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, 2007.





o  **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 o No





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












APPLICABLE
      ONLY TO CORPORATE ISSUERS:





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





The
      number of shares of the Registrant’s Common Stock, par value $0.01 (“Common
      Stock”), outstanding, as of August 9, 2007, was 116,190,935.




-2-


**Table
      of Contents**








Page**PART
                I — FINANCIAL INFORMATION**Item
                1. Consolidated Financial Statements.Condensed
                Consolidated Balance Sheets at June 30, 2007 (unaudited) and December
                31,
                2006
            
            4Unaudited
                Condensed Consolidated Statements of Operations,Three
                and Six Months Ended June 30, 2007 and 2006
            
            5Unaudited
                Condensed Consolidated Statements of Comprehensive Loss for the Three
                andSix
                Months Ended June 30, 2007 and 2006
            
            6Unaudited
                Condensed Consolidated Statements of Cash FlowsSix
                Months Ended June 30, 2007 and 2006
            
            7Notes
                to Unaudited Condensed Consolidated Financial Statements
            
            9Item
                2. Management’s Discussion and Analysis of Financial Condition and Results
                of Operations
            
            14Item
                3.Quantitative
                and Qualitative Disclosures About Market Risk
            
            25Item
                4. Controls and Procedures
            
            25**PART
                II — OTHER INFORMATION**Item
                1. Legal Proceedings
            
            26Item
                1A. Risk Factors
            
            27Item
                6. Exhibits and Reports on Form 8-K
            
            36Signatures
            
            37Certifications
            
            38







-3-




**PART
      I — FINANCIAL INFORMATION**





Item
      1.
      Consolidated Financial Statements





**ON2
      TECHNOLOGIES, INC.**


**CONDENSED
      CONSOLIDATED BALANCE SHEETS**





June
                30,
              2007
            
            December
                31,
              2006(unaudited)**ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            10,369,000
            
            $
            4,961,000Marketable
                securities, at market
            
            
            96,000
            
            
            154,000Accounts
                receivable, net
            
            
            2,277,000
            
            
            1,335,000Prepaid
                and other current assets
            
            
            259,000
            
            
            231,000Total
                current assets
            
            
            13,001,000
            
            
            6,681,000Acquired
                Software, net
            
            
            367,000
            
            
            467,000Other
                Acquired Intangibles, net
            
            
            85,000
            
            
            108,000Goodwill
            
            
            244,000
            
            
            244,000Property
                and equipment, net
            
            
            261,000
            
            
            157,000Deferred
                acquisition costs
            
            
            1,107,000Other
                assets
            
            
            131,000
            
            
            230,000Total
                assets
            
            $
            15,196,000
            
            $
            7,887,000**LIABILITIES
                AND STOCKHOLDERS’ EQUITY**Current
                liabilities:Accounts
                payable
            
            $
            343,000
            
            $
            194,000Accrued
                expenses
            
            
            897,000
            
            
            454,000Deferred
                revenue
            
            
            648,000
            
            
            708,000Term-loan
            
            
            143,000
            
            
            33,000Capital
                lease obligation
            
            
            21,000
            
            
            24,000Total
                current liabilities
            
            
            2,052,000
            
            
            1,413,000Capital
                lease obligation, excluding current portion
            
            
            23,000
            
            
            29,000Warrant
                derivative liability
            
            
            3⁄4
            
            
            2,329,000Total
                liabilities
            
            
            2,075,000
            
            
            3,771,000Commitments
                and contingenciesSeries
                D redeemable convertible preferred stock
            
            
            677,000
            
            
            3,083,000Stockholders’
                equity:Preferred
                stock
            
            
            3⁄4
            
            
            19,000Common
                stock
            
            
            1,161,000
            
            
            1,012,000Additional
                paid-in capital
            
            
            139,452,000
            
            
            124,554,000Accumulated
                other comprehensive loss
            
            
            (51,000
            )
            
            (46,000
            )Accumulated
                deficit
            
            
            (128,118,000
            )
            
            (124,506,000
            )Total
                stockholders’ equity
            
            
            12,444,000
            
            
            1,033,000Total
                liabilities and stockholders’ equity
            
            $
            15,196,000
            
            $
            7,887,000




*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
                30,2007
            
            2006
            
            2007
            
            2006Revenue
            
            $
            2,554,000
            
            $
            1,535,000
            
            $
            5,369,000
            
            $
            2,752,000Operating
                expenses:Cost
                of revenue (1)
            
            
            389,000
            
            
            705,000
            
            
            812,000
            
            
            1,288,000Research
                and development (2)
            
            
            562,000
            
            
            214,000
            
            
            1,055,000
            
            
            439,000Sales
                and marketing (2)
            
            
            614,000
            
            
            172,000
            
            
            1,210,000
            
            
            360,000General
                and administrative (2)
            
            
            980,000
            
            
            1,280,000
            
            
            1,939,000
            
            
            2,540,000Equity-based
                compensation:Research
                and development
            
            
            19,000
            
            
            25,000
            
            
            20,000
            
            
            52,000Sales
                and marketing
            
            
            27,000
            
            
            23,000
            
            
            54,000
            
            
            58,000General
                and administrative
            
            
            108,000
            
            
            663,000
            
            
            228,000
            
            
            711,000Total
                operating expenses
            
            
            2,699,000
            
            
            3,082,000
            
            
            5,318,000
            
            
            5,448,000(Loss)
                income from operations
            
            
            (145,000
            )
            
            (1,547,000
            )
            
            51,000
            
            
            (2,696,000
            )Interest
                and other income (expense), net
            
            
            (2,672,000
            )
            
            1,000
            
            
            (3,585,000
            )
            
            (26,000
            )Loss
                before provision for income taxes
            
            
            (2,817,000
            )
            
            (1,546,000
            )
            
            (3,534,000
            )
            
            (2,722,000
            )Provision
                for income taxes
            
            
            (3,000
            )
            
            (3,000
            )
            
            (7,000
            )
            
            (6,000
            )Net
                loss
            
            
            (2,820,000
            )
            
            (1,549,000
            )
            
            (3,541,000
            )
            
            (2,728,000
            )Convertible
                preferred stock 8% dividend expense
            
            
            (18,000
            )
            
            (73,000
            )
            
            (71,000
            )
            
            (146,000
            )Net
                loss attributable to common shareholders
            
            $
            (2,838,000
            )
            $
            (1,622,000
            )
            $
            (3,612,000
            )
            $
            (2,874,000
            )Basic
                and diluted net loss attributable to common shareholders per common
                share
            
            $
            (0.03
            )
            $
            (0.02
            )
            $
            (0.03
            )
            $
            (0.03
            )Weighted
                average basic and diluted common shares outstanding:
            
            
            111,752,000
            
            
            95,530,000
            
            
            107,698,000
            
            
            94,232,000




(1)
              Includes
                  equity-based compensation of $14,000 and $15,000 for the three
                  and six
                  months ended June30, 2007 30, 200730,
                  2007. 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
                30,2007
            
            2006
            
            2007
            
            2006Net
                loss
            
            $
            (2,820,000
            )
            $
            (1,549,000
            )
            $
            (3,541,000
            )
            $
            (2,728,000
            )Other
                comprehensive income (loss):Foreign
                currency translation adjustment
            
            
            (3,000
            )
            
            (1,000
            )
            
            (5,000
            )
            
            (2,000
            )Comprehensive
                loss
            
            $
            (2,823,000
            )
            $
            (1,550,000
            )
            $
            (3,546,000
            )
            $
            (2,730,000
            )




*See
      accompanying notes to unaudited condensed consolidated financial
      statements*





-6-


**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**





Six
                Months Ended June 30,2007
            
            2006Cash
                flows from operating activities:Net
                loss
            
            $
            (3,541,000
            )
            $
            (2,728,000
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Equity-based
                compensation
            
            
            317,000
            
            
            930,000Charge
                recognized for warrant amendment
            
            
            86,000Depreciation
                and amortization
            
            
            182,000
            
            
            159,000Amortization
                of debt discount
            
            
            
            
            
            6,000Unrealized
                loss on marketable securities
            
            
            
            
            
            50,000Insurance
                expense financed with term-loan
            
            
            7,000Realized
                loss on marketable securities
            
            
            27,000Change
                in fair value of warrant derivative liability
            
            
            3,582,000Changes
                in operating assets and liabilities:Accounts
                receivable
            
            
            (942,000
            )
            
            (44,000
            )Prepaid
                expenses and other assets
            
            
            101,000
            
            
            (13,000
            )Accounts
                payable, accrued expenses and other liabilities
            
            
            608,000
            
            
            49,000Deferred
                revenue
            
            
            (60,000
            )
            
            (77,000
            )Net
                cash provided by (used in) operating activities
            
            
            367,000
            
            
            (1,668,000
            )Cash
                flows from investing activities:Purchase
                of marketable securities
            
            
            (96,000
            )Proceeds
                form the sale of marketable securities
            
            
            127,000
            
            
            75,000Deferred
                acquisition costs
            
            
            (1,107,000
            )Purchases
                of property and equipment
            
            
            (154,000
            )
            
            (44,000
            )Net
                (used in) cash provided by investing activities
            
            
            (1,230,000
            )
            
            31,000Cash
                flows from financing activities:Principal
                payments on capital lease obligations
            
            
            (15,000
            )
            
            (10,000
            )Principal
                payments on term-loan
            
            
            (33,000
            )Purchase
                of treasury stock
            
            
            (472,000
            )Proceeds
                from term-loan, net of repayments
            
            
            
            
            
            96,000Proceeds
                from exercise of common stock options and warrants
            
            
            6,796,000
            
            
            353,000Net
                cash provided by financing activities
            
            
            6,276,000
            
            
            439,000Net
                change in cash and cash equivalents
            
            
            5,413,000
            
            
            (1,198,000
            )Effect
                of exchange rate changes on cash and cash equivalents
            
            
            (5,000
            )
            
            (2,000
            )Cash
                and cash equivalents, beginning of period
            
            
            4,961,000
            
            
            3,976,000Cash
                and cash equivalents, end of period
            
            $
            10,369,000
            
            $
            2,776,000






-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 30,2007
            
            2006Cash
                paid during the period for:Interest
            
            $
            3,000
            
            $
            2,000Taxes
            
            $
            8,000
            
            $
            8,000Conversion
                of debentures into shares of common stock
            
            
            
            
            $
            250,000Conversion
                of preferred stock into shares of common stock
            
            $
            2,425,000
            
            $
            175,000Decrease
                in accrued dividend on Series D Preferred Stock
            
            $
            16,000
            
            $
            3,000Stock
                issued to Wildform pursuant to the Support and Services
                Agreement
            
            
            
            
            $
            258,000Common
                stock issued for dividends on Series D Preferred Stock
            
            $
            81,000
            
            $
            149,000Write
                off of warrant derivative liability
            
            $
            5,911,000Prepaid
                insurance financed with term-loan
            
            $
            143,000Acquisition
                of fixed assets under capital lease
            
            $
            6,000Deferred
                financing costs charged to paid-in-capital on exercise of
                warrants
            
            $
            106,000Cashless
                exercises of stock options and warrants
            
            $
            959,000Retirement
                of treasury stock
            
            $
            1,431,000




*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 media, 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
      Annual Report for the fiscal year ended December 31, 2006, filed with the SEC
      on
      March 23, 2007, as amended April 30, 2007 and May 10, 2007.





(3)
      Recently Issued Accounting Pronouncements




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




-9-





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





(4)
      Stock-Based Compensation





The
      following table summarizes the activity of the Company’s stock options for the
      six months ended June 30, 2007:





Shares
            
            Weighted
                Average Exercise Price
            
            Weighted
                Average Remaining Contractual Life
            
            Aggregate
                Intrinsic ValueNumber
                of shares under option:Outstanding
                at January 1, 2007
            
            
            9,497,000
            
            $
            1.07Granted
            
            
            10,000
            
            
            2.04Exercised
            
            
            (3,625,000
            )
            
            0.69Canceled
                or expired
            
            
            (3,000
            )
            
            0.98Outstanding
                at June 30, 2007
            
            
            5,879,000
            
            $
            1.32
            
            
            6.65
            
            $
            12,193,000Vested
                and expected to vest at June 30, 2007
            
            
            5,843,000
            
            $
            1.29
            
            
            6.28
            
            $
            12,118,000Exercisable
                at June 30, 2007
            
            
            5,237,000
            
            $
            1.36
            
            
            6.38
            
            $
            10,836,000




The
      aggregate intrinsic value of options exercised was $11,212,000 for six months
      ended June 30, 2007.





Stock
      based compensation expense recognized in the Statement of Operations was
      $168,000 and $317,000 for the three and six months ended June 30, 2007,
      respectively. 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.





The
      following summarizes the activity of the Company’s non-vested stock options for
      the six months ended June 30, 2007:





Shares
            
            Weighted
                Average Grant Date Fair ValueNon-vested
                at January 1, 2007
            
            
            1,064,000
            
            $
            0.72Granted
            
            
            10,000
            
            
            2.04Cancelled
                or expired
            
            
            (3,000
            )
            
            0.98Vested
                during the period
            
            
            (429,000
            )
            
            0.70Non-vested
                at June 30, 2007
            
            
            642,000
            
            $
            1.38






-10-




As
      of
      June 30, 2007, there was $286,000 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, 2007 was $301,000.





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:





Six
                Months Ended
              June
                30, 2007Weighted
                average fair value at date of grant for options granted during the
                period
            
            $
            1.71Expected
                stock price volatility
            
            
            99
            %Expected
                life of options
            
            
            5
                yearsRisk
                free interest rates
            
            
            4.82
            %Expected
                dividend yield
            
            
            0
            %





The
      following summarizes the activity of the Company’s non-vested restricted common
      stock for the six months ended June 30, 2007:





Shares
            
            Weighted
                Average Grant Date Fair ValueNon-vested
                at January 1, 2007
            
            
            85,000
            
            $
            0.49Granted
            
            
            592,000
            
            
            2.84Cancelled
                or expired
            
            
            (20,000
            )
            
            0.63Vested
                during the period
            
            
            (0
            )
            
            0.00Non-vested
                at June 30, 2007
            
            
            657,000
            
            $
            2.49





During
      the six months ended June 30, 2007 the Company granted 139,000 shares of
      restricted common stock to its Board of Directors which vests on March 12,
      2008
      and 453,000 shares of restricted common stock to its employees which vests
      over
      the next four years. As of June 30, 2007, the Company recognized $97,000 in
      compensation expense related to this grants and there was $1,382,000 of
      unrecognized compensation cost which will be recognized through the second
      quarter of 2010.





(5) Marketable Securities





As
      of
      December 31, 2006 the Company held 42,000 shares of a customer’s common stock
      with a market value of $60,000. During the six months ended June 30, 2007 the
      Company sold all 42,000 shares of this stock and received proceeds of $33,000
      and recorded a realized loss of $27,000 on the sale. The Company’s former Chief
      Executive Officer (who was a director and shareholder of the Company) was a
      director of this customer.





The
      Company invests most of its idle cash in 30 and 60 day United States Treasury
      Bills and they are recorded as cash equivalents. The Company does not accrue
      interest on these Treasury Bills rather the interest is recorded at maturity.
      For the six months ended June 30, 2007, there was $38,000 of un-accrued interest
      on these Treasury Bills.




-11-





(6)
      Deferred Acquisition Costs





During
      the six months ended June 30, 2007 the Company incurred expenditures of
      $1,107,000 for legal and professional fees associated with the pending
      acquisition of Hantro Products Oy. These expenditures will be added to the
      acquisition price when the acquisition is complete. Should the acquisition
      not
      take place, the Company would expense the entire amount. Included in this
      expenditure is approximately $413,000 of legal services provided by a law firm
      a
      partner of which is a member of the Company’s Board of Directors.




(7)
      Term-loan





During
      June 2007 the Company renewed its Directors and Officers Liability Insurance
      and
      financed the $143,000 premium with a nine-month term loan that carries an
      effective annual interest rate of 8%.





(8)
      Warrant Derivative Liability





During
      the three and six months ended June 30, 2007 the Company recorded charges of
      $2,668,000 and $3,582,000, respectively to reflect the change in the fair value
      of the warrant derivative liability. The fair value was calculated using the
      Black-Scholes pricing model. On June 11, 2007 the Company entered into a Letter
      Agreement with Midsummer Investments Ltd. and Rockmore Investment Master Fund
      where the parties agreed to place a $0.41 per share floor on the base share
      price for subsequent dilutive share issuances and received consideration in
      the
      form of a decrease in the warrant exercise price, from $0.77 to $0.69. The
      number of additional shares to be issued upon subsequent dilutive issuances
      is
      now finite and the Company will reserve for the issuance from its authorized
      common shares. The warrants are no longer considered a liability and the Company
      reclassified the warrant derivative liability of $5,911,000 to additional paid
      in capital. The Company also recorded $86,000 in other expense related to the
      modification of the warrant.





(9)
      Series D Redeemable Convertible Preferred Stock





During
      the three and six months ended June 30, 2007 Midsummer Capital and Islandia
      converted/redeemed 1,212 and 2,406 shares of the Series D redeemable,
      convertible preferred stock into 1,543,000 and 3,133,000 shares of the Company’s
      common stock, respectively. During the three and six months ended June 30,
      2007
      the Company accrued dividends of $18,000 and $71,000 and paid dividends in
      the
      amount of $26,000 and $81,000 through the issuance of 13,000 and 90,000 shares
      of common stock, respectively.





(10)
      Warrants





During
      the six months ended June 30, 2007 5,487,000 warrants were exercised and the
      Company received proceeds of $5,471,000.





(11)
      Common Stock





During
      the six months ended June 30, 2007, the Company issued 139,000 shares of
      restricted stock to its Board of Directors. The restricted stock vests in March
      2008. The Company recognized $40,000 and $54,000 in compensation expense for
      the
      three and six months ended June 30, 2007, respectively.




-12-





During
      the six months ended June 30, 2007, the Company issued 453,000 shares of
      restricted stock to its employees. The restricted stock vests over a 48-month
      period. The Company recognized $43,000 in compensation expense for the three
      and
      six months ended June 30, 2007, respectively.





During
      the six months ended June 30, 2007 the Company received $1,325,000 in proceeds
      and issued 1,898,000 shares of its common stock for stock option exercises.
      In
      addition, during the six months ended June 30, 2007 the Company issued 1,004,000
      shares of its common stock in cashless exercises of stock options and 722,000
      shares were retained by the Company in payment of the options and related
      taxes.





(12)
      Treasury Stock





During
      the six months ended June 30, 2007 the Company allowed its employees cashless
      exercises of their stock options. Some of the Company’s stock option plans
      require that the shares retained by the Company in payment of the options and
      related taxes be recorded as Treasury stock. During the six months ended June
      30, 2007 the Company received a total of 673,000 shares at a value of
      $1,431,000, of which 215,000 shares at a value of $472,000 were received for
      payment of taxes. In April 2007 the Company’s Board of Directors authorized that
      all the shares recorded as Treasury stock be cancelled and that all subsequent
      shares received from cashless exercises be cancelled immediately after receipt.





(13)
      Customer Concentration





For
      the
      three and six months ended June 30, 2007, there were no customers that accounted
      for 10% or more of the Company’s revenue. 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.





(14)
      Pending Acquisition of Hantro Products Oy




On
        May
        21, 2007, we entered into a definitive agreement with Nexit Ventures Oy,
        as the
        authorized representative of the holders of all outstanding equity securities
        (including outstanding share options) of Hantro Products Oy, a corporation
        organized under the laws of Finland ("Hantro") to acquire all outstanding
        equity
        securities of Hantro. Under the terms of the agreement, which has been approved
        by the boards of directors of both the Company and Hantro, at the closing
        the
        Company will pay $6,841,775 in cash and issue shares of the Company's common
        stock, par value $.01 per share, directly to the Hantro securityholders.
        Based
        on the closing price of the Company's common stock on August 10, 2007, the
        shares to be issued to the Hantro securityholders at the closing prior to
        adjustment would represent approximately 18% of the Company's currently
        outstanding common stock, after giving effect to the Hantro share exchange.
        Upon
        completion of the share exchange, Hantro and its subsidiary will become
        wholly-owned subsidiaries of the Company. The number of shares to be issued
        will
        be determined at the closing of the share exchange based on the volume-weighted
        average price of the Company's common stock for the 10 trading days prior
        to the
        closing (the "Closing Share Price"). A portion of the shares payable at the
        closing will be held in escrow for a period of one year. The number of shares
        issued at the closing to the Hantro securityholders is subject to adjustment
        based on Hantro's stockholders' equity as of the closing date.
 
 If
        the
        Closing Share Price is between $1.50 and $2.50 per share, the total value
        of the
        shares to be issued by the Company at the closing will equal $45,000,000
        less
        the cash component of $6,841,775. If the Closing Share Price is $1.50 or
        less,
        the Company will issue approximately 25,440,000 shares. If the Closing Share
        Price is $2.50 or more, the Company will issue approximately 15,300,000 shares.
 
 The
        Company intends to fund the cash portion of the purchase price primarily
        through
        its internal cash resources. Closing of the transaction is, however, conditional
        upon the Company's having raised at least $20,000,000 from one or more offerings
        of its equity securities. The purpose of the offering is to raise equity
        capital
        for the combined companies.
 
 The
        Share
        Exchange Agreement provides that the Hantro securityholders may become entitled
        to receive additional consideration of up to 12,500,000 additional shares
        of the
        Company's common stock (the "Contingent Consideration") if Hantro's net revenue
        for 2007 exceeds targets of €6,000,000 and €7,500,000. The full 12,500,000
        additional shares will be issued if Hantro's 2007 net revenue exceeds
€9,000,000. Based on the closing price of the Company's common stock on August
        10, 2007, the Contingent Consideration, if fully issued, would represent
        an
        additional approximately 8.8% of the Company's currently outstanding common
        stock, after giving effect to the Hantro share exchange.
 
 The
        acquisition, which is expected to close in Fall 2007, is subject to customary
        closing conditions, including approval by the stockholders of the
        Company.


-13-





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





**Forward-Looking
      Statement**





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




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




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




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





**Pending
      Acquisition of Hantro Products Oy**




On
      May
      21, 2007, we entered into a definitive agreement with Nexit Ventures Oy, as
      the
      authorized representative of the holders of all outstanding equity securities
      (including outstanding share options) of Hantro Products Oy, a corporation
      organized under the laws of Finland ("Hantro") to acquire all outstanding equity
      securities of Hantro. Under the terms of the agreement, which has been approved
      by the boards of directors of both the Company and Hantro, at the closing the
      Company will pay $6,841,775 in cash and issue shares of the Company's common
      stock, par value $.01 per share, directly to the Hantro securityholders. Based
      on the closing price of the Company's common stock on August 10, 2007, the
      shares to be issued to the Hantro securityholders at the closing prior to
      adjustment would represent approximately 18% of the Company's currently
      outstanding common stock, after giving effect to the Hantro share exchange.
      Upon
      completion of the share exchange, Hantro and its subsidiary will become
      wholly-owned subsidiaries of the Company. The number of shares to be issued
      will
      be determined at the closing of the share exchange based on the volume-weighted
      average price of the Company's common stock for the 10 trading days prior to
      the
      closing (the "Closing Share Price"). A portion of the shares payable at the
      closing will be held in escrow for a period of one year. The number of shares
      issued at the closing to the Hantro securityholders is subject to adjustment
      based on Hantro's stockholders' equity as of the closing date.




-14-





If
      the
      Closing Share Price is between $1.50 and $2.50 per share, the total value of
      the
      shares to be issued by the Company at the closing will equal $45,000,000 less
      the cash component of $6,841,775. If the Closing Share Price is $1.50 or less,
      the Company will issue approximately 25,440,000 shares. If the Closing Share
      Price is $2.50 or more, the Company will issue approximately 15,300,000 shares.





The
      Company intends to fund the cash portion of the purchase price primarily through
      its internal cash resources. Closing of the transaction is, however, conditional
      upon the Company's having raised at least $20,000,000 from one or more offerings
      of its equity securities. The purpose of the offering is to raise equity capital
      for the combined companies.





The
      Share
      Exchange Agreement provides that the Hantro securityholders may become entitled
      to receive additional consideration of up to 12,500,000 additional shares of
      the
      Company's common stock (the "Contingent Consideration") if Hantro's net revenue
      for 2007 exceeds targets of €6,000,000 and €7,500,000. The full 12,500,000
      additional shares will be issued if Hantro's 2007 net revenue exceeds
€9,000,000. Based on the closing price of the Company's common stock on August
      10, 2007, the Contingent Consideration, if fully issued, would represent an
      additional approximately 8.8% of the Company's currently outstanding common
      stock, after giving effect to the Hantro share exchange.





The
      acquisition, which is expected to close in Fall 2007, is subject to customary
      closing conditions, including approval by the stockholders of the
      Company.





Set
      forth
      under Part II, Item 1A of this report is a description of some of the risks
      related to the Hantro share exchange that should be taken into consideration
      when making an investment decision regarding On2.





**Overview**




On2
      Technologies is a developer of video compression technology. 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/decompression technology is based solely on intellectual property
      that we developed and own ourselves.




In
      2004,
      we licensed our video compression technology to Macromedia, Inc. (now Adobe
      Systems Incorporated) for use in the Flash® multimedia player. In anticipation
      of Adobe using our codec in the Flash platform, we launched our business of
      developing and marketing video encoding software for the Flash platform. While
      our primary focus remains the development of video compression technology,
      our
      Flash encoding business is a significant part of our business.




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




-15-






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





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




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





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




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




-16-




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




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




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




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




One
      of
      the most significant recent trends in our business is our increasing reliance
      on
      the success of the product deployments of our customers. As referenced above,
      an
      increasing number of our license agreements with customers provide for the
      payment of license fees that are dependent on the number of units of a
      customer’s product incorporating our software that are sold or the amount of
      revenue generated by a customer from the sale of products or services that
      incorporate our software. We have chosen this royalty-dependent licensing model
      because, as a company of approximately 40 employees and in light of the vast
      range of conceivable video-enabled devices, we do not have the product
      development or marketing resources to develop and market end-to-end video
      solutions. Instead, our codec software is primarily intended to be used as
      a
      building block for companies that are developing end-to-end video products
      and/or services.




-17-




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




We
      believe that we have adopted the licensing model most appropriate for a business
      of our size and expertise. However, a natural result of this licensing model
      is
      that the amount of revenue we generate is highly dependent on the success of
      our
      customers’ product deployments. In certain circumstances, we may decide to
      reduce the amount of up-front license fees and charge a higher per-unit royalty.
      If the products of customers with whom we have established per unit royalty
      or
      revenue sharing relationships or for which we expect to market complementary
      products do not generate significant sales, these revenues may not attain
      significant levels. In addition, our agreements with our customers usually
      do
      not require that they use our technology exclusively, so it is possible that
      a
      customer may never implement our technology or may at some point choose to
      support competing technology on which we do not receive a royalty. Conversely,
      if one or more of such customers’ products are widely adopted, our revenues will
      likely be enhanced.




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




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




-18-




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




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




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




The
      market for digital media creation and delivery technology is constantly changing
      and becoming increasingly competitive. Our strategy includes focusing on
      providing our customers with video compression/decompression technology that
      delivers the highest possible video quality at the lowest possible data rates.
      To do this, we devote a significant portion of our engineering capacity to
      research and development. We also are devoting significant attention to enabling
      our codecs to operate on a wide array of chips. This should encourage use by
      customers who want to develop video-enabled consumer products in a short
      timeframe. We are doing this both by bolstering our team of engineers who
      integrate our codecs on chips and by developing relationships with chip
      companies and enabling them to perform such integration.




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




-19-





**Critical
      Accounting Policies and Estimates**





This
      discussion and analysis of our financial condition and results of operations
      are
      based on our unaudited consolidated financial statements that have been prepared
      under accounting principles generally accepted in the United States of America.
      The preparation of financial statements in conformity with accounting principles
      generally accepted in the United States of America requires our management
      to
      make estimates and assumptions that affect the reported amounts of assets and
      liabilities and the disclosure of contingent assets and liabilities at the
      date
      of the financial statements and the reported amounts of revenue and expenses
      during the reporting period. Actual results could materially differ from those
      estimates. The unaudited condensed consolidated financial statements and the
      related notes thereto should be read in conjunction with the discussion of
      our
      critical accounting policies and our Form 10K filed with the Securities and
      Exchange Commission on March 23, 2007. Our critical accounting policies and
      estimates are:





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





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





We
      recognize revenue in accordance with SOP 97-2, “SOFTWARE REVENUE RECOGNITION”
(“SOP 97-2”), as amended by SOP 98-4, “DEFERRAL OF THE EFFECTIVE DATE OF SOP
      97-2, SOFTWARE REVENUE RECOGNITION” and SOP 98-9, “MODIFICATION OF SOP 97-2 WITH
      RESPECT TO CERTAIN TRANSACTIONS” (“SOP 98-9”). Under each arrangement, revenues
      are recognized when a non-cancelable agreement has been signed and the customer
      acknowledges an unconditional obligation to pay, the products or applications
      have been delivered, there are no uncertainties surrounding customer acceptance,
      the fees are fixed and determinable, and collection is considered probable.
      Revenues recognized from multiple-element software arrangements are allocated
      to
      each element of the arrangement based on the fair values of the elements, such
      as product licenses, post-contract customer support, or training. The
      determination of the fair value is based on the vendor specific objective
      evidence available to us. If such evidence of the fair value of each element
      of
      the arrangement does not exist, we defer all revenue from the arrangement until
      such time that evidence of the fair value does exist or until all elements
      of
      the arrangement are delivered.





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




-20-





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





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





*Equity-Based
      Compensation* We
      adopted the provisions of SFAS No. 123R effective January 1, 2006, using the
      modified prospective transition method. Under the modified prospective method,
      non-cash compensation expense is recognized under the fair value method for
      the
      portion of outstanding share based awards granted prior to the adoption of
      SFAS
      123R for which service has not been rendered, and for any future share based
      awards granted or modified after adoption. Accordingly, periods prior to
      adoption have not been restated. We recognize share-based compensation cost
      associated with awards subject to graded vesting in accordance with the
      accelerated method specified in FASB Interpretation No. 28 pursuant to which
      each vesting tranche is treated as a separate award. The compensation cost
      associated with each vesting tranche is recognized as expense evenly over the
      vesting period of that tranche.





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




Long-lived
      assets and identifiable intangibles with finite lives are reviewed for
      impairment whenever events or changes in circumstances indicate that the
      carrying amount of an asset may not be recoverable. Recoverability of assets
      to
      be held and used is measured by a comparison of the carrying amount of an asset
      to future undiscounted net cash flows expected to be generated by the asset.
      If
      such assets are considered to be impaired, the impairment recognized is measured
      by the amount by which the carrying amount of the assets exceeds the fair value
      of the assets. Assets to be disposed of are reported at the lower of the
      carrying amount or fair value less costs to sell. As of June 30, 2007, we
      believe that no such impairment has occurred.





**Results
      of Operations**





*Revenue.*





Revenue
      for the three months ended June 30, 2007 was $2,554,000 as compared with
      $1,535,000 for the three months ended June 30, 2006. Revenue for the six months
      ended June 30, 2007 was $5,369,000 as compared with $2,752,000 for the six
      months ended June 30, 2006. Revenue for the three and six months ended June
      30,
      2007 and 2006 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, 2007 is primarily attributed to increases in
      sales
      of our Flix and Adobe® Flash® related products.




-21-





*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, 2007 were $2,699,000 as compared to $3,082,000 for the three months ended
      June 30, 2006. Operating expenses were $5,318,000 for the six months ended
      June
      30, 2007 as compared to $5,448,000 for the six months ended June 30,
      2006.





*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 intangible assets recorded in connection with the Flix
      acquisition, costs associated with the Wildform Support and Maintenance
      Agreement and depreciation. Cost of revenue for the three months ended June
      30,
      2007 was $389,000 as compared to $705,000 for the three months ended June 30,
      2006. Cost of revenues for the six months ended June 30, 2007 was $812,000
      as
      compared to $1,288,000 for the six months ended June 30, 2006. The decrease
      in
      expenses for the three and six months ended June 30, 2007 is primarily due
      to a
      decrease in the number of personnel hours spent on customer projects, costs
      associated with the Wildform Support and Maintenance Agreement which ended
      in
      October 2006 and stock-based compensation costs.





*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, 2007 were $562,000 as compared to $214,000 for the three months
      ended June 30, 2006. Research and development expenses for the six months ended
      June 30, 2007 were $1,055,000 as compared to $439,000 for the six months ended
      June 30, 2006. The increase in expenses was primarily attributed to an increase
      in the number of personnel hours spent on research and development
      projects.




*Sales
      and Marketing.*





Sales
      and
      marketing expenses, excluding equity-based compensation, consist primarily
      of
      salaries and related costs, commissions, business development costs, 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, 2007 were $614,000 as compared to $172,000 for the three months
      ended June 30, 2006. Sales and marketing expenses for the six months ended
      June
      30, 2007 were $1,210,000 as compared to $360,000 for the six months ended June
      30, 2006. The increase for the three and six months ended June 30, 2007 as
      compared with 2006 is primarily due to an increase in marketing personnel and
      related costs, commissions, tradeshow expenses and advertising and marketing
      costs.





*General
      and Administrative* .





General
      and administrative expenses, excluding equity-based compensation, consist
      primarily of salaries and related 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, 2007 were $980,000
      as compared with $1,280,000 for the three months ended June 30, 2006. General
      and administrative expenses for the six months ended June 30, 2007 were
      $1,939,000 as compared with $2,540,000 for the six months ended June 30, 2006.
      The decrease for the both the three and six-month periods is primarily due
      to a
      decrease 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 decreases in other professional fees for consulting services and
      recruiting and relocation expenses.




-22-





*Equity-Based
      Compensation.*





Equity
      based compensation, which is presented separately, was $154,000 and $302,000
      for
      the three and six months ended June 30, 2007, respectively. Equity-based
      compensation of $14,000 and $15,000 is included in cost of revenue for the
      three
      and six months ended June 30, 2007, respectively. Equity based compensation
      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.
      The decrease is primarily due to the completion of amortization as options
      become fully vested coupled with a decrease of new grants in the current
      year.





*Interest
      and other income (expense), net*





Interest
      and other income (expense), net consists of other income/expense and interest
      income/expense.





Other
      income/expense consists primarily of the change in the fair value of the
      derivative liability, gains and losses on marketable securities and the fair
      value of the change in the Midsummer/Rockmore warrants. Interest income/expense
      consists primarily of interest paid for capital lease obligations and debt,
      amortization of debt discount and interest earned on the Company’s cash
      balances.





Interest
      and other income (expense), net was $(2,672,000) and $(3,585,000) for the three
      and six months ended June 30, 2007, respectively as compared with $1,000 and
      $(26,000) for the three and six months ended June 30, 2006, respectively. The
      increase of $2,673,000 and $3,558,000 in interest and other expense, net, for
      the three and six months ended June 30, 2007 as compared with 2006, is primarily
      a result of the following:





·
            For
                the three months ended June 30, 2007 there was an increase in other
                expense, net of $2,753,000 which consists of primarily $2,668,000
                increase
                in the fair value of the warrant derivative liability, as a result
                of the
                Company’s increased stock price and an $86,000 charge for the fair value
                of the change in the exercise price of the Midsummer/Rockmore warrants
                from $0.77 to $0.69 partially offset by interest income of $83,000
                earned
                on cash invested in Treasury Bills.





·
            For
                the six months ended June 30, 2007 there was an increase in other
                expense,
                net of $3,669,000 which consists primarily of $3,582,000 increase
                in the
                fair value of the warrant derivative liability, as a result of the
                Company’s increased stock price, an $86,000 charge for the fair value of
                the change in the exercise price of the Midsummer/Rockmore warrant
                from
                $0.77 to $0.69 offset by a decreases in losses on marketable securities
                and net interest income of $111,000 earned on cash invested in Treasury
                Bills.





At
      June
      30, 2007, the Company had approximately 38 full-time employees. The Company
      expects to hire employees as necessary in order to attain its strategic
      objectives





**Liquidity
      and Capital Resources**





At
      June
      30, 2007, we had cash and cash equivalents of $10,369,000 as compared to
      $4,961,000 at December 31, 2006. At June 30, 2007, the Company had working
      capital of $10,956,000 as compared with $5,268,000 at December 31, 2006.




-23-





Net
      cash
      provided by (used in) operating activities was $359,000 and $(1,668,000) for
      the
      six months ended June 30, 2007 and 2006, respectively. Although the Company
      had
      a larger net loss, the decrease in net cash used in operating activities is
      primarily related to a charge recorded for the increase in the warrant
      derivative liability and the change in accounts payable partially offset by
      the
      changes in accounts receivable and deferred revenue.




Net
      cash
      (used in) provided by investing activities was $(1,122,000) and $31,000 for
      the
      six months ended June 30, 2007 and 2006, respectively. The increase of net
      cash
      used in investing activities for the six months ended June 30, 2007 is primarily
      a result of an increase in deferred acquisition costs associated with the
      pending Hantro acquisition, the purchase of marketable securities and fixed
      assets partially offset by an increase in proceeds from the sale of marketable
      securities.





Net
      cash
      provided by financing activities was $6,276,000 and $439,000 for the six months
      ended June 30, 2007 and 2006, respectively. The increase is primarily
      attributable to a increase 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 Tarrytown, New
      York
      and in the UK. The aggregate required payments for the next 12 months under
      these arrangements are $186,000. 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 $900,000 per month in cash
      operating costs.





The
      Company believes that existing funds are sufficient to fund its operations
      through June 30, 2008. The Company plans to increase cash flows from operations
      principally from increases in revenue generated from its compression technology
      services and products. The Company may also pursue additional financings. See
      “ *Management’s
      Discussion and Analysis of Financial Condition and Results of Operations -
      Risk
      Factors That May Affect Future Operating Results* ”
in
      the
      Company’s 10-K for the year ended December 31, 2006.





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.





**Impact
      of Recently-Issued Accounting Pronouncements**





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




-24-





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





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





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





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





**Item
      4. Controls and Procedures**





(a)
      Evaluation of Disclosure Controls and Procedures:





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 over financial reporting
      that
      occurred during our most recent fiscal quarter that have materially affected,
      or
      are reasonably likely to materially affect our internal control over financial
      reporting.




-25-


**PART
      II — OTHER INFORMATION**





**Item
      1. Legal Proceedings**





**Internal
      Investigation**





On
      March
      2, 2006, On2 filed a Form 8-K, which disclosed that it had voluntarily reported
      to the Securities and Exchange Commission (“SEC”) that On2 had undertaken an
      internal investigation into facts and circumstances concerning investor and
      other communications made by its former Chairman, Chief Executive Officer and
      President. On2 has completed its internal investigation, and, on May 5, 2006,
      the Company’s outside law firm submitted its final report to the Board of
      Directors. On2 subsequently delivered the report to the SEC and the American
      Stock Exchange on May 9, 2006. To date, since delivery of the report,
      neither the SEC nor the AMEX has contacted On2 with respect to the
      investigation. The Company has agreed to work with the SEC and the American
      Stock Exchange in connection with any investigations conducted by them. The
      Company has not uncovered any evidence of financial impropriety, and thus the
      Company continues to believe that the investigation will have no effect on
      previously filed financial statements or lead to any restatement of reported
      financial results.





**Beijing
      E-World**





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





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





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





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





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





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




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





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





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





On2
      has
      requested that the arbitrator award it approximately $5,690,000 in damages
      under
      the contract and grant it further relief as may be just and equitable.





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




-26-





**Item
      1A Risk Factors.**





In
      addition to those risks described in On2’s Annual Report on Form 10-K filed
      March 23, 2007, as amended April 30, 2007 and May 10, 2007, there are certain
      additional risks relating to On2’s proposed share exchange transaction pursuant
      to which On2 intends to acquire Hantro Products Oy. These risks include the
      following:





**RISK
      FACTORS RELATING TO THE SHARE EXCHANGE**




***The
      number of shares of On2’s common stock that Hantro securityholders will receive
      in the share exchange is based on the market value of On2’s common stock. As a
      result of daily changes in the market value of On2’s common stock before the
      completion of the share exchange, it will not be possible to ascertain the
      exact
      number of On2 shares to be issued in the share exchange until
      closing.***




Under
      the
      terms of the Share Exchange Agreement, at the closing of the share exchange
      On2
      will pay $6,841,775 in cash and issue shares of its common stock, par value
      $.01
      per share, directly to the Hantro securityholders. The amount of shares will
      be
      calculated using the volume-weighted average price of On2’s common stock for the
      10 trading days prior to the closing. Based on the closing price of On2’s common
      stock on August 10, 2007,
      the shares to be issued to the Hantro securityholders at the closing prior
      to
      adjustment would represent approximately
      18% of On2’s
      currently outstanding common stock, after giving effect to the Hantro share
      exchange.





If
      the
      closing share price in the share exchange is between $1.50 and $2.50 per share,
      the total value of the shares to be issued by On2 at the closing will equal
      $45,000,000 less the cash component of $6,841,775. If the closing share price
      is
      $1.50 or less, On2 will issue approximately 25,440,000 shares. If the closing
      share price is $2.50 or more, On2 will issue approximately 15,300,000 shares.





***Although
      the number of shares that On2 is obligated to issue to the Hantro
      securityholders is limited, the value of those shares is not, and, as a result,
      the additional goodwill reported on On2’s balance sheet as a result of On2’s
      acquisition of Hantro may become impaired at a future date and accordingly
      require On2 to record a loss in the amount of the impairment in its results
      of
      operations.***




The
      dollar value of the purchase price associated with the shares that On2 will
      issue to the Hantro securityholders will vary with the market price of On2’s
      common stock. For example, if the volume weighted average price per share for
      On2’s common stock for the 10 trading days prior to the closing is $2.50, at the
      closing, On2 will issue approximately 15.3 million shares of its common stock
      to
      the Hantro securityholders in the share exchange, with a corresponding value
      of
      approximately $38.25 million. Following the end of 2007, based on the
      performance of Hantro’s product lines during 2007, On2 may pay the Hantro
      securityholders additional consideration of up to 12,500,000 shares of On2’s
      common stock, adding an additional amount to the purchase price. For example,
      if
      the full amount of the Contingent Consideration becomes due, and the market
      price per share for On2’s common stock is $2.00at the time of payment, an
      additional $25,000,000 will be added to the purchase price. Although On2 has
      not
      yet valued the acquisition of Hantro for its accounting purposes, it is likely
      that substantially all of the purchase price, or $63.25 million in the above
      example, will be allocated to goodwill. Under generally accepted accounting
      principles, On2 will test the goodwill at regular intervals to determine whether
      the carrying value of goodwill associated with the Hantro acquisition exceeds
      the fair value. To the extent that it does, On2 will be forced to make a
      corresponding reduction in the carrying value of its goodwill, and will also
      be
      required to take a corresponding charge against earnings for the period in
      which
      it recorded the impairment. The size of the impairment could be significant,
      and
      could have a material adverse effect on the business and financial position
      of
      On2, as well as on the trading price of its shares.




-27-




The
      market value of On2’s common stock has varied since On2 and Hantro entered into
      the Share Exchange Agreement and will continue to vary in the future due to
      changes in the business, operations or prospects of On2, market assessments
      of
      the business combination, regulatory considerations, market and economic
      considerations, and other factors both within and beyond the control of On2
      and
      Hantro.




**The
      share exchange is subject to the receipt of certain waivers from Hantro’s bank
      lenders and a Finnish governmental entity relating to the repayment of certain
      indebtedness of Hantro or of grants to Hantro, as a result of the share
      exchange. Such lenders or such entity could impose conditions that could have
      an
      adverse effect on On2 or Hantro or could cause abandonment of the share
      exchange.**




Completion
      of the share exchange is conditioned upon the receipt of waivers from Hantro’s
      bank lenders and a Finnish governmental agency that has granted funds to Hantro
      so that Hantro’s existing credit facilities and grants will remain in place
      without acceleration or requirement of repayment.




On2
      has
      agreed that it will guarantee Hantro’s outstanding lines of credit up to a limit
      of €3,653,000. Since On2 currently has no long-term debt, the guarantees may
      adversely affect On2’s financial position.




**Any
      delay in completing the share exchange may significantly reduce the benefits
      expected to be obtained from the business combination.**




In
      addition to the required waivers from third parties, the share exchange is
      subject to other conditions beyond the control of On2 and Hantro that may
      prevent, delay or otherwise materially adversely affect its completion,
      including On2’s ability to raise $20,000,000 in one or more equity financing
      transactions. On2 and Hantro cannot predict whether and when these conditions
      will be satisfied. Further, the requirements for obtaining the required waivers
      from third parties could delay the completion of the share exchange or prevent
      it from occurring. Any delay in completing the share exchange may significantly
      reduce the synergies and other benefits that On2 and Hantro expect to achieve
      from successfully completing the share exchange and integrating their respective
      businesses within the expected timeframe.




**Customer
      uncertainties related to the business combination could adversely affect the
      businesses, revenues and gross margins of On2, Hantro and the combined
      company.**




In
      response to the announcement of the share exchange or due to ongoing uncertainty
      about the business combination, customers of On2 or Hantro may delay or defer
      purchasing decisions or elect to switch to other suppliers. In particular,
      prospective customers could be reluctant to purchase the products and services
      of On2, Hantro or the combined company due to uncertainty about the direction
      of
      the combined company’s offerings and willingness to support existing products.
      To the extent that the business combination creates uncertainty among those
      persons and organizations contemplating purchases, or a significant group of
      customers delays, defers or changes purchases, the revenues of the combined
      company would be adversely affected. Customer assurances may be made by On2
      and
      Hantro to address their customers’ uncertainty about the direction of the
      combined company’s product and related support offerings, which may result in
      additional obligations of On2, Hantro or the combined company. In addition,
      the
      announcement of the share exchange may cause prospective licensees of Hantro’s
      intellectual property to delay or defer licensing decisions resulting in a
      decline in Hantro’s licensing revenues which could have a significant impact on
      the profitability of Hantro and the combined company. Quarterly revenues and
      net
      earnings of On2, Hantro or the combined company could be substantially below
      expectations of market analysts, and a decline in the companies’ respective
      stock prices could result.




-28-




**If
      the share exchange is not completed, On2 will have incurred substantial costs
      that may adversely affect On2’s financial results and operations and the market
      price of On2’s common stock.**




The
      current trading price of On2’s common stock reflects a market assumption that
      the share exchange will be completed. If the share exchange is not completed,
      the price of On2’s common stock may decline. In addition, On2 has incurred and
      will incur substantial costs in connection with the proposed share exchange.
      These costs are primarily associated with the fees of attorneys, accountants
      and
      On2’s financial advisors. In addition, On2 has diverted significant management
      resources in an effort to complete the share exchange. If the share exchange
      is
      not completed, On2 will have incurred significant costs, including the diversion
      of management resources, for which it will have received little or no benefit.




In
      addition, if the share exchange is not completed, On2 may experience negative
      reactions from the financial markets and On2’s suppliers, customers and
      employees. Each of these factors may adversely affect the trading price of
      On2’s
      common stock and On2’s financial results and operations.




**RISK
      FACTORS RELATING TO THE COMBINED COMPANY FOLLOWING THE BUSINESS
      COMBINATION**




***The
      combined company may fail to realize the benefits expected from the business
      combination, which could adversely affect the value of On2’s common
      stock.***




The
      business combination involves the integration of On2 and Hantro, two companies
      that have previously operated independently. On2 and Hantro entered into the
      Share Exchange Agreement with the expectation that, among other things, the
      business combination would enable the combined company to consolidate support
      functions, leverage its research and development, patents and services across
      a
      larger base, and integrate its workforce, to create opportunities to achieve
      cost savings and to become a stronger and more competitive company. Although
      On2
      and Hantro expect significant benefits to result from the business combination,
      there can be no assurance that the combined company will actually realize these
      or any other anticipated benefits of the business combination.




The
      value
      of On2’s common stock following completion of the share exchange may be affected
      by the ability of the combined company to achieve the benefits expected to
      result from the business combination. On2 and Hantro currently operate in
      several countries, with a combined workforce of approximately 110 employees.
      Achieving the benefits of the business combination will depend in part upon
      meeting the challenges inherent in the successful combination and integration
      of
      global business enterprises of the size and scope of On2 and Hantro. The
      challenges involved in this integration include the following:




-
      demonstrating to customers of On2 and Hantro that the business combination
      will
      not result in adverse changes to the ability of the combined company to address
      the needs of customers, or the loss of attention or business focus;




-
      coordinating and integrating independent research and development teams across
      technologies and product platforms to enhance product development while reducing
      costs;




-
      combining product offerings;




-29-




-
      consolidating and integrating corporate, information technology, finance, and
      administrative infrastructures;




-
      coordinating sales and marketing efforts to effectively position the
      capabilities of the combined company and the direction of product development;
      and




-
      minimizing the diversion of management attention from important business
      objectives.




If
      the
      combined company does not successfully manage these issues and the other
      challenges inherent in integrating businesses of the size and complexity of
      On2
      and Hantro, then the combined company may not achieve the anticipated benefits
      of the business combination and the revenues, expenses, operating results and
      financial condition of the combined company could be materially adversely
      effected. For example, goodwill and other intangible assets could be determined
      to be impaired which could adversely impact the company’s financial results. The
      successful integration of the On2 and Hantro businesses is likely to require
      significant management attention both before and after the completion of the
      business combination, and may divert the attention of management from business
      and operational issues of On2, Hantro and the combined company.




***Uncertainties
      associated with the business combination may cause a loss of employees and
      may
      otherwise materially adversely affect the businesses of On2 and Hantro, and
      the
      future business and operations of the combined
      company.***




The
      combined company’s success after the business combination will depend in part
      upon the ability of the combined company to retain key employees of On2 and
      Hantro. In some of the fields in which On2 and Hantro operate, there are only
      a
      limited number of people in the job market who possess the requisite skills.
      Each of On2 and Hantro has experienced difficulty in hiring and retaining
      sufficient numbers of qualified engineers in parts of their respective
      businesses. Current and prospective employees of On2 and Hantro may experience
      uncertainty about their post-business combination roles with the combined
      company following the share exchange. This may materially adversely affect
      the
      ability of each of On2 and Hantro to attract and retain key management, sales,
      marketing, technical and other personnel. In addition, key employees may depart
      because of issues relating to the uncertainty and difficulty of integration
      or a
      desire not to remain with the combined company following the share exchange.
      The
      loss of services of any key personnel or the inability to hire new personnel
      with the requisite skills could restrict the ability of On2, Hantro and the
      combined company to develop new products or enhance existing products in a
      timely manner, to sell products to customers or to effectively manage the
      business of On2, Hantro and the combined company.




**General
      economic weakness and geopolitical factors may harm the combined company’s
      operating results and financial condition.**




The
      results of operations of the combined company will be dependent to a large
      extent upon the global economy. Geopolitical factors such as terrorist
      activities, armed conflict or global health conditions that adversely affect
      the
      global economy may adversely affect the operating results and financial
      condition of the combined company.




**The
      combined company will conduct a significant amount of activity outside of the
      United States, and will be exposed to legal, business, political and economic
      risks associated with its international operations.**




Each
      of
      On2 and Hantro derive a substantial portion of their revenue from sales of
      products shipped to locations outside of the United States. In addition, On2
      and
      Hantro manufacture a significant portion of their products outside of the United
      States and will be dependent on non-U.S. suppliers for many parts and services.
      The combined company may also pursue growth opportunities in sales, design
      and
      manufacturing outside of the United States. Operations outside of the United
      States are subject to a number of risks and potential costs that could adversely
      affect revenue and results of operations, including:




-30-




-
      political, social and economic instability;




-
      fluctuations in currency exchange rates;




-
      exposure to different legal standards, particularly with respect to intellectual
      property;




-
      natural
      disasters and public health emergencies;




-
      nationalization of business and blocking of cash flows;




-
      trade
      and travel restrictions;




-
      imposition of governmental controls and restrictions;




-
      burdens
      of complying with a variety of foreign laws;




-
      import
      and export license requirements and restrictions;




-
      unexpected changes in regulatory requirements;




-
      foreign
      technical standards;




-
      difficulties in staffing and managing international operations;




-
      international trade disputes;




-
      difficulties in collecting receivables from foreign entities or delayed revenue
      recognition; and




-
      potentially adverse tax consequences.




***The
      trading price of the combined company’s stock may be affected by factors
      different from those currently affecting the prices of On2 or Hantro common
      stock.***




Upon
      completion of the share exchange, the Hantro securityholders will become holders
      of On2’s common stock. The results of operations of the combined company, as
      well as the trading price of On2’s common stock after the share exchange, may be
      affected by factors different from those currently affecting Hantro’s results of
      operations.




**The
      combined company will face uncertainties related to the effectiveness of
      internal controls.**




Public
      companies in the United States are required to review their internal controls
      over financial reporting under Section 404 of the Sarbanes-Oxley Act of 2002.
      It
      should be noted that any system of controls, however well designed and operated,
      can provide only reasonable, and not absolute, assurance that the objectives
      of
      the system are met. In addition, the design of any control system is based
      in
      part upon certain assumptions about the likelihood of future events. Because
      of
      these and other inherent limitations of control systems, there can be no
      assurance that any design will achieve its stated goal under all potential
      future conditions, regardless of how remote.




Although
      each of On2’s and Hantro’s management has determined, and each of their
      respective independent registered public accounting firms have attested, that
      their respective internal controls were effective as of as of the end of their
      most recent fiscal years, there can be no assurance that the integration of
      On2
      and Hantro, and their respective internal control systems and procedures, will
      not result in or lead to a future material weakness in the combined company’s
      internal controls, or that the combined company or its independent registered
      public accounting firm will not identify a material weakness in its internal
      controls in the future. A material weakness in internal controls over financial
      reporting would require management and the combined company’s independent public
      accounting firm to evaluate their internal controls as ineffective. If internal
      controls over financial reporting are not considered adequate, On2 may
      experience a loss of public confidence, which could have an adverse effect
      on
      its business and stock price.




-31-




**Internal
      control deficiencies or weaknesses that are not yet identified could
      emerge.**




Over
      time
      the combined company may identify and correct deficiencies or weaknesses in
      its
      internal controls and, where and when appropriate, report on the identification
      and correction of these deficiencies or weaknesses. However, the internal
      control procedures can provide only reasonable, and not absolute, assurance
      that
      deficiencies or weaknesses are identified. Deficiencies or weaknesses that
      are
      not yet identified by On2 or Hantro could emerge and the identification and
      correction of these deficiencies or weaknesses could have a material impact
      on
      the results of operations for the combined company.




**The
      combined company may need to obtain additional cash to operate its business
      and
      to be able to execute its business plan.**




Since
      its
      inception, On2 has incurred significant losses and negative cash flow from
      operations, and as of December 31, 2006, On2 had an accumulated deficit of
      approximately $128 million. On June 30, 2007, On2 had cash reserves of
      approximately $10.4 million. Since its inception, Hantro has also incurred
      significant losses and negative cash flow from operations. As of June 30, 2007,
      Hantro had cash reserves of approximately $96,000. On2 plans to raise an
      additional $20 million of cash from sales of its equity securities prior to
      the
      closing under the Share Exchange Agreement.




During
      the remainder of fiscal 2007, the combined company expects to meet its working
      capital obligations and other cash requirements with cash derived from the
      sale
      of products and services and from cash reserves, including the funds raised
      by
      the sale of equity securities. There can be no assurance, however, that cash
      derived from the sale of products and services will be sufficient for its
      operating needs or that it will be able to achieve profitability on a consistent
      basis. If cash used in operations is higher than anticipated and it is unable
      to
      secure additional funding, On2 would be required to further reduce expenditures
      to preserve cash, and effect further reductions in its corporate infrastructure,
      either of which could have a material adverse effect on the ability of the
      combined company to continue current levels of operations.




Even
      if
      the combined company obtains additional working capital in the near future,
      to
      the extent that operating expenses increase or it needs additional funds to
      make
      acquisitions, develop new technologies or acquire strategic assets, the need
      for
      additional funding may be accelerated and there can be no assurances that any
      such additional funding can be obtained on terms acceptable to On2, if at
      all.




**If
      the combined company cannot generate sufficient positive cash flows from its
      operations in the future, the combined company’s operating results and its stock
      price may be negatively impacted.**




Prior
      to
      the closing under the Share Exchange Agreement, neither On2 nor Hantro generated
      sufficient revenues to offset their operating costs. Moreover, as they continue
      to expand their product and service offerings to maintain competitive advantage,
      the combined company may be required to incur additional costs to hire and
      retain additional personnel, license complementary third party technology for
      use in their proprietary technology or expand both their international and
      domestic presence to enter new markets. These costs may significantly increase
      the combined company’s level of monthly operating expenses. Failure to generate
      sufficient capital through both their revenue streams and financings may require
      the combined company to execute additional corporate restructurings, scale
      back
      product or service offerings or limit the markets into which they enter. Any
      of
      these items, or a combination thereof, could have a harmful effect on On2’s
      operating results and its stock price.




-32-




**On2
      and Hantro have a history of losses and negative cash flow from operations,
      and
      anticipate continued losses.**




On2
      and
      Hantro have not achieved profitability, and it is a possibility that the
      combined company will continue to incur operating losses for the foreseeable
      future as it funds operating and capital expenditures in implementing its
      business plan. The combined company’s business model assumes that consumers will
      be attracted to and use broadband-specific video compression technology to
      access content available on customer Web sites or over proprietary networks
      that
      will, in turn, allow the combined company to provide its technology solutions
      to
      customers. The combined company’s business model is not yet proven, and it may
      never achieve or sustain profitability, further, there can be no assurance
      that
      its operating losses will not increase in the future. The combined company’s
      business strategy may be unsuccessful and they may not be able to adequately
      address all or any of these risks. Even if the combined company is able to
      achieve profitability, it may be unable to sustain, or increase, its
      profitability. In either case, the combined company’s operating results and
      liquidity would be adversely affected.




**On2’s
      stock price may fluctuate for reasons beyond its control, which could result
      in
      losses on your investment in On2’s common stock.**




Fluctuations
      in the market price of common stock may adversely affect On2’s access to capital
      and financing, and its ability to attract and retain qualified personnel.
      Historically, On2’s common stock price has fluctuated widely, with a 52-week
      range as of August 9, 2007 of $0.74 to $3.99. On2 expects fluctuations to
      continue in the future for a number of reasons, including:




-
      quarterly variations in its operating results;




-
      competitive announcements;




-
      the
      operating and stock price performance of other companies that investors may
      deem
      comparable to On2;




-
      news
      relating to trends in its markets; and




-
      changes
      in financial estimates by securities analysts or failure to meet analyst
      estimates.




In
      addition, the stock market generally has experienced significant price and
      volume fluctuations, and the market prices of companies in the combined
      company’s industry have been highly volatile. Due to the volatility of the stock
      market generally, the price of the combined company’s common stock could
      fluctuate for reasons beyond its control.




***If
      the combined company is unable to continue to attract, retain and motivate
      highly skilled employees, it may not be able to execute its business plan.***




The
      combined company’s ability to execute its growth plans and be successful depends
      on its continuing ability to attract, retain and motivate highly skilled
      employees. As the combined company continues to grow, it will need to hire
      additional personnel in all operational areas. On2 may be unable to retain
      its
      key employees or attract, assimilate or retain other highly qualified employees
      in the future. On2 and Hantro have from time to time in the past experienced,
      and the combined company expects to continue to experience in the future,
      difficulty in hiring and retaining highly skilled employees with appropriate
      qualifications. If the combined company does not succeed in attracting new
      personnel or retaining and motivating their current personnel, customers could
      experience delays in service, which could, in turn, adversely affect On2’s
      operating results and revenue. Additionally, retention of highly skilled
      employees may require additional personnel costs or the issuance of certain
      equity compensation. These factors would reduce profitability and the price
      of
      the combined company’s common stock.




-33-




***Strategic
      acquisitions could have a dilutive effect on your investment. Failure to make
      accretive acquisitions and successfully integrate them could adversely affect
      the combined company’s future financial results.***




As
      part
      of its growth strategy, On2 may seek to acquire or invest in complementary
      businesses or technologies. On2’s goal is to make such acquisitions, integrate
      these acquired assets into its operations, and expand the market for On2’s
      products and services and possibly offer additional products or services. The
      process of integrating these acquired assets into On2’s operations may result in
      unforeseen operating difficulties and expenditures, and may absorb significant
      management attention that would otherwise be available for the ongoing
      development of the combined company’s business. The combined company cannot be
      certain that the anticipated benefits of any acquisitions will be realized.
      Acquisitions also involve other risks, including entering geographic markets
      in
      which the combined company may have no or limited prior experience and the
      potential loss of key employees.




In
      addition, future acquisitions by the combined company could result in
      potentially dilutive issuances of equity securities, the incurrence of debt
      and
      contingent liabilities, and amortization expenses related to intangible assets,
      any of which could materially and adversely affect the combined company’s
      operating results and financial position. The combined company cannot be certain
      that it will be able to obtain the capital necessary to consummate acquisitions
      or alliances on satisfactory terms, if at all. Further, any businesses that
      the
      combined company acquires will likely have its own capital needs, which may
      be
      significant, and which the combined company could be called upon to satisfy
      independently of the acquisition price.




**Much
      of the combined company’s technology will rely on owned or licensed intellectual
      property, and if such rights are not protected from the use of others, including
      potential competitors, the combined company’s business prospects may be
      harmed.**




The
      failure to protect the combined company’s intellectual property could seriously
      harm its businesses and prospects because the combined company believes that
      its
      technology is unique and that the proprietary nature of the combined company’s
      intellectual property is critical to its success. If the combined company’s
      prospects are harmed, the price of the combined company’s common stock may
      decline because it may be less attractive to investors. The combined company’s
      efforts to protect its intellectual property through trademarks, copyrights,
      patents, trade secret laws, access to information and confidentiality agreements
      may not be adequate to protect the combined company’s proprietary rights. Even
      with all of these precautions, it could be possible for someone else to either
      copy or otherwise obtain and use the combined company’s proprietary information
      without authorization or to develop similar technology independently. In
      addition, effective trademark, copyright and trade secret protection may not
      be
      available in every country in which the combined company’s products and services
      are made available, and policing unauthorized use of its proprietary information
      is difficult and expensive. The combined company cannot be sure that the steps
      it takes will prevent misappropriation of the combined company’s proprietary
      information. In the future, the combined company may need to go to court to
      either enforce their intellectual property rights, to protect their trade
      secrets, or to determine the validity and scope of the proprietary rights of
      others. That litigation might result in substantial costs and diversion of
      resources and management attention.




-34-




Although
      the combined company does not currently license material third party
      technologies, the loss of which could adversely affect our business, we do
      from
      time to time license from third parties technologies incorporated into some
      of
      our products and services. As we continue to introduce new services that
      incorporate new technologies, we may be required to license additional
      technology from others. We cannot be sure that these third-party technology
      licenses will continue to be available on commercially reasonable terms, if
      at
      all.




**The
      broadband video services and technology markets are highly competitive, and
      the
      combined company’s failure to compete effectively could hurt its revenue and
      reduce its gross margins and profitability.**




The
      combined company faces significant competition in the market for its technology
      and services. In establishing the combined company’s broadband strategy, it
      faces a number of strong, firmly entrenched competitors, who are currently
      providing similar services to low-bandwidth users and high-bandwidth users
      and
      have greater financial, technical and marketing resources than the combined
      company. These and other companies have announced plans to provide broadband
      video-based services and technology. In addition to competition from other
      Internet content and technology companies, well-established media distribution
      companies, particularly in the cable television and satellite markets, have
      established, and continue to seek to establish, interactive, on-demand digital
      services through the development of sophisticated digital set-top technology
      and
      related back-end server systems. Those competitors could cause the combined
      company to lose customers and impair its ability to attract new
      customers.




**If
      the combined company fails to keep pace with technological advances in its
      industry, or if its pursues technologies that do not become commercially
      accepted, customers may not buy the combined company’s products and the combined
      company’s revenues may decline.**




The
      combined company’s future success depends, in large part, on its ability to use
      leading technologies effectively, to develop its technological expertise, to
      enhance its existing services and to develop new services that meet changing
      customer needs on a timely and cost-effective basis. The combined company is
      unable to predict which technological developments will challenge our
      competitive position or the amount of expenditures that will be required to
      respond to a rapidly changing technological environment. The combined company’s
      failure to respond in a timely and effective manner to new and evolving
      technologies could have a negative impact on its operating results and financial
      condition.




**Regulatory
      changes in the Internet industry involve uncertainties, and the resolution
      of
      these uncertainties could adversely affect the combined company’s business by
      raising its costs or reducing potential revenues.**




Although
      the combined company is not currently subject to direct regulation by any
      governmental agency other than rules and regulations that apply to businesses
      generally and any export and import controls that may apply to its products,
      laws and regulations specifically pertaining to the Internet are new and
      developing. These laws, when enacted, may require the combined company to comply
      with new procedures or limit the scope of its technology or services, which
      could raise the combined company’s expenses or reduce its revenues. The
      developing laws and regulations govern matters such as online content,
      intellectual property, user privacy, e-commerce, information security and
      taxation. Moreover, the combined company may be liable to third parties for
      any
      content that they encode, distribute or make available on their website if
      that
      content violates a third party’s intellectual property rights or violates any
      applicable laws, such as obscenity laws or defamation laws. In addition, the
      applicability of existing laws to the Internet is uncertain and
      evolving.




-35-




**The
      combined company has never paid common stock dividends and does not anticipate
      paying common stock dividends in the foreseeable future.**




The
      combined company currently intends to retain earnings, if any, to support their
      growth strategy. The combined company does not anticipate paying dividends
      on
      their common stock in the foreseeable future.




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





(a)
            Exhibits


31.1
              Certification
                  by the Chief Executive Officer pursuant to Section 302 ofthe
                  Sarbanes-Oxley Act of 2002
 
 31.2
              Certification
                  by the Chief Financial Officer pursuant to Section 302 ofthe
                  Sarbanes-Oxley Act of 2002
 
 32.1
              Certification
                  of Principal Executive Officer pursuant to Section 906 ofthe
                  Sarbanes-Oxley Act of 2002
 
 32.2
              Certification
                  of Principal Financial Officer pursuant to Section 906 ofthe
                  Sarbanes-Oxley Act of 2002




(b)
            Reports
                on Form 8-K





On
      May 3,
      2007, On2 issued a Current Report on Form 8-K announcing its earnings for the
      first quarter of 2007.





On
      May
      22, 2007, On2 issued a Current Report on Form 8-K announcing the Hantro share
      exchange.





On
      May
      24, 2007, On2 issued a Current Report on Form 8-K disclosing the transcript
      of
      On2’s conference call regarding the Hantro share exchange.





On
      June
      19, 2007, On2 issued a Current Report on Form 8-K announcing the resignation
      of
      its Executive Vice President and Chief Technology Officer.





On
      June
      20, 2007, On2 issued a Current Report on Form 8-K disclosing the amendment
      of
      certain warrant agreements with Midsummer Investment Ltd. and Rockmore
      Investment Master Fund.





-36-


**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
                14, 2007(Date)
            (Signature)Anthony PrincipeSenior Vice President and Chief Financial
              Officer(Principal
                Financial Officer)