurance that the Company will be able to obtain the third party technology
  necessary to
   
                                         7
  continue to develop and introduce new and enhanced products and services, that
  the Company will obtain third party technology on commercially reasonable
  terms or that the Company will be able to replace third party technology in
  the event such technology becomes unavailable, obsolete or incompatible with
  future versions of the Company's products or services. The absence of or any
  significant delay in the replacement of third party technology would have a
  material adverse effect on the Company's business, financial condition,
  prospects and ability to service its indebtedness.
   
    In addition, the Internet Services Division and MTC currently depend on a
  limited number of suppliers for certain key products and services. In
  particular, the Internet Services Division depends on Excite, Inc. ("Excite")
  for national content aggregation, 3Com Corporation ("3Com") and Com21, Inc.
  ("Com21") for headend and cable modem equipment, Cisco Systems, Inc. ("Cisco")
  for specific network routing and switching equipment, and, among others, MCI
  Communications Corporation ("MCI") for national Internet backbone services.
  Certain of the Company's cable modem and headend equipment suppliers are in
  litigation over their patents. The Company could experience disruptions in the
  delivery or increases in the prices of products and services purchased from
  such vendors as a result of intellectual property litigation involving such
  vendors. There can be no assurance that delays in key components or product
  deliveries will not occur in the future due to shortages resulting from the
  limited number of suppliers, the financial or other difficulties of such
  suppliers or the possible limited availability in the suppliers' underlying
  raw materials. In addition, the Company may not have adequate remedies against
  such third parties as a result of breaches of their agreement with the
  Company. The inability to obtain sufficient key components or to develop
  alternative sources for such components, if and as required in the future,
  could result in delays or reductions in product shipments, which in turn could
  have a material adverse effect on the Company's customer relationships,
  business, financial condition, prospects and ability to repay its
  indebtedness.
   
    Certain key products resold by the Company are currently contracted
  exclusively for distribution in certain of the Company's markets. For
  instance, the Company's Telecommunications Division currently maintains an
  exclusive contract with Executone Information Systems, Inc. ("Executone") for
  the resale of Executone's products in certain specified markets. For the
  fiscal year ended September 30, 1997, such products accounted for
  approximately 30% of the Telecommunications Division's revenues and 13% of the
  Company's total revenues. Any change in the exclusivity provisions of these
  types of contracts, or loss thereof, could have a materially adverse effect on
  the Company's business, financial condition, prospects and ability to repay
  its indebtedness.
   
  COMPETITION
   
    The markets for the Company's products and services are intensely
  competitive, and the Company expects competition to increase in the future.
  Many of the Company's competitors and potential competitors have substantially
  greater financial, technical and marketing resources, larger subscriber bases,
  longer operating histories, greater name recognition and more established
  relationships with advertisers and content and application providers than the
  Company. Such competitors may be able to undertake more extensive marketing
  campaigns, adopt more aggressive pricing policies and devote substantially
  more resources to developing Internet services or on-line content than the
  Company. There can be no assurance that the Company will be able to compete
  successfully against current or future competitors or that competitive
  pressures faced by the Company will not materially adversely affect the
  Company's business, financial condition, prospects or ability to repay its
  indebtedness. Any increase in competition could reduce the Company's gross
  margins, require increased spending by the Company on research and development
  and sales and marketing, and otherwise materially adversely affect the
  Company's business, financial condition, prospects and ability to repay its
  indebtedness.
   
    Internet Services. The markets for the Company's Internet products and
  services are extremely competitive, and the Company expects this competition
  to intensify in the future. In the cable-based segment of the Internet access
  industry, the Company also competes with other cable-based data services that
  are seeking to contract with cable system operators to bring their services
  into geographic areas that are not covered by an agreement
   
                                         8
  between the Company and its cable affiliates. These competitors include
  systems integrators such as Convergence.com, Online System Services, HSAnet
  and Frontier Communications' Global Center business, as well as ISPs such as
  Earthlink Network, Inc. ("Earthlink"), MindSpring Enterprises, Inc.
  ("MindSpring"), and IDT Corporation. Several cable system operators, including
  CableVision Systems Corporation ("Cablevision"), Comcast Corporation
  ("Comcast"), Cox Enterprise, Inc. ("Cox"), MediaOne Group, Inc. ("MediaOne"),
  Tele-Communications, Inc. ("TCI") and Time Warner Inc. ("Time Warner") have
  deployed high-speed Internet access services over their existing local hybrid
  fiber and coaxial cable networks. TCI, Cox and Comcast market through At Home
  Corporation ("@Home") while Time Warner plans to market the RoadRunner service
  through Time Warner's own cable systems as well as to other cable system
  operators nationwide.
   
    Some of the Company's most direct competitors in the access markets are
  telephony-based access providers, including incumbent local exchange carriers
  ("ILECs"), national interexchange or long distance carriers ("IXCs"), fiber-
  based competitive local exchange carriers ("CLECs"), Internet service
  providers ("ISPs"), on-line service providers ("OSPs"), wireless and satellite
  data service providers, and DSL-focused CLECs. Competitors in the Internet
  services industry include AT&T Corp. ("AT&T"), BBN Corporation, Earthlink,
  Netcom Online Communications Services, Inc., Concentric Network, PSInet Inc.,
  and WorldCom, Inc., which provide basic Internet access to residential
  consumers and businesses, generally using the existing telephone network
  infrastructure. This method is widely available and inexpensive, and barriers
  to entry are low, resulting in a highly competitive and fragmented market.
   
    Some of the Company's competitors are offering diversified packages of
  telecommunications services, including Internet access service, to residential
  customers and could bundle such services, which could place the Company at a
  competitive disadvantage. Many of these competitors are offering (or may soon
  offer) technologies that will attempt to compete with some or all of the
  Company's high-speed data service offerings. The bases of competition in these
  markets include transmission speed, reliability of service, ease of access,
  ratio of price to performance, ease of use, content quality, quality of
  presentation, timeliness of content, customer support, brand recognition,
  operating experience and revenue sharing.
   
    In addition, the market for high-speed data transmission services is
  characterized by several competing technologies that offer alternative
  solutions. Competitive technologies include telecom-related wireline
  technologies that utilize telephone copper twisted-pair wiring, such as ISDN
  and DSL implementations, as well as wireless technologies such as local
  multipoint distribution service ("LMDS"), multichannel multipoint distribution
  service ("MMDS") and DBS. The Company's prospects may be further compromised
  by Federal Communications Commission ("FCC") rules and regulations, which are
  designed, at least in part, to increase competition in video and related
  services, for example, new multi-channel video technologies and services known
  as Open Video Systems ("OVS") and LMDS. While both are in nascent stages of
  development, OVS and LMDS offer the potential for providing competition to
  traditional cable television and other multi-channel video services. One form
  of OVS involves delivery of signals over existing telephone lines. LMDS is a
  broadband, wireless, digital service, and offers the potential for providing
  Internet access along with a variety of other services, including traditional
  multi-channel video entertainment. The FCC has also created a General Wireless
  Communications Service ("GWCS") in which licensees are afforded broad latitude
  in defining the nature and service area of the communications services they
  offer. The full impact of the GWCS remains to be seen. Nevertheless, all of
  these new technologies pose potential competition to the Company and its
  business. Significant market acceptance of alternative solutions for high-
  speed data transmission could decrease the demand for the Company's services
  if such alternatives are viewed as providing faster access, greater
  reliability, increased cost-effectiveness or other advantages over cable
  solutions. Competition from telecom-related solutions is expected to be
  intense.
   
    There can be no assurance that technological developments will not have a
  material adverse effect on the competitive position of the Company. The rapid
  development of new competing technologies and standards increases the risk
  that current or new competitors could develop products and services that would
  reduce the competitiveness of the Company's products and services, which could
  have a material adverse effect on the Company's business, financial condition,
  prospects and ability to repay its indebtedness.
   
                                         9
  Document Management. In the document management industry, the Company
  competes on the basis of breadth of offering, cost, flexibility and customer
  service. The Company has two direct competitors to its hardware products: Agfa
  AG in Europe and Anacomp, Inc. worldwide. Indirect competitors include
  International Business Machines Corp., Fuji Photo Film Co., Ltd., Mobius
  Management Systems, Inc., Storage Technology and others. In most cases, the
  Company's competitors have longer operating histories, greater name
  recognition, and significantly greater financial, technical and marketing
  resources. While the Company is not aware of any direct competitors to its
  software product offerings, the industry is rapidly evolving and the Company
  may face significant competition in the future.
   
  UNPROVEN NETWORK SCALABILITY AND SPEED
   
    Due to the limited deployment of the Company's ISP Channel service, the
  ability of the Company to connect and manage a substantial number of on-line
  subscribers at high transmission speeds is as yet unknown, and the Company
  faces risks related to its ability to scale up to its expected subscriber
  levels while maintaining superior performance. While peak downstream data
  transmission speeds across cable infrastructure approaches 3 megabits per
  second ("Mbps") in each 6 MHz channel, the actual downstream data transmission
  speeds are likely to be significantly slower and will depend on a variety of
  factors, including type and location of content, Internet traffic, the number
  of active subscribers on a given cable network node, the number of 6 MHz
  channels allocated by the cable affiliate (in its discretion) to carry the
  Company's service, the capability of cable modems used and the service quality
  of the cable affiliates' cable infrastructures. As subscriber penetration
  increases, it may be necessary for the cable affiliates to add additional 6
  MHz channels in order to maintain adequate downstream data transmission
  speeds, which would render such additional channels unavailable to such cable
  affiliates for video or other programming. There can be no assurance that
  cable affiliates will provide additional capacity for this purpose. On two-way
  cable systems, the upstream transmission data channel is located in a range
  not used for broadcast by traditional cable infrastructures and is more
  susceptible to interference than the downstream channel, resulting in a slower
  peak upstream transmission speed. In addition to the factors affecting
  downstream data transmission speeds, the level of interference in the cable
  affiliates' upstream data broadcast range can materially affect actual
  upstream data transmission speeds. The actual data delivery speeds that can be
  realized by subscribers will be significantly lower than peak data
  transmission speeds and will vary depending on the subscriber's hardware,
  operating system and software configurations. There can be no assurance that
  the Company will be able to achieve or maintain a speed of data transmission
  sufficiently high to enable the Company to attract and retain its planned
  numbers of subscribers, especially as the number of the subscribers to the
  Company's services grows, and a perceived or actual failure by the Company to
  achieve or maintain sufficiently high speed data transmission could
  significantly reduce consumer demand for its services and have a material
  adverse effect on its business, financial condition, prospects and ability to
  repay its indebtedness.
   
  DEPENDENCE ON NETWORK
   
    The Company's success will depend upon the capacity, reliability and
  security of the infrastructure used to carry data between its subscribers and
  the Internet. A significant portion of such infrastructure is owned by third
  parties, and accordingly the Company has no control over its quality and
  maintenance. The Company relies on cable operators to maintain their cable
  infrastructure. In addition, the Company relies on other third parties to
  provide a connection from the cable infrastructure to the Internet. Currently,
  the Company has transit agreements with MCI, MFS, Sprint Communications
  Company ("Sprint"), and others to support the exchange of traffic between the
  Company's network operations center ("NOC"), cable infrastructure and the
  Internet. The failure of the Internet backbone, or the NOC, or any other link
  in the delivery chain resulting in an interruption in the Company's operations
  would have a material adverse effect on the Company's business, financial
  condition, prospects and ability to repay its indebtedness.
   
  RISK OF SYSTEM FAILURE
   
    The Company's operations are dependent upon its ability to support its
  highly complex infrastructure and avoid damages from fires, earthquakes,
  floods, power losses, telecommunications failures, network software
   
                                        10
  flaws, transmission cable cuts and similar events. The occurrence of one of
  these events could cause interruptions in the services provided by the
  Company. In addition, failure of an ILEC or other service provider to provide
  communications capacity required by the Company, as a result of a natural
  disaster, operational disruption or any other reason, could cause
  interruptions in the services provided by the Company. Any damage or failure
  that causes interruptions in the Company's operations could have a material
  adverse effect on the Company's business, financial condition, prospects and
  ability to repay its indebtedness.
   
  SECURITY RISKS
   
    Despite the implementation of security measures, the Company's or its cable
  affiliates' networks may be vulnerable to unauthorized access, computer
  viruses and other disruptive problems. ISPs and OSPs have in the past
  experienced, and may in the future experience, interruptions in service as a
  result of the accidental or intentional actions of Internet users.
  Unauthorized access by current and former employees or others could also
  potentially jeopardize the security of confidential information stored in the
  computer systems of the Company and its subscribers. Such events may result in
  liability of the Company to its subscribers and also may deter potential
  subscribers. Although the Company intends to continue to implement industry-
  standard security measures, such measures have been circumvented in the past,
  and there can be no assurance that measures implemented by the Company will
  not be circumvented in the future. Moreover, the Company has no control over
  the security measures that the Company's cable affiliates adopt. Eliminating
  computer viruses and alleviating other security problems may require
  interruptions, delays or cessation of service to the Company's subscribers,
  which could have a material adverse effect on the Company's business,
  financial condition, prospects and ability to repay its indebtedness. In
  addition, the threat of these and other security risks may deter potential ISP
  channel subscribers from purchasing the ISP Channel service, which could have
  a material adverse effect on the Company's business, financial condition,
  prospects and ability to repay its indebtedness.
   
  DEPENDENCE ON HIGH-QUALITY CONTENT PROVISION AND ACCEPTANCE; DEVELOPING MARKET
  FOR HIGH-QUALITY CONTENT
   
    A key component of the Company's strategy is to provide a more compelling
  interactive experience to Internet users than the experience currently
  available to customers of dial-up ISPs and OSPs. The Company believes that, in
  addition to providing high-speed, high-performance Internet access, it must
  also develop and aggregate high-quality multimedia content. The Company's
  success in providing and aggregating such content will depend in part on the
  Company's ability to develop a customer base sufficiently large to justify
  investments in the development of such content as well as (i) the ability of
  content providers to create and support high-quality multimedia content; and
  (ii) the Company's ability to aggregate content offerings in a manner that
  subscribers find attractive. There can be no assurance that the Company will
  be successful in these endeavors. In addition, the market for high-quality
  multimedia Internet content has only recently begun to develop and is rapidly
  evolving, and there is significant competition among ISPs and OSPs for
  aggregating such content. If the market were to fail to develop, or were to
  develop more slowly than expected, or if competition were to increase, or if
  the Company's content offerings did not achieve or sustain market acceptance,
  the Company's business, financial condition, prospects and ability to repay
  its indebtedness would be materially adversely affected.
   
  DEPENDENCE ON ADVERTISING REVENUES
   
    The success of the Company's Internet Services Division depends in part on
  the ability of the Company to entice advertisers to advertise through the ISP
  Channel. The Company expects to derive significant revenues from
  advertisements placed on co-branded and ISP Channel web pages and "click
  through" revenues from products and services purchased through links from the
  ISP Channel to vendors. While the Company believes that it can leverage the
  ISP Channel to provide information to advertisers to help them better target
  prospective customers, there can be no assurance that advertisers will find
  such information useful or choose to advertise through the ISP Channel. There
  can be no assurance that the Company will be able to attract advertising
  revenues in quantities and at rates that are satisfactory to the Company. The
  failure to do so could have a material adverse effect on the Company's
  business, financial condition, prospects and ability to repay its
  indebtedness.
   
                                        11
  UNCERTAIN ACCEPTANCE AND MAINTENANCE OF THE ISP CHANNEL BRAND
   
    The Company believes that establishing and maintaining the ISP Channel brand
  are critical to attracting and expanding its subscriber base. Promotion of the
  ISP Channel brand will depend, among other things, on the Company's success in
  providing high-speed, high-quality consumer and business Internet products,
  services and content, the marketing efforts of the cable affiliates, and the
  reliability of the cable affiliates' networks and services, none of which can
  be assured. The Company has little control over the cable affiliates'
  marketing efforts or the reliability of their networks and services. If
  consumers and businesses do not perceive the Company's existing products and
  services to be of high quality or if the Company introduces new products or
  services or enters into new business ventures that are not favorably received
  by consumers and businesses, the Company will be unsuccessful in promoting and
  maintaining its brand. To the extent the Company expands the focus of its
  marketing efforts to geographic areas where the ISP Channel service is not
  available, the Company risks frustrating potential subscribers who are not
  able to access the Company's products and services. Furthermore, in order to
  attract and retain subscribers, and to promote and maintain the ISP Channel
  brand in response to competitive pressures, the Company may find it necessary
  to increase substantially its financial commitment to creating and maintaining
  a distinct brand loyalty among customers. If the Company were unable to
  establish or maintain the ISP Channel brand successfully or if the Company
  were to incur excessive expense in an attempt to improve its offerings or
  promote and maintain its brand, the Company's business, financial condition,
  prospects and ability to repay its indebtedness would be materially adversely
  affected.
   
  BILLING AND COLLECTIONS RISKS
   
    The Company has recently commenced the process of designing and implementing
  its billing and collections system for its Internet Services Division. It is
  the Company's intention to bill for the services provided by this business
  over the Internet and, in most cases, to collect these invoices through
  payments received via the Internet. Such invoices and payments have security
  risks. Given the complexities of such a system, there can be no assurance that
  the Company will be successful in developing and implementing the system in a
  timely manner or that it will be able to scale the system quickly and
  efficiently if necessary to accommodate potential growth in the number of
  subscribers requiring such a billing format. In some circumstances, the
  Company's cable affiliates are responsible for billing and collection for the
  Company's Internet access services. In any such instance, the Company has
  little or no control over the accuracy and timeliness of its invoices or over
  collection efforts. Given its relatively limited history with billing and
  collection for Internet services, the Company cannot predict the extent to
  which it may experience bad debts or the extent to which it will be able to
  minimize such bad debts. If the Company encounters significant problems with
  its billing and collections process, the Company's business, financial
  condition, prospects and ability to repay its indebtedness could be materially
  adversely affected.
   
  DEPENDENCE ON THE GROWTH AND EVOLUTION OF THE INTERNET
   
    Market acceptance of the Company's Internet services is substantially
  dependent upon the growth and evolution of the Internet in ways that are best
  suited for the Company's products and services. High-speed cable-based
  Internet access is of greatest value to consumers of multimedia and other
  bandwidth-intensive content. The nature of the content available over the
  Internet, and the technologies available to access that content, are evolving
  rapidly, and there can be no assurance that those applications that most favor
  the Company's services and technology will be widely accepted by the
  marketplace. In addition, to the extent that the Internet continues to
  experience significant growth in the number of users and level of use, there
  can be no assurance that the Internet infrastructure will continue to be able
  to support the demands placed on it by such potential growth or that the
  performance or reliability of the Internet will not be adversely affected. The
  Internet could lose its commercial viability due to delays in the development
  or adoption of new standards and protocols to handle increased levels of
  Internet activity. There can be no assurance that the infrastructure or
  complementary services necessary to make the Internet a viable commercial
  marketplace will be developed. In particular, the Internet has only recently
  become a medium for advertising and electronic commerce. If the necessary
  infrastructure or
   
                                        12
  complementary services or facilities are not developed, or if the Internet
  does not become a viable commercial marketplace or platform for advertising
  and electronic commerce, the Company's business, financial condition,
  prospects and ability to repay its indebtedness could be materially adversely
  affected.
   
  POTENTIAL LIABILITY FOR DEFAMATORY OR INDECENT CONTENT
   
    The law relating to liability of ISPs and OSPs for information carried on or
  disseminated through their networks is currently unsettled. A number of
  lawsuits have sought to impose such liability for defamatory speech and
  indecent materials. A recent federal statute seeks to impose such liability,
  in some circumstances, for transmission of obscene or indecent materials. In
  one case, a court has held that an OSP could be found liable for defamatory
  matter provided through its service, on the ground that the service provider
  exercised active editorial control over postings to its service. The
  imposition upon ISPs or OSPs of potential liability for materials carried on
  or disseminated through their systems could require the Company to implement
  measures to reduce its exposure to such liability, which may require the
  expenditure of substantial resources or the discontinuation of certain
  products or service offerings. In addition, the imposition of liability on the
  Company for information carried on the Internet could have a material adverse
  effect on the Company's business, financial condition, prospects and ability
  to repay its indebtedness.
   
  POTENTIAL LIABILITY FOR INFORMATION RETRIEVED AND REPLICATED
   
    Because materials will be downloaded and redistributed by subscribers and
  cached or replicated by the Company in connection with the Company's offering
  of its services, there is a possibility that claims may be made against the
  Company or its cable affiliates under both U.S. and foreign law for
  defamation, negligence, copyright or trademark infringement, or other theories
  based on the nature and content of such materials. Such types of claims have
  been successfully brought against OSPs. In particular, copyright and trademark
  laws are evolving both domestically and internationally, and there is
  uncertainty concerning how broadly the rights afforded under these laws will
  be applied to on-line environments. It is impossible for the Company to
  determine who the potential rights holders may be with respect to all
  materials available through the Company's services. In addition, a number of
  third party owners of patents have claimed to hold patents that cover various
  forms of on-line transactions or on-line technology. As with other OSPs,
  patent claims could be asserted against the Company based upon its services or
  technologies. The Company's liability insurance may not cover potential claims
  of the foregoing types or may not be adequate to indemnify the Company for all
  liability that may be imposed. Any imposition of liability that is not covered
  by insurance or is in excess of insurance coverage could have a material
  adverse effect on the Company's business, financial condition, prospects and
  ability to repay its indebtedness.
   
  RAPID TECHNOLOGICAL CHANGE; DEPENDENCE ON NEW PRODUCTS AND SERVICES
   
    There can be no assurance that the Company's future development efforts will
  result in commercially successful products or that the Company's products and
  services will not be rendered obsolete by changing technology, new industry
  standards or new product announcements by competitors. The markets for all of
  the Company's products and services are characterized by intense competition,
  rapid technological advances, evolving industry standards, changes in
  subscriber requirements, frequent new product introductions and enhancements,
  and rapidly evolving, alternative service offerings. For example, the Company
  expects digital set-top boxes capable of supporting high-speed Internet access
  services to be commercially available in the next 18 months. Although the
  widespread availability of set-top boxes could increase the demand for the
  Company's Internet Service, there is no assurance that the demand for set-top
  boxes will ever reach the level estimated by the Company and industry experts
  or, if set-top boxes reach this level of popularity, that the Company will be
  able to capitalize on such demand. If this scenario occurs or if other
  technologies or standards applicable to the Company's products or service
  offerings become obsolete or fail to gain widespread commercial acceptance,
  then the Company's business, financial condition, prospects and ability to
  repay its indebtedness will be materially adversely affected.
   
   
                                        13
  The introduction of products or services embodying, or purporting to embody,
  new technology or the emergence of new industry standards could also render
  the Company's existing products and services, as well as products or services
  under development, obsolete and unmarketable. Internet, telecommunications and
  cable technologies are evolving rapidly. Many large corporations, including
  large telecommunications providers, Regional Bell Operating Companies
  ("RBOCs") and telecommunications equipment providers, as well as large cable
  system operators, regularly announce new and planned technologies and service
  offerings that could impact the market for the Company's services. These
  announcements can have the effect of delaying purchasing decisions by the
  Company's customers and confusing the marketplace regarding available
  alternatives. Such announcements could in the future adversely impact the
  Company's business, financial condition, prospects and ability to repay its
  indebtedness.
   
    The Company's ability to adapt to changes in technology and industry
  standards, and to develop and introduce new and enhanced products and service
  offerings will be significant factors in maintaining or improving its
  competitive position and its prospects for growth. Due to rapid technological
  changes in the Internet and telecommunications industries, the lengthy product
  approval and purchase processes of the Company's customers and the Company's
  reliance on third party technology for the development of new products and
  service offerings, there can be no assurance that the Company will
  successfully introduce new products and services on a timely basis or achieve
  sales of new products and services in the future, or, if sales are achieved,
  that latent defects will not exist in the Company's products or equipment
  purchased by the Company from third parties. In addition, there can be no
  assurance that the Company will have the financial and manufacturing resources
  necessary to continue to successfully develop new products or services based
  on emerging technologies or to otherwise successfully respond to changing
  technology and/or industry standards. Moreover, due to intense competition,
  there may be a time-limited market opportunity for the Company's cable-based
  consumer and business Internet services. There can be no assurance that the
  Company will be successful in achieving widespread acceptance of its services
  before competitors offer products and services with speed and performance
  similar to the Company's current offerings. In addition, the widespread
  adoption of new Internet or telecommuting technologies or standards, cable-
  based or otherwise, could require substantial expenditures by the Company to
  modify or adapt its equipment, products and services and could fundamentally
  alter the character, viability and frequency of Internet-based advertising,
  either of which could have a material adverse effect on the Company's
  business, financial condition, prospects and ability to repay its
  indebtedness.
   
    The technology underlying capital equipment used by the Company such as
  headends and cable modems is continuing to evolve and, accordingly, it is
  possible that the equipment acquired by the Company could become out-of-date
  or obsolete prior to the time the Company would otherwise intend to replace
  such equipment. In any such circumstance, the Company may need to acquire
  substantial amounts of new capital equipment, which could have a material
  adverse effect on the Company's business, financial condition, prospects and
  ability to repay its indebtedness.
   
  ADVERSE EFFECT ON MTC OF GROWTH OF ALTERNATE TECHNOLOGIES
   
    Revenues for MTC's products and services have been adversely affected in
  recent years, and could in the future be substantially adversely affected by,
  among other things, the increasing use of digital technology. MTC's revenues,
  after giving effect to the discontinuation of the Telecommunications Division,
  have represented substantially all of the Company's revenues for the past
  several years.
   
    The effect of digital and other technologies on the demand for MTC's
  products and services depends, in part, on the extent of technological
  advances and cost decreases in such technologies. The recent trend of
  technological advances and attendant price declines in digital systems and
  products is expected to continue. As a result, in certain instances, potential
  MTC customers have deferred, and may continue to defer, investments in MTC
  systems while evaluating the abilities of digital and other technologies.
   
    The continuing development of local area computer networks and similar
  systems based on digital technologies has resulted and will continue to result
  in many MTC customers changing their use of MTC
   
                                        14
  products from data storage and retrieval to primarily archival use. The
  rapidly changing data storage and management industry also has resulted in
  intense price competition in certain of MTC's markets.
   
    Therefore, the Company has been and expects to continue to be impacted
  adversely by the decline in the market for COM services, the high fixed costs
  and declining market for COM systems and the attendant reduction in equipment
  and supplies. The Company's revenues for maintenance of COM systems have
  declined in part because of efficiencies associated with the Company's systems
  and could decline further in the event of lesser use and fewer sales of COM
  systems. The growth of alternate technologies has created consolidation in the
  micrographics industry. To the extent consolidation in the micrographics
  industry has the effect of causing major providers of micrographics services
  and products to cease providing such services and products, the negative
  trends in the industry, such as competition from alternate technologies
  described above, may accelerate.
   
  MTC PROPRIETARY TECHNOLOGY; RISK OF THIRD PARTY CLAIMS OF INFRINGEMENT
   
    The industry in which MTC operates may be affected by an increasing number
  of patents and frequent litigation based on allegations of patent and other
  intellectual property infringement. To develop and maintain its competitive
  position, MTC relies primarily upon the technical expertise and creative
  skills of its personnel, confidentiality agreements and, to some degree,
  patents and copyrights that it owns or, with respect to patents held by third
  parties, has license rights to use. There can be no assurance that such
  confidentiality or licensing agreements will not be breached, that others may
  not infringe upon such patents or licenses, or that the Company would have
  adequate remedies for any such breach for infringement. There can be no
  assurance that patents issued to or licensed by the Company will not be
  challenged or circumvented by competitors or be found to be sufficiently broad
  to protect the Company's technology or to provide it with any competitive
  advantage. Moreover, the Company may be materially adversely affected by
  competitors who independently develop substantially equivalent technology.
  Further, any litigation, either on behalf of or against the Company, relating
  to such confidentiality or licensing agreements, patents or copyrights,
  regardless of outcome, could result in substantial costs to the Company and
  diversion of effort by management. Any infringement claim or other litigation
  against or by the Company could have a material adverse effect on the
  Company's business, financial condition, prospects and ability to repay its
  indebtedness.
   
  ACQUISITION-RELATED RISKS
   
    The Company may from time to time acquire other businesses that the Company
  believes will complement its existing business. The Company is unable to
  predict whether or when any prospective acquisitions will occur or the
  likelihood of a material transaction being completed on favorable terms and
  conditions, if at all. The Company's ability to finance acquisitions may be
  constrained by, among other things, its high degree of leverage following the
  Debt Offering, if completed. The indenture that would govern the Senior Notes
  may significantly limit the Company's ability to make desired acquisitions and
  to incur indebtedness in connection with acquisitions. Such transactions, if
  effected, are likely to involve certain risks, including, among other things:
  the difficulty of assimilating the acquired operations and personnel; the
  potential disruption of the Company's ongoing business and diversion of
  resources and management time; the possible inability of management to
  maintain uniform standards, controls, procedures and policies; the risks of
  entering markets in which the Company has little or no direct prior
  experience; and the potential impairment of relationships with employees or
  customers as a result of changes in management. There can be no assurance that
  any acquisition will be so made, that the Company will be able to obtain
  additional financing needed to finance such acquisitions and, if any
  acquisitions are so made, that the acquired business will be successfully
  integrated into the Company's operations or that the acquired business will
  perform as expected.
   
  DEPENDENCE ON KEY PERSONNEL
   
    The success of the Company is dependent, in part, on its ability to attract
  and retain qualified technical, marketing, sales and management personnel.
  Competition for such personnel is intense and the Company's
   
                                        15
  inability to attract and retain additional key employees or the loss of one or
  more of its current key employees could materially adversely affect the
  Company's business, financial condition, prospects and ability to repay its
  indebtedness. The Company has recently assembled a new management team to
  implement its strategy for launching its ISP Channel concept on a large-scale
  basis, most of whom have been with the Company for less than six months. The
  Company is currently seeking new employees in connection with the expansion of
  its Internet Services Division. The loss of any member of the new team, or
  failure to attract such personnel, could also have a material adverse effect
  on the Company's business, financial condition, prospects and ability to repay
  its indebtedness. There can be no assurance that the Company will be
  successful in hiring or retaining key personnel.
   
  GOVERNMENT REGULATION
   
    Although the Company's services are not currently subject to direct
  regulation by the FCC or any other federal or state communications regulatory
  agency, changes in law or regulation relating to Internet connectivity and the
  telecommunications markets, including changes that, directly or indirectly,
  affect costs, limit usage of subscriber-related information or increase the
  likelihood or scope of competition from the RBOCs or other telecommunications
  companies, could affect the nature, scope and prices of the Company's
  services. For example, proceedings are pending at the FCC to determine
  whether, and to what extent, ISPs should be considered "telecommunications
  carriers" and, if so, whether they should be required to contribute to the
  Universal Service Fund. Although the FCC has decided for the moment that ISPs
  are not telecommunications carriers, that decision is not yet final and is
  being challenged by various parties, including the RBOCs. Some members of
  Congress have also challenged the FCC's conclusion. Congressional
  dissatisfaction with the FCC's conclusions could result in further changes to
  the FCC's governing law. The Company cannot predict the impact, if any, that
  future legal or regulatory changes might have on its business. In addition,
  regulation of cable television may affect the speed at which the Company's
  cable affiliates upgrade their cable infrastructures to two-way hybrid fiber
  coaxial cable. Currently, the Company's cable affiliates have generally
  elected to classify the distribution of the Company's services as "additional
  cable services" under their respective franchise agreements, and to pay
  franchise fees in accordance therewith. However, the election by cable
  operators to classify Internet access as an additional cable service may be
  challenged before the FCC, the courts or Congress, and any alteration in the
  classification of service could potentially have an adverse impact on the
  Company and its business.
   
    Another risk lies in the possibility that local franchise authorities may
  attempt to subject the cable affiliates to higher or other franchise fees or
  taxes or otherwise require them to obtain additional franchises in connection
  with their distribution of the Company's services. There are thousands of
  franchise authorities in the United States alone, and thus it will be
  difficult or impossible for the Company or its cable affiliates to operate
  under a unified set of franchise requirements. In the event that the FCC or
  another governmental agency were to classify the cable system operators as
  "common carriers" or "telecommunications carriers" because of their provision
  of Internet services, or if cable system operators were to seek such
  classification as a means of limiting their liability, the Company's rights as
  the exclusive ISP over the systems of certain of the cable affiliates could be
  lost. In addition, if the Company or its cable affiliates were classified as
  common carriers, they could be subject to government-regulated tariff
  schedules for the amounts they charge for their services. To the extent the
  Company increases the number of foreign jurisdictions in which it offers its
  services, the Company will be subject to additional governmental regulation.
  Any future implementation of any changes in law or regulation including those
  discussed herein, could have a material adverse effect on the Company's
  business, financial condition, prospects and ability to repay its
  indebtedness.
   
    In addition, the Company's business, financial condition, prospects and
  ability to repay its indebtedness may also be adversely affected by the
  imposition of certain tariffs, duties and other import restrictions on
  components that the Company obtains from non-domestic suppliers. Changes in
  law or regulation, in the United States or elsewhere, could materially
  adversely affect the Company's business, financial condition, prospects and
  ability to repay its indebtedness.
   
   
                                        16
  PRODUCT LIABILITY
   
    Some of the Company's products, such as those sold by MTC, are used to
  provide information that relates to the customer's enterprise operations and
  information that may be used in other critical applications. Any failure by
  the Company's products to provide accurate and timely information could result
  in claims against the Company. There can be no assurance that the Company's
  insurance coverage would adequately cover any claim asserted against the
  Company. A successful claim brought against the Company in excess of its
  insurance coverage could have a material adverse effect on the Company's
  business, financial condition, prospects and ability to repay its
  indebtedness. Even unsuccessful claims could result in the Company's
  expenditure of funds in litigation and management time and resources. There
  can be no assurance that the Company will not be subject to product liability
  claims, that such claims will not result in liability in excess of its
  insurance coverage or that the Company's insurance will cover such claims or
  that appropriate insurance will continue to be available to the Company in the
  future at commercially reasonable rates.
   
  RISKS RELATING TO MTC'S INTERNATIONAL OPERATIONS
   
    After giving effect to discontinued operations, sales outside of the United
  States accounted for approximately 22% and 27% of the Company's total revenues
  for Fiscal 1997 and 1996, respectively, which are attributable solely to MTC.
  Further development of foreign distribution channels for MTC's products and
  services could require a significant investment, which could adversely affect
  short-term results of operations. The Company believes that its future revenue
  growth and profitability in the foreign markets will principally depend on its
  success in developing these new distribution channels. Failure to increase
  revenues from the introduction of new products and services to these markets
  could have a material adverse effect on the Company's business, financial
  condition, prospects and ability to repay its indebtedness. Because of its
  export sales, MTC is subject to the risks of conducting business
  internationally, including unexpected changes in regulatory requirements
  (including the regulation of Internet access), uncertainty regarding liability
  for information retrieved and replicated in foreign institutions, foreign
  currency fluctuations which could result in reduced revenues or increased
  operating expenses, tariffs and trade barriers, potentially longer payment
  cycles, difficulty in accounts receivable collection, foreign taxes, and the
  burdens of complying with a variety of foreign laws and trade standards. MTC
  is also subject to general geopolitical risks, such as political and economic
  instability and changes in diplomatic and trade relationships, in connection
  with its international operations. In addition, the laws of certain foreign
  countries may not protect MTC's proprietary technology to the same extent as
  do the laws of the United States. There can be no assurance that the risks
  associated with MTC's international operations will not materially adversely
  affect the Company's business, financial condition, prospects and ability to
  repay its indebtedness or require MTC to modify significantly its current
  business practices.
   
  SHARES ELIGIBLE FOR FUTURE SALE
   
    Future sales of shares of the Common Stock by its existing shareholders
  under Rule 144 of the Securities Act, or through the exercise of registration
  rights or the issuance of shares of the Common Stock upon the exercise of
  options or warrants, could materially adversely affect the market price of
  shares of the Common Stock and could materially impair the Company's future
  ability to raise capital through an offering of equity securities. No
  predictions can be made as to the effect, if any, of market sales of such
  shares or the availability of such shares for future sale will have on the
  market price of shares of the Common Stock prevailing from time to time. At
  June 30, 1998, the Company has reserved for issuance 2,886,493 shares of
  Common Stock for issuance pursuant to outstanding Convertible Subordinated
  Debentures, options and warrants. The Company also has reserved up to 19.9% of
  its outstanding Common Stock as of May 29, 1998 for issuance under its cable
  affiliate incentive program. The Company has issued Convertible Preferred
  Stock that has a conversion price that fluctuates in relation to the price of
  the Common Stock. At June 30, 1998, such Convertible Preferred Stock would be
  convertible into 1,127,442 shares of Common Stock.
   
   
                                        17
  HOLDING COMPANY STRUCTURE; RESTRICTIONS ON ACCESS TO SUBSIDIARY CASH FLOW
   
    The Company is a holding company, conducting all of its operations through
  its Subsidiaries. Because the Company conducts all of its operations through
  subsidiaries, the Company's cash flow and its ability to service its
  indebtedness will depend upon the cash flow of its subsidiaries and payments
  of funds by those subsidiaries to the Company in the form of repayment of
  loans, dividends or otherwise. In addition, these subsidiaries may incur
  indebtedness or become parties to financing arrangements, which may contain
  limitations on the ability of such subsidiaries to pay dividends or to make
  loans or advances to the Company. Further, any holders of indebtedness
  (including subordinated indebtedness and trade payables) of subsidiaries of
  the Company would be entitled to repayment of such indebtedness from the
  assets of the affected subsidiaries before such assets were made available for
  distribution to the Company.
   
    In the event that the Company is unable to generate sufficient cash flow or
  is otherwise unable to obtain funds necessary to meet required payments of
  principal, premium, if any, and interest on its indebtedness, the Company
  would be in default under the terms of the agreements governing such
  indebtedness. In the event of such default, the holders of such indebtedness
  could elect to declare all of the funds borrowed thereunder to be due and
  payable together with accrued and unpaid interest. If such an acceleration
  were effected and the Company did not have sufficient funds to pay the
  accelerated indebtedness, the holders could initiate foreclosure or other
  enforcement action against the Company.
   
  FAILURE TO SELL THE TELECOMMUNICATIONS DIVISION
   
    The Company has decided to discontinue its Telecommunications Division, and
  is currently seeking a buyer for this division. However, there can be no
  assurance these efforts will be successful. If the Company is unable to
  consummate a sale of the Telecommunications Division on terms it believes are
  satisfactory, it will not obtain the proceeds anticipated from such sale,
  which will correspondingly diminish the capital available to the Company to
  implement its Internet Service Division's strategy. In the absence of such a
  sale, management's attention could be substantially diverted to operate or
  otherwise dispose of the Telecommunications Division. If a sale of the
  Telecommunications Division is delayed, its value could be diminished.
  Moreover, the Telecommunications Division could incur losses and operate on a
  cash flow negative basis in the future. Any such event could have a material
  adverse effect on the Company's business, financial condition, prospects and
  ability to repay its indebtedness.
   
  ABSENCE OF DIVIDENDS
   
    The Company has not historically paid any cash dividends on its Common Stock
  and does not expect to declare any such dividends in the foreseeable future.
  Payment of any future dividends will depend upon earnings and capital
  requirements of the Company, the Company's debt facilities and other factors
  the Board of Directors deems relevant. The Company currently intends to retain
  its earnings, if any, to finance the development and expansion of the Internet
  Services Division, and therefore does not anticipate paying any cash dividends
  in the foreseeable future. The Company's Certificate of Incorporation
  prohibits the payment of cash dividends on the Common Stock, without the
  consent of the holders of the Convertible Preferred Stock, while shares of the
  Convertible Preferred Stock are outstanding and, upon liquidation of the
  Company, requires payment of the liquidation value of the Convertible
  Preferred Stock prior to any payments with respect to the Common Stock. The
  Company's ability to pay dividends on its Common Stock is also restricted by
  certain of the Company's financing agreements.
   
  VOLATILITY OF STOCK PRICE
   
    The market price for the Common Stock has been volatile and market
  fluctuations may adversely affect the market price of the Common Stock without
  regard to the operating performance of the Company. The Company believes that
  factors such as announcements of developments related to the Company's
  business, fluctuations in the Company's results of operations, sales of
  substantial amounts of securities of the Company into the
   
                                        18
  marketplace, general conditions in the Company's industries or the worldwide
  economy, an outbreak of hostilities, a shortfall in revenues or earnings
  compared to analysts' expectations, changes in analysts' recommendations or
  projections, announcements of new products or services by the Company or its
  competitors or developments in the Company's relationships with its suppliers
  or customers could cause the price of the Common Stock to fluctuate in the
  future, perhaps substantially. There can be no assurance that the market price
  of the Common Stock will not experience significant fluctuations in the
  future, including fluctuations that are unrelated to the Company's
  performance. General market price declines or market volatility in the future
  could adversely affect the market price of the Common Stock, and the current
  market price of the Common Stock may not be indicative of future market
  prices.
   
  PROSPECTIVE ANTI-TAKEOVER PROVISIONS
   
    The Company is a New York corporation. Following the Offering, it is the
  Company's intention to solicit shareholder approval to reincorporate in
  Delaware. Both the New York Business Corporation Law and the Delaware General
  Corporation Law contain certain provisions that may have the effect of
  discouraging, delaying or making more difficult a change in control of the
  Company or preventing the removal of incumbent directors. In addition, the
  Company is currently reviewing proposed changes to its Certificate of
  Incorporation and Bylaws that would have the same effect. The existence of
  these provisions may have a negative impact on the price of the Common Stock
  and may discourage third party bidders from making a bid for the Company or
  may reduce any premiums paid to shareholders for their Common Stock.
   
  YEAR 2000 ISSUES
   
    Many existing computer systems, related software applications and other
  control devices use only two digits to identify a year in a date field,
  without considering the impact of the upcoming change in the century. Such
  systems, applications and/or devices could fail or create erroneous results
  unless corrected so that they can process data related to the Year 2000. The
  Company relies on such computer systems, applications and devices in operating
  and monitoring all major aspects of its business, including, but not limited
  to, its financial systems (such as general ledger, accounts payable and
  payroll modules), customer services, internal networks and telecommunications
  equipment, and end products. The Company also relies, directly and indirectly,
  on the external systems of various independent business enterprises, such as
  its customers, suppliers, creditors, financial organizations, and of
  governments, both domestically and internationally, for the accurate exchange
  of data and related information.
   
    The Company is currently in the process of evaluating the potential impact
  of the Year 2000 issue on its business and the related expenses that could
  likely be incurred in attempting to remedy such impact (including testing and
  implementation of remedial action). Management's current estimate is that the
  costs associated with the Year 2000 issue should not have a material adverse
  affect on the results of operations or financial position of the Company in
  any given year. However, despite the Company's efforts to address the Year
  2000 impact on its internal systems, the Company is not sure that it has fully
  identified such impact or that it can resolve it without disruption of its
  business and without incurring significant expenses. In addition, even if the
  internal systems of the Company are not materially affected by the Year 2000
  issue, the Company could be affected as a result of any disruption in the
  operation of the various third party enterprises with which the Company
  interacts such as cable affiliates, vendors and suppliers.
   
                                        19
  SUMMARY CONSOLIDATED FINANCIAL DATA
   
    The following summary consolidated financial data should be read in
  conjunction with the Company's Consolidated Financial Statements and the
  related Notes thereto and "Management's Discussion and Analysis of Financial
  Condition and Results of Operations" included herein. The consolidated
  statement of operations data for the three years ended September 30, 1995,
  1996 and 1997 and the consolidated balance sheet data at September 30, 1997
  are derived from, and are qualified by reference to, the audited Consolidated
  Financial Statements and the related Notes thereto included herein.
  (UNAUDITED)
                                                                         SIX MONTHS
                                  YEAR ENDED SEPTEMBER 30,             ENDED MARCH 31,
                           ------------------------------------------  ----------------
                            1993    1994     1995     1996     1997     1997     1998
                           ------  -------  -------  -------  -------  -------  -------
                                     ($ IN THOUSANDS, EXCEPT PER SHARE)
  STATEMENT OF OPERATIONS
   DATA:
   Revenues:
   MTC:
    COM equipment and
     system software...... $   --  $    --  $   265  $ 6,014  $ 6,347  $ 3,761  $ 1,020
    All other.............     43      188      823   13,403   13,983    6,956    5,625
   Internet Services:
    Cable service.........      0        0        0        0       20        0      237
    Dial-up service.......      0        0        0      150      587      305      339
    Misc. one-time........      0        0        0       17      401      313        8
                           ------  -------  -------  -------  -------  -------  -------
     Total revenues....... $   43  $   188  $ 1,088  $19,584  $21,338  $11,335  $ 7,229
                           ======  =======  =======  =======  =======  =======  =======
   Cost of revenues.......     --      172      783   11,375   11,935    6,371    5,252
   Selling, engineering,
    general and
    administrative........    837    1,180    7,548   10,921   11,191    4,400    5,257
   Income (loss) from
    continuing operations.   (794)  (1,164)  (7,243)  (2,712)  (1,788)     564   (3,280)
   Interest expense.......    (37)    (601)    (456)  (1,220)  (1,145)    (533)    (596)
   Other income ..........      3        2        5    5,708       49       81      170
   Gain (loss) from
    discontinued
    operations............    348      335   (1,962)  (1,812)     739      426      115
   Loss from extraordinary
    items.................      0        0        0   (6,061)    (486)       0        0
                           ------  -------  -------  -------  -------  -------  -------
   Net income (loss)...... $ (480) $(1,428) $(9,656) $(6,097) $(2,631) $   538  $(3,591)
   Preferred dividends....      0        0        0        0        0        0      (63)
                           ------  -------  -------  -------  -------  -------  -------
   Net income (loss)
    applicable to common
    shares................ $ (480) $(1,428) $(9,656) $(6,097) $(2,631) $   538  $(3,654)
                           ======  =======  =======  =======  =======  =======  =======
   Net income (loss) per
    share:
   Diluted................ $(0.14) $ (0.38) $ (2.22) $ (1.05) $ (0.40) $  0.08  $ (0.52)
                           ======  =======  =======  =======  =======  =======  =======
   Shares used in per
    share calculations:
   Diluted................  3,555    3,802    4,353    5,819    6,627    6,864    6,966
                           ======  =======  =======  =======  =======  =======  =======
  OTHER FINANCIAL DATA:
   Depreciation and
    amortization..........    116       68      194    1,374    1,798      829      951
   Capital Expenditures...     12       75    1,418      973      626      530      319
   EBITDA (1).............   (678)  (1,096)  (2,049)     162    1,010    1,393   (2,329)
   Ratio of earnings to
    fixed charges (2)(3)..     --       --       --      2.2       --      1.2       --
  (UNAUDITED)
                                                          AS OF MARCH 31, 1998
                                                          --------------------
                                                              ($ IN THOUSANDS)
  CONSOLIDATED BALANCE SHEET DATA:
   Cash and cash equivalents.............................        $   17
   Total assets..........................................        21,934
   Total debt............................................        13,168
   Total stockholders' equity............................         3,387
  20
  ---------------------
  (1) EBITDA consists of net income (loss) from operations excluding net
      interest, depreciation and amortization. EBITDA is presented to enhance an
      understanding of the Company's operating results and is not intended to
      represent cash flow or results of operations in accordance with generally
      accepted accounting principles for the periods indicated and may be
      calculated differently than EBITDA for other companies. EBITDA presented
      for Fiscal 1995 excludes a one-time write-off of $5.0 million for in
      process, unproven technology associated with the Company's acquisition of
      MTC on September 15, 1995. EBITDA presented for the fiscal year 1996
      excludes a charge of $1.5 million for the write-down of certain software
      inventory associated with the Company's decision to discontinue the
      distribution of certain imaging products in favor of others. EBITDA
      presented for the fiscal year 1997 excludes a charge of $1.0 million for
      the write-off of prepaid license fees associated with certain imaging
      products. See the Company's Consolidated Financial Statements and the
      related Notes thereto.
   
  (2) For purposes of these computations, earnings consist of income (loss) from
      continuing operations before income taxes and extraordinary item plus
      fixed charges. Fixed charges consist of interest expense (including
      capitalized interest), amortization of deferred financing costs and one-
      third of rental expense (the portion deemed representative of the interest
      factor).
   
  (3) Fixed charges did not exceed the Company's net losses for the fiscal years
      ended 1993, 1994, 1995 and 1997 and for the six months ended March 31,
      1998. Accordingly, the Company had a deficiency of earnings to fixed
      charges of $(790), $(1,129), $(7,144), $(1,463) and $(2,972) for the
      respective periods.
   
                                        21
  SELECTED CONSOLIDATED HISTORICAL FINANCIAL DATA
   
    The selected consolidated historical financial data set forth below for and
  as of the three years ended September 30, 1995, 1996 and 1997 have been
  derived from the audited Consolidated Financial Statements of the Company. The
  following selected consolidated financial data should be read in conjunction
  with the Consolidated Financial Statements and the related notes thereto, and
  "Management's Discussion and Analysis of Financial Condition and Results of
  Operations."
   
    The following table sets forth for the periods selected consolidated
  financial and operating data for the Company. The statement of operations and
  balance sheet data have been derived from the Company's consolidated financial
  statements audited by PricewaterhouseCoopers L.L.P. The selected consolidated
  financial data should be read in conjunction with "Management's Discussions
  and Analysis of Financial Conditions and Results of Operations" and the
  consolidated financial statements and the notes thereto.
  (UNAUDITED)
                                                                          SIX MONTHS
                                   YEAR ENDED SEPTEMBER 30,             ENDED MARCH 31,
                            ------------------------------------------  ----------------
                             1993    1994     1995     1996     1997     1997     1998
                            ------  -------  -------  -------  -------  -------  -------
                                      ($ IN THOUSANDS, EXCEPT PER SHARE)
  STATEMENT OF OPERATIONS
   DATA:
   Revenues:
   MTC:
    COM equipment and
     system software......  $   --  $    --  $   265  $ 6,014  $ 6,347  $ 3,761  $ 1,020
    All other.............      43      188      823   13,403   13,983    6,956    5,625
   Internet Services:
    Cable service.........       0        0        0        0       20        0      237
    Dial-up service.......       0        0        0      150      587      305      339
    Misc. one-time........       0        0        0       17      401      313        8
                            ------  -------  -------  -------  -------  -------  -------
    Total revenues........  $   43  $   188  $ 1,088  $19,584  $21,338  $11,335  $ 7,229
                            ======  =======  =======  =======  =======  =======  =======
   Cost of revenues.......      --      172      783   11,375   11,935    6,371    5,252
   Selling, engineering,
    general and
    administrative........     837    1,180    7,548   10,921   11,191    4,400    5,257
   Income (loss) from
    continuing operations.    (794)  (1,164)  (7,243)  (2,712)  (1,788)     564   (3,280)
   Interest expense.......     (37)    (601)    (456)  (1,220)  (1,145)    (533)    (596)
   Other income ..........       3        2        5    5,708       49       81      170
   Gain (loss) from
    discontinued
    operations............     348      335   (1,962)  (1,812)     739      426      115
   Loss from extraordinary
    items.................       0        0        0   (6,061)    (486)       0        0
                            ------  -------  -------  -------  -------  -------  -------
   Net income (loss)......  $ (480) $(1,428) $(9,656) $(6,097) $(2,631) $   538  $(3,591)
   Preferred dividends....       0        0        0        0        0        0      (63)
                            ------  -------  -------  -------  -------  -------  -------
   Net income (loss)
    applicable to common
    shares................  $ (480) $(1,428) $(9,656) $(6,097) $(2,631) $   538  $(3,654)
                            ======  =======  =======  =======  =======  =======  =======
   Net income (loss) per
    share:
   Diluted................  $(0.14) $ (0.38) $ (2.22) $ (1.05) $ (0.40) $  0.08  $ (0.52)
                            ======  =======  =======  =======  =======  =======  =======
   Shares used in per
    share calculations:
   Diluted................   3,555    3,802    4,353    5,819    6,627    6,864    6,966
                            ======  =======  =======  =======  =======  =======  =======
  OTHER FINANCIAL DATA:
   Depreciation and
    amortization..........     116       68      194    1,374    1,798      829      951
   Capital Expenditures...      12       75    1,418      973      626      530      319
   EBITDA (1).............    (678)  (1,096)  (2,049)     162    1,010    1,393   (2,329)
   Ratio of earnings to
    fixed charges (2)(3)..      --       --       --      2.2       --      1.2       --
  (UNAUDITED)
                                                                AS OF MARCH
                                                                  31, 1998
                                                                --------------
                                                                ($ IN THOUSANDS)
  CONSOLIDATED BALANCE SHEET DATA:
   Cash and cash equivalents...................................   $       17
   Total assets................................................       21,934
   Total debt..................................................       13,168
   Total stockholders' equity..................................        3,387
  22
  ---------------------
  (1) EBITDA consists of net income (loss) from operations excluding net
      interest, depreciation and amortization. EBITDA is presented to enhance an
      understanding of the Company's operating results and is not intended to
      represent cash flow or results of operations in accordance with generally
      accepted accounting principles for the periods indicated and may be
      calculated differently than EBITDA for other companies. EBITDA presented
      for Fiscal 1995 excludes a one-time write-off of $5.0 million for in
      process, unproven technology associated with the Company's acquisition of
      MTC on September 15, 1995. EBITDA presented for the Fiscal 1996 excludes a
      charge of $1.5 million for the write-down of certain software inventory
      associated with the Company's decision to discontinue the distribution of
      certain imaging products in favor of others. EBITDA presented for the
      Fiscal 1997 excludes a charge of $1.0 million for the write-off of prepaid
      license fees associated with certain imaging products. See the Company's
      Consolidated Financial Statements and the related Notes thereto.
   
  (2) For purposes of these computations, earnings consist of income (loss) from
      continuing operations before income taxes and extraordinary item plus
      fixed charges. Fixed charges consist of interest expense (including
      capitalized interest), amortization of deferred financing costs and one-
      third of rental expense (the portion deemed representative of the interest
      factor).
   
  (3) Fixed charges did not exceed the Company's net losses for the fiscal years
      ended 1993, 1994, 1995 and 1997 and for the six months ended March 31,
      1998. Accordingly, the Company had a deficiency of earnings to fixed
      charges of $(790), $(1,129), $(7,144), $(1,463) and $(2,972) for the
      respective periods.
   
                                        23
  MANAGEMENT'S DISCUSSION AND ANALYSIS OF
                   FINANCIAL CONDITION AND RESULTS OF OPERATIONS
   
    The following discussion of the financial condition and results of
  operations of the Company should be read in conjunction with, and is qualified
  in its entirety by reference to, the Consolidated Financial Statements of the
  Company and the related Notes. The Company's fiscal year ends on September
  30th of each year. "Fiscal 1998" refers to the twelve months ended September
  30, 1998 with comparable references for other twelve month periods ending
  September 30th. This discussion contains forward-looking statements that
  involve risks and uncertainties. The Company's actual results could differ
  materially from those anticipated in the forward-looking statements as a
  result of certain factors including, but not limited to, those discussed in
  "Risk Factors." The Company disclaims any obligation to update information
  contained in any forward-looking statement.
   
  OVERVIEW
   
    The Company currently operates through two continuing divisions: the
  Internet Services Division and MTC. SoftNet is in the process of implementing
  a new strategic focus that involves emphasizing the Internet Services
  Division. As part of its new focus, the Company is currently seeking a buyer
  for its Telecommunications Division and is now accounting for this division as
  a discontinued operation.
   
    MTC. Through MTC, the Company develops and manufactures sophisticated,
  automated electronic document management and film-based imaging solutions for
  customers with large-scale, complex, document-intensive requirements. MTC's
  hardware and software products are based on an industry standard client-server
  architecture, providing flexibility to connect to a wide variety of
  information systems and produce output to various storage media, including
  optical disk, magnetic disk and tape, CD-ROM, and microfilm and microfiche,
  spanning the entire document lifecycle.
   
    MTC's electronic and film-based imaging hardware systems typically range in
  price between $200,000 and $1,000,000, and may represent a significant capital
  commitment by MTC's customers, leading to a lengthy sales cycle of up to 24
  months. Accordingly, MTC's operating results may fluctuate significantly from
  period to period.
   
    The Internet Services Division. The Company began providing Internet
  services following its acquisition of the Internet Services Division in June
  1996. The Company seeks to become the dominant provider of high-speed Internet
  access via the existing cable television infrastructure to homes and
  businesses in the franchise areas of small- and medium-sized cable television
  systems. In addition, the Company seeks to maintain and build its traditional
  dial-up Internet access business. The Company commenced marketing its cable
  modem-based service, the ISP Channel, to selected cable operators and
  potential subscribers in March 1998.
   
    Potential Market. The growth of the Internet has been significant. By 2002,
  Forrester estimates that 59% of U.S. households and 50% of U.S. businesses
  will be on-line, and that annual spending by residential and business end-
  users on U.S. Internet access and related services will increase from an
  estimated approximately $6 billion in 1997 to nearly $50 billion. For many
  users, the speed of such access will become an increasingly important factor
  in choosing among service providers.
   
    The Company's solution emphasizes the use of cable modems and, in the
  future, television set-top boxes, due to the fact that the existing cable
  infrastructure can be equipped to provide Internet access to over 90% of U.S.
  households at speeds significantly in excess of those readily available using
  the telecommunications infrastructure. Of the approximately 92.2 million U.S.
  homes passed by cable, approximately 65% are under
   
                                        24
  exclusive contract with competing cable-based Internet access services or, in
  the Company's judgment, are located in cable systems to which one of these
  competitors is likely to obtain exclusive rights for the provision of such
  services. Such competitors include @Home and RoadRunner, both of which are
  affiliated with large MSOs including, among others, Cablevision, Comcast, Cox,
  MediaOne, TCI and Time Warner.
   
    The Company believes that the above-mentioned competitive providers of
  cable-based Internet access services presently intend to target large,
  clustered systems in major DMAs, and that the remaining systems owned by the
  MSO affiliates of such competitors, particularly systems with under 50,000
  subscribers that have not been upgraded to carry two-way traffic, will in many
  cases not be offered high-speed Internet capability by such competitors in the
  next two to three years. In certain cases, the Company believes that such
  systems may be divested by such competitors' MSO affiliates or permitted to
  contract for high-speed Internet capability with non-affiliated providers such
  as the Company. The remaining U.S. homes passed by cable are located in a
  large number of small- and medium-sized cable systems as well as certain large
  Independent MSOs. In evaluating the potential of these systems for investment,
  the Company has targeted only those systems that are sufficiently large to
  provide an adequate return on the required invested capital. Based on this
  analysis, the Company believes that its addressable market is approximately 30
  million homes, located in approximately 2,000 cable systems. Set forth below
  is a summary of the total U.S. cable market, based on data compiled by
  Claritas, an independent industry research consultant, and a summary of the
  portion of this market that SoftNet intends to address, based on the
  parameters described above.
   
            ISP CHANNEL--POTENTIAL U.S. MARKET BASED ON SUBSCRIBERS(A)
  ISP CHANNEL ADDRESSABLE U.S.
                                 TOTAL U.S. MARKET                    MARKET
                           ------------------------------ ------------------------------
                              CABLE      HOMES               CABLE      HOMES
  SYSTEM SIZE              SUBSCRIBERS   PASSED   SYSTEMS SUBSCRIBERS   PASSED   SYSTEMS
  -----------              ----------- ---------- ------- ----------- ---------- -------
  Cable Subs over 50,000.. 27,870,684  41,316,994    287   2,583,314   3,775,979     30
  Cable Subs 5,000 to
   49,999................. 28,317,985  39,565,810  1,793  16,774,574  22,772,280  1,183
  Cable Subs 2,500 to
   4,999..................  3,100,040   4,156,319    891   2,558,862   3,396,048    741
  Cable Subs 1,000 to
   2,499..................  2,300,091   3,542,782  1,473          --          --     --
  Cable Subs less than
   1,000..................  2,039,717   3,623,699  6,957          --          --     --
                           ----------  ---------- ------  ----------  ----------  -----
                           63,628,517  92,205,604 11,401  21,916,750  29,944,307  1,954
                           ==========  ========== ======  ==========  ==========  =====
  ---------------------
  (a) Source: Claritas (Total U.S. Market only) and the Company.
   
    Market Penetration. As of July 14, 1998, the Company had contracts for its
  ISP Channel service with 19 cable operators, including Galaxy, Palo Alto Cable
  Co-op and Coral Springs Cable, representing over 100 cable systems and
  approximately 575,000 homes passed. Nine of these systems, representing
  approximately 175,000 homes passed, have been equipped and have begun offering
  the Company's services, in most cases during the past two months. In addition,
  the Company has non-binding letters of intent with three cable operators,
  including Northland, representing approximately 525,000 homes passed.
  Currently, the Company has approximately 500 residential and business
  subscribers to its ISP Channel service. The Company also provides dial-up and
  dedicated Internet access to approximately 1,100 residential and business
  subscribers. The Company's contract with Galaxy for its ISP Channel service
  represents 82% of its cable systems and 57% of its homes passed currently
  under contract. In addition, the Company believes that its agreement with
  Northland, if executed, will also constitute a significant percentage of its
  cable systems and homes passed to date. See "Risk Factors--Dependence on Local
  Cable Operators and their Cable Infrastructure" and "--Dependence on Exclusive
  Access to Cable Subscribers Need for Aggressive Implementation and
  Deployment."
   
    In order to expand its cable-based Internet subscriber base significantly,
  the Company expects to pursue aggressively affiliation agreements with cable
  operators which will provide it with the exclusive right to market cable-based
  Internet services to existing cable television subscribers in such cable
  operators' systems. The Company's objective is to enter into exclusive
  arrangements with cable operators representing approximately 7.5 million homes
  passed in the next three years.
   
   
                                        25
  It is the Company's objective to market its services aggressively and to
  install its systems in as many cable systems as possible in the next few
  years. The Company anticipates that this policy of rapid deployment will
  result in substantial capital expenditures, operating losses and negative cash
  flow in the near term. The Company believes it will need to raise substantial
  additional capital to achieve its market penetration objectives. There can be
  no assurance, however, that the Company will be able to raise sufficient
  capital on acceptable terms, or at all, or that it will be able to implement
  its strategy or achieve positive cash flow or profitability in a timely
  fashion, or at all.
   
    Revenue Sources. In providing its Internet services, the Company receives
  revenue from the provision of (i) cable modem-based Internet access services
  and (ii) traditional dial-up Internet access services. Currently, the Company
  typically charges new cable modem-based Internet access subscribers a one-time
  connection fee of $99, which fee includes modem installation and any required
  modification of the existing cable television connection. Thereafter, each
  subscriber pays an access fee, which is currently as low as $49 per month. The
  Company anticipates that it will purchase a majority of cable modems used by
  subscribers, who will be charged a nominal lease charge. The Company does not
  charge new dial-up subscribers a connection fee, but does charge a monthly
  access fee of approximately $20.
   
    In addition to connection fees and monthly access fees, the Company intends
  to pursue additional revenue opportunities from Internet advertising, e-
  commerce and IP telephony. The Company also intends to pursue long distance
  telephone services and telephony debit and credit cards.
   
    In the future, as digital set-top boxes become available and are introduced
  into the Company's affiliated cable systems, the Company expects to charge
  those subscribers monthly access fees comparable to those now charged
  traditional dial-up subscribers. The Company also expects to charge customers
  a set-top connection fee to help defray installation expenses.
   
    For cable-based Internet services, the Company typically shares 25% of total
  revenues with cable affiliates for the first 200 subscribers in each system
  and 50% thereafter. For other services, such as IP telephony, e-commerce and
  advertising, the Company expects to share between 25% and 50% of total
  revenues with the cable affiliates. The Company expects that no commissions
  will be paid on cable modem lease income. The Company expects that these
  commissions will be netted against revenues.
   
    Cost of Services. Costs to the Company include installation costs, network
  and cable operation costs and personnel and other costs. Operator commissions
  vary by type of connectivity and size of contract.
   
    Installation costs are expected to vary by type of connectivity and type of
  customer. The Company charges new subscribers a one time fee to defray the
  costs of installation, which includes labor and overhead. While currently the
  installation fee does not cover the entire cost incurred, the Company expects
  that over time installation costs will decline as cable modems become more
  commercially available and are eventually bundled as standard equipment in new
  PCs.
   
    Other network costs include the cost of connection to the public switch
  telephone network and the cost of leased fiber capacity.
   
    Sales, Marketing and Operating Expenses. Sales, marketing and operating
  expenses include the costs of the Company's cable affiliate program,
  maintenance of its infrastructure, customer care, content and new business
  development in addition to sales and marketing expenses.
   
    EBITDA. Over the next three years, the Company will seek to become the
  exclusive provider of Internet based high-speed data, video and telephony
  services over cable systems representing approximately 7.5 million homes
  passed, and to attract approximately 470,000 ISP Channel subscribers, or
  approximately 6.3% of such homes passed. If it is able to accomplish this
  objective, the Company expects the Internet Services Division to achieve
  positive EBITDA within this timeframe. The Company's ability to generate
  positive EBITDA will be
   
                                        26
  affected by the Company's ability to contract with cable operators, attract
  customers for its services, achieve anticipated pricing levels for its
  services and maintain costs at anticipated levels. No assurance can be given
  that the Company will be able to contract with sufficient cable operators,
  attract an adequate amount of subscribers, or achieve and sustain the pricing
  and cost levels that would be required for it to obtain such financial
  results.
   
    Capital Expenditures. In order to pursue its business plan, the Company
  expects to incur significant capital expenditures to provision its turnkey
  solution for cable operators, principally relating to the installation of
  headend equipment and the purchase of customer premise equipment such as cable
  modems. The cost of headend provisioning has averaged $45,000 for the nine
  systems in which the Company currently provides service. The costs of cable
  modems, currently approximately $179 to $349, is expected to decline. With
  respect to the costs of cable modems, the Company believes that it will be
  able to recoup a limited amount of such costs from its subscribers, either
  through subscriber purchases or monthly lease charges. However, the Company
  recognizes that, in line with experience in other subscription service
  industries, it will need to subsidize both installation and customer premises
  equipment (cable modems) costs. Such expenditures, however, are expected to be
  offset in part by the savings resulting from decreased prices for such
  equipment as production volumes increase.
   
  HISTORICAL RESULTS OF OPERATION
   
    The Company has changed significantly over the last several years as it has
  entered certain businesses and exited or prepared to exit, others. For
  example, on April 7, 1998, the Company announced its decision to divest its
  Telecommunications Division and is currently considering purchase offers. The
  discussion of the Company's results of operation below therefore treats the
  Telecommunication Division as a discontinued operation. In addition, the
  Company entered the Internet business in June 1996 with the purchase of the
  Internet Services Division and began offering cable-based Internet services in
  the first quarter of Fiscal 1998. Accordingly, year-to- year comparisons may
  not be meaningful.
  (UNAUDITED)
                                          FISCAL              SIX MONTHS ENDED
                                  -------------------------  -------------------
                                                             MARCH 31, MARCH 31,
  SEGMENT INFO                     1995     1996     1997      1997      1998
  ------------                    -------  -------  -------  --------- ---------
                                               ($ IN THOUSANDS)
  Sales
    MTC.......................... $ 1,088  $19,417  $20,330   $10,717   $ 6,645
    Internet Services............      --      167    1,008       618       584
  Cost of Sales
    MTC..........................     783   11,375   11,050     5,863     4,571
    Internet Services............      --       --      885       508       681
  Gross Profit
    MTC..........................     305    8,042    9,280     4,854     2,074
    Internet Services............      --      167      123       110       (97)
  Operating Expenses
    MTC..........................   6,329    8,162    8,714     3,282     3,296
    Internet Services............      --      478    1,273       566     1,047
  Income (loss) from continuing
   operations
    MTC..........................  (6,024)    (120)     566     1,572    (1,222)
    Internet Services............      --     (311)  (1,150)     (456)   (1,144)
    Corporate Overhead...........  (1,219)  (2,281)  (1,204)     (552)     (914)
                                  -------  -------  -------   -------   -------
    Consolidated................. $(7,243) $(2,712) $(1,788)  $   564   $(3,280)
                                  =======  =======  =======   =======   =======
  SIX MONTHS ENDED MARCH 31, 1998 COMPARED TO SIX MONTHS ENDED MARCH 31, 1997
   
    Consolidated net sales decreased $4.1 million, or 36.2%, for the six months
  ended March 31, 1998, as compared to the six months ended March 31, 1997. The
  decrease in consolidated net sales was primarily the result of a decrease in
  net sales of MTC. Sales in this division decreased $4.1 million, or 38.0%, to
  $6.6 million
   
                                        27
  for the six months ended March 31, 1998, as compared to sales of $10.7 million
  for the six months ended March 31, 1997. The decrease in MTC sales was
  primarily the result of a decrease in the sale of COM equipment. COM equipment
  sales were affected in the first quarter of Fiscal 1998 by the fact that MTC
  entered the year with an order backlog of $1.4 million, as compared to an
  order backlog of $3.4 million in the prior period. Internet Services Division
  sales decreased $34,000, or 5.5%, to $584,000 for the six months ended March
  31, 1998, as compared to sales of $618,000 for the six months ended March 31,
  1997. Miscellaneous one-time sales decreased $305,000 to $8,000 for the six
  months ended March 31, 1998, as compared to $313,000 for the same period in
  1997. A miscellaneous one-time sales opportunity for the installation of an
  Internet access system in the country of Milawi accounted for $187,000 of
  these sales in the six months ended March 31, 1997. The decrease in
  miscellaneous one-time sales was partially offset by an increase in sales of
  $237,000 for the Division's cable services. The Internet Services Division had
  not yet introduced this service to the market during the six months ended
  March 31, 1997.
   
    Consolidated gross profit decreased $3.0 million, or 60.2%, to $2.0 million
  for the six months ended March 31, 1998, as compared to $5.0 million for the
  six months ended March 31, 1997, with profit margins decreasing to 27.3% from
  43.8% for the comparable period in 1997. The decrease in gross profit is
  primarily the result of a decrease in gross profits of $2.8 million, or 57.3%,
  of MTC. Gross profit margins in this division decreased to 31.2% from 45.3%
  for the comparable period in 1997, primarily as the result of the decrease in
  MTC's COM equipment sales, which contribute the highest product profit
  margins. Gross profit decreased $207,000 in the Internet Services Division for
  the six months ended March 31, 1998, primarily as a result of the
  reclassification of certain web development expenses and certain other
  expenses associated with the expansion of the division's technical support
  staff to cost of goods sold. Similar expenses in prior year presentations have
  not been reclassified, due to immateriality.
   
    Operating expenses (including selling, engineering, general and
  administrative expenses, less amortization) increased $874,000, or 23.3%, to
  $4.6 million for the six months ended March 31, 1998, as compared to
  $3.7 million for the six months ended March 31, 1997. The increase in
  operating expenses is partially the result of the consolidation and relocation
  of the Company's operations formerly based in Chicago to the Company's
  facilities in Mountain View, California. These activities included a one time
  write-off of leasehold improvements and moving expenses of $240,000. In
  addition, operating expenses increased in the Internet Services Division by
  $481,000, or 134.0%, to $840,000 for the six months ended March 31, 1998, as
  compared with $359,000 for the same period in 1997. This increase in operating
  expense is primarily the result of the increase in the Internet Services
  Division's administrative, sales and marketing efforts supporting the
  division's cable service offering.
   
    Amortization expense decreased $17,000, or 2.6%, to $643,000 for the six
  months ended March 31, 1998 from $660,000 for the six months ended March 31,
  1997.
   
    For the six months ended March 31, 1998, the Company had a net loss from
  continuing operations of $3.3 million, as compared to net income from
  continuing operations of $564,000 for the six months ended March 31, 1997.
   
    Interest expense increased $63,000, or 11.8%, to $596,000 for the six months
  ended March 31, 1998 from $533,000 for the six months ended March 31, 1997.
   
    The Company made no provisions for income taxes for the six months ended
  March 31, 1998 and the six months ended March 31, 1997 as a result of the
  Company's net operating loss carry-forward.
   
    The Company recognized a gain from operations with respect to its
  discontinued Telecommunications Division of $115,000 for the six months ended
  March 31, 1998, as compared to a gain from operations of $426,000 for the same
  period in 1997.
   
    For the six months ended March 31, 1998, the Company had a net loss
  applicable to common shareholders  of $3.7 million, as compared to net income
  of $538,000 for the six months ended March 31, 1997.
   
                                        28
  FISCAL 1997 COMPARED TO FISCAL 1996
   
    Consolidated net sales increased $1.8 million, or 9.2%, to $21.3 million for
  Fiscal 1997, as compared to $19.6 million for Fiscal 1996. MTC's sales
  increased $913,000, or 4.7%, to $20.3 million for Fiscal 1997 as compared to
  $19.4 million for Fiscal 1996. This increase in net sales is primarily the
  result of increased monthly rental streams associated with the Division's
  continued implementation of alternative customer leasing arrangements for its
  core COM products. Sales in the Internet Services Division increased $841,000
  to $1.0 million for Fiscal 1997 from $167,000 for Fiscal 1996. Sales in the
  Internet Services Division for Fiscal 1996 consist only of fourth quarter
  sales, as the Division was acquired in June 1996.
   
    Consolidated gross profit increased $1.2 million, or 14.6%, to $9.4 million
  for Fiscal 1997, as compared to $8.2 million for Fiscal 1996, with profit
  margins increasing to 44.1% from 41.9% for the same period in 1996. Gross
  profit increased $1.3 million, or 15.4%, in MTC to $9.3 million for Fiscal
  1997 from $8.0 million for Fiscal 1996, with gross profit margins increasing
  to 45.7% from 41.4% for the same period in 1996. The increase in gross profit
  margin was primarily the result of increased productivity efficiencies in the
  manufacturing operation, which in turn resulted from a strong backlog and
  steady, customer order driven, manufacturing schedules. The Internet Services
  Division recorded gross profits of $123,000 for Fiscal 1997, however year to
  year comparisons are not meaningful, given the fact that the Division operated
  for only one quarter in Fiscal 1996 and allocated no expense to cost of goods
  sold during this one quarter period.
   
    Operating expenses (including selling, engineering, general and
  administrative, less amortization) decreased $24,000, or 0.2%, to $9.9 million
  for Fiscal 1997 as compared to $9.9 million for Fiscal 1996. General and
  administrative expenses associated with MTC and Corporate Overhead decreased a
  combined $810,000, or 20.2%, to $3.2 million for Fiscal 1997, as compared to
  $4.0 million in the same period in 1996. The decrease in these combined
  general and administrative expenses is the result of certain overhead cost
  cutting measures implemented to achieve back office efficiencies throughout
  the Company. For MTC, engineering expenses increased $324,000, or 19.1%, to
  $2.0 million for Fiscal 1997, as compared to $1.7 million for Fiscal 1996, as
  a result of the Division's continued effort to expand and improve the products
  offered to its customers. Included in the consolidated operating expenses are
  two separate, one-time charges associated with changes in the Company's
  product lines, in the amounts of $2.1 million for Fiscal 1997 and $2.2 million
  for Fiscal 1996. Operating expenses in the Internet Services Division
  increased $483,000 to $858,000 for Fiscal 1997, however year to year
  comparisons are not meaningful given the fact that the Division operated for
  only one quarter in Fiscal 1996.
   
    Amortization expense increased $294,000, or 29.6%, to $1.3 million for
  Fiscal 1997 from $993,000 for Fiscal 1996. This increase in amortization
  expense is primarily the result of the additional amortization expense
  associated with the acquisition of the Internet Services Division in June
  1996.
   
    The Company had a net loss from continuing operations of $1.8 million for
  Fiscal 1997, as compared to a net loss from continuing operations of $2.7
  million for Fiscal 1996.
   
    Consolidated interest expense decreased $75,000, or 6.2%, to $1.1 million
  for Fiscal 1997 as compared to $1.2 million for Fiscal 1996, primarily as a
  result of the conversion of $4.5 million of convertible subordinated notes
  since June 1996.
   
    The Company recognized a gain on the sale of securities of $5.7 million in
  Fiscal 1996. This gain was the result of the sale of all shares of IMNET
  Systems, Inc. ("IMNET") held by the Company.
   
    The Company made no provisions for income taxes for Fiscal 1997 and Fiscal
  1996 as a result of the Company's net operating loss carry-forward.
   
    The Company recognized a gain from operations with respect to its
  discontinued Telecommunications Division of $739,000 for Fiscal 1997, as
  compared to a loss from operations of $1.8 million for the same period in
  1996. The loss incurred in Fiscal 1996 includes a loss from operations of $2.5
  million associated with the disposal of the Company's wholly-owned subsidiary,
  Communicate Direct, Inc.
   
                                        29
  The Company recognized a loss from extraordinary item of $486,000 for Fiscal
  1997, as compared to a loss from extraordinary item of $6.1 million for the
  same period in 1996. The losses are associated with the disposal of the
  Company's wholly-owned subsidiary, Communicate Direct, Inc.
   
    For Fiscal 1997, the Company had a net loss applicable to common
  shareholders of $2.6 million, as compared to a net loss of $6.1 million for
  Fiscal 1996.
   
  FISCAL 1996 COMPARED TO FISCAL 1995
   
    Consolidated net sales increased by $18.5 million to $19.6 million for
  Fiscal 1996 as compared to $1.1 million for Fiscal 1995. The increase in sales
  was primarily the result of the acquisition of MTC in September 1995.
   
    Consolidated gross profit increased $7.9 million to $8.2 million for Fiscal
  1996 as compared to $305,000 for Fiscal 1995, with gross profit margin
  increasing to 41.9% from 28.0% for the comparable period in 1995. The increase
  in gross profit relates primarily to the inclusion of MTC's results for Fiscal
  1996. During Fiscal 1996, in order to conform with industry practices, the
  Company classified certain expenses as cost of sales which under prior
  presentations would have been classified as general and administrative
  expenses. Consistent with this presentation, the Company has reclassified
  certain general and administrative expenses as cost of sales for Fiscal 1995.
   
    Operating expenses (including selling, engineering, general and
  administrative expenses, less amortization) increased $2.4 million to $9.9
  million for Fiscal 1996, as compared to $7.5 million for Fiscal 1995. Selling,
  engineering, general and administrative expenses increased a combined $6.1
  million to $7.8 million for Fiscal 1996, as compared to $1.7 million for
  Fiscal 1995, primarily from the inclusion of MTC's operations for the entire
  fiscal year ended September 30, 1996. Included in the operating expenses for
  Fiscal 1996 is a one-time charge of $2.2 million associated with changes in
  the Company's product lines. Included in the operating expenses for Fiscal
  1995 is a write-off of acquired in process, unproven technology of $5.0
  million and acquisition expenses of $846,000, both of which are associated
  with the acquisition of MTC in September 1995.
   
    Amortization expense increased $964,000 to $993,000 for Fiscal 1996 as
  compared to $29,000 for Fiscal 1995. This increase in amortization expense is
  primarily the result of the additional amortization expense associated with
  the acquisition of MTC in September 1995.
   
    The Company had a net loss from continuing operations of $2.7 million for
  Fiscal 1996, as compared to a net loss from continuing operations of $7.2
  million for Fiscal 1995.
   
    Consolidated interest expense increased $764,000 to $1.2 million for Fiscal
  1996 as compared to $456,000 for Fiscal 1995. Interest expense increased as a
  result of increased outstanding indebtedness during Fiscal 1996. The increase
  in outstanding indebtedness was principally a result of acquisition debt and
  borrowings to fund working capital.
   
    The Company recognized a gain on the sale of securities of $5.7 million in
  Fiscal 1996. This gain was the result of the sale of all shares of IMNET held
  by the Company.
   
    The Company recognized a loss from operations with respect to its
  discontinued Telecommunications Division of $1.8 million for Fiscal 1996. The
  Company recognized a loss from operations with respect to its discontinued
  Telecommunications Division of $898,000 for Fiscal 1995, in addition to a loss
  of $1.1 million associated with the discontinued operations and disposal of
  Utilization Management Associates, Inc.
   
    For Fiscal 1996, the Company had a net loss applicable to common
  shareholders of $6.1 million, as compared to a net loss of $9.7 million for
  Fiscal 1995.
   
                                        30
  LIQUIDITY AND CAPITAL RESOURCES
   
    For fiscal 1997, cash flows used in operating activities of continuing
  operations were $1.4 million, as compared to $3.3 million for fiscal 1996. The
  Company used $1.1 million in investing activities of continuing operations
  during fiscal 1997, as compared to cash flows of $5.2 million provided by
  investing activities of continuing operations in fiscal 1996. During fiscal
  1996, the Company realized net proceeds of $7.7 million on the sale of
  marketable securities. Cash flows provided by financing activities of
  continuing operations increased $4.5 million to $2.4 million for fiscal 1997,
  as compared to cash flows used in financing activities of continuing
  operations of $2.1 million for fiscal 1996. This increase in cash flows was
  primarily the result of the establishment of additional credit facilities
  associated with certain lease arrangements the Company entered into with its
  customers.
   
    For the six months ended March 31, 1998, cash flows used in operating
  activities of continuing operations were $2.5 million, as compared to $908,000
  for the six months ended March 31, 1997. The Company used $243,000 in
  investing activities of continuing operations during the six months ended
  March 31, 1998, as compared to $924,000 for the same period in 1997. Cash
  flows provided by financing activities of continuing operations increased
  $962,000 million to $2.7 million for the six months ended March 31, 1998, as
  compared to $1.8 million for the six months ended March 31, 1997. This
  increase in cash flows was primarily the result of the realization of $4.6
  million in net proceeds associated with the Company's private equity placement
  on December 31, 1997 and the repayment of long-term debt of $2.0 million, as
  compared to net borrowings of $1.9 million over the six months ended March 31,
  1997.
   
    On December 31, 1997, the Company sold 5,000 shares of Series A Preferred
  Stock and warrants to purchase 150,000 shares of Common Stock for $5,000,000.
  On January 2, 1998, $4.6 million in net proceeds from this sale were applied
  to the Company's Revolving Credit Facility. On May 28, 1998, the Company sold
  10,000 shares of Series B Preferred Stock and warrants to purchase 200,000
  shares of Common Stock for $10,000,000. The Company has extended the maturity
  of its Revolving Credit Facility, which has a maximum borrowing capacity of
  $9.5 million, through July 15, 1999. During fiscal 1997, the Company obtained
  an additional credit facility from the same lender, whereby MTC can borrow up
  to $1.5 million against qualified lease arrangements it enters into with its
  customers.
   
    The Company believes that it will need to raise substantial additional
  capital to fund the Company's aggregate capital expenditures and working
  capital requirements, including operating losses, associated with achieving
  its market penetration objectives. The Company's future cash requirements for
  its business plan expansion will depend on a number of factors including (i)
  the number of cable affiliate contracts, (ii) cable modem and associated costs
  of equipment, (iii) the rate at which subscribers purchase the Company's
  Internet service offering and (iv) the level of marketing required to acquire
  and retain subscribers and to attain a competitive position in the
  marketplace. In addition, the Company may wish to selectively pursue possible
  acquisitions of businesses, technologies, content or products complementary to
  those of the Company in the future in order to expand its Internet presence
  and achieve operating efficiencies. The Company may seek to obtain additional
  funding through the sale of public or private debt and/or equity securities or
  through a bank credit facility. There can be no assurance as to the
  availability or terms upon which such financing might be available.
   
   
  YEAR 2000 ISSUE
   
    Many existing computer systems and related software applications, and other
  control devices, use only two digits to identify a year in a date field,
  without considering the impact of the upcoming change in the century. Such
  systems, applications and/or devices could fail or create erroneous results
  unless corrected so that they can process data related to the Year 2000. The
  Company relies on such computer systems, applications and devices in operating
  and monitoring all major aspects of its business, including, but not limited
  to, its financial systems (such as general ledger, accounts payable and
  payroll modules), customer services, internal networks and telecommunications
  equipment, and end products. The Company also relies, directly and indirectly,
  on the
   
                                        31
  external systems of various independent business enterprises, such as its
  customers, suppliers, creditors, financial organizations, and of governments,
  both domestically and internationally, for the accurate exchange of data and
  related information.
   
    The Company is currently in the process of evaluating the potential impact
  of the Year 2000 issue on its business and the related expenses that could
  likely be incurred in attempting to remedy such impact (including testing and
  implementation of remedial action). Management's current estimate is that the
  costs associated with the Year 2000 issue should not have a material adverse
  affect on the results of operations or financial position of the Company in
  any given year. However, despite the Company's efforts to address the Year
  2000 impact on its internal systems, the Company is not sure that it has fully
  identified such impact or that it can resolve it without disruption of its
  business and without incurring significant expenses. In addition, even if the
  internal systems of the Company are not materially affected by the Year 2000
  issue, the Company could be affected as a result of any disruption in the
  operation of the various third party enterprises with which the Company
  interacts such as cable affiliates, vendors and suppliers.
   
                                        32
  INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
  PAGE
                                                                             ----
  Report of Independent Auditors............................................  33
  Consolidated Statements of Operations for years ended September 30, 1997,
   1996 and 1995............................................................  34
  Consolidated Balance Sheets, September 30, 1997 and 1996..................  35
  Consolidated Statements of Shareholders' Equity for years ended September
   30, 1997, 1996 and 1995..................................................  36
  Consolidated Statements of Cash Flows for years ended September 30, 1997,
   1996 and 1995............................................................  37
  Notes to Consolidated Financial Statements................................  38
  Condensed Consolidated Statement of Operations for the Three Months and
   Six Months Ended March 31, 1998 and March 31, 1997 (unaudited)...........  55
  Condensed Consolidated Balance Sheets, March 31, 1998 and September 30,
   1997 (unaudited).........................................................  56
  Condensed Consolidated Statements of Cash Flows for the Six Months Ended
   March 31, 1998 and March 31, 1997 (unaudited)............................  57
  Notes to Condensed Consolidated Financial Statements......................  58
  REPORT OF INDEPENDENT ACCOUNTANTS
   
  To the Board of Directors and Shareholders of SoftNet Systems, Inc.:
   
    We have audited the consolidated financial statements of SoftNet Systems,
  Inc. and Subsidiaries as listed in the preceding index to the consolidated
  financial statements. 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 audits 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 consolidated financial position of SoftNet
  Systems, Inc. and Subsidiaries as of September 30, 1997 and 1996 and the
  consolidated results of their operations and their cash flows for each of the
  three years in the period ended September 30, 1997 in conformity with
  generally accepted accounting principles.
   
    As discussed in Note 2 to the consolidated financial statements, the Company
  adopted Statement of Financial Accounting Standard No. 115, "Accounting for
  Certain Investments in Debt and Equity Securities" in 1995.
   
    The accompanying consolidated financial statements have been restated for
  the effects of the discontinued operations of the telecommunications segment
  as discussed in Note 17.
   
                                            COOPERS & LYBRAND L.L.P.
   
                                            /s/ PricewaterhouseCoopers L.L.P.
   
  Chicago, Illinois
  December 24, 1997 except for Note 17
  as to which the date is July 27, 1998
   
                                        33
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
                       CONSOLIDATED STATEMENTS OF OPERATIONS
               FOR THE YEARS ENDED SEPTEMBER 30, 1997, 1996 AND 1995
                       (IN THOUSANDS, EXCEPT PER SHARE DATA)
  1997     1996     1995
                                                       -------  -------  -------
  Net sales........................................... $21,338  $19,584  $ 1,088
  Cost of sales.......................................  11,935   11,375      783
                                                       -------  -------  -------
      Gross profit....................................   9,403    8,209      305
                                                       -------  -------  -------
  Operating expenses:
    Selling...........................................   1,905    1,794      168
    Engineering.......................................   2,234    1,770       59
    General and administrative........................   3,628    4,200    1,446
    Amortization of goodwill and transaction costs....   1,287      993       29
    Costs associated with change in product line and
     other............................................   2,137    2,164       --
    Write off of acquired in process unproven
     technology.......................................      --       --    5,000
    Acquisition costs and other.......................      --       --      846
                                                       -------  -------  -------
      Total operating expenses........................  11,191   10,921    7,548
                                                       -------  -------  -------
  Loss from continuing operations.....................  (1,788)  (2,712)  (7,243)
    Interest expense..................................  (1,145)  (1,220)    (456)
    Gain on sale of available-for-sale securities.....      --    5,689       --
    Other income......................................      49       19        5
                                                       -------  -------  -------
  Income (loss) from continuing operations before
   income taxes and extraordinary item................  (2,884)   1,776   (7,694)
  Provision for income taxes..........................      --       --       --
                                                       -------  -------  -------
  Income (loss) before discontinued operations and
   extraordinary item.................................  (2,884)   1,776   (7,694)
  Discontinued operations:
    Income (loss) from operations.....................     739   (1,812)  (1,318)
    Loss on disposal..................................      --       --     (644)
                                                       -------  -------  -------
  Loss before extraordinary item......................  (2,145)     (36)  (9,656)
  Extraordinary item:
  Loss on sale of business............................    (486)  (6,061)      --
                                                       -------  -------  -------
  Net loss............................................ $(2,631) $(6,097) $(9,656)
                                                       =======  =======  =======
  Loss per share:
    Continuing operations............................. $ (0.44) $  0.30  $ (1.77)
    Discontinued operations...........................    0.11    (0.31)   (0.30)
    Loss on disposal..................................      --       --    (0.15)
    Extraordinary item................................   (0.07)   (1.04)      --
                                                       -------  -------  -------
    Net loss.......................................... $ (0.40) $ (1.05) $ (2.22)
                                                       =======  =======  =======
    Weighted average shares outstanding...............   6,627    5,819    4,353
                                                       -------  -------  -------
  The accompanying notes are an integral part of these consolidated financial
                                    statements.
   
                                         34
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
                            CONSOLIDATED BALANCE SHEETS
                         AS OF SEPTEMBER 30, 1997 AND 1996
                         (IN THOUSANDS, EXCEPT SHARE DATA)
  1997      1996
                                                              --------  --------
  ASSETS
  Current assets:
    Cash..................................................... $     37  $    426
    Accounts receivable, net.................................    5,135     3,837
    Inventories..............................................    1,326     2,793
    Prepaid expenses and other...............................      319       254
                                                              --------  --------
      Total current assets...................................    6,817     7,310
                                                              --------  --------
  Property & equipment, net..................................    1,108     1,336
  Costs in excess of fair value of net assets acquired, net..    5,141     6,255
  Other assets...............................................    3,820     2,312
  Net assets associated with discontinued operations.........    3,435     1,783
                                                              --------  --------
                                                              $ 20,321  $ 18,996
                                                              ========  ========
             LIABILITIES AND SHAREHOLDERS' EQUITY
  Current liabilities:
    Accounts payable and accrued expenses.................... $  4,969  $  4,039
    Current portion of long-term debt........................    1,384       603
    Current portion of capital leases........................       23        79
    Deferred revenue.........................................      143       159
                                                              --------  --------
      Total current liabilities..............................    6,519     4,880
                                                              --------  --------
  Long-term debt, net of current portion.....................   11,727    10,247
                                                              --------  --------
  Capital leases, net of current portion.....................       47        76
                                                              --------  --------
  Shareholders' equity
    Preferred Stock, $.10 par value, 4 million shares
     authorized, none outstanding............................       --        --
    Common stock, $.01 par value, 25 million shares
     authorized, 6,870,559 and 6,540,065 shares outstanding,
     respectively............................................       69        65
    Capital in excess of par.................................   34,379    33,517
    Accumulated deficit......................................  (32,420)  (29,789)
                                                              --------  --------
      Total shareholders' equity.............................    2,028     3,793
                                                              --------  --------
                                                              $ 20,321  $ 18,996
                                                              ========  ========
  The accompanying notes are an integral part of these consolidated financial
                                    statements.
   
                                         35
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
                  CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
               FOR THE YEARS ENDED SEPTEMBER 30, 1997, 1996 AND 1995
                                  (IN THOUSANDS)
  COMMON STOCK  CAPITAL IN
                                             ------------- EXCESS OF  ACCUMULATED
                                             SHARES AMOUNT PAR VALUE    DEFICIT
                                             ------ ------ ---------- -----------
  Balance, October 1, 1994.................. 3,903   $39    $16,434    $(14,036)
    Sale of common stock, net of issuance
     costs..................................   200     2        708          --
    Value assigned to options and warrants
     issued with the extension of senior
     notes..................................    --    --         66          --
    Exercise of warrants....................   100     1        187          --
    Common stock issued in connection with
     acquisitions, net of issuance costs.... 1,143    11      7,533          --
    Conversion of convertible subordinated
     notes..................................   201     2      1,628          --
    Settlement of related party receivable..    --    --      1,028          --
    Net loss................................    --    --         --      (9,656)
                                             -----   ---    -------    --------
  Balance, September 30, 1995............... 5,547    55     27,584     (23,692)
    Exercise of warrants....................    12    --         21          --
    Settlements of related party receivable.    --    --        815          --
    Conversion of convertible subordinated
     notes..................................   781     8      4,077          --
    Common stock issued in connection with
     acquisitions, net of acquisition costs.   200     2      1,020          --
    Net loss................................    --    --         --      (6,097)
                                             -----   ---    -------    --------
  Balance, September 30, 1996............... 6,540    65     33,517     (29,789)
    Exercise of warrants....................   251     3        432          --
    Conversion of convertible subordinated
     notes..................................    70     1        386          --
    Common stock issued to pay acquisition
     costs..................................    10    --         44          --
    Net loss................................    --    --         --      (2,631)
                                             -----   ---    -------    --------
  Balance, September 30, 1997............... 6,871   $69    $34,379    $(32,420)
                                             =====   ===    =======    ========
  In fiscal 1995, the Company recorded $7,738,000 of unrealized appreciation
  of available-for-sale securities in a Shareholders' Equity account. In fiscal
  1996, this amount was eliminated upon the sale of the securities.
   
    The accompanying notes are an integral part of these consolidated financial
                                    statements.
   
                                        36
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
                       CONSOLIDATED STATEMENTS OF CASH FLOWS
               FOR THE YEARS ENDED SEPTEMBER 30, 1997, 1996 AND 1995
                                   (IN THOUSANDS)
  1997     1996     1995
                                                       -------  -------  -------
  Cash flows from operating activities:
   Net loss........................................... $(2,631) $(6,097) $(9,656)
   Adjustments to reconcile net loss to net cash used
    in operating activities:
   (Income) loss from discontinued operations.........    (739)   1,812    1,318
   Write-off of acquired in-process unproven
    technology........................................      --       --    5,000
   Depreciation and amortization......................   1,798    1,374      194
   Write-off of prepaid software licenses.............   1,000       --       --
   Write-off of capitalized product design costs......   1,137       --       --
   Acquisition costs..................................      --       --      543
   Loss on the disposal of property and equipment.....      40       --       25
   Gain on sale of available-for-sale securities......      --   (5,689)      --
   Debt discount and deferred financing amortization..      19       95       87
   Provision for bad debts............................     174      101       --
   Loss on sale of business...........................      --    6,061       --
   Changes in operating assets and liabilities, net
    of effect of purchase transactions and disposal
    of discontinued operations:
    Accounts receivable...............................  (1,471)    (521)    (125)
    Non-current lease receivable......................  (3,054)      --       --
    Inventories.......................................   1,466   (1,076)    (464)
    Prepaid expenses..................................     (65)     (25)     (27)
    Accounts payable and accrued expenses.............     930      775      395
    Deferred revenue..................................      17      (81)      (8)
                                                       -------  -------  -------
     Net cash used in operating activities of
      continuing operations...........................  (1,379)  (3,271)  (2,718)
                                                       -------  -------  -------
     Net cash used in operating activities of
      discontinued operations.........................  (1,089)  (1,132)  (1,951)
                                                       -------  -------  -------
  Cash flows from investing activities:
   Net cash paid in connection with acquisitions......      --     (195)  (2,450)
   Purchase of prepaid software licenses..............      --   (1,000)      --
   Purchase of property and equipment.................    (510)    (732)    (415)
   Additions to capitalized product design............    (654)    (462)      --
   Settlement of remaining obligations to owners of
    discontinued operations...........................      --     (117)      --
   Proceeds from sale of investment securities........      --    7,678    1,027
   Proceeds from sale of property and equipment.......      15       --       31
   Other..............................................      15       --     (115)
                                                       -------  -------  -------
     Net cash provided by (used in) investing
      activities of continuing operations.............  (1,134)   5,172   (1,922)
                                                       -------  -------  -------
     Net cash used in investing activities of
      discontinued operations.........................     (46)  (2,073)  (1,134)
                                                       -------  -------  -------
  Cash flows from financing activities:
   Proceeds from issuance of long-term debt, net of
    deferred financing costs..........................   3,665       --    3,135
   Repayment of long-term debt........................    (753)     (48)    (475)
   Net borrowings (payments) under revolving credit
    note..............................................    (831)  (2,540)   1,659
   Proceeds from settlement of related party
    receivable........................................      --      815       --
   Repayment of prior revolving credit facility.......      --       --     (383)
   Proceeds from sale of available-for-sale
    securities........................................      --       --      720
   Payment of put obligation..........................      --     (200)      --
   Proceeds from exercise of warrants.................     435       22      169
   Capitalized lease obligations paid.................     (85)    (100)    (118)
                                                       -------  -------  -------
     Net cash provided by (used in) financing
      activities of continuing operations.............   2,431   (2,051)   4,707
                                                       -------  -------  -------
     Net cash provided by financing activities of
      discontinued operations.........................     828    3,208    3,144
                                                       -------  -------  -------
  Net increase (decrease) in cash.....................    (389)    (147)     126
  Cash, beginning of period...........................     426      573      447
                                                       -------  -------  -------
  Cash, end of period................................. $    37  $   426  $   573
                                                       =======  =======  =======
  The accompanying notes are an integral part of these consolidated financial
                                    statements.
   
                                         37
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
   
  1. NATURE OF BUSINESS AND BASIS FOR PRESENTATION
   
    SoftNet Systems, Inc. and Subsidiaries (the "Company") is engaged in the
  business of developing, marketing, installing and servicing electronic
  information and document management systems that allow customers to
  electronically request and electronically receive information. The Company
  operates through three segments: document management, telecommunications, and
  Internet services. The document management segment designs, develops,
  manufactures and integrates comprehensive, non-paper based systems and
  components that enable the Company to deliver to its customers cost-effective
  solutions for the storage, indexing and/or distribution of high-volume
  computer generated or entered information. The telecommunications segment
  sells and services telephone and computer hardware manufactured by others to
  provide communications solutions through the design, implementation,
  maintenance and integration of voice, data and video communications equipment
  and services. Additionally, the telecommunications segment sells and installs
  local and long distance network services. The Internet services segment
  provides Internet access, World Wide Web and database development.
   
    On September 15, 1995, a wholly-owned subsidiary of the Company merged with
  Kansas Communications, Inc. ("KCI"), which was the surviving corporation in
  the merger, pursuant to an Agreement and Plan of Reorganization dated March
  24, 1995, by and between the Company and KCI (see Note 3). The transaction was
  accounted for as a pooling of interests for financial reporting purposes and,
  accordingly, the financial statements of the merged companies relating to all
  periods presented had previously been restated and presented on a combined
  basis. However, in July 1998, the Company's Board of Directors adopted a plan
  to discontinue operations of the telecommunications segment (see Note 17),
  which includes the operations of KCI. Accordingly, the operating results of
  the telecommunications segment have been segregated from continuing operations
  and reported as a separate line item on the statement of operations. The
  assets and liabilities of such operations have been reflected as a net asset.
   
    During 1995, the Company adopted a formal plan to dispose of Utilization
  Management Association, Inc., a medical cost containment business.
  Accordingly, the results of discontinued operations and the estimated loss on
  disposal thereof have been reported separately from the continuing operations
  of the Company for fiscal 1995 (see Note 5).
   
  2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
   
   Principles of Consolidation
   
    The consolidated financial statements include the accounts of SoftNet
  Systems, Inc. ("SoftNet") and its subsidiaries ("Company"). All significant
  intercompany accounts and transactions have been eliminated in preparation of
  the consolidated financial statements.
   
   Concentration of Credit Risk
   
    Financial instruments that potentially subject the Company to concentrations
  of credit risk consist primarily of trade receivables. Credit risk is
  minimized as a result of the large number and diverse nature of the Company's
  customers. As of September 30, 1997, the Company had no significant
  concentrations of credit risk.
   
   Significant Customer
   
    For the fiscal years ended September 30, 1997 and 1996, one customer
  (different customer each year) accounted for 20% and 27%, respectively, of the
  Company's consolidated revenue. No single customer of the Company accounted
  for more than 20% of the Company's consolidated revenue in fiscal 1995.
   
                                        38
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
   
   Cash and Cash Equivalents
   
    The Company considers cash equivalents to include all highly liquid
  financial instruments purchased with a maturity of three months or less to be
  cash equivalents.
   
   Inventories
   
    Inventories are stated at the lower of cost or market. Cost is determined
  using the first-in, first-out method. The components of inventories as of
  September 30, 1997 and 1996 are as follows (in thousands):
  1997   1996
                                                                     ------ ------
  Raw materials............................................... $  126 $  472
        Work-in-process.............................................    217    424
        Finished goods..............................................    983  1,897
                                                                     ------ ------
                                                                     $1,326 $2,793
                                                                     ====== ======
  Receivables
   
    The Company has recorded an allowance for uncollectible accounts of $320,000
  and $164,000 at September 30, 1997 and 1996, respectively.
   
   Property and Equipment
   
    Property and equipment are carried at cost less allowances for accumulated
  depreciation. The cost of property and equipment held under capital leases is
  equal to the lower of the net present value of the minimum lease payments or
  the fair value of the leased property at the inception of the lease. Repairs
  and maintenance are charged to expense as incurred.
   
    Depreciation is computed by the straight-line method over the useful lives
  of the related assets. The estimated useful lives range from three to five
  years for equipment to seven years for property, principally office furniture.
  Amortization of capital leases is included with depreciation expense.
   
   Capitalized Software Costs
   
    Certain costs of acquired software to be sold, leased, or otherwise marketed
  are capitalized and amortized over the economic useful life of the related
  software product, which is generally five years. Net unamortized capitalized
  software costs, which resulted from the acquisition of MTC, are included in
  other non-current assets and were $592,000, $792,000 and $991,000 at September
  30, 1997, 1996 and 1995, respectively.
   
   Investments in Equity Securities
   
    In 1995, the Company adopted Statement of Financial Accounting Standards
  (SFAS) No. 115 "Accounting for Certain Investments in Debt and Equity
  Securities." The adoption of SFAS No. 115 resulted in an increase to
  shareholders' equity in the fourth quarter of 1995 of $7.7 million upon the
  completion by IMNET Systems, Inc. of its initial public offering of common
  stock. Prior to this offering, there had been no public market for this common
  stock. At September 30, 1995, the Company's investment in marketable equity
  securities was classified as available-for-sale and, as a result, was stated
  at fair value. During fiscal 1996 the Company sold its entire holdings of
  IMNET Systems, Inc. and realized a gain of $5.7 million.
   
   Fair Value of Financial Instruments
   
    The fair value of the Company's debt, current and long-term, is estimated to
  approximate the carrying value of these liabilities based upon borrowing rates
  currently available to the Company for borrowings with similar terms.
   
                                        39
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
   
   Costs in Excess of Fair Value of Net Assets Acquired
   
    The excess of costs of acquired companies over the fair value of net assets
  acquired (goodwill) are amortized on a straight-line basis over 10 to 20
  years. Amortization expense for fiscal 1997, 1996 and 1995 was $1.1 million,
  $813,000 and $29,000, respectively. During fiscal 1996 the Company wrote off
  $3.6 million of net goodwill resulting from the sale of the non-application
  oriented interconnect business in Chicago, IL (see Note 5). Accumulated
  amortization at September 30, 1997, 1996 and 1995 was $1.9 million, $870,000
  and $29,000, respectively.
   
    The Company assesses the recoverability of unamortized goodwill by reviewing
  the sufficiency of estimated future operating income and undiscounted cash
  flows of the related entities to cover the amortization during the remaining
  amortization period.
   
   Revenue Recognition
   
    Revenue from the document management segment is generated from four primary
  sources, including product sales, installations, royalty and on-going
  maintenance. Product sales and installation revenue are recognized upon
  shipment, installation, or final customer acceptance, depending on specific
  contract terms. Royalty revenue is recognized monthly based upon estimated
  maintenance fees and is subject to verification against actual fees on a semi-
  annual basis. Revenue from on-going maintenance is recognized as services are
  completed.
   
    Revenue from the Internet services segment is generated from initial and
  recurring monthly Internet access and Web and database development. Set-up
  fees for Internet access customers is recognized upon completion of the
  service. Monthly access fees are recognized in the month of service. World
  Wide Web and database development is recognized upon completion of the
  service.
   
   Leases to Customers
   
    The Company's equipment lease transactions with its customers primarily
  involve the leasing of Computer Output Microfiche ("COM") equipment. Lease
  terms are typically for periods of 3 to 5 years. The Company typically leases
  its COM equipment on a "price per fiche" basis, in which monthly rents are
  driven by actual monthly microfiche production by the lessee. Leases contain
  minimum monthly rents by establishing provisions for minimum production
  volumes per month.
   
    At September 30, 1997, the Company has entered into various sales-type
  leases with its customers. These leases provide for minimum future rents of
  $4.4 million and equipment residual values of $542,000. Unearned interest
  relating to these leases total $673,000. The present value of these leases
  ($4.3 million) is recorded in trade receivables and other assets in the
  accompanying consolidated balance sheet. Future minimum lease payments are as
  follows (in thousands):
  1998.............................. $1,491
               1999..............................  1,362
               2000..............................    892
               2001..............................    471
               2002..............................    168
                                                  ------
                   Total......................... $4,384
                                                  ======
  40
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
   
   Research and Development
   
    Research and development is primarily incurred by the document management
  segment. During fiscal 1997 and 1996, the Company expended $1.8 million and
  $1.1 million, respectively, for research and development.
   
   Income Taxes
   
    The Company recognizes the amount of taxes payable or refundable for the
  current year and recognizes deferred tax liabilities and assets for the
  expected future tax consequences of events and transactions that have been
  recognized in the Company's financial statements or tax returns. The Company
  currently has substantial net operating loss carryforwards. The Company has
  recorded a 100% valuation allowance against net deferred tax assets due to
  uncertainty of their ultimate realization.
   
   Loss Per Share
   
    Loss per share is based on the weighted average number of common shares
  outstanding during the periods. Common stock equivalents (outstanding options
  warrants and convertible securities) are not included in the computations of
  loss per share since their effect is anti-dilutive.
   
   Recently Issued Accounting Pronouncements
   
    In February 1997, the Financial Accounting Standards Board (FASB) issued
  Statement of Financial Accounting Standards No. 128. Earnings per Share (FAS
  128), which specifies the computation, presentation and disclosure
  requirements for earnings per share in order to simplify the computation of
  earnings per share. FAS 128 is effective for financial statements ending after
  December 15, 1997 and earlier application is not permitted. After the
  effective date, all prior period earnings per share data shall be restated to
  conform with the provisions of FAS 128. The adoption of FAS 128 is not
  expected to have a material impact on the Company's earnings per share data.
   
    In June 1997, the FASB issued FAS 130, Reporting Comprehensive Income. This
  statement, effective for fiscal years beginning after December 15, 1997, would
  require the Company to report components of comprehensive income in a
  financial statement that is displayed with the same prominence as other
  financial statements. Comprehensive income is defined by Concepts Statement
  No. 6, Elements of Financial Statements, as the change in equity of a business
  enterprise during a period from transactions and other events and
  circumstances from nonowner sources. It includes all changes in equity during
  a period except those resulting from investments by owners and distributions
  to owners. The Company has not yet determined its comprehensive income.
   
    Also in June 1997, the FASB issued FAS 131, Disclosures about Segments of an
  Enterprise and Related Information. This statement, effective for financial
  statements for periods beginning after December 15, 1997, requires that a
  public business enterprise report financial and descriptive information about
  its reportable operating segments. Generally, financial information is
  required to be reported on the basis that it is used internally for evaluating
  segment performance and deciding how to allocate resources to segments. The
  adoption of FAS 131 is not expected to have a material impact on the Company's
  financial statements.
   
   Use of Estimates in the Preparation of Financial Statements
   
    The preparation of financial statements in conformity with generally
  accepted accounting principles requires management to make estimates and
  assumptions that affect the reported amounts of assets and liabilities and
  disclosure of contingent assets and liabilities at the date of the financial
  statements and the reported amounts of the revenues and expenses during the
  reporting period. Actual results could differ from those estimates.
   
                                        41
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
   
   Reclassifications
   
    Certain reclassifications have been made in the 1995 financial statements to
  conform with the 1997 and 1996 presentations.
   
  3. MERGER
   
    On September 15, 1995, a wholly-owned subsidiary of the Company merged
  Kansas Communications, Inc. ("KCI") pursuant to an Agreement and Plan of
  Reorganization dated March 24, 1995, by and between the Company and KCI. The
  KCI shareholders received 1.3 million shares of the Company's common stock in
  exchange for all of the outstanding shares of KCI. The business combination
  was accounted for as a pooling of interests and, accordingly, the operations
  of KCI had been included with the results of the Company for all periods
  presented. However, in July 1998, the Company's Board of Directors adopted a
  plan to discontinue operations of the telecommunications segment (see Note
  17), which includes the operations of KCI. Accordingly, the operating results
  of the telecommunications segment have been segregated from continuing
  operations and reported as a separate line item on the statement of
  operations. The assets and liabilities of such operations have been reflected
  as a net asset.
   
    KCI is a Kansas City-based company which sells and services telephone
  systems, third-party computer hardware and application oriented peripheral
  products such as voice mail, automated attendant systems, interactive voice
  response (IVR) and video conferencing systems.
   
    The following are the net revenues from continuing operations and net income
  (loss) of the separate companies for the period preceding the acquisition (in
  thousands):
  SOFTNET
                                                  SYSTEMS, INC.  KCI   COMBINED
                                                  ------------- ------ --------
  Nine months ended June 30, 1995
         (Unaudited):
          Net sales..............................    $8,285     $7,564 $15,849
          Net income (loss)......................    (1,777)       272  (1,505)
  In connection with the merger, the Company recorded transaction related
  charges of $648,000 in fiscal 1995. The merger costs relate to expenses
  incurred to consummate the transaction, including investment banking, legal
  and accounting fees.
   
  4. ACQUISITIONS
   
   Milwaukee Operation of Executone Management Systems, Inc.
   
    On December 29, 1995, the Company acquired the Milwaukee operations of
  Executone Information Systems, Inc. ("Executone-Milwaukee"), in a business
  combination accounted for as a purchase. Executone-Milwaukee sells and
  services proprietary voice processing systems. The purchase price of
  approximately $1.9 million consisted of $100,000 of cash and a note payable
  for $1.8 million. The note was paid in February, 1996. The operations of
  Executone-Milwaukee have been included in the results of the Company since
  December 29, 1995. However, in July 1998, the Company's Board of Directors
  adopted a plan to discontinue operations of the telecommunications segment
  (see Note 17), which includes these operations. Accordingly, the operating
  results of the telecommunications segment have been segregated from continuing
  operations and reported as a separate line item on the statement of
  operations. The assets and liabilities of such operations have been reflected
  as a net asset.
   
                                        42
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
    As a result of the acquisition, the Company recorded costs in excess of fair
  value of net assets acquired of $1.8 million, an amount which is being
  amortized on a straight-line basis over twenty years.
   
   MediaCity World, Inc.
   
    On June 21, 1996, the Company acquired MediaCity World, Inc. ("MCW"), in a
  business combination accounted for as a purchase. MCW is an Internet Service
  Provider with operations in the San Francisco Bay Area and Reno, Nevada. The
  purchase price consisted of 200,000 shares of the Company's common stock
  valued at $5.11 per share. The operations of MCW have been included in the
  results of the Company since June 21, 1996. As a result of the acquisition of
  MCW, the Company recorded costs in excess of fair value of net assets acquired
  of $1.2 million, being amortized on a straight line basis over three years.
   
   Communicate Direct, Inc.
   
    On October 31, 1994, the Company acquired Communicate Direct, Inc. ("CDI")
  in a business combination accounted for as a purchase. CDI, a Chicago-based
  company, sold and serviced telephone systems, third-party computer hardware
  and application oriented peripheral products such as voice mail, automated
  attendant systems, interactive voice response ("IVR") and video conferencing
  systems. The operations of CDI have been included with the results of the
  Company from November 1, 1994 until they were subsequently sold. During fiscal
  1996, the Company sold a significant portion of the CDI business and, during
  fiscal 1997, all of the remaining operation was sold.
   
    The Company acquired all of the outstanding stock of CDI for $1.9 million,
  such consideration consisting of 290,858 shares of the Company's Series A
  Convertible Preferred Stock ("Preferred Shares") valued at $6.00 per share and
  cash. In April 1995, the Preferred Shares were converted into common shares on
  a one-to-one basis following the approval of the Company's shareholders. The
  acquisition price has been adjusted for settlement of an earn-out agreement
  and resolution of certain post-closing purchase adjustments. The cost in
  excess of fair value of net assets acquired incurred in connection with the
  acquisition of CDI of $4.2 million was originally to be amortized on a
  straight-line basis over ten years. As a result of the 1996 sale, the Company
  wrote off the unamortized balance of the goodwill which arose from the
  original acquisition (See Note 5).
   
   Micrographic Technology Corporation
   
    On September 15, 1995, the Company acquired Micrographic Technology
  Corporation ("MTC") pursuant to an Agreement and Plan of Reorganization dated
  March 24, 1995 in a business combination accounted for as a purchase
  transaction. MTC is a designer, developer, manufacturer and integrator of
  comprehensive, non-paper based systems and components that enable MTC to
  deliver to its customers cost-effective solutions for storage, indexing and/or
  distribution of high-volume output data streams. The MTC shareholders'
  received 778,000 shares of the Company's common stock valued at $6.95 per
  share, $1.1 million in cash and $2.8 million principal amount of the Company's
  debentures. The operations of MTC have been included with the results of the
  Company since September 16, 1995.
   
    The cost in excess of fair value of net assets acquired incurred in
  connection with the acquisition of MTC of $6.1 million is being amortized on a
  straight-line basis over ten years. Additionally, in connection with the
  acquisition of MTC, the Company incurred a one-time charge in fiscal 1995 of
  $5.0 million for the write-off of acquired in-process unproven technology.
   
    The following unaudited pro forma summary presents information as if the
  acquisitions accounted for as purchases had occurred at the beginning of each
  fiscal year. The pro forma information is provided for informational purposes
  only. It is based on historical information and does not necessarily reflect
  the actual
   
                                        43
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
  results that would have occurred nor is it necessarily indicative of future
  results of operations of the combined enterprise (in thousands, except per
  share data):
  YEARS ENDED
                                                                 SEPTEMBER 30,
                                                                ----------------
                                                                 1996     1995
                                                                -------  -------
                                                                  (UNAUDITED)
  Net sales from continuing operations................... $42,270  $40,020
        Net loss from continuing operations....................    (328)  (9,175)
        Net loss per share..................................... $ (0.05) $ (2.02)
  5. DIVESTITURES
   
   Utilization Management Associates, Inc.
   
    During September 1995, the Company's Board of Directors approved a plan to
  rescind its November 1993 acquisition of Utilization Management Associates,
  Inc. ("UMA"). The plan provided for the exchange of the Company's interest in
  UMA for all common shares of the Company held by the former shareholders of
  UMA, including related put options, and the cancellation of SoftNet stock
  options held by the former shareholders of UMA.
   
    Effective November 20, 1995, the plan was executed such that the Company
  paid the former shareholders of UMA $200,000 in satisfaction of it's common
  stock put obligation and received in exchange 29,630 shares of SoftNet common
  stock. In addition, the Company paid approximately $300,000 in cash and notes
  for the termination of non-compete, employment, and earn-out agreements and an
  irrevocable and unconditional release of the Company from any outstanding
  obligations and liabilities to UMA or the shareholders of UMA.
   
    In connection with the disposition, in fiscal 1995, the Company recorded a
  loss on disposal of discontinued operations of $644,000, along with a loss
  from discontinued operations of $420,000. Such amounts have not been adjusted
  for any income tax effect given the Company's net operating loss carryforward.
  For the year ended September 30, 1995, UMA contributed revenue of
  approximately $860,000 to the consolidated revenues of the Company.
   
   Communicate Direct, Inc.
   
    In June 1996, CDI sold its non-application oriented interconnect business
  located in the Chicago, IL metropolitan area to Next Call, Inc. ("Next Call")
  for a $600,000 ten year note receivable. In connection with the sale, CDI
  agreed to lend Next Call up to $1.0 million to fund operating losses, as
  defined, for the first twelve months of operations. The loan agreement
  required CDI to advance cash to Next Call on a monthly basis to cover
  operating cash short fall. Next Call was required to repay such advances when
  it became profitable on a cumulative basis. After the first twelve months, any
  amount still outstanding from Next Call was to be forgiven. As of September
  30, 1996, the Company had made $189,000 in advances pursuant to this
  agreement. Subsequent to September 30, 1996, Next Call ceased operations.
   
    As a result of the sale to Next Call and the uncertainty resulting from Next
  Call's subsequent shut down, the Company incurred an extraordinary charge of
  $6.0 million for the loss on the sale of this business, including the write-
  off of unamortized goodwill which resulted from the initial purchase of CDI in
  October 1994, deferred acquisition costs associated with the purchase of CDI,
  severance payments, inventory, leasehold improvements, the notes receivable
  from Next Call and all amounts loaned to the buyer. The loss resulting from
  the disposition of certain assets and the assumption of certain liabilities of
  CDI, within a two year period following a pooling of interests has been
  classified as an extraordinary item as required by generally accepted
  accounting principles.
   
                                        44
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
  The disposition of CDI was not contemplated at the time of the pooling with
  KCI. During fiscal 1997, CDI sold its operations that support its Fujitsu
  maintenance base in the Chicago metropolitan area to a new company formed by
  John I. Jellinek, the Company's former president, chief executive officer and
  director and Philip Kenny, a former SoftNet director. The buyer acquired
  certain assets in exchange for a $209,000 promissory note and the assumption
  of current liabilities of approximately $750,000. In addition, at the closing
  the buyer paid off $438,000 of existing Company bank debt and entered into a
  sub-lease of CDI's facility in Buffalo Grove, Illinois. At the closing, the
  buyer merged with Telcom Midwest, LLC., and the two former directors and the
  other two shareholders of the merged company personally guaranteed obligations
  arising out of the promissory note, the sub-lease arrangement and the
  assumption of certain liabilities. The personal guarantees of the promissory
  note are several. The personal guarantees of the sub-lease are limited to
  $400,000 and are on a joint and several basis. The personal guarantees of
  assumed liabilities are on a joint and several basis but are limited to the
  two former directors. Concurrent with this transaction, Messrs. Jellinek and
  Kenny resigned from the Company's board.
   
  6. CHANGE IN PRODUCTS
   
    During fiscal 1996, the Company acquired from IMNET an exclusive worldwide
  manufacturing right to certain microfilm retrieval technology, partially in
  exchange for the prepayment of fees for 250 software licenses. Accordingly,
  the Company recorded a prepaid license fee of $1.0 million in other non-
  current assets in the accompanying consolidated balance sheets. As of
  September 30, 1997, the transfer to the Company of the technical and
  manufacturing know-how for this technology has continued to be delayed.
  Despite the ongoing negotiation and cooperation between the parties, the
  Company determined there was a potential material risk in completing the
  transfer and getting the product to market. As a result, the Company wrote-off
  the prepaid license fee of $1.0 million in the fourth quarter of fiscal 1997
  (see Note 14).
   
    Also, in the fourth quarter of 1997, the Company reevaluated the development
  and timely offering of its RAPID (Rapid Archiving Peripheral for Images and
  Documents) product. Market driven product enhancements, and the resulting
  technological setbacks, delayed the estimated product offering date at least
  one year to the second quarter of fiscal 1998. As a result, the Company has
  written-off $1.1 million of capitalized product design costs associated with
  this product.
   
    In June, 1996, the Company signed an agreement to distribute Lucent
  Technologies, Inc. products in the Chicago, Illinois metropolitan area. In
  connection with this distribution agreement and the repositioning of its
  Chicago operations, the Company incurred one-time charges of $1.3 million for
  severance payments, asset write-downs and other.
   
    Included in the fourth quarter 1996 results is a charge of $1.5 million for
  the write-down of certain software inventory resulting from the Company's
  decision to discontinue the distribution of certain imaging products in favor
  of others (see Note 14).
   
  7. SIGNIFICANT FOURTH QUARTER EVENTS
   
    Operating results in the fourth quarter of fiscal 1997 include the effects
  of the following:
   
    A. A charge of $1.0 million related to the write-off of prepaid license
       fees (see Notes 6 and 14).
   
    B. A charge of $1.1 million related to the write-off of capitalized product
       design costs (see Notes 6 and 14).
   
                                        45
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
   
  8. PROPERTY AND EQUIPMENT
   
    Balances of major classes of fixed assets and allowances for depreciation at
  September 30, 1997 and 1996 are as follows: (in thousands)
  1997    1996
                                                                   ------  ------
  Leasehold improvements.................................... $  155  $  118
        Furniture and fixtures....................................    276     605
        Equipment.................................................  1,566   1,214
                                                                   ------  ------
            Total.................................................  1,997   1,937
        Less allowance for depreciation and amortization..........   (889)   (601)
                                                                   ------  ------
        Property and equipment, net............................... $1,108  $1,336
                                                                   ======  ======
  9. DEBT
  1997     1996
                                                                -------  -------
  Debt is summarized as follows: (in thousands)
    Revolving Credit Note with maximum borrowings of $9.5
     million bearing interest, payable monthly, at the bank's
     prime rate plus 1% (the bank's prime rate 8.5% at
     September 30, 1997). The note matures on January 15, 1999. $ 5,900  $ 6,099
    Equipment Financing Agreement with a maximum borrowing
     limit of $3.15 million, bearing interest at the bank's
     prime rate plus 1% (the bank's prime rate being 8.5% at
     September 30, 1997), principal and interest due in 60
     monthly payments with the final payment due May 2002......   2,398       --
    Draw Note with maximum borrowings for $1.5 million bearing
     interest, payable monthly, at the bank's prime rate plus
     1% (the bank's prime rate being 8.5% at September 30,
     1997).....................................................     675       --
    9% Convertible Debentures due September 2000, interest
     payable quarterly, convertible into the Company's common
     shares at $6.75 per share.................................   2,619    2,856
    9% Convertible Subordinated Notes due December 1998,
     interest payable quarterly, subordinated to all other
     liabilities of the Company, convertible into the Company's
     common shares at $5.00 per share..........................      25       75
    6% Convertible Subordinated Debentures, due February 2002
     with semi-annual interest payments, convertible into the
     Company's common stock at $8.10 per share (subject to
     adjustment for anti-dilution).............................     780      780
    10% Convertible Subordinated Notes due October 1999,
     bearing interest, payable quarterly, at 10% for the first
     two years only and no interest thereafter, subordinated to
     all other liabilities of the Company, convertible into the
     Company's common shares at $4.10 per share................     200      300
    Promissory note due June 1998, interest payable at maturity
     accruing at 5% (terms revised in 1997.....................     161      409
    Promissory notes due November 1997, interest payable in
     arrears on each principal due date accruing at 8.75%......      75      200
    Promissory note bearing interest at 12.25%, principal and
     interest due in 24 monthly payments with final payment due
     October 1999..............................................     278       --
    Bank loan dated August 25, 1995, bearing interest at prime
     plus 1%, principal and interest due in 36 monthly
     instalments with final payment due August 1998............      --       74
    Other......................................................      --       57
                                                                -------  -------
                                                                 13,111   10,850
    Less current portion debt..................................  (1,384)    (603)
                                                                -------  -------
      Total long-term debt..................................... $11,727  $10,247
                                                                =======  =======
  46
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
    The availability under the revolving credit note is subject to revisions on
  a monthly basis based upon available assets (as defined). The revolving credit
  note and the bank term loan (issued from the same bank) are collateralized by
  substantially all of the assets of the Company.
   
    The equipment financing agreement and the draw note were obtained from the
  same bank as the revolving credit note and the assets collateralizing each
  financing facility are excluded from the collateral associated with the
  revolving credit note. The equipment financing agreement covers a specific
  lease agreement and the draw note covers certain bank approved leases. The
  leases are initiated by the Company acting as lessor through the ordinary
  course of business.
   
    In connection with the issuance of the 10% Convertible Subordinated Notes,
  the Company issued warrants to purchase 298,000 shares of the Company's common
  stock exercisable for five years expiring in 1999 at an exercise price of
  $6.875 per share.
   
    During fiscal 1997 and 1996, holders of the 6%, 9% and 10% convertible
  subordinated notes converted $386,000 and $4.1 million face amount of notes
  into 69,000 and 781,000 shares, respectively, of the Company's common stock.
  An additional $200,000 of notes were converted into 49,000 shares of the
  Company's common stock after year end.
   
    In connection with the acquisition of MTC, the Company issued $2.9 million
  of its 9% Convertible Subordinated Debentures (the "MTC 9% Debentures") due
  September 2000. The MTC 9% Debentures are subordinated to senior indebtedness
  of the Company and are convertible after September 15, 1996, into the
  Company's common shares at $6.75 per share. The MTC 9% Debentures may be
  prepaid by the Company in whole or in part at face value. During fiscal 1997,
  of the total $386,000 of notes converted, $236,000 of these 9% debentures were
  converted into 35,000 shares of the Company's common stock.
   
    Also in connection with the acquisition of MTC, the Company assumed $1.8
  million of 6% Convertible Subordinated Secured Debentures (the "Debentures")
  due February 2002. The Debentures are convertible into the Company's common
  stock at $8.10 per share. The Debentures are subject to redemption at the
  option of the Company at face value, provided, however, that the Company
  issues common share purchase warrants to purchase the same number of shares as
  would have been issuable if the Debentures were converted. During fiscal 1996,
  certain holders of the debentures converted $1.0 million face amount
  Debentures into 126,000 shares of the Company's common stock.
   
    During fiscal 1997, the Company sold certain assets of its
  telecommunications segment for cash, a note receivable and the assumption of
  certain liabilities. In addition, the buyer repaid certain bank loans of the
  Company in the principal amount of $438,000 plus accrued interest (see Note
  5).
   
    Aggregate maturities of long-term debt for each of the next five fiscal
  years are as follows (in thousands):
  1998....................................... $1,384
             1999.......................................  6,985
             2000.......................................  3,521
             2001.......................................    315
             2002.......................................    906
  10. SALE OF COMMON STOCK
   
    On October 26, 1994, the Company sold 200,000 shares of its common stock in
  a Regulation S offering at $4.00 per share. In connection with the sale of
  common stock, the Company incurred fees of $90,000 and issued warrants to
  purchase 250,000 shares of its common stock exercisable for five years at an
  exercise price of $6.875 per share (fair market value at the date of grant).
   
                                        47
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
   
  11. CAPITALIZED LEASE OBLIGATIONS AND OTHER LEASE COMMITMENTS
   
    The Company leases computer equipment and certain other office equipment
  under leases which are capital in nature. The Company has net assets of
  $314,000 and $520,000 under these capital leases as of September 30, 1997 and
  1996, respectively.
   
    The Company has entered into operating leases for office space and
  manufacturing facilities. These leases provide for minimum rents. These leases
  generally include options to renew for additional periods. The Company's rent
  expense for the years ended September 30, 1997, 1996 and 1995 was $828,000,
  $755,000 and $282,000, respectively.
   
    The aggregate amount of the lease payments under capital and operating
  leases for the Company's continuing operations for each of the five fiscal
  years ending September 30 is as follows (in thousands):
  CAPITAL OPERATING
                                                                 LEASES   LEASES
                                                                 ------- ---------
  1998....................................................  $ 29    $  644
        1999....................................................    22       264
        2000....................................................    23       248
        2001....................................................     9       230
        2002....................................................    --        75
                                                                  ----    ------
        Total minimum lease payments............................  $ 83    $1,461
                                                                  ====    ======
          Amount representing interest..........................   (13)
                                                                  ----
        Present value of net minimum payments...................    70
          Less current portion..................................   (23)
                                                                  ----
        Capital lease obligation................................  $ 47
                                                                  ====
  12. INCOME TAXES
   
    The Company's provision for income taxes in fiscal 1995 relates exclusively
  to the operations of KCI, for tax liabilities incurred by KCI prior to the
  merger with the Company. These amounts are included in "Loss from operations"
  for discontinued operations in the accompanying statement of operations due to
  the Company's decision to discontinue the telecommunications segment (see Note
  17).
   
    The components of the provision for income taxes are as follows for the
  fiscal years ending September 30 (in thousands):
  1997 1996 1995
                                                                   ---- ---- ----
  Current
          Federal................................................  $--  $--  $113
          State..................................................   --   --    23
                                                                   ---  ---  ----
            Total current........................................   --   --   136
        Deferred
          Federal................................................   --   --   (10)
          State..................................................   --   --    (2)
                                                                   ---  ---  ----
            Total deferred.......................................   --   --   (12)
                                                                   $--  $--  $124
                                                                   ===  ===  ====
  48
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
   
    The types of temporary differences between the tax basis of assets and
  liabilities and their financial reporting amounts that give rise to deferred
  taxes at September 30 and the approximate tax effects are as follows (in
  thousands):
  1997                  1996
                                      --------------------- ---------------------
                                      TEMPORARY             TEMPORARY
                                      DIFFERENCE TAX EFFECT DIFFERENCE TAX EFFECT
                                      ---------- ---------- ---------- ----------
  Inventory and other operating
   reserves..........................   $  499    $   170     $1,240    $   422
  Allowance for doubtful accounts....      104         35        541        184
  Reserve for note receivable........       --         --        624        212
  Unpaid accruals....................      477        162        794        270
  Reserve for lease termination......       --         --         75         26
  Deferred revenue...................    1,479        503      1,369        465
  Other..............................      (17)        (6)        (9)        (3)
  Net operating loss carryforwards...    6,747      2,294      7,854      2,670
                                        ------    -------     ------    -------
  Total deferred tax asset...........               3,158                 4,246
  Valuation allowance................              (3,158)               (4,246)
                                                  -------               -------
  Net deferred tax asset.............             $    --               $    --
                                                  =======               =======
  A valuation allowance was recorded as a reduction to the deferred tax assets
  due to the uncertainty of the ultimate realization of future benefits from
  such deferred taxes.
   
    Net operating loss carryforwards of approximately $6.7 million are available
  as of September 30, 1997 to be applied against future taxable income. In
  addition, net operating loss carryforwards of approximately $750,000 acquired
  in connection with the acquisition of MTC are available to reduce recorded
  goodwill when utilized. The net operating loss carryforwards expire between
  1999 and 2010 and are subject to certain annual limitations as a result of the
  changes in equity ownership.
   
                                        49
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
   
  13. STOCK OPTIONS AND WARRANTS
   
    During fiscal 1995 the Company adopted the 1995 Long Term Incentive Plan
  (the "1995 LTIP") whereby the Company, under the direction of the committee
  appointed by the Board of Directors, can grant a variety of stock-based
  compensation awards. The Company has reserved 1.5 million shares (including an
  increase of 900,000 shares approved by the shareholders during fiscal 1997)
  for issuance under the plan. Outstanding options and warrants to purchase
  shares of common stock at September 30, 1997, 1996 and 1995 were as follows
  (in thousands, except price per option data):
  SHARES  PRICE PER OPTION
                                                          ------  ----------------
  Outstanding at October 1, 1994...................   730      1.75-6.125
          Granted........................................   924       1.75-8.50
          Canceled.......................................    (4)         4.0429
          Expired........................................    --              --
          Exercised......................................  (100)           1.75
                                                          -----
        Outstanding at September 30, 1995................ 1,550       1.75-8.50
          Granted........................................   574     8.125-10.00
          Canceled.......................................  (542)      6.50-8.25
          Expired........................................    --              --
          Exercised......................................   (13)           1.75
                                                          -----
        Outstanding at September 30, 1996................ 1,569      1.75-10.00
          Granted........................................   400     4.938-5.313
          Canceled.......................................  (283)     4.938-5.00
          Expired........................................    --              --
          Exercised......................................  (251)           1.75
        Outstanding at September 30, 1997................ 1,435      1.75-10.00
                                                          -----
  Shares available under the Plan were 1,058,000, 303,000 and 600,000 at
  September 30, 1997, 1996 and 1995, respectively. As of September 30, 1997,
  1996 and 1995, there were 1.0 million, 1.2 million and 1.3 million exercisable
  options and warrants, respectively.
   
    During fiscal 1997, the Board of Directors elected to reduce the exercise
  price on 297,000 options from $8.25 to $4.94 per share, the market price on
  the day the board took such action. In addition, during fiscal 1996, the Board
  of Directors elected to reduce the exercise price on 117,000 options from
  $12.75 to $8.25 per share, the market price on the day the board took such
  action.
   
    During fiscal 1997, the Company was required to adopt Statement of Financial
  Standards No. 123, Accounting for Stock-Based Compensation (FAS 123), which
  encourages entities to adopt a fair value based method of accounting for stock
  based compensation plans in place of the provisions of Accounting Principles
  Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), for
  all arrangements under which employees receive shares of stock or other equity
  instruments of the employer.
   
    As allowed by FAS 123, the Company will continue to apply the provisions of
  APB 25 in accounting for its stock based employee compensation arrangements,
  and will disclose the pro forma net loss and loss per share information in its
  footnotes as if the fair value method suggested in FAS 123 had been applied.
   
    Had compensation cost for the Company's LTIP been determined based on the
  fair value at grant date for awards in fiscal 1997 and 1996 consistent with
  the provisions of FAS 123, the Company's net loss and loss per share would
  have been increased to the pro forma amounts indicated below:
   
                                        50
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
   
    (Dollar amounts in thousands, except per share data)
  1997     1996
                                                                -------  -------
  Net loss, as reported.................................. $(2,631) $(6,097)
        Net loss, pro forma....................................  (3,207)  (6,348)
        Loss per common share, as reported..................... $  (.40) $ (1.05)
        Loss per common share, pro forma.......................    (.48)   (1.09)
  The fair value of each option grant is estimated on the date of grant using
  the Black-Scholes option pricing model with the following weighted average
  assumptions used for grants in 1997: dividend yield of 0.0%; expected
  volatility of 58%; risk free interest rate spread of 5.8%-6.4%; and expected
  life of 4 years. Options outstanding at September 30, 1997 had exercise prices
  ranging from $4.94 to $5.31. The weighted average exercise price of these
  outstanding options outstanding is $4.98 and the weighted average remaining
  contractual life of those options is 8.8 years.
   
  14. RELATED PARTY TRANSACTIONS
   
    As of September 30, 1994, the Company was owed $4.2 million plus accrued
  interest by Ozite Corporation (Ozite). A Director of the Company and the
  former Chairman of the Board held substantial interests in Ozite. Due to
  uncertainties about collecting these funds, the receivable from Ozite was
  written off and charged against earnings in 1991, and, accordingly no amount
  related to this receivable is recorded on the Company's consolidated financial
  statements.
   
    On July 26, 1995, Ozite shareholders approved a merger of Ozite with Pure
  Tech with Pure Tech being the surviving corporation. As a condition of the
  merger, Ozite was required to secure a general release from the Company and to
  surrender certain securities in satisfaction of the amount owed to the
  Company. As a result, the Company received 311,000 shares of Pure Tech common
  stock, 267,000 shares of Artra Group Incorporated (ARTRA) Common Stock and 932
  shares of Artra Preferred Stock. Subsequently, the Company sold all 311,025
  shares of Pure Tech for net proceeds of $1.0 million, which was recorded as a
  capital contribution during fiscal 1995. During fiscal 1996, the remaining
  securities were sold for net proceeds of $815,000, which was recorded as a
  capital contribution.
   
    During fiscal 1997, CDI sold its operations that support its Fujitsu
  maintenance base in the Chicago metropolitan area to a new company formed by
  John I. Jellinek, the Company's former president, chief executive officer, and
  director and Philip Kenny, a former SoftNet director. The buyer acquired
  certain assets in exchange for a $209,000 promissory note and the assumption
  of current liabilities of approximately $750,000. In addition, at the closing
  the buyer paid off $438,000 of Company bank debt and entered into a sub-lease
  of CDI's facility in Buffalo Grove, Illinois. At the closing, the buyer merged
  with Telcom Midwest, LLC., and the two former directors and the other two
  shareholders of the merged company personally guaranteed obligations arising
  out of the promissory note, the sub-lease arrangement and the assumption of
  certain liabilities. The personal guarantees of the promissory note are
  several. The personal guarantees of the sub-lease are limited to $400,000 and
  are on a joint and several basis. The personal guarantees of assumed
  liabilities are on a joint and several basis but are limited to the two former
  directors. Concurrent with this transaction, Messrs. Jellinek and Kenny
  resigned from the Company's board.
   
    In June 1996, the Company acquired the exclusive worldwide manufacturing
  rights to IMNET's MegaSAR Microfilm Jukebox and completed and amended its
  obligations under a previous agreement. The Company issued a $2.9 million note
  for prepaid license fees, software inventory, the manufacturing rights, and
  certain other
   
                                        51
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
  payables. Approximately $2.5 million was paid on this note during the fourth
  quarter of fiscal 1996. Subsequently, in fiscal 1997, the outstanding $410,000
  promissory note was further reduced by $249,000, and a new promissory not in
  the face amount of $161,000 was executed.
   
    In July 1997, due to a delay in the transfer to the Company of the technical
  and manufacturing know-how for the MegaSAR product, the Company and IMNET
  further amended the June 1996 Agreement. In an attempt to facilitate the
  technology transfer, the Company accepted an order from IMNET for the first 14
  MegaSAR units to be manufactured by the Company. A portion of the payment for
  these initial units would be applied against the outstanding promissory note.
  The transfer of the technology and the parts needed for production was to have
  occurred no later than September 1, 1997.
   
    As of September 30, 1997, the transfer to the Company of the technical and
  manufacturing know-how for this product offering has continued to be delayed.
  Despite the ongoing negotiation and cooperation between the two parties, the
  Company determined there was a potential material risk in completing the
  technology transfer and getting the product to market. As a result, in the
  fourth quarter of fiscal 1997, the Company recorded a one-time charge of $1.0
  million to write-off the associated prepaid licenses. The Company is currently
  negotiating with IMNET to either complete the transfer or seek an alternative
  solution.
   
    During the fourth quarter of fiscal 1996, the Company decided to discontinue
  its plans for distributing the IMNET microfilm retrieval software in favor of
  another software developer's product. As a result, the Company recorded a one-
  time charge of $1.5 million to write-off software inventory which is included
  under the caption costs associated with change in product lines and other in
  the accompanying consolidate statements of operations.
   
    During fiscal 1996, the Company sold its entire holdings in IMNET for net
  proceeds of $7.7 million. Accordingly, the Company recorded a gain on sale of
  the securities of $5.7 million.
   
  15. SUPPLEMENTAL CASH FLOW INFORMATION
  1997   1996   1995
                                                             ------ ------ ------
                                                                (IN THOUSANDS)
  Cash paid during the year for:
    Interest................................................ $1,220 $1,730 $  465
    Income taxes............................................     --     --    194
  Non-cash investing and financing activities:
    Common stock issued for acquisitions....................     --  1,022  7,931
    Securities received in settlement of $4,150,000 related
     party receivable, at net realized value................     --     --  1,027
    Convertible subordinated debt issued for acquisitions...     --     --  2,856
    Common stock issued for the conversion of subordinated
     notes..................................................    387  4,077  1,630
    Conversion of Senior Notes and accrued interest to 9%
     Convertible Notes......................................     --     --    309
    Note received in sale of a portion of CDI's operations..    209     --     --
    Equipment acquired by capital lease.....................     83     89    332
    Common stock issued to pay acquisition costs............     44     --     --
  52
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
   
  16. SEGMENT INFORMATION
   
    The Company operates principally in three industry segments: document
  management, telecommunications and Internet services. The Company's
  acquisition of MTC in September, 1995, significantly broadened its operations
  in the document management industry. Prior to the acquisition, the Company's
  document management operations were not material. Although the Company
  acquired MCW, an Internet service provider, in June of 1996, its revenue and
  results of operations in fiscal 1996 are immaterial. In July 1998, the Company
  decided to discontinue its telecommunications operations and therefore, the
  data relating to this segment is included as discontinued. Note 17 provides
  segment data for telecommunications.
  AS OF AND FOR THE YEARS ENDED
                                                          SEPTEMBER 30,
                                                 ----------------------------
                                                  1997       1996       1995
                                                 ------     ------     ------
                                                   (IN THOUSANDS OF DOLLARS)
  Net Sales
    Document Management......................... 20,330     19,417      1,088
    Internet Services...........................  1,008         --         --
    Other.......................................     --        167         --
                                                 ------     ------     ------
                                                 21,338     19,584      1,088
                                                 ======     ======     ======
  Income (loss) from continuing operations
  Before income taxes
    Document Management.........................    572 (a)   (227)(b) (6,031)(c)
    Internet Services........................... (1,152)        --         --
    Other....................................... (2,304)     2,003 (d) (1,663)
                                                 ------     ------     ------
                                                 (2,884)     1,776     (7,694)
                                                 ======     ======     ======
  Identifiable Assets
    Document Management......................... 15,049     14,426     11,262
    Discontinued Business.......................  7,491      8,373     11,582
    Internet Services...........................  1,364         --         --
    Corporate...................................    473      1,467     12,552
    Other.......................................     --      1,320         --
                                                 ------     ------     ------
                                                 24,377     25,586     35,396
                                                 ======     ======     ======
  Depreciation and Amortization Expense
    Document Management.........................  1,263        958        139
    Internet Services...........................    458         --         --
    Corporate...................................     76        306         55
    Other.......................................      1        110         --
                                                 ------     ------     ------
                                                  1,798      1,374        194
                                                 ======     ======     ======
  Capital Expenditures
    Document Management.........................    137        614          2
    Internet Services...........................    361         --         --
    Corporate...................................     11        100        332
    Other.......................................      1         18         81
                                                 ------     ------     ------
                                                    510        732        415
                                                 ======     ======     ======
  ---------------------
  (a) Includes $2.1 million charge for costs associated with change in product
      line and other
  (b) Includes $1.5 million charge for costs associated with change in product
  (c) Includes $5.0 million charge for the write-off of acquired in-process
      unproven technology
  (d) Includes $5.7 million gain on sale of available-for-sale securities
   
                                        53
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
   
   
  17. SUBSEQUENT EVENT
   
    On July 27, 1998, the Board of Directors of the Company approved a plan to
  offer for sale its telecommunications segment. Accordingly, operating results
  have been reclassified and reported in discontinued operations. The Company is
  in the process of negotiating the sale of these operations and expects that
  the sale will be completed within a twelve month period. Management does not
  anticipate a loss on the sale and intends to use sale proceeds to reduce
  outstanding indebtedness and provide additional working capital.
   
    Operating results of discontinued telecommunications segment are as follows
  (in thousands):
  1997    1996     1995
                                                        ------- -------  -------
  Revenues....................................... $17,218 $21,803  $20,164
        Income (loss) before income taxes.............. $   739 $(1,812) $  (898)
        Provision for income taxes.....................      --      --  $  (124)
        Net income (loss).............................. $   739 $(1,812) $(1,022)
  Interest expense allocated to the discontinued telecommunications segment
  totaled $49,000, $377,000 and $194,000 in 1997, 1996 and 1995 respectively.
   
    Assets and liabilities of the discontinued telecommunications segment are as
  follows at September 30:
  1997   1996
                                                                    ------ ------
  Current assets:
          Cash..................................................... $   -- $   --
          Accounts receivable, net.................................  1,848  2,237
          Inventories..............................................  2,984  3,111
          Prepaid expenses.........................................    154     86
                                                                    ------ ------
                                                                     4,986  5,434
                                                                    ------ ------
          Property, plant and equipment, net.......................    529 $  978
          Goodwill, net............................................  1,759  1,846
          Other noncurrent assets..................................    217    115
                                                                    ------ ------
                                                                    $7,491 $8,373
                                                                    ====== ======
        Current liabilities:
          Accounts payable......................................... $2,295 $4,633
          Current portion, long term debt..........................    328    141
          Current portion, capital lease obligation................     23    108
          Deferred revenue.........................................  1,336  1,269
                                                                    ------ ------
                                                                     3,982  6,151
                                                                    ------ ------
        Long-term debt, net of current portion.....................     20    351
        Capital lease obligation, net of current portion...........     54     88
                                                                    ------ ------
                                                                    $4,056 $6,590
                                                                    ====== ======
          Net assets associated with discontinued operations....... $3,435 $1,783
                                                                    ====== ======
  The financial statements have been restated for the effects of the
  discontinued operations of the telecommunications segment.
   
                                        54
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
                  CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
         FOR THE THREE MONTHS AND SIX MONTHS ENDED MARCH 31, 1998 AND 1997
                       (IN THOUSANDS, EXCEPT PER SHARE DATA)
                                    (UNAUDITED)
  THREE MONTHS ENDED     SIX MONTHS
                                                MARCH 31,        ENDED MARCH 31,
                                            -------------------- ----------------
                                              1998       1997     1998     1997
                                            ---------  --------- -------  -------
  Net sales...............................  $   4,308  $  5,680  $ 7,229  $11,335
  Cost of sales...........................      2,957     3,214    5,252    6,371
                                            ---------  --------  -------  -------
      Gross profit........................      1,351     2,466    1,977    4,964
                                            ---------  --------  -------  -------
  Operating expenses:
    Selling...............................        547       476    1,104    1,058
    Engineering...........................        643       564    1,225    1,114
    General and administrative............      1,106       888    2,285    1,568
    Amortization of goodwill and
     transaction costs....................        322       321      643      660
                                            ---------  --------  -------  -------
      Total operating expenses............      2,618     2,249    5,257    4,400
                                            ---------  --------  -------  -------
  Income (loss) from continuing
   operations.............................     (1,267)      217   (3,280)     564
    Interest expense......................       (267)     (294)    (596)    (533)
    Other income..........................         99         6      170       81
                                            ---------  --------  -------  -------
  Income (loss) from continuing operations
   before income taxes and extraordinary
   item...................................     (1,435)      (71)  (3,706)     112
  Provision for income taxes..............         --        --       --       --
                                            ---------  --------  -------  -------
  Income (loss) before discontinued
   operations and extraordinary item......     (1,435)      (71)  (3,706)     112
  Discontinued operations:
    Income from operations................        222       354      115      426
                                            ---------  --------  -------  -------
  Net income (loss).......................  $  (1,213) $    283  $(3,591) $   538
                                            =========  ========  =======  =======
  Preferred dividends.....................        (63)       --      (63)      --
                                            ---------  --------  -------  -------
  Net income (loss) applicable to common
   shares.................................  $  (1,276) $    283  $(3,654) $   538
                                            =========  ========  =======  =======
  Earnings (loss) per common share:
    Basic.................................  $   (0.18) $   0.04  $ (0.52) $  0.08
                                            =========  ========  =======  =======
    Diluted...............................  $   (0.18) $   0.04  $ (0.52) $  0.08
                                            =========  ========  =======  =======
  The accompanying notes are an integral part of these condensed consolidated
                               financial statements.
   
                                         55
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
                       CONDENSED CONSOLIDATED BALANCE SHEETS
                    AS OF MARCH 31, 1998 AND SEPTEMBER 30, 1997
                         (IN THOUSANDS, EXCEPT SHARE DATA)
  MARCH 31,  SEPT. 30,
                                                                1998       1997
                                                              ---------  ---------
  ASSETS
  Current assets:
    Cash..................................................... $     17   $     37
    Accounts receivables, net................................    5,449      5,135
    Inventories..............................................    2,303      1,326
    Prepaid expenses and other...............................      436        319
                                                              --------   --------
      Total current assets...................................    8,205      6,817
                                                              --------   --------
  Property and equipment, net................................    1,089      1,108
  Costs in excess of fair value of net assets acquired, net..    4,598      5,141
  Other assets...............................................    3,856      3,820
  Net assets associated with discontinued operations.........    4,186      3,435
                                                              --------   --------
                                                              $ 21,934   $ 20,321
                                                              ========   ========
             LIABILITIES AND SHAREHOLDERS' EQUITY
  Current liabilities:
    Accounts payable and accrued expenses.................... $  5,022   $  4,969
    Current portion of long-term debt........................    1,230      1,384
    Current portion of capital leases........................       10         23
    Deferred revenue.........................................      357        143
                                                              --------   --------
      Total current liabilities..............................    6,619      6,519
                                                              --------   --------
  Long-term debt, net of current portion.....................   11,887     11,727
                                                              --------   --------
  Capital leases, net of current portion.....................       41         47
                                                              --------   --------
  Shareholders' equity:
    Preferred stock, $.10 par value, 4 million shares
     authorized, Series A Convertible, 5,062.5 shares
     outstanding at March 31, 1998...........................       --         --
    Common stock, $.01 par value, 25 million shares
     authorized, 7,014,673 and 6,870,559 shares outstanding,
     respectively............................................       70         69
    Capital in excess of par value...........................   39,391     34,379
    Accumulated deficit......................................  (36,074)   (32,420)
                                                              --------   --------
      Total shareholders' equity.............................    3,387      2,028
                                                              --------   --------
                                                              $ 21,934   $ 20,321
                                                              ========   ========
  The accompanying notes are an integral part of these condensed consolidated
                               financial statements.
   
                                         56
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
                  CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                  FOR THE SIX MONTHS ENDED MARCH 31, 1998 AND 1997
                             (IN THOUSANDS) (UNAUDITED)
  MARCH 31, MARCH 31,
                                                                 1998      1997
                                                               --------- ---------
  Cash flows from operating activities:
   Net income (loss).........................................   $(3,591)  $   538
   Adjustments to reconcile net income (loss) to net cash
    used in operating activities:
    Income from discontinued operations......................      (115)     (426)
    Depreciation and amortization............................       951       829
    Provision for bad debts..................................       157         2
    Changes in operating assets and liabilities, net of
     effect of purchase transactions And disposal of
     discontinued operations:
     Receivables.............................................       409    (4,525)
     Inventories.............................................      (658)      683
     Prepaid expenses........................................       (52)      125
     Accounts payable and accrued expenses...................       178     1,614
     Deferred revenue........................................       215       252
                                                                -------   -------
      Net cash used in operating activities of continuing
       operations............................................    (2,506)     (908)
                                                                -------   -------
      Net cash used in operating activities of discontinued
       operations............................................      (382)     (725)
                                                                -------   -------
  Cash flows from investing activities:
    Purchase of property and equipment.......................      (259)     (422)
    Additions to capitalized product design..................        --      (502)
    Other....................................................        16        --
                                                                -------   -------
      Net cash used in investing activities of continuing
       operations............................................      (243)     (924)
                                                                -------   -------
      Net cash used in investing activities of discontinued
       operations............................................       (60)     (103)
                                                                -------   -------
  Cash flows from financing activities:
   Repayment of long-term debt...............................      (748)      (64)
   Net borrowings (repayments) under revolving credit note...    (1,235)    1,982
   Proceeds from sale of preferred stock.....................     4,600        --
   Proceeds from exercise of warrants........................       141        --
   Capitalized lease obligations paid........................       (21)     (143)
                                                                -------   -------
  Net cash provided by financing activities of continuing op-
   erations..................................................     2,737     1,775
                                                                -------   -------
  Net cash provided by financing activities of discontinued
   operations................................................       434       522
                                                                -------   -------
  Decrease in cash...........................................       (20)     (363)
  Cash, beginning of period..................................        37       426
                                                                -------   -------
  Cash, end of period........................................   $    17   $    63
                                                                =======   =======
  Cash paid during the period for:
  Interest...................................................   $   671   $   504
  Income taxes...............................................        --        --
  Supplemental non-cash transactions
   Convertible debt issued for acquisition of equipment
    leases...................................................   $ 1,444        --
   Common stock issued for the conversion of subordinated
    notes....................................................       210        --
   Note received in sale of net assets.......................       110        --
  The accompanying notes are an integral part of these condensed consolidated
                               financial statements.
   
                                         57
  SOFTNET SYSTEMS, INC. AND SUBSIDIARIES
   
               NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
   
  1. BASIS OF PRESENTATION
   
    The financial information, except for the balance sheet as of September 30,
  1997, included herein is unaudited; however, such information reflects all
  adjustments (consisting solely of normal recurring adjustments) which are, in
  the opinion of management, necessary for a fair presentation of the condensed
  consolidated statements of financial position, results of operations and cash
  flows as of and for the interim periods ended March 31, 1998 and 1997.
   
    The Company's annual report on Form 10-K for the fiscal year ended September
  30, 1997, as filed with the Securities and Exchange Commission, should be read
  in conjunction with the accompanying condensed consolidated financial
  statements. The condensed consolidated balance sheet as of September 30, 1997
  was derived from the Company's audited Consolidated Financial Statements.
   
    The results of operations for the three months and six months ended March
  31, 1998 are based in part on estimates that may be subject to year-end
  adjustments and are not necessarily indicative of the results to be expected
  for the full year.
   
  2. DEBT
   
    Long-term debt is summarized as follows (in thousands):
  MARCH 31, SEPTEMBER 30,
                                                             1998        1997
                                                           --------- -------------
  Bank Debt (See Note 3)............................  $ 7,912     $ 8,973
        Convertible Subordinated Notes....................    4,858       3,624
        Other.............................................      347         514
                                                            -------     -------
                                                             13,117      13,111
        Less current portion..............................   (1,230)     (1,384)
                                                            -------     -------
                                                            $11,887     $11,727
                                                            =======     =======
  On January 2, 1998, the Company issued $1,443,750 principal amount of its 5%
  Convertible Subordinated Debentures due September 30, 2002 to a single
  investor in exchange for the assignment to the Company of certain equipment
  leases and other consideration. The debentures are convertible into Common
  Stock of the Company, at $8.25 per share, after December 31, 1998.
   
    Subsequent to March 31, 1998, the Company issued 120,000 shares of common
  stock pursuant to the conversion of $810,000 of convertible debt by a single
  holder of the Company's 9% convertible subordinated notes due September 15,
  2000. These 9% notes have a conversion price of $6.75 per share.
   
  3. PREFERRED STOCK
   
    On December 31, 1997, the Company sold 5,000 shares of Series A Convertible
  Preferred Stock, $0.01 par value per share ("Convertible Preferred"), for an
  aggregate purchase price of $5 million. The Convertible Preferred shares
  accrue dividends at a rate of 5% per annum, payable quarterly, at the
  Company's option, in cash or additional Convertible Preferred shares. In
  addition, the Company issued warrants to purchase 170,000 shares of the
  Company's common stock at prices at or above the market price (20,000 shares
  at $6.625 expiring on December 31, 2000 and 150,000 shares at $7.95 expiring
  on December 31, 2001). On January 2, 1998, the Company used the net proceeds
  of $4.6 million, after issuance costs of $400,000, to reduce the balance of
  the bank revolving credit note.
   
                                        58
  Each share of Convertible Preferred is convertible, at the option of the
  holder, into the number of shares of common stock as defined by the stated
  value of the Convertible Preferred multiplied by 5% per annum, less any
  dividends paid, divided by the conversion price. The stated value of the
  Convertible Preferred is $1,000 per share and the conversion price is the
  lower of $8.28 or a two day average market price within a 20 day trading
  period prior to the conversion. Pursuant to the Company's Articles of
  Incorporation, as amended, the holders of the Convertible Preferred stock may
  only convert their outstanding Convertible Preferred stock into an aggregate
  amount of common stock that does not exceed 19.99% of the outstanding common
  stock of the Company. Any excess shares of common stock that are issuable upon
  conversion of outstanding Convertible Preferred, that exceed this 19.99%
  limitation, are subject to mandatory redemption at the option of the holder of
  the Convertible Preferred stock, unless the Company either obtains stockholder
  approval for the additional conversions over 20%, or the Company receives
  permission to allow such an issuance from the American Stock Exchange. All
  outstanding shares of Convertible Preferred, subject to the aforementioned
  restrictions, automatically convert to common stock on December 31, 2000.
   
    Holders of Convertible Preferred do not have voting rights, except for
  certain protective provisions relating to changes in the rights of holders of
  Convertible Preferred. The Convertible Preferred ranks senior to the Company's
  common stock as to dividends, distributions and distribution of assets upon
  liquidation, dissolution or winding up of the Company. The Convertible
  Preferred is subject to mandatory redemption upon certain circumstances,
  including the Company's (i) failure to convert the Convertible Preferred when
  required (ii) bankruptcy, and (iii) suspension from trading on the American
  Stock Exchange. The Company shall have the right to redeem the Convertible
  Preferred on or after December 31, 1998 at a price equal to the greater of
  130% of the stated value or the market price multiplied by the number of
  shares of common stock into which the Convertible Preferred can be converted.
   
    On March 31, 1998, the Company issued an additional 62.5 shares of
  Convertible Preferred as payment for $62,500 of earned dividends on the
  outstanding Convertible Preferred stock.
   
    Subsequent to March 31, 1998, the Company issued a combined total of 299,946
  shares of common stock, pursuant to the conversion of 2,000 shares of the
  Company's outstanding Series A Convertible Preferred Stock. The Series A
  Convertible Preferred Stock, including accrued dividends, was converted into
  common shares at the conversion price of $6.69 per share.
   
  4. STOCK OPTIONS AND WARRANTS
   
    Outstanding options and warrants to purchase shares of common stock at March
  31, 1998 were as follows (in thousands, except price per option data):
  Outstanding at September 30, 1997................................. 1,435
          Granted at exercise prices ranging from $6.625 to $7.95 per
           share..........................................................   862
          Canceled........................................................   (18)
          Exercised at exercise prices ranging from $1.75 to $5.313 per
           share..........................................................  (103)
                                                                           -----
        Outstanding at March 31, 1998..................................... 2,176
                                                                           =====
  5. EARNINGS (LOSS) PER SHARE
   
    The Company adopted Statement of Financial Accounting Standard (SFAS) No.
  128, "Earnings Per Share," in the quarter ended December 31, 1997. SFAS 128
  requires the computation of basic and diluted earnings per share. Basic
  earnings (loss) per common share is computed using the weighted average number
  of common shares outstanding. Diluted earnings (loss) per common share is
  computed using the weighted average number of common shares outstanding and
  the dilutive common stock equivalents (using the treasury stock
   
                                        59
  method for warrants and options). Summarized below is the reconciliation of
  basic and diluted earnings (loss) per common share for the three months and
  the six months ended March 31, 1998 and 1997 (in thousands except per common
  share amounts):
  FOR THE THREE MONTHS ENDED   FOR THE SIX MONTHS ENDED
                           --------------------------- ---------------------------
                           NET INCOME        PER SHARE NET INCOME        PER SHARE
                             (LOSS)   SHARES  AMOUNT     (LOSS)   SHARES  AMOUNT
                           ---------- ------ --------- ---------- ------ ---------
  March 31, 1998:
    Basic earnings (loss).  $(1,276)  6,992   $(0.18)   $(3,654)  6,966   $(0.52)
     Effect of outstanding
      securities (a)--
      Warrants and
       options............       --      --                  --      --
      Convertible debt....       --      --                  --      --
      Convertible
       preferred stock....       --      --                  --      --
                            -------   -----             -------   -----
    Diluted earnings
     (loss)...............  $(1,276)  6,992   $(0.18)   $(3,654)  6,966   $(0.52)
                            -------   -----             -------   -----
  March 31, 1997:
    Basic earnings........  $   283   6,580   $ 0.04    $   538   6,567   $ 0.08
     Effect of outstanding
      securities (b)--
      Warrants and
       options............       --     351                  --     297
      Convertible debt....       --      --                  --      --
      Convertible
       preferred stock....       --      --                  --      --
                            -------   -----             -------   -----
    Diluted earnings......  $   283   6,931   $ 0.04    $   538   6,864   $ 0.08
                            -------   -----             -------   -----
  ---------------------
  (a) As the Company had a net loss, the outstanding securities were
      antidilutive.
  (b) The remaining outstanding securities were antidilutive.
   
  6. SUBSEQUENT EVENT
   
    On July 27, 1998, the Board of Directors of the Company approved a plan to
  offer for sale its telecommunications segment. Accordingly, operating results
  have been reclassified and reported in discontinued operations. The Company is
  in the process of negotiating the sale of these operations and expects that
  the sale will be completed within a twelve month period. Management does not
  anticipate a loss on the sale and intends to use sale proceeds to reduce
  outstanding indebtedness and provide additional working capital.
   
    Operating results of discontinued telecommunications segment are as follows
  (in thousands):
  THREE MONTHS   SIX MONTHS
                                                        ENDED MARCH      ENDED
                                                            31,        MARCH 31,
                                                       ------------- -------------
                                                        1998   1997   1998   1997
                                                       ------ ------ ------ ------
  Revenues...................................... $4,443 $4,494 $8,392 $9,617
        Net income.................................... $  222 $  354 $  115 $  426
  60
  Assets and liabilities of the discontinued telecommunications segment are as
  follows:
  MARCH 31, SEPTEMBER 30,
                                                            1998        1997
                                                          --------- -------------
  Current assets:
          Cash...........................................  $   --      $   --
          Accounts receivable, net.......................   2,142       1,848
          Inventories....................................   2,904       2,984
          Prepaid expenses...............................     204         154
                                                           ------      ------
                                                            5,250       4,986
                                                           ------      ------
          Property, plant and equipment, net.............     430         529
          Goodwill, net..................................   1,711       1,759
          Other noncurrent assets........................     132         217
                                                           ------      ------
                                                           $7,523      $7,491
                                                           ======      ======
        Current liabilities:
          Accounts payable...............................  $2,450      $2,295
          Current portion, long term debt................      38         328
          Current portion, capital lease obligation......      23          23
          Deferred revenue...............................     783       1,336
                                                           ------      ------
                                                            3,294       3,982
                                                           ------      ------
          Long-term debt, net of current portion.........      --          20
          Capital lease obligation, net of current
           portion.......................................      43          54
                                                           ------      ------
                                                           $3,337      $4,056
                                                           ======      ======
          Net assets associated with discontinued
           operations....................................  $4,186      $3,435
                                                           ======      ======
  The financial statements have been restated for the effects of the
  discontinued operations of the telecommunications segment.
   
                                         61
  SIGNATURES
   
    Pursuant to the requirements of the Securities Exchange Act of 1934, the
  Registrant has duly caused this report to be signed on its behalf by the
  undersigned hereto duly authorized.
   
  Dated: July 27, 1998
   
                                                    /s/ Mark A. Phillips
                                            By:__________________________________
                                                      MARK A. PHILLIPS,
                                                          Secretary
                                                  Chief Accounting Officer
   
                                         62