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, 2008.





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


For
      the
      transition period from ____ to ____.





Commission
      file number 1-15117.





**On2
      Technologies, Inc.**





(Exact
      name of registrant as specified in its charter)








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





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





(518)
      348-0099





(Registrant’s
      telephone number, including area code)









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





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




Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, a non-accelerated filer or a smaller reporting company.
      See
      the definition of “accelerated filer”, “large accelerated filer” and “smaller
      reporting company” in Rule 12b-2 of the Exchange Act (Check one).





 ̈Large
                accelerated filer
            
            þAccelerated
                filer ̈Non-accelerated
                filer
            
             ̈Smaller
                reporting company









APPLICABLE
      ONLY TO ISSUERS INVOLVED IN BANKRUPTCY


PROCEEDINGS
      DURING THE PRECEDING FIVE YEARS:





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





APPLICABLE
      ONLY TO CORPORATE ISSUERS:





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





The
      number of shares of the Registrant’s Common Stock, par value $0.01 (“Common
      Stock”), outstanding, as of August 1, 2008, were 170,990,000.





**Table
      of Contents**





Page**PART
                I — FINANCIAL INFORMATION**Item
                1. Financial Statements.Condensed
                Consolidated Balance Sheets at June 30, 2008 (unaudited) and December
                31,
                2007
            3Unaudited
                Condensed Consolidated Statements of Operations for the Three and
                Six
                Months Ended June 30, 2008 and 2007
            4Unaudited
                Condensed Consolidated Statements of Comprehensive Loss for the Three
                and
                Six Months Ended June 30, 2008 and 2007
            5Unaudited
                Condensed Consolidated Statements of Cash Flows for the Six Months
                Ended
                June 30, 2008 and 2007
            6Notes
                to Unaudited Condensed Consolidated Financial Statements
            8Item
                2. Management’s Discussion and Analysis of Financial Condition and Results
                of Operations
            17Item
                3. Quantitative and Qualitative Disclosures About Market
                Risk
            33Item
                4. Controls and Procedures
            33**PART
                II — OTHER INFORMATION**Item
                1. Legal Proceedings
            37Item
                6. Exhibits
            38Signatures
            39Certifications
            41


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          2
          -


**PART
      I — FINANCIAL INFORMATION**





Item
      1.
      Consolidated Financial Statements





**ON2
      TECHNOLOGIES, INC.**


**CONDENSED
      CONSOLIDATED BALANCE SHEETS**





June 30, 2008
            
            December 31, 2007(unaudited)**ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            7,998,000
            
            $
            9,573,000Short-term
                investments
            
            
            131,000
            
            
            5,521,000Accounts
                receivable, net
            
            
            4,079,000
            
            
            7,513,000Prepaid
                and other current assets
            
            
            1,502,000
            
            
            1,492,000Total
                current assets
            
            
            13,710,000
            
            
            24,099,000Property
                and equipment, net
            
            
            1,176,000
            
            
            751,000Acquired
                software, net
            
            
            9,847,000
            
            
            10,333,000Other
                acquired intangibles, net
            
            
            7,249,000
            
            
            7,144,000Goodwill
            
            
            39,695,000
            
            
            37,023,000Other
                assets
            
            
            170,000
            
            
            175,000Total
                assets
            
            $
            71,847,000
            
            $
            79,525,000**LIABILITIES
                AND STOCKHOLDERS’ EQUITY**Current
                liabilities:Accounts
                payable
            
            $
            1,552,000
            
            $
            1,433,000Accrued
                expenses
            
            
            4,420,000
            
            
            4,820,000Deferred
                revenue
            
            
            3,723,000
            
            
            1,887,000Short-term
                borrowings
            
            
            -
            
            
            2,198,000Current
                portion of long-term debt
            
            
            526,000
            
            
            491,000Capital
                lease obligations
            
            
            182,000
            
            
            24,000Total
                current liabilities
            
            
            10,403,000
            
            
            10,853,000Long-term
                debt
            
            
            3,171,000
            
            
            3,082,000Capital
                lease obligations, excluding current portion
            
            
            225,000
            
            
            18,000Total
                liabilities
            
            
            13,799,000
            
            
            13,953,000Commitments
                and contingenciesStockholders’
                equity:Preferred
                stock, $0.01 par value; 20,000,000 authorized and -0-
                outstanding
            
            
            -
            
            
            -Common
                stock, $0.01 par value; 250,000,000 shares authorized; 170,958,000
                and
                170,475,000 shares issued and issuable, and outstanding at June 30,
                2008
                and December 31, 2007, respectively
            
            
            1,710,000
            
            
            1,705,000Additional
                paid-in capital
            
            
            195,415,000
            
            
            194,453,000Accumulated
                other comprehensive income
            
            
            4,329,000
            
            
            906,000Accumulated
                deficit
            
            
            (143,406,000
            )
            
            (131,492,000
            )Total
                stockholders’ equity
            
            
            58,048,000
            
            
            65,572,000Total
                liabilities and stockholders’ equity
            
            $
            71,847,000
            
            $
            79,525,000





*See
      accompanying notes to unaudited condensed consolidated financial statements.*


-
          3
          -


**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**





Three Months Ended
              June 30,
            
            Six Months Ended
              June 30,2008
            
            2007
            
            2008
            
            2007Revenue
            
            $
            3,265,000
            
            $
            2,369,000
            
            $
            7,717,000
            
            $
            5,184,000Operating
                expenses:Costs
                of revenue (1)
            
            
            1,194,000
            
            
            389,000
            
            
            2,624,000
            
            
            812,000Research
                and development (2)
            
            
            3,009,000
            
            
            562,000
            
            
            5,817,000
            
            
            1,055,000Sales
                and marketing (2)
            
            
            1,875,000
            
            
            614,000
            
            
            3,764,000
            
            
            1,210,000General
                and administrative (2)
            
            
            3,926,000
            
            
            983,000
            
            
            6,694,000
            
            
            1,946,000Equity-based
                compensation:Research
                and development
            
            
            105,000
            
            
            19,000
            
            
            224,000
            
            
            20,000Sales
                and marketing
            
            
            74,000
            
            
            27,000
            
            
            112,000
            
            
            54,000General
                and administrative
            
            
            258,000
            
            
            108,000
            
            
            471,000
            
            
            228,000Total
                operating expenses
            
            
            10,441,000
            
            
            2,702,000
            
            
            19,706,000
            
            
            5,325,000Loss
                from operations
            
            
            (7,176,000
            )
            
            (333,000
            )
            
            (11,989,000
            )
            
            (141,000
            )Other
                income (expense), net:Interest
                income (expense), net
            
            
            (14,000
            )
            
            81,000
            
            
            61,000
            
            
            111,000Other
                income (expense), net
            
            
            15,000
            
            
            (2,753,000
            )
            
            14,000
            
            
            (3,696,000
            )Total
                other income (expense)
            
            
            1,000
            
            
            (2,672,000
            )
            
            75,000
            
            
            (3,585,000
            )Net
                loss
            
            
            (7,175,000
            )
            
            (3,005,000
            )
            
            (11,914,000
            )
            
            (3,726,000
            )Convertible
                preferred stock 8% dividend expense
            
            
            -
            
            
            (18,000
            )
            
            -
            
            
            (71,000
            )Net
                loss attributable to common stockholders
            
            $
            (7,175,000
            )
            $
            (3,023,000
            )
            $
            (11,914,000
            )
            $
            (3,797,000
            )Basic
                and diluted net loss attributable to common stockholders per common
                share
            
            $
            (0.04
            )
            $
            (0.03
            )
            $
            (0.07
            )
            $
            (0.04
            )Weighted
                average basic and diluted common shares outstanding
            
            
            170,971,000
            
            
            111,752,000
            
            
            170,729,000
            
            
            107,698,000





(1)
            Includes
                equity-based compensation of $79,000 and $162,000 for the three and
                six
                months ended June 30, 2008. Includes equity-based compensation of
                $14,000
                and $15,000 for the three and six months ended June 30, 2007.




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




*See
      accompanying notes to unaudited condensed consolidated financial
      statements.*


-
          4
          -


**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS**





Three Months Ended
              June 30,
            
            Six Months Ended
              June 30,2008
            
            2007
            
            2008
            
            2007Net
                loss
            
            $
            (7,175,000
            )
            $
            (3,005,000
            )
            $
            (11,914,000
            )
            $
            (3,726,000
            )Other
                comprehensive loss:Foreign
                currency translation adjustments
            
            
            (57,000
            )
            
            (3,000
            )
            
            3,423,000
            
            
            (5,000
            )Comprehensive
                loss
            
            $
            (7,232,000
            )
            $
            (3,008,000
            )
            $
            (8,491,000
            )
            $
            (3,731,000
            )





*See
      accompanying notes to unaudited condensed consolidated financial
      statements.*


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          5
          -


**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**





Six Months Ended June 30,2008
            
            2007Cash
                flows from operating activities:Net
                loss
            
            $
            (11,914,000
            )
            $
            (3,726,000
            )Adjustments
                to reconcile net loss to net cash (used in) provided by operating
                activities:Equity-based
                compensation
            
            
            969,000
            
            
            317,000Charge
                recognized for warrant amendment
            
            
            -
            
            
            86,000Depreciation
                and amortization
            
            
            1,843,000
            
            
            182,000Insurance
                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
            
            
            3,885,000
            
            
            (792,000
            )Prepaid
                expenses and other assets
            
            
            74,000
            
            
            101,000Accounts
                payable, and accrued expenses
            
            
            (679,000
            )
            
            608,000Deferred
                revenue
            
            
            1,745,000
            
            
            (25,000
            )Net
                cash (used in) provided by operating activities
            
            
            (4,077,000
            )
            
            367,000Cash
                flows from investing activities:Purchases
                of short-term investments
            
            
            (17,684,000
            )
            
            (96,000
            )Proceeds
                from the sale of short-term investments
            
            
            23,074,000
            
            
            127,000Deferred
                acquisition costs
            
            
            -
            
            
            (1,107,000
            )Purchases
                of property and equipment
            
            
            (204,000
            )
            
            (154,000
            )Net
                cash provided by (used in) investing activities
            
            
            5,186,000
            
            
            (1,230,000
            )Cash
                flows from financing activities:Principal
                payments on capital lease obligations
            
            
            (95,000
            )
            
            (15,000
            )Principal
                payments on short-term borrowings
            
            
            (2,281,000
            )
            
            -Principal
                payments on term-loans
            
            
            (183,000
            )
            
            (33,000
            )Purchase
                of treasury stock
            
            
            (52,000
            )
            
            (472,000
            )Proceeds
                from exercise of common stock options and warrants
            
            
            49,000
            
            
            6,796,000Net
                cash (used in) provided by financing activities
            
            
            (2,562,000
            )
            
            6,276,000Effect
                of exchange rate on cash and cash equivalents
            
            
            (122,000
            )
            
            (5,000
            )Net
                (decrease) increase in cash and cash equivalents
            
            
            (1,575,000
            )
            
            5,408,000Cash
                and cash equivalents, beginning of period
            
            
            9,573,000
            
            
            4,961,000Cash
                and cash equivalents, end of period
            
            $
            7,998,000
            
            $
            10,369,000





*See
      accompanying notes to unaudited condensed consolidated financial
      statements.*


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          6
          -


**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 30,2008
            
            2007Cash
                paid during the period for:Interest
            
            $
            76,000
            
            $
            3,000Conversion
                of preferred stock into shares of common stock
            
            
            -
            
            $
            2,425,000Stock
                dividend on Series D Preferred Stock
            
            
            -
            
            $
            16,000Common
                stock issued for dividends on Series D Preferred Stock
            
            
            -
            
            $
            81,000Write
                off of warrant derivative liability
            
            
            -
            
            $
            5,911,000Prepaid
                insurance financed with term-loan
            
            
            -
            
            $
            143,000Acquisition
                of fixed assets under capital lease
            
            $
            461,000
            
            $
            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
            
            $
            52,000
            
            $
            1,431,000





*See
      accompanying notes to unaudited condensed consolidated financial
      statements.*


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          7
          -


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**





(1)
      Nature of Operations and Liquidity





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.





The
      Company has experienced significant operating losses and negative operating
      cash
      flows to date. At June 30, 2008, the Company had working capital of $3,307,000.
      For the six months ended June 30, 2008, the Company incurred a net loss of
      $11,914,000 which included non-cash charges of $2,812,000. Cash used from
      operating activities was $4,077,000 for the six months ended June 30, 2008.





The
      Company’s plan to increase cash flows from operations relies significantly on
      increases in revenue generated from our compression and video codec technology
      services and products. Additionally, in order to reduce operating costs,
      management has begun the implementation of a Company-wide cost savings plan.
      Given our cash and short-term investments of $8,129,000 at June 30, 2008, and
      the Company’s forecasted cash requirements, the Company’s management anticipates
      that the Company’s existing capital resources will be sufficient to satisfy our
      cash flow requirements through June 30, 2009. Should sales be less than
      forecasted and expenses higher than anticipated, the Company may need to seek
      other sources of funds through the issuance of equity financing, or implement
      further reductions of operating expenses, in order for the Company to generate
      positive cash flows to sustain the operations of the Company.





(2)
      Basis
      of Presentation





The
      accompanying 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 condensed consolidated 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 principles 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, 2007, filed
      with
      the SEC on June 27, 2008.


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          8
          -


*Reclassifications*





We
      have
      reclassified certain prior period amounts to conform with the current period
      presentation.





(3) Acquisitions





On
      November 1, 2007, the Company completed the acquisition of all of the share
      capital of Hantro Products Oy (“Hantro”), a Finnish corporation. The Hantro
      acquisition was structured as a share exchange transaction. In accordance with
      the exchange agreement that governed the exchange transaction, on November
      1,
      2007, Hantro’s security holders each transferred to On2 all of the outstanding
      capital shares, and all outstanding options to purchase capital shares, that
      together constituted all of the equity ownership of Hantro, in exchange for
      cash, shares and a commitment to issue additional shares in an amount to be
      determined in accordance with a formula for calculating contingent
      consideration.





*Pro
      Forma Financial Information*





The
      unaudited information in the table below summarizes the combined results of
      operations of On2 Technologies, Inc. and Hantro, on a pro forma basis, as though
      the companies had been combined as of the beginning of each of the periods
      presented. The pro forma financial information is presented for informational
      purposes only and is not indicative of the results of operations that would
      have
      been achieved if the acquisition had taken place at the beginning of each of
      the
      periods presented. The pro forma financial information for all periods presented
      includes the business combination accounting effect of historical Hantro
      revenues and amortization charges from acquired intangible assets.





Three Months
              Ended June 30,
              2007
            
            Six Months
              Ended June 30,
              2007Total
                revenues
            
            $
            5,478,000
            
            $
            10,089,000Net
                loss
            
            
            (3,738,000
            )
            
            (6,636,000
            )Net
                loss per share – basic and diluted
            
            
            (.02
            )
            
            (.05
            )





(4)
      Recently Issued Accounting Pronouncements





In
      May
      2008, the Financial Accounting Standards Board (FASB) has issued Statements
      of
      Financial Accounting Standards (SFAS) 162, *The
      Hierarchy of Generally Accepted Accounting Principles.* Statement 162 is intended to improve financial reporting by identifying a
      consistent framework, or hierarchy, for selecting accounting principles to
      be
      used in preparing financial statements that are presented in conformity with
      U.S. generally accepted accounting principles for nongovernmental entities.
      SFAS
      162 is effective 60 days following the SEC's approval of the PCAOB amendments
      to
      AU Section 411. The Company is currently evaluating the impact of adopting
      SFAS
      162 on its financial position, and results of operations.





On
      March
      19, 2008, the FASB issued SFAS 161, *Disclosures
      about Derivative Instruments and Hedging Activities - an Amendment of FASB
      Statement 133.* SFAS 161
      enhances required disclosures regarding derivatives and hedging activities,
      including enhanced disclosures regarding how: ( *a* )
      an
      entity uses derivative instruments; ( *b* )
      derivative instruments and related hedged items are accounted for under FASB
      Statement No. 133, *Accounting
      for Derivative Instruments and Hedging Activities;* and
      ( *c* )
      derivative instruments and related hedged items affect an entity's financial
      position, financial performance, and cash flows. Specifically, SFAS 161
      requires:


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          9
          -




·
            Disclosure
                of the objectives for using derivative instruments be disclosed in
                terms
                of underlying risk and accounting designation;




·
            Disclosure
                of the fair values of derivative instruments and their gains and
                losses in
                a tabular format;




·
            Disclosure
                of information about credit-risk-related contingent features; and




·
            Cross-reference
                from the derivative footnote to other footnotes in which
                derivative-related information is
                disclosed.




SFAS
      161
      is effective for fiscal years and interim periods beginning after November
      15,
      2008. Early application is encouraged.





The
      Company is currently evaluating the impact of adopting SFAS No. 161 on its
      financial position and results of operations.





In
      December 2007, the FASB issued SFAS No. 160, *Non-controlling Interests in Consolidated Financial Statements - An Amendment
      of
      ARB No. 51.* SFAS
      160
      establishes new accounting and reporting standards for the non-controlling
      interest in a subsidiary and for the deconsolidation of a subsidiary.
      Specifically, this Statement requires the recognition of a non-controlling
      interest (minority interest) as equity in the consolidated financial statements
      and separate from the parent's equity. The amount of net income attributable
      to
      the non-controlling interest is to be included in consolidated net income on
      the
      face of the income statement. SFAS 160 clarifies that changes in a parent's
      ownership interest in a subsidiary that do not result in deconsolidation are
      equity transactions if the parent retains its controlling financial interest.
      In
      addition, this Statement requires that a parent recognize a gain or loss in
      net
      income when a subsidiary is deconsolidated. Such gain or loss will be measured
      using the fair value of the non-controlling equity investment on the
      deconsolidation date. SFAS 160 also includes expanded disclosure requirements
      regarding the interests of the parent and its non-controlling interest. SFAS
      160
      is effective for fiscal years, and interim periods within those fiscal years,
      beginning on or after December 15, 2008. Earlier adoption of SFAS 160 is
      prohibited. Although the Company will continue to evaluate the application
      of
      SFAS 160, management does not currently believe adoption will have a material
      impact on the Company’s consolidated results of operations or financial
      position.





(5)
      Stock-Based Compensation





The
      Company adopted the provision of SFAS No. 123R effective January 1, 2006, using
      the modified prospective transition method. Under the modified prospective
      method, non-cash compensation expense is recognized 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 share based
      awards granted or modified after adoption. Accordingly, periods prior to
      adoption have not been restated. Prior to the adoption of SFAS 123R the Company
      accounted for stock based compensation using the intrinsic value method. The
      Company recognizes 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.





The
      following table summarizes the activity of the Company’s stock options for the
      six months ended June 30, 2008:


-
          10
          -





Shares
            
            Weighted
              Average
              Exercise
              Price
            
            Weighted
              Average
              Remaining
              Contractual
              Life
            
            Aggregate
              Intrinsic
              ValueNumber
                of shares under option:Outstanding
                at January 1, 2008
            
            
            7,956,000
            
            $
            1.03Granted
            
            
            408,000
            
            
            0.90Exercised
            
            
            (71,000
            )
            
            0.70Cancelled
                or expired
            
            
            (61,000
            )
            
            1.85Outstanding
                at June 30, 2008
            
            
            8,232,000
            
            $
            1.02
            
            
            5.96
            
            $
            156,000Vested
                and expected to vest at June 30, 2008
            
            
            8,186,000
            
            $
            1.02
            
            
            5.97
            
            $
            156,000Exercisable
                at June 30, 2008
            
            
            5,279,000
            
            $
            1.01
            
            
            5.20
            
            $
            156,000





The
      aggregate intrinsic value of options exercised was $18,000 for the six months
      ended June 30, 2008.





Stock
      based compensation expense recognized in the Unaudited Condensed Consolidated
      Statement of Operations was $516,000 and $969,000 for the three and six months
      ended June 30, 2008, respectively. Stock based compensation expense recognized
      in the Unaudited Condensed Consolidated Statement of Operations was $168,000
      and
      $317,000 for the three and six months ended June 30, 2007,
      respectively.





The
      following summarizes the activity of the Company’s non-vested stock options for
      the six months ended June 30, 2008:





Shares
            
            Weighted
              Average
              Grant
                Date
              Fair
                ValueNon-vested
                at January 1, 2008
            
            
            3,108,000
            
            $
            0.58Granted
            
            
            408,000
            
            
            0.48Cancelled
                or expired
            
            
            (39,000
            )
            
            0.79Vested
                during the period
            
            
            (524,000
            )
            
            0.73Non-vested
                at June 30, 2008
            
            
            2,953,000
            
            $
            0.53





As
      of
      June 30, 2008, there was $1,172,000 of total unrecognized compensation cost
      related to non-vested share-based compensation arrangements granted under
      existing stock option plans. This cost is expected to be recognized over a
      weighted-average period of 1.30 years. The total grant date fair value of shares
      vested during the six-months ended June 30, 2008 was $383,000.


-
          11
          -


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





Three Months
              Ended
              June 30, 2007Weighted
                average fair value at date of grant for options granted during the
                period
            
            $
            3.16Expected
                stock price volatility
            
            
            93
            %Expected
                life of options
            
            
            5
                yearsRisk
                free interest rates
            
            
            4.97
            %Expected
                dividend yield
            
            
            0
            %





There
      were no options granted during the three months ended June 30, 2008. The
      following table compares characteristics of the Company’s stock options granted
      during the six months ended June 30, 2008 and June 30, 2007:





Six Months Ended
              June 30, 2008
            
            Six Months Ended
              June 30, 2007Weighted
                average fair value at date of grant for options granted during the
                period
            
            $
            0.48
            
            $
            1.71Expected
                stock price volatility
            
            
            80
            %
            
            99
            %Expected
                life of options
            
            
            3
                years
            
            
            5
                yearsRisk
                free interest rates
            
            
            2.27
            %
            
            4.82
            %Expected
                dividend yield
            
            
            0
            %
            
            0
            %





The
      following summarizes the activity of the Company’s non-vested restricted common
      stock for the six months ended June 30, 2008:





Shares
            
            Weighted
              Average Grant
              Date Fair ValueNon-vested
                at January 1, 2008
            
            
            1,053,000
            
            $
            2.04Granted
            
            
            539,000
            
            
            0.88Cancelled
                or expired
            
            
            (18,000
            )
            
            3.54Vested
                during the period
            
            
            (315,000
            )
            
            2.32Non-vested
                at June 30, 2008
            
            
            1,259,000
            
            $
            1.46





During
      the six months ended June 30, 2008 the Company granted 454,000 shares of
      restricted common stock to its Board of Directors which vest in April 2009,
      and
      85,000 shares of restricted common stock to its employees which vest in March
      2011. As of June 30, 2008, the Company recognized $97,000 in compensation
      expense related to these grants and there was $1,397,000 of unrecognized
      compensation cost which will be recognized through the second quarter of
      2011.


-
          12
          -




(6) Cash
      and
      cash equivalents and short-term investments





As
      of
      June 30, 2008, the Company held $131,000 in short-term securities, all of which
      are in a certificate of deposit in a United States bank.





(7)
      Intangible Assets and Goodwill





The
      assets recognized with respect to acquired software, trademarks, customer
      relationships and non-compete agreements are being amortized over their
      estimated lives. Amortization expense related to these intangible assets was
      $757,000 and $1,562,000 for the three and six months ended June 30, 2008,
      respectively, and $ 62,000 and $ 123,000 for the three and six months ended
      June
      30, 2007, respectively.


The
      intangible assets and goodwill, decreased by $59,000 and increased by $3,853,000
      for the three and six months ended June 30, 2008, respectively, for the effects
      of the foreign currency translation adjustment. There were no other additions
      of
      intangible assets during the six months ended June 30, 2008.





Based
      on
      the current amount of intangibles subject to amortization, the estimated future
      amortization expense related to our intangible assets at June 30, 2008 is as
      follows:





FutureFor
                the Year Ending June 30,
            
            Amortization2009
            
            $
            3,212,0002010
            
            
            3,007,0002011
            
            
            3,007,0002012
            
            
            3,007,0002013
            
            
            1,517,000Thereafter
            
            
            3,346,000Total
            
            $
            17,096,000





(8)
      Short-Term Borrowings





At
      June
      30, 2008, short-term borrowings consisted of the following:





A
      line of
      credit with a Finnish bank for $711,000 (€450,000 at June 30, 2008). The line of
      credit has no expiration date. Borrowings under the line of credit bear interest
      at one month EURIBOR plus 1.25% (total of 5.722% at June 30, 2008). The bank
      also requires a commission payable at .45% of the loan principal.
      Borrowings are collateralized by substantially all assets of Hantro and a
      guarantee by On2. The outstanding balance on the line of credit was $-0- at
      June
      30, 2008.





(9)
      Long-Term Debt





At
      June
      30, 2008, long-term debt consisted of the following:





Unsecured
      notes payable to a Finnish funding agency of $3,122,000, including interest
      at
      1.75%, due at dates ranging from January 2009 to December 2011; $338,000 to
      a
      Finnish bank, including interest at the 3-month EURIBOR (4.94% at June 30,
      2008)
      plus 1.1%, due March 2011, secured by a guarantee by On2, and the Finnish
      Government Organization, which also requires additional interest at 2.65% of
      the
      loan principal; and an unsecured note payable to a Finnish financing company
      of
      $237,000, including interest at the 6 month EURIBOR (5.088% at June 30, 2008)
      plus .5%, due March 2011.


-
          13
          -


Future
      maturities of long-term debt are as follows as of June 30, 2008:


For
                  the Year Ending June 30,2009
              
              $
              526,0002010
              
              
              1,302,0002011
              
              
              1,110,0002012
              
              
              759,000Total
              
              $
              3,697,000





(10)
      Common Stock





During
      the six months ended June 30, 2008, the Company received $49,000 in proceeds
      and
      issued 71,000 shares of its common stock for stock option exercises. The Company
      cancelled 64,000 shares of restricted common stock grants from 2007 as a result
      of terminated employees and cancelled 53,000 shares of common stock resulting
      from the retirement of Treasury Stock, as outlined in Note 11
      below.





(11)
      Treasury Stock





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. During the six months
      ended June 30, 2008, the Company allowed its employees to relinquish shares
      from
      the vesting of a portion of restricted stock grants for payment of taxes. The
      Company received a total of 53,000 shares at a value of $52,000 for payment
      of
      taxes.





(12)
      Geographical Reporting and Customer Concentration





The
      components of the Company’s revenue for the three and six months ended June 30,
      2008 and 2007 are summarized as follows:





For the three months ended June 302008
            
            2007License
                software revenue
            
            $
            2,087,000
            
            $
            1,733,000Engineering
                services and support
            
            
            482,000
            
            
            228,000Royalties
            
            
            677,000
            
            
            385,000Other
            
            
            19,000
            
            
            23,000Total
            
            $
            3,265,000
            
            $
            2,369,000





For the six months ended June 302008
            
            2007License
                software revenue
            
            $
            5,002,000
            
            $
            3,915,000Engineering
                services and support
            
            
            1,062,000
            
            
            463,000Royalties
            
            
            1,615,000
            
            
            768,000Other
            
            
            38,000
            
            
            38,000Total
            
            $
            7,717,000
            
            $
            5,184,000


-
          14
          -


For
      the
      three and six months ended June 30, 2008 foreign customers accounted for
      approximately 62% and 46%, respectively of the Company’s total revenue. For the
      three and six months ended June 30, 2007 foreign customers accounted for
      approximately 45% and 47%, respectively of the Company’s total revenue. These
      customers are primarily located in Europe and Middle East, and Asia.





Selected
      information by geographic location is a follows:





For the three months ended June 302008
            
            2007Revenue
                from unaffiliated customers:United
                States Operations
            
            $
            1,952,000
            
            $
            2,369,000Finland
                Operations
            
            
            1,313,000
            
            
            -Total
            
            $
            3,265,000
            
            $
            2,369,000Net
                loss:United
                States Operations
            
            $
            (4,069,000
            )
            $
            (3,005,000
            )Finland
                Operations
            
            
            (3,106,000
            )
            
            -Total
            
            $
            (7,175,000
            )
            $
            (3,005,000
            )





For the six months ended June 302008
            
            2007Revenue
                from unaffiliated customers:United
                States Operations
            
            $
            4,857,000
            
            $
            5,184,000Finland
                Operations
            
            
            2,860,000
            
            
            -Total
            
            $
            7,717,000
            
            $
            5,184,000Net
                loss:United
                States Operations
            
            $
            (5,018,000
            )
            $
            (3,726,000
            )Finland
                Operations
            
            
            (6,896,000
            )
            
            -Total
            
            $
            (11,914,000
            )
            $
            (3,726,000
            )





June 30,
            
            December 31,2008
            
            2007Identifiable
                assets:United
                States Operations
            
            $
            15,248,000
            
            $
            17,631,000Finland
                Operations
            
            
            56,599,000
            
            $
            61,894,000Total
            
            $
            71,847,000
            
            $
            79,525,000




For
      the
      three and six months ended June 30, 2008, there was one customer that accounted
      for 23% and 10%, respectively of the Company’s revenue. 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.




-
          15
          -




(13)
      Net
      Loss Per Share





Basic
      net
      loss per share is computed by dividing the net loss applicable to common shares
      by the weighted average number of common shares outstanding during the
      period.  Diluted loss attributable to common shares adjusts basic loss per
      share for the effects of convertible securities, warrants, stock options and
      other potentially dilutive financial instruments, only in the periods in which
      such effect is dilutive.  The shares issuable upon the conversion of
      preferred stock, the exercise of stock options and warrants are excluded from
      the calculation of net loss per share as their effect would be
      anti-dilutive. ****





Securities
      that could potentially dilute earnings per share in the future that were not
      included in the computation of diluted loss per share consist of the following
      as of June 30:





**2008**
            
            **2007**Series
                D redeemable convertible preferred stock
            
            
            -
            
            
            973,000Warrants
                to purchase common stock
            
            
            123,000
            
            
            1,919,000Options
                to purchase common stock
            
            
            1,649,000
            
            
            4,830,000Total
            
            
            1,772,000
            
            
            7,722,000





(14)
      Subsequent Events





On
      November 1, 2007, the Company completed the acquisition of all of the share
      capital of Hantro. The Hantro acquisition was structured as a share exchange
      transaction. The exchange agreement also required On2 to issue additional shares
      of common stock, depending on Hantro’s net revenue in 2007. Hantro’s 2007 net
      revenue exceeded €9,000,000, and accordingly, the Company became obligated to
      issue to the former security holders of Hantro an additional 12,500,000 shares
      of On2 common stock (the maximum number of shares issuable as contingent
      payment). Certain of the former Hantro security holders requested that the
      Company defer the issuance of a total of 1,399,560 of these shares until later
      in 2008. On July 8, 2008, the Company issued 11,100,440 of the shares due to
      the
      former Hantro security holders, and agreed to issue the remaining 1,399,560
      shares when so instructed. Additionally, on July 8, 2008, the Company issued
      32,000 shares of restricted stock to certain members of the Board of
      Directors.





(15)
      Related Party Transactions





During
      the six months ended June 30, 2008 and 2007, the Company retained McGuireWoods
      LLP to perform certain legal services on our behalf and incurred approximately
      $148,000 and $169,000 for the three and six months ended June 30, 2008,
      respectively, and $271,000 and $537,000 for the three and six months ended
      June
      30, 2007, respectively, for such legal services. William A. Newman, a director
      of our Company, was a partner of McGuireWoods LLP until May 2008. Subsequent
      to
      May 2008, Mr. Newman became a partner at Sullivan & Worcester LLP and we
      incurred $27,000 in legal service fees to Sullivan & Worcester LLP for the
      six months ended June 30, 2008.


-
          16
          -





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





**Forward-Looking
      Statements**





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. Forward-looking statements include
      statements with respect to:




•
            future
                revenues, income taxes, net loss per share, acquisition costs and
                related
                amortization, and other measures of results of operations;•
            the
                effects of acquiring Hantro;•
            difficulties
                in controlling expenses, legal compliance matters or internal control
                over
                financial reporting review, improvement and
                remediation;•
            risks
                associated with the ineffectiveness of the Company’s internal control over
                financial reporting and our ability to remediate material
                weaknesses;•
            the
                financial performance and growth of our business, including future
                international growth;•
            our
                financial position and the availability of resources;•
            future
                competition; and•
            the
                degree of seasonality in our
                revenue.




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,
      2007.




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, 2007 in
      addition to the other information set forth herein.




-
          17
          -




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.





**Costs
      Associated with Restatement of Financial Statements**





Since
      December 31, 2007, we have incurred legal and accounting and other costs related
      to the Audit Committee review and restatement of our financial statements for
      the second and third quarters of 2007. These restatements are set forth in
      Amendment No. 1 to our Quarterly Report on Form 10-Q, filed on June 27, 2008
      and
      Amendment No. 1 to our Quarterly Report on Form 10-Q for the period ended
      September 30, 2007, both filed on June 27, 2008, and are also described in
      our
      Annual Report on Form 10-K for the year ended December 31, 2007, filed on June
      28, 2008. In connection with this, we incurred costs of approximately
      $2,186,000, as of June 30, 2008, of which we expensed approximately $373,000
      in
      the first quarter of 2008 and an additional $1,813,000 in the second quarter
      of
      2008.  We expensed these costs in the period in which the legal, accounting
      and other services are provided and we recorded these costs as general and
      administrative expenses. These costs will have a material adverse effect on
      our
      net loss for the period in which they are expensed and on our liquidity for
      the
      period in which they are paid. The Company believes it continues to have
      sufficient cash and other resources available to meet working capital and other
      needs that might arise over the next twelve months.




Acquisition
      of Hantro Products Oy





On
      May
      21, 2007, we entered into an exchange agreement with Nexit Ventures Oy, as
      the
      authorized representative of the holders of all outstanding equity securities
      (including outstanding share options) of Hantro to acquire all outstanding
      equity securities of Hantro in exchange for cash and common stock. We completed
      the acquisition on November 1, 2007 for a total purchase price of $49,501,000.
      Under the terms of the exchange agreement, On2 paid $6,608,102 in cash and
      issued 25,438,817 shares of the Company's common stock, par value $.01 per
      share, directly to the Hantro security holders, of which two million On2 shares
      are being held in escrow until the anniversary of the Hantro closing to secure
      the indemnification obligations of the shareholders of Hantro. At that time,
      Hantro and its subsidiary became wholly-owned subsidiaries of the Company.





The
      exchange agreement also required On2 to issue additional shares of common stock,
      depending on Hantro’s net revenue in 2007. Hantro’s 2007 net revenue exceeded
€9,000,000, and accordingly, the Company became obligated to issue to the former
      security holders of Hantro an additional 12,500,000 shares of On2 common stock
      (the maximum number of shares issuable as contingent payment). Certain of the
      former Hantro security holders requested that the Company defer the issuance
      of
      a total of 1,399,560 of these shares until later in 2008. On July 8, 2008,
      the
      Company issued 11,100,440 of the shares due to the former Hantro security
      holders, and agreed to issue the remaining 1,399,560 shares when so
      instructed.




**Overview**




On2
      Technologies is a developer of video compression technology and technology
      that
      enables multimedia in resource-limited environments, such as cellular networks
      transmitting to battery operated mobile handsets or High Definition (HD) video
      over the Internet. We have developed a proprietary technology platform and
      the
      TrueMotion® VPx family (e.g., VP6®, VP7TM) of video compression/decompression
      (“codec”) software to deliver high-quality video at the lowest possible data
      rates over proprietary networks and the Internet to personal computers, wireless
      devices, set-top boxes and other 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
      addition, through our wholly-owned subsidiary, On2 Finland (formerly Hantro),
      a
      Finnish corporation which we acquired on November 1, 2007, we license to chip
      and mobile handset manufacturers the hardware and software designs that make
      the
      encoding or decoding of video possible on devices such as mobile handsets,
      set
      top boxes, portable media players and cameras. On2 Finland’s headquarters and
      research and development teams are based in Oulu, Finland and it has a global
      sales network with satellite offices in Korea, Japan, Taiwan, Germany, Hong
      Kong
      and Mainland China. We also provide integration, customization and support
      services to enable high quality video on, and faster interoperability between
      devices.




-
          18
          -




Since
      2004, we have 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:




·
            Video
                codecs;





·
            Audio
                codecs; and





·
            Encoding
                and server software, for use with video delivery
                platforms.





We
      also
      offer the following suite of hardware and software products that incorporate
      our
      mobile video technology:





·
            TrueMotion
                VP6 and VP7 software video codec
                designs;





·
            MPEG-4,
                H.263, H.264 / AVC and VC-1 hardware and software video codec
                designs;





·
            Hardware
                and software JPEG codecs supporting up to
                16MP;





·
            AMR-NB
                and Enhanced aacPlus audio codecs;





·
            Pre-
                and post-processing technologies (such as cropping, rotation, scaling)
                implemented in both software and
                hardware;





·
            File
                format and streaming components;
                and





·
            Recorder
                and player application logic.





In
      addition, we offer the following services in connection with both our
      proprietary video compression technology and our mobile video
      technology:





·
            Customized
                engineering and consulting services;
                and





·
            Technical
                support.





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




-
          19
          -


**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
                  surveillanceVideo
                  and Audio Distribution over IP-based
              
              ·
              Video-on-demandNetworks
                  (Internet)
              
              ·
              Teleconferencing
                  services·
              Video
                  instant messaging·
              Video
                  for Voice-over-IP (VOIP) servicesConsumer
                  Electronic Devices
              
              ·
              Digital
                  video players·
              Digital
                  video recorders·
              Mobile
                  TV·
              Video
                  Camera Recorder·
              Mobile
                  Video PlayerWireless
                  Applications
              
              ·
              Delivery
                  of video via satellite·
              Providing
                  video to web-enabled cell phones and PDAsUser-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





On2’s
      goal is to be a premier provider of video compression software and hardware
      technology and compression tools. We are striving to achieve that goal and
      the
      goal of building a stable base of quarterly revenues by implementing the
      following key strategies:




•
            Continuing
                our research and development efforts to improve our current codecs
                and
                developing new technologies that increase the quality of video technology
                and improve the experience of end users;•
            Continuing
                our research and development efforts to design hardware decoders
                and
                encoders that minimize the space used on a chip and to continue to
                improve
                the quality of those products;•
            Using
                the success of current customer implementations of our TrueMotion
                technology (e.g., Adobe Flash 8, Skype) and other high-profile customers
                (e.g., Sun Microsystems) to increase our brand recognition, promote
                new
                business and encourage proliferation across
                platforms;


•
                Updating
                    and enhancing our existing consumer products, such as the Flix
                    line and
                    embedded technologies;
  •
              Employing
                  flexible licensing strategies to offer customers more attractive
                  business
                  terms than those available for competing technologies;


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          -




•
            Attempting
                to negotiate licensing arrangements with customers that provide for
                receipt of recurring revenue and/or that offer us the opportunity
                to
                market products that complement our customers implementations of
                our
                software; and•
            Using
                the expertise of our subsidiary, On2 Finland, to develop hardware
                designs
                of our TrueMotion codecs and optimizations for embedded processors
                that
                will allow those products to be easily implemented on
                devices.




We
      earn
      revenue chiefly through licensing our software technology and hardware designs
      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 and
      hardware **** products.
      The royalties may come in the form of either a fee for each unit of the
      customer’s products containing our software products or hardware designs 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 (e.g., minimum annual
      royalties) and/or maximum amounts (e.g., annual caps) that may vary
      substantially from deal to deal.




We
      also
      sell additional products and services that relate to our existing relationships
      with licensees of our TrueMotion codec products. 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 that customer’s 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.




We
      made
      the decision to acquire Hantro in large part because of our recognition of
      the
      strategic importance of implementing our TrueMotion codecs in hardware and
      developing highly optimized software libraries for operation on the digital
      signal processors (DSPs) used in embedded devices. The Hantro acquisition has
      allowed us to increase the resources devoted to improving the ease of
      implementation of our codecs across platforms. Prior to the acquisition, we
      did
      not have off-the-shelf optimized software that we could license to customers
      who
      were interested in implementing our codecs on devices. Those customers were
      therefore required to pay us to customize our software, or to perform the
      customizations themselves, or to hire third-party consultants to perform the
      customizations. The Hantro acquisition has given us access to experienced
      internal resources to enable us to develop hardware and software implementations
      that will allow customers to implement our codecs quickly and efficiently on
      embedded devices.




As
      part
      of our strategy to develop complementary products that could allow us to
      capitalize on our customers’ success, in 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 video engine for Flash 8 video,
      which 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 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. Following Adobe’s announcement in late 2007 of
      support for the H.264 codec in its Flash 9 player, we announced support for
      H.264 in our Flix products and have been adding support for additional codecs.
      These additional features have helped to make the Flix product line **** a
      more
      complete encoding solution for users.


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A
      primary
      factor that will be critical to our success is our ability to improve
      continually on our current TrueMotion video compression technology, 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 higher 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 TrueMotion
      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,
      our license agreements with customers increasingly 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
      114
      employees competing in a market that offers a vast range of video-enabled
      devices, we do not have the product development or marketing resources to
      develop and market end-to-end video solutions. Instead, our codec software
      is
      primarily intended to be used as a building block for companies that are
      developing end-to-end video products and/or services.




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


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          -


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




We
      are
      continuing to participate in the trend towards the proliferation of user
      generated video content on the web. As Internet use has grown worldwide and
      Internet connection speeds have increased, sites such as MySpace and YouTube,
      which allow visitors to create and view user generated content, have sprung
      up
      and seen their popularity soar. Although initially consumer generated content
      consisted primarily of text content and still photographs, the availability
      of
      relatively inexpensive digital video cameras and video-enabled mobile phones,
      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 have 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 increased interest by UGC site operators and device
      manufacturers to allow users to access UGC content by means of mobile handsets,
      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 has only
      recently become available on chip-based devices, such as mobile devices and
      set
      top boxes. We are therefore witnessing demand on two fronts: (1) demand to
      integrate Flash 8 video onto non-PC platforms, and (2) until most devices can
      play Flash 8 content, demand to provide transcoding software that allows Flash
      8
      content to be decoded and re-encoded into a format (such as the 3GPP standard)
      that is supported on devices. 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.




H.264
      continues to rise as a competitor in the video compression field. H.264 is
      a
      standards-based codec that is the successor to MPEG-4. We believe that our
      technology is superior to H.264, and that we can offer significantly more
      flexibility in licensing terms than customers get when licensing H.264. H.264
      has nevertheless 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 has thus chosen
      H.264
      for the current generation of video iPods. Finally, there is already a
      significant amount of professional content that has been encoded in H.264.
      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 TrueMotion video might require. In addition,
      there are certain customers that prefer to license standards-based codecs.
      In
      August 2007, our customer Adobe announced that the latest version of the Flash
      video player would support H.264. We continue to believe that VP6 will be an
      important part of the Flash video ecosystem for three reasons: (1) Adobe has
      in
      the past provided backwards compatibility with all generations of Flash video
      codecs; (2) VP6 has certain performance advantages over H.264 (e.g., HD VP6
      content may be played back on a lower-powered processor than HD H.264 content);
      and (3) there is a vast amount of existing VP6 content that consumers want
      on
      portable and mobile devices.


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          23
          -


The
      market for digital media creation and delivery technology is constantly changing
      and becoming more 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, both in software and in hardware. Our
      acquisition of Hantro has significantly increased the resources that we can
      devote to these efforts. We have also increased the number of our engineers
      who
      integrate our codecs on chips, and we have cultivated relationships with chip
      companies to enable those companies to perform such integration. By increasing
      support for our technology on the chips that power embedded devices, we hope
      to
      encourage use by customers who want to develop video-enabled consumer products
      in a short timeframe.




A
      continuing trend in our business is the growing presence of Microsoft, Inc.
      as a
      significant competitor in the market for digital media creation and distribution
      technology. In 2007, Microsoft released Silverlight, a rich Internet application
      that allows users to integrate multimedia features, such as vector graphics,
      audio and video, into web applications. Silverlight may compete directly with
      Flash. If Silverlight gains market share at the expense of Flash, it could
      have
      a negative impact on our Flix business. In addition, Microsoft VC1 format also
      competes in the marketplace with H.264 and our VPx technologies. We believe
      that
      our VPx technologies have the same advantages over VC1 as they do over H.264.
      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 to, 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
      financial resources and its competitive position in the computer industry to
      secure preferential or exclusive distribution, use and bundling contracts for
      its media delivery technologies, and products with third parties, such as ISPs,
      content delivery networks, content providers, entertainment and media companies,
      VARs and OEMs, including third parties with whom we have relationships.




The
      Microsoft 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 could become more comfortable with using DRM technology produced
      by
      companies other than Microsoft.




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 like Microsoft and the MPEG consortium. We 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. We believe our ability to provide both our VPx codecs and standards
      based codecs has positioned us uniquely as a one stop shop for the
      implementation of multiple codecs on a variety of devices.




Another
      one of our primary businesses is the development and marketing of digital
      electronic hardware designs (known as register transfer level designs or RTL)
      of
      video and audio codecs to manufacturers of computer chips and multimedia
      devices. A licensee of our RTL design might use that product to implement a
      video decoder on the licensee’s chip, and the decoder would be built into the
      circuitry of the licensee’s chip. One of the factors affecting our hardware
      business is our ability to develop efficient RTL designs that minimize the
      physical area of a chip devoted to our designs. Increasing the surface area
      of a
      chip increases the manufacturer’s production costs. Our ability to produce RTL
      designs that require less surface area than our competitors’ designs results in
      lower production costs for our licensees and gives us a competitive advantage.


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Another
      factor affecting our hardware business is our reputation for producing reliable
      products that have been thoroughly tested, are accompanied by good
      documentation, and are supported by a strong technical support team. Chip and
      device manufacturers that are potential customers for our hardware products
      develop the products with which they will integrate our RTL designs. Our
      technology is hard-wired into chip circuitry rather than loaded as software.
      In
      connection with high volume chip production, the per-unit price of a specialized
      chip that has had multimedia support built into the chip can be substantially
      less than the costs of using a more powerful software-upgradable digital signal
      processor (DSP). However, any errors in the software operating on a DSP can
      be
      relatively easily corrected through a software upgrade or patch, while errors
      that have been hardwired into a circuit are more difficult, and may be
      impossible, to correct. Because customers for our RTL designs will invest a
      great deal of time and money into the designs, our reputation as a
      well-established provider of reliable, well-supported RTL designs is an
      important factor in our continuing success.




As
      multimedia content has proliferated on the Internet, manufacturers of mobile
      devices such as cell phones and personal media players (PMPs) have expanded
      their product lines to support playback and creation of that content. As noted
      above, in general, manufacturers have two options to add multimedia support
      to
      their devices. They can use either a specialized chip that has multimedia
      support hard-wired into it (RTL) or a more powerful DSP that can run software
      to
      provide the necessary multimedia functions. Hardware implementations that
      require RTL designs such as ours offer a number of advantages over DSPs with
      software layers:




·
            RTLs
                are cheaper to produce in high
                volumes;




·
            They
                use less energy, which prolongs battery life of mobile
                devices;




·
            They
                produce less heat, which has important implications for, among other
                things, circuit design; and




·
            They
                allow for simultaneous encoding and decoding of HD video
                content.




But
      there
      are also disadvantages to hardware implementations of multimedia
      tools:




·
            Initial
                implementation costs are high; and




·
            Hardware
                implementations are generally not
                upgradeable.




Similarly,
      software-upgradable DSPs offer certain advantages:




·
            Modifying
                software to operate on a DSP is easier and less expensive then
                implementing the software in hardware, reducing initial project costs
                and
                speeding deployment;




·
            DSPs
                do not require costly re-designs and re-tooling to operate new software;
                and




·
            They
                are more easily upgradeable.




But
      they
      also have certain disadvantages:




·
            Per-chip
                costs are higher than pure hardware solutions as volumes
                increase;


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          25
          -


·
            The
                increased processor power required to operate diverse software increases
                heat and power consumption.




Manufacturers
      that want to maintain the ability to upgrade mobile devices and PMPs to support
      new multimedia software may opt for DSPs rather than hardware solutions, which
      could impact our business of licensing hardware codecs. Nevertheless, we believe
      that even if manufacturers do choose to use DSPs in their devices, it is likely
      that many will continue to implement hardware codecs alongside the DSPs to
      take
      advantage of the efficiency of those hardware implementations. In addition,
      support for DSPs on multimedia devices would have the benefit of making those
      devices more easily upgraded to new generations of our TrueMotion codecs. We
      are
      continuing to monitor this trend and make the adjustments to our business model
      necessary to address changing markets.




**Critical
      Accounting Policies and Estimates**





This
      discussion and analysis of our financial condition and results of operations
      are
      based on our unaudited condensed 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
      annual report for the fiscal year ended December 31, 2007 on Form 10K, filed
      with the Securities and Exchange Commission on June 27, 2008. Our critical
      accounting policies and estimates are:





•
            Revenue
                recognition;•
            Accounts
                receivable allowance;•
            Acquisitions;•
            Equity-based
                compensation; and•
            Valuation
                of goodwill and intangible assets, including impairment, 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* ,”
SOP
      98-9, “ *Modification
      of SOP 97-2 with Respect to Certain Transactions* (SOP
      98-9) and Staff
      Accounting Bulletin No. 104 (SAB 104) .
      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
      collectibility is 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.


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





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





*Accounts
      Receivable Allowance.* We
      perform ongoing credit evaluations of our customers and adjust credit limits,
      as
      determined by our review of current credit information. We continuously monitor
      collections and payments from our customers and maintain an allowance for
      doubtful accounts based upon our historical experience, our anticipation of
      uncollectible accounts receivable and any specific customer collection issues
      that we have identified. Our credit losses have historically been low and within
      our expectations.





*Acquisitions.* We are
      required to allocate the purchase price of acquired companies to the tangible
      and intangible assets acquired, liabilities assumed, as well as purchased
      in-process research and development (IPR&D) based on the estimated fair
      values. We use various models to determine the fair values of the assets
      acquired and liabilities assumed. These models include the discounted cash
      flow
      (DCF), the royalty savings method and the cost savings approach. The valuation
      requires management to make significant estimates and assumptions, especially
      with respect to long-lived and intangible assets.





Critical
      estimates in valuing certain of the intangible assets include, but are not
      limited to, future expected cash flows from customer contracts, customer lists,
      distribution agreements and acquired developed technologies and patents; the
      acquired company’s brand awareness and market position as well as assumptions
      about the period of time the brand will continue to be used in the combined
      company’s product portfolio; and discount rates. We derive our discount rates
      from our internal rate of return based on our internal forecasts and we may
      adjust the discount rate giving consideration to specific risk factors of each
      asset. Management’s estimates of fair value are based upon assumptions believed
      to be reasonable but which are inherently uncertain and unpredictable.
      Assumptions may be incomplete or inaccurate, and unanticipated events and
      circumstances may occur.





*Equity-Based
      Compensation.* The
      Company adopted the provisions of SFAS No. 123R effective January 1, 2006,
      using
      the modified prospective transition method. Under the modified prospective
      method, 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.


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          27
          -


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





Long-lived
      assets and identifiable intangibles with finite lives are reviewed for
      impairment whenever events or changes in circumstances indicate that the
      carrying amount of an asset may not be recoverable. Recoverability of assets
      to
      be held and used is measured by a comparison of the carrying amount of an asset
      to future undiscounted net cash flows expected to be generated by the asset.
      If
      such assets are considered to be impaired, the impairment recognized is measured
      by the amount by which the carrying amount of the assets exceeds the fair value
      of the assets. Assets to be disposed of are reported at the lower of the
      carrying amount or fair value less costs to sell. As of June 30, 2008, we
      believe that no such impairment has occurred.





**Results
      of Operations**





*Revenue*





Revenue
      for the three months ended June 30, 2008 was $3,265,000, as compared to
      $2,369,000 for the three months ended June 30, 2007. Revenue for the six months
      ended June 30, 2008 was $7,717,000, as compared to $5,184,000 for the six months
      ended June 30, 2007. Revenue for the three and six months ended June 30, 2008
      and 2007 was derived primarily from the sale of software licenses and RTL
      licenses and engineering and consulting services. The increase in revenue for
      both the three and six months ended June 30, 2008 is primarily attributed to
      the
      revenue contribution of $1,313,000 and $2,860,000, respectively, from our
      subsidiary, On2 Finland (formerly Hantro), acquired in November
      2007.





*Costs
      of Revenue*





Costs
      of
      revenue includes personnel and related overhead expenses, royalties paid for
      software that is incorporated into the Company’s software, consulting
      compensation costs, operating lease costs and depreciation and amortization
      costs. Costs of revenue for the three months ended June 30, 2008 was $1,194,000
      as compared to $389,000 for the three months ended June 30, 2007. Costs of
      revenues for the six months ended June 30, 2008 was $2,624,000 as compared
      to
      $812,000 for the six months ended June 30, 2007. The increase of $1,812,000
      for
      the six months ended June 30, 2008, as compared to the six months ended June
      30,
      2007 is primarily attributable to an increase in production and engineering
      costs associated with On2 Finland of $1,921,000 of which $1,253,000 is
      amortization of the Hantro purchased technology, an increase in equity based
      compensation of $147,000, offset by a decrease in production and engineering
      costs for the US operations of $256,000 due to less hours allocated by our
      engineering staff.


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          28
          -


*Operating
      expenses*





The
      Company's operating expenses consist of research and development, sales and
      marketing and general and administrative expenses and equity-based compensation.
      Operating expenses for the three months ended June 30, 2008 were $10,441,000
      as
      compared to $2,702,000 for the three months ended June 30, 2007. Operating
      expenses were $19,706,000 for the six months ended June 30, 2008 as compared
      to
      $5,325,000 for the six months ended June 30, 2007.





*Research
      and Development*





Research
      and development expenses, excluding equity-based compensation, primarily consist
      of personnel and related overhead expenses and consulting compensation costs
      associated with the development and production of our products and services,
      operating lease costs and depreciation costs. Research and development expenses
      for the three months ended June 30, 2008 were $3,009,000 as compared to $562,000
      for the three months ended June 30, 2007. The increase of $2,447,000 for the
      three months ended June 30, 2008 is primarily the result of an increase of
      $2,134,000 in research and development costs incurred by our Finnish subsidiary
      that utilizes a greater portion of their engineers in research and development
      activities and a $313,000 increase in research and development costs incurred
      by
      our US operations, that is a result of increases in personnel and related costs
      and an increase in the amount of hours that our engineering staff worked on
      development projects. Research and development expenses for the six months
      ended
      June 30, 2008 were $5,817,000 as compared to $1,055,000 for the six months
      ended
      June 30, 2007. The increase of $4,762,000 for the six months ended June 30,
      2008
      is primarily a result of an increase of $4,030,000 in research and development
      costs incurred by our Finnish subsidiary that utilizes a greater portion of
      their engineers in research and development activities and a $732,000 increase
      in research and development costs incurred by our US operations.




*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, 2008 were $1,875,000 as compared to $614,000 for the three months
      ended June 30, 2007. The increase of $1,261,000 for the three months ended
      June
      30, 2008 is primarily a result of an increase of $807,000 in sales and marketing
      personnel and related costs attributable to our Finnish subsidiary and a
      $454,000 increase in sales and marketing costs incurred by US operations that
      is
      a result of increases in personnel and travel related expenses for marketing.
      Sales and marketing expenses for the six months ended June 30, 2008 were
      $3,764,000 as compared to $1,210,000 for the six months ended June 30, 2007.
      The
      increase of $2,554,000 for the six months ended June 30, 2008 is primarily
      a
      result of an increase of $2,185,000 in sales and marketing personnel and related
      costs attributable to our Finnish subsidiary and a $369,000 increase in sales
      and marketing costs incurred by US operations that is a result of increases
      in
      personnel and related 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, 2008 were
      $3,926,000, as compared to $983,000 for the three months ended June 30, 2007.
      The increase of $2,943,000 for the three months ended June 30, 2008 is primarily
      due to an increase in legal and accounting fees of $1,813,000 related to the
      Audit Committee’s review of certain 2007 sales contracts in connection with the
      restatement and $670,000 in related costs attributable to our Finnish
      subsidiary, and an increase in consulting fees related to the implementation
      of
      Sarbanes Oxley Section 404 and other consulting and professional services.
      General and administrative expenses for the six months ended June 30, 2008
      were
      $6,694,000, as compared to $1,946,000 for the six months ended June 30, 2007.
      The $4,748,000 increase for the six months ended June 30, 2008 is primarily
      due
      to an increase in legal and accounting fees of $2,349,000 of which $2,186,000
      is
      related to the Audit Committee’s review of certain 2007 sales contracts in
      connection with the restatement, a $541,000 increase in professional fees
      related to the implementation of Sarbanes Oxley Section 404 and other consulting
      and professional services, a $187,000 increase in personnel and related
      expenses, and an increase of $1,531,000 in related costs attributable to our
      Finnish subsidiary.


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          29
          -


*Equity-Based
      Compensation*





Equity
      based compensation, which is presented separately, was $516,000 and $969,000
      for
      the three and six months ended June 30, 2008, respectively. Equity-based
      compensation of $79,000 and $162,000 is included in cost of revenue for the
      three and six months ended June 30, 2008, respectively. Equity based
      compensation 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. The increase is primarily due to the amortization of options
      granted in association with the acquisition of our Finnish subsidiary on
      November 1, 2007.





*Other
      income (expense), net*





Interest
      income (expense), net primarily consists of interest incurred for capital lease
      obligations and long-term debt, offset by interest earned on the Company’s
      invested cash balances. Interest income (expense), net was $(14,000) and $61,000
      for the three and six months ended June 30, 2008, respectively ,
      as
      compared to $81,000
      and $111,000 for the three and six months ended June 30, 2007,
      respectively.





Other
      income (expense), net primarily consists of the change in the fair value of
      the
      warrant derivative liability and realized losses on marketable securities.
      The
      decrease in expense of $3,710,000 for the six months ended June 30, 2008 is
      primarily a result of the elimination of the derivative liability in the second
      quarter of 2007 which accounted for $3,582,000, the elimination of a one time
      fee for a warrant amendment which accounted for $86,000 and the sale of
      marketable securities at a loss which accounted for $27,000. The warrant
      derivative liability was recorded in connection with the August 2006 sale of
      common stock and warrants to a group of investors led by Midsummer
      Capital.





*Other
      comprehensive income (loss)*





Other
      comprehensive income (loss) consists of the foreign currency translation
      adjustment. The foreign currency translation adjustment for the three and six
      months ended June 30, 2008 was $(57,000) and $3,423,000,
      respectively.





**Liquidity
      and Capital Resources**





At
      June
      30, 2008, we had cash and cash equivalents and short-term investments of
      $8,129,000 as compared to $15,094,000 at December 31, 2007. At June 30, 2008,
      the Company had working capital of $3,307,000 ,
      as
      compared to $13,246,000 at December 31, 2007.





Net
      cash
      (used in) provided by operating activities was $(4,077,000) and $367,000 for
      the
      six months ended June 30, 2008 and 2007, respectively. The decrease in net
      cash
      used in operating activities is primarily related to a net loss of $11,914,000
      and a decrease in accounts payable and accrued expenses of $679,000, partially
      offset by a decrease in accounts receivable of $3,885,000, an increase in
      deferred revenue of $1,745,000, an increase in depreciation and amortization
      of
      $1,843,000 and an increase in equity-based compensation of
      $969,000.




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          30
          -


Net
        cash
        provided by (used in) investing activities was $5,186,000 and $(1,230,000)
        for
        the six months ended June 30, 2008 and 2007, respectively. The increase in
        net
        cash used in investing activities for the six months ended June 30, 2007
        is
        primarily a result of the sale of short-term investments and a decrease in
        deferred acquisition costs associated with the then-pending Hantro acquisition,
        offset by increases in the purchase of short-term investments and property
        and
        equipment.




Net
      cash
      (used in) provided by financing activities was $(2,562,000) and $6,276,000
      for
      the six months ended June 30, 2008 and 2007, respectively. The decrease is
      primarily attributable to a decrease in proceeds received from the exercise
      of
      common stock options and warrants and an increase in payments on short-term
      and
      long-term debt.





We
      currently have material commitments for the next 12 months under our operating
      lease arrangements and borrowings. These arrangements consist primarily of
      lease
      arrangements for our office space in Clifton Park and Tarrytown, New York,
      Cambridge UK, and Oulu and Espoo, Finland. The aggregate required payments
      for
      the next 12 months under these arrangements are $831,000. Notwithstanding the
      above, our most significant non-contractual operating costs for the next 12
      months are compensation and benefit costs, insurance costs and general overhead
      costs such as telephone and utilities.





At
      June
      30, 2008, short-term borrowings consisted of the following:





A
      line of
      credit with a Finnish bank for $711,000 (€450,000 at June 30, 2008). The line of
      credit has no expiration date. Borrowings under the line of credit bear interest
      at one month EURIBOR plus 1.25% (total of 5.722% at June 30, 2008). The bank
      also requires a commission payable at .45% of the loan principal.
      Borrowings are collateralized by substantially all assets of Hantro and a
      guarantee by On2. The outstanding balance on the line of credit was $-0- at
      June
      30, 2008.





At
      June
      30, 2008, long-term debt consisted of the following:





Unsecured
      notes payable to a Finnish funding agency of $3,122,000, including interest
      at
      1.75%, due at dates ranging from January 2009 to December 2011; $338,000 to
      a
      Finnish bank, including interest at the 3-month EURIBOR (4.94% at June 30,
      2008)
      plus 1.1%, due March 2011, secured by a guarantee by On2, and the Finnish
      Government Organization, which also requires additional interest at 2.65% of
      the
      loan principal; and an unsecured note payable to a Finnish financing company
      of
      $237,000, including interest at the 6 month EURIBOR (5.088% at June 30, 2008)
      plus .5%, due March 2011.




The
      Company believes that existing funds are sufficient to fund its operations
      through June 30, 2009. 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, 2007.





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


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          31
          -


**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**





In
      May
      2008 the FASB has issued SFAS Statement No. 162, *The
      Hierarchy of Generally Accepted Accounting Principles.* Statement 162 is intended to improve financial reporting by identifying a
      consistent framework, or hierarchy, for selecting accounting principles to
      be
      used in preparing financial statements that are presented in conformity with
      U.S. generally accepted accounting principles for nongovernmental entities.
      SFAS
      162 is effective 60 days following the SEC's approval of the PCAOB amendments
      to
      AU Section 411. The Company is currently evaluating the impact of adopting
      SFAS
      162 on its financial reporting **.**





On
      March
      19, 2008, the FASB issued SFAS Statement No. 161, *Disclosures
      about Derivative Instruments and Hedging Activities - an Amendment of FASB
      Statement 133.* SFAS 161
      enhances required disclosures regarding derivatives and hedging activities,
      including enhanced disclosures regarding how: ( *a* )
      an
      entity uses derivative instruments; ( *b* )
      derivative instruments and related hedged items are accounted for under FASB
      Statement No. 133, *Accounting
      for Derivative Instruments and Hedging Activities;* and
      ( *c* )
      derivative instruments and related hedged items affect an entity’s financial
      position, financial performance, and cash flows. Specifically, SFAS 161
      requires:





·
            Disclosure
                of the objectives for using derivative instruments be disclosed in
                terms
                of underlying risk and accounting designation;





·
            Disclosure
                of the fair values of derivative instruments and their gains and
                losses in
                a tabular format;





·
            Disclosure
                of information about credit-risk-related contingent features; and





·
            Cross-reference
                from the derivative footnote to other footnotes in which
                derivative-related information is
                disclosed.





SFAS
      161
      is effective for fiscal years and interim periods beginning after November
      15,
      2008. Early application is encouraged.





The
      Company is currently evaluating the impact of adopting SFAS 161 on its financial
      position and results of operations.





In
      December 2007, the FASB issued SFAS No. 160, *Non-controlling Interests in Consolidated Financial Statements - An Amendment
      of
      ARB No. 51.* SFAS
      160
      establishes new accounting and reporting standards for the non-controlling
      interest in a subsidiary and for the deconsolidation of a subsidiary.
      Specifically, this Statement requires the recognition of a non-controlling
      interest (minority interest) as equity in the consolidated financial statements
      and separate from the parent's equity. The amount of net income attributable
      to
      the non-controlling interest will be included in consolidated net income on
      the
      face of the income statement. SFAS 160 clarifies that changes in a parent's
      ownership interest in a subsidiary that do not result in deconsolidation are
      equity transactions if the parent retains its controlling financial interest.
      In
      addition, this Statement requires that a parent recognize a gain or loss in
      net
      income when a subsidiary is deconsolidated. Such gain or loss will be measured
      using the fair value of the non-controlling equity investment on the
      deconsolidation date. SFAS 160 also includes expanded disclosure requirements
      regarding the interests of the parent and its non-controlling interest. SFAS
      160
      is effective for fiscal years, and interim periods within those fiscal years,
      beginning on or after December 15, 2008. Earlier adoption of SFAS 160 is
      prohibited. Although the Company will continue to evaluate the application
      of
      SFAS 160, management does not currently believe adoption will have a material
      impact on the Company’s results of operations or financial
      position.


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          32
          -


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





The
      Company does not currently have any material exposure to interest rate risk,
      commodity price risk or other relevant market rate or price risks. However,
      the
      Company does have exposure to foreign currency rate fluctuations arising from
      maintaining offices in the U.K. and Finland for its wholly-owned subsidiaries
      which transacts business in the local functional currency. The U.K. based
      subsidiary does not conduct any sales and all its costs are funded in United
      States dollars. The Finnish subsidiary conducts sales in both Euros and US
      dollars and pays its employees and other material obligations in Euros, and
      therefore can be substantially impacted by currency translation gains and
      losses. To date, the Company has not entered into any derivative financial
      instrument to manage foreign currency risk and is not currently evaluating
      the
      future use of any such financial instruments.





**Item
      4. Controls and Procedures**





(a)
      Evaluation of Disclosure Controls and Procedures:





The
      term
      "disclosure controls and procedures," as defined in Rule 13a-15(e) and
      15d-15(e) under the Securities Exchange Act of 1934, or Exchange Act, means
      controls and other procedures of a company that are designed to ensure that
      information required to be disclosed in the reports that the company files
      or
      submits 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 by a company in
      the
      reports that it files or submits under the Exchange Act is accumulated and
      communicated to the company’s management, including its principal financial
      officers, as appropriate, to allow timely decisions regarding required
      disclosure. There are inherent limitations to the effectiveness of any system
      of
      disclosure controls and procedures, including the possibility of human error
      and
      the circumvention or overriding of the controls and procedures. Accordingly,
      even effective disclosure controls and procedures can only provide reasonable
      assurance of achieving their control objectives and management necessarily
      applies its judgment in evaluating the cost-benefit relationship of possible
      controls and procedures.





In
      connection with the restatement of the Company’s condensed consolidated
      financial statements for the second and third quarters of 2007, as described
      more fully under the caption “Explanatory Note” in On2’s Annual Report on Form
      10-K for the year ended December 31, 2007, management identified three material
      weaknesses in our internal control over financial reporting and reported those
      to our Audit Committee. The Public Company Accounting Oversight Board’s Auditing
      Standard No. 5 defines a material weakness as a deficiency, or combination
      of
      deficiencies, that result in a reasonable possibility that a material
      misstatement of the annual or interim financial statements will not be prevented
      or detected. Based on the identification of the material weaknesses in internal
      control over financial reporting described below, our Interim Chief Executive
      Officer and our Chief Financial Officer have concluded that, as the Audit
      Committee determined and reported to management on May 6, 2008, upon completion
      of the internal review described herein, our disclosure controls and procedures
      were not effective because of the following material weaknesses in our internal
      control over financial reporting that existed as of that date:


-
          33
          -




·
            *Revenue
                recognition procedures*– Our
                controls were not adequate to ensure that revenue was properly recognized
                when it was earned. Pursuant to American Institute of Certified Public
                Accountants’ Statement of Position (SOP) 97-2,*Software
                Revenue Recognition*(“SOP 97-2”) and Staff Accounting Bulletin No. 104 (“SAB 104”) one element
                of revenue recognition is consideration of whether the collectibility
                of
                sales revenue is probable (*i.e.*,
                whether the purchaser is creditworthy with respect to that transaction).We
                did not maintain effective procedures for the consideration of the
                probability that revenue is collectible. This control deficiency
                resulted
                in our incorrect recognition of revenue in our financial statements
                for
                the second and third quarters of
                2007.




·
            *Control
                environment*– We
                did not maintain an effective control environment, specifically relating
                to our tone at the top. This material weakness was evidenced by the
                control tone and control consciousness of our former Chief Executive
                Officer and resulted in the override and the possibility of override
                of
                controls or interference with our policies, procedures and internal
                control over financial reporting.




·
            *Allowance
                for Doubtful Account Procedures*– Effective
                controls were not designed and in place to ensure that an appropriate
                analysis of receivables from customers was conducted, reviewed, approved
                and documented in order to identify and estimate required allowance
                for
                doubtful accounts in accordance with generally accepted accounting
                principles. This material weakness resulted in a misstatement of
                accounts
                receivable, net of allowance for doubtful accounts on our condensed
                consolidated balance sheet at the end of the third quarter of 2007
                and an
                understatement of our general and administrative expenses for the
                period.




(b)  Changes
      in Internal Controls:





There
      were no changes in our internal control
      over financial reporting identified in connection with the evaluation required
      by Rules 13a-15 and 15d-15 that occurred during the quarter ended June 30,
      2008
      that have materially affected,
      or are reasonably likely to materially affect, our internal control
      over financial reporting. However, in connection with the restatement of the
      Company’s condensed consolidated financial statements for the second and third
      quarters of 2007, as described more fully under the caption “Explanatory Note”
in On2’s Annual Report on Form 10-K for the year ended December 31, 2007,
      management determined that the material weaknesses described above existed
      as of
      June 30, 2008 (pending the implementation of remediation initiatives commenced
      during the second quarter of 2008). As a result, during the period ended June
      30, 2008, we have taken certain steps to remediate these material weaknesses,
      discussed below, that will constitute changes in our internal control over
      financial reporting in that period that materially affect our internal control
      over financial reporting. In addition, we are in the process of finalizing
      a
      plan and timetable for the implementation of additional remediation measures,
      also discussed below, to further address these weakness, which will constitute
      additional changes in our internal control over financial reporting that we
      anticipate will materially affect our internal control over financial reporting
      when implemented. Since
      identifying the material weaknesses, we have implemented remediation measures
      and intend to implement these additional remediation measures as soon as
      practicable following finalization of our plan


-
          34
          -


**Remediation
      Initiatives**





In
      response to the identified material weaknesses, our management, with oversight
      from the Audit Committee, has taken certain actions related to their remediation
      during the second quarter of 2008, prior to the filing of this report. These
      actions have involved meetings among (i) our Chief Financial Officer, EVP,
      Legal
      and Business Affairs (and now Interim Chief Executive Officer and Chief
      Operating Officer) and certain members of our accounting staff and (ii) our
      Chief Financial Officer, EVP, Legal and Business Affairs (and now Interim Chief
      Executive Officer and Chief Operating Officer) and the Audit Committee.
      Representatives of our independent registered public accountants and our
      consultant on Sarbanes-Oxley compliance attended certain of these meetings.
      Due
      to the connection between our former Chief Executive Officer and the material
      weakness that we identified in our control environment, he has had limited
      involvement in our remediation actions. Prior to the filing of this report,
      we
      have taken certain steps to remediate these material weaknesses and are in
      the
      process of finalizing a plan and timetable for the implementation of additional
      remediation measures. As we continue to work to finalize our plan to improve
      our
      internal control over financial reporting, we may determine to take additional
      remediation measures or determine to modify, or in appropriate circumstances
      not
      to complete, certain of the remediation measures described below.





From
      a
      control environment and tone at the top perspective, during the second quarter
      of 2008, we have taken the following remedial steps: (i) our Board of Directors
      sought and on June 11, 2008, obtained the resignation of our former Chief
      Executive Officer, Bill Joll, from all positions with us and our subsidiaries,
      including as an officer, employee and director, (he will remain with us as
      an
      advisor to the chief executive officer until September 30, 2008 to effect a
      smooth transition of customer relationships and business development
      opportunities); (ii) on June 10, 2008, our Board of Directors elected
      Matthew Frost, our EVP, Legal and Business Affairs, as Interim Chief Executive
      Officer and Chief Operating Officer; and (iii) we have segregated the duties
      of
      our accounting personnel from our non-accounting personnel other than those
      whose involvement in accounting-related matters is specifically authorized.
      At
      the time of the filing of this report, we anticipate that we will implement
      the
      following additional remediation measures with respect to this material weakness
      as soon as reasonably practicable: (i) establishing an independent third party
      ethics hotline so that employees can anonymously report violations of our Code
      of Ethics and other employee concerns, and educating employees about the hotline
      process; and (ii) revising our Code of Ethics to emphasize the importance of
      adherence to our policies and procedures relating to accounting and financial
      reporting and internal control of financial reporting and the availability
      of
      the ethics hotline for the reporting of violations of our Code of Ethics and
      other employee concerns.





The
      remedial steps we have taken during the second quarter of 2008 to address the
      material weakness in our revenue recognition procedures, specifically our
      procedures for assessing whether the collectibility of revenue is probable
      prior
      to recognition, are as follows: (i) we have revised the process that we and
      our
      operating subsidiary will follow in assessing whether the collectibilty of
      revenue is probable, as well as in determining that the other requirements
      for
      recognizing revenue have been met, so that this assessment occurs at the outset
      of the arrangement and is thereafter reviewed and confirmed in connection with
      our period end closing and financial statement preparation process; (ii) we
      have
      revised, formalized and expanded the documentation of the procedures we and
      our
      operating subsidiary will follow with respect to assessing probability of
      collectibility, as well as determining that the other requirements for
      recognizing revenue have been met; including, specifically, enhancing and
      documenting our policy with respect to the types of information that can be
      used
      in establishing creditworthiness; and (iii) we have added a position to our
      accounting staff and will fill this position as soon as possible. We also
      terminated the firm with which the sales agent who provided us falsified
      documents was affiliated. In addition, in the first quarter of 2008, we added
      a
      certified public accountant to our accounting and financial reporting staff.
      The
      addition of trained staff will both provide additional assistance in the
      accounting department and should allow other members of the accounting staff
      to
      devote additional time to responsibilities connected with financial reporting.





With
      respect to addressing the material weakness in the design and operation of
      our
      procedures for estimating our allowance for doubtful accounts, we have enhanced,
      formalized and documented our procedures for analyzing our accounts receivable
      from customers so that we can appropriately estimate the collectibility of
      receivables at the end of a period based on aging categories and information
      related to collection efforts and formalized and documented timely review of
      that information, and sign off on the recommended allowance for doubtful
      accounts, by senior management.


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At
      the
      time of the filing of this report, we anticipate that we will implement the
      following additional remediation measures as soon as reasonably practicable:
      (i)
      continued improvement to the documentation of the procedures we and our
      operating subsidiary will follow with respect to determining that the
      requirements for recognizing revenue have been met; (ii) Company-wide training
      (led by our Chief Financial Officer, with the assistance of our consultant
      on
      Sarbanes-Oxley compliance, our legal personnel and other accounting and
      financial reporting staff, as appropriate )
      to
      enhance awareness and understanding of standards and principles for accounting
      and financial reporting and
      internal control of financial reporting; and (iii) improve the
      processes and procedures around the completion and review of quarterly
      management representation letters .
      The
      training we plan to implement will deal specifically with revenue recognition
      requirements and requirements related to accounts receivable and allowance
      for
      doubtful accounts **** and
      will
      include appropriate programs for senior management to emphasize the importance
      of accounting and financial reporting integrity .
      This
      training will address all of the material weaknesses we have identified.





The
      Audit
      Committee has directed management to develop a detailed plan and timetable
      for
      the implementation of the foregoing remedial measures (to the extent not already
      completed). The Audit Committee has approved our initial remediation efforts
      and
      will monitor the implementation. In addition, under the direction of the Audit
      Committee, management will continue to review and make necessary changes to
      the
      overall design of our internal control environment, as well as policies and
      procedures to improve the overall effectiveness of internal control over
      financial reporting. Our plan to remediate the material weaknesses in our
      internal control over financial reporting will be finalized and implemented
      as
      soon as reasonably practicable. We will continue to use external consultants
      to
      review our procedures and assist us in testing the effectiveness in our
      procedures on an on-going basis.





We
      believe that the steps we have heretofore taken have significantly improved
      our
      internal control over financial reporting. We are committed to remediating
      our
      material weaknesses and intend that, when finalized and fully implemented,
      our
      remediation measures will address the identified material weaknesses and will
      strengthen our overall internal control over financial reporting as well. We
      are
      committed to continuing to improve our internal control processes and will
      continue to diligently and vigorously review our financial reporting controls
      and procedures. As we continue to evaluate and work to improve our internal
      control over financial reporting, we may determine to take additional measures
      to address control deficiencies or determine to modify, or in appropriate
      circumstances not to complete, certain of the remediation measures described
      above.





Remediation
      generally requires making changes to how controls are designed and then adhering
      to those changes for a sufficient period of time such that the effectiveness
      of
      those changes is demonstrated with an appropriate amount of consistency. We
      believe that we have made significant improvements in our internal control
      over
      financial reporting and are committed to remediating our material
      weaknesses.


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**PART
      II — OTHER INFORMATION**





**Item
      1. Legal Proceedings**





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
      over three years have passed since the arbitrator issued his March 2005 ruling,
      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 of this report, Beijing
      E-World has not paid the amount agreed for settlement. Accordingly, our
      arbitration claim is still pending. We are unaware of any material developments
      with respect to Beijing E-World’s actions in arbitration to defend itself in
      response to our claims or with respect to settlement.


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          37
          -


**Item
      6. Exhibits.**





Certification
      of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted
      Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.





Certification
      of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted
      Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


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          38
          -


**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.August
                14, 2008
            
            (Registrant)
              
              
              /s/
                MATTHEW FROST(Date)
            
            (Signature)
              Matthew
                Frost
              Interim
                Chief Executive Officer




On2
                Technologies, Inc.August
                14, 2008
            
            (Registrant)
              
              
              /s/
                ANTHONY PRINCIPE(Date)
            
            (Signature)
              Anthony
                Principe
              Senior
                Vice President and Chief Financial Officer
              (Principal
                Financial Officer)


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