UNITED
      STATES


SECURITIES
      AND EXCHANGE COMMISSION


Washington,
      D.C. 20549





FORM
      10-Q/A


(Amendment
      No. 1)





(Mark
      One)





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


For
      the
      quarterly period ended September 30, 2007.





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


For
      the
      transition period from ____ to ____.





Commission
      file number 1-15117.




**On2
      Technologies, Inc.**





(Exact
      name of registrant as specified in its charter)




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





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





(518)
      348-0099





(Registrant’s
      telephone number, including area code)







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





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




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





APPLICABLE
      ONLY TO ISSUERS INVOLVED IN BANKRUPTCY


PROCEEDINGS
      DURING THE PRECEDING FIVE YEARS:





Indicate
      by check mark whether the registrant has filed all documents and reports
      required to be filed by Sections12, 13 or 15(d) of the Securities Exchange
      Act
      of 1934 subsequent to the distribution of securities under a plan confirmed
      by a
      court.   ̈ 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 June 16, 2008, was 159,563,152 (this number does not
      include an additional 12,500,000 shares of the Registrant’s common stock that
      the Registrant is obligated to issue to the former shareholders of Hantro
      Products Oy, acquired by the Registrant in November 2007).








**Explanatory
      Note**





*Except
      as otherwise stated or where the context requires otherwise, the words “On2,”
“we,” “company,” “us” and “our” refer to On2 Technologies, Inc. and its
      consolidated subsidiaries.*





We
      are
      filing this Amendment No. 1 to our Quarterly Report on Form 10-Q for the
      quarterly period ended September 30, 2007, originally filed on November 14,
      2007, to restate our unaudited condensed consolidated financial statements
      as of
      and for the three and nine months ended September 30, 2007 and related
      disclosures. As announced in our Current Report on Form 8-K which we filed
      with the Securities and Exchange Commission on May 27, 2008, the Audit Committee
      of our Board of Directors determined on May 26, 2008 that these previously
      issued financial statements can no longer be relied upon and will be restated
      due to errors in those financial statements related to the Company’s recognition
      of revenue. The restatement arose from the independent review conducted by
      the
      Audit Committee of our Board of Directors concerning certain contracts with
      customers and the recognition of revenue that we had previously recognized
      in
      2007 regarding those contracts. The Audit Committee reached its determination
      following the completion of its review of five of our sales accounts. The Audit
      Committee’s review commenced after the Audit Committee was informed by our
      management that certain documentation provided to us relating to two sales
      accounts for which revenue had been recognized in the third quarter of 2007
      had
      been falsified. Management made this discovery during the preparation of our
      2007 annual financial statements. The Audit Committee concluded, with respect
      to
      four of the accounts, including the two sales accounts previously mentioned,
      that we incorrectly recognized revenue of $185,000 for the second quarter of
      2007 and $589,000 **** for
      third
      quarter of 2007. In addition, during the preparation of our 2007 annual
      financial statements and prior to discovery of the falsified documentation
      mentioned above, management determined that revenue of $42,000 had been
      incorrectly recognized in the third quarter of 2007.  The
      revenue that was incorrectly recognized during these periods will be recognized
      on a cash basis when and if collected. As of the filing date of this report,
      only a portion of the amounts owed in connection with Account 4, defined below,
      has been collected. When the Company filed its Current Report Form 8-K on May
      27, 2008, the Audit Committee had also preliminarily determined to establish
      a
      bad debt reserve of $383,000 in the fourth quarter of 2007 for certain sales
      to
      a fifth account. Upon further examination of the facts and circumstances
      involved in sales to this account, we confirmed that sales had occurred to
      this
      account, that a reserve for $383,000 was required, but that the reserve should
      have been established in the third quarter, rather than the fourth quarter,
      of
      2007. To establish that reserve we recorded a general charge to general and
      administrative expense of $383,000 which increased our net loss for the third
      quarter of 2007 by that amount (in addition to the $631,000 of revenue that
      was
      reversed in the period). The establishment of the reserve also resulted in
      a
      reduction in accounts receivable, net of allowance for doubtful accounts on
      our
      balance sheet at September 30, 2007, by the same amount.





The
      foregoing correction to our financial statements for the second quarter of
      2007
      increased our net loss by $185,000. The effect of the foregoing corrections
      to
      our financial statements for the third quarter of 2007 was to increase our
      net
      loss by $1,014,000.





In
      addition to this amended quarterly report on Form 10-Q/A, we are also
      amending our quarterly reports on Form 10-Q for the quarter ended June 30,
      2007, originally filed on August 14, 2007 to restate
      our unaudited condensed consolidated financial statements for that period.
      For
      more information on these matters, please refer to Part I, Item 2,
      Management’s Discussion and Analysis of Financial Condition and Results of
      Operations — Restatement of Consolidated Financial Statements and
      Item 4, Controls and Procedures, Part II, Item 1A, Risk Factors, as well as
      Note 3 to the accompanying unaudited condensed consolidated financial statements
      for additional information.


-
          1
          -


**Audit
      Committee Review**





On
        May
        26, 2008, the Audit Committee determined that the financial statements in
        the
        Company’s Quarterly Reports on Form 10-Q for the three months ended June 30 and
        September 30, 2007, should no longer be relied upon. The Audit Committee
        reached
        this determination based on its review of the Company’s sales to five accounts
        and its conclusion that the Company’s revenue recognition as to four of those
        accounts did not comply with applicable accounting principles. One account
        of
        $300,000 ($280,000 for software and $20,000 for post-contract support), of
        which
        $280,000 was recognized in the third quarter of 2007, which represented
        approximately 10.9% of the previously-reported revenues for that quarter
        (“Account 1”); a second account of $320,000 ($300,000 for software and $20,000
        for post-contract support), of which $300,000 was recognized in the third
        quarter of 2007, which represented approximately 11.7% of the
        previously-reported revenues for that quarter (“Account 2”); a third account of
        $150,000 ($125,000 for software and $25,000 for post-contract support), of
        which
        $125,000 was recognized in the second quarter of 2007, which represented
        approximately 4.9% of the previously-reported revenues for that quarter
        (“Account 3”); and a fourth account of $70,000 ($60,000 for software and $10,000
        for post-contract support), of which $60,000 was recognized in the second
        quarter of 2007, which represented approximately 2.4% of the previously-reported
        revenues for that quarter (“Account 4”). With respect to the fifth account
        (“Account 5”) reviewed by the Audit Committee, the Company established a bad
        debt reserve in the third quarter of 2007 in the amount of $383,000, which
        reflects an estimate of the uncollectibility of certain revenues that had
        previously been recognized in the first three quarters in 2007. The Company
        is
        restating its previously issued financial statements for the three and nine
        months ended September 30, 2007 in this Amendment No. 1 to the Company’s
        Quarterly Report on Form 10-Q for the quarterly period ended September 30,
        2007,
        to correct the incorrect recognition of revenue in the period relating to
        Account 1 and Account 2, as well as the incorrect recognition in the period
        of
        additional $42,000 (because the Company did not have sufficient evidence
        to
        establish the creditworthiness of the customer) and the establishment of
        a bad
        debt reserve related to Account 5. The Company has also restated its previously
        issued financial statements for the three and six months ended June 30, 2007
        in
        Amendment No. 1 to its Quarterly Report on Form 10-Q for quarterly period
        ended
        June 30, 2007, to correct the incorrect recognition of revenue in the period
        relating to Account 3 and Account 4. The restatements herein of the Company’s
        previously issued financial statements for the three and nine months ended
        September 30, 2007, reflect the restatement of the Company’s financial
        statements for three and six months ended June 30, 2007.





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
      reasonably assured ( *i.e.* ,
      whether
      the purchaser is creditworthy with respect to that transaction). During
      the 2007 year-end audit process, management learned that the creditworthiness
      of
      Account 1 and Account 2, both of which were European customers, had been
      assessed, and approximately $580,000 in revenue had been recognized in the
      third
      quarter of 2007, based upon falsified documentation that the Company
      received . The
      Company learned of the falsified documentation when the sales representative
      (the “Sales Representative”) responsible for Accounts 1, 2 and 4; and who was
      also involved with Account 3; who was employed by a European outsourcing company
      that the Company initially retained in 2006 (and to whom the Company paid
      commissions in connection with Accounts 1, 2, 3 and 4, but whom we terminated
      in
      April 2008 as a result of this review) admitted to the Company’s Executive
      Vice-President, Legal and Business Affairs, to falsifying documentation
      purporting to establish the creditworthiness of Account 1. The documentation
      purporting to establish the creditworthiness of Account 2 was subsequently
      determined to be false, although the identity of the person or persons
      responsible for falsifying such documentation was not ascertained during the
      Audit Committee review.





After
        determining that the documentation purporting to support the creditworthiness
        of
        Accounts 1 and 2 was false, management informed the Audit Committee, which
        then
        commenced its review. The Audit Committee’s review focused exclusively on the
        following issues: (1) whether the false documentation identified with respect
        to
        Accounts 1 and 2 was limited to those accounts, or whether it affected other
        accounts that were either affiliated with the Sales Representative or were
        deemed by management to be material to the quarter in 2007 in which revenue
        for
        those accounts had been recognized (Accounts 3, 4 and 5); (2) whether the
        Sales
        Representative falsified documentation for his own financial benefit and/or
        at
        the direction, or with the knowledge, of management; and (3) whether information
        obtained during the review indicated that Accounts 1 and 2 were not legitimate
        transactions.


-
          2
          -


The
        Audit
        Committee conducted its review of Accounts 1 through 5 with the assistance
        of
        Latham & Watkins LLP and FTI Consulting, and with the support and
        cooperation of management and personnel. The review was conducted over a
        period
        of approximately six weeks, and included collection and review of more than
        two
        million pages of documents, as well as interviews of eight members of the
        Company's management and sales force teams in the United States and the Sales
        Representative in Europe.





With
        respect to Account 1, with which the Company had no previous business
        relationship, the Audit Committee found that the Company paid a sales commission
        to the European outsourcing company upon execution of the contract with Account
        1, and that the Sales Representative received a commission from the outsourcing
        company in connection with Account 1, but found no evidence that the commission
        was affected by the Sales Representative’s falsification of documentation
        concerning the creditworthiness of Account 1. Although the Audit Committee
        found
        no evidence that the Sales Representative acted at the direction, or with
        the
        knowledge, of any member of management in falsifying documentation concerning
        the creditworthiness of Account 1, it found that the Sales Representative
        had
        been directed by senior management to obtain evidence of the creditworthiness
        of
        Account 1 so that revenue could be recognized in the third quarter of 2007.
        The
        Audit Committee also found that senior management did not adequately instruct
        the Sales Representative regarding (and the Company did not have a practice
        or
        policy regarding) the types of information that could be used in making a
        creditworthiness determination pursuant to the applicable revenue recognition
        accounting principles. In addition, the Audit Committee determined that,
        although sales revenue from Account 1 was recognized in the third quarter
        of
        2007, evidence relating to creditworthiness was not obtained until the fourth
        quarter of 2007, however, prior to filing of the third quarter Form 10-Q.
        The
        Audit Committee concluded that the sales revenue of $280,000 from Account
        1,
        which was previously recognized in the third quarter of 2007, did not constitute
        a sale for which revenue could be recognized, and therefore no revenue should
        have been recognized in the third quarter of 2007 or any other
        period.





With
        respect to Account 2, with which the Company had no previous business
        relationship, the Audit Committee has been unable to determine the identity
        of
        the person or persons who falsified documentation concerning the
        creditworthiness of Account 2. Although the Audit Committee has found no
        evidence establishing that management directed or had knowledge of the
        falsification of any document, it has found that the Sales Representative
        had
        been directed by senior management to obtain evidence of the creditworthiness
        of
        Account 2 so that revenue could be recognized in the third quarter of 2007.
        The
        Audit Committee determined that, although sales revenue from Account 2 was
        recognized in the third quarter of 2007, evidence relating to creditworthiness
        was not obtained until the fourth quarter 2007, however, prior to the filing
        of
        the third quarter Form 10-Q. The Audit Committee also found that senior
        management did not adequately instruct the Sales Representative regarding
        (and
        the Company did not have a policy or practice regarding) the types of
        information that could be used in making a creditworthiness determination
        pursuant to the applicable revenue recognition accounting principles. The
        Audit
        Committee has concluded that the sales revenue of $300,000 from Account 2,
        which
        was previously recognized in the third quarter of 2007, did not constitute
        a
        sale for which revenue could be recognized, and therefore no revenue should
        have
        been recognized in the third quarter of 2007 or any other period. The revenue
        will be recognized on a cash basis when and if collected.





With
        respect to Accounts 3 and 4, with which the Company did not have previous
        business relationships, the Audit Committee did not find evidence of falsified
        documentation. The Audit Committee determined that the Company did not have
        sufficient evidence to establish the creditworthiness of Accounts 3 or 4
        when it
        recognized $125,000 and $60,000, respectively, in revenue in the second quarter
        2007, and that the Company did not have a practice or policy regarding the
        types
        of information that could be used in making such creditworthiness
        determinations. Neither Account 3 nor 4 has acknowledged its contract to
        the
        Company’s independent registered public accountants, and there is evidence that
        Account 3 disputes the terms of its contract with the Company. Account 3
        has
        made no payments to the Company. Account 4 has paid a portion of its outstanding
        receivable, which is now current. The Audit Committee concluded that the
        sales
        revenue of $185,000 from Accounts 3 and 4 was untimely recognized in the
        second
        quarter of 2007. Account 3 was determined not to constitute a sale for which
        revenue could be recognized in any period. The $60,000 of revenue from Account
        4
        was reclassified to deferred revenue in the second quarter of 2007 and revenue
        will be recognized as the payments are received. The Company received payments
        of $8,000 in the fourth quarter of 2007 and $30,000 in the first quarter
        of
        2008. The balance is not yet due. Additionally, the Company reversed $9,000
        of
        support revenue associated with Accounts 3 and 4 in the third quarter of
        2007.




-
          3
          -


With
        respect to Account 5, with which the Company had a prior business relationship,
        the Audit Committee did not find evidence of falsified documentation. The
        Audit
        Committee found that the creditworthiness of Account 5 was based on the past
        credit payment history with the Company. It also found that, when payments
        associated with Account 5 became past due in 2007, the Company continued
        selling
        to Account 5 without re-assessing its creditworthiness until September 2007,
        when the account was significantly past due. Further sales were suspended
        in the
        fourth quarter of 2007. The Audit Committee concurred with management’s
        recommendation that a bad debt reserve of $383,000 should be taken in the
        fourth
        quarter of 2007 in connection with its sales to Account 5. Upon further
        examination of the facts and circumstances involved in Account 5, the Company
        confirmed that sales had occurred to Account 5, that a reserve for $383,000
        was
        required, but that the reserve should have been established in the third
        quarter, rather than the fourth quarter, of 2007. To establish that reserve,
        the
        Company recorded a general charge to general and administrative expense of
        $383,000 which increased the Company's net loss for the third quarter of
        2007 by
        that amount (in addition to the $631,000 of revenue that was reversed in
        the
        period). The establishment of the reserve also resulted in a reduction in
        accounts receivable, net of allowance for doubtful accounts on the Company’s
        balance sheet at September 30, 2007, by the same amount.





In
      addition, during the preparation of the Company’s 2007 annual financial
      statements and prior to discovery of the falsified documentation mentioned
      above, management determined that revenue of $42,000 had been incorrectly
      recognized in the third quarter of 2007 because of insufficient evidence to
      establish the creditworthiness of the customer.





Management
        also conducted a review of the Company’s sales to all accounts for which revenue
        was recognized in fiscal 2007, including the accounts of Hantro Products
        Oy,
        which the Company acquired in November 2007, for the purposes of determining
        that the criteria set forth in SOP 97-2 and SAB 104 was satisfied and that
        revenue was properly recognized for each account. Management concluded that,
        except for the accounts discussed above and the $42,000 that also was
        incorrectly recognized, the criteria set forth in SOP 97-2 and SAB 104 were
        satisfied and revenue was properly recognized for all of these
        accounts.





**Identification
      of Material Weaknesses in Internal Control over Financial
      Reporting**





As
        a
        result of the determination to restate the Company’s financial statements and in
        connection with the preparation of its Annual Report on Form 10-K for the
        year
        ended December 31, 2007, management identified three material weaknesses
        in the
        Company's disclosure controls and procedures and internal control over financial
        reporting and reported those to the Company's Audit Committee. Management
        identified a material weakness in the Company's procedures for recognizing
        revenue, specifically with respect to the Company's procedures for assessing
        whether collectibility is reasonably assured. This material weakness resulted
        in
        the incorrect recognition of revenue in the Company's financial statements
        for
        the second and third quarters of 2007. In addition, management identified
        a
        material weakness in the Company's control environment, specifically relating
        to
        the Company's tone at the top. This material weakness was evidenced by the
        control tone and control consciousness of the Company's former chief executive
        officer, resulting in the override and the possibility of override of controls
        or interference with the Company's policies, procedures and internal control
        over financial reporting. Management also identified a material weakness
        in the Company's procedures for determining the accuracy and completeness
        of its estimate of allowance for doubtful accounts. This material weakness
        resulted in a misstatement of accounts receivable, net of allowance for doubtful
        accounts on the Company's balance sheet at the end of the third quarter of
        2007
        and an understatement of the Company's general and administrative expenses
        for
        the period. **** Prior
        to
        the filing of this report, the Company has taken certain steps to remediate
        these material weaknesses and is in the process of finalizing a plan and
        timetable for the implementation of additional remediation measures to further
        address these material weaknesses. These material weaknesses and the remediation
        measures are further described below in Item 4 of this Form
        10-Q/A.


-
          4
          -





For
      the
      convenience of the reader, this Form 10-Q/A restates the September 30, 2007
      Form
      10-Q in its entirety. Generally, no attempt has been made in this Form 10Q/A
      to
      modify or update other disclosures presented in the original report on Form
      10-Q
      except as required to reflect the effects of the restatement. This Form 10-Q/A
      does not reflect events occurring after the filing of the original Form 10-Q
      or
      modify or update those disclosures. Information not affected by the restatement
      is unchanged and reflects the disclosures made at the time of the original
      filing of the Form 10-Q with the Securities and Exchange Commission on November
      14, 2007. Accordingly, this Form 10-Q/A should be read in conjunction with
      our
      filings made with the Securities and Exchange Commission subsequent to the
      filing of the original Form 10-Q. The following items have been amended as
      a
      result of the restatement:





·
            Part
                I, Item 1: Financial Information


·
            Part
                I, Item 2: Management’s Discussion and Analysis of Financial Condition and
                Results of Operations


·
            Part
                I, Item 4: Controls and Procedures


·
            Part
                II, Item 1A: Risk Factors (solely to reflect this
                restatement)





In
      addition, in accordance with applicable SEC rules, this Form 10-Q/A includes
      updated certifications from our Interim Chief Executive Officer and Chief
      Financial Officer as Exhibits 31.1, 31.2, 32.1 and 32.2.


-
          5
          -





**Table
      of Contents**





Page**PART
              I
              — FINANCIAL INFORMATION**Item
                1. Consolidated Financial Statements.Condensed
                Consolidated Balance Sheets at September 30, 2007 (unaudited) (restated)
                and December 31, 2006
            7Unaudited
                Condensed Consolidated Statements of Operations
              Three
                and Nine Months Ended September 30, 2007 (restated) and
                2006
            8Unaudited
                Condensed Consolidated Statements of Comprehensive Loss
              Three
                and Nine Months Ended September 30, 2007 (restated) and
                2006
            9Unaudited
                Condensed Consolidated Statements of Cash Flows
              Nine
                Months Ended September 30, 2007 (restated) and 2006
            10Notes
                to Unaudited Condensed Consolidated Financial Statements
            12Item
                2. Management’s Discussion and Analysis of Financial Condition and Results
                of Operations
            23Item
                3. Quantitative and Qualitative Disclosures About Market
                Risk
            38Item
                4. Controls and Procedures
            38**PART
                II — OTHER INFORMATION**Item
                1. Legal Proceedings
            43Item
                1A. Risk Factors
            44Item
                6. Exhibits
            46Signatures
            47Certifications
            48




-
          6
          -


**PART
      I — FINANCIAL INFORMATION**





**Item
      1.**  **Consolidated
      Financial Statements**




**ON2
      TECHNOLOGIES, INC.**


**CONDENSED
      CONSOLIDATED BALANCE SHEETS**





**September 30,**
              **2007**
            
            **December 31,**
              **2006****(unaudited and as**
              **restated)****ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            9,634,000
            
            $
            4,961,000Marketable
                securities
            
            
            
            
            
            154,000Accounts
                receivable
            
            
            1,577,000
            
            
            1,335,000Prepaid
                and other current assets
            
            
            237,000
            
            
            231,000Total
                current assets
            
            
            11,448,000
            
            
            6,681,000Acquired
                software, net
            
            
            317,000
            
            
            467,000Other
                acquired intangibles, net
            
            
            73,000
            
            
            108,000Goodwill
            
            
            244,000
            
            
            244,000Property
                and equipment, net
            
            
            352,000
            
            
            157,000Deferred
                acquisition costs
            
            
            1,727,000Deferred
                financing costs
            
            
            62,000Other
                assets
            
            
            104,000
            
            
            230,000Total
                assets
            
            $
            14,327,000
            
            $
            7,887,000**LIABILITIES
                AND STOCKHOLDERS’ EQUITY**Current
                liabilities:Accounts
                payable
            
            $
            501,000
            
            $
            194,000Accrued
                expenses
            
            
            1,095,000
            
            
            454,000Deferred
                revenue
            
            
            792,000
            
            
            708,000Term-loan
            
            
            96,000
            
            
            33,000Capital
                lease obligation
            
            
            22,000
            
            
            24,000Total
                current liabilities
            
            
            2,506,000
            
            
            1,413,000Capital
                lease obligation, excluding current portion
            
            
            18,000
            
            
            29,000Warrant
                derivative liability
            
            
            
            
            
            2,329,000Total
                liabilities
            
            
            2,524,000
            
            
            3,771,000Commitments
                and contingenciesSeries
                D redeemable convertible preferred stock
            
            
            -
            
            
            3,083,000Stockholders’
                equity:Preferred
                stock
            
            
            
            
            
            19,000Common
                stock
            
            
            1,173,000
            
            
            1,012,000Additional
                paid-in capital
            
            
            140,374,000
            
            
            124,554,000Accumulated
                other comprehensive loss
            
            
            (52,000
            )
            
            (46,000
            )Accumulated
                deficit
            
            
            (129,692,000
            )
            
            (124,506,000
            )Total
                stockholders’ equity
            
            
            11,803,000
            
            
            1,033,000Total
                liabilities and stockholders’ equity
            
            $
            14,327,000
            
            $
            7,887,000




*See
      accompanying notes to unaudited condensed consolidated financial statements*


-
          7
          -





**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**





**Three Months Ended**
              **September 30,**
            
            **Nine Months Ended**
              **September 30,****2007**
            
            **2006**
            
            **2007**
            
            **2006****(as restated)**
            
            
            
            **(as restated)**Revenue
            
            $
            1,935,000
            
            $
            1,703,000
            
            $
            7,119,000
            
            $
            4,455,000Operating
                expenses:Cost
                of revenue (1)
            
            
            603,000
            
            
            529,000
            
            
            1,415,000
            
            
            1,817,000Research
                and development (2)
            
            
            445,000
            
            
            261,000
            
            
            1,500,000
            
            
            700,000Sales
                and marketing (2)
            
            
            676,000
            
            
            263,000
            
            
            1,886,000
            
            
            623,000General
                and administrative (2)
            
            
            1,529,000
            
            
            843,000
            
            
            3,468,000
            
            
            3,383,000Equity-based
                compensation:Research
                and development
            
            
            46,000
            
            
            30,000
            
            
            66,000
            
            
            82,000Sales
                and marketing
            
            
            34,000
            
            
            61,000
            
            
            88,000
            
            
            119,000General
                and administrative
            
            
            102,000
            
            
            303,000
            
            
            330,000
            
            
            1,014,000Total
                operating expenses
            
            
            3,435,000
            
            
            2,290,000
            
            
            8,753,000
            
            
            7,738,000Loss
                from operations
            
            
            (1,500,000
            )
            
            (587,000
            )
            
            (1,634,000
            )
            
            (3,283,000
            )Interest
                and other income (expense), net
            
            
            121,000
            
            
            (10,000
            )
            
            (3,464,000
            )
            
            (36,000
            )Loss
                before provision for income taxes
            
            
            (1,379,000
            )
            
            (597,000
            )
            
            (5,098,000
            )
            
            (3,319,000
            )Provision
                for income taxes
            
            
            3,000
            
            
            11,000
            
            
            10,000
            
            
            17,000Net
                loss
            
            $
            (1,382,000
            )
            $
            (608,000
            )
            $
            (5,108,000
            )
            $
            (3,336,000
            )Convertible
                preferred stock deemed dividend
            
            
            
            
            
            68,000
            
            
            
            
            
            68,000Convertible
                preferred stock 8%dividend
            
            
            7,000
            
            
            74,000
            
            
            78,000
            
            
            220,000Net
                loss attributable to common shareholders
            
            $
            (1,389,000
            )
            $
            (750,000
            )
            $
            (5,186,000
            )
            $
            (3,624,000
            )Basic
                and diluted net loss attributable to common shareholders per common
                share
            
            $
            (0.01
            )
            $
            (0.01
            )
            $
            (0.05
            )
            $
            (0.04
            )Weighted-average
                basic and dilutedcommon
                shares
            
            
            116,353,000
            
            
            97,436,000
            
            
            110,615,000
            
            
            96,838,000





(1)  Includes
      equity-based compensation of $48,000 and $63,000 for the three and nine months
      ended September 30, 2007, respectively, and $45,000 and $154,000 for the three
      and nine months ended September 30, 2006, respectively.


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





*See
      accompanying notes to unaudited condensed consolidated financial
      statements*


-
          8
          -


**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS**





**Three Months Ended**
              **September 30,**
            
            **Nine Months Ended**
              **September 30,****2007**
            
            **2006**
            
            **2007**
            
            **2006****(as
                restated)**
            
            
            
            **(as
                restated)**Net
                (loss)
            
            $
            (1,382,000
            )
            $
            (608,000
            )
            $
            (5,108,000
            )
            $
            (3,336,000
            )Other
                comprehensive (loss):Foreign
                currency translation
            
            
            (1,000
            )
            
            (1,000
            )
            
            (6,000
            )
            
            (3,000
            )Comprehensive
                (loss)
            
            $
            (1,383,000
            )
            $
            (609,000
            )
            $
            (5,114,000
            )
            $
            (3,339,000
            )





*See
      accompanying notes to unaudited condensed consolidated financial
      statements*


-
          9
          -





**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**





**Nine Months Ended September 30,****2007**
            
            **2006****(as
                restated)**Cash
                flows from operating activities:Net
                loss
            
            $
            (5,108,000
            )
            $
            (3,336,000
            )Adjustments
                to reconcile net loss to net cash provided by (used in) operating
                activities:Equity-based
                compensation
            
            
            547,000
            
            
            1,369,000Other
                expense recognized for warrant amendment
            
            
            86,000Common
                stock issued for debenture interest
            
            
            
            
            
            5,000Depreciation
                and amortization
            
            
            275,000
            
            
            244,000Amortization
                of debt discount
            
            
            
            
            
            6,000Write
                off of fixed assets
            
            
            (21,000
            )Loss
                on marketable securities
            
            
            27,000
            
            
            42,000Change
                in fair value of warrant liability
            
            
            3,582,000
            
            
            (20,000
            )Changes
                in operating assets and liabilities:Accounts
                receivable, net
            
            
            (242,000
            )
            
            (415,000
            )Prepaid
                expenses and other current assets
            
            
            138,000
            
            
            112,000Other
                assets
            
            
            20,000
            
            
            (112,000
            )Accounts
                payable, accrued expenses and other liabilities
            
            
            969,000
            
            
            (50,000
            )Deferred
                revenue
            
            
            84,000
            
            
            403,000Net
                cash provided by (used in) operating activities
            
            
            357,000
            
            
            (1,752,000
            )Cash
                flows from investing activities:Proceeds
                from the sale of marketable securities
            
            
            223,000
            
            
            75,000Purchase
                of marketable securities
            
            
            (96,000
            )Deferred
                acquisition costs
            
            
            (1,727,000
            )Deferred
                financing costs
            
            
            (62,000
            )Purchases
                of property and equipment
            
            
            (257,000
            )
            
            (54,000
            )Net
                cash (used in) provided by investing activities
            
            
            (1,919,000
            )
            
            21,000Cash
                flows from financing activities:Principal
                payments on capital lease
            
            
            (19,000
            )
            
            (21,000
            )Principal
                payments on term-loan
            
            
            (81,000
            )
            
            (31,000
            )Proceeds
                from the exercise of common stock options and warrants
            
            
            6,813,000
            
            
            737,000Purchase
                of treasury stock
            
            
            (472,000
            )Proceeds
                from the issuance of common stock, net
            
            
            
            
            
            428,000Proceeds
                attributed to warrant derivative liability
            
            
            
            
            
            1,251,000Net
                cash provided by financing activities
            
            
            6,241,000
            
            
            2,364,000Net
                change in cash and cash equivalents
            
            
            4,679,000
            
            
            633,000Effect
                of exchange rate changes on cash and cash equivalents
            
            
            (6,000
            )
            
            (3,000
            )Cash
                and cash equivalents, beginning of period
            
            
            4,961,000
            
            
            3,976,000Cash
                and cash equivalents, end of period
            
            $
            9,634,000
            
            $
            4,606,000


-
          10
          -





**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**


**(CONTINUED)**





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





Nine Months Ended September 30,**2007**
              **(as restated)**
            
            **2006**Cash
                paid during the period for:Interest
            
            $
            6,000
            
            $
            5,000Taxes
            
            $
            11,000
            
            $
            14,000Acquisition
                of fixed assets under capital leases
            
            $
            6,000
            
            $
            58,000Insurance
                premium financed with a term-loan
            
            $
            143,000
            
            $
            96,000Conversion
                of debentures into shares of common stock
            
            
            
            
            $
            250,000Conversion
                of preferred stock into shares of common stock#
            
            $
            3,102,000
            
            $
            175,000Common
                stock issued for accrued dividend on Series D Preferred Stock
            
            $
            21,000Common
                stock issued for dividends on Series D Preferred Stock
            
            $
            93,000
            
            $
            223,000Common
                stock issued for Wildform Support and Services Agreement
            
            
            
            
            $
            258,000Write
                off of warrant derivative liability
            
            $
            5,911,000Deferred
                financing costs charged to paid-in-capital on exercise of
                warrants
            
            $
            106,000Cashless
                exercise of options and warrants
            
            $
            959,000Retirement
                of treasury stock
            
            $
            1,431,000Convertible
                Preferred Stock deemed dividend
            
            
            
            
            $
            68,000




*See
      accompanying notes to unaudited condensed consolidated financial
      statements*


-
          11
          -





**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**





(1)
      Description of On2 Technologies, Inc.





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





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





(2)
      Basis
      of Presentation





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





The
      interim condensed consolidated financial statements are unaudited. However,
      in
      the opinion of management, such financial statements contain all adjustments
      (consisting of normally recurring accruals) necessary to present fairly the
      financial position of the Company and its results of operations and cash flows
      for the interim periods presented. The condensed consolidated financial
      statements included herein have been prepared pursuant to the rules and
      regulations of the Securities and Exchange Commission (“SEC”). Certain
      information and footnote disclosures normally included in consolidated financial
      statements prepared in accordance with accounting 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, for the year ended December 31, 2006,
      included in the Company's Form 10-K Report filed with the SEC on March 23,
      2007
      as amended April 30, 2007, May 10, 2007 and October 10, 2007.





(3)
      Restatement





On2
      has
      restated its unaudited condensed consolidated financial statements for the
      three
      and nine months ended September 30, 2007 to eliminate revenue when the criteria
      for revenue recognition under American Institute of Certified Public
      Accountants’ Statement of Position (SOP) 97-2, *Software
      Revenue Recognition* (“SOP
      97-2”) was not met. The impact of the restatement in this report is to decrease
      revenues in the third quarter of 2007 by $631,000.


-
          12
          -


The
      restatement arose from the independent review conducted by the Audit Committee
      of the Company’s Board of Directors concerning certain contracts with customers
      and the recognition of revenue that the Company had previously recognized in
      2007 regarding those contracts. The Audit Committee reached its determination
      following the completion of its review of five of the Company’s sales accounts.
      The Audit Committee’s review commenced after the Audit Committee was informed by
      the Company’s management that certain documentation provided to the Company
      relating to two sales accounts for which revenue had been recognized in the
      third quarter of 2007 had been falsified. Management made this discovery during
      the preparation of the Company’s 2007 annual financial statements. The Audit
      Committee concluded, with respect to four accounts, including the two sales
      accounts previously mentioned, that the Company incorrectly recognized revenue
      of $185,000 for the second quarter of 2007 and $589,000 for the third quarter
      of
      2007. In addition, during the preparation of the Company’s 2007 annual financial
      statements and prior to discovery of the falsified documentation mentioned
      above, management determined that revenue of $42,000 had been incorrectly
      recognized in the third quarter of 2007 because the Company did not have
      sufficient evidence to establish the creditworthiness of the customer. The
      revenue that was incorrectly recognized during these periods will be recognized
      on a cash basis when and if collected. As
      of the
      filing date of this report, only a portion of the amounts owed in connection
      with Account 4, defined below, has been collected. When
      the
      Company filed its Current Report Form 8-K on May 27, 2008, the Audit Committee
      had also preliminarily determined to establish a bad debt reserve of $383,000
      in
      the fourth quarter of 2007 for certain sales to a fifth account. Upon further
      examination of the facts and circumstances involved in sales to this account,
      the Company confirmed that sales had occurred to this account, that a reserve
      for $383,000 was required, but that the reserve should have been established
      in
      the third quarter, rather than the fourth quarter, of 2007. To establish that
      reserve the Company recorded a general charge to general and administrative
      expense of $383,000 which increased the Company’s net loss for the third quarter
      of 2007 by that amount. The establishment of the reserve also resulted in a
      reduction in accounts receivable, net of allowance for doubtful accounts on
      the
      Company’s balance sheet at September 30, 2007, by the same amount.





The
      foregoing correction to the Company’s financial statements for the second
      quarter of 2007 increased the Company’s net loss by $185,000. The effect of the
      foregoing corrections to the Company’s financial statements for the third
      quarter of 2007 was to increase the Company’s net loss by
      $1,014,000.





Financial
      information included in the reports on Form 10-Q and Form 8-K filed by the
      Company and all earnings press releases and similar communications issued by
      the
      Company for the period ended on September 30, 2007 should not be relied upon
      and
      are superseded in their entirety by the information contained in this amended
      Quarterly Report on Form 10-Q/A for the quarter ended September 30,
      2007.





Audit
      Committee Review





On
        May
        26, 2008, the Audit Committee determined that the financial statements in
        the
        Company’s Quarterly Reports on Form 10-Q for the three months ended June 30 and
        September 30, 2007, should no longer be relied upon. The Audit Committee
        reached
        this determination based on its review of the Company’s sales to five accounts
        and its conclusion that the Company’s revenue recognition as to four of those
        accounts did not comply with applicable accounting principles. One account
        of
        $300,000 ($280,000 for software and $20,000 for post-contract support), of
        which
        $280,000 was recognized in the third quarter of 2007, which represented
        approximately 10.9% of the previously-reported revenues for that quarter
        (“Account 1”); a second account of $320,000 ($300,000 for software and $20,000
        for post-contract support), of which $300,000 was recognized in the third
        quarter of 2007, which represented approximately 11.7% of the
        previously-reported revenues for that quarter (“Account 2”); a third account of
        $150,000 ($125,000 for software and $25,000 for post-contract support), of
        which
        $125,000 was recognized in the second quarter of 2007, which represented
        approximately 4.9% of the previously-reported revenues for that quarter
        (“Account 3”); and a fourth account of $70,000 ($60,000 for software and $10,000
        for post-contract support), of which $60,000 was recognized in the second
        quarter of 2007, which represented approximately 2.4% of the previously-reported
        revenues for that quarter (“Account 4”). With respect to the fifth account
        (“Account 5”) reviewed by the Audit Committee, the Company established a bad
        debt reserve in the third quarter of 2007 in the amount of $383,000, which
        reflects an estimate of the uncollectibility of certain revenues that had
        previously been recognized in the first three quarters in 2007. The Company
        is
        restating its previously issued financial statements for the three and nine
        months ended September 30, 2007 in this Amendment No. 1 to the Company’s
        Quarterly Report on Form 10-Q for the quarterly period ended September 30,
        2007,
        to correct the incorrect recognition of revenue in the period relating to
        Account 1 and Account 2, as well as the incorrect recognition in the period
        of
        additional $42,000 (because the Company did not have sufficient evidence
        to
        establish the creditworthiness of the customer) and the establishment of
        a bad
        debt reserve related to Account 5. The Company has also restated its previously
        issued financial statements for the three and six months ended June 30, 2007
        in
        Amendment No. 1 to its Quarterly Report on Form 10-Q for quarterly period
        ended
        June 30, 2007, to correct the incorrect recognition of revenue in the period
        relating to Account 3 and Account 4. The restatements herein of the Company’s
        previously issued financial statements for the three and nine months ended
        September 30, 2007, reflect the restatement of the Company’s financial
        statements for three and six months ended June 30, 2007.


-
          13
          -





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
        reasonably assured ( *i.e.* ,
        whether
        the purchaser is creditworthy with respect to that transaction). During the
        2007
        year-end audit process, management learned that the creditworthiness of Account
        1 and Account 2, both of which were European customers, had been assessed,
        and
        approximately $580,000 in revenue had been recognized in the third quarter
        of
        2007, based upon falsified documentation that the Company received. The Company
        learned of the falsified documentation when the sales representative (the
“Sales
        Representative”) responsible for Accounts 1, 2 and 4; and who was also involved
        with Account 3; who was employed by a European outsourcing company that the
        Company initially retained in 2006 (and to whom the Company paid commissions
        in
        connection with Accounts 1, 2, 3 and 4, but whom we terminated in April 2008
        as
        a result of this review) admitted to the Company’s Executive Vice-President,
        Legal and Business Affairs, to falsifying documentation purporting to establish
        the creditworthiness of Account 1. The documentation purporting to establish
        the
        creditworthiness of Account 2 was subsequently determined to be false, although
        the identity of the person or persons responsible for falsifying such
        documentation was not ascertained during the Audit Committee review.





After
        determining that the documentation purporting to support the creditworthiness
        of
        Accounts 1 and 2 was false, management informed the Audit Committee, which
        then
        commenced its review. The Audit Committee’s review focused exclusively on the
        following issues: (1) whether the false documentation identified with respect
        to
        Accounts 1 and 2 was limited to those accounts, or whether it affected other
        accounts that were either affiliated with the Sales Representative or were
        deemed by management to be material to the quarter in 2007 in which revenue
        for
        those accounts had been recognized (Accounts 3, 4 and 5); (2) whether the
        Sales
        Representative falsified documentation for his own financial benefit and/or
        at
        the direction, or with the knowledge, of management; and (3) whether information
        obtained during the review indicated that Accounts 1 and 2 were not legitimate
        transactions.





The
      Audit
      Committee conducted its review of Accounts 1 through 5 with the assistance
      of
      Latham & Watkins LLP and FTI Consulting, and with the support and
      cooperation of management and personnel. The review was conducted over a period
      of approximately six weeks, and included collection and review of more than
      two
      million pages of documents, as well as interviews of eight members of the
      Company’s management and sales force teams in the United States and the Sales
      Representative in Europe.





With
        respect to Account 1, with which the Company had no previous business
        relationship, the Audit Committee found that the Company paid a sales commission
        to the European outsourcing company upon execution of the contract with Account
        1, and that the Sales Representative received a commission from the outsourcing
        company in connection with Account 1, but found no evidence that the commission
        was affected by the Sales Representative’s falsification of documentation
        concerning the creditworthiness of Account 1. Although the Audit Committee
        found
        no evidence that the Sales Representative acted at the direction, or with
        the
        knowledge, of any member of management in falsifying documentation concerning
        the creditworthiness of Account 1, it found that the Sales Representative
        had
        been directed by senior management to obtain evidence of the creditworthiness
        of
        Account 1 so that revenue could be recognized in the third quarter of 2007.
        The
        Audit Committee also found that senior management did not adequately instruct
        the Sales Representative regarding (and the Company did not have a practice
        or
        policy regarding) the types of information that could be used in making a
        creditworthiness determination pursuant to the applicable revenue recognition
        accounting principles. In addition, the Audit Committee determined that,
        although sales revenue from Account 1 was recognized in the third quarter
        of
        2007, evidence relating to creditworthiness was not obtained until the fourth
        quarter of 2007, prior to the filing of the third quarter Form 10-Q. The
        Audit
        Committee concluded that the sales revenue of $280,000 from Account 1, which
        was
        previously recognized in the third quarter of 2007, did not constitute a
        sale
        for which revenue could be recognized, and therefore no revenue should have
        been
        recognized in the third quarter of 2007 or any other
        period.


-
          14
          -


With
        respect to Account 2, with which the Company had no previous business
        relationship, the Audit Committee has been unable to determine the identity
        of
        the person or persons who falsified documentation concerning the
        creditworthiness of Account 2. Although the Audit Committee has found no
        evidence establishing that management directed or had knowledge of the
        falsification of any document, it has found that the Sales Representative
        had
        been directed by senior management to obtain evidence of the creditworthiness
        of
        Account 2 so that revenue could be recognized in the third quarter of 2007.
        The
        Audit Committee determined that, although sales revenue from Account 2 was
        recognized in the third quarter of 2007, evidence relating to creditworthiness
        was not obtained until the fourth quarter 2007, however, prior to the filing
        of
        the third quarter Form 10-Q. The Audit Committee also found that senior
        management did not adequately instruct the Sales Representative regarding
        (and
        the Company did not have a policy or practice regarding) the types of
        information that could be used in making a creditworthiness determination
        pursuant to the applicable revenue recognition accounting principles. The
        Audit
        Committee has concluded that the sales revenue of $300,000 from Account 2,
        which
        was previously recognized in the third quarter of 2007, did not constitute
        a
        sale for which revenue could be recognized, and therefore no revenue should
        have
        been recognized in the third quarter of 2007 or any other period. The revenue
        will be recognized on a cash basis when and if collected.





With
        respect to Accounts 3 and 4, with which the Company did not have previous
        business relationships, the Audit Committee did not find evidence of falsified
        documentation. The Audit Committee determined that the Company did not have
        sufficient evidence to establish the creditworthiness of Accounts 3 or 4
        when it
        recognized $125,000 and $60,000, respectively, in revenue in the second quarter
        2007, and that the Company did not have a practice or policy regarding the
        types
        of information that could be used in making such creditworthiness
        determinations. Neither Account 3 nor 4 has acknowledged its contract to
        the
        Company’s independent registered public accountants, and there is evidence that
        Account 3 disputes the terms of its contract with the Company. Account 3
        has
        made no payments to the Company. Account 4 has paid a portion of its outstanding
        receivable, which is now current. The Audit Committee concluded that the
        sales
        revenue of $185,000 from Accounts 3 and 4 was untimely recognized in the
        second
        quarter of 2007. Account 3 was determined not to constitute a sale for which
        revenue could be recognized in any period. The $60,000 of revenue from Account
        4
        was reclassified to deferred revenue in the second quarter of 2007 and revenue
        will be recognized as the payments are received. The Company received payments
        of $8,000 in the fourth quarter of 2007 and $30,000 in the first quarter
        of
        2008. The balance is not yet due. Additionally, the Company reversed $9,000
        of support revenue associated with Accounts 3 and 4 in the third quarter
        of
        2007.




With
        respect to Account 5, with which the Company had a prior business relationship,
        the Audit Committee did not find evidence of falsified documentation. The
        Audit
        Committee found that the creditworthiness of Account 5 was based on the past
        credit payment history with the Company. It also found that, when payments
        associated with Account 5 became past due in 2007, the Company continued
        selling
        to Account 5 without re-assessing its creditworthiness until September 2007,
        when the account was significantly past due. Further sales were suspended
        in the
        fourth quarter of 2007. The Audit Committee concurred with management’s
        recommendation that a bad debt reserve of $383,000 should be taken in the
        fourth
        quarter of 2007 in connection with its sales to Account 5. Upon further
        examination of the facts and circumstances involved in Account 5, the Company
        confirmed that sales had occurred to Account 5, that a reserve for $383,000
        was
        required, but that the reserve should have been established in the third
        quarter, rather than the fourth quarter, of 2007.  To establish that
        reserve, the Company recorded a general charge to general and administrative
        expense of $383,000 which increased the Company's net loss for the third
        quarter
        of 2007 by that amount (in addition to the $631,000 of revenue that was reversed
        in the period).  The establishment of the reserve also resulted in a
        reduction in accounts receivable, net of allowance for doubtful accounts
        on the
        Company’s balance sheet at September 30, 2007, by the same
        amount.


-
          15
          -


In
      addition, during the preparation of the Company’s 2007 annual financial
      statements and prior to discovery of the falsified documentation mentioned
      above, management determined that revenue of $42,000 had been incorrectly
      recognized in the third quarter of 2007 because of insufficient evidence to
      establish the creditworthiness of the customer.





Management
      also conducted a review of the Company’s sales to all accounts for which revenue
      was recognized in fiscal 2007, including the accounts of Hantro, which the
      Company acquired in November 2007, for the purposes of determining that the
      criteria set forth in SOP 97-2 and SAB 104 was satisfied and that revenue was
      properly recognized for each account. Management concluded that, except for
      the
      accounts discussed above and the $42,000 that also was incorrectly recognized,
      the criteria set forth in SOP 97-2 and SAB 104 were satisfied and revenue was
      properly recognized for all of these accounts.





Identification
      of Material Weaknesses in Internal Control over Financial
      Reporting





As
        a
        result of the determination to restate the Company’s financial statements and in
        connection with the preparation of its Annual Report on Form 10-K for the
        year
        ended December 31, 2007, management identified three material weaknesses
        in the
        Company’s disclosure controls and procedures and internal control over financial
        reporting and reported those to the Company’s Audit Committee. Management
        identified a material weakness in the Company’s procedures for recognizing
        revenue, specifically with respect to the Company’s procedures for assessing
        whether collectibility is reasonably assured. This material weakness resulted
        in
        the incorrect recognition of revenue in the Company’s financial statements for
        the second and third quarters of 2007. In addition, management identified
        a
        material weakness in the Company’s control environment, specifically relating to
        the Company’s tone at the top. This material weakness was evidenced by the
        control tone and control consciousness of the Company’s former chief executive
        officer, resulting in the override and the possibility of override of controls
        or interference with the Company’s policies, procedures and internal control
        over financial reporting. Management also identified a material weakness
        in the
        design and operation of the Company’s procedures for determining the accuracy
        and completeness of its estimate of allowance for doubtful accounts. This
        material weakness resulted in a misstatement of accounts receivable, net
        of
        allowance for doubtful accounts on the Company’s balance sheet at the end of the
        third quarter of 2007 and an understatement of the Company’s general and
        administrative expenses for the period. Prior to the filing of this report,
        the
        Company has taken certain steps to remediate these material weaknesses and
        is in
        the process of finalizing a plan and timetable for the implementation of
        additional remediation measures to further address these material weaknesses.
        These material weaknesses and the remediation measures are further described
        below in Item 4 of this Form 10-Q/A.





Restatement
      Adjustments





The
      following tables present the effects of the restatement adjustments on the
      following financial information as of September 30, 2007 and for the three
      and
      nine month periods ended September 30, 2007:


-
          16
          -


Consolidated
      Balance Sheet:





**September 30, 2007**
            
            **As Previously**
              **Reported**
            
            **Adjustments**
            
            **As Adjusted**Accounts
                receivable, net
            
            $
            2,780,000
            
            $
            (1,203,000
            )
            $
            1,577,000Total
                Assets
            
            $
            15,530,000
            
            $
            (1,203,000
            )
            $
            14,327,000Deferred
                revenue
            
            $
            796,000
            
            $
            (4,000
            )
            $
            792,000Accumulated
                deficit
            
            $
            (128,493,000
            )
            $
            (1,199,000
            )
            $
            (129,692,000
            )Stockholders’
                Equity
            
            $
            13,002,000
            
            
            (1,199,000
            )
            $
            11,803,000





Consolidated
      Statement of Operations:


**Three Months Ended September 30, 2007**
            
            **As Previously**
              **Reported**
            
            **Adjustments**
            
            **As Adjusted**Revenue
            
            $
            2,566,000
            
            $
            (631,000
            )
            $
            1,935,000Operating
                Expenses
            
            $
            1,146,000
            
            $
            383,000
            
            $
            1,529,000Loss
                from operations
            
            $
            (486,000
            )
            $
            (1,014,000
            )
            $
            (1,500,000
            )Net
                loss
            
            $
            (368,000
            )
            $
            (1,014,000
            )
            $
            (1,382,000
            )Net
                loss attributable to common shareholders
            
            $
            (375,000
            )
            $
            (1,014,000
            )
            $
            (1,389,000
            )Basic
                and diluted net loss attributable to common shareholders per common
                share
            
            $
            (0.00
            )
            $
            (0.01
            )
            $
            (0.01
            )**Nine Months Ended September 30, 2007**
            
            
            **As Previously**
              **Reported**
            
            
            **Adjustments**
            
            
            **As Adjusted**Revenue
            
            $
            7,935,000
            
            $
            (816,000
            )
            $
            7,119,000Operating
                expenses
            
            $
            8,370,000
            
            $
            383,000
            
            $
            8,753,000Loss
                from operations
            
            $
            (435,000
            )
            $
            (1,199,000
            )
            $
            (1,634,000
            )Net
                loss
            
            $
            (3,909,000
            )
            $
            (1,199,000
            )
            $
            (5,108,000
            )Net
                loss attributable to common shareholders
            
            $
            (3,987,000
            )
            $
            (1,199,000
            )
            $
            (5,186,000
            )Basic
                and diluted net loss attributable to common shareholders per common
                share
            
            $
            (0.04
            )
            $
            —
            
            $
            (0.05
            )





(4)
      Recently Issued Accounting Pronouncements




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





The
      Company performed an analysis of the limitations on the use of its net operating
      losses under Section 382 of the Internal Revenue Code. It was determined that
      on
      June 7, 2000, the Company experienced an ownership change to which Internal
      Revenue Code Section 382 applied. Of the current $87,827,000 in the Company’s
      United States net operating loss carryforward, $33,800,000 was incurred prior
      to
      the June 7, 2000 change date. The annual Internal Revenue Code Section 382
      limitation is $14,000,000. Based on this limitation, the Company believes the
      entire pre-change net operating loss was available for use by 2004. However,
      because the Company's ability to utilize these net operating losses is in doubt,
      the Company maintains a full valuation allowance against its total net operating
      loss carryforward.


-
          17
          -


As
      of
      January 1, 2007 and for the nine months ended September 30, 2007, no interest
      or
      penalties have been accrued or incurred. The Company files U.S. federal income
      tax returns, as well as filing various returns in states and with respect to
      taxes applicable localities where it holds properties. Should
      the accrual of any interest or penalties relative to unrecognized tax benefits
      be necessary, it is our policy to record such accruals in our income tax
      accounts. The
      Company’s filed income tax returns are no longer subject to examination by
      taxing authorities for years before 2003.





In
      February 2007, the FASB issued SFAS No. 159 “The Fair Value Option for Financial
      Assets and Financial Liabilities” (“SFAS 159”).  SFAS 159 permits entities
      to choose to measure many financial instruments and certain other items at
      fair
      value. The objective is to improve financial reporting by providing entities
      with the opportunity to mitigate volatility in reported earnings caused by
      measuring related assets and liabilities differently without having to apply
      complex hedge accounting provisions. This Statement is expected to expand the
      use of fair value measurement, which is consistent with the Board’s long-term
      measurement objectives for accounting for financial instruments. This Statement
      is effective as of the beginning of an entity’s first fiscal year that begins
      after November 15, 2007. Early adoption is permitted as of the beginning of
      a
      fiscal year that begins on or before November 15, 2007, provided the entity
      also
      elects to apply the provisions of FASB Statement No. 157, *Fair
      Value Measurements.* The Company is currently evaluating the impact of adopting SFAS 159 on its
      financial position and results of operations.





In
      September 2007, the FASB issued SFAS No. 157 “Fair Value Measurements” (“SFAS
      157”).  SFAS 157 defines fair value, establishes a framework for measuring
      fair value in generally accepted accounting principles (GAAP), and expands
      disclosures about fair value measurements. This Statement applies under other
      accounting pronouncements that require or permit fair value measurements, the
      Board having previously concluded in those accounting pronouncements that fair
      value is the relevant measurement attribute. Accordingly, this Statement does
      not require any new fair value measurements. However, for some entities, the
      application of this Statement will change current practice.  This Statement
      is effective for financial statements issued for fiscal years beginning after
      November 15, 2007, and interim periods within those fiscal years. Earlier
      application is encouraged, provided that the reporting entity has not yet issued
      financial statements for that fiscal year, including financial statements for
      an
      interim period within that fiscal year. The Company is currently evaluating
      the
      impact of adopting SFAS 157 on our financial position and results of
      operations.





(5)
      Stock-Based Compensation





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





**Shares**
            
            **Weighted-average**
              **Exercise Price**
            
            **Weighted-average**
              **Remaining**
              **Contractual**
              **Life**
            
            **Aggregate**
              **Intrinsic**
              **Value**Number
                of shares under option:Outstanding
                at January 1, 2007
            
            
            9,497,000
            
            $
            1.07Granted
            
            
            92,000
            
            
            1.75Exercised
            
            
            (3,651,000
            )
            
            0.69Canceled
                or expired
            
            
            (153,000
            )
            
            13.15Outstanding
                at September 30, 2007
            
            
            5,785,000
            
            $
            1.01
            
            
            6.55
            
            $
            2,242,000Vested
                and expected to vest at September 30, 2007
            
            
            5,748,000
            
            $
            0.95
            
            
            6.19
            
            $
            2,233,000Exercisable
                at September 30, 2007
            
            
            5,121,000
            
            $
            1.00
            
            
            6.27
            
            $
            2,071,000




-
          18
          -


Stock-based
      compensation expense recognized in the Statement of Operations was $230,000
      and
      $547,000 for the three and nine months ended September 30, 2007, respectively,
      which included $176,000 of compensation expense from restricted stock grants.
      Stock-based compensation expense recognized in the Statement of Operations
      was
      $439,000 and $1,369,000 for the three and nine months ended September 30, 2006,
      respectively, which included $32,000 of compensation expense from restricted
      stock grants and $20,000 for the extension of stock options to the Company’s
      former president and chief executive officer.




The
      aggregate intrinsic value of options exercised during the nine months ended
      September 30, 2007 was $8,858,000.




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





**Shares**
            
            **Weighted-average Grant**
              **Date Fair Value**Non-vested
                at January 1, 2007
            
            
            1,064,000
            
            $
            0.72Granted
            
            
            92,000
            
            
            1.75Cancelled
                or expired
            
            
            (3,000
            )
            
            1.13Vested
                during the period
            
            
            (489,000
            )
            
            0.68Non-vested
                at September 30, 2007
            
            
            664,000
            
            $
            1.49





As
      of
      September 30, 2007, there was $309,000 of total unrecognized compensation cost
      related to non-vested share-based compensation arrangements granted under
      existing stock option plans. This cost is expected to be recognized over a
      weighted-average period of 0.64 years. The total grant date fair value of shares
      vested during the nine-months ended September 30, 2007 was
      $334,000.





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





**Nine Months**
              **Ended**
              **September 30,**
              **2007**
            
            **Nine Months**
              **Ended**
              **September 30,**
              **2006**Weighted-average
                fair value at date of grant for options granted duringthe
                period
            
            $
            1
                .31
            
            $
            0.72Expected
                stock price volatility
            
            
            94
            %
            
            119
            %Expected
                life of options
            
            
            5
                years
            
            
            5
                yearsRisk
                free interest rates
            
            
            4.95
            %
            
            5.02
            %Expected
                dividend yield
            
            
            0
            %
            
            0
            %




-
          19
          -


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





**Shares**
            
            **Weighted-average**
              **Grant Date**
              **Fair Value**Non-vested
                at January 1, 2007
            
            
            85,000
            
            $
            0.49Granted
            
            
            592,000
            
            
            2.84Cancelled
                or expired
            
            
            (20,000
            )
            
            1.16Vested
                during the period
            
            
            (65,000
            )
            
            1.16Non-vested
                at September 30, 2007
            
            
            592,000
            
            $
            2.84





During
      the nine months ended September 30, 2007, the Company granted 139,000 shares
      of
      restricted common stock to its Board of Directors which vest on March 12, 2008
      and 453,000 shares of restricted common stock to its employees which vest over
      a
      four year period through June 2011. As of September 30, 2007, the Company
      recognized $267,000 in compensation expense related to these grants and
      $1,212,000 of unrecognized compensation cost will be recognized through the
      second quarter of 2011.





During
      the nine months ended September 30, 2007, the Company received $1,341,000 in
      proceeds and issued 1,924,000 shares of its common stock for stock option
      exercises. In addition, during the nine months ended September 30, 2007, the
      Company issued 1,004,000 shares of its common stock in cashless exercises of
      stock options and 722,000 shares were retained by the Company in payment of
      the
      options and related taxes.





During
      the nine months ended September 30, 2007, the Company granted 92,000 stock
      options to new employees that had an aggregate grant date fair value of
      $121,000.





(6) Marketable Securities





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





The
      Company invests most of its idle cash in 30 and 60 day United States Treasury
      Bills and they are recorded as cash equivalents.




(7)
      Deferred Acquisition Costs





During
      the nine months ended September 30, 2007, the Company incurred expenditures
      of
      $1,727,000 for legal and professional fees associated with the acquisition
      of
      Hantro Products Oy. These expenditures will be added to the acquisition price.
      Included in this expenditure is approximately $639,000 of legal services
      provided by a law firm, a partner of which is a member of the Company’s Board of
      Directors.


-
          20
          -


(8)
      Term-loan





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





(9)
      Warrant Derivative Liability





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





(10)
      Series D Redeemable Convertible Preferred Stock





During
      the three and nine months ended September 30, 2007, Midsummer Capital and
      Islandia converted/redeemed 677 and 3,083 shares of the Series D redeemable,
      convertible preferred stock into 766,000 and 3,899,000 shares of the Company’s
      common stock, respectively. During the three and nine months ended September
      30,
      2007, the Company accrued dividends of $7,000 and $78,000 and paid dividends
      in
      the amount of $12,000 and $93,000 through the issuance of 8,000 and 98,000
      shares of common stock, respectively. As of September 30, 2007, all the Series
      D
      Redeemable Convertible Preferred Stock was converted/redeemed.





(11)
      Warrants





During
      the nine months ended September 30, 2007 5,487,000 warrants were exercised
      and
      the Company received proceeds of $5,472,000.





(12)
      Treasury Stock





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





(13)
      Customer Concentration





For
      the
      three and nine months ended September 30, 2007, there were no customers that
      accounted for 10% or greater of revenue. For the three months ended September
      30, 2006, two customers accounted for 25% and 16% of revenue, respectively
      and
      for the nine months ended September 30, 2006, two customers accounted for 13%
      and 10% of revenue, respectively.





(14)
      Acquisition of Hantro Products Oy





On
      November 1, 2007, the Company completed its previously announced acquisition
      of
      all of the share capital of Hantro Products Oy (“Hantro”), a Finnish
      corporation. Under the exchange agreement pursuant to which the acquisition
      was
      completed, Hantro’s security holders each exchanged all of the outstanding
      capital shares, and all outstanding options to purchase capital shares, that
      together constituted all of the equity ownership of Hantro.


-
          21
          -


Accordingly,
      the Company acquired all of the issued and outstanding shares of capital stock
      of Hantro and all outstanding stock options of Hantro. In exchange, On2 paid
      at
      closing total consideration of $6,841,775 in cash and 25,438,817 shares of
      On2’s
      common stock. The number of shares issued was determined on the basis of the
      volume weighted average price of On2’s common stock during the 10 business days
      prior to the closing, with an upper limit of $2.50 per share and a lower limit
      of $1.50 per share. Because the closing share price as calculated pursuant
      to
      the foregoing formula was less than $1.50, On2 issued the set number of
      25,438,817 shares, as specified in the share exchange agreement. The 25,438,817
      shares so issued represent approximately 22% of On2’s outstanding common stock
      as of November 1, 2007.





The
      number of shares issued at closing is subject to an adjustment based on the
      difference between Hantro’s actual closing net worth and a baseline of
      (€3,450,000). If the actual closing net worth is more than the baseline, On2
      will pay the net worth surplus to the Hantro security holders by issuing On2’s
      shares of common stock in such number equal to the net worth surplus divided
      by
      the deemed closing share price of $1.50. If the actual closing net worth is
      less
      than the baseline, the Hantro security holders will pay the net worth deficiency
      by cash or by returning On2’s common stock to On2 in such number equal to the
      net worth deficiency divided by the deemed closing share price of
      $1.50.





Of
      the
      shares to be delivered to the Hantro security holders at the closing under
      the
      share exchange agreement, 2,000,000 shares were delivered into escrow for a
      period of one year from the closing date to secure the indemnification
      obligations of the Hantro security holders. These shares may be canceled if
      On2
      makes a claim for indemnification in accordance with the applicable terms of
      the
      share exchange agreement and the claim is resolved in On2’s favor and monetary
      settlement is not made. At the end of the one-year period, the shares will
      be
      released from escrow and delivered to the Hantro security holders except for
      such portion having a value equal to the aggregate dollar amount of all the
      outstanding claims for indemnification unresolved at such time. Any dividends
      paid on the escrowed shares during the pendency of the escrow will be added
      to
      the property that the escrow agent holds and will be available for distribution
      under the escrow agreement.





In
      addition, under the share exchange agreement, On2 is obligated to issue
      additional shares of its common stock to the Hantro security holders if Hantro’s
      net revenue for the fiscal year 2007 exceeds €6,000,000. For example, if
      Hantro’s net revenue for fiscal 2007 is €6,000,000, no additional shares will be
      issued. If the net revenue for fiscal 2007 is €7,000,000, On2 will issue an
      additional 3,333,333 common shares. If the net revenue for fiscal 2007 is
€8,000,000, On2 will issue an additional 7,500,000 common shares. The maximum
      additional shares which may be issued will be 12,500,000 shares if Hantro’s net
      revenue for 2007 exceeds €9,000,000. Hantro’s net revenue for the fiscal year
      2007 will be calculated based on the net revenue of Hantro and its subsidiary
      as
      if Hantro had continued post-closing on a stand-alone basis independent of
      On2.
      Further, all license, maintenance and support, and services revenue recognizable
      in fiscal year 2007 and associated with (a) all Hantro products based on
      Hantro’s RTL code, and all other H.264, VC1 and similar software licenses and
      royalty payments and (b) all Hantro products with which any of On2’s products
      are integrated (e.g., if VP6 is integrated with a Hantro product and the Hantro
      product is sold, the entire revenue amount of such sale) will be included in
      Hantro’s net revenue. For the nine-months ended September 30, 2007, Hantro’s net
      sales were €6,327,000. Hantro’s net sales for 2006 were €7,144,000. The number
      of shares issued in the share exchange, including the escrowed shares, will
      be
      reduced proportionately by the one-for-five reverse stock split that On2’s
      stockholders authorized its board of directors to implement in their discretion
      at On2’s 2007 annual meeting of stockholders held October 10, 2007, if such
      reverse split is effected.





There
      were no material relationships between On2 and Hantro or their respective
      affiliates outside of the share exchange transaction itself. Mr. Pekka Salanoja,
      who was previously designated by Nexit Ventures Oy, authorized representative
      of
      the Hantro security holders and elected as a director by On2’s stockholders at
      On2’s annual meeting, became a director of On2 when the Hantro acquisition was
      completed.


-
          22
          -


(15)
      Subsequent Events




**Sale
      of Common Stock**





On
      October 17, 2007, the Company entered into an Underwriting Agreement with
      ThinkEquity Partners LLC and Merriman Curhan Ford & Co. (collectively, the
“Underwriters”), pursuant to which the Company agreed to sell to the
      Underwriters, and the Underwriters agreed to purchase from the Company, in
      a
      firm commitment underwritten offering, 13,000,000 shares of the Company’s common
      stock at a purchase price of $1.00 per share. The Company also agreed to sell
      to
      the Underwriters up to an additional 1,950,000 shares of common stock at a
      purchase price of $1.00 per share at the option of the Underwriters to cover
      over-allotments, which option was required to be exercised within 30 days of
      the
      filing date of the Company’s prospectus covering the shares to be issued in the
      offering. The Company filed this prospectus with the Securities and Exchange
      on
      October 18, 2007 and sold common stock thereunder to the public through the
      Underwriters. The Company issued the 13,000,000 committed shares on October
      23,
      2007, and the Company issued these option shares on November 9, 2007 after
      the
      Underwriters exercised their option to purchase the additional 1,950,000 shares.
      On November 9, 2007, On2 completed the sale of the additional 1,950,000 which
      were subject to the Underwriter's over-allotment option. The 1,950,000 shares
      were sold for $0.94 per share (net of underwriting discounts), resulting in
      $1,833,000 proceeds to On2.





**Item
      2.**  **Management’s
      Discussion and Analysis of Financial Condition and Results** **of
      Operations (As Restated).**





**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 income per diluted share, acquisition
                costs
                and related amortization, and other measures of results of operations;•
            the
                effects of acquiring Hantro;•
            the
                effects of the restatement of our financial statements for the quarters
                ended June 30, 2007 and September 30, 2007;•
            the
                detection of wrongdoing or improper activities not identified by
                the Audit
                Committee’s review;•
            difficulties
                in controlling expenses, including the costs of the Audit Committee
                review, legal compliance matters or internal control over financial
                reporting review, improvement and remediation;•
            risks
                associated with the delisting of the Company’s shares of common stock from
                the American Stock Exchange;•
            risks
                associated with the ineffectiveness of the Company’s internal control over
                financial reporting and our ability to remediate material
                weaknesses;




-
          23
          -





•
            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 in “ *Risk
      Factors That May Affect Future Operating Results* "
      in the
      Company's Annual Report on Form 10-K for the year ended December 31, 2006,
      as
      amended and Quarterly Report on Form 10-Q for the quarter ended June 30, 2007,
      as amended.





Many
      of
      the forward-looking statements are subject to additional risks related to our
      need to either secure additional financing or to increase revenues to support
      our operations or business or technological factors. We believe that between
      the
      funds we have on hand and the funds we expect to generate, we have sufficient
      funds to finance our operations for the next 12 months. However, additional
      funds may be required in order to pursue strategic opportunities or for capital
      expenditures. In addition, there is no assurance that additional funds will
      not
      be required to support our operations. In this regard, the business and
      operations of the Company are subject to substantial risks that increase the
      uncertainty inherent in the forward-looking statements contained in this Form
      10-Q. In evaluating our business, you should give careful consideration to
      the
      information set forth below in the risk factors set forth in the Company's
      Annual Report on Form 10-K for the year ended December 31, 2006, as amended,
      and
      Quarterly Report on Form 10-Q for the quarter ended June 30, 2007, as amended,
      in addition to the other information set forth herein.





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





**Restatement
      of Financial Statements**





On
      April
      1, 2008, we announced the Audit Committee was conducting an independent review
      of certain contracts with customers and the recognition of revenue that the
      Company had previously recognized in 2007 regarding those contracts. Upon
      concluding its investigation and after consultation with and upon the
      recommendation of management and the Company’s independent registered accounting
      firm, the Audit Committee determined that revenue for certain of our customer
      contracts was recognized earlier than it should have been and that the financial
      statements for the affected periods should be restated. On May 27, 2008, we
      announced that the Audit Committee had determined that our previously issued
      financial statements for the interim periods contained in the quarterly reports
      on Form 10-Q filed with respect to each of the quarterly periods ended June
      30
      and September 30, 2007 should not be relied upon and would be restated. When
      the
      Company filed its Current Report Form 8-K on May 27, 2008, the Audit Committee
      had also preliminarily determined to establish a bad debt reserve of $383,000
      in
      the fourth quarter of 2007 for certain sales to one of the sales accounts
      reviewed. Upon further examination of the facts and circumstances involved
      in
      sales to this account, we confirmed that sales had occurred to this account,
      that a reserve for $383,000 was required, but that the reserve should have
      been
      established in the third quarter, rather than the fourth quarter, of 2007.


-
          24
          -


We
      are
      filing simultaneously this amendment and an amendment to the Quarterly Report
      for the fiscal quarter ended June 30, 2007 to restate the financial statements
      and related disclosures therein.





The
      discussion and analysis set forth in this Item 2 has been amended to reflect
      the
      restatement as described in the Explanatory Note at the beginning of this
      Quarterly Report on Form 10-Q/A. The amount by which we have reduced revenues
      for the three and nine months ended September 30, 2007 is $631,000 and $816,000,
      respectively. The foregoing correction to our financial statements for the
      second quarter of 2007 increased our net loss by $185,000. The effect of the
      foregoing corrections to our financial statements for the third quarter of
      2007
      was to increase our net loss by $1,014,000.





We
      have
      incurred legal and accounting and other costs related to the Audit Committee
      review and restatement of our financial statements described above of
      approximately $1,530,000, as of May 30, 2008, of which approximately $373,000
      was expensed the first quarter of 2008 and an additional $1,157,000 will be
      expensed in the second quarter of 2008.  These costs are expensed in the
      period in which the legal, accounting and other services are provided and are
      recorded 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. We
      anticipate that we will incur additional legal, accounting and other fees
      related to the Audit Committee review and restatement. We also will incur other
      fees and costs related to the execution of the remediation plan adopted by
      us
      after the conclusion of the Audit Committee review.  At this time, we
      cannot estimate the amount of additional legal, accounting and other fees and
      costs that may be incurred in the second quarter of 2008 and beyond to
      execute this remediation plan. 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.





**Overview**




On2
      Technologies is a developer of video compression technology. We have developed
      a
      proprietary technology platform and the TrueMotion® VPx family (e.g., VP5, VP6,
      VP7) of video compression/ decompression (“codec”) software to deliver
      high-quality video at the lowest possible data rates over proprietary networks
      and the Internet to set-top boxes, personal computers and wireless devices.
      Unlike many other video codecs that are based on standard compression
      specifications set by industry groups (e.g., MPEG-2 and H.264), our video
      compression/decompression technology is based solely on intellectual property
      that we developed and own ourselves.





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




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





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





-
          25
          -





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





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





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





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





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





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




-
          26
          -




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





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





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




Under
      our
      agreements with certain customers, we have retained the right to market products
      that complement those customers’ 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 substantial 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.




-
          27
          -


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




We
      are
      continuing to participate in the trend towards the proliferation of user
      generated video content on the web. As Internet use has grown worldwide and
      Internet connection speeds have increased, sites such as MySpace and YouTube,
      which allow visitors to create and view user generated content (“UGC”), have
      sprung up and seen their popularity soar. Although initially that UGC consisted
      primarily of text content and still photographs, the availability of relatively
      inexpensive digital video cameras, the growth in the number of users with
      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 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 or UGC sites, or to
      individual users of those services.




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




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




-
          28
          -


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




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




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




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




**Acquisition
      of Hantro Products**




On
      November 1, 2007, the Company completed its previously announced acquisition
      of
      all of the share capital of Hantro Products Oy (“Hantro”), a Finnish
      corporation. Under the exchange agreement pursuant to which the acquisition
      was
      completed, Hantro’s security holders each exchanged all of the outstanding
      capital shares, and all outstanding options to purchase capital shares, that
      together constituted all of the equity ownership of Hantro. Accordingly, the
      Company acquired all of the issued and outstanding shares of capital stock
      of
      Hantro and all outstanding stock options of Hantro. In exchange, On2 paid at
      closing total consideration of $6,841,775 in cash and 25,438,817 shares of
      On2’s
      common stock. The number of shares issued was determined on the basis of the
      volume weighted average price of On2’s common stock during the 10 business days
      prior to the closing, with an upper limit of $2.50 per share and a lower limit
      of $1.50 per share. Because the closing share price as calculated pursuant
      to
      the foregoing formula was less than $1.50, On2 issued a set number of 25,438,817
      shares, as specified in the share exchange agreement. The 25,438,817 shares
      so
      issued represent approximately 22% of On2’s outstanding common stock as of
      November 1, 2007. The number of shares issued at closing is subject to an
      adjustment based on the difference between Hantro’s actual closing net worth and
      a baseline of (€3,450,000). If the actual closing net worth is more than the
      baseline, On2 will pay the net worth surplus to the Hantro security holders
      by
      issuing On2’s shares of common stock in such number equal to the net worth
      surplus divided by the deemed closing share price of $1.50. If the actual
      closing net worth is less than the baseline, the Hantro security holders will
      pay the net worth deficiency by cash or by returning On2’s common stock to On2
      in such number equal to the net worth deficiency divided by the deemed closing
      share price of $1.50.




-
          29
          -


Of
      the
      shares to be delivered to the Hantro security holders at the closing under
      the
      share exchange agreement, 2,000,000 shares were delivered into escrow for a
      period of one year from the closing date to secure the indemnification
      obligations of the Hantro security holders. These shares may be canceled if
      On2
      makes a claim for indemnification in accordance with the applicable terms of
      the
      share exchange agreement and the claim is resolved in On2’s favor and monetary
      settlement is not made. At the end of the one-year period, the shares will
      be
      released from escrow and delivered to the Hantro security holders except for
      such portion having a value equal to the aggregate dollar amount of all the
      outstanding claims for indemnification unresolved at such time. Any dividends
      paid on the escrowed shares during the pendency of the escrow will be added
      to
      the property that the escrow agent holds and will be available for distribution
      under the escrow agreement.




In
      addition, under the share exchange agreement, On2 is obligated to issue
      additional shares of its common stock to the Hantro security holders if Hantro’s
      net revenue for the fiscal year 2007 exceeds €6,000,000. For example, if
      Hantro’s net revenue for fiscal 2007 is €6,000,000, no additional shares will be
      issued. If the net revenue for fiscal 2007 is €7,000,000, On2 will issue an
      additional 3,333,333 common shares. If the net revenue for fiscal 2007 is
€8,000,000, On2 will issue an additional 7,500,000 common shares. The maximum
      additional shares which may be issued will be 12,500,000 shares if Hantro’s net
      revenue for 2007 exceeds €9,000,000. Hantro’s net revenue for the fiscal year
      2007 will be calculated based on the net revenue of Hantro and its subsidiary
      as
      if Hantro had continued post-closing on a stand-alone basis independent of
      On2.
      Further, all license, maintenance and support, and services revenue recognizable
      in fiscal year 2007 and associated with (a) all Hantro products based on
      Hantro’s RTL code, and all other H.264, VC1 and similar software licenses and
      royalty payments and (b) all Hantro products with which any of On2’s products
      are integrated (e.g., if VP6 is integrated with a Hantro product and the Hantro
      product is sold, the entire revenue amount of such sale) will be included in
      Hantro’s net revenue. For the nine-months ended September 30, 2007, Hantro’s net
      sales were €6,327,000. Hantro’s net sales for 2006 were €7,144,000. Of the
      shares to be delivered to the Hantro security holders at the closing under
      the
      share exchange agreement, 2,000,000 shares were delivered into escrow for a
      period of one year from the closing date to secure the indemnification
      obligations of the Hantro security holders. These shares may be canceled if
      On2
      makes a claim for indemnification in accordance with the applicable terms of
      the
      share exchange agreement and the claim is resolved in On2’s favor and monetary
      settlement is not made. At the end of the one-year period, the shares will
      be
      released from escrow and delivered to the Hantro security holders except for
      such portion having a value equal to the aggregate dollar amount of all the
      outstanding claims for indemnification unresolved at such time. Any dividends
      paid on the escrowed shares during the pendency of the escrow will be added
      to
      the property that the escrow agent holds and will be available for distribution
      under the escrow agreement.




The
      number of shares issued in the share exchange, including the escrowed shares,
      will be reduced proportionately by the one-for-five reverse stock split that
      On2’s stockholders authorized its board of directors to implement in their
      discretion at On2’s 2007 annual meeting of stockholders held October 10, 2007,
      if such reverse split is effected.




There
      were no material relationships between On2 and Hantro or their respective
      affiliates outside of the share exchange transaction itself. Mr. Pekka Salanoja,
      who was previously designated by Nexit Ventures Oy, authorized representative
      of
      the Hantro security holders and elected as a director by On2’s stockholders at
      On2’s annual meeting, became a director of On2 when the Hantro acquisition was
      completed.




Hantro
      develops technology for enabling multimedia in resource-limited environments
      such as battery operated mobile handsets. In addition to licensing hardware
      and
      software designs to its customers, Hantro also provides its customers with
      integration, customization and support services.




-
          30
          -


Founded
      in 1992, Hantro initially provided integrated circuit and system-on-chip design
      services to leading mobile handset manufacturers. In 1998, Hantro dedicated
      its
      resources and experience to developing technology that helps to make mobile
      video possible. Hantro provides both software and hardware technologies that
      enable Hantro to deliver a complete solution that is optimal for the target
      environment. Hantro’s ability to participate in the design process from
      application-specific integrated circuit design right up to the user interface,
      allows it to balance high chip performance with minimal CPU load and power
      consumption.





Delivering
      a compelling user experience is critical to the successful uptake of mobile
      video. Hantro therefore focuses significant resources to enable high quality
      video and to foster interoperability between devices.





Hantro
      offers the following products and services:





**Core Modules**
            
            MPEG-4,
                H.263, H.264 / AVC and VC-1 hardware and software video codec designs
                supporting resolutions up to HD 720p (1280 x 720
                pixels)Hardware
                and software JPEG codecs supporting up to 16MPAMR-NB
                and Enhanced aacPlus audio codecsPre
                and Post-processing technologies implemented in both software and
                hardwareFile
                format and streaming componentsRecorder
                and player application logic**Application**
            
            Mobile
                TV**Solutions**
            
            CamcorderPlayer
                / Streamer**Professional**
            
            Architecture
                consultancy**Services**
            
            Customization
                services to integrate customer specific requirementsIntegration
                services to port to operating system and device
                peripheralsOn-site
                and telephone supportMaintenance
                and upgrades for Hantro’s
                technology




-
          31
          -




Currently
      employing over 90 staff, Hantro has a global sales network with satellite
      offices in Korea, Japan, Taiwan, Germany and the United States. Hantro’s
      headquarters and research and development teams are based in Oulu, Finland.





**Critical
      Accounting Policies and Estimates**





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





·
            Revenue
                recognition


·
            Equity-based
                compensation


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





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





We
      recognize revenue in accordance with The American Institute of Certified Public
      Accountants, Statement of Position (“SOP 97-2”), “SOFTWARE REVENUE RECOGNITION”
SOP 97-2, as amended by SOP 98-4, “DEFERRAL OF THE EFFECTIVE DATE OF SOP 97-2,
      SOFTWARE REVENUE RECOGNITION” and SOP 98-9, “MODIFICATION OF SOP 97-2 WITH
      RESPECT TO CERTAIN TRANSACTIONS” (“SOP 98-9”) 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 collection is reasonably assured. 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.




-
          32
          -


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 support fee 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. When reliable
      estimates are available for the costs and efforts necessary to complete the
      engineering or consulting services and those services do not include contractual
      milestones or other acceptance criteria, we recognize revenue under the
      percentage of completion contract method based upon input measures, such as
      hours. When such estimates are not available, we defer all revenue recognition
      until we have completed the contract and have no further obligations to the
      customer.





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





*Equity-Based
      Compensation.* The
      Company adopted the provisions of the Financial Accounting Standards Board
      (“FASB”), Statement of Financial Accounting Standard (“SFAS No. 123R”) effective
      January 1, 2006, using the modified prospective transition method. 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. The significant assumptions
      used
      in calculating the compensation cost for the nine months ended September 30,
      2007 are as follows: expected stock price volatility was 94%, expected life
      of
      the options was 5 years, risk free interest rate was 4.95% and the expected
      dividend yield was 0%.





*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
      142”). SFAS 142 requires goodwill and other intangible assets to be tested for
      impairment at least annually, and written off when impaired.




Long-lived
      assets and identifiable intangibles with finite lives are reviewed for
      impairment whenever events or changes in circumstances indicate that the
      carrying amount of an asset may not be recoverable. Recoverability of assets
      to
      be held and used is measured by a comparison of the carrying amount of an asset
      to future undiscounted net cash flows expected to be generated by the asset.
      If
      such assets are considered to be impaired, the impairment recognized is measured
      by the amount by which the carrying amount of the assets exceeds the fair value
      of the assets. Assets to be disposed of are reported at the lower of the
      carrying amount or fair value less costs to sell.





As
      of
      September 30, 2007, we believe that no such impairment has occurred for both
      goodwill and intangibles.




-
          33
          -


**Results
      of Operations**





*Revenue.* Revenue
      for the three months ended September 30, 2007 (restated) was $1,935,000 as
      compared to $1,703,000 for the three months ended September 30, 2006. Revenue
      for the nine months ended September 30, 2007 (restated) was $7,119,000 as
      compared to $4,455,000 for the nine months ended September 30, 2006. Revenue
      for
      the three and nine months ended September 30, 2007 (restated) and 2006 was
      derived primarily from the sale of software licenses, engineering and consulting
      services and royalties. The increase in revenue for the three and nine months
      ended September 30, 2007 (restated) is primarily attributed to increases in
      sales of our Flix products.





*Operating
      Expenses.* The
      Company's operating expenses consist of cost of revenue, research and
      development, sales and marketing, general and administrative expenses and equity
      based compensation. Operating expenses for the three months ended September
      30,
      2007 were $3,435,000 as compared to $2,290,000 for the three months ended
      September 30, 2006. Operating expenses were $8,753,000 for the nine months
      ended
      September 30, 2007 as compared to $7,738,000 for the nine months ended September
      30, 2006.





*Cost
      of Revenue.* Cost of
      revenue includes personnel and consulting compensation costs, equity based
      compensation costs, related overhead expenses, fees paid for licensed
      technology, amortization of assets recorded in connection with the Flix
      acquisition and depreciation costs. Cost of revenue for the three months ended
      September 30, 2007 was $603,000 as compared to $529,000 for the three months
      ended September 30, 2006. Cost of revenues for the nine months ended September
      30, 2007 was $1,415,000 as compared to $1,817,000 for the nine months ended
      September 30, 2006. The increase in expenses for the three months ended
      September 30, 2007 as compared with the three months ended September 30, 2006
      is
      primarily due to an increase in the cost of third party software. The decrease
      in expenses for the nine months ended September 30, 2007 as compared with the
      nine months ended September 30, 2006 is primarily attributed to an increase
      in
      engineering efforts being focused on longer term development projects.





*Research
      and Deve* l *opment.* Research
      and development expenses, excluding equity-based compensation, consists
      primarily of salaries and related expenses and consulting fees associated with
      the development and production of our products and services, operating lease
      costs and depreciation costs. Research and development expenses for the three
      months ended September 30, 2007 were $445,000 as compared to $261,000 for the
      three months ended September 30, 2006. Research and development expenses for
      the
      nine months ended September 30, 2007 were $1,500,000 as compared to $700,000
      for
      the nine months ended September 30, 2006. The increase of $184,000 for the
      three
      months and the increase of $800,000 for the nine months ended September 30,
      2007
      as compared with September 30, 2006 is primarily attributed to an increase
      in to
      engineering efforts being focused on longer term development projects.




*Sales
      and Marketing.* Sales
      and marketing expenses, excluding equity-based compensation, consist primarily
      of salaries and related overhead costs, commissions, business development costs,
      trade show costs, marketing and promotional costs incurred to create brand
      awareness and public relations expenses. Sales and marketing expenses for the
      three months ended September 30, 2007 were $676,000 as compared to $263,000
      for
      the three months ended September 30, 2006. Sales and marketing expenses for
      the
      nine months ended September 30, 2007 were $1,886,000 as compared to $623,000
      for
      the nine months ended September 30, 2006. The increases were primarily
      attributed to an increase in personnel in the sales and marketing area and
      increases in commissions.




*General
      and Administrative* .
      General
      and administrative expenses excluding equity-based compensation, consist
      primarily of salaries and related overhead costs for general corporate functions
      including finance, human resources, legal, information technology, facilities,
      outside legal and professional fees and insurance. General and administrative
      expenses for the three months ended September 30, 2007 were $1,529,000 as
      compared with $843,000 for the three months ended September 30, 2006. General
      and administrative expenses for the nine months ended September 30, 2007 were
      $3,468,000 as compared with $3,383,000 for the nine months ended September
      30,
      2006. The increase for the three months ended September 30, 2007 is primarily
      due to increases in legal and professional fees, consulting fees for compliance
      with Sarbanes-Oxley, Section 404, stock listing fees, salaries, increase in
      bad
      debt reserve (related to sales to one of the accounts reviewed by the Audit
      Committee discussed above under the caption “Explanatory Note”) and related
      overhead. The increase for the nine months ended September 30, 2007 is primarily
      attributable to increases in salaries and related benefit costs, consulting
      services related to the Company’s compliance with Sarbanes-Oxley, Section 404
      and professional fees associated with the Company’s proxy statement and annual
      report, and an increase in the bad debt reserve as a result of the Audit
      Committee review. This was partially offset by a $717,000 decrease in legal
      fees
      that were incurred in 2006 in connection with the Company’s internal
      investigation into facts and circumstances concerning investor and other
      communications made by the Company’s former Chairman, Chief Executive Officer
      and President.




-
          34
          -


*Equity-Based
      Compensation.* Equity
      based compensation, which is presented separately, was $182,000 for the three
      months ended September 30, 2007 as compared with $394,000 for the three months
      ended September 30, 2006. Equity based compensation was $484,000 for the nine
      months ended September 30, 2007 as compared with $1,215,000 for the nine months
      ended September 30, 2006. The decrease for the three and nine months ended
      September 30, 2007 is primarily due to an increased number of option grants
      that
      have become fully amortized. Equity-based
      compensation of $48,000 and $45,000 is included in cost of revenue for the
      three
      months ended September 30, 2007 and 2006, respectively. Equity-based compensation of $63,000 and $154,000 is included in cost of revenue
      for the nine months ended September 30, 2007 and 2006,
      respectively.





*Interest
      and Other Income (Expense), net.*





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





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





Interest
      and other income (expense), net was $121,000 and $(3,464,000) for the three
      and
      nine months ended September 30, 2007, respectively as compared with $(10,000)
      and $(36,000) for the three and nine months ended September 30, 2006,
      respectively. The decrease of $131,000 in interest and other expense, net,
      for
      the three months ended September 30, 2007 as compared with 2006, is primarily
      a
      result of the following:





·
            For
                the three months ended September 30, 2007 there was an increase in
                interest income, net of $106,000 as a result of investing the Company’s
                idle cash and a decrease in other expense of $25,000 as a result
                of the
                elimination of the derivative financial instrument in the second
                quarter
                of 2007.





The
      increase of $3,428,000 in interest and other expense, net, for the nine months
      ended September 30, 2007 as compared with 2006, is primarily a result of the
      following:





·
            For
                the nine months ended September 30, 2007 there was an increase in
                other
                expense, of $3,624,000 as a result the increase in the Company’s stock
                price which increased the derivative financial instrument. This was
                partially offset by a net increase in interest income net of
                $196,000.




-
          35
          -




**Liquidity
      and Capital Resources**





At
      September 30, 2007, the Company had a cash balance of $9,634,000 as compared
      to
      $4,961,000 at December 31, 2006. At September 30, 2007 (restated), the Company
      had working capital of $8,942,000 as compared with $5,268,000 at December 31,
      2006.





Net
      cash
      provided by (used in) operating activities was $357,000 and $(1,752,000) for
      the
      nine months ended September 30, 2007 and 2006, respectively. The increase in
      net
      cash provided by operating activities is primarily attributable to increases
      in
      accounts payable, accrued expenses and other liabilities, deferred revenue,
      depreciation and amortization and other expense recognized for warrant amendment
      and decreases in prepaid expenses and other current assets and other assets
      partially offset by decreases in equity based compensation and loss on
      marketable securities and increases in write off of fixed assets and accounts
      receivable.





Net
      cash
      (used in) provided by investing activities was $(1,919,000) and $21,000 for
      the
      nine months ended September 30, 2007 and 2006, respectively. The increase in
      net
      cash used in investing activities is primarily due to the increases in purchases
      of marketable securities, deferred acquisition costs, deferred financing costs
      and the purchases of fixed assets partially offset by an increase in the
      proceeds from the sale of marketable securities.





Net
      cash
      provided by financing activities was $6,241,000 and $2,364,000 for the nine
      months ended September 30, 2007 and 2006, respectively. The increase is
      attributable to an increase in proceeds received from the exercise of common
      stock options and warrants and the decrease in principal payments on capital
      leases partially offset by increases in principal payments on term loan, and
      on
      the purchase of treasury stock and by decreases in proceeds from the issuance
      of
      common stock and proceeds attributable to the derivative financial
      instrument.





On
      October 17, 2007, the Company entered into an Underwriting Agreement with
      ThinkEquity Partners LLC and Merriman Curhan Ford & Co. (collectively, the
“Underwriters”), pursuant to which the Company agreed to sell to the
      Underwriters, and the Underwriters agreed to purchase from the Company, in
      a
      firm commitment underwritten offering, 13,000,000 shares of the Company’s common
      stock at a purchase price of $1.00 per share. The Company also agreed to sell
      to
      the Underwriters up to an additional 1,950,000 shares of common stock at the
      option of the Underwriters to cover over-allotments, which option must be
      exercised within 30 days of the filing date of the Company’s prospectus covering
      the shares to be issued in the offering. The Company filed this prospectus
      with
      the Securities and Exchange on October 18, 2007 and sold to the public through
      the Underwriters. The Company issued the committed shares on November 1, 2007;
      the option shares may be issued from time to time within four business days
      following the date when the Underwriters exercise their option to purchase
      these
      shares during the option period. On November 9, 2007, On2 completed the sale
      of
      the additional 1,950,000 which were subject to the Underwriter's over-allotment
      option. The 1,950,000 shares were sold for $0.94 per share (net of underwriting
      discounts), resulting in $1,833,000 proceeds to On2.





We
      currently have no material commitments for the next 12 months other than those
      under our operating lease arrangements. These arrangements consist primarily
      of
      lease arrangements for our office space in Clifton Park, New York, Tarrytown,
      New York and Cambridge, UK. The aggregate required payments for the next 12
      months under these lease arrangements are $186,000. Notwithstanding the above,
      our most significant non-contractual operating costs for the next 12 months
      are
      compensation and benefit costs, insurance costs and general overhead costs
      such
      as telephone and utilities. During the next 12 months, we anticipate incurring
      approximately $800,000 per month in cash operating costs.





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




-
          36
          -


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.





We
      have
      incurred legal and accounting and other costs related to the Audit Committee
      review and restatement of our financial statements described above of
      approximately $1,530,000, as of May 30, 2008, of which approximately $373,000
      was expensed the first quarter of 2008 and an additional $1,157,000 will be
      expensed in the second quarter of 2008.  These costs are expensed in the
      period in which the legal, accounting and other services are provided and are
      recorded 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. We
      anticipate that we will incur additional legal, accounting and other fees
      related to the Audit Committee review and restatement. We also will incur other
      fees and costs related to the execution of the remediation plan adopted by
      us
      after the conclusion of the Audit Committee review.  At this time, we
      cannot estimate the amount of additional legal, accounting and other fees and
      costs that may be incurred in the second quarter of 2008 and beyond to
      execute this remediation plan. 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.





**Off-Balance
      Sheet Arrangements**





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





**Impact
      of Recently-Issued Accounting Pronouncements**





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





The
      Company performed an analysis of the limitations on the use of its net operating
      losses under Section 382 of the Internal Revenue Code. It was determined that
      on
      June 7, 2000, the Company experienced an ownership change to which Internal
      Revenue Code Section 382 applied. Of the current $87,827,000 in the Company’s
      United States, net operating loss carryforward, $33,800,000 was incurred prior
      to the June 7, 2000 change date. The annual Internal Revenue Code Section 382
      limitation is $14,000,000. Based on this limitation, the Company believes the
      entire pre-change net operating loss was available for use by 2004. However,
      because the Company's ability to utilize these net operating losses is in doubt,
      the Company maintains a full valuation allowance against its total net operating
      loss carryforward.




-
          37
          -


As
      of
      January 1, 2007 and for the nine months ended September 30, 2007, no interest
      or
      penalties have been accrued or incurred for taxes. The Company files U.S.
      federal income tax returns, as well as filing various returns in states and
      applicable localities where it holds properties. The Company’s filed income tax
      returns are no longer subject to examination by taxing authorities for years
      before 2003.





In
      February 2007, the FASB issued SFAS No. 159 “The Fair Value Option for Financial
      Assets and Financial Liabilities” (“SFAS 159”).  SFAS 159 permits entities
      to choose to measure many financial instruments and certain other items at
      fair
      value. The objective is to improve financial reporting by providing entities
      with the opportunity to mitigate volatility in reported earnings caused by
      measuring related assets and liabilities differently without having to apply
      complex hedge accounting provisions. This Statement is expected to expand the
      use of fair value measurement, which is consistent with the Board’s long-term
      measurement objectives for accounting for financial instruments. This Statement
      is effective as of the beginning of an entity’s first fiscal year that begins
      after November 15, 2007. Early adoption is permitted as of the beginning of
      a
      fiscal year that begins on or before November 15, 2007, provided the entity
      also
      elects to apply the provisions of FASB Statement No. 157, *Fair
      Value Measurements.* The Company is currently evaluating the impact of adopting SFAS 159 on its
      financial position and results of operations.





In
      September 2007, the FASB issued SFAS No. 157 “Fair Value Measurements” (“SFAS
      157”).  SFAS 157 defines fair value, establishes a framework for measuring
      fair value in generally accepted accounting principles (GAAP), and expands
      disclosures about fair value measurements. This Statement applies under other
      accounting pronouncements that require or permit fair value measurements, the
      Board having previously concluded in those accounting pronouncements that fair
      value is the relevant measurement attribute. Accordingly, this Statement does
      not require any new fair value measurements. However, for some entities, the
      application of this Statement will change current practice.  This Statement
      is effective for financial statements issued for fiscal years beginning after
      November 15, 2007, and interim periods within those fiscal years. Earlier
      application is encouraged, provided that the reporting entity has not yet issued
      financial statements for that fiscal year, including financial statements for
      an
      interim period within that fiscal year. The Company is currently evaluating
      the
      impact of adopting SFAS 157 on our financial position and results of
      operations.





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





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





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





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





(a)
      Evaluation of Disclosure Controls and Procedures





Our
        management had previously concluded that our disclosure controls and procedures
        were effective as of September 30, 2007. However, in connection with the
        restatements of the Company’s consolidated financial statements for the second
        and third quarters of 2007, as fully described in Explanatory Note of this
        Amendment, our management re-evaluated, under the supervision and with the
        participation of our Interim Chief Executive Officer and Chief Financial
        Officer, the effectiveness of the design and operation of our disclosure
        controls and procedures as of September 30, 2007. 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 procedure s.
        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.




-
          38
          -


As
        described below, three **** material
        weaknesses were identified in our internal control over financial reporting.
        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
        re-evaluation and the identification of the material weaknesses in internal
        control over financial reporting described below, our Interim Chief Executive
        Officer and our Chief Financial Officer concluded that, as of September 30,
        2007, and as of the date of this filing, 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:





·
            *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 reasonably assured (*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 balance sheet at the end of the third quarter of
                2007 and
                an understatement of our general and administrative expenses for
                the
                period.





In
        light
        of this conclusion, management conducted a review of our sales to all accounts
        for which revenue was recognized in the second quarter of 2007, including
        the
        accounts of Hantro, which we acquired in November 2007, for the purposes
        of
        determining that the criteria set forth in SOP 97-2 and SAB 104 was satisfied
        and that revenue was properly recognized for each account. Management also
        reviewed our accounts receivable at period end and concluded that allowance
        for
        doubtful accounts has been properly estimated as of September 30, 2007, in
        accordance with generally accepted accounting principles.




-
          39
          -


(b) *Changes
      in Internal Controls*





Management
      had previously reported that there was no change in our internal control over
      financial reporting that occurred during the quarter ended September 30,
      2007, that materially affected, or was reasonably likely to materially affect,
      our internal control over financial reporting. However, in connection with
      the
      restatements of our consolidated financial statements for the second and third
      quarters of 2007, as fully described in the Explanatory Note of this Amendment,
      management determined that the material weaknesses described above existed
      as of
      September 30, 2007. As a result, we have taken certain steps, discussed below,
      and we are in the process of finalizing a plan and timetable for the
      implementation of additional remediation measures to further address these
      material weaknesses, also discussed below, and we anticipate that material
      changes will be effected in our internal control over financial reporting
      subsequent to the period covered by this report to remediate these material
      weaknesses.





**Remediation
      Initiatives**





In
      response to the identified material weaknesses, our management, with oversight
      from the Audit Committee, has taken certain actions related totheir
      remediation. These actions have involvedmeetings
      among (i) our Chief Financial Officer,EVP,
      Legal and Business Affairs (and now Interim Chief Executive Officer and Chief
      Operating Officer) and certain members ofour
      accounting staffand
      (ii)
      our Chief Financial Officer,
      EVP,
      Legal and Business Affairs (and now Interim Chief Executive Officer and Chief
      Operating Officer) andthe
      Audit Committee.
      Representativesof our
      independent registered public accountantsand our
      consultant on Sarbanes-Oxley compliance attended certain of these
      meetings.
      Due to
      the connection between ourformer****Chief
      Executive Officer and the material weaknessthat we
      identifiedin our
      control environment, he hashad
      limited involvement in our remediation actions. Prior to the filing of this
      report, we have taken certain steps to remediate thesematerial
      weaknessesand
      are
      in the process of finalizing a plan andtimetable for the implementation ofadditional
      remediation measures. As we continue to work to finalize our plan to improve
      ourinternal
      control over financialreporting, we may determine to take additional remediation measures or determine
      to modify, or in appropriate circumstances not to complete, certain of the
      remediation measures describedbelow.





From
      a
      control environment and tone at the top perspective, we have,
      prior to the filing of this report, taken the
      following remedial steps :
      (i) our Board
      of
      Directors sought and 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, on June 11, 2008 (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 effective upon
      the resignation of Mr. Joll and on June 11, 2008 our Board of Directors elected
      Mr. Frost Chief Operating Officer as well; 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 .




-
          40
          -


The
      remedial steps
      we
      have taken prior to the filing of this report to
      address the material weakness in our revenue
      recognition procedures ,
      specifically our procedures for assessing whether the collectibility of revenue
      is reasonably assured 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 reasonably assured ,
      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 reasonable assuredness 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, prior to the
      filing of this report, 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.





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) and will monitor their 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.




-
          41
          -


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.




-
          42
          -





**PART
      II — OTHER INFORMATION**




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





**2006
      Internal Investigation**





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





**Beijing
      E-World**





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





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




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




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




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





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




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




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




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




-
          43
          -


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





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





**Item
      1A.**  **Risk
      Factors**





In
      addition to those risks described in On2’s Annual Report on Form 10-K for the
      year ended December 31, 2006, as amended, and On2’s Quarterly Report on Form
      10-Q for the quarter ended June 30, 2007, as amended, there are certain
      additional risks relating to the identification of material weaknesses in our
      internal control over financial reporting and our restatement of financial
      statements for the quarters ended June 30, 2007 and September 30, 2007. These
      risks include the following:





***In
      May 2008, our management identified [three] material weaknesses in our internal
      control over financial reporting and, as a result, has concluded that our
      disclosure controls and procedures were ineffective as of June 30, 2007 and
      September 30, 2007 and our internal control over financial reporting and our
      disclosure controls and procedures were ineffective as of December31,
      2007.***





As
      described in “Part II — Item 4. Controls and Procedures” of this report, in May
      2008, we identified three **** material
      weaknesses in our internal control over financial reporting as a result of
      which
      our Interim CEO and CFO concluded that our disclosure controls and procedures
      were ineffective as of September 30, 2007, due to the conditions that led
      to the identification of the material weaknesses. These material weaknesses
      were
      identified by management during its assessment of the effectiveness of the
      Company’s internal control over financial reporting pursuant to Section 404 of
      the Sarbanes-Oxley Act of 2002 in connection with the preparation of the
      Company’s Annual Report on Form 10-K for the year ended December 31, 2007. As a
      result of these material weaknesses, our Interim CEO and CFO also concluded
      that
      our internal control over financial reporting and our disclosure controls and
      procedures were ineffective as of December31, 2007, due to the conditions that
      led to the identification of the material weaknesses. Prior to the filing of
      this report, we have taken certain steps to remediate these material weaknesses
      and are in the process of finalizing, and will present to the Audit Committee,
      a
      final plan and timetable for the implementation of remediation measures to
      further address these material weaknesses. The Audit Committee intends to
      monitor such implementation. Although we anticipate that these actions will
      remediate the material weaknesses we have identified and strengthen our internal
      control over financial reporting, we cannot assure that the finalized measures
      that we implement will effectively address such material
      weaknesses.





In
      addition, we or our independent auditors may identify further material
      weaknesses or significant deficiencies in the future. If a material weakness
      exists as of a future period year-end (including a material weakness identified
      prior to year-end for which there is an insufficient period of time to evaluate
      and confirm the effectiveness of the corrections or related new procedures),
      our
      management will be unable to report favorably as of such future period year-end
      to the effectiveness of our internal control over financial reporting. If we
      are
      unable to assert that our internal control over financial reporting is effective
      in any future period, or if we continue to experience material weaknesses in
      our
      internal control over financial reporting, we could lose investor confidence
      in
      the accuracy and completeness of our financial reports, which could have an
      adverse effect on our stock price and potentially subject us to litigation.




-
          44
          -


Remedying
      the currently existing material weaknesses, as well as any additional
      significant deficiencies or material weaknesses that we or our independent
      auditors may identify in the future, may require us to incur significant costs
      and expend significant time and management resources.   If we fail to
      timely remedy any current or additional material weaknesses or significant
      deficiencies that we or our auditors may identify, we may be unable to comply
      with our periodic reporting requirements, accurately report our financial
      results, detect fraud or comply with the requirements of Section 404 of the
      Sarbanes-Oxley Act of 2002 all of which could result in a loss of investor
      confidence in the accuracy, timeliness and completeness of our financial
      reports. In addition, we can give no assurance that our independent auditors
      will agree with our management’s assessment of the effectiveness of our internal
      control over financial reporting at that time. If we cannot produce reliable
      financial reports, investors could lose confidence in our reported financial
      information, the market price of our common stock could decline significantly,
      we may be unable to obtain additional financing to operate and expand our
      business, and our business and financial condition could be harmed.





In
      addition, we or our independent auditors may identify further material
      weaknesses or significant deficiencies in the future. If a material weakness
      exists as of a future period year-end (including a material weakness identified
      prior to year-end for which there is an insufficient period of time to evaluate
      and confirm the effectiveness of the corrections or related new procedures),
      our
      management will be unable to report favorably as of such future period year-end
      to the effectiveness of our internal control over financial reporting. If we
      are
      unable to assert that our internal control over financial reporting is effective
      in any future period, or if we continue to experience material weaknesses in
      our
      internal control over financial reporting, we could lose investor confidence
      in
      the accuracy and completeness of our financial reports, which could have an
      adverse effect on our stock price and potentially subject us to litigation.





Remedying
      the currently existing material weaknesses, as well as any additional
      significant deficiencies or material weaknesses that we or our independent
      auditors may identify in the future, may require us to incur significant costs
      and expend significant time and management resources.   If we fail to
      timely remedy any current or additional material weaknesses or significant
      deficiencies that we or our auditors may identify, we may be unable to comply
      with our periodic reporting requirements, accurately report our financial
      results, detect fraud or comply with the requirements of Section 404 of the
      Sarbanes-Oxley Act of 2002 all of which could result in a loss of investor
      confidence in the accuracy, timeliness and completeness of our financial
      reports. In addition, we can give no assurance that our independent auditors
      will agree with our management’s assessment of the effectiveness of our internal
      control over financial reporting at that time. If we cannot produce reliable
      financial reports, investors could lose confidence in our reported financial
      information, the market price of our common stock could decline significantly,
      we may be unable to obtain additional financing to operate and expand our
      business, and our business and financial condition could be harmed.





***We
      experienced additional risks and costs as a result of the restatement of our
      financial statements.***





As
      a
      result of the restatement of our financial statements for the quarters ended
      June 30, 2007 and September 30, 2007, we have become subject to a number of
      additional risks and uncertainties, including substantial unanticipated costs
      for accounting and legal fees in connection with or related to the restatement.
      It is possible that we will become involved in proceedings in the future in
      relation to these restatements. In connection with such potential proceedings,
      any incurred expenses not covered by available insurance or any adverse
      resolution could have a material adverse effect on us. Any such proceedings
      could be time consuming and distract our management from the conduct of our
      business. In addition, the restatement was time-consuming and required us to
      incur significant incremental expenses and affected management’s attention and
      resources. Further, the measures being implemented to strengthen our internal
      control over financial reporting continue to require and will likely require
      in
      the future greater management time, company resource and outside professional
      resources to implement and monitor.




-
          45
          -




***Our
      success depends upon the continuing service and capabilities of our management
      team. The failure to retain existing management could have a material adverse
      effect on our business.***




Our
      success will be dependent on our continued ability to attract, retain and
      motivate highly skilled employees. On June 11, 2008, Bill Joll resigned
      as our CEO
      and
      as a member of our Board of Directors. During his service as our CEO, Mr. Joll
      had established relationships with many of our customers the disruption of
      which, as a result of his resignation, could adversely affect our business.
      On
      June 10, 2008, the Board of Directors appointed Matthew Frost, our EVP, Legal
      and Business Affairs, to serve as Interim Chief Executive Officer upon the
      resignation of Mr. Joll and on June 11, 2008 appointed him Chief Operating
      Officer as well. Mr. Joll 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.The
      Board
      of Directors is currently conducting a search for a permanent CEO. Leadership
      transitions can be inherently difficult to manage and may cause disruption
      to
      our business or further turnover in our workforce or management team. The loss
      of services of one or more other members of senior management, or the inability
      to attract a qualified permanent CEO, would likely have a material adverse
      effect on our business. We are not protected by any key-man or similar life
      insurance for any of our executive officers.




**Item
      6.**  **Exhibits**





31.1
            
            Certification
                by the Interim Chief Executive Officer pursuant to Section 302 of
                the
                Sarbanes-Oxley Act of 2002.31.2
            
            Certification
                by the Chief Financial Officer pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002.32.1
            
            Certification
                of Principal Executive Officer pursuant to Section 906 of the
                Sarbanes-Oxley Act of 2002.32.2
            
            Certification
                of Principal Financial Officer pursuant to Section 906 of the
                Sarbanes-Oxley Act of 2002




-
          46
          -




**SIGNATURES**





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




On2
                  Technologies, Inc.(Registrant)June
                  27, 2008
              
              /s/
                  ANTHONY PRINCIPE(Date)
              
              (Signature)Anthony
                  Principe
                Senior
                  Vice President and Chief Financial Officer
                (Principal
                  Financial Officer)




-
          47
          -