UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                   FORM 10-QSB

|X|   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
      EXCHANGE ACT OF 1934

                              For the quarterly period ended September 30, 2004.

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             (I.R.S. Employer Identification No.)
 incorporation or organization)


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

                                 (518) 348-0099
--------------------------------------------------------------------------------
              (Registrant's telephone number, including area code)

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

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      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.                  [X] Yes       [_] No

The number of shares of the Registrant's Common Stock, par value $0.01 ("Common
Stock"), outstanding as of November 2, 2004 was 79,614,881.

Transitional Small Business Disclosure Format (Check one): [_] Yes       [X] No


                                      -1-
<PAGE>

<TABLE>
<CAPTION>
                                TABLE OF CONTENTS

PART I -- FINANCIAL INFORMATION
                                                                                          Page

Item 1.  Consolidated Financial Statements.
<S>                                                                                        <C>
Condensed Consolidated Balance Sheets at September 30, 2004 (unaudited)
  and December 31, 2003.................. ................................................  3
Unaudited Condensed Consolidated Statements of Operations
  Three and Nine Months Ended September 30, 2004 and 2003.................................  4
Unaudited Condensed Consolidated Statements of Comprehensive loss
  Nine Months Ended September 30, 2004 and 2003...........................................  5
Unaudited Condensed Consolidated Statements of Cash Flows
  Nine Months Ended September 30, 2004 and 2003...........................................  6
Notes to Unaudited Condensed Consolidated Financial Statements............................  8

Item 2.  Management's Discussion and Analysis of Financial Condition and
  Results of Operations................. ................................................. 12

Item 3.  Controls and Procedures.......................................................... 22
PART II -- OTHER INFORMATION

Item 1.  Legal Proceedings................................................................ 23

Item 6.  Exhibits and Reports on Form 8-K................................................. 23
Signatures................................................................................ 24
Certifications............................................................................ 25
</TABLE>


                                      -2-
<PAGE>

<TABLE>
<CAPTION>
                         PART I -- FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements

                             ON2 TECHNOLOGIES, INC.
                      CONDENSED CONSOLIDATED BALANCE SHEETS

                                                                  September 30,         December 31,
                                                                     2004                  2003
                                                               ----------------       ---------------
                                                                  (unaudited)
                                    ASSETS
<S>                                                            <C>                     <C>
   Current assets:
  Cash and cash equivalents .................................  $   2,538,000           $   2,963,000
   Marketable equity securities .............................        701,000
  Accounts receivable, net of allowance for doubtful accounts        444,000                 826,000
  Prepaid expenses and other current assets .................        180,000                 164,000
                                                               ----------------       ---------------
     Total current assets ...................................      3,863,000               3,953,000

Property and equipment, net .................................        112,000                 149,000
Other assets ................................................        108,000                  26,000
                                                               ----------------       ---------------
     Total assets ...........................................  $   4,083,000           $   4,128,000
                                                               ================       ===============
                  LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
  Accounts payable ..........................................  $       8,000           $     119,000
  Accrued and other liabilities .............................        337,000                 221,000
  Deferred revenue ..........................................        121,000                  30,000
  Current portion of capital lease obligations ..............         16,000
  Term loan .................................................        123,000                  63,000
                                                               ----------------       ---------------
     Total current liabilities ..............................        605,000                 433,000

Capital lease obligations, net of current portion ...........         31,000
Convertible debentures ......................................        327,000                 409,000

Commitments and contingencies

Stockholders' equity:
  Preferred stock ...........................................         40,000                  56,000
  Common stock ..............................................        792,000                 741,000
  Additional paid-in ........................................    111,772,000             110,229,000
  capital ...................................................                                      .
  Accumulated other comprehensive gain (loss) ...............          2,000                 (18,000)
   Deferred compensation ....................................       (186,000)
  Accumulated deficit .......................................   (109,300,000)           (107,722,000)
                                                               ----------------       ---------------
    Total stockholders' equity ..............................      3,120,000               3,286,000
                                                               ----------------       ---------------
    Total liabilities and stockholders' equity ..............  $   4,083,000           $   4,128,000
                                                               ================       ===============
</TABLE>

See accompanying notes to unaudited condensed consolidated financial statements


                                      -3-
<PAGE>

<TABLE>
<CAPTION>
                             ON2 TECHNOLOGIES, INC.
           UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

                                                          Three Months Ended               Nine Months Ended
                                                             September 30,                     September 30,
                                                  ------------------------------    ------------------------------
                                                        2004             2003            2004             2003
                                                  -------------    -------------    -------------    -------------
<S>                                               <C>              <C>              <C>              <C>
Revenues .....................................    $    762,000     $    866,000     $  2,926,000     $  2,976,000

Operating expenses:
     Cost of revenues (1) ....................         399,000          410,000        1,076,000        1,252,000
     Research and development (2) ............         231,000          249,000          679,000          865,000
     Sales and marketing (2) .................         123,000          158,000          354,000          350,000
     General and administrative (2) ..........       1,091,000          650,000        2,158,000        1,833,000
     Equity-based compensation:
             Research and development ........          23,000                            53,000
             Sales and marketing .............           6,000                            15,000
             General and administrative ......         194,000                           455,000
                                                  -------------    -------------    -------------    -------------
Total operating expenses .....................       2,067,000        1,467,000        4,790,000        4,300,000
                                                  -------------    -------------    -------------    -------------
Loss from operations .........................      (1,305,000)        (601,000)      (1,864,000)      (1,324,000)

Interest and other
  income (expense), net ......................         388,000          (21,000)         289,000          21,000
                                                  -------------    -------------    -------------    -------------
Loss before provision for income taxes .......        (917,000)        (622,000)      (1,575,000)      (1,303,000)

Provision for income taxes ...................                            3,000            3,000            9,000
                                                  -------------    -------------    -------------    -------------
Net loss .....................................        (917,000)        (625,000)      (1,578,000)      (1,312,000)

Non-cash convertible preferred stock
 dividend ....................................                          228,000                           228,000
                                                  -------------    -------------    -------------    -------------
Net loss attributable to common
   stockholders ..............................    $   (917,000)    $   (853,000)    $ (1,578,000)    $ (1,540,000)
                                                  =============    =============    =============    =============
Basic and diluted net loss per common share ..    $      (0.01)    $      (0.01)    $      (0.02)    $      (0.02)
                                                  =============    =============    =============    =============
Weighted average basic and diluted common
   shares outstanding ........................      78,587,000       65,339,000       76,673,000       62,678,000
                                                  =============    =============    =============    =============
</TABLE>

(1)   Includes equity-based compensation of $55,000 and $126,000 for the three
      and nine months ended September 30, 2004.

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

 See accompanying notes to unaudited condensed consolidated financial statements


                                      -4-
<PAGE>

<TABLE>
<CAPTION>
                             ON2 TECHNOLOGIES, INC.
        UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

                                            Three Months Ended                Nine Months Ended
                                               September 30,                   September 30,
                                       ---------------------------     -----------------------------
                                           2004            2003          2004            2003

<S>                                    <C>             <C>             <C>              <C>
Net loss ............................  $ (917,000)     $ (625,000)     $(1,578,000)     $(1,312,000)
Other Comprehensive income (loss):

     Foreign currency translation
      adjustment                           (3,000)         (1,000)          20,000           (3,000)
                                       -------------------------------------------------------------
Comprehensive loss ..................  $ (920,000)     $ (626,000)     $(1,558,000)     $(1,315,000)
                                       =============================================================
</TABLE>

 See accompanying notes to unaudited condensed consolidated financial statements


                                      -5-
<PAGE>

<TABLE>
<CAPTION>
                             ON2 TECHNOLOGIES, INC.
            UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

                                                                     Nine Months Ended September 30,
                                                                     -------------------------------
                                                                         2004            2003
<S>                                                                  <C>              <C>
 Cash flows from operating activities:

Net loss .......................................................     $(1,578,000)     $(1,312,000)
    Adjustments to reconcile net loss to net cash used in ......
     operating activities: .....................................
     Equity-based compensation .................................         649,000
     Non-cash bond interest ....................................                           26,000
     Depreciation and ..........................................          90,000          672,000
     amortization ..............................................
     Write-off of fixed assets .................................          20,000
     Amortization of debt discount .............................          18,000           22,000
     Marketable equity securities received as payment of license        (289,000)
     fees ......................................................
     Unrealized gain on marketable equity securities, net ......        (344,000)
     Realized loss on the sale of marketable equity securities .          15,000
   Changes in operating assets and liabilities: ................
     Accounts receivable, net ..................................         232,000         (360,000)
     Prepaid expenses and other current assets .................         (16,000)        (120,000)
     Other assets ..............................................         (82,000)         (17,000)
     Accounts payable, accrued expenses and other liabilities ..           5,000         (172,000)
     Deferred revenue ..........................................          91,000           53,000
                                                                     -------------    --------------
Net cash used in operating activities ..........................      (1,189,000)      (1,208,000)
                                                                     -------------    ==============
Cash flows from investing activities: ..........................

  Proceeds from the sale of marketable equity securities .......          67,000
  Purchases of property and equipment ..........................         (19,000)         (30,000)
                                                                     -------------    --------------
Net cash provided by (used in) investing activities ............          48,000          (30,000)
                                                                     -------------    ==============
Cash flows from financing activities: ..........................

    Principal payments on capital lease obligations ............          (7,000)          (9,000)
    Purchase of common stock warrants ..........................                          (42,000)
    Proceeds from term-loan, net of repayments .................          60,000          108,000
    Proceeds from the sale of common stock .....................                        1,313,000
    Proceeds from exercise of common stock options and warrants          643,000        2,233,000
                                                                     -------------    --------------
Net cash provided by financing activities ......................         696,000        3,603,000
                                                                     -------------    --------------
Net change in cash and cash equivalents ........................        (445,000)       2,364,000

Effect of exchange rate changes on cash and cash equivalents ...          20,000           (3,000)
                                                                     -------------    --------------
Cash and cash equivalents, beginning of period .................       2,963,000          553,000
Cash and cash equivalents, end of period .......................     $ 2,538,000      $ 2,915,000
                                                                     =============    ==============
</TABLE>


                                      -6-
<PAGE>

<TABLE>
<CAPTION>
                             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,
                                                                   --------------------------------
                                                                        2004                2003
                                                                   --------------------------------
<S>                                                                  <C>                   <C>
 Cash paid during the period for:
  Interest ..................................................        $  8,000              $ 10,000
                                                                   ================================
  Taxes .....................................................        $  8,000              $ 13,000
                                                                   ================================
Acquisition of fixed assets under capital leases ............        $ 54,000
                                                                   ================================
Conversion of debentures into shares of common stock ........        $100,000              $ 50,000
                                                                   ================================
Conversion of preferred stock into shares of common stock ...        $ 16,000
                                                                   ================================
Marketable equity securities received for accounts receivable        $150,000
                                                                   ================================
Unearned compensation from the issuance of restricted common
stock, net of forfeiture ....................................        $835,000
                                                                   ================================
Non-cash convertible preferred stock dividends ..............                              $228,000
                                                                   ================================
</TABLE>

 See accompanying notes to unaudited condensed consolidated financial statements


                                      -7-
<PAGE>

                             ON2 TECHNOLOGIES, INC.
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(1) Description of On2 Technologies, Inc.

      On2 Technologies, Inc. ("On2" or the "Company") is a leading video
compression technology firm. The Company 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, the acceptance of the Company's technology solutions by the
marketplace, and the Company's ability to compete with rivals that offer
integrated product solutions.

(2) Basis of Presentation

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

      The interim condensed consolidated financial statements are unaudited.
However, in the opinion of management, the interim data include all adjustments,
consisting only of normal, recurring adjustments, necessary for a fair
presentation of the consolidated results for the interim periods. The condensed
consolidated financial statements included herein have been prepared pursuant to
the rules and regulations of the Securities and Exchange Commission ("SEC").
Certain information and footnote disclosures normally included in consolidated
financial statements prepared in accordance with accounting principals generally
accepted in the United States of America have been condensed or omitted pursuant
to such rules and regulations. The Company believes that the disclosures
included herein are adequate to make the information presented not misleading.
These condensed consolidated financial statements should be read in conjunction
with the annual financial statements and notes thereto included in the Company's
Annual Report on Form 10-KSB filed with the SEC on March 30, 2004.

(3) Stock-Based Compensation

      Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting
for Stock-Based Compensation" encourages the use of the fair value based method
of accounting for stock-based employee compensation. Alternatively, SFAS No.123
allows entities to continue to apply the intrinsic value method prescribed by
Accounting Principles Board ("APB") Opinion 25, "Accounting for Stock Issued to
Employees", and related interpretations and provide pro forma disclosures of net
income (loss) and earnings (loss) per share, as if the fair value based method
of accounting had been applied to employee awards. The Company has elected to
continue to apply the provisions of APB Opinion 25 and provide the disclosures
required by SFAS No. 123 and SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure". The following table illustrates the
effect on net income (loss) and earnings (loss) per share if the fair value
based method had been applied to all awards.


                                      -8-
<PAGE>

<TABLE>
<CAPTION>
                                                        Three months ended,                   Nine months ended,
                                                           September 30,                        September 30,
                                                  ---------------------------------     ---------------------------------
                                                      2004              2003               2004               2003

<S>                                               <C>                <C>                <C>                <C>
Reported net loss                                 $    (917,000)     $    (853,000)     $  (1,578,000)     $  (1,540,000)

Stock-based employee compensation  determined
under the fair value-based method                      (522,000)           (54,000)          (880,000)          (440,000)
                                                  -------------      -------------      -------------      -------------
Pro forma net loss                                $  (1,439,000)     $    (907,000)     $  (2,458,000)     $  (1,980,000)
                                                  =============      =============      =============      =============

Loss per common share (basic and diluted):
    As reported                                   $       (0.01)     $       (0.01)     $       (0.02)     $       (0.02)
                                                  =============      =============      =============      =============
    Pro forma                                     $       (0.02)     $       (0.01)     $       (0.03)     $       (0.03)
                                                  =============      =============      =============      =============
</TABLE>

      During 2004 the company granted restricted stock to its employees and
directors as compensation. The company issued 870,000 shares of its common
stock, net of forfeitures of 20,000 shares, with a fair value of $835,000. The
restricted stock vests over a period of nine months and requires the
employee/director to be employed/affiliated with the company on the vesting
date. The related compensation expense of $278,000 and $649,000 for the three
and nine months ended September 30, 2004, respectively, is included in the
determination of reported net income (loss) for those periods.

(4) Marketable Equity Securities

      During the third quarter of 2004 the Company received 2,224,000 shares of
a customer's common stock in payment of license fees pursuant to the terms of a
August 2004 license agreement. The market value of the stock on the date the
contract was signed was $289,000 and subsequently increased to $701,000 as of
September 30, 2004. The Company recorded an unrealized gain on marketable equity
securities of $412,000 for the three months ended September 30, 2004. During the
nine months ended September 30, 2004 the Company also received 469,000 shares of
this customer's common stock pursuant to the terms of a license agreement as
payment for a license fee of $150,000 that was recognized in 2003. During the
nine months ended September 30, 2004 the Company recorded an unrealized loss of
$68,000 and, upon the sale of these shares for proceeds of $67,000, an
additional loss of $15,000. These unrealized and realized gains and losses are
included in other income (expense), net. The Company's chief executive officer
is a director of this customer.

(5) Beijing E-world

      In June 2003, On2 entered into two source code license and software
distribution agreements with Beijing E-World Technology Co., Ltd ("E-world").
The two separate license arrangements granted E-World rights to use On2's source
code in its video disk (EVD) and high definition television (HDTV) products and
in its non-EVD/HDTV products.


                                      -9-
<PAGE>

      The EVD/HDTV agreement provides that E-World will pay On2 $50,000 within
10 days of the effective date of the agreement and also establishes royalty
rates for each unit manufactured. The arrangement provides that, beginning in
the first calendar quarter of 2004 and continuing through the last quarter of
2005, E-world will pay On2 certain minimum amounts based on anticipated numbers
of units to be manufactured in the relevant quarters (with excess actual units
manufactured in 2004 reducing the subsequent year's minimum obligation). The
total two-year minimum royalty value due to On2 is approximately $4,900,000.
Nonrefundable payments for royalties, including minimum royalties, are payable
quarterly, beginning with the quarter ending March 31, 2004.

      The non-EVD/HDTV arrangement provides that E-World will pay On2 $250,000
within 10 days of the effective date of the agreement, $400,000 upon completion
of the Initial Port (porting of the Encoder and Decoder to the Chips by E-World)
and $350,000 within 6 months of completion of the Initial Port. The non-EVD/HDTV
license arrangement also provides that, beginning in the first calendar quarter
of 2004 and continuing through the last quarter of 2005, E-world will pay On2
certain minimum amounts based on anticipated numbers of units to be manufactured
in the relevant quarters (with excess actual units manufactured in 2004 reducing
the subsequent year's minimum obligation). The total two-year minimum royalty
value to On2 for the non-EVD HDTV license is approximately $100,000.
Nonrefundable payments for royalties, including minimum royalties, are payable
quarterly beginning with the quarter ending March 31, 2004.

      The initial payments aggregating $300,000 were received in June 2003.

      Beyond the licensing of the software, On2 will provide E-World with phone
and email source code porting, optimization and integration technical support
for a period of 24 months at no additional charge. E-World can elect to receive
an additional 12 months of technical support for an additional $37,500 under
each of the two arrangements.

      The accompanying condensed consolidated financial statements do not
reflect $1,232,000 for minimum royalties for the nine months ended September 30,
2004. Management believes these payments are due from E-World under the license
agreements, however E-world has not yet paid this sum. On2 has begun an
arbitration proceeding in London against E-world as provided for in the license
agreements. The Company has consulted with attorneys in New York and Beijing and
believes that it is likely that it will prevail in the arbitration, and that any
judgment in the arbitration proceeding will be enforceable in China, which is a
signatory to the New York Convention on enforcement of foreign arbitration
awards. In addition, the Company also believes that the $750,000 source code
fees are due and payable because E-World has not made reasonable best efforts to
complete the Initial Port as provided for under the contract. See "PART II --
OTHER INFORMATION - Item 1. Legal Proceedings".

      Under its agreements with E-World, as amended during the quarter ended
December 31, 2003, On2 has agreed to pay to E-world a portion of royalties that
the Company receives from sales to other customers in China. Cost of revenue for
the nine months ended September 30, 2004 includes $47,000 paid to E-World.

(6) Customer concentration

      For the three months ended September 30, 2004, four customers accounted
for 85% of revenue. Approximately 38% was generated from the license of software
and the performance of engineering services for Powerlinx, approximately 16% was
generated from the license of software to MCS K.K, approximately 17% was
generated from the license of software and the performance of engineering
services for Leapfrog and approximately 13% was generated from the license of
software and the performance of engineering services for Analog Devices. For the
nine months ended September 30, 2004 three customers accounted for 69% of
revenue, one customer accounted for 50% of revenue for the nine-month period.


                                      -10-
<PAGE>

(7) Conversion of Preferred Stock

      During the third quarter of 2004 the holder of Series C-V preferred stock
converted some of its preferred stock into shares of common stock. The
conversion consisted of 364,000 shares of Series C-V into 500,000 shares of the
Company's common stock.

(8) Subsequent Events

      On October 28, 2004, the Company completed a private placement of its
convertible securities to certain institutional investors (the "Investors"). The
Company received gross proceeds of $4,000,000. In exchange for the proceeds, the
Company issued 4,000 shares of a new Series D convertible preferred stock (the
"Series D Preferred Stock"), which are convertible into an aggregate of
5,714,286 shares of the Company's common stock, par value $0.01 (the "Common
Stock"). The Series D Preferred Stock is subject to a guaranteed 8% annual
dividend, payable quarterly, and is mandatorily redeemable by the Company over
an eighteen-month period starting in October 2006. Such redemptions can be made
in cash or Common Stock, at the Company's option. If redemptions are made in
Common Stock, the shares are valued at the average of the volume weighted
average trading price of the Common Stock for the twenty trading days
immediately prior to the redemption date. In addition, the Company granted the
Investors a Series A Warrant and Series B Warrant, each of which is convertible
into 2,993,197 shares of Common Stock. The Series A Warrant bears an exercise
price of $0.65 and may be redeemed by the Company for $0.01 if the Common Stock
trades at or above $0.84.5 for 10 consecutive trading days. The warrant expires
on October 27, 2005. The Series B Warrant bears an exercise price of $0.76 and
expires on October 27, 2009. The Series D Preferred Stock and warrants are
subject to weighted-average anti-dilution protection for issuances of securities
below the conversion price. The Series D Preferred Stock and warrants were
granted certain registration rights as are further described in the Current
Report on Form 8-K filed on November 1, 2004.


                                      -11-
<PAGE>

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.

      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," "should," "could," "expect," "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 our existing funds and funds that we expect to
generate will be sufficient 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-QSB. You should consider
the material presented in this Form 10-QSB 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-KSB
for the year ended December 31, 2003.

      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 leading video compression technology firm. We have developed a
proprietary technology platform and the VPx family (e.g., VP4, VP5, VP6) 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.


                                      -12-
<PAGE>

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

PRODUCTS                     o video codecs;
                             o audio codecs; and
                             o encoding and server software, for use with
                               video delivery platforms
                             o hardware products on which our
                               compression and/or server
                               software have been installed

SERVICES                     o customized engineering and
                               consulting services;
                             o technical support; and
                             o high-level video encoding

      Our customers use our products and services chiefly to provide the
following video-related products and services to end users:

    TYPE OF CUSTOMER                             EXAMPLES
    ----------------                             --------
       APPLICATION
       -----------
Video and Audio Distribution over           o providing video-on-demand services
Proprietary Networks                          to residents in multi-dwelling
                                              units (MDUs)
                                            o video surveillance

Consumer Electronic Devices                 o digital video players
                                            o digital video recorders
                                            o video-enabled toys
                                            o mobile wireless video units

Wireless Applications                       o delivery of video via satellite
                                            o providing video to web-enabled
                                              cell phones and PDAs

Video and Audio Distribution over           o video-on-demand
IP-based Networks (Internet)                o teleconferencing services
                                            o video instant messaging

      As discussed in greater detail below, we earn revenue chiefly through
licensing our software and providing specialized software engineering and
consulting services to customers. We also sell customized high-end hardware on
which we have preinstalled our compression and/or server software. 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 may only apply after a threshold number of
per-unit sales has been met. We also sell licenses to third-party resellers. In
addition, we generally require that customers pay us if they desire to receive
any upgrades to our software (e.g., from VP6 to VP7). We charge a fee for
engineering and consulting services, based on an estimate of the time it will
take our software engineers to provide the services, or an hourly fee for
ongoing services such as product support.


                                      -13-
<PAGE>

      The 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 On2's highly-efficient codec
has over our competition in allowing initial, breakthrough or first-time
consumer-acceptable video delivery may be less compelling. Nevertheless, in an
increasingly demanding, high-bandwidth world, greater compression rates are seen
as having more broadly applicable value, as growing demand and competition drive
efforts to maximize efficiency in the use of bandwidth and storage.

      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).

      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 30 full-time 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 for use
as a building block for companies that are developing end-to-end video products
and/or services. 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 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 recent 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 ability to offer an integrated software package including
multimedia compression and digital rights management applications may be
attractive to potential customers, especially in the video-on-demand market.
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 practices have led in some cases,
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 monopoly 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.


                                      -14-
<PAGE>

      A potential trend that we are currently monitoring is the possible
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. Although we believe our
technology is superior to H.264, H.264 may become widely adopted by potential
customers because, as a standards-based codec, there are numerous developers
programming to the H.264 standard and developing products based on such
standard. In addition, there are certain customers that prefer to license
standards-based codecs.

      The market for digital media creation and delivery technology is
constantly changing and 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. To do this, we devote a significant
portion of our engineering capacity to research and development. Although we
expect that competition from Microsoft and others will continue to intensify,
and that additional competition from H.264 may emerge, we currently expect that
our video compression technology will remain competitive and that we will
continue to innovate in the video compression field. 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-KSB filed with the SEC on March 30, 2004.
Our critical accounting policies and estimates are:

      o     Revenue recognition
      o     Valuation of goodwill, intangible assets and other long-lived assets


                                      -15-
<PAGE>

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

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

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

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

      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.

      Valuation of goodwill and intangible assets. We evaluate our long-lived
assets in accordance with SFAS No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed Of" ("SFAS No. 121").
Long-lived assets that are not identified with an impaired asset are reviewed
for impairment whenever events or changes in circumstances indicate that the net
carrying value of the asset may not be recoverable. Certain circumstances
include a deterioration of our financial resources, poor economic trends within
the industry, significant changes in our business model or a significant decline
in the demand for video delivery solutions. In such circumstances, the net
carrying value of the asset is compared to the undiscounted future cash flows of
the business segment to which that asset is attributable. As we operate under
one business segment, the net carrying value of all long-lived assets are
compared to our consolidated undiscounted future cash flows. Impairment losses
are measured by the amount in which the net carrying value of the assets exceed
the fair value.


                                      -16-
<PAGE>

      In July of 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and
Other Intangible Assets" ("SFAS No. 142"). SFAS 142 requires goodwill and other
intangible assets to be tested for impairment at least annually, and written off
when impaired, rather than being amortized as previously required. As of
September 30, 2004, we had no recorded goodwill or intangible assets. The
adoption of SFAS 142 had no significant impact on our results of operations or
financial position.

RESULTS OF OPERATIONS

      Revenue. Revenue for the three months ended September 30, 2004 was
$762,000 as compared with $866,000 for the three months ended September 30,
2003. Revenue for the nine months ended September 30, 2004 was $2,926,000 as
compared with $2,976,000 for the nine months ended September 30, 2003. Revenue
for the three and nine months ended September 30, 2004 and 2003 was derived
primarily from the sale of software licenses, engineering and consulting
services. The decrease in revenue for the three months ended September 30, 2004
is primarily attributable to a decrease in licenses sold to a third party
reseller. For the three months ended September 30, 2004, three customers
accounted for approximately 71% of revenue. Approximately 38 % was generated
from the license of software and the performance of engineering services for
Powerlinx, approximately 16% was generated from the license of software to MCS
K.K., approximately 17% was generated from the license of software and the
performance of engineering services for Leapfrog and approximately 13% was
generated from the license of software and the performance of engineering
services for Analog Devices. For the nine months ended September 30, 2004 three
customers accounted for 69% of revenue, one customer accounted for 50% of
revenue for the nine-month period.

      Operating expenses

      The Company's operating expenses consist of cost of revenue, research and
development, sales and marketing, general and administrative expenses,
impairment charges and cost curtailment and restructuring charges. Operating
expenses for the three months ended September 30, 2004 were $2,067,000 as
compared to $1,467,000 for the three months ended September 30, 2003. Operating
expenses were $4,790,000 for the nine months ended September 30, 2004 as
compared to $4,300,000 for the nine months ended September 30, 2003.

      Cost of Revenue. Cost of revenue includes personnel and consulting
compensation costs, related overhead expenses, certain hardware costs, fees paid
for licensed technology, depreciation costs and the amortization of purchased
technology. Cost of revenue for the three months ended September 30, 2004 was
$399,000 as compared to $410,000 for the three months ended September 30, 2003.
Cost of revenues for the nine months ended September 30, 2004 was $1,076,000 as
compared with $1,252,000 for the nine months ended September 30, 2003. The
decrease in expenses for the nine months ended September 30, 2004 is primarily
due to a reduction in amortization of purchased technology partially offset by
the cost of equipment that was resold, certain commissions paid to E-World for
sales made in China and the inclusion of stock-based compensation expenses for
the restricted stock grant of $126,000. There was no amortization of purchased
technology for the three and nine months ended September 30, 2004 as compared
with $150,000 and $464,000 for the three and nine months ended September 30,
2003. The purchased technology became fully amortized in the quarter ended
September 30, 2003.


                                      -17-
<PAGE>

      Research and Development. Research and development expenses 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, 2004 were $231,000 as compared with $249,000 for the three
months ended September 30, 2003. Research and development expenses for the nine
months ended September 30, 2004 were $679,000 as compared with $865,000 for the
nine months ended September 30, 2003. The decreases in expenses were primarily
attributed to a reduction in compensation and benefits costs due to a reduction
in headcount and a reduction in depreciation.

      Sales and Marketing. Sales and marketing expenses consist primarily of
salaries and related costs of sales, business development and marketing
personnel, tradeshow costs, marketing and promotional costs incurred to create
brand awareness and public relations expenses. Sales and marketing expenses for
the three months ended September 30, 2004 were $123,000 as compared with
$158,000 for the three months ended September 30, 2003. Sales and marketing
expenses for the nine months ended September 30, 2004 were $354,000 as compared
with $350,000 for the nine months ended September 30, 2003. The decrease for the
three months ended September 30, 2004 is primarily attributable to a decrease in
consulting fees paid for certain customer related projects.

      General and Administrative. General and administrative expenses consist
primarily of salaries and related personnel costs for general corporate
functions including administration, finance, human resources, legal and
facilities, consulting, outside legal and professional fees and insurance.
General and administrative expenses for the three months ended September 30,
2004 were $1,091,000 as compared with $650,000 for the three months ended
September 30, 2003. General and administrative expenses for the nine months
ended September 30, 2004 were $2,158,000 as compared with $1,833,000 for the
nine months ended September 30, 2003. The increase for the three and nine months
ended September 30, 2004 was primarily attributed to an increase in legal,
consulting and other professional fees related to an acquisition the company was
pursuing in the amount of $90,000, costs related to the E World arbitration in
the amount of $92,000 and bad debt expense of $125,000 for a sale made in the
first quarter of 2004 with related legal costs of collection in the amount of
$27,000 and additional stock listing fees of $125,000 covering equity issued in
prior periods.

      Equity-based compensation During 2004 the company granted restricted stock
to its employees and directors as compensation. The Company issued 870,000
shares of its common stock, net of forfeitures of 20,000 shares, with a fair
value of $835,000. The restricted stock vests over a period of nine months and
requires the employee/director to be employed/affiliated with the company on the
vesting date. The related compensation expense of $278,000 and $649,000 for the
three and nine months ended September 30, 2004, respectively, is included in the
determination of reported net income (loss) for those periods, including $55,000
and $126,000 which is included in cost of revenue.

      Interest and other income (expense), net. Interest and other income
(expense), net was $388,000 as compared to $(21,000) for the three months ended
September 30, 2004 and 2003, respectively. Interest and other income (expense),
net was $289,000 as compared with $21,000 for the nine months ended September
30, 2004 and 2003, respectively. Interest and other income (expense), net
primarily consists interest earned on our rental security deposits and money
market accounts, interest incurred for capital lease obligations and the
interest and amortization of debt discount related to the Series A secured
convertible debentures. The increase in interest and other income for the three
months ended September 30, 2004 was primarily attributable to an unrealized gain
on marketable equity securities of $412,000. The increase in interest and other
income for the nine months ended September 30, 2004 was primarily attributable
to an unrealized gain of $412,000 on marketable equity securities held as of
September 30, 2004 and a loss of $83,000 attributable to marketable equity
securities that were sold during the third quarter.


                                      -18-
<PAGE>

      As of September 30, 2004, the Company had approximately 30 full-time
employees.

LIQUIDITY AND CAPITAL RESOURCES

      As of September 30, 2004, the Company had cash reserves and working
capital of $2,538,000 and $3,258,000, respectively as compared with $2,963,000
and $3,520,000 at December 31, 2003.

      Net cash used in operating activities was $1,189,000 and $1,208,000 for
the nine months ended September 30, 2004 and 2003, respectively. Net cash used
in operating activities for the nine months ended September 30, 2004 was
primarily from a net loss of $1,578,000, marketable equity securities received
as payment of license fees of $289,000 and a net unrealized gain on marketable
equity securities of $344,000, partially offset by equity based compensation of
$649,000 and a decrease in accounts receivable, net of $232,000. Net cash used
in operations for the nine months ended September 30, 2003 was primarily from a
net loss of $1,312,000, an increase in accounts receivable, net of $360,000, an
increase in prepaid expenses and other current assets of $120,000 and a decrease
in accounts payable, accrued expenses and other liabilities of $172,000,
partially offset by depreciation and amortization of $672,000.

      Net cash provided by (used in) investing activities was $48,000 and
$(30,000) for the nine months ended September 30, 2004 and 2003. Net cash
provided by investing activities for the nine months ended September 30, 2004
reflects proceeds from the sale of marketable securities, partially offset by
purchases of property and equipment. Net cash provided by investing activities
for the nine months ended September 30, 2003 reflects purchases of property and
equipment.

      Net cash provided by financing activities was $696,000 and $3,603,000 for
the nine months ended September 30, 2004 and 2003, respectively. Net cash
provided by financing activities for the nine months ended September 30, 2004 is
primarily from proceeds of $643,000 from the exercise of common stock options
and warrants and $60,000 of proceeds from a term loan net of repayments. Net
cash provided by financing activities during the nine months ended September 30,
2003 is primarily from proceeds of $1,313,000 from the sale of common stock
under the equity line of credit, $2,233,000 from the exercise of common stock
options and warrants and $108,000 of proceeds from a term loan net of
repayments.

      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 New York City and
Clifton Park, New York. The lease on our New York office space terminates in
February 2005. The aggregate required payments for the next 12 months under
these arrangements are $113,000. 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
$400,000 per month in cash operating costs.

      The Company had two equity lines of credit. In December 2000, the Company
entered into a common stock purchase agreement ("Initial Stock Purchase
Agreement") with an accredited investor ("Investor"), for the sale, from time to
time, of the Company's Common Stock. Pursuant to the Initial Stock Purchase
Agreement, the Investor had committed to purchase up to $23,000,000 of Common
Stock over a 36-month period. The Investor may be required to invest an
additional $17,000,000 upon the attainment of certain trading volumes and
weighted average market prices in the Company's Common Stock. However, the
Company's ability to procure funds through the Initial Stock Purchase Agreement
may be limited or prohibited based on certain trading volumes and weighted
average market prices in the Company's Common Stock.


                                      -19-
<PAGE>

      Under the Initial Stock Purchase Agreement, shares of Common Stock are
periodically sold to the Investor at a discount from market value ranging from
6%-10%, depending on the closing price of the Company's Common Stock. The amount
of Common Stock sold is at the sole discretion of the Company and at no time
throughout the term of the Stock Purchase Agreement is the Company obligated to
sell its Common Stock, unless the Company issues a draw-down notice. The Company
issued warrants to purchase 50,000 shares of the Company's Common Stock and
incurred $25,000 of transaction costs in connection with the Stock Purchase
Agreement.

      In May 2001, the Company's shareholders approved the sale, at the sole
discretion of the Company, of up to 15,500,000 shares of Common Stock in
connection with the Initial Stock Purchase Agreement. The Company has sold
15,500,000 shares of Common Stock for net proceeds of approximately $6,670,000
under the Initial Stock Purchase Agreement,

      In November 2001, the Company entered into a second common stock purchase
agreement ("Second Stock Purchase Agreement") with the Investor, for sale, from
time to time, of the Company's Common Stock. Under the Second Stock Purchase
Agreement, the Investor has committed to purchase an additional $23,000,000
million over a 36-month period, with an additional commitment for $17,000,000
upon the attainment of certain price and volume thresholds. Under the Second
Stock Purchase Agreement, providing that the volume weighted average stock price
for the 30-day period preceding a draw-down notice is at least $0.30, the
Company may request (a) a minimum amount of $300,000 or (b) a maximum amount
equal to the greater of $500,000 or $300,000 plus 4.5% of the volume weighted
average stock price for the preceding 30-day period multiplied by the total
trading volume for the preceding 3-month period. If the volume weighted average
stock price is below $0.30 and greater than $0.10, the minimum draw down amount
is pro-ratably reduced from $300,000 to $100,000.

      Under the Second Stock Purchase Agreement, shares of Common Stock are
periodically sold to the Investor at a discount from market value ranging from
6%-10%, depending on the closing price of the Company's Common Stock. The amount
of Common Stock sold is at the sole discretion of the Company and at no time
throughout the term of the Stock Purchase Agreement is the Company obligated to
sell its Common Stock, unless the Company issues a draw down notice. The Company
issued 100,000 shares of unrestricted Common Stock and incurred approximately
$10,000 of transaction costs in connection with the Second Stock Purchase
Agreement.

      Since April 2002, when the Company's shareholders approved the sale, at
the sole discretion of the Company, of up to 9,000,000 shares of Common Stock in
connection with the Second Stock Purchase Agreement, the Company sold 9,000,000
shares of Common Stock for net proceeds of approximately $2,073,000 and has
issued all the stock registered for the Second Stock Purchase Agreement. For the
nine months ended September 30, 2003 the Company issued 3,387,000 shares of its
common stock and received proceeds of $1,313,000 in connection with the Second
Stock Purchase Agreement.

      Based on our current working capital requirements, management does not
believe the Company will require additional funding during the next 12 months to
finance our current level of operations.


                                      -20-
<PAGE>

      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
broadband technology services, products and licenses. 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.

      On October 28, 2004, the Company completed a private placement of its
convertible securities to certain institutional investors (the "Investors"). The
Company received gross proceeds of $4,000,000. In exchange for the proceeds, the
Company issued 4,000 shares of a new Series D convertible preferred stock (the
"Series D Preferred Stock"), which are convertible into an aggregate of
5,714,286 shares of the Company's common stock, par value $0.01 (the "Common
Stock"). The Series D Preferred Stock is subject to a guaranteed 8% annual
dividend, payable quarterly, and is mandatorily redeemable by the Company over
an eighteen-month period starting in October 2006. Such redemptions can be made
in cash or Common Stock, at the Company's option. If redemptions are made in
Common Stock, the shares are valued at the average of the volume weighted
average trading price of the Common Stock for the twenty trading days
immediately prior to the redemption date. In addition, the Company granted the
Investors a Series A Warrant and Series B Warrant, each of which is convertible
into 2,993,197 shares of Common Stock. The Series A Warrant bears an exercise
price of $0.65 and may be redeemed by the Company for $0.01 if the Common Stock
trades at or above $0.84.5 for 10 consecutive trading days. The warrant expires
on October 27, 2005. The Series B Warrant bears an exercise price of $0.76 and
expires on October 27, 2009. The Series D Preferred Stock and warrants are
subject to weighted-average anti-dilution protection for issuances of securities
below the conversion price. The Series D Preferred Stock and warrants were
granted certain registration rights as are further described in the Current
Report on Form 8-K filed on November 1, 2004.

IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

      None


                                      -21-
<PAGE>

ITEM 3. CONTROLS AND PROCEDURES.

(a) Evaluation of Disclosure Controls and Procedures:

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

(b) Changes in Internal Controls:

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


                                      -22-
<PAGE>

PART II -- OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On May 3, 2004, On2 commenced arbitration against its customer, Beijing E-world.
The arbitration is pending in the London Court of International Arbitration and
relates 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. The license agreements imposed a number of
obligations on E-world, including the requirements that:

o Commencing in the first calendar quarter of 2004 and continuing through 2005,
E-world pay to On2 certain minimum quarterly payments;

o E-world cause On2's software to be included in a new Chinese national standard
for EVD by December 31, 2003; and

o 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's arbitration claim alleges that, despite its obligations under the
contract, E-world has:

o Failed to pay On2 the quarterly payments of $1,232,000, which is currently due
and owing;

o Failed to cause On2's software to be included in the EVD standard; and

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

On2 has requested that the arbitrator award it $4,992,000 in damages under the
contract and grant it further relief as may be just and equitable.

E-world has responded by denying each of On2's claims and has requested that the
arbitrator find that E-world has complied with the terms of the license
agreements.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.

(a) Exhibits

31.1    Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2    Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1    Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2    Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(b) Reports on Form 8-K

Current Report on Form 8-K filed on April 29, 2004.


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<PAGE>

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 2, 2004                     /s/ Anthony Principe
                                     -------------------------------------------
-----------------------------
(Date)                               (Signature) Anthony Principe
                                     Vice President and Chief Financial Officer


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