*Table
            of Contents*





**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


Washington,
      D.C. 20549





**FORM
      10-Q**


(Mark
      One)





þ
            **QUARTERLY
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934**


For
      the
      quarterly period ended March 31, 2007.





 ̈
            **TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934**.


For
      the
      transition period from ____ to ____.





Commission
      file number 1-15117.




**On2
      Technologies, Inc.**





(Exact
      name of registrant as specified in its charter)








Delaware
            
            84-1280679(State
                or other jurisdiction of incorporation or organization)
            
            (I.R.S.
                Employer Identification No.)





21
                Corporate Drive, Suite 103, Clifton Park, New York
            
            12065(Address
                of principal executive offices)
            
            (Zip
                Code)





(518)
      348-0099


(Registrant’s
      telephone number, including area code)










(Former
      name, former address and former fiscal year, if changed since last
      report)




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




Indicate
      by check mark whether the registrant is an accelerated filer (as defined in
      Rule
      12b-2 of the Exchange Act).  ̈ Yes   ̈ No





APPLICABLE
      ONLY TO ISSUERS INVOLVED IN BANKRUPTCY


PROCEEDINGS
      DURING THE PRECEDING FIVE YEARS:




Indicate
      by check mark whether the registrant has filed all documents and reports
      required to be filed by Sections12, 13 or 15(d) of the Securities Exchange
      Act
      of 1934 subsequent to the distribution of securities under a plan confirmed
      by a
      court.  p Yes   ̈ No




APPLICABLE
      ONLY TO CORPORATE ISSUERS:





Indicate
      the number of shares outstanding of each of the issuer’s classes of common
      stock, as of the latest applicable date:





The
      number of shares of the Registrant’s Common Stock, par value $0.01 (“Common
      Stock”), outstanding, as of May
      14,
      2007 ,
      was
      112,860,904.





*Table
        of Contents*


**Table
      of Contents**




**PART
                I — FINANCIAL INFORMATION**PageItem
                1. Consolidated Financial
                Statements.Condensed
                Consolidated Balance Sheets at March 31, 2007
                (unaudited) and December 31, 2006
            3Unaudited
                Condensed Consolidated Statements of Operations,
                Three Months Ended March 31, 2007 and 2006
            4Unaudited
                Condensed Consolidated Statements of Comprehensive
                loss, Three Months Ended March 31, 2007 and 2006
            5Unaudited
                Condensed Consolidated Statements of Cash Flows Three
                Months Ended March 31, 2007 and 2006
            6Notes
                to Unaudited Condensed Consolidated Financial
                Statements
            8Item
                2. Management’s Discussion and Analysis of Financial
                Condition and Results of Operations
            13Item
                3. Quantitative and Qualitative Disclosures About
                Market Risk
            23Item
                4. Controls and Procedures
            23**PART
                II — OTHER INFORMATION**Item
                1. Legal Proceedings
            24Item
                6. Exhibits and Reports on Form
                8-K
            25Signatures
            26Certifications
            27




-2-
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          of Contents*




**PART
      I — FINANCIAL INFORMATION**





Item
      1. Consolidated Financial Statements




**ON2
      TECHNOLOGIES, INC.**


**CONDENSED
      CONSOLIDATED BALANCE SHEETS**





March
                31,
              2007
            
            December
                31, 2006(unaudited)**ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            5,281,000
            
            $
            4,961,000Marketable
                securities, at market
            
            
            12,000
            
            
            154,000Accounts
                receivable
            
            
            2,070,000
            
            
            1,335,000Prepaid
                expenses and other current assets
            
            
            402,000
            
            
            231,000Total
                current assets
            
            
            7,765,000
            
            
            6,681,000Acquired
                software, net
            
            
            418,000
            
            
            467,000Other
                acquired intangibles, net
            
            
            96,000
            
            
            108,000Goodwill
            
            
            244,000
            
            
            244,000Property
                and equipment, net
            
            
            215,000
            
            
            157,000Other
                assets
            
            
            230,000
            
            
            230,000Total
                assets
            
            $
            8,968,000
            
            $
            7,887,000**LIABILITIES
                AND STOCKHOLDERS’ EQUITY**Current
                liabilities:Accounts
                payable
            
            $
            376,000
            
            $
            194,000Accrued
                expenses
            
            
            804,000
            
            
            454,000Deferred
                revenue
            
            
            704,000
            
            
            708,000Term
                loan
            
            
            
            
            
            33,000Capital
                lease obligation
            
            
            21,000
            
            
            24,000Total
                current liabilities
            
            
            1,905,000
            
            
            1,413,000Capital
                lease obligation, excluding current portion
            
            
            29,000
            
            
            29,000Warrant
                derivative liability
            
            
            3,243,000
            
            
            2,329,000Total
                liabilities
            
            
            5,177,000
            
            
            3,771,000Series
                D redeemable convertible preferred stock
            
            
            1,889,000
            
            
            3,083,000Commitments
                and contingenciesStockholders’
                equity:Preferred
                stock
            
            
            
            
            
            19,000Common
                stock
            
            
            1,072,000
            
            
            1,012,000Additional
                paid-in capital
            
            
            126,651,000
            
            
            124,554,000Treasury
                stock at cost
            
            
            (492,000
            )Accumulated
                other comprehensive loss
            
            
            (48,000
            )
            
            (46,000
            )Accumulated
                deficit
            
            
            (125,281,000
            )
            
            (124,506,000
            )Total
                stockholders’ equity
            
            
            1,902,000
            
            
            1,033,000Total
                liabilities and stockholders’ equity
            
            $
            8,968,000
            
            $
            7,887,000


*See
      accompanying notes to unaudited condensed consolidated financial
      statements*


-3-
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          of Contents*




**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF
      OPERATIONS**





Three
                Months Ended March 31,2007
            
            2006Revenue
            
            $
            2,815,000
            
            $
            1,217,000Operating
                expenses:Cost
                of revenue (1)
            
            
            423,000
            
            
            583,000Research
                and development (2)
            
            
            493,000
            
            
            225,000Sales
                and marketing (2)
            
            
            596,000
            
            
            188,000General
                and administrative (2)
            
            
            959,000
            
            
            1,260,000Equity-based
                compensation:Research
                and development
            
            
            1,000
            
            
            27,000Sales
                and marketing
            
            
            27,000
            
            
            35,000General
                and administrative
            
            
            120,000
            
            
            48,000Total
                operating expenses
            
            
            2,619,000
            
            
            2,366,000Income
                (loss) from operations
            
            
            196,000
            
            
            (1,149,000
            )Interest
                and other expense, net
            
            
            (913,000
            )
            
            (27,000
            )Loss
                before provision for income taxes
            
            
            (717,000
            )
            
            (1,176,000
            )Provision
                for income taxes
            
            
            4,000
            
            
            3,000Net
                loss
            
            $
            (721,000
            )
            $
            (1,179,000
            )Convertible
                preferred stock 8% dividend
            
            
            54,000
            
            
            73,000Net
                loss attributable to common stockholders
            
            $
            (775,000
            )
            $
            (1,252,000
            )Basic
                and diluted net loss attributable to common stockholders per common
                share
            
            $
            (0.01
            )
            $
            (0.01
            )Weighted
                average basic and diluted commonshares
                outstanding
            
            
            103,599,000
            
            
            92,919,000





(1)
            Includes
                equity-based compensation of $1,000 and $57,000 for the three months
                ended
                March 31, 2007 and 2006,
                respectively.





(2)
            Excludes
                equity-based compensation, which is presented
                separately.






*See
      accompanying notes to unaudited condensed consolidated financial
      statements*


-4-
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          of Contents*


**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE
      LOSS**





Three
                Months Ended
              March
                31,2007
            
            2006Net
                loss
            
            $
            (721,000
            )
            $
            (1,179,000
            )Other
                Comprehensive income:Foreign
                currency translation adjustment
            
            
            (2,000
            )
            
            (1,000
            )Comprehensive
                loss
            
            $
            (723,000
            )
            $
            (1,180,000
            )






*See
      accompanying notes to unaudited condensed consolidated financial
      statements*


-5-
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          of Contents*




**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF CASH
      FLOWS**





Three
                Months Ended March 31,2007
            
            2006Cash
                flows from operating activities:Net
                loss
            
            $
            (721,000
            )
            $
            (1,179,000
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Equity
                based compensation
            
            
            149,000
            
            
            167,000Depreciation
                and amortization
            
            
            86,000
            
            
            80,000Amortization
                of debt discount
            
            
            
            
            
            6,000Realized
                and unrealized loss on marketable equity securities
            
            
            29,000
            
            
            38,000Change
                in warrant derivative liability
            
            
            914,000Changes
                in operating assets and liabilities:Accounts
                receivable, net
            
            
            (735,000
            )
            
            (44,000
            )Prepaid
                expenses and other current assets
            
            
            (171,000
            )
            
            38,000Other
                assets
            
            
            
            
            
            (34,000
            )Accounts
                payable and accrued expenses
            
            
            539,000
            
            
            135,000Deferred
                revenue
            
            
            (4,000
            )
            
            (99,000
            )Net
                cash provided by (used in) operating activities
            
            
            86,000
            
            
            (892,000
            )Cash
                flows from investing activities:Proceeds
                from the sale of marketable securities
            
            
            113,000
            
            
            75,000Purchases
                of property and equipment
            
            
            (77,000
            )
            
            (24,000
            )Net
                cash provided by investing activities
            
            
            36,000
            
            
            51,000Cash
                flows from financing activities:Principal
                payments on capital lease obligations
            
            
            (9,000
            )
            
            (5,000
            )Principal
                payments on term-loan
            
            
            (33,000
            )Proceeds
                from exercise of common stock options and warrants
            
            
            400,000
            
            
            158,000Purchase
                of treasury shares
            
            
            (158,000
            )Net
                cash provided by financing activities
            
            
            200,000
            
            
            153,000Net
                change in cash and cash equivalents
            
            
            322,000
            
            
            (688,000
            )Effect
                of exchange rate changes on cash and cash equivalents
            
            
            (2,000
            )
            
            (1,000
            )Cash
                and cash equivalents, beginning of period
            
            
            4,961,000
            
            
            3,976,000Cash
                and cash equivalents, end of period
            
            $
            5,281,000
            
            $
            3,287,000




-6-
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          of Contents*




**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
      (CONTINUED)**






**Supplemental
      disclosure of cash flow information and non-cash investing and financing
      activities:**




Three
              Months Ended March 31,2007
            
            2006Cash
                paid during the period for:Interest
            
            $
            2,000
            
            $
            1,000Taxes
            
            $
            5,000
            
            $
            6,000Non-cash
                transactions:Acquisition
                of fixed assets under capital lease
            
            $
            6,000Cashless
                exercise of stock options
            
            $
            466,000Common
                stock issued for dividends on Series D Preferred Stock
            
            $
            61,000
            
            $
            75,000Conversion
                of Series C-IV Preferred Stock into common stock
            
            $
            19,000
            
            $
            250,000Conversion
                / redemption of Series D Convertible Preferred stock
            
            $
            1,194,000
            
            $
            175,000Decrease
                in accrued dividend on Series D Preferred Stock
            
            $
            (6,000
            )
            $
            (2,000
            )


*See
      accompanying notes to unaudited condensed consolidated financial
      statements*


-7-
 *Table
          of Contents*




**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL
      STATEMENTS**






(1)
            Description
                of On2 Technologies, Inc.





On2
      Technologies, Inc. (“On2” or the “Company”) is a video compression technology
      firm that has developed its own proprietary technology platform and video
      compression/decompression software (“codec”) to deliver high-quality video at
      the lowest possible data rates over intra- and internets, such as cable
      networks, the Internet and wireless networks. The Company offers a suite of
      products and professional services that encompass its proprietary compression
      technology. The Company’s professional service offerings include customized
      engineering and consulting services and high-level video encoding. In addition,
      the Company licenses its software products for use with video delivery
      platforms.




The
      Company’s business is characterized by rapid technological change, new product
      development and evolving industry standards. Inherent in the Company’s business
      model are various risks and uncertainties, including its limited operating
      history, unproven business model and the limited history of the industry in
      which it operates. The Company’s success may depend, in part, upon the wide
      adoption of video delivery mediums, prospective product and service development
      efforts, and the acceptance of the Company’s technology solutions by the
      marketplace.





(2)
            Basis
                of Presentation





The
      unaudited condensed consolidated financial statements include the accounts
      of
      the Company and its wholly owned subsidiaries. All significant intercompany
      balances and transactions have been eliminated in consolidation.




The
      interim condensed consolidated financial statements are unaudited. However,
      in
      the opinion of management, such financial statements contain all adjustments
      necessary to present fairly the financial position of the Company and its
      results of operations and cash flows for the interim periods presented. The
      condensed consolidated financial statements included herein have been prepared
      pursuant to the rules and regulations of the Securities and Exchange Commission
      (“SEC”). Certain information and footnote disclosures normally included in
      consolidated financial statements prepared in accordance with accounting
      principals generally accepted in the United States of America have been
      condensed or omitted pursuant to such rules and regulations. The Company
      believes that the disclosures included herein are adequate to make the
      information presented not misleading. These condensed consolidated financial
      statements should be read in conjunction with the annual financial statements
      and notes thereto included in the Company's Form 10-K Report filed with the
      SEC
      on March 23, 2007.


-8-
 *Table
          of Contents*




(3)
            Stock-Based
                Compensation




The
      following table summarizes the activity of the Company’s stock options for the
      three months ended March 31, 2007:





Shares
              
              Weighted
                  Average
                Exercise
                  Price
              
              Weighted
                  Average
                Remaining
                Contractual
                  Life
              
              Aggregate
                  Intrinsic
                ValueNumber
                  of shares under option:Outstanding
                  at January 1, 2007
              
              
              9,497,000
              
              $
              1.07Granted
              
              
              5,000
              
              
              1.40Exercised
              
              
              (1,310,000
              )
              
              0.65Canceled
                  or expired
              
              
              (0
              )
              
              0.00Outstanding
                  at March 31, 2007
              
              
              8,192,000
              
              $
              1.14
              
              
              6.76
              
              $
              6,780,000Vested
                  and expected to vest at March 31, 2007
              
              
              8,138,000
              
              $
              1.10
              
              
              6.39
              
              $
              6,740,000Exercisable
                  at March 31, 2007
              
              
              7,211,000
              
              $
              1.17
              
              
              6.45
              
              $
              6,048,000


The
      aggregate intrinsic value of options exercised during the three months ended
      March 31, 2007 and 2006 was $2,145,000 and $33,000, respectively.




The
      following summarizes the activity of the Company’s non-vested stock options for
      the three months ended March 31, 2007:




Shares
            
            Weighted
                Average
              Grant
                Date Fair ValueNon-vested
                at January 1, 2007
            
            
            1,064,000
            
            $
            0.69Granted
            
            
            5,000
            
            
            1.40Cancelled
                or expired
            
            
            (0
            )
            
            0.00Vested
                during the period
            
            
            (88,000
            )
            
            0.68Non-vested
                at March 31, 2007
            
            
            981,000
            
            $
            0.90




-9-
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          of Contents*




As
      of
      March 31, 2007, there was $274,000 of total unrecognized compensation cost
      related to non-vested share-based compensation arrangements granted under
      existing stock option plans. This cost is expected to be recognized over a
      weighted-average period of 1.07 years. The total grant date fair value of shares
      vested during the three-months ended March 31, 2007 was $24,000.




The
      Company uses the Black-Scholes option-pricing model to determine the weighted
      average fair value of options. The fair value of options at date of grant and
      the assumptions utilized to determine such values are indicated in the following
      table:




Three
                months ended
              March
                31, 2007Weighted
                average fair value at date of grant for options granted during the
                period
            
            $
            1.09Expected
                stock price volatility
            
            
            104
            %Expected
                life of options
            
            
            5
                yearsRisk
                free interest rates
            
            
            4.67
            %Expected
                dividend yield
            
            
            0
            %




The
      following summarizes the activity of the Company’s non-vested restricted common
      stock for the three months ended March 31, 2007:




Shares
            
            Weighted
                Average
              Grant
                Date Fair ValueNon-vested
                at January 1, 2007
            
            
            85,000
            
            $
            0.49Granted
            
            
            139,000
            
            
            1.16Cancelled
                or expired
            
            
            (20,000
            )
            
            0.63Vested
                during the period
            
            
            (0
            )
            
            0.00Non-vested
                at March 31, 2007
            
            
            204,000
            
            $
            1.03


During
      the three months ended March 31, 2007 the Company granted 139,000 shares of
      restricted common stock to its Board of Directors which vests on March 12,
      2008.
      As of March 31, 2007, the Company recognized $13,000 in compensation expense
      related to this grant and there was $148,000 of unrecognized compensation cost,
      which will be recognized through the first quarter of 2008.




(4)
            Marketable
                Securities





As
      of
      December 31, 2006 the Company held 42,000 shares of a customer’s common stock
      with a market value of $60,000. During the three months ended March 31, 2007
      the
      Company sold 26,000


-10-
 *Table
          of Contents*


shares
      of
      this stock and received proceeds of $19,000 and recorded a realized loss of
      $1,000 on the sale. For the three months ended March 31, 2007, the market value
      of the remaining shares decreased to $12,000 ($0.72 per share) and the Company
      recorded an unrealized loss of $28,000. The Company classifies these shares
      as
      trading securities and pursuant to SFAS No. 115, “ *Accounting
      for Certain Investments in Debt and Equity Securities* ”,
      unrealized gains and losses are included in the determination of net income
      (loss). Other expense includes $28,000 and $38,000 of net unrealized loss for
      the three months ended March 31, 2007 and 2006, respectively, on these
      securities. The Company’s former Chief Executive Officer (who was a director and
      shareholder of the Company) was a director of this customer.





The
      Company invests its idle cash in 30 and 60 day United States Treasury Bills.
      The
      Company does not accrue interest on these Treasury Bills rather the interest
      is
      recorded at maturity. For the three months ended March 31, 2007, there was
      $23,000 of un-accrued interest on these Treasury Bills.




(5)
            Series
                C-IV Convertible Preferred Stock





During
      the three months ended March 31, 2007 all 1,849,000 shares of Series C-IV
      Convertible Preferred Stock were converted into 3,072,000 shares of the
      Company’s common stock. As of March 31, 2007 there are no remaining shares of
      the Series C-IV Convertible Preferred stock.




(6)
            Series
                D Redeemable, Convertible Preferred
                Stock





During
      the three months ended March 31, 2007 Midsummer Capital and Islandia converted
      1,194 shares of the Series D redeemable, convertible preferred stock into
      1,590,000 shares of the Company’s common stock. During the three months ended
      March 31, 2006 Midsummer Capital converted 175 shares of their Series D
      redeemable, convertible preferred stock into 250,000 shares of the Company’s
      common stock. During the three months ended March 31, 2007 the Company accrued
      dividends of $53,000 and paid dividends in the amount of $55,000 through the
      issuance of 77,000 shares.





(7)
            Common
                Stock Options





During
      the three months ended March 31, 2007 certain employees exercised 677,000 stock
      options in cashless exercises and subsequently surrendered 295,000 shares in
      payment of the options and taxes and the Company recorded these shares as
      Treasury shares at cost. During the three months ended March 31, 2007 certain
      former employees exercised their stock options and the Company received $400,000
      in proceeds and issued 633,000 shares of common stock.




(8)
            Common
                Stock Warrants





During
      the three months ended March 31, 2007 certain warrant holders exercised their
      warrants in a cashless exercise and the Company issued 27,000 shares of Common
      Stock.  During
      the three months ended March 31, 2006 certain warrant holders exercised their
      warrants and the Company received proceeds of $127,000 and issued 232,000 shares
      of Common Stock.


-11-
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          of Contents*





(9)
            Warrant
                Derivative Liability




During
      the three months ended March 31, 2007 the Company recorded $914,000 of other
      expense to reflect the change in the fair value of the warrant derivative
      liability.




(10)
            Customer
                Concentration





For
      the
      three months ended March 31, 2007, one customer accounted for 14% of revenue.
      For the three months ended March 31, 2006, three customers accounted for 16%,
      16% and 14% of the revenue.




(11)
            Subsequent
                Events





Subsequent
      to March 31, 2007, Midsummer Capital converted 998 shares, all their remaining
      Series D Redeemable, Convertible Preferred Stock and received 1,438,000 shares
      of common stock. Midsummer also exercised a portion of their B Warrant and
      received 1,058,000 shares of common stock and the Company received proceeds
      of
      $798,000.




(12)
            Effect
                of Recently Issued Accounting
                Pronouncements




On
      January 1, 2007, the Company adopted the provisions of Financial Accounting
      Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in
      Income Taxes” (“FIN 48”), an interpretation of FASB Statement No. 109,
“Accounting for Income Taxes.” FIN 48 prescribes a recognition threshold and
      measurement attribute for the financial statement recognition and measurement
      of
      a tax position taken or expected to be taken in a tax return. The interpretation
      requires that the Company recognize the impact of a tax position in the
      financial statements if that position is more likely than not of being sustained
      on audit, based on the technical merits of the position. FIN 48 also provides
      guidance on derecognition, classification, interest and penalties, accounting
      in
      interim periods and disclosure. In accordance with the provisions of FIN 48,
      any
      cumulative effect resulting from the change in accounting principle is to be
      recorded as an adjustment to the opening balance of accumulated
      deficit.




The
      Company is in the process of performing an analysis of the limitations on use
      of
      our net operating losses under Section 382 of the Internal Revenue Code. Once
      determined, the effect of the net operating loss limitation will be a reduction
      of the deferred tax asset and corresponding reduction of the related valuation
      allowance.


-12-
 *Table
          of Contents*
  **Item
                2.**
              **Management’s
                  Discussion and Analysis of Financial Condition and Results****of
                  Operations.**





**Forward-Looking
      Statement**





This
      document contains forward-looking statements concerning our expectations, plans,
      objectives, future financial performance and other statements that are not
      historical facts. These statements are “forward-looking statements” within the
      meaning of the Private Securities Litigation Reform Act of 1995. In most cases,
      you can identify forward-looking statements by terminology such as “may,”
“might,” “will,” “would,” “can”, “could,” “should,” “expect,” “foresee,” “plan,”
“anticipate,” “assume,” “believe,” “estimate,” “predict,” “potential,”
“objective,” “forecast,” “goal” or “continue,” the negative of such terms, their
      cognates, or other comparable terminology.




These
      statements are only predictions, and actual events or results may differ
      materially. The forward-looking statements are based on management’s beliefs and
      assumption using information available at the time. We cannot guarantee future
      results, levels of activity, performance or achievements. Factors that may
      cause
      actual results to differ are often presented with the forward-looking statements
      themselves. Additionally, other risks that may cause actual results to differ
      from predicted results are set forth, and in “ *Risk
      Factors That May Affect Future Operating Results* "
      in the
      Company's Form 10-K for the year ended December 31, 2006.




Many
      of
      the forward-looking statements are subject to additional risks related to our
      need to either secure additional financing or to increase revenues to support
      our operations or business or technological factors. We believe that between
      the
      funds we have on hand and the funds we expect to generate, we have sufficient
      funds to finance our operations for the next 12 months. However, additional
      funds may be required in order to pursue strategic opportunities or for capital
      expenditures. In addition, there is no assurance that additional funds will
      not
      be required to support our operations. In this regard, the business and
      operations of the Company are subject to substantial risks that increase the
      uncertainty inherent in the forward-looking statements contained in this Form
      10-Q. In evaluating our business, you should give careful consideration to
      the
      information set forth below under the caption “ *Risk
      Factors That May Affect Future Operating Results* "
      in the
      Company's Form 10-K for the year ended December 31, 2006, in addition to the
      other information set forth herein.




We
      undertake no duty to update any of the forward-looking statements, whether
      as a
      result of new information, future events or otherwise. In light of the
      foregoing, readers are cautioned not to place undue reliance on the
      forward-looking statements contained in this report.





**Overview**




On2
      Technologies is a developer of video compression technology. We have developed
      a
      proprietary technology platform and the TrueMotion® VPx family (e.g., VP5TM,
      VP6TM, VP7TM) of video compression/decompression (“codec”) software to deliver
      high-quality video at the lowest possible data rates over proprietary networks
      and the Internet to set-top boxes, personal computers and wireless devices.
      Unlike many other video codecs that are based on standard compression
      specifications set by industry groups (e.g., MPEG-2 and H.264), our video
      compression/decompression technology is based solely on intellectual property
      that we developed and own ourselves.




In
      2004,
      we licensed our video compression technology to Macromedia, Inc. (now Adobe
      Systems Incorporated) for use in the Flash® multimedia player. In anticipation
      of Adobe using our codec in the


-13-
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          of Contents*




Flash
      platform, we launched our business of developing and marketing video encoding
      software for the Flash platform. While our primary focus remains the development
      of video compression technology, our Flash encoding business has become an
      increasingly important part of our business.




We
      offer
      the following suite of products and services that incorporate our proprietary
      compression technology:




**Products**
            ·Video
                codecs;
              ·Audio
                codecs; and
              ·Encoding
                and server software, for use with video delivery
                platforms**Services**
            ·Customized
                engineering and consulting services; and
              ·Technical
                support





Many
      of
      our customers are software developers who use our products and services chiefly
      to provide the following video-related products and services to end users:




**TYPE
                OF CUSTOMER APPLICATION**
            **EXAMPLES**Video
                and Audio Distribution over Proprietary Networks
            ·Providing
                video-on-demand services to residents in multi-dwelling units
                (MDUs)
              ·Video
                surveillanceConsumer
                Electronic Devices
            ·Digital
                video players
              ·Digital
                video recordersWireless
                Applications
            ·Delivery
                of video via satellite
              ·Providing
                video to web-enabled cell phones and PDAsVideo
                and Audio Distribution over IP-based Networks (Internet)
            ·Video-on-demand
              ·Teleconferencing
                services
              ·Video
                instant messaging
              ·Video
                for Voice-over-IP (VOIP) servicesUser-Generated
                Content (“UGC”) Sites
            ·Providing
                encoding software for use on UGC site operators’ servers
              ·Providing
                encoding software for users who are creating UGC
              ·Providing
                transcoding software to allow UGC site operators to convert video
                from one
                format to another





We
      have
      begun marketing encoding software for use either by end users or by developers
      who want to add video-encoding functionality to the software they have
      developed.


-14-
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          of Contents*




We
      earn
      revenue chiefly through licensing our software and providing specialized
      software engineering and consulting services to customers. In addition to
      up-front license fees, we often require that customers pay us royalties in
      connection with their use of our software. The royalties may come in the form
      of
      either a fee for each unit of the customer’s products containing the relevant
      On2 software products that are sold or distributed or payments based on a
      percentage of the revenues that the customer earns from any of its products
      or
      services that use our software. Royalties may be subject to guaranteed minimum
      amounts and/or maximum amounts (e.g., annual caps).




We
      have
      begun selling additional products and services that relate to our existing
      relationships with licensees. For instance, if a customer has licensed our
      software to develop its own proprietary video format and video players, we
      may
      sell encoding software to users who want to encode video for playback on our
      customers’ players or we may provide engineering services to companies that want
      to modify our customer’s software for use on a specific platform, such as a cell
      phone. As with royalties or revenue share arrangements, complementary sales
      of
      encoding software or engineering services should allow us to participate in
      the
      success of our customers’ products. For instance, if a customer’s video platform
      does well commercially, we would expect there to be a market for encoding
      software and/or engineering services in support of that platform.




As
      part
      of our strategy to develop complementary products that could allow us to
      capitalize on our customers’ success, in April 2005 we completed the acquisition
      from Wildform, Inc., of its Flix® line of encoding software. The Flix software
      allows users to prepare video and other multimedia content for playback on
      the
      Adobe Flash player, which is one of the most widely distributed multimedia
      players. Adobe is currently using our VP6 software as the core video engine
      for
      Flash 8 video, which is the latest version of Flash video and is used in the
      Flash 8 and Flash 9 players. We therefore believed that there was an opportunity
      for us to sell Flash 8 encoding software to end users, such as video
      professionals and web designers, and to software development companies that
      wish
      to add Flash 8 encoding functionality to their software. We concluded that
      by
      taking the well-regarded Flix software and updating it with Flash 8 encoding
      capability, we could best take advantage of the anticipated success of Flash
      8
      by taking the most up-to-date Flash 8 encoding software straight from the
      company that developed Flash 8 video and combining it with the already
      well-known Flix brand, which has existed since the advent of Flash video and
      has
      a loyal following among users.




A
      primary
      factor that will be critical to our success is our ability to improve
      continually on our current video compression software, so that it streams the
      highest-quality video at the lowest transmission rates (bit rate). We believe
      that our video compression software is highly efficient, allowing customers
      to
      stream good quality video (as compared with that of our competitors) at low
      bit
      rates (i.e., over slow connections) and unsurpassed high-resolution video at
      high bit rates (i.e., over broadband connections). As connection speeds
      increase, however, the advantage that our highly efficient software has over
      competing technology may decrease.




Another
      factor that may affect our success is the relative complexity of our video
      compression software compared with other compression software producing
      comparable compression rates and image quality. Software with lower complexity
      can run on a computer chip that is less powerful, and therefore generally less
      expensive, than would be required to run software that is comparatively more
      complex. In addition, the process of getting software to operate on a chip
      is
      easier if the software is less complex. Increased compression rates frequently
      result in increased complexity. While potential customers desire software that
      produces the highest possible compression rates while producing the best
      possible decompressed image, they also want to keep production costs low by
      using the lowest-powered and accordingly least expensive chips that will still
      allow them to perform the processing they require. In addition, in some
      applications, such as mobile devices, constraints such as size and battery
      life
      rather than price issues limit the power of the chips embedded in such devices.
      Of course, in devices where a great deal of processing


-15-
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power
      can
      be devoted to video compression and decompression, the issue of software
      complexity is less important. In addition, in certain applications, savings
      in
      chip costs related to the use of low complexity software may be offset by
      increased costs (or reduced revenue) stemming from less efficient compression
      (e.g., increased bandwidth costs).




One
      of
      the most significant recent trends in our business is our increasing reliance
      on
      the success of the product deployments of our customers. As referenced above,
      an
      increasing number of our license agreements with customers provide for the
      payment of license fees that are dependent on the number of units of a
      customer’s product incorporating our software that are sold or the amount of
      revenue generated by a customer from the sale of products or services that
      incorporate our software. We have chosen this royalty-dependent licensing model
      because, as a company of only 37 employees and in light of the vast range of
      conceivable video-enabled devices, we do not have the product development or
      marketing resources to develop and market end-to-end video solutions. Instead,
      our codec software is primarily intended to be used as a building block for
      companies that are developing end-to-end video products and/or services.




Under
      our
      agreements with certain customers, we have retained the right to market products
      that complement those customer applications. These arrangements allow us to
      take
      advantage of our customers’ superior ability to produce and market end-to-end
      video products, while offering those customers the benefit of having us produce
      technologically-advanced products that should contribute to the success of
      their
      applications. As with arrangements in which we receive royalties, the ability
      to
      market complementary products can yield revenues in excess of any initial,
      one-time license fee. In instances where we have licensed our products to
      well-known customers, our right to sell complementary products may be very
      valuable. But unlike royalties, which we receive automatically without any
      additional effort on our part, the successful sale of complementary products
      requires that we effectively execute an end-user product development and
      marketing program. Until recently, we have generally produced software targeted
      at developers, who integrate our software into their products, and developing
      and marketing products aimed at end users is therefore a relatively new business
      for us.




We
      believe that we have adopted the licensing model most appropriate for a business
      of our size and expertise. However, a natural result of this licensing model
      is
      that the amount of revenue we generate is highly dependent on the success of
      our
      customers’ product deployments. In certain circumstances, we may decide to
      reduce the amount of up-front license fees and charge a higher per-unit royalty.
      If the products of customers with whom we have established per unit royalty
      or
      revenue sharing relationships or for which we expect to market complementary
      products do not generate significant sales, these revenues may not attain
      significant levels. Conversely, if one or more of such customers’ products are
      widely adopted, our revenues will likely be enhanced.




We
      are
      continuing to participate in the trend towards the proliferation of user
      generated video content on the web. As Internet use has grown worldwide and
      Internet connection speeds have increased, sites such as MySpace and YouTube,
      which allow visitors to create and view user generated content (“UGC”), have
      sprung up and seen their popularity soar. Although initially that consumer
      generated content consisted primarily of text content and still photographs,
      the
      availability of relatively inexpensive digital video cameras, the growth in
      the
      number of users with access to broadband Internet connections and improvements
      in video compression technology have contributed to a rapid rise in
      consumer-created video content. Weblogs (blogs) and podcasts (broadcasts of
      audio content to iPod® and MP3 devices) have evolved to include video content.
      The continued proliferation of UGC video on the Internet and the popularity
      of
      Adobe® Flash® video on the web have had a positive effect on our business and
      has given us the opportunity to license Flash encoding tools for use in video
      blogs, video podcasts, and to UGC sites or to individual users of those
      services.


-16-
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  We
        have
        recently experienced an increase interest by UGC site operators and device
        manufacturers to allow users to access UGC content by means of mobile devices,
        set-top boxes, and other devices. Many of the UGC sites use Flash 8 VP6 video,
        and while Flash 8 video is available on a vast number of PCs, it is just
        now
        beginning to become available on chip-based devices, such as mobile devices
        and
        set top boxes. We are therefore witnessing a twofold demand: to integrate
        Flash
        8 video onto non-PC platforms and, until most devices can play Flash 8 content,
        to provide transcoding software that allows Flash 8 content to be decoded
        and
        re-encoded into a format that is supported on devices, such as the 3GPP
        standard. We are actively working to provide solutions for both of these
        demands
        and plan to continue to respond as necessary to the evolution and migration
        of
        Flash video.




A
      continuing trend in our business is the growing presence of Microsoft, Inc.
      as a
      principal competitor in the market for digital media creation and distribution
      technology. Microsoft currently competes with us in the market for digital
      media
      servers, players, codecs and other technology and services related to digital
      distribution of media. Microsoft distributes its competing streaming encoder,
      media server, player, tools and digital rights management products by bundling
      them with its Windows operating systems and servers at no additional cost or
      otherwise making them available free of charge or at a low cost. Microsoft’s
      practices have caused, and may continue to cause, pricing pressure on our
      revenue generating products and services and may affect usage of our competing
      products and formats. Microsoft’s marketing and licensing model has in some
      cases led, and could continue to lead, to longer sales cycles, decreased sales,
      loss of existing and potential customers and reduced market share. In addition,
      we believe that Microsoft has used and may continue to use its competitive
      position in the computer industry and its financial resources to secure
      preferential or exclusive distribution, use and bundling contracts for its
      media
      delivery technologies and products with third parties, such as ISPs, content
      delivery networks, content providers, entertainment and media companies, VARs
      and OEMs, including those third parties with whom we have relationships.
      Finally, Microsoft’s DRM (digital rights management) product, which prevents
      unauthorized copying and re-distribution of proprietary content, is widely
      accepted among movie studios and others in the content industry. Unfortunately,
      Microsoft’s DRM does not integrate well with non-Microsoft video and audio
      software, such as ours.




We
      believe that the latest generation of codec technology, which includes VP7,
      is
      superior to Microsoft’s video compression software. We also believe that
      companies may become more comfortable with using DRM technology produced by
      companies other than Microsoft.




H.264
      is
      also a competitor in the video compression field. H.264 is a standards-based
      codec that is the successor to MPEG-4. We believe our technology is superior
      to
      H.264, and that we can offer significantly more flexibility in licensing terms
      than customers will receive when licensing H.264. H.264 has nevertheless gained
      significant adoption by potential customers because, as a standards-based codec,
      it has the advantage of having numerous developers who are programming to the
      H.264 standard and developing products based on that standard. In addition,
      a
      number of manufacturers of multimedia processors have done the work necessary
      to
      have H.264 operate on their chips, which makes H.264 attractive to potential
      customers who would like to enable video on devices. For example, Apple Inc.
      uses H.264 in its QuickTime® player and, as a result, has chosen H.264 for the
      current generation of video iPods®. These advantages may make H.264 attractive
      to potential customers and allow them to implement a solution based on H.264
      with less initial development time and expense than a solution using On2 Video
      might require. In addition, there are certain customers that prefer to license
      standards-based codecs.




The
      market for digital media creation and delivery technology is constantly changing
      and becoming increasingly competitive. Our strategy includes focusing on
      providing our customers with video compression/decompression technology that
      delivers the highest possible video quality at the lowest possible data rates.
      To do this, we devote a significant portion of our engineering capacity to
      research and


-17-
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          of Contents*




development.
      We also are devoting significant attention to enabling our codecs to operate
      on
      a wide array of chips. This should encourage use by customers who want to
      develop video-enabled consumer products in a short timeframe. We are doing
      this
      both by bolstering our team of engineers who integrate our codecs on chips
      and
      by developing relationships with chip companies and enabling them to perform
      such integration.




Although
      we expect that competition from Microsoft, H.264 developers, and others will
      continue to intensify, we expect that our video compression technology will
      remain competitive and that our relatively small size will allow us to innovate
      in the video compression field and respond to emerging trends more quickly
      than
      monolithic organizations, such as Microsoft and the MPEG consortium. We also
      focus on developing relationships with customers who find it appealing to work
      with a smaller company that is not bound by complex and rigid standards-based
      licenses and fee structures and that is able to offer sophisticated custom
      engineering services.




**Critical
      Accounting Policies and Estimates**




This
      discussion and analysis of our financial condition and results of operations
      are
      based on our unaudited consolidated financial statements that have been prepared
      under accounting principles generally accepted in the United States of America.
      The preparation of financial statements in conformity with accounting principles
      generally accepted in the United States of America requires our management
      to
      make estimates and assumptions that affect the reported amounts of assets and
      liabilities and the disclosure of contingent assets and liabilities at the
      date
      of the financial statements and the reported amounts of revenue and expenses
      during the reporting period. Actual results could materially differ from those
      estimates. We have disclosed all significant accounting policies in note 1
      to
      the consolidated financial statements included in this Form 10-K. The
      unaudited consolidated financial statements and the related notes thereto should
      be read in conjunction with the following discussion of our critical accounting
      policies. Our critical accounting policies and estimates are:




•
            Revenue
                recognition•
            Equity-based
                compensation•
            Valuation
                of goodwill, intangible assets and other long-lived assets




*Revenue
      Recognition.* We
      currently recognize revenue from professional services and the sale of software
      licenses. As described below, significant management judgments and estimates
      must be made and used in determining the amount of revenue recognized in any
      given accounting period. Material differences may result in the amount and
      timing of our revenue for any given accounting period depending upon judgments
      made by or estimates utilized by management.





We
      recognize revenue in accordance with SOP 97-2, “SOFTWARE REVENUE RECOGNITION”
(“SOP 97-2”), as amended by SOP 98-4, “DEFERRAL OF THE EFFECTIVE DATE OF SOP
      97-2, SOFTWARE REVENUE RECOGNITION” and SOP 98-9, “MODIFICATION OF SOP 97-2 WITH
      RESPECT TO CERTAIN TRANSACTIONS” (“SOP 98-9”). Under each arrangement, revenues
      are recognized when a non-cancelable agreement has been signed and the customer
      acknowledges an unconditional obligation to pay, the products or applications
      have been delivered, there are no uncertainties surrounding customer acceptance,
      the fees are fixed and determinable, and collection is considered probable.
      Revenues recognized from multiple-element software arrangements are allocated
      to
      each element of the arrangement based on the fair values of the elements, such
      as product licenses, post


-18-
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          of Contents*




contract
      customer support, or training. The determination of the fair value is based
      on
      the vendor specific objective evidence available to us. If such evidence of
      the
      fair value of each element of the arrangement does not exist, we defer all
      revenue from the arrangement until such time that evidence of the fair value
      does exist or until all elements of the arrangement are delivered.




Our
      software licensing arrangements typically consist of two elements: a software
      license and post-contract customer support (“PCS”). We recognize license
      revenues based on the residual method after all elements other than PCS have
      been delivered as prescribed by SOP 98-9. We recognize PCS revenues over the
      term of the maintenance contract or on a “per usage” basis, whichever is stated
      in the contract. Vendor specific objective evidence of the fair value of PCS
      is
      determined by reference to the price the customer will have to pay for PCS
      when
      it is sold separately (i.e. the renewal rate). Most of our license agreements
      offer additional PCS at a stated price. Revenue is recognized on a per copy
      basis for licensed software when each copy of the licensed software purchased
      by
      the customer or reseller is delivered. We do not allow returns, exchanges or
      price protection for sales of software licenses to our customers or resellers,
      and we do not allow our resellers to purchase software licenses under
      consignment arrangements.





When
      engineering and consulting services are sold together with a software license,
      the arrangement typically requires customization and integration of the software
      into a third party hardware platform. In these arrangements, we require the
      customer to pay a fixed fee for the engineering and consulting services and
      a
      licensing fee in the form of a per-unit royalty. We account for engineering
      and
      consulting arrangements in accordance with SOP 81-1, “ACCOUNTING FOR PERFORMANCE
      OF CONSTRUCTION TYPE AND CERTAIN PRODUCTION TYPE CONTRACTS,” (“SOP 81-1”). When
      reliable estimates are available for the costs and efforts necessary to complete
      the engineering or consulting services and those services do not include
      contractual milestones or other acceptance criteria, we recognize revenue under
      the percentage of completion contract method based upon input measures, such
      as
      hours. When such estimates are not available, we defer all revenue recognition
      until we have completed the contract and have no further obligations to the
      customer.





Encoding
      services consist of services that convert video and audio content into formats
      for delivery to end-users. Encoding services are generally provided under per
      unit or time and materials contracts. Under these contracts, we recognize
      revenue when services have been rendered and we have no further interest or
      obligation in the goods and services, which is generally the date on which
      the
      goods or services have been delivered to the customer.




*Equity-Based
      Compensation* In
      December 2004, the Financial Accounting Standards Board (“FASB”) issued
      Statement of Financial Accounting Standards (“SFAS”) No. 123R “Share-Based
      Payment” (“SFAS 123R”), which requires all share-based payments to
      employees, including grants of employee stock options, to be recognized in
      the
      statement of operations as an operating expense, based on their fair values
      on
      grant date. Prior to the adoption of SFAS 123R, we accounted for stock based
      compensation using the intrinsic value method. We adopted the provisions of
      SFAS
      No. 123R effective January 1, 2006, using the modified prospective transition
      method. Under the modified prospective method, non-cash compensation expense
      is
      recognized under the fair value method for the portion of outstanding share
      based awards granted prior to the adoption of SFAS 123R for which service has
      not been rendered, and for any future share based awards granted or modified
      after adoption. Accordingly, periods prior to adoption have not been restated.
      We recognize share-based compensation cost associated with awards subject to
      graded vesting in accordance with the accelerated method specified in FASB
      Interpretation No. 28 pursuant to which each vesting tranche is treated as
      a
      separate award. The compensation cost associated with each vesting tranche
      is
      recognized as expense evenly over the vesting period of that
      tranche.


-19-
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          of Contents*




*Valuation
      of Goodwill, Intangible Assets and Other Long-Lived Assets.* In
      June
      2001, the FASB issued SFAS No. 142, *“Goodwill
      and Other Intangible Assets”* (“SFAS
      No. 142”). SFAS 142 requires goodwill and other intangible assets to be
      tested for impairment at least annually, and written off when impaired, rather
      than being amortized as previously required.





Long-lived
      assets and identifiable intangibles with finite lives are reviewed for
      impairment whenever events or changes in circumstances indicate that the
      carrying amount of an asset may not be recoverable. Recoverability of assets
      to
      be held and used is measured by a comparison of the carrying amount of an asset
      to future undiscounted net cash flows expected to be generated by the asset.
      If
      such assets are considered to be impaired, the impairment recognized is measured
      by the amount by which the carrying amount of the assets exceeds the fair value
      of the assets. Assets to be disposed of are reported at the lower of the
      carrying amount or fair value less costs to sell. As of March 31, 2007, we
      believe that no such impairment has occurred.




**Results
      of Operations**





*Revenue.*





Revenue
      for the three months ended March 31, 2007 was $2,815,000 as compared to
      $1,217,000 for the three months ended March 31, 2006. Revenue is derived
      primarily from the sale of software licenses and engineering and support
      services.





For
      the
      three months ended March 31, 2007, one customer accounted for 14% of revenue.
      For the three months ended March 31, 2006, three customers accounted for 16%,
      16% and 14% of the revenue.





*Operating
      expenses*





The
      Company's operating expenses consist of cost of revenue, research and
      development, sales and marketing and general and administrative expenses.
      Operating expenses for the three months ended March 31, 2007, were $2,619,000
      as
      compared to $2,366,000 for the three months ended March 31, 2006.





*Cost
      of Revenue.* Cost of
      revenue includes personnel and related overhead expenses, royalties paid for
      software that is incorporated into the Company’s software, consulting
      compensation costs, operating lease costs and depreciation and amortization
      costs. Cost of revenue was $423,000 for the three months ended March 31, 2007
      as
      compared to $583,000 for the three months ended March 31, 2006. The decrease
      of
      $160,000 for the three months ended March 31, 2007 as compared with the three
      months ended March 31, 2006 is principally a result of a decrease in the costs
      associated with the support of the Flix software, equity-based compensation
      and
      the decreased use of resources in connection with engineering service related
      projects for current customers.




*Research
      and Development.* Research
      and development expenses, excluding equity-based compensation, primarily consist
      of personnel and related overhead expenses and consulting compensation costs
      associated with the development and production of our products and services,
      operating lease costs and depreciation costs. Research and development expenses
      for the three months ended March 31, 2007 were $493,000, as compared with
      $225,000 for the three months ended March 31, 2006. The increase of $268,000
      in
      2007 is primarily a result of using research and development personnel in prior
      years in software implementations and their costs were then charged to cost
      of
      revenue. We believe that continued investments in research and development
      are
      necessary to maintain our competitive advantage and we will continue to invest
      in such costs as considered necessary.


-20-
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          of Contents*




*Sales
      and Marketing.* Sales
      and marketing expenses, excluding stock-based compensation, consist primarily
      of
      salaries and commissions and related overhead costs, business development and
      marketing personnel, tradeshow costs, marketing and promotional costs incurred
      to create brand awareness and public relations expenses. Sales and marketing
      expenses for the three months ended March 31, 2007, were $596,000, as compared
      to $188,000 for the three months ended March 31, 2006. The increase of $408,000
      is primarily a result of increases in personnel and related overhead from the
      addition of three sales people, one business development person and two
      marketing people and increases in sales commissions. There were also increases
      in marketing consulting fees, tradeshow fees and advertising costs. We intend
      to
      continue to recruit and hire experienced personnel or consultants, as necessary,
      to sell and market our products and services.





*General
      and Administrative* .
      General
      and administrative expenses, excluding stock-based compensation, consist
      primarily of salaries and related personnel costs for general corporate
      functions, professional fees, insurance, rent and utilities and depreciation.
      General and administrative costs for the three months ended March 31, 2007,
      were
      $959,000, as compared with $1,260,000 for the three months ended March 31,
      2006.
      The $301,000 decrease is principally attributable to a decrease in professional
      fees in connection with the Company’s internal investigation into facts and
      circumstances concerning investor and other communications made by the Company’s
      former Chairman, Chief Executive Officer and President.





*Equity-based
      compensation,* In
      December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No.
      123R “Share-Based Payment” (“SFAS 123R”), which requires all share-based
      payments to employees, including grants of employee stock options, to be
      recognized in the statement of operations as an operating expense, based on
      their fair values on grant date. Pro forma disclosure is no longer an
      alternative. The Company adopted the provision of SFAS No. 123R effective
      January 1, 2006.





The
      equity-based compensation expense for the three months ended March 31, 2007
      was
      $149,000, of which $1,000 is included in cost of revenue and $148,000 is shown
      separately, as compared with $167,000, of which $57,000 is included in cost
      of
      revenue and $110,000 is shown separately for the three months ended March 31,
      2006.





*Interest
      and other expense, net.* Interest
      and other expense, net primarily consists the change in the fair value of the
      derivative liability in connection with the warrants issued in August 2006,
      interest paid for capital lease obligations and long-term debt, interest earned
      on the Company’s cash balances, amortization of debt discount and unrealized
      losses on marketable securities. Interest and other expense, net was $913,000
      for the three months ended March 321, 2007 as compared with $27,000 for the
      three months ended March 31, 2006.





The
      increase of $907,000 is primarily a result of an increase of $914,000 in the
      fair value of the derivative liability as a result of the increase in the
      Company’s stock price at March 31, 2007 as compared with December 31, 2006. The
      warrant derivative liability was recorded in connection with the August 2006
      sale of common stock and warrants to a group of investors led by Midsummer
      Capital.





Interest
      income, net of interest expense was $29,000 for the three months ended March
      31,
      2007 as compared with $8,000 for the three months ended March 31, 2006. The
      increase of $21,000 is a result of additional cash available for investment
      partially offset by a decrease in interest expense as a result of the
      elimination of the Series A Secured Convertible Debentures at the end of the
      first quarter of 2006.


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At
      March
      31, 2007, we had approximately 39 full-time employees. We expect to hire
      employees as necessary in order to attain our strategic objectives.




**Liquidity
      and Capital Resources**





At
      March
      31, 2007, we had cash and cash equivalents of $5,281,000 as compared to
      $4,961,000 at December 31, 2006. At March 31, 2007 the Company had working
      capital of $5,860,000 as compared with $5,268,000 at December 31, 2006.





Net
      cash
      used in operating activities was $72,000 and $892,000 for the three months
      ended
      March 31, 2007 and 2006, respectively. The decrease in net cash used in
      operating activities is primarily attributable to a decrease in the net loss,
      an
      increase in warrant derivative liability and the changes in accounts receivable.
      Accounts payable and accrued expenses.





Net
      cash
      provided by investing activities was $36,000 and $51,000 for the three months
      ended March 31, 2007 and 2006, respectively. The decrease of $15,000 is a result
      of a $53,000 increase in the purchase of property and equipment offset by a
      $38,000 increase in proceeds from the sale of marketable securities.





Net
      cash
      provided by financing activities was $358,000 and $153,000 for the three months
      ended March 31, 2007 and 2006, respectively. The $205,000 increase is primarily
      attributable to $242,000 increase in proceeds from the exercise of common stock
      options and warrants partially offset by increases in principal payments on
      capital leases and term loan. .





We
      currently have no material commitments for the next 12 months other than those
      under our operating lease arrangements. These arrangements consist primarily
      of
      lease arrangements for our office space in Clifton Park, Tarrytown, New York
      and
      Cambridge UK. The aggregate required payments for the next 12 months under
      these
      arrangements are $159,000. Notwithstanding the above, our most significant
      non-contractual operating costs for the next 12 months are compensation and
      benefit costs, insurance costs and general overhead costs such as telephone
      and
      utilities. During the next 12 months, we anticipate incurring approximately
      $785,000 per month in cash operating costs.





The
      Company believes that existing funds are sufficient to fund its operations
      through March 31, 2008. The Company plans to increase cash flows from operations
      principally from increases in revenue generated from its compression technology
      services and products. The Company may also pursue additional financings. See
      “ *Management’s
      Discussion and Analysis of Financial Condition and Results of Operations -
      Risk
      Factors That May Affect Future Operating Results* ”
in
      the
      Company’s 10-K for the year ended December 31, 2006, filed on March 23,
      2007.





We
      have
      experienced significant operating losses and negative operating cash flows
      to
      date. Our management's plan to increase our cash flows from operations relies
      significantly on increases in revenue generated from our technology services
      and
      products. However, there are no assurances that we will be successful in
      effecting such increases. The market for distribution of broadband technology
      services is highly competitive. Additionally, our capital requirements depend
      on
      numerous factors, including market acceptance of our technology and services,
      research and development costs and the resources we spend on marketing and
      selling our products and services. Additionally, we continue to evaluate
      investments in complementary businesses, products and services, some of which
      may be significant.


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**Off-Balance
      Sheet Arrangements**





The
      Company has no off-balance sheet arrangements that have or are reasonably likely
      to have a current or future effect on the Company's financial condition, changes
      in financial condition, revenues or expenses, results of operations, liquidity,
      capital expenditures or capital resources that is material to
      investors.




**Impact
      of Recently-Issued Accounting Pronouncements**





On
      January 1, 2007, the Company adopted the provisions of Financial Accounting
      Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in
      Income Taxes” (“FIN 48”), an interpretation of FASB Statement No. 109,
“Accounting for Income Taxes.” FIN 48 prescribes a recognition threshold and
      measurement attribute for the financial statement recognition and measurement
      of
      a tax position taken or expected to be taken in a tax return. The interpretation
      requires that the Company recognize the impact of a tax position in the
      financial statements if that position is more likely than not of being sustained
      on audit, based on the technical merits of the position. FIN 48 also provides
      guidance on derecognition, classification, interest and penalties, accounting
      in
      interim periods and disclosure. In accordance with the provisions of FIN 48,
      any
      cumulative effect resulting from the change in accounting principle is to be
      recorded as an adjustment to the opening balance of accumulated deficit.





The
      Company is in the process of performing an analysis of the limitations on use
      of
      our net operating losses under Section 382 of the Internal Revenue Code. Once
      determined, the effect of the net operating loss limitation will be a reduction
      of the deferred tax asset and corresponding reduction of the related valuation
      allowance.




**Item
              3.**
            **Quantitative
                and Qualitative Disclosures About
                Risk**





The
      Company does not currently have any material exposure to interest rate risk,
      foreign currency risk, exchange rate risk, commodity price risk or other
      relevant market rate or price risks. However, the Company does have some
      exposure to foreign currency rate fluctuations arising from maintaining an
      office for the Company's U.K. based, wholly-owned subsidiary which transacts
      business in the local functional currency. The U.K. based subsidiary does not
      conduct any sales and all their costs are funded in United States dollars.
      To
      date, the Company has not entered into any derivative financial instrument
      to
      manage foreign currency risk and is not currently evaluating the future use
      of
      any such financial instruments.





In
      addition, changes in the value of the Company’s common stock changes the fair
      value of the warrant derivative liability.




**Item
              4.**
            **Controls
                and Procedures**





(a)
            Evaluation
                of Disclosure Controls and
                Procedures:





(a)
            Evaluation
                of Disclosure Controls and
                Procedures:




An
      evaluation as of the end of the period covered by this report was carried out
      under the supervision and with the participation of our management, including
      our Chief Executive Officer and Chief Financial Officer, of the effectiveness
      of
      the design and operation of our disclosure controls and procedures (as defined
      in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934)
      as
      required by Securities Exchange Act Rules 13a-15(b) or 15d-15(b). Based on
      that
      evaluation, our Chief Executive Officer and our Chief Financial Officer have
      concluded that as of the end of the period covered by this report, our
      disclosure controls and procedures were effective.




(b)
            Changes
                in internal controls. ]





There
      were no changes in our internal control over financial reporting that occurred
      during our most recent fiscal quarter that have materially affected, or are
      reasonably likely to materially affect, our internal control over financial
      reporting.


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**PART
      II — OTHER INFORMATION**




**Item
              1.**
            **Legal
                Proceedings**





**Internal
      Investigation**





On
      March
      2, 2006, On2 filed a Form 8-K, which disclosed that it had voluntarily reported
      to the Securities and Exchange Commission (“SEC”) that On2 had undertaken an
      internal investigation into facts and circumstances concerning investor and
      other communications made by its former Chairman, Chief Executive Officer and
      President. On2 has completed its internal investigation, and, on May 5, 2006,
      the Company’s outside law firm submitted its final report to the Board of
      Directors. On2 subsequently delivered the report to the SEC and the American
      Stock Exchange on May 9, 2006. The Company has agreed to work with the SEC
      and
      the American Stock Exchange in connection with any investigations conducted
      by
      them. The Company has not uncovered any evidence of financial impropriety,
      and
      thus the Company continues to believe that the investigation will have no effect
      on previously filed financial statements or lead to any restatement of reported
      financial results.





**Beijing
      E-World**





On
      March
      31, 2006, On2 commenced arbitration against its customer, Beijing E-World,
      relating to a dispute arising from two license agreements that On2 and Beijing
      E-World entered into in June 2003.





Under
      those agreements, On2 licensed the source code to its video compression (codec)
      technology to Beijing E-World for use in Beijing E-World’s video disk (EVD) and
      high definition television (HDTV) products as well as for other non-EVD/HDTV
      products. We believe that the license agreements impose a number of obligations
      on Beijing E-World, including the requirements that:





·
            Beijing
                E-World pay to On2 certain minimum quarterly payments; and





·
            Beijing
                E-World use best reasonable efforts to have On2’s video codec “ported” to
                (i.e., integrated with) a chip to be used in EVD players.





On2
      has
      previously commenced arbitration regarding the license agreements with Beijing
      E-World. In March 2005, the London Court of International Arbitration tribunal
      released the decision of the arbitrator, in which he dismissed On2’s claims in
      the prior arbitration, as well as Beijing E-World’s counterclaims, and ruled
      that the license agreements remained in effect; and that the parties had a
      continuing obligation to work towards porting On2’s software to two
      commercially-available DSPs.





Although
      almost two years have passed since the conclusion of the previous arbitration,
      the parties have nevertheless not completed the required porting of On2’s
      software to two commercially available DSPs.




On2’s
      current arbitration claim alleges that, despite its obligations under the
      license agreements, Beijing E-World has:





·
            failed
                to pay On2 the quarterly payments of $1,232,000, which On2 believes
                are
                currently due and owing; and





·
            failed
                to use best reasonable efforts to have On2’s video codec ported to a chip.





On2
      has
      requested that the arbitrator award it approximately $5,690,000 in damages
      under
      the contract


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          of Contents*




and
      grant
      it further relief as may be just and equitable.





Beijing
      E-World has appeared in the arbitration, although it has not yet filed any
      responses to On2’s filings in the proceeding. Following Beijing E-World’s
      appearance, it entered into an agreement with On2 pursuant to which Beijing
      E-World agreed by November 30, 2006 to pay On2 an amount in settlement equal
      to
      approximately 25% of the remaining unpaid portion of the license fees set forth
      in the license agreements. Upon payment of the settlement payment, the parties
      will terminate the arbitration, the license agreements will terminate, and
      On2
      will release Beijing E-World from all liability arising from the matters
      underlying the arbitration. As of the date of filing, Beijing E-World has not
      paid the amount agreed for settlement.





**Item
              6.**
            **Exhibits
                and Reports on Form 8-K.**





(a)
            Exhibits





31.1
            Certification
                of Chief Executive Officer Pursuant to Rule
                13a-14(a)/15d-14(a)31.2
            Certification
                of Chief Financial Officer Pursuant to Rule
                13a-14(a)/15d-14(a)32.1
            Certification
                of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as
                Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.32.2
            Certification
                of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as
                Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.




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          of Contents*




**SIGNATURES**





In
      accordance with the requirements of the Exchange Act, the registrant has caused
      this report to be signed on its behalf by the undersigned, thereunto duly
      authorized.





**ON2
              TECHNOLOGIES, INC.(Registrant)**Date: May
              14,
              2007
            By:
            /s/ Anthony
              PrincipeName:  
                Anthony Principe
              Title:    
                Senior Vice President and Chief Financial Officer
              (Principal Financial Officer)




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