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 June 30, 2006.





 ̈  **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  þ 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.  ̈ Yes   ̈ No


-1-





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 August 1, 2006, was **** 96,110,049.





-2-


**Table
      of Contents**





**PART
      I — FINANCIAL INFORMATION**




PageItem
                1. Consolidated Financial Statements.Condensed
                Consolidated Balance Sheets at June 30, 2006 (unaudited) and December
                31,
                2005
            4Unaudited
                Condensed Consolidated Statements of Operations,Three
                and Six Months Ended June 30, 2006 and 2005
            5Unaudited
                Condensed Consolidated Statements of Comprehensive Loss for the Three
                andSix
                Months Ended June 30, 2006 and 2005
            6Unaudited
                Condensed Consolidated Statements of Cash FlowsSix
                Months Ended June 30, 2006 and 2005
            7Notes
                to Unaudited Condensed Consolidated Financial Statements
            9Item
                2. Management’s Discussion and Analysis of Financial Condition and Results
                of Operations
            15Item
                3. Quantitative and Qualitative Disclosures About Market
                Risk
            24Item
                4. Controls and Procedures
            24**PART
                II — OTHER INFORMATION**Item
                1. Legal Proceedings
            25Item
                4. Submission of Matters to a Vote of Security Holders
            26Item
                6. Exhibits and Reports on Form 8-K
            26Signatures
            28Certifications
            29





-3-


**PART
      I — FINANCIAL INFORMATION**





Item
      1.
      Consolidated Financial Statements





**ON2
      TECHNOLOGIES, INC.**


**CONDENSED
      CONSOLIDATED BALANCE SHEETS**





June
                30,2006
            
            December
                31, 2005(unaudited)**ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            2,776,000
            
            $
            3,976,000Marketable
                securities, at market
            
            
            56,000
            
            
            181,000Accounts
                receivable
            
            
            790,000
            
            
            746,000Prepaid
                and other current assets
            
            
            264,000
            
            
            186,000Total
                current assets
            
            
            3,886,000
            
            
            5,089,000Acquired
                Software, net
            
            
            567,000
            
            
            667,000Other
                Acquired Intangibles, net
            
            
            131,000
            
            
            154,000Goodwill
            
            
            244,000
            
            
            244,000Property
                and equipment, net
            
            
            136,000
            
            
            131,000Other
                assets
            
            
            50,000
            
            
            29,000Total
                assets
            
            $
            5,014,000
            
            $
            6,314,000**LIABILITIES
                AND STOCKHOLDERS’ EQUITY**Current
                liabilities:Accounts
                payable
            
            $
            165,000
            
            $
            41,000Accrued
                expenses
            
            
            357,000
            
            
            608,000Deferred
                revenue
            
            
            164,000
            
            
            241,000Term-loan
            
            
            96,000Capital
                lease obligation
            
            
            16,000
            
            
            20,000Total
                current liabilities
            
            
            798,000
            
            
            910,000Capital
                lease obligation, excluding current portion
            
            
            
            
            
            6,000Convertible
                debentures
            
            
            
            
            
            244,000Total
                liabilities
            
            
            798,000
            
            
            1,160,000Commitments
                and contingenciesSeries
                D redeemable convertible preferred stock
            
            
            3,615,000
            
            
            3,790,000Stockholders’
                equity:Preferred
                stock
            
            
            19,000
            
            
            19,000Common
                stock
            
            
            961,000
            
            
            923,000Additional
                paid-in capital
            
            
            121,847,000
            
            
            119,772,000Accumulated
                other comprehensive loss
            
            
            (45,000
            )
            
            (43,000
            )Accumulated
                deficit
            
            
            (122,181,000
            )
            
            (119,307,000
            )Total
                stockholders’ equity
            
            
            601,000
            
            
            1,364,000Total
                liabilities and stockholders’ equity
            
            $
            5,014,000
            
            $
            6,314,000




*See
      accompanying notes to unaudited condensed consolidated financial statements*





-4-


**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**





Three
                Months Ended
              June
                30,
            
            Six
                Months Ended
              June
                30,2006
            
            2005
            
            2006
            
            2005Revenue
            
            $
            1,535,000
            
            $
            346,000
            
            $
            2,752,000
            
            $
            699,000Operating
                expenses:Cost
                of revenue (1)
            
            
            705,000
            
            
            410,000
            
            
            1,288,000
            
            
            779,000Research
                and development (2)
            
            
            214,000
            
            
            248,000
            
            
            439,000
            
            
            506,000Sales
                and marketing (2)
            
            
            172,000
            
            
            194,000
            
            
            360,000
            
            
            305,000General
                and administrative (2)
            
            
            1,280,000
            
            
            564,000
            
            
            2,540,000
            
            
            1,281,000Equity-based
                compensation:Research
                and development
            
            
            25,000
            
            
            
            
            
            52,000Sales
                and marketing
            
            
            23,000
            
            
            
            
            
            58,000General
                and administrative
            
            
            663,000
            
            
            
            
            
            711,000Total
                operating expenses
            
            
            3,082,000
            
            
            1,416,000
            
            
            5,448,000
            
            
            2,871,000Loss
                from operations
            
            
            (1,547,000
            )
            
            (1,070,000
            )
            
            (2,696,000
            )
            
            (2,172,000
            )Interest
                and other income (expense), net
            
            
            1,000
            
            
            (59,000
            )
            
            (26,000
            )
            
            (259,000
            )Loss
                before provision for income taxes
            
            
            (1,546,000
            )
            
            (1,129,000
            )
            
            (2,722,000
            )
            
            (2,431,000
            )Provision
                for income taxes
            
            
            3,000
            
            
            12,000
            
            
            6,000
            
            
            12,000Net
                loss
            
            $
            (1,549,000
            )
            $
            (1,141,000
            )
            $
            (2,728,000
            )
            $
            (2,443,000
            )Convertible
                preferred stock deemed dividend
            
            
            
            
            
            180,000
            
            
            
            
            
            360,000Convertible
                preferred stock 8% dividend
            
            
            73,000
            
            
            81,000
            
            
            146,000
            
            
            162,000Accretion
                of costs associated with the Series D Preferred Stock
            
            
            
            
            
            22,000
            
            
            
            
            
            43,000Net
                loss attributable to common shareholders
            
            $
            (1,622,000
            )
            $
            (1,424,000
            )
            $
            (2,874,000
            )
            $
            (3,008,000
            )Basic
                and diluted net loss attributable to common shareholders per common
                share
            
            $
            (0.02
            )
            $
            (0.02
            )
            $
            (0.03
            )
            $
            (0.03
            )Weighted
                average basic and diluted common shares outstanding:
            
            
            95,530,000
            
            
            88,750,000
            
            
            94,232,000
            
            
            87,261,000




(1)
              Includes
                  equity-based compensation of $52,000 and $109,000 for the three
                  and six
                  monthsended
                  June 30, 2006.




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




*See
      accompanying notes to unaudited condensed consolidated financial
      statements*





-5-





**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS**





Three
                Months Ended
              June
                30,
            
            Six
                Months Ended
              June
                30,2006
            
            2005
            
            2006
            
            2005Net
                loss
            
            $
            (1,549,000
            )
            $
            (1,141,000
            )
            $
            (2,728,000
            )
            $
            (2,443,000
            )Other
                comprehensive income (loss):Foreign
                currency translation adjustment
            
            
            (1,000
            )
            
            (3,000
            )
            
            (2,000
            )
            
            4,000Comprehensive
                loss
            
            $
            (1,550,000
            )
            $
            (1,144,000
            )
            $
            (2,730,000
            )
            $
            (2,439,000
            )





*See
      accompanying notes to unaudited condensed consolidated financial
      statements*





-6-





**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**





Six
                Months Ended June 30,2006
            
            2005Cash
                flows from operating activities:Net
                loss
            
            $
            (2,728,000
            )
            $
            (2,443,000
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Equity-based
                compensation
            
            
            930,000Depreciation
                and amortization
            
            
            159,000
            
            
            73,000Amortization
                of debt discount
            
            
            6,000
            
            
            6,000Unrealized
                loss on marketable securities
            
            
            50,000
            
            
            286,000Changes
                in operating assets and liabilities:Accounts
                receivable
            
            
            (44,000
            )
            
            (193,000
            )Prepaid
                expenses and other assets
            
            
            (13,000
            )
            
            30,000Accounts
                payable, accrued expenses and other liabilities
            
            
            49,000
            
            
            (339,000
            )Deferred
                revenue
            
            
            (77,000
            )
            
            67,000Net
                cash used in operating activities
            
            
            (1,668,000
            )
            
            (2,513,000
            )Cash
                flows from investing activities:Acquisition
                of Flix Software line
            
            
            
            
            
            (1,229,000
            )Proceeds
                form the sale of marketable securities
            
            
            75,000Purchases
                of property and equipment
            
            
            (44,000
            )
            
            (104,000
            )Net
                cash provided by (used in) investing activities
            
            
            31,000
            
            
            (1,333,000
            )Cash
                flows from financing activities:Principal
                payments on capital lease obligations
            
            
            (10,000
            )
            
            (7,000
            )Proceeds
                from term-loan, net of repayments
            
            
            96,000
            
            
            (62,000
            )Proceeds
                from exercise of common stock options and warrants
            
            
            353,000
            
            
            4,158,000Net
                cash provided by financing activities
            
            
            439,000
            
            
            4,089,000Net
                change in cash and cash equivalents
            
            
            (1,198,000
            )
            
            243,000Effect
                of exchange rate changes on cash and cash equivalents
            
            
            (2,000
            )
            
            4,000Cash
                and cash equivalents, beginning of period
            
            
            3,976,000
            
            
            5,418,000Cash
                and cash equivalents, end of period
            
            $
            2,776,000
            
            $
            5,665,000





-7-




**ON2
      TECHNOLOGIES, INC.**


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





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





Six
                Months Ended June 30,2006
            
            2005Cash
                paid during the period for:Interest
            
            $
            2,000
            
            $
            4,000Taxes
            
            $
            8,000
            
            $
            11,000Conversion
                of debentures into shares of common stock
            
            $
            250,000Conversion
                of preferred stock into shares of common stock
            
            $
            175,000
            
            $
            14,000(Decrease)
                in accrued dividend on Series D Preferred Stock
            
            $
            (3,000
            )Stock
                issued to Wildform pursuant to the Support and Maintenance
                Agreement
            
            $
            258,000Common
                stock issued for dividends on Series D Preferred Stock
            
            $
            149,000
            
            $
            162,000Accretion
                of costs associated with the issuance of Series D Preferred
                Stock
            
            
            
            
            $
            43,000Convertible
                Preferred Stock deemed dividend
            
            
            
            
            $
            360,000





*See
      accompanying notes to unaudited condensed consolidated financial
      statements*





-8-





**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 proprietary technology platform and video
      compression/decompression software (“codec”) to deliver high-quality video at
      the lowest possible data rates to intra- and internets, such as set-top boxes,
      the Internet and wireless devices. 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
      (consisting of normally recurring accruals) 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 15, 2006.





(3)
      Recent Accounting Standards




In
      July
      2006, the FASB issued FASB Interpretation Number 48, *Accounting
      for Uncertainty in Income Taxes, an Interpretation of FASB Statement
      No. 109* ,
      (“FIN48”). FIN 48 prescribes a recognition threshold and measurement attribute
      for the financial statement recognition and measurement of a tax position taken
      in a tax return. The Company must determine whether it is “more-likely-than-not”
that a tax position will be sustained upon examination, including resolution
      of
      any related appeals or litigation processes, based on the technical merits
      of
      the position. Once it is determined that a position meets the
      more-likely-than-not recognition threshold, the position is measured to
      determine the amount of benefit to recognize in the financial statements. FIN
      48
      applies to all tax positions related to income taxes subject to FASB Statement
      No. 109, *Accounting
      for Income Taxes.* The
      interpretation clearly scopes out income tax positions related to FASB Statement
      No. 5, *Accounting
      for Contingencies.* The
      Company will adopt the provisions of this statement beginning in the first
      quarter of 2007. The cumulative effect of applying the provisions of FIN 48
      will
      be reported as an adjustment to the opening balance of retained earnings on
      January 1, 2007. The Company does not anticipate that the adoption of this
      statement will have a material effect on our financial position or results
      of
      operations.





-9-





(4)
      Stock-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. Prior to the adoption of SFAS 123R the
      Company accounted for stock based compensation using the intrinsic value, if
      any. The Company adopted the provision 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 for the portion
      of outstanding stock option awards granted prior to the adoption of SFAS 123R
      for which service has not been rendered, and for any future stock option grants.
      Accordingly, periods prior to adoption have not been restated. The Company
      recognizes share-based compensation costs on a straight-line basis over the
      requisite service periods of awards. That cost is recognized as compensation
      expense over the service period, which would normally be the vesting period
      of
      the options.





Pursuant
      to the Company’s 1999 Amended and Restated Incentive and Nonqualified Stock
      Option Plan (the “1999 Plan”), 5,500,000 shares of Common Stock are reserved for
      issuance. The 1999 Plan provides for the issuance of incentive stock options,
      which are intended to qualify under Section 422 of the Internal Revenue Code,
      non-qualified stock options and restricted stock grants. The granting of
      incentive stock options is subject to the limitations as set forth in the 1999
      Plan. Directors, officers, employees and consultants are eligible to receive
      grants under the 1999 Plan. A committee selected by the Company’s Board of
      Directors has the authority to approve option grants and the terms, which
      include the option price and the vesting terms. Options granted under the 1999
      Plan expire after a ten-year period and are subject to acceleration upon the
      occurrence of certain events.





Pursuant to the Company’s 2000 Nonqualified Stock Option Plan (the “2000 Plan”),
      5,000,000 shares of the Company’s Common Stock are reserved for issuance. The
      2000 Plan authorizes the Board of Directors to issue nonqualified stock options
      as provided in Section 422 of the Internal Revenue Code, restricted stock and
      stock appreciation rights. Only employees, including officers, of the Company
      and its subsidiaries are eligible to receive grants under the 2000 Plan. A
      committee selected by the Company’s Board of Directors has the authority to
      approve option grants and the terms, which include the option price and the
      vesting terms. Options granted under the 2000 Plan expire after a ten-year
      period and are subject to acceleration upon the occurrence of certain events.





In May 2005, the Company's stockholders approved the On2 Technologies, Inc.
      2005
      Incentive Compensation Plan (the “2005 Plan”). Pursuant to the Company’s 2005
      Plan, 7,000,000 shares of the Company’s Common Stock are reserved for issuance,
      as Performance Grants, Restricted Stock, Goal-Based Stock options, or Stock
      Appreciation rights. Options granted under the 2005 Plan may be incentive Stock
      Options or Nonstatutory Stock Options. Employees, including officers, of the
      Company and its subsidiaries are eligible to receive grants under the 2005
      Plan.
      The 2005 Plan also permits the award of only Nonstatutory Stock Options and
      Restricted Stock to directors on the On2 Board, if such directors are not
      employees of On2 and individuals who are consultants or advisors to On2. The
      2005 Plan is administered by the Compensation Committee, of the Board for all
      present and future employees of the Company and its subsidiaries. The Board
      will
      administer the 2005 Plan for outside directors and consultants, based upon
      recommendations by the Compensation Committee. The Compensation Committee has
      the authority to approve option grants and the terms, which include the option
      price and the vesting terms. Options granted under the 2005 Plan expire after
      an
      eight-year period.





-10-





The
      following table illustrates the effect on net loss attributable to common
      stockholders and loss per share if the fair value based method had been applied
      to the prior period.





Three
                months ended, June 30, 2005
            
            Six
                months ended, June 30, 2005Reported
                net loss attributable to common stockholders
            
            $
            (1,424,000
            )
            $
            (3,008,000
            )Stock-based
                employee compensation determined under
              the
                fair value-based method, prior to the adoption of SFAS
              123R
            
            
            (828,000
            )
            
            (1,136,000
            )Pro
                forma net loss attributable to common stockholders
            
            $
            (2,252,000
            )
            $
            (4,144,000
            )Loss
                per common share (basic and diluted):As
                reported
            
            $
            (0.02
            )
            $
            (0.03
            )Pro
                forma
            
            $
            (0.03
            )
            $
            (0.05
            )





Stock
      based compensation expense recognized in the Statement of Operations was
      $763,000 and $930,000 for the three and six months ended June 30, 2006,
      respectively. Stock based compensation expense recognized in the Statement
      of
      Operations was $0 for the three and six months ended June 30, 2005,
      respectively.





The
      following table summarizes the activity of the Company’s stock options for the
      six months ended June 30, 2006:





Shares
            
            Weighted
                Average Exercise Price
            
            Weighted
                Average Remaining Contractual Life
            
            Aggregate
                Intrinsic ValueNumber
                of shares under option:Outstanding
                at January 1, 2006
            
            
            10,299,000
            
            $
            0.98Granted
            
            
            1,698,000
            
            
            0.89Exercised
            
            
            (672,000
            )
            
            0.34Canceled
                or expired
            
            
            (865,000
            )
            
            0.67Outstanding
                at June 30, 2006
            
            
            10,460,000
            
            $
            1.03
            
            
            7.13
            
            $
            1,259,000Exercisable
                at June 30, 2006
            
            
            8,358,000
            
            $
            1.07
            
            
            7.0
            
            $
            1,231,000





-11-





The
      aggregate intrinsic value of options exercised during the six months ended
      June
      30, 2006 was $323,000.





The
      following summarizes the activity of the Company’s non-vested stock options for
      the six months ended June 30, 2006:





Shares
            
            Weighted
                Average Grant Date Fair ValueNon-vested
                at January 1, 2006
            
            
            2,035,000
            
            $
            0.69Granted
            
            
            1,698,,000
            
            
            0.89Cancelled
                or expired
            
            
            (855,000
            )
            
            0.68Vested
                during the period
            
            
            (776,000
            )
            
            0.73Non-vested
                at June 30, 2006
            
            
            2,102,000
            
            $
            0.72





As
      of
      June 30, 2006, there was $986,000 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 0.87 years. The total grant date fair value of shares
      vested during the six-months ended June 30, 2006 was $125,000.





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:





June
                30, 2006Three
                Months Ended
            
            Six
                Months EndedWeighted
                average fair value at date of grant for options granted during the
                period
            
            $
            0.73
            
            $
            0.73Expected
                stock price volatility
            
            
            115
            %
            
            116
            %Expected
                life of options
            
            
            5
                years
            
            
            5
                yearsRisk
                free interest rates
            
            
            5.03
            %
            
            5.03
            %Expected
                dividend yield
            
            
            0
            %
            
            0
            %





(5) Marketable
      Equity Securities





As
      of
      December 31, 2005 the Company held 2,119,000 shares of a customer’s common stock
      with a market value of $106,000, which were received as payment of license
      fees.
      On March 22, 2006 there was a 50/1 reverse stock split and the number of shares
      was reduced to 42,000. As of June 30, 2006, the market value of these shares
      decreased to $56,000 ($1.32 per share). The market value of these shares was
      $1.40 per share as of August 1, 2006. 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 for the three and six months ended June 30, 2006 includes
      $12,000 and $50,000 of net unrealized loss on these securities, respectively.
      Other expense for the three and six months ended June 30, 2005 includes $74,000
      and $286,000 of net unrealized loss on these securities, respectively. The
      Company’s former Chief Executive Officer (who was a director and shareholder of
      the Company) was a director of this customer.




-12-


(6)
      Issuance of Common Stock





During
      the three months ended June 30, 2006, the Company issued 280,000 shares of
      its
      Common Stock to Wildform, Inc. pursuant to the Support and Maintenance
      Agreement, dated April 29, 2005. The value of the stock was $258,000, determined
      at the closing price on April 28, 2006. The $258,000 is being amortized over
      the
      18-month period of the Support and Maintenance Agreement, which ends in October
      2006.





(7)
      Common Stock Options





The
      Company entered into an agreement with Douglas A. McIntyre, the Company's former
      Chairman, President and CEO, effective as of May 2, 2006, under which the
      parties agreed to extend the expiration date of 1,475,000 vested options to
      purchase the common stock of the Company, held by Mr. McIntyre to September
      30,
      2006 from May 2, 2006. The company recognized a charge of $109,000 in the
      quarter ended June 30, 2006 in connection with this extension. The Agreement
      also contains a number of restrictions on Mr. McIntyre's ability to exercise
      the
      Options and sell shares of Common Stock received upon such exercise, including
      an undertaking from Mr. McIntyre not to sell, or cause to be sold, more than
      a
      fixed number of shares of Common Stock in any one-week period, including by
      means of direct sales, acquisitions of put options, or other transactions with
      the effect of a short transaction. During the three months ended June 30, 2006,
      Mr. McIntyre exercised 625,000 stock options and the Company received $194,000
      in proceeds from the exercise.




On
      May 1,
      2006 Bill Joll, the Company’s new CEO was granted 1,500,000 options to purchase
      the Company’s common stock at an exercise price of $0.90 per share. The options
      vest on various dates beginning on May 1, 2006 through May 8, 2008.





(8)
      Customer Concentration





For
      the
      three months ended June 30, 2006, four customers accounted for 16%, 13%, 13%
      and
      10% of revenue and for the six months ended June 30, 2006, one customer
      accounted for 16% of revenue. For the three months ended June 30, 2005, three
      customers accounted for 35%, 14% and 14% of revenue and for the six months
      ended
      June 30, 2005, two customers accounted for 35%, and 17% of revenue.





(9)
      Flix
      Acquisition





On
      April
      29, 2005 the Company acquired certain assets related to the Flix software line
      of Wildform, pursuant to the terms of the Asset Purchase And Software License
      Agreement. Pursuant to the terms of the agreement, the Company acquired certain
      assets related to the Flix software and received a perpetual, irrevocable,
      royalty-free, sub-licensable license to use certain other intellectual property
      (the “Licensed Flix IP”) related to the Flix software. The Company also received
      a perpetual, irrevocable, royalty-free license to use certain web sales software
      (“E-Commerce Software”). In addition, the Company granted Wildform a perpetual
      license to use the purchased Flix assets and new versions of the Flix software
      in certain new software products being developed by Wildform in exchange for
      a
      payment of a royalty to the Company by Wildform.





Had
      the Company acquired the Flix assets as of January 1, 2005 there would have
      been
      a nominal effect on revenue and expenses for the three and six months ended
      June
      30, 2005 other than additional amortization of approximately $21,000 and
      $83,000, respectively.





-13-


(10)
      Series A Secured Convertible Debentures





On
      March
      15, 2006, a debenture holder converted $250,000 face value Series A Secured
      Convertible Debentures into 2,232,000 shares of the Company’s common stock. As
      of March 31, 2006 all the Series A Secured Convertible Debentures have been
      converted into the Companies common stock. The Company recognized $6,000 of
      interest expense upon the conversion for the unamortized balance of the debt
      discount.





(11)
      Series D Redeemable, Convertible Preferred Stock





On
      January 10, 2006 Midsummer Capital converted 175 shares of their Series D
      redeemable, convertible preferred stock into 250,000 shares of the Company’s
      common stock.


-14-


**Item
      2.**  **Management’s
      Discussion and Analysis of Financial Condition and Results** **of
      Operations.**





**Forward-Looking
      Statement**





This
      document contains forward-looking statements within the meaning of Section
      27A
      of the Securities Act of 1933 and Section 21E of the Securities Exchange Act
      of
      1934. These statements relate to future events or our future financial
      performance and are not statements of historical fact. In some cases, you can
      identify forward-looking statements by terminology such as "may," “might,”
"will," "would," "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. Although we believe that the
      expectations reflected in the forward-looking statements are reasonable, we
      cannot guarantee future results, levels of activity, performance or
      achievements, and in all cases, such statements are subject to the Company’s
      ability to secure additional financing or to increase revenues to support its
      operations. We believe that we have sufficient funds and will generate
      sufficient funds to finance our operations for the next 12 months. 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. You should consider the material
      presented in this Form 10-Q in conjunction with "Management's Discussion and
      Analysis of Financial Condition and Results of Operations - Risk Factors That
      May Affect Future Operating Results" in the Company's Form 10-K for the year
      ended December 31, 2005.





The
      inclusion of the forward-looking statements should not be regarded as a
      representation by the Company, or any other person, that such forward-looking
      statements will be achieved. 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 video compression technology firm. We have developed a
      proprietary technology platform and the TrueMotion VPx family (e.g., VP5, VP6,
      VP7) 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 software is based solely on intellectual property that we developed
      and own ourselves.




-15-


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;
              ·Technical
                support; and
              ·High-level
                video encoding








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) services





In
      addition, as discussed at greater length below, we have recently 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.





As
      covered in greater detail below, we earn revenue chiefly through licensing
      our
      software and providing specialized software engineering and consulting services
      to customers. In addition to license fees, we often charge a royalty fee based
      on the number of units of some or all of the customer’s products that contain
      the relevant On2 software products that are sold or distributed. Some of our
      agreements with customers also require that the customers pay us a percentage
      of
      the revenues that they earn from any of their products or services that use
      our
      software. Royalties may be subject to guaranteed minimum amounts and/or maximum
      amounts (e.g., annual caps).





-16-


We
      have
      recently begun selling products and services that extend from 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 encode video and other multimedia content for playback on Adobe®
Flash® player, which is a widely distributed multimedia player. The Flix brand
      has existed since the advent of Flash video and has a loyal following among
      its
      users. Because Adobe has integrated our VP6 codec software into its Flash 8
      player, we 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 wide distribution of the Flash 8 player.





In
      addition to licensing our software to software developers and end users for
      their own use, we sell licenses to certain third-party resellers. We also
      generally require that customers pay us if they desire to receive any upgrades
      to our software (e.g., from VP6 to VP7). We charge a fee for engineering and
      consulting services, based on an estimate of the time it will take our software
      engineers to provide the services, or an hourly fee for ongoing services such
      as
      product support.





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, as 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 with greater complexity.
      Increased compression rates frequently result in increased complexity. While
      customers want software that produces the highest possible compression rates
      and
      the best possible decompressed image, they also want to keep production costs
      low by using the lowest-powered and accordingly least expensive chips that
      still
      perform the processing they require. In addition, in some embedded applications,
      such as mobile devices, size and power constraints, in addition to price issues,
      can limit the capability of the chips. Of course, in devices in which a great
      deal of processing 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).




-17-


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 mentioned above,
      an
      increasing number of our license agreements with customers provide for the
      payment of fees that are dependent either on the number of units of a customer’s
      product incorporating our software that are sold or on the amount of revenue
      generated by a customer from the sale of products or services that incorporate
      our software. We have chosen this licensing model because, as a company of
      only
      approximately 36 employees, we do not have the product development or marketing
      resources to develop and market end-to-end video solutions. Instead, our
      software is primarily intended to be used as a building block for companies
      that
      are developing end-to-end video products and/or services.





As
      addressed above, 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’ often superior ability
      to produce and market end-to-end video products and services, while offering
      those customers the benefit of including technologically-advanced software
      in
      their applications. As with arrangements in which we receive royalties or
      revenue shares, the ability to market complementary products can yield total
      revenues over time in excess of an 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 of significant value. But unlike royalties and
      revenue shares, which we generally expect to receive without any significant
      additional effort on our part, the successful sale of complementary products
      requires that we effectively execute an end-user product development and
      marketing program. Developing and marketing products aimed at end users is
      a
      relatively new business for us. Until recently, we had generally produced
      software targeted at developers, who integrate our software into their products.





Although
      we believe that we have adopted the licensing model most appropriate for a
      business of our size and expertise, a natural result of this licensing model
      is
      that the revenue we generate is highly dependent on the success of our
      customers’ product deployments. 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,
      the
      revenues we earn from that relationship are likely not to attain significant
      levels. Conversely, if one or more of such customers’ products is widely
      adopted, our revenues will likely be enhanced.





Another
      significant trend in our business is the emergence of Microsoft 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’s commitment to and presence in the media
      delivery industry has increased. Microsoft distributes its competing streaming
      encoder, media server, player, tools and digital rights management (“DRM”)
      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 third parties with whom we have relationships. Finally,
      Microsoft’s DRM 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 DRM does not integrate well with
      non-Microsoft video and audio software. Many companies that want to distribute
      copy-protected content are therefore forced to choose Microsoft video technology
      to be able to use Microsoft’s DRM technology.





-18-


Another
      trend is the emergence of H.264 as 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 get when licensing H.264. H.264
      has nevertheless started to gain 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 such
      standard. In addition, at least several manufacturers of multimedia processors
      have done the work necessary to have H.264 operate on their chips. These
      advantages may allow potential customers to implement a solution based on H.264
      with less initial development time and expense than a solution using On2 Video
      might require, even though the H.264 solution could be less efficient and more
      expensive than On2 Video solution in the final analysis. In addition, there
      are
      certain customers that prefer to license standards-based codecs.





We
      are
      also watching with interest and participating in the trend towards the
      proliferation of consumer-created video content on the web. As Internet use
      has
      grown worldwide and Internet connection speeds have increased, there has been
      a
      marked increase in consumer-created content on the web. While that content
      initially 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 groundswell in
      consumer-created video content. Weblogs (blogs) and podcasts (broadcasts of
      audio content to iPod® and MP3 devices) are evolving to include video content. A
      number of services are being offered to host consumer-created video, and many
      commercial sites now also feature amateur videos. The continued proliferation
      of
      consumer-created video on the Internet may have a positive effect on our
      business. The Adobe® Flash® video is a popular format for Web video. Because
      Flash 8 uses On2’s VP6 codec, On2 may have the opportunity to license Flash
      encoding tools for use in video blogs, video podcasts, and to consumer-created
      video services or to individual users of those services.





The
      market for digital media creation and delivery technology is constantly changing
      and has become intensely and increasingly competitive. We have and continue
      to
      take a number of steps to address this competition. First and foremost, we
      focus
      on providing our customers with video compression/decompression technology
      that
      delivers the highest possible video quality at the lowest possible data rates.
      In order to do this, we devote a significant portion of our engineering capacity
      to research and development. Although we expect that competition from Microsoft,
      H.264 developers, and others will - intensify, we also 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 address the competitive threats that we face by
      focusing on developing relationships with customers who do not want to do
      business with Microsoft and/or do not find the complex and rigid standards-based
      licenses and fee structures appealing.





**Critical
      Accounting Policies and Estimates**





This
      discussion and analysis of our financial condition and results of operations
      are
      based on our condensed consolidated financial statements that have been prepared
      pursuant to the rules and regulations of the Securities and Exchange Commission
      (“SEC”). The preparation of our condensed consolidated financial statements
      requires management to make estimates and assumptions that affect the reported
      amounts of 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. The condensed consolidated
      financial statements and the related notes thereto should be read in conjunction
      with the following discussion of our critical accounting policies and our Form
      10-K filed with the SEC on March 15, 2006. Our critical accounting policies
      and
      estimates are:





·
            Revenue
                recognition


·
            Equity-based
                compensation


·
            Valuation
                of goodwill, intangible assets and other long-lived
                assets





-19-


*Revenue
      recognition.* We
      currently recognize revenue from the sale of software licenses and professional
      services. 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 Statement of Position (“SOP”) 97-2,
“ *Software
      Revenue Recognition* ”,
      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* ”.
      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-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, depending upon
      the
      terms of 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). Each license agreement
      offers 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 (porting)
      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 generally require 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* ”.
      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 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, using the modified prospective transition method. Under the
      modified prospective method, equity compensation expense is recognized for
      the
      portion of outstanding stock option awards granted prior to the adoption of
      SFAS
      123R for which service has not been rendered, and for any future stock option
      grants and modifications. The Company recognizes share-based compensation costs
      on a straight-line basis over the requisite service periods of awards which
      would normally be the vesting period of the options.





-20-


*Valuation
      of goodwill and intangible assets.* We
      evaluate our long-lived assets in accordance with Statement of Financial
      Accounting Standards (“SFAS”) No. 121, “ *Accounting
      for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed
      Of* .
      Long-lived assets are reviewed for impairment whenever events or changes in
      circumstances indicate that the net carrying value of the asset may not be
      recoverable. In such circumstances, the net carrying value of the asset is
      compared to the undiscounted future cash flows which that asset is expected
      to
      generate.





SFAS
      No.
      142, “ *Goodwill
      and Other Intangible Assets* ”
      requires goodwill and other intangible assets with indefinite lives to be tested
      for impairment at least annually, and written off when impaired, rather than
      being amortized as previously required.





**Results
      of Operations**





*Revenue.* Revenue
      for the three months ended June 30, 2006 was $1,535,000 as compared with
      $346,000 for the three months ended June 30, 2005. Revenue for the six months
      ended June 30, 2006 was $2,752,000 as compared with $699,000 for the six months
      ended June 30, 2005. Revenue for the three and six months ended June 30, 2006
      and 2005 was derived primarily from the sale of software licenses and
      engineering and consulting services. The increase in revenue for both the three
      and six months ended June 30, 2006 is primarily attributed to sales of our
      Flix
      and Adobe® Flash® related products.





*Operating
      expenses*





The
      Company's operating expenses consist of cost of revenue, research and
      development, sales and marketing and general and administrative expenses and
      equity-based compensation. Operating expenses for the three months ended June
      30, 2006 were $3,082,000 as compared to $1,416,000 for the three months ended
      June 30, 2005. Operating expenses were $5,448,000 for the six months ended
      June
      30, 2006 as compared to $2,871,000 for the six months ended June 30,
      2005.





*Cost
      of Revenue.* Cost of
      revenue includes personnel and consulting compensation costs, related overhead
      expenses, stock-based compensation cost, fees paid for licensed technology,
      amortization of assets recorded in connection with the Flix acquisition and
      costs associated with the Wildform Support and Maintenance Agreement and
      depreciation. Cost of revenue for the three months ended June 30, 2006 was
      $705,000 as compared to $410,000 for the three months ended June 30, 2005.
      Cost
      of revenues for the six months ended June 30, 2006 was $1,288,000 as compared
      to
      $779,000 for the six months ended June 30, 2005. The increase in expenses for
      the three and six months ended June 30, 2006 is primarily due to an increase
      in
      compensation costs from the addition of personnel, the number of personnel
      hours
      spent on customer projects, the amortization of assets recorded in connection
      with the Flix acquisition and costs associated with the Wildform Support and
      Maintenance Agreement and stock-based compensation costs as a result of the
      adoption of SFAS 123(R) in January, 2006.





*Research
      and Development.* Research
      and development expenses, excluding equity-based compensation, consist of
      salaries and related expenses and consulting fees 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 June 30, 2006 were $214,000 as compared to $248,000 for the three months
      ended June 30, 2005. Research and development expenses for the six months ended
      June 30, 2006 were $439,000 as compared to $506,000 for the six months ended
      June 30, 2005. The decreases in expenses were primarily attributed to a decrease
      in the number of personnel hours spent on research and development
      projects.




-21-


*Sales
      and Marketing.* Sales
      and marketing expenses, excluding equity-based compensation, consist primarily
      of salaries, commissions and related 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 June 30, 2006 were $172,000 as compared to $194,000
      for
      the three months ended June 30, 2005. Sales and marketing expenses for the
      six
      months ended June 30, 2006 were $360,000 as compared to $305,000 for the six
      months ended June 30, 2005. The decrease for the three months ended June 30,
      2006 as compared with 2005 is primarily due to a decrease in advertising costs.
      The increases for the six months ended June 30, 2006 as compared with 2005
      is
      primarily due to increases in compensation costs and related expenses and
      commissions partially offset by decreases in consulting and tradeshow
      expenses.




*General
      and Administrative* .
      General
      and administrative expenses, excluding equity-based compensation, consist
      primarily of salaries and related personnel costs for general corporate
      functions including finance, human resources, management information systems,
      legal and facilities, outside legal and other professional fees and insurance.
      General and administrative expenses for the three months ended June 30, 2006
      were $1,280,000 as compared with $564,000 for the three months ended June 30,
      2005. General and administrative expenses for the six months ended June 30,
      2006
      were $2,540,000 as compared with $1,281,000 for the six months ended June 30,
      2005. The increase for the both the three and six-month periods is primarily
      due
      to a $860,000 increase, approximately $430,000 in each quarter, in legal 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. There were also
      increases in other professional fees for consulting services related to the
      Company’s implementation of Sarbanes-Oxley, Section 404, recruiting and
      relocation expenses for the Company’s new CEO.





*Equity-Based
      Compensation.* The
      Company adopted the provisions of SFAS No. 123R effective January 1, 2006,
      using
      the modified prospective transition method. Under the modified prospective
      method, equity compensation expense is recognized for the portion of outstanding
      stock option awards granted prior to the adoption of SFAS 123R for which service
      has not been rendered, and for any future stock option grants and modifications.
      Equity based compensation, which is presented separately, was $711,000 and
      $821,000 for the three and six months ended June 30, 2006, respectively.
      Equity-based compensation of $52,000 and $109,000 is included in cost of revenue
      for the three and six months ended June 30, 2006, respectively. On May 1, 2006
      Bill Joll, the Company’s new CEO was granted 1,500,000 options to purchase the
      Company’s common stock at an exercise price of $0.90 per share. The options vest
      on various dates beginning on May 1, 2006 through May 8, 2008. The aggregate
      estimated fair value was $1,114,000, of which $402,000 was recognized as
      compensation expense.





*Interest
      and other income (expense), net* Interest
      and other income (expense), net was $1,000 for the three months ended June
      30,
      2006 as compared to $(59,000) for the three months ended June 30, 2005. Interest
      and other income (expense), net was $(27,000) for the six months ended June
      30,
      2006 as compared to $(259,000) for the six months ended June 30, 2005. Interest
      and other income (expense), net primarily consists of interest earned money
      market accounts, interest incurred for capital lease obligation, term-loan,
      the
      interest and amortization of debt discount related to the Series A secured
      convertible debentures and gains and losses incurred on marketable equity
      securities. The decrease in interest and other expense, net for the three and
      six months ended June 30, 2006 is primarily attributable to decreases in the
      write down, to market, of the publicly traded stock the company received as
      payment for a license sold in the last quarter of 2004.





-22-


At
      June
      30, 2006, we had approximately 36 full-time employees. We expect to hire
      employees as necessary in order to attain our strategic objectives





**Liquidity
      and Capital Resources**





At
      June
      30, 2006, we had cash reserves of $2,776,000 as compared to $3,976,000 at
      December 31, 2005. At June 30, 2006, the Company had working capital of
      $3,088,000 as compared with $4,179,000 at December 31, 2005.





Net
      cash
      used in operating activities was $1,668,000 and $2,513,000 for the six months
      ended June 30, 2006 and 2005, respectively. Although we had a larger net loss,
      the decrease in net cash used in operating activities is primarily attributable
      to equity-based compensation and the change in accounts payable, accrued
      expenses and other liabilities.




Net
      cash
      provided by (used) in investing activities was $31,000 and $(1,333,000) for
      the
      six months ended June 30, 2006 and 2005, respectively. The increase for the
      six
      months ended June 30, 2006 primarily reflects the acquisition of the Flix
      product line in 2005.





Net
      cash
      provided by financing activities was $439,000 and $4,089,000 for the six months
      ended June 30, 2006 and 2005, respectively. The decrease is primarily
      attributable to a decrease in proceeds received from the exercise of common
      stock options and warrants.





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 and New York City and
      the UK. The aggregate required payments for the next 12 months under these
      arrangements are $125,000. 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 $700,000 per month in cash
      operating costs.





The
      Company believes that existing funds are sufficient to fund its operations
      through June 30, 2007. 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, 2005.





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.





**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.




-23-





**Impact
      of Recently-Issued Accounting Pronouncements**





None





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





**Item
      4. Controls and Procedures**





(a)
      Evaluation of Disclosure Controls and Procedures:





Disclosure
      controls and procedures are designed to ensure that information required to
      be
      disclosed in the reports filed or submitted under the Exchange Act is recorded,
      processed, summarized and reported, within the time periods specified in the
      SEC's rules and forms. Disclosure controls and procedures include, without
      limitation, controls and procedures designed to ensure that information required
      to be disclosed in the reports filed under the Exchange Act is accumulated
      and
      communicated to management, including the Chief Executive Officer and Chief
      Financial Officer, as appropriate, to allow timely decisions regarding required
      disclosure. Within the 90 days prior to the filing of this report, the Company
      carried out an evaluation, under the supervision and with the participation
      of
      the Company's management, including the Company's Chief Executive Officer and
      Chief Financial Officer, of the effectiveness of the design and operation of
      the
      Company's current disclosure controls and procedures. Based upon and as of
      the
      date of that evaluation, the Chief Executive Officer and Chief Financial Officer
      concluded that the Company's disclosure controls and procedures are effective
      to
      ensure that information required to be disclosed in the reports the Company
      files and submits under the Exchange Act is recorded, processed, summarized
      and
      reported as and when required.





(b)
      Changes in Internal Controls:





There
      were no changes in the Company's internal controls or in other factors that
      could have significantly affected those controls subsequent to the date of
      the
      Company's most recent evaluation.





-24-


PART
      II —
OTHER INFORMATION





**Item
      1. Legal Proceedings**





**Internal
      Investigation**





On
      March
      2, 2006, the Company filed a Form 8-K, which disclosed that it had voluntarily
      reported to the Securities and Exchange Commission ("SEC") that the Company
      had
      undertaken an internal investigation into facts and circumstances concerning
      investor and other communications made by the Company's former Chairman, Chief
      Executive Officer and President. The Company 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. ** The
      Company 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 E-World
      entered into in June 2003.





Under
      those agreements, On2 licensed the source code to its video compression (codec)
      technology to E-World for use in 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 E-World,
      including the requirements that:





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





·
            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 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 E-World’s counter claims, 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
      a year has 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, 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.





-25-


On2
      has
      requested that the arbitrator award it approximately $5,690,000.00 in damages
      under the contract and grant it further relief as may be just and equitable.
      E-World has not yet responded to On2's claims.





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





The
      Company's 2006 Annual Meeting of Stockholders was held on May 15, 2006.
      Represented at the Annual Meeting, either in person or by proxy, were 95,109,522
      voting shares. The following actions were taken by a vote of the Company's
      stockholders at the Annual Meeting:





Messrs.
      William A. Newman, J. Allen Kosowsky, Tom Weigman, Mike Kopetski, Michael J.
      Alfant, Afsaneh Naimollah, and James Meyer were elected to serve as members
      of
      the Company's Board of Directors. The votes for Messrs. McIntyre, Newman,
      Kosowsky, Weigman, Kopetski, Alfant and Meyer and Ms. Naimollah were as
      follows:





**FOR**
            
            **AGAINST/WITHHELD**
            
            **ABSTAIN**William
                A. Newman
            
            
            78,997,726
            
            
            2,532,360
            
            
            0J.
                Allen Kosowsky
            
            
            79,135,844
            
            
            2,394,242
            
            
            0Tom
                Weigman
            
            
            78,992,719
            
            
            2,537,367
            
            
            0Mike
                Kopetski
            
            
            78,547,834
            
            
            2,982,252
            
            
            0Mike
                Alfant
            
            
            79,340,756
            
            
            2,189,330
            
            
            0Afsaneh
                Naimollah
            
            
            79,217,328
            
            
            2,312,758
            
            
            0James
                Meyer
            
            
            79,448,270
            
            
            2,081,816
            
            
            0





There
      were no broker non-votes with respect to the election of directors.





The
      appointment of Eisner LLP as the Company's independent certified public
      accountants for the fiscal year ending December 31, 2006 was ratified;
      80,643,726 votes were cast for the ratification; 563,768 votes were cast against
      or were withheld with respect to the ratification; there were 322,592
      abstentions; and there were no broker non-votes.





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





(a)
            Exhibits




10.1
            Amended
                and Restated Employment Agreement, dated May 1, 2006, by and between
                the
                Company and Tim Reusing31.1
            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.





(b)
            Reports
                on Form 8-K





The
      Company filed Form 8-K on May 4, 2006, announcing:





·
            The
                appointment of Bill Joll as President and CEO of the
                Company;


·
            The
                resignation of James Meyer as interim CEO of the Company;
                and


·
            The
                entry into an employment agreement with Mr.
                Joll.





-26-


The
      8-K
      filed on May 4 also contained a press release announcing the Company’s results
      of operations for the fiscal quarter ending March 31, 2006.





·
            The
                Company filed Form 8-K on May 9, 2006 announcing that the Company
                had
                completed an internal investigation and had delivered to the SEC
                and the
                American Stock Exchange a copy of a report relating to the investigation
                prepared by the Company’s outside
                attorneys.





The
      Company filed Form 8-K on May 15, 2006 announcing that the Company had entered
      into an agreement with Douglas A. McIntyre, the Company's former Chairman,
      President and CEO, under which the parties (i) agreed to extend the expiration
      date of all vested options to purchase the common stock of the Company held
      by
      Mr. McIntyre to September 30, 2006 and (ii) placed certain restrictions on
      Mr.
      McIntyre’s ability to exercise the options.





The
      Company filed Form 8-K on June 1, 2006, announcing that the Company’s Board of
      Directors had appointed Bill Joll, the Company’s President and CEO, to the Board
      and that Mr. Joll will also serve on the Executive Committee of the
      Board.





The
      Company filed a Current Report on Form 8-K on June 12 announcing:





·
            The
                adoption of the annual meeting fees and option grants for the
                non-executive chairman of the Company’s Board of Directors for the coming
                year; and


·
            That
                the Board had granted Allen Kosowsky, the Company’s non-executive
                chairman, options to purchase 115,000 shares of the Company’s common
                stock.





-27-


**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)August
                2, 2006
              
              (Date)
            
            /s/
                Anthony Principe
              
              (Signature)
              Anthony
                  Principe
                Senior
                  Vice President and Chief Financial Officer
                (Principal
                  Financial Officer)






-28-