UNITED
      STATES


SECURITIES
      AND EXCHANGE COMMISSION


Washington,
      D.C. 20549





FORM
      10-Q


(Mark
      One)





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




For
      the
      quarterly period ended September 30, 2006.





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




For
      the
      transition period from ____ to ____.





Commission
      file number 1-15117.








**On2
      Technologies, Inc.**


(Exact
      name of registrant as specified in its charter)








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





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





(518)
      348-0099


(Registrant’s
      telephone number, including area code)

















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








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





APPLICABLE
      ONLY TO ISSUERS INVOLVED IN BANKRUPTCY


PROCEEDINGS
      DURING THE PRECEDING FIVE YEARS:





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




-1-





APPLICABLE
      ONLY TO CORPORATE ISSUERS:





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





The
      number of shares of the Registrant’s Common Stock, par value $0.01 (“Common
      Stock”), outstanding as of November 5, 2006, was 101,199,303.










-2-


**Table
      of Contents**





**PART
      I — FINANCIAL INFORMATION**


PageItem
                1. Consolidated Financial Statements.Condensed
                Consolidated Balance Sheets at September 30, 2006 (unaudited) and
                December
                31, 2005
            4Unaudited
                Condensed Consolidated Statements of Operations,Three
                and Nine Months Ended September 30, 2006 and 2005
            5Unaudited
                Condensed Consolidated Statements of Comprehensive LossThree
                and Nine Months Ended September 30, 2006 and 2005
            6Unaudited
                Condensed Consolidated Statements of Cash FlowsNine
                Months Ended September 30, 2006 and 2005
            7Notes
                to Unaudited Condensed Consolidated Financial Statements
            9Item
                2. Management’s Discussion and Analysis of Financial Condition and Results
                of Operations
            17Item
                3.Quantitative
                and Qualitative Disclosures About Market Risk
            26Item
                4. Controls and Procedures
            27**PART
                II — OTHER INFORMATION**Item
                5. Legal Proceedings
            28Item
                6. Exhibits and Reports on Form 8-K
            29Signatures
            30Certifications
            31








-3-


**PART
      I — FINANCIAL INFORMATION**





Item
      1.
      Consolidated Financial Statements





**ON2
      TECHNOLOGIES, INC.**


**CONDENSED
      CONSOLIDATED BALANCE SHEETS**








September
                30,
              2006
            
            December
                31,
              2005(unaudited)**ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            4,606,000
            
            $
            3,976,000Marketable
                securities
            
            
            64,000
            
            
            181,000Accounts
                receivable
            
            
            1,161,000
            
            
            746,000Prepaid
                and other current assets
            
            
            256,000
            
            
            186,000Total
                current assets
            
            
            6,087,000
            
            
            5,089,000Acquired
                software, net
            
            
            517,000
            
            
            667,000Other
                acquired intangibles, net
            
            
            119,000
            
            
            154,000Goodwill
            
            
            244,000
            
            
            244,000Property
                and equipment, net
            
            
            181,000
            
            
            131,000Other
                assets
            
            
            141,000
            
            
            29,000Total
                assets
            
            $
            7,289,000
            
            $
            6,314,000**LIABILITIES
                AND STOCKHOLDERS’ EQUITY**Current
                liabilities:Accounts
                payable
            
            $
            41,000
            
            $
            41,000Accrued
                expenses
            
            
            383,000
            
            
            608,000Deferred
                revenue
            
            
            644,000
            
            
            241,000Term-loan
            
            
            65,000Capital
                lease obligation
            
            
            29,000
            
            
            20,000Total
                current liabilities
            
            
            1,162,000
            
            
            910,000Capital
                lease obligation, excluding current portion
            
            
            34,000
            
            
            6,000Convertible
                debentures
            
            
            
            
            
            244,000Warrant
                derivative liability
            
            
            1,231,000Total
                liabilities
            
            
            2,427,000
            
            
            1,160,000Commitments
                and contingenciesSeries
                D redeemable convertible preferred stock
            
            
            3,615,000
            
            
            3,790,000Stockholders’
                equity:Preferred
                stock
            
            
            19,000
            
            
            19,000Common
                stock
            
            
            1,000,000
            
            
            923,000Additional
                paid-in capital
            
            
            123,205,000
            
            
            119,772,000Accumulated
                other comprehensive loss
            
            
            (46,000
            )
            
            (43,000
            )Accumulated
                deficit
            
            
            (122,931,000
            )
            
            (119,307,000
            )Total
                stockholders’ equity
            
            
            1,247,000
            
            
            1,364,000Total
                liabilities and stockholders’ equity
            
            $
            7,289,000
            
            $
            6,314,000




*See
      accompanying notes to unaudited condensed consolidated financial statements*





-4-


**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**





Three
                Months Ended
              September
                30,
            
            Nine
                Months Ended
              September
                30,2006
            
            2005
            
            2006
            
            2005Revenue
            
            $
            1,703,000
            
            $
            507,000
            
            $
            4,455,000
            
            $
            1,206,000Operating
                expenses:Cost
                of revenue (1)
            
            
            529,000
            
            
            470,000
            
            
            1,817,000
            
            
            1,249,000Research
                and development (2)
            
            
            261,000
            
            
            249,000
            
            
            700,000
            
            
            755,000Sales
                and marketing (2)
            
            
            263,000
            
            
            219,000
            
            
            623,000
            
            
            524,000General
                and administrative (2)
            
            
            843,000
            
            
            586,000
            
            
            3,383,000
            
            
            1,867,000Equity-based
                compensation:Research
                and development
            
            
            30,000
            
            
            
            
            
            82,000Sales
                and marketing
            
            
            61,000
            
            
            
            
            
            119,000General
                and administrative
            
            
            303,000
            
            
            
            
            
            1,014,000Total
                operating expenses
            
            
            2,290,000
            
            
            1,524,000
            
            
            7,738,000
            
            
            4,395,000Loss
                from operations
            
            
            (587,000
            )
            
            (1,017,000
            )
            
            (3,283,000
            )
            
            (3,189,000
            )Interest
                and otherincome
                (expense), net
            
            
            (10,000
            )
            
            (14,000
            )
            
            (36,000
            )
            
            (273,000
            )Loss
                before provision for income taxes
            
            
            (597,000
            )
            
            (1,031,000
            )
            
            (3,319,000
            )
            
            (3,462,000
            )Provision
                for income taxes
            
            
            11,000
            
            
            13,000
            
            
            17,000
            
            
            25,000Net
                loss
            
            $
            (608,000
            )
            $
            (1,044,000
            )
            $
            (3,336,000
            )
            $
            (3,487,000
            )Convertible
                preferred stock deemed dividend
            
            
            68,000
            
            
            2,484,000
            
            
            68,000
            
            
            2,844,000Convertible
                preferred stock 8% dividend
            
            
            74,000
            
            
            81,000
            
            
            220,000
            
            
            243,000Accretion
                of costs associated with the Series D Preferred Stock
            
            
            
            
            
            22,000
            
            
            
            
            
            65,000Net
                loss attributable to common shareholders
            
            $
            (750,000
            )
            $
            (3,631,000
            )
            $
            (3,624,000
            )
            $
            (6,639,000
            )Basic
                and diluted net loss attributable to common shareholders per common
                share
            
            $
            (0.01
            )
            $
            (0.04
            )
            $
            (0.04
            )
            $
            (0.08
            )Weighted
                average basic and diluted common shares outstanding
            
            
            97,436,000
            
            
            90,566,000
            
            
            96,838,000
            
            
            88,375,000(1)
                Includes equity-based compensation of $45,000 and $154,000 for the
                three
                and nine months ended September30,
                2006, respectively.(2)
                Excludes equity-based compensation, which is presented separately
                for the
                three and nine months endedSeptember
                30, 2006.





*See
      accompanying notes to unaudited condensed consolidated financial
      statements*




-5-





**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS**





Three
                Months Ended
              September
                30,
            
            Nine
                Months Ended
              September
                30,2006
            
            2005
            
            2006
            
            2005Net
                (loss)
            
            $
            (608,000
            )
            $
            (1,044,000
            )
            $
            (3,336,000
            )
            $
            (3,487,000
            )Other
                comprehensive (loss):Foreign
                currency translation adjustment
            
            
            (1,000
            )
            
            (3,000
            )
            
            (3,000
            )
            
            1,000Comprehensive
                (loss)
            
            $
            (609,000
            )
            $
            (1,047,000
            )
            $
            (3,339,000
            )
            $
            (3,486,000
            )











*See
      accompanying notes to unaudited condensed consolidated financial
      statements*




-6-


**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**





Nine
                Months Ended
              September
                30,2006
            
            2005Cash
                flows from operating activities:Net
                loss
            
            $
            (3,336,000
            )
            $
            (3,487,000
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Equity-based
                compensation
            
            
            1,369,000Common
                stock issued for debenture interest
            
            
            5,000Depreciation
                and amortization
            
            
            244,000
            
            
            160,000Change
                in fair value of warrant liability
            
            
            (20,000
            )Amortization
                of debt discount
            
            
            6,000
            
            
            11,000Provision
                for uncollectible accounts receivable
            
            
            60,000Loss
                on marketable securities
            
            
            42,000
            
            
            313,000Changes
                in operating assets and liabilities:Accounts
                receivable, net
            
            
            (475,000
            )
            
            (382,000
            )Prepaid
                expenses and other current assets
            
            
            112,000
            
            
            (30,000
            )Other
                assets
            
            
            (112,000
            )
            
            51,000Accounts
                payable, accrued expenses and other liabilities
            
            
            (50,000
            )
            
            (328,000
            )Deferred
                revenue
            
            
            403,000
            
            
            56,000Net
                cash used in operating activities
            
            
            (1,752,000
            )
            
            (3,636,000
            )Cash
                flows from investing activities:Proceeds
                from the sale of marketable securities
            
            
            75,000Acquisition
                of the Flix Software line
            
            
            
            
            
            (1,229,000
            )Purchases
                of property and equipment
            
            
            (54,000
            )
            
            (116,000
            )Net
                cash provided by (used in) investing activities
            
            
            21,000
            
            
            (1,345,000
            )Cash
                flows from financing activities:Principal
                payments on capital lease
            
            
            (21,000
            )
            
            (12,000
            )Principal
                payments on term-loan
            
            
            (31,000
            )
            
            (62,000
            )Proceeds
                from the exercise of common stock options and warrants
            
            
            737,000
            
            
            4,365,000Proceeds
                from the issuance of common stock, net
            
            
            428,000Proceeds
                attributed to warrant derivative liability
            
            
            1,251,000Net
                cash provided by financing activities
            
            
            2,364,000
            
            
            4,114,000Net
                change in cash and cash equivalents
            
            
            633,000
            
            
            (867,000
            )Effect
                of exchange rate changes on cash and cash equivalents
            
            
            (3,000
            )
            
            1,000Cash
                and cash equivalents, beginning of period
            
            
            3,976,000
            
            
            5,418,000Cash
                and cash equivalents, end of period
            
            $
            4,606,000
            
            $
            4,552,000







-7-




**ON2
      TECHNOLOGIES, INC.**


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





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





Nine
                Months Ended September 30,2006
            
            2005Cash
                paid during the period for:Interest
            
            $
            5,000
            
            $
            6,000Taxes
            
            $
            14,000
            
            $
            22,000Acquisition
                of fixed assets under capital leases
            
            $
            58,000Insurance
                premium financed with a term-loan
            
            $
            96,000Conversion
                of debentures into shares of common stock
            
            $
            250,000
            
            $
            100,000Conversion
                of preferred stock into shares of common stock#
            
            $
            175,000
            
            $
            14,000Common
                stock issued for accrued interest on Series A Convertible
                Debentures
            
            
            
            
            $
            10,000Common
                stock issued for dividends and accrued dividends on Series D Preferred
                Stock
            
            $
            223,000
            
            $
            244,000Common
                stock issued for Wildform Support and Services Agreement
            
            $
            258,000Accretion
                of costs associated with the issuance of Series D Preferred
                Stock
            
            
            
            
            $
            65,000Convertible
                Preferred Stock deemed dividend
            
            $
            68,000
            
            $
            2,844,000








*See
      accompanying notes to unaudited condensed consolidated financial
      statements*




-8-


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**











(1)
      Description of On2 Technologies, Inc.





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





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





(2)
      Basis
      of Presentation





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





The
      interim condensed consolidated financial statements are unaudited. However,
      in
      the opinion of management, such financial statements contain all adjustments
      (consisting of normally recurring accruals) necessary to present fairly the
      financial position of the Company and its results of operations and cash flows
      for the interim periods presented. The condensed consolidated financial
      statements included herein have been prepared pursuant to the rules and
      regulations of the Securities and Exchange Commission (“SEC”). Certain
      information and footnote disclosures normally included in consolidated financial
      statements prepared in accordance with accounting principals generally accepted
      in the United States of America have been condensed or omitted pursuant to
      such
      rules and regulations. The Company believes that the disclosures included herein
      are adequate to make the information presented not misleading. These condensed
      consolidated financial statements should be read in conjunction with the annual
      financial statements and notes thereto, for the year ended December 31, 2005,
      included in the Company's Form 10-K Report filed with the SEC on March 15,
      2006.





(3)
      Recently Issued Accounting Standards




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





-9-




In
      September 2006, the Financial Accounting Standards Board (FASB) issued SFAS
      No. 158, “Employers’ Accounting for Defined Benefit Pension and Other
      Postretirement Plans—an amendment of FASB Statements No. 87, 88, 106, and
      132(R),” which requires employers to: (a) recognize in its statement of
      financial position an asset for a plan’s over funded status or a liability for a
      plan’s underfunded status; (b) measure a plan’s assets and its obligations
      that determine its funded status as of the end of the employer’s fiscal year;
      and (c) recognize changes in the funded status of a defined benefit
      postretirement plan in the year in which the changes occur. Those changes will
      be reported in comprehensive income of a business entity. The requirement to
      recognize the funded status of a benefit plan and the disclosure requirements
      are effective as of the end of the fiscal year ending after December 15,
      2006, for entities with publicly traded equity securities. The requirement
      to
      measure plan assets and benefit obligations as of the date of the employer’s
      fiscal year-end statement of financial position is effective for fiscal years
      ending after December 15, 2008. The Company currently has no Post
      Retirement Benefit Plan.





Also
      in
      September 2006, FASB issued SFAS No. 157, “ *Fair
      Value Measurements’* ”
which
      defines fair value, establishes a framework for measuring fair value in
      generally accepted accounting principles and expands disclosures about fair
      value measurements. 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 believes that several accounts will be affected on the adoption
      of
      SFAS No. 157.





(4)
      Stock-Based Compensation




In
      December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No.
      123R “Share-Based Payment” (“SFAS 123R”), which requires all share-based
      payments to employees, including grants of employee stock options, to be
      recognized in the statement of operations as an operating expense, based on
      their fair values on grant date. Prior to the adoption of SFAS 123R the Company
      accounted for stock based compensation using the intrinsic value, if any. The
      Company adopted the provision of SFAS No. 123R effective January 1, 2006, using
      the modified prospective transition method. Under the modified prospective
      method, non-cash compensation expense is recognized for the portion of
      outstanding stock option awards granted prior to the adoption of SFAS 123R
      for
      which service has not been rendered, and for any future stock option grants.
      Accordingly, periods prior to adoption have not been restated. The Company
      recognizes share-based compensation costs on a straight-line basis over the
      requisite service periods of awards. That cost is recognized as compensation
      expense over the service period, which would normally be the vesting period
      of
      the options.





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





-10-




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




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





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





Three
                months ended, September 30, 2005
            
            Nine
                months ended, September 30, 2005Reported
                net loss attributable to common stockholders
            
            $
            (3,631,000
            )
            $
            (6,639,000
            )Stock-based
                employee compensation determined under
              the
                fair value-based method, prior to the adoption of SFAS
              123R
            
            
            (325,000
            )
            
            (1,461,000
            )Pro
                forma net loss attributable to common stockholders
            
            $
            (3,956,000
            )
            $
            (8,100,000
            )Loss
                per common share (basic and diluted):As
                reported
            
            $
            (0.04
            )
            $
            (0.08
            )Pro
                forma
            
            $
            (0.04
            )
            $
            (0.09
            )




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 option for the Company’s
      former president and chief executive officer. Stock based compensation expense
      recognized in the Statement of Operations was $0 for the three and nine months
      ended September 30, 2005, respectively.





-11-


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





Shares
            
            Weighted
                Average Exercise Price
            
            Weighted
                Average Remaining Contractual Life
            
            Aggregate
                Intrinsic ValueNumber
                of shares under option:Outstanding
                at January 1, 2006
            
            
            10,299,000
            
            $
            0.98Granted
            
            
            1,760,000
            
            
            0.88Exercised
            
            
            (1,272,000
            )
            
            0.48Canceled
                or expired
            
            
            (877,000
            )
            
            0.68Outstanding
                at September 30, 2006
            
            
            9,910,000
            
            $
            1.05
            
            
            6.89
            
            $
            681,000Exercisable
                at September 30, 2006
            
            
            7,783,000
            
            $
            1.11
            
            
            6.76
            
            $
            670,000





The
      aggregate intrinsic value of options exercised during the nine months ended
      September 30, 2006 was $610,000.




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





Shares
            
            Weighted
                Average Grant Date Fair ValueNon-vested
                at January 1, 2006
            
            
            2,035,000
            
            $
            0.69Granted
            
            
            1,760,000
            
            
            0.88Cancelled
                or expired
            
            
            (867,000
            )
            
            0.68Vested
                during the period
            
            
            (801,000
            )
            
            0.73Non-vested
                at September 30, 2006
            
            
            2,127,000
            
            $
            0.72





As
      of
      September 30,
      2006,
      there was $632,000 of total unrecognized compensation cost related to non-vested
      share-based compensation arrangements granted under existing stock option plans.
      This cost is expected to be recognized over a weighted-average period of 1.00
      years. The total grant date fair value of shares vested during the nine-months
      ended September 30, 2006 was $476,000.




-12-
 
  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:





September
                30, 2006Three
                Months Ended
            
            Nine
                Months EndedWeighted
                average fair value at date of grant for options granted during the
                period
            
            $
            0.54
            
            $
            0.72Expected
                stock price volatility
            
            
            113
            %
            
            119
            %Expected
                life of options
            
            
            5
                years
            
            
            5
                yearsRisk
                free interest rates
            
            
            4.82
            %
            
            5.02
            %Expected
                dividend yield
            
            
            0
            %
            
            0
            %




(5)
      Capital Lease





During
      the three months ended September 30, 2006 the Company entered into a capital
      lease for $58,000 to purchase certain computer equipment and software. The
      lease
      has a three-year term with a $1.00 buyout, an effective interest rate of 9.25%
      and is secured by a certificate of deposit for $65,000 held by the leasing
      bank.





(6) Marketable
      Securities





As
      of
      December 31, 2005 the Company held 2,119,000 shares of a customer’s common stock
      with a market value of $106,000, which were received as payment of license
      fees.
      On March 22, 2006 there was a 50/1 reverse stock split and the number of shares
      was reduced to 42,000. As of September 30, 2006, the market value of these
      shares decreased to $64,000 ($1.50 per share). The market value of these shares
      was $1.06 per share as of October 25, 2006. The Company classifies these shares
      as trading securities and pursuant to SFAS No. 115, “ *Accounting
      for Certain Investments in Debt and Equity Securities* ”,
      unrealized gains and losses are included in the determination of net income
      (loss). Included in interest and other income (expense) is an unrealized gain
      of
      $8,000 for the three months ended September 30, 2006 and an unrealized loss
      of
      $42,000 for the nine months ended September 30, 2006. Other expense for the
      three and nine months ended September 30, 2005 includes $27,000 and $313,000
      of
      net unrealized loss on these securities, respectively. The Company’s former
      Chief Executive Officer (who was a director and shareholder of the Company)
      was
      a director of this customer.







(7)
      Issuance of Common Stock





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








(8)
      Common Stock Options, Warrants and Restricted Stock Grant





The
      Company entered into an agreement with Douglas A. McIntyre, the Company's former
      Chairman, President and CEO, effective as of May 2, 2006, under which the
      parties agreed to extend the expiration date of 1,475,000 vested options to
      purchase the common stock of the Company, held by Mr. McIntyre from May 2,
      2006
      to September 30, 2006. The company recognized a charge of $109,000 in the
      quarter ended June 30, 2006 in connection with this extension. The charge was
      calculated using the Black-Scholes pricing model.





-13-


On
      September 30, 2006, the Company entered into a second agreement with Mr.
      McIntyre under which the parties agreed to extend the expiration date of 250,000
      vested options to purchase the common stock of the Company, held by Mr. McIntyre
      from September 30, 2006 to March 30, 2007. The company recognized a charge
      of
      $20,000 in the quarter ended September 30, 2006 in connection with this
      extension. The charge was calculated using the Black-Scholes pricing
      model.





The
      Agreements also contain a number of restrictions on Mr. McIntyre's ability
      to
      exercise the Options and sell shares of Common Stock received upon such
      exercise, including an undertaking from Mr. McIntyre not to sell, or cause
      to be
      sold, more than a fixed number of shares of Common Stock in any one-week period,
      including by means of direct sales, acquisitions of put options, or other
      transactions with the effect of a short transaction.





The
      second Agreement contains a mandatory exercise provision, providing that
      if, prior to the expiration of the Agreement the volume weighted average
      price of the stock, for five consecutive trading days, equals
      or
      exceeds the price that is $0.15 greater than the exercise price of either
      option, then Mr. McIntyre must either exercise that option or the option will
      automatically terminate. During the nine months ended September 30, 2006,
      Mr. McIntyre exercised 1,225,000 stock options and the Company received $578,000
      in proceeds.




During
      the three months ended September 30, 2006 the Company granted 110,000 shares
      of
      its restricted common stock to certain employees and consultants that had a
      fair value on the date of grant of $70,000, of which 25,000 shares vested on
      September 16, 2006 and the remaining shares vest through August 2007. The
      Company recorded compensation expense of $31,000 for the nine months ended
      September 30, 2006 for these grants.





In
      addition the Company received proceeds of $127,000 and issued 202,000 shares
      of
      its common stock for the exercise of warrants for the three and nine months
      ended September 30, 2006.





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





Although
      the Company has extended options and warrants that were due to expire, there
      are
      no current plans for any additional modifications to such
      instruments.





(9)
      Customer Concentration





For
      the
      three months ended September 30, 2006, two customers accounted for 25% and
      16%
      of revenue and for the nine months ended September 30, 2006, two customers
      accounted for 13% and 10% of revenue. For the three months ended September
      30,
      2005, three customers accounted for 25%, 17% and 16% of revenue and for the
      nine
      months ended September 30, 2005, two customers accounted for 13% and 10% of
      revenue.




(10)
      Flix
      Acquisition





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





-14-


Had
      the Company acquired the Flix assets as of January 1, 2005 there would have
      been
      a nominal effect on revenue and expenses for the nine months ended September
      30,
      2005 other than additional amortization of approximately $185,000,
      respectively.





(11)
      Series A Secured Convertible Debentures





On
      March
      15, 2006, a debenture holder converted all of the remaining $250,000 face value
      Series A Secured Convertible Debentures into 2,232,000 shares of the Company’s
      common stock.




(12)
      Sale
      of Common Stock and Warrants





In
      August
      2006, the Company completed the sale of 3,070,000 shares of its common stock
      with detachable, five-year warrants to purchase 2,303,000 shares of the
      Company’s common stock at an exercise price of $0.77, to two institutional
      investors, led by Midsummer Investments Ltd., and received net proceeds of
      $1,628,000.





In
      connection with the offering, the parties entered into a registration rights
      agreement. The registration rights agreement requires that the Company file
      a
      registration statement registering the securities sold in the offering and
      use
      its best efforts to have the registration statement declared effective on or
      before the date that is ninety days after the date on which the parties entered
      into the agreement. The registration rights agreement also provides for
      liquidated damages of 2% of the aggregate purchase price for the first month
      and
      1% for each subsequent month if the Company failed to register the related
      common shares and maintain effectiveness of such registration. The Company
      filed
      a registration statement with the Securities and Exchange Commission (“SEC”) on
      September 25, 2006 and
      an amendment thereto on October 30, 2006 .
      The
      registration statement has not yet been declared effective by the SEC. The
      Company accounts for the registration rights agreement as a separate
      freestanding instrument and accounts for the liquidated damages provision as
      a
      derivative liability subject to SFAS No. 133. The estimated fair value of the
      derivative liability is based on estimates of the probability and costs of
      cash
      penalties expected to be incurred and such estimates are revalued at each
      balance sheet date with changes in value recorded in other income. As of
      September 30, 2006 the Company has estimated the fair values of these derivative
      liabilities to be nominal and accordingly no liability has been recorded.





The
      warrants contain certain anti-dilution provisions and accordingly the Company
      accounted for the fair value of the warrants as a derivative liability (Warrant
      derivative liability) subject to SFAS No. 133. The fair value of the warrants
      issued, as calculated using the Black Scholes pricing model, was $1,251,000
      and
      represents the portion of the proceeds from the financing that was attributed
      to
      the warrant derivative liability. The warrant fair value will be revalued at
      each balance sheet date, using the Black Scholes pricing model, with changes
      in
      value recorded in the statement of operations as income or expense. On September
      30, 2006 the warrant fair value was $1,231,000 and the other decrease in value
      of $20,000 is included in interest and other income (expense), net. The Company
      paid financing costs in the amount of $122,000 of which $51,000 is associated
      with the warrants, and is included in interest and other income (expense),
      net
      in the Company’s condensed consolidated financial statements for the three and
      nine months ended September 30, 2006.





-15-





(13)
      Preferred Stock





*Series
      D Redeemable, Convertible Preferred Stock*





The
      August 2006 sale of common stock with detachable warrants triggered certain
      anti-dilution provisions of the Series D Redeemable, Convertible Preferred
      Stock
      and the related Warrants, and the number of common shares issuable upon
      conversion or redemption of the Series D Preferred Stock was increased by 30,000
      and the exercise price was reduced to $0.69598. The exercise price of the
      related warrants was also reduced to $0.7541.





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




*Series
      C-IV Convertible Preferred Stock*





The
      August 2006 sale of common stock with detachable warrants triggered certain
      anti-dilution provisions of the Series C-IV Preferred Stock and accordingly
      the
      Company increased the number of shares issuable upon conversion by 86,000 and
      reduced the conversion price to $1.595.




The
        issuance of the 3,070,000 shares of common stock triggered certain anti-dilution
        provisions of the Series C-IV and Series D Preferred Stock. Accordingly the
        Company recorded a deemed dividend of $68,000 for the anti-dilution triggered
        above, during the three months ended September 30, 2006.


-16-





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





**Forward-Looking
      Statement**





This
      document contains forward-looking statements within the meaning of Section
      27A
      of the Securities Act of 1933 and Section 21E of the Securities Exchange Act
      of
      1934. These statements relate to future events or our future financial
      performance and are not statements of historical fact. In some cases, you can
      identify forward-looking statements by terminology such as ”may,” “might,”
“will,” ”would,” ”could,” ”should,” ”expect,” ”foresee,” ”plan,” ”anticipate,’
”assume,” ”believe,” ”estimate,” ”predict,” ”potential,” ”objective,”
”forecast,” ”goal“ or ”continue,” the negative of such terms, their cognates, or
      other comparable terminology. These statements are only predictions, and actual
      events or results may differ materially. Although we believe that the
      expectations reflected in the forward-looking statements are reasonable, we
      cannot guarantee future results, levels of activity, performance or
      achievements, and in all cases, such statements are subject to the Company’s
      ability to secure additional financing or to increase revenues to support its
      operations. We believe that we have sufficient funds and will generate
      sufficient funds to finance our operations for the next 12 months. There is
      no
      assurance that additional funds will not be required to support our operations.
      In this regard, the business and operations of the Company are subject to
      substantial risks that increase the uncertainty inherent in the forward-looking
      statements contained in this Form 10-Q. You should consider the material
      presented in this Form 10-Q in conjunction with "Management's Discussion and
      Analysis of Financial Condition and Results of Operations - Risk Factors That
      May Affect Future Operating Results" in the Company's Form 10-K for the year
      ended December 31, 2005.





The
      inclusion of the forward-looking statements should not be regarded as a
      representation by the Company, or any other person, that such forward-looking
      statements will be achieved. We undertake no duty to update any of the
      forward-looking statements, whether as a result of new information, future
      events or otherwise. In light of the foregoing, readers are cautioned not to
      place undue reliance on the forward-looking statements contained in this report.





**Overview**





We
      are a
      video compression technology firm. We have developed a proprietary technology
      platform and the TrueMotion VPx family (e.g., VP5, VP6, VP7) of video
      compression/decompression software (“codec”) 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 other video
      codecs that are based on standard compression specifications set by industry
      groups (e.g., MPEG and H.264), our video compression software is based solely
      on
      intellectual property that we developed and own ourselves.




-17-




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




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








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





**TYPE
                OF CUSTOMER APPLICATION**
            
            **EXAMPLES**Video
                and Audio Distribution over Proprietary Networks
            
            ·Providing
                video-on-demand services to residents in multi-dwelling units
                (MDUs)
              ·Video
                surveillanceConsumer
                Electronic Devices
            
            ·Digital
                video players
              ·Digital
                video recordersWireless
                Applications
            
            ·Delivery
                of video via satellite
              ·Providing
                video to web-enabled cell phones and
              PDAsVideo
                and Audio Distribution over IP-based Networks (Internet)
            
            ·Video-on-demand
              ·Teleconferencing
                services
              ·Video
                instant messaging
              ·Video
                for Voice-over-IP (VOIP) services





In
      addition, as discussed at greater length below, we have recently begun marketing
      encoding software for use either by end users or by developers who want to
      add
      video-encoding functionality to the software they have developed.





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





-18-


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





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





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





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





Another
      factor that may affect our success is the relative complexity of our video
      compression software compared with other compression software producing
      comparable compression rates and image quality. Software with lower complexity
      can run on a computer chip that is less powerful, and therefore generally less
      expensive, than would be required to run software that is comparatively more
      complex. 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 desire 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, size constraints 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).





-19-


One
      of
      the most significant recent trends in our business is our increasing reliance
      on
      the success of the product deployments of our customers. As referenced above,
      an
      increasing number of our license agreements with customers provide for the
      payment of license fees that are dependent on the number of units of a
      customer’s product incorporating our software that are sold or the amount of
      revenue generated by a customer from the sale of products or services that
      incorporate our software. We have chosen this royalty-dependent licensing model
      because, as a company of only 38 employees, we do not have the product
      development or marketing resources to develop and market end-to-end video
      solutions. Instead, our software is primarily intended to be used as a building
      block for companies that are developing end-to-end video products and/or
      services.





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





Although
      we are confident that we have adopted the licensing model most appropriate
      for a
      business of our size and expertise, a natural result of this licensing model
      is
      that the amount of revenue we generate is highly dependent on the success of
      our
      customers’ product deployments. If the products of customers with whom we have
      established per unit royalty or revenue sharing relationships or for which
      we
      expect to market complementary products do not generate significant sales,
      such
      revenue may not attain significant levels. Conversely, if one or more of such
      customers’ products are widely adopted, our revenues will likely be enhanced.





Another
      significant trend in our business is the emergence of Microsoft as a principal
      competitor in the market for digital media creation and distribution technology.
      Microsoft currently competes with us in the market for digital media servers,
      players, codecs and other technology and services related to digital
      distribution of media. Microsoft’s commitment to and presence in the media
      delivery industry has increased. Microsoft distributes its competing streaming
      encoder, media server, player, tools and digital rights management products
      by
      bundling them with its Windows operating systems and servers at no additional
      cost or otherwise making them available free of charge or at a low cost.
      Microsoft’s practices have caused, and may continue to cause, pricing pressure
      on our revenue generating products and services and may affect usage of our
      competing products and formats. Microsoft’s marketing and licensing model has in
      some cases led, and could continue to lead, to longer sales cycles, decreased
      sales, loss of existing and potential customers and reduced market share. In
      addition, we believe that Microsoft has used and may continue to use its
      competitive position in the computer industry and its financial resources to
      secure preferential or exclusive distribution, use and bundling contracts for
      its media delivery technologies and products with third parties, such as ISPs,
      content delivery networks, content providers, entertainment and media companies,
      VARs and OEMs, including third parties with whom we have relationships. Finally,
      Microsoft’s DRM (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. Many
      companies that want to distribute copy-protected content are therefore forced
      to
      choose Microsoft’s video technology to be able to use Micorosoft’s DRM
      technology.





-20-


Another
      trend is the emergence of H.264 as a competitor in the video compression field.
      H.264 is a standards-based codec that is the successor to MPEG-4. We believe
      our
      technology is superior to H.264, and that we can offer significantly more
      flexibility in licensing terms than customers will get when licensing H.264.
      H.264 may nevertheless become widely adopted by potential customers because,
      as
      a standards-based codec, it has the advantage of having numerous developers
      who
      are programming to the H.264 standard and developing products based on such
      standard and several manufacturers of multimedia processors have done the work
      necessary to have H.264 operate on their chips. These advantages may allow
      potential customers to implement a solution based on H.264 with less initial
      development time and expense than a solution using On2 Video might require,
      and
      those upfront time- and cost-savings might convince such customers to adopt
      a
      solution that, in the end, is less efficient and more expensive than On2 Video.
      In addition, there are certain customers that prefer to license standards-based
      codecs.





We
      are
      also watching with interest and participating in the trend towards the
      proliferation of consumer-created video content on the web. As Internet use
      has
      grown worldwide and Internet connection speeds have increased, there has been
      a
      marked increase in consumer-created content on the web. While that content
      initially consisted primarily of text content and still photographs, the
      availability of relatively inexpensive digital video cameras, the growth in
      the
      number of users with access to broadband Internet connections and improvements
      in video compression technology have contributed to a groundswell in
      consumer-created video content. Weblogs (blogs) and podcasts (broadcasts of
      audio content to iPod® and MP3 devices) are evolving to include video content. A
      number of services are being offered to host consumer-created video, and many
      commercial sites now also feature amateur videos. The continued proliferation
      of
      consumer-created video on the Internet may have a positive effect on our
      business. The Adobe® Flash® video is a popular format for Web video. Because
      Flash 8 and Flash 9 use On2’s VP6 codec, On2 may have the opportunity to license
      Flash encoding tools for use in video blogs, video podcasts, and to
      consumer-created video services or to individual users of those services.





The
      market for digital media creation and delivery technology is constantly changing
      and intensely and increasingly competitive. We have and continue to take a
      number of steps to address this competition. First and foremost, we focus on
      providing our customers with video compression/decompression technology that
      delivers the highest possible video quality at the lowest possible data rates.
      In order to do this, we devote a significant portion of our engineering capacity
      to research and development. Although we expect that competition from Microsoft,
      H.264 developers, and others will continue to intensify, we currently expect
      that our video compression technology will remain competitive and that our
      relatively small size will allow us to innovate in the video compression field
      and respond to emerging trends more quickly than monolithic organizations such
      as Microsoft and the MPEG consortium. We also address the competitive threats
      that we face by focusing on developing relationships with customers who do
      not
      want to do business with Microsoft and/or do not find the complex and rigid
      standards-based licenses and fee structures appealing.








**Critical
      Accounting Policies and Estimates**





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




-21-





·
            Revenue
                recognition


·
            Equity-based
                compensation


·
            Impairment
                of long-lived assets





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





We
      recognize revenue in accordance with Statement of Position (“SOP”) 97-2,
“ *Software
      Revenue Recognition* ”,
      as
      amended by SOP 98-4, “ *Deferral
      of the Effective Date of SOP 97-2, Software Revenue Recognition* ”
and
      SOP
      98-9, “ *Modification
      of SOP 97-2 with Respect to Certain Transactions* ”.
      Under
      each arrangement, revenues are recognized when a non-cancelable agreement has
      been signed and the customer acknowledges an unconditional obligation to pay,
      the products or applications have been delivered, there are no uncertainties
      surrounding customer acceptance, the fees are fixed and determinable, and
      collection is considered probable. Revenues recognized from multiple-element
      software arrangements are allocated to each element of the arrangement based
      on
      the fair values of the elements, such as product licenses, post-contract
      customer support, or training. The determination of the fair value is based
      on
      the vendor specific objective evidence available to us. If such evidence of
      the
      fair value of each element of the arrangement does not exist, we defer all
      revenue from the arrangement until such time that evidence of the fair value
      does exist or until all elements of the arrangement are delivered.





Our
      software licensing arrangements typically consist of two elements: a software
      license and post-contract customer support ("PCS"). We recognize license
      revenues based on the residual method after all elements other than PCS have
      been delivered as prescribed by SOP 98-9. We recognize PCS revenues over the
      term of the maintenance contract or on a "per usage" basis, depending upon
      the
      terms of the contract. Vendor specific objective evidence of the fair value
      of
      PCS is determined by reference to the price the customer will have to pay for
      PCS when it is sold separately (i.e. the renewal rate). Most 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 (porting)
      of
      the software into a third party hardware platform. In these arrangements, we
      require the customer to pay a fixed fee for the engineering and consulting
      services and generally require a licensing fee in the form of a per-unit
      royalty. We account for engineering and consulting arrangements in accordance
      with SOP 81-1, “ *Accounting
      for Performance of Construction Type and Certain Production Type
      Contracts* ”.
      When
      reliable estimates are available for the costs and efforts necessary to complete
      the engineering or consulting services and those services do not include
      contractual milestones or other acceptance criteria, we recognize revenue under
      the percentage of completion contract method based upon input measures, such
      as
      hours. When such estimates are not available, we defer all revenue recognition
      until we have completed the contract and have no further obligations to the
      customer.





-22-


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





*Equity-based
      compensation.* In
      December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No.
      123R “Share-Based Payment” (“SFAS 123R”), which requires all share-based
      payments to employees, including grants of employee stock options, to be
      recognized in the statement of operations as an operating expense, based on
      their fair values on grant date. Pro forma disclosure is no longer an
      alternative. The Company adopted the provision of SFAS No. 123R effective
      January 1, 2006, using the modified prospective transition method. Under the
      modified prospective method, equity compensation expense is recognized for
      the
      portion of outstanding stock option awards granted prior to the adoption of
      SFAS
      123R for which service has not been rendered, and for any future stock option
      grants and modifications. The Company recognizes share-based compensation costs
      on a straight-line basis over the requisite service periods of awards which
      would normally be the vesting period of the options.





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





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








**Results
      of Operations**





*Revenue.* Revenue
      for the three months ended September 30, 2006 was $1,703,000 as compared to
      $507,000 for the three months ended September 30, 2005. Revenue for the nine
      months ended September 30, 2006 was $4,455,000 as compared to $1,206,000 for
      the
      nine months ended September 30, 2005. Revenue for the three and nine months
      ended September 30, 2006 and 2005 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, 2006
      is
      primarily attributed to increases in sales of our Flix and Flash related
      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,
      2006 were $2,290,000 as compared to $1,524,000 for the three months ended
      September 30, 2005. Operating expenses were $7,738,000 for the nine months
      ended
      September 30, 2006 as compared to $4,395,000 for the nine months ended September
      30, 2005.





*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, 2006 was $529,000 as compared to $470,000 for the three months
      ended September 30, 2005. Cost of revenues for the nine months ended September
      30, 2006 was $1,817,000 as compared to $1,249,000 for the nine months ended
      September 30, 2005. The increase in expenses for the three and nine months
      ended
      September 30, 2006 is primarily due to an increase in stock based compensation
      costs related to the adoption of SFAS 123(R) in January 2006, compensation
      costs
      from the addition of technical personnel and the amortization of the acquired
      assets recorded in connection with the Flix acquisition and the Wildform Support
      and Services Agreement.





-23-


*Research
      and Development.* Research
      and development expenses excluding equity-based compensation, primarily consist
      of salaries and related expenses and consulting fees associated with the
      development and production of our products and services, operating lease costs
      and depreciation costs. Research and development expenses for the three months
      ended September 30, 2006 were $261,000 as compared to $249,000 for the three
      months ended September 30, 2005. Research and development expenses for the
      nine
      months ended September 30, 2006 were $700,000 as compared to $755,000 for the
      nine months ended September 30, 2005. The increase of $12,000 for the three
      months ended September 30, 2006 is primarily attributed to an increase in
      activity in the improvement of the Flix product line. The decrease of $55,000
      for the nine months ended September 30, 2006 as compared with 2005 is primarily
      attributed to engineering efforts being focused on fulfilling current sales
      orders.




*Sales
      and Marketing.* Sales
      and marketing expenses excluding equity-based compensation, consist primarily
      of
      salaries and related overhead costs, commissions, business development,
      tradeshow 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, 2006 were $263,000 as compared to $219,000
      for
      the three months ended September 30, 2005. Sales and marketing expenses for
      the
      nine months ended September 30, 2006 were $623,000 as compared to $524,000
      for
      the nine months ended September 30, 2005. The increases were primarily
      attributed to an increase in personnel in the marketing area and increases
      in
      commissions, tradeshows and targeted advertising.




*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, 2006 were $843,000 as compared
      with $586,000 for the three months ended September 30, 2005. General and
      administrative expenses for the nine months ended September 30, 2006 were
      $3,383,000 as compared with $1,867,000 for the nine months ended September
      30,
      2005. The increase for the three months ended September 30, 2006 is primarily
      due to a increases in bad debt expense, director’s fees, legal and professional
      fees, consulting fees for the implementation of Sarbanes-Oxley, Section 404,
      stock listing fees, salaries and related overhead for the addition of personnel
      and commissions paid for business development.  The
      increase for the nine months ended September 30, 2006 is primarily attributable
      to $873,000 in legal fees in connection with the Company’s internal
      investigation into facts and circumstances concerning investor and other
      communications made by the Company’s former Chairman, Chief Executive Officer
      and President. There were also increases in professional fees for consulting
      services related to the Company’s implementation of Sarbanes-Oxley, Section 404,
      recruiting and relocation expenses for the Company’s new CEO.





*Equity-Based
      Compensation.* The
      Company adopted the provisions of SFAS No. 123R effective January 1, 2006,
      using
      the modified prospective transition method. Under the modified prospective
      method, equity compensation expense is recognized for the portion of outstanding
      stock option awards granted prior to the adoption of SFAS 123R for which service
      has not been rendered, and for any future stock option grants and modifications.
      Equity based compensation, which is presented separately, was $394,000 and
      $1,215,000 for the three and nine months ended September 30, 2006, respectively.
      Equity-based compensation of $45,000 and $154,000 is included in cost of revenue
      for the three and nine months ended September 30, 2006, respectively. On May
      1,
      2006, the Company’s new CEO was granted 1,500,000 options to purchase the
      Company’s common stock at an exercise price of $0.90 per share. The options vest
      on various dates beginning on May 1, 2006 through May 8, 2008. The aggregate
      estimated fair value was $1,114,000, of which $232,000 and $635,000 was
      recognized as compensation expense for the three and nine months ended September
      30, 2006, respectively. During the three months ended September 2006 the company
      granted 110,000 shares of restricted common stock to certain employees as
      compensation, which had a fair value of $70,000 on the date of grant. The
      Company recognized $31,000 in compensation expense for the three months ended
      September 30, 2006. The restricted stock vests, on various dates beginning
      on
      September 16, 2006.





-24-


*Interest
      and other income (expense), net.* Interest
      and other income (expense), net was $(10,000) for the three months ended
      September 30, 2006 as compared to $(14,000) for the three months ended September
      30, 2005. Interest and other income (expense), net was $(36,000) for the nine
      months ended September 30, 2006 as compared to $(273,000) for the nine months
      ended September 30, 2005. Interest and other income (expense), net primarily
      consists of interest earned on money market accounts, interest incurred for
      capital lease obligations, term-loan, the interest and amortization of debt
      discount related to the Series A Secured Convertible Debentures, gains and
      losses incurred on marketable securities and changes in the derivative financial
      instrument and financing fees for the derivative financial instrument. The
      decrease in interest and other income (expense), net for the three and nine
      months ended September 30, 2006 is primarily attributable to a decrease in
      unrealized losses on marketable securities of the publicly traded stock the
      company received in 2004 as payment for a license, a decrease in interest and
      amortization of debt discount related to the Series A Secured Convertible
      Debentures as a result of the conversion of the debentures into common stock
      and
      offset by $51,000 for the costs related to the derivative financing
      instrument.





At
      September 30, 2006, the Company had approximately 38 full-time employees. We
      expect to hire employees as necessary in order to attain our strategic
      objectives.







**Liquidity
      and Capital Resources**





At
      September 30, 2006, the Company had cash balances of $4,606,000 as compared
      to
      $3,976,000 at December 31, 2005. At September 30, 2006, the Company had working
      capital of $4,925,000 as compared with $4,179,000 at December 31, 2005.





Net
      cash
      used in operating activities was $1,687,000 and $3,636,000 for the nine months
      ended September 30, 2006 and 2005, respectively. The decrease in net cash used
      in operating activities is primarily attributable to a decrease in the net
      loss,
      an increase in equity based compensation and changes in deferred revenue
      accounts payable, accrued expenses and other liabilities and prepaid expenses
      and other current assets partially offset by a decrease in the unrealized loss
      on marketable securities.





Net
      cash
      used in investing activities was $44,000 and $1,345,000 for the nine months
      ended September 30, 2006 and 2005, respectively. The decrease in net cash used
      in investing activities is primarily due to the 2005 acquisition of the Filx
      product line from Wildform, Inc.





Net
      cash
      provided by financing activities was $2,364,000 and $4,114,000 for the nine
      months ended September 30, 2006 and 2005, respectively. The decrease is
      attributable to a decrease in proceeds received from the exercise of common
      stock options and warrants partially offset by an increase in proceeds form
      the
      issuance of common stock and the warrant derivative liability.





We
      currently have no material commitments for the next 12 months other than those
      under our operating lease arrangements. These arrangements consist primarily
      of
      lease arrangements for our office space in Clifton Park, Tarrytown and New
      York
      City. The aggregate required payments for the next 12 months under these
      arrangements are $163,000. 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
      $600,000 per month in cash operating costs.





-25-


The
      Company believes that existing funds are sufficient to fund its operations
      through 2007. The Company plans to increase cash flows from operations
      principally from increases in revenue generated from its compression technology
      services and products. The Company may also pursue additional financings. See
      “ *Management’s
      Discussion and Analysis of Financial Condition and Results of Operations -
      Risk
      Factors That May Affect Future Operating Results* ”
in
      the
      Company’s 10-K for the year ended December 31, 2005.





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







**Off-Balance
      Sheet Arrangements**





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





**Impact
      of Recently-Issued Accounting Pronouncements**





None








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





The
      Company does not currently have any material exposure to interest rate risk,
      foreign currency risk, exchange rate risk, commodity price risk or other
      relevant market rate or price risks. However, the Company does have some
      exposure to foreign currency rate fluctuations arising from both maintaining
      an
      office for the Company's U.K. based, wholly owned subsidiary which transacts
      business in the local functional currency and paying compensation for contract
      sales personnel based in Europe. The U.K. based subsidiary does not conduct
      any
      sales and all their costs are funded in United States dollars. The Company
      employs on a contract basis two sales consultants based in Europe, each of
      whom
      is paid monthly compensation denominated in Euros. 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.




-26-




**Item
      4. Controls and Procedures**





(a)
      Evaluation of Disclosure Controls and Procedures:





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





(b)
      Changes in internal controls.





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








-27-


PART
      II —
OTHER INFORMATION











**Item
      5. Legal Proceedings.**





Internal
      Investigation





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





Beijing
      E-World





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





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





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





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





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





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




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





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





·
            Failed
                to use best reasonable efforts to have On2's video codec ported to
                a chip.






-28-




On2
      has
      requested that the arbitrator award it approximately $5,690,000.00 in damages
      under the contract and grant it further relief as may be just and equitable.





E-World
      has appeared in the arbitration, although it has not yet filed any responses
      to
      On2’s filings in the proceeding. Following E-World’s appearance, it entered into
      an agreement with On2 pursuant to which E-World agreed by November 30, 2006,
      to
      pay On2 an amount (“Settlement Payment”) equal to approximately 25% of the
      remaining unpaid portion of the License Fees (but not royalties) 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 E-World from all liability arising from the matters underlying
      the
      arbitration.





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





(a)
            Exhibits




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





(b)
            Reports
                on Form 8-K





The
      Company filed Current Report Form 8-K on July 27, 2006, containing a press
      release announcing the Company’s results of operations for the quarter ending
      June 30, 2006.





The
      Company filed a Current Report on Form 8-K on August 25, 2006 announcing that
      it
      had entered into a series of definitive agreements with two institutional
      investors, led by MidSummer Investment Ltd., in connection with a private
      placement of $1,750,000 of the Company's common stock, par value
      $0.01.





The
      Company filed a Current Report on Form 8-K on September 25, 2006, announcing
      that it had extended the terms of the employment agreement of Eric Ameres,
      the
      Company’s Executive Vice-President and Chief Technology Officer.





The
      Company filed a Current Report on Form 8-K on October 5, 2006, announcing that
      it had entered into an agreement with Douglas A. McIntyre, the Company’s former
      Chairman, President and CEO, under which the parties (i) agreed to extend the
      expiration date of all vested options to purchase the common stock of the
      Company held by Mr. McIntyre to March 30, 2007 and (ii) placed certain
      restrictions on Mr. McIntyre’s ability to exercise the options. In addition, the
      agreement includes a provision that, if the volume weighted average trading
      price of the Company’s common stock for each of five consecutive trading days
      equals or exceeds the exercise price for any option, then either Mr. McIntyre
      must exercise such option in its entirety or the option shall terminate
      automatically.





-29-


**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)November
                8, 2006(Date)
            
            /s/
                Anthony Principe
                (Signature)Anthony
                  Principe
                Senior
                  Vice President and Chief Financial Officer
                (Principal
                  Financial Officer)







-30-