**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, 2007.





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


For
      the
      transition period from ____ to ____.





Commission
      file number 1-15117.





**On2
      Technologies, Inc.**


(Exact
      name of registrant as specified in its charter)








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





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





(518)
      348-0099


(Registrant’s
      telephone number, including area code)









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








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





APPLICABLE
      ONLY TO CORPORATE ISSUERS:





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





The
      number of shares of the Registrant’s Common Stock, par value $0.01 (“Common
      Stock”), outstanding as of November 9, 2007, was 159,748,414.











**Table
      of Contents**





**PART
      I — FINANCIAL INFORMATION**


PageItem
                1. Consolidated Financial
                Statements.Condensed
                Consolidated Balance Sheets at September 30, 2007
                (unaudited) and December 31, 2006
            3Unaudited
                Condensed Consolidated Statements of Operations
                Three and Nine Months Ended September 30, 2007 and
                2006
            4Unaudited
                Condensed Consolidated Statements of Comprehensive
                Loss Three and Nine Months Ended September 30, 2007 and
                2006
            5Unaudited
                Condensed Consolidated Statements of Cash Flows Nine
                Months Ended September 30, 2007 and 2006
            6Notes
                to Unaudited Condensed Consolidated Financial
                Statements
            8Item
                2. Management’s Discussion and Analysis of Financial
                Condition and Results of Operations
            15Item
                3.Quantitative
                and Qualitative Disclosures About Market Risk
            29Item
                4. Controls and Procedures
            30**PART
                II — OTHER INFORMATION**Item
                1. Legal Proceedings
            31Item
                6. Exhibits
            32Signatures
            33Certifications
            34




-2-




**PART
      I — FINANCIAL INFORMATION**





Item
      1. Consolidated Financial Statements





**ON2
      TECHNOLOGIES, INC.**


**CONDENSED
      CONSOLIDATED BALANCE SHEETS**





September
                30,
              2007
            
            December
                31,
              2006(unaudited)**ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            9,634,000
            
            $
            4,961,000Marketable
                securities
            
            
            
            
            
            154,000Accounts
                receivable
            
            
            2,780,000
            
            
            1,335,000Prepaid
                and other current assets
            
            
            237,000
            
            
            231,000Total
                current assets
            
            
            12,651,000
            
            
            6,681,000Acquired
                software, net
            
            
            317,000
            
            
            467,000Other
                acquired intangibles, net
            
            
            73,000
            
            
            108,000Goodwill
            
            
            244,000
            
            
            244,000Property
                and equipment, net
            
            
            352,000
            
            
            157,000Deferred
                acquisition costs
            
            
            1,727,000Deferred
                financing costs
            
            
            62,000Other
                assets
            
            
            104,000
            
            
            230,000Total
                assets
            
            $
            15,530,000
            
            $
            7,887,000**LIABILITIES
                AND STOCKHOLDERS’ EQUITY**Current
                liabilities:Accounts
                payable
            
            $
            501,000
            
            $
            194,000Accrued
                expenses
            
            
            1,095,000
            
            
            454,000Deferred
                revenue
            
            
            796,000
            
            
            708,000Term-loan
            
            
            96,000
            
            
            33,000Capital
                lease obligation
            
            
            22,000
            
            
            24,000Total
                current liabilities
            
            
            2,510,000
            
            
            1,413,000Capital
                lease obligation, excluding current portion
            
            
            18,000
            
            
            29,000Warrant
                derivative liability
            
            
            
            
            
            2,329,000Total
                liabilities
            
            
            2,528,000
            
            
            3,771,000Commitments
                and contingenciesSeries
                D redeemable convertible preferred stock
            
            
            
            
            
            3,083,000Stockholders’
                equity:Preferred
                stock
            
            
            
            
            
            19,000Common
                stock
            
            
            1,173,000
            
            
            1,012,000Additional
                paid-in capital
            
            
            140,374,000
            
            
            124,554,000Accumulated
                other comprehensive loss
            
            
            (52,000
            )
            
            (46,000
            )Accumulated
                deficit
            
            
            (128,493,000
            )
            
            (124,506,000
            )Total
                stockholders’ equity
            
            
            13,002,000
            
            
            1,033,000Total
                liabilities and stockholders’ equity
            
            $
            15,530,000
            
            $
            7,887,000


*See
      accompanying notes to unaudited condensed consolidated financial
      statements*




-3-




**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF
      OPERATIONS**




Three
                Months Ended
              September
                30,
            
            Nine
                Months Ended
              September
                30,2007
            
            2006
            
            2007
            
            2006Revenue
            
            $
            2,566,000
            
            $
            1,703,000
            
            $
            7,935,000
            
            $
            4,455,000Operating
                expenses:Cost
                of revenue (1)
            
            
            603,000
            
            
            529,000
            
            
            1,415,000
            
            
            1,817,000Research
                and development (2)
            
            
            445,000
            
            
            261,000
            
            
            1,500,000
            
            
            700,000Sales
                and marketing (2)
            
            
            676,000
            
            
            263,000
            
            
            1,886,000
            
            
            623,000General
                and administrative (2)
            
            
            1,146,000
            
            
            843,000
            
            
            3,085,000
            
            
            3,383,000Equity-based
                compensation:Research
                and development
            
            
            46,000
            
            
            30,000
            
            
            66,000
            
            
            82,000Sales
                and marketing
            
            
            34,000
            
            
            61,000
            
            
            88,000
            
            
            119,000General
                and administrative
            
            
            102,000
            
            
            303,000
            
            
            330,000
            
            
            1,014,000Total
                operating expenses
            
            
            3,052,000
            
            
            2,290,000
            
            
            8,370,000
            
            
            7,738,000Loss
                from operations
            
            
            (486,000
            )
            
            (587,000
            )
            
            (435,000
            )
            
            (3,283,000
            )Interest
                and otherincome
                (expense), net
            
            
            121,000
            
            
            (10,000
            )
            
            (3,464,000
            )
            
            (36,000
            )Loss
                before provision for income taxes
            
            
            (365,000
            )
            
            (597,000
            )
            
            (3,899,000
            )
            
            (3,319,000
            )Provision
                for income taxes
            
            
            3,000
            
            
            11,000
            
            
            10,000
            
            
            17,000Net
                loss
            
            $
            (368,000
            )
            $
            (608,000
            )
            $
            (3,909,000
            )
            $
            (3,336,000
            )Convertible
                preferred stock deemed dividend
            
            
            
            
            
            68,000
            
            
            
            
            
            68,000Convertible
                preferred stock 8% dividend
            
            
            7,000
            
            
            74,000
            
            
            78,000
            
            
            220,000Net
                loss attributable to common shareholders
            
            $
            (375,000
            )
            $
            (750,000
            )
            $
            (3,987,000
            )
            $
            (3,624,000
            )Basic
                and diluted net loss attributable to common shareholders per common
                share
            
            $
            0.00
            
            $
            (0.01
            )
            $
            (0.04
            )
            $
            (0.04
            )Weighted-average
                basic and diluted common shares outstanding:
            
            
            116,353,000
            
            
            97,436,000
            
            
            110,615,000
            
            
            96,838,000





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


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




*See
      accompanying notes to unaudited condensed consolidated financial
      statements*




-4-




**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE
      LOSS**




Three
                Months Ended
              September
                30,
            
            Nine
                Months Ended
              September
                30,2007
            
            2006
            
            2007
            
            2006Net
                (loss)
            
            $
            (368,000
            )
            $
            (608,000
            )
            $
            (3,909,000
            )
            $
            (3,336,000
            )Other
                comprehensive (loss):Foreign
                currency translation
            
            
            (1,000
            )
            
            (1,000
            )
            
            (6,000
            )
            
            (3,000
            )Comprehensive
                (loss)
            
            $
            (369,000
            )
            $
            (609,000
            )
            $
            (3,915,000
            )
            $
            (3,339,000
            )


*See
      accompanying notes to unaudited condensed consolidated financial
      statements*




-5-




**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF CASH
      FLOWS**




Nine
                Months Ended
              September
                30,2007
            
            2006Cash
                flows from operating activities:Net
                loss
            
            $
            (3,909,000
            )
            $
            (3,336,000
            )Adjustments
                to reconcile net loss to net cash provided by (used in) operating
                activities:Equity-based
                compensation
            
            
            547,000
            
            
            1,369,000Other
                expense recognized for warrant amendment
            
            
            86,000Common
                stock issued for debenture interest
            
            
            
            
            
            5,000Depreciation
                and amortization
            
            
            275,000
            
            
            244,000Amortization
                of debt discount
            
            
            
            
            
            6,000Write
                off of fixed assets
            
            
            (21,000
            )Loss
                on marketable securities
            
            
            27,000
            
            
            42,000Change
                in fair value of warrant liability
            
            
            3,582,000
            
            
            (20,000
            )Changes
                in operating assets and liabilities:Accounts
                receivable, net
            
            
            (1,445,000
            )
            
            (415,000
            )Prepaid
                expenses and other current assets
            
            
            138,000
            
            
            112,000Other
                assets
            
            
            20,000
            
            
            (112,000
            )Accounts
                payable, accrued expenses and other liabilities
            
            
            969,000
            
            
            (50,000
            )Deferred
                revenue
            
            
            88,000
            
            
            403,000Net
                cash provided by (used in) operating activities
            
            
            357,000
            
            
            (1,752,000
            )Cash
                flows from investing activities:Proceeds
                from the sale of marketable securities
            
            
            223,000
            
            
            75,000Purchase
                of marketable securities
            
            
            (96,000
            )Deferred
                acquisition costs
            
            
            (1,727,000
            )Deferred
                financing costs
            
            
            (62,000
            )Purchases
                of property and equipment
            
            
            (257,000
            )
            
            (54,000
            )Net
                cash (used in) provided by investing activities
            
            
            (1,919,000
            )
            
            21,000Cash
                flows from financing activities:Principal
                payments on capital lease
            
            
            (19,000
            )
            
            (21,000
            )Principal
                payments on term-loan
            
            
            (81,000
            )
            
            (31,000
            )Proceeds
                from the exercise of common stock options and warrants
            
            
            6,813,000
            
            
            737,000Purchase
                of treasury stock
            
            
            (472,000
            )Proceeds
                from the issuance of common stock, net
            
            
            
            
            
            428,000Proceeds
                attributed to warrant derivative liability
            
            
            
            
            
            1,251,000Net
                cash provided by financing activities
            
            
            6,241,000
            
            
            2,364,000Net
                change in cash and cash equivalents
            
            
            4,679,000
            
            
            633,000Effect
                of exchange rate changes on cash and cash equivalents
            
            
            (6,000
            )
            
            (3,000
            )Cash
                and cash equivalents, beginning of period
            
            
            4,961,000
            
            
            3,976,000Cash
                and cash equivalents, end of period
            
            $
            9,634,000
            
            $
            4,606,000






-6-




**ON2
      TECHNOLOGIES, INC.**


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








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




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


*See
      accompanying notes to unaudited condensed consolidated financial
      statements*




-7-




**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL
      STATEMENTS**




(1)
            Description
                of On2 Technologies, Inc.





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




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





(2)
            Basis
                of Presentation





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




The
      interim condensed consolidated financial statements are unaudited. However,
      in
      the opinion of management, such financial statements contain all adjustments
      (consisting of normally recurring accruals) necessary to present fairly the
      financial position of the Company and its results of operations and cash flows
      for the interim periods presented. The condensed consolidated financial
      statements included herein have been prepared pursuant to the rules and
      regulations of the Securities and Exchange Commission (“SEC”). Certain
      information and footnote disclosures normally included in consolidated financial
      statements prepared in accordance with accounting principals generally accepted
      in the United States of America have been condensed or omitted pursuant to
      such
      rules and regulations. The Company believes that the disclosures included herein
      are adequate to make the information presented not misleading. These condensed
      consolidated financial statements should be read in conjunction with the annual
      financial statements and notes thereto, for the year ended December 31, 2006,
      included in the Company's Form 10-K Report filed with the SEC on March 23,
      2007
      as amended April 30, 2007, May 10, 2007 and October 10, 2007.





(3)
            Recently
                Issued Accounting Pronouncements




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




-8-




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




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




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




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




-9-





(4)
            Stock-Based
                Compensation





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





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





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




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




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




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






-10-




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





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





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








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





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





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




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




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




-11-






(5)
            Marketable
                Securities





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




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




(6)
            Deferred
                Acquisition Costs





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




(7)
            Term-loan




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




(8)
            Warrant
                Derivative Liability





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




(9)
            Series
                D Redeemable Convertible Preferred
                Stock





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




-12-





(10)
            Warrants





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




(11)
            Treasury
                Stock





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





(12)
            Customer
                Concentration





For
      the
      three months ended September 30, 2007, two customers accounted for 12% and
      11%
      of revenue, respectively and for the nine months ended September 30, 2007 there
      were no customers that accounted for 10% or greater of revenue. For the three
      months ended September 30, 2006, two customers accounted for 25% and 16% of
      revenue, respectively and for the nine months ended September 30, 2006, two
      customers accounted for 13% and 10% of revenue, respectively.




(13)
            Acquisition
                of Hantro Products Oy





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




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




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




-13-




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




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




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




(14)
            Subsequent
                Events




Sale
      of
      Common Stock





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




-14-




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





**Forward-Looking
      Statement**





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




These
      statements are only predictions, and actual events or results may differ
      materially. The forward-looking statements are based on management’s beliefs and
      assumption using information available at the time. We cannot guarantee future
      results, levels of activity, performance or achievements. Factors that may
      cause
      actual results to differ are often presented with the forward-looking statements
      themselves. Additionally, other risks that may cause actual results to differ
      from predicted results are set forth in “ *Risk
      Factors That May Affect Future Operating Results* "
      in the
      Company's Annual Report on Form 10-K for the year ended December 31, 2006,
      as
      amended and Quarterly Report on Form 10-Q for the quarter ended June 30,
      2007.




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




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




-15-




**Overview**




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




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




-16-




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




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





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




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





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




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




-17-




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




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




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




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




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




-18-




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




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




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




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




-19-




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




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




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




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




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




-20-




**Acquisition
      of Hantro Products**




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




Of
          the
          shares to be delivered to the Hantro security holders at the closing under
          the
          share exchange agreement, 2,000,000 shares were delivered into escrow for
          a
          period of one year from the closing date to secure the indemnification
          obligations of the Hantro security holders. These shares may be canceled
          if On2
          makes a claim for indemnification in accordance with the applicable terms
          of the
          share exchange agreement and the claim is resolved in On2’s favor and monetary
          settlement is not made. At the end of the one-year period, the shares will
          be
          released from escrow and delivered to the Hantro security holders except
          for
          such portion having a value equal to the aggregate dollar amount of all
          the
          outstanding claims for indemnification unresolved at such time. Any dividends
          paid on the escrowed shares during the pendency of the escrow will be added
          to
          the property that the escrow agent holds and will be available for distribution
          under the escrow agreement.
  In
        addition, under the share exchange agreement, On2 is obligated to issue
        additional shares of its common stock to the Hantro security holders if Hantro’s
        net revenue for the fiscal year 2007 exceeds €6,000,000. For example, if
        Hantro’s net revenue for fiscal 2007 is €6,000,000, no additional shares will be
        issued. If the net revenue for fiscal 2007 is €7,000,000, On2 will issue an
        additional 3,333,333 common shares. If the net revenue for fiscal 2007 is
        €8,000,000, On2 will issue an additional 7,500,000 common shares. The maximum
        additional shares which may be issued will be 12,500,000 shares if Hantro’s net
        revenue for 2007 exceeds €9,000,000. Hantro’s net revenue for the fiscal year
        2007 will be calculated based on the net revenue of Hantro and its subsidiary
        as
        if Hantro had continued post-closing on a stand-alone basis independent of
        On2.
        Further, all license, maintenance and support, and services revenue recognizable
        in fiscal year 2007 and associated with (a) all Hantro products based on
        Hantro’s RTL code, and all other H.264, VC1 and similar software licenses and
        royalty payments and (b) all Hantro products with which any of On2’s products
        are integrated (e.g., if VP6 is integrated with a Hantro product and the
        Hantro
        product is sold, the entire revenue amount of such sale) will be included
        in
        Hantro’s net revenue. For the nine-months ended September 30, 2007, Hantro’s net
        sales were €6,327,000. Hantro’s net sales for 2006 were €7,144,000. Of the
        shares to be delivered to the Hantro security holders at the closing under
        the
        share exchange agreement, 2,000,000 shares were delivered into escrow for
        a
        period of one year from the closing date to secure the indemnification
        obligations of the Hantro security holders. These shares may be canceled
        if On2
        makes a claim for indemnification in accordance with the applicable terms
        of the
        share exchange agreement and the claim is resolved in On2’s favor and monetary
        settlement is not made. At the end of the one-year period, the shares will
        be
        released from escrow and delivered to the Hantro security holders except
        for
        such portion having a value equal to the aggregate dollar amount of all the
        outstanding claims for indemnification unresolved at such time. Any dividends
        paid on the escrowed shares during the pendency of the escrow will be added
        to
        the property that the escrow agent holds and will be available for distribution
        under the escrow agreement.
  The
        number of shares issued in the share exchange, including the escrowed shares,
        will be reduced proportionately by the one-for-five reverse stock split that
        On2’s stockholders authorized its board of directors to implement in their
        discretion at On2’s 2007 annual meeting of stockholders held October 10, 2007,
        if such reverse split is effected.
  There
        were no material relationships between On2 and Hantro or their respective
        affiliates outside of the share exchange transaction itself. Mr. Pekka Salanoja,
        who was previously designated by Nexit Ventures Oy, authorized representative
        of
        the Hantro security holders and elected as a director by On2’s stockholders at
        On2’s annual meeting, became a director of On2 when the Hantro acquisition was
        completed.




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





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





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




-21-




Hantro
      offers the following products and services:





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





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




-22-




**Critical
      Accounting Policies and Estimates**





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





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





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





We
      recognize revenue in accordance with The American Institute of Certified Public
      Accountants, Statement of Position (“SOP 97-2”), “SOFTWARE REVENUE RECOGNITION”
SOP 97-2, as amended by SOP 98-4, “DEFERRAL OF THE EFFECTIVE DATE OF SOP 97-2,
      SOFTWARE REVENUE RECOGNITION” and SOP 98-9, “MODIFICATION OF SOP 97-2 WITH
      RESPECT TO CERTAIN TRANSACTIONS” (“SOP 98-9”). 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 support fee renewal rate). Most of our license
      agreements offer additional PCS at a stated price. Revenue is recognized on
      a
      per copy basis for licensed software when each copy of the licensed software
      purchased by the customer or reseller is delivered. We do not allow returns,
      exchanges or price protection for sales of software licenses to our customers
      or
      resellers, and we do not allow our resellers to purchase software licenses
      under
      consignment arrangements.




-23-





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





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





*Equity-Based
      Compensation* The
      Company adopted the provisions of the Financial Accounting Standards Board
      (“FASB”), Statement of Financial Accounting Standard (“SFAS No. 123R”) effective
      January 1, 2006, using the modified prospective transition method. We recognize
      share-based compensation cost associated with awards subject to graded vesting
      in accordance with the accelerated method specified in FASB Interpretation
      No.
      28 pursuant to which each vesting tranche is treated as a separate award. The
      compensation cost associated with each vesting tranche is recognized as expense
      evenly over the vesting period of that tranche. The significant assumptions
      used
      in calculating the compensation cost for the nine months ended September 30,
      2007 are as follows: expected stock price volatility was 94%, expected life
      of
      the options was 5 years, risk free interest rate was 4.95% and the expected
      dividend yield was 0%.





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




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





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




**Results
      of Operations**





*Revenue.* Revenue
      for the three months ended September 30, 2007 was $2,566,000 as compared to
      $1,703,000 for the three months ended September 30, 2006. Revenue for the nine
      months ended September 30, 2007 was $7,935,000 as compared to $4,455,000 for
      the
      nine months ended September 30, 2006. Revenue for the three and nine months
      ended September 30, 2007 and 2006 was derived primarily from the sale of
      software licenses, engineering and consulting services and royalties. The
      increase in revenue for the three and nine months ended September 30, 2007
      is
      primarily attributed to increases in sales of our Flix products.




-24-





*Operating
      Expenses.* The
      Company's operating expenses consist of cost of revenue, research and
      development, sales and marketing, general and administrative expenses and equity
      based compensation. Operating expenses for the three months ended September
      30,
      2007 were $3,052,000 as compared to $2,290,000 for the three months ended
      September 30, 2006. Operating expenses were $8,370,000 for the nine months
      ended
      September 30, 2007 as compared to $7,738,000 for the nine months ended September
      30, 2006.





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





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




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




*General
      and Administrative* .
      General
      and administrative expenses excluding equity-based compensation, consist
      primarily of salaries and related overhead costs for general corporate functions
      including finance, human resources, legal, information technology, facilities,
      outside legal and professional fees and insurance. General and administrative
      expenses for the three months ended September 30, 2007 were $1,146,000 as
      compared with $843,000 for the three months ended September 30, 2006. General
      and administrative expenses for the nine months ended September 30, 2007 were
      $3,085,000 as compared with $3,383,000 for the nine months ended September
      30,
      2006. The increase for the three months ended September 30, 2007 is primarily
      due to increases in legal and professional fees, consulting fees for compliance
      with Sarbanes-Oxley, Section 404, stock listing fees, salaries and related
      overhead.  The
      decrease for the nine months ended September 30, 2007 is primarily attributable
      to a $717,000 decrease in legal fees that were incurred in 2006 in connection
      with the Company’s internal investigation into facts and circumstances
      concerning investor and other communications made by the Company’s former
      Chairman, Chief Executive Officer and President. This was partially offset
      by
      increases in salaries and related benefit costs, consulting services related
      to
      the Company’s compliance with Sarbanes-Oxley, Section 404 and professional fees
      associated with the Company’s proxy statement and annual report.




-25-





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





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





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





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





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





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





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





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








At
      September 30, 2007, the Company had approximately 39 full-time employees. We
      expect to hire employees as necessary in order to attain our strategic
      objectives.




-26-




**Liquidity
      and Capital Resources**





At
      September 30, 2007, the Company had a cash balance of $9,634,000 as compared
      to
      $4,961,000 at December 31, 2006. At September 30, 2007, the Company had working
      capital of $10,141,000 as compared with $5,268,000 at December 31, 2006.





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





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





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





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





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




-27-





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





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.





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




**Off-Balance
      Sheet Arrangements**





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





**Impact
      of Recently-Issued Accounting Pronouncements**





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




-28-





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





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





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





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





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





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




-29-





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





**Item
      4. Controls and Procedures**





(a)
            Evaluation
                of Disclosure Controls and
                Procedures:





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





(b)
            Changes
                in Internal Controls:




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





-30-




**PART
      II — OTHER INFORMATION**




**Item
      1. Legal Proceedings**





**Internal
      Investigation**





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





**Beijing
      E-World**





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





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





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





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





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





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




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





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





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




-31-





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





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





**Item
      6. Exhibits**




31.1
            Certification
                by the Chief Executive Officer pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002




31.2
            Certification
                by the Chief Financial Officer pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002




32.1
              Certification
                  of Principal Executive Officer pursuant to Section 906 of the
                  Sarbanes-Oxley Act of 2002
  32.2
                Certification
                    of Principal Financial Officer pursuant to Section 906 of the
                    Sarbanes-Oxley Act of
                    2002




-32-




**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.**Date: November
              14, 2007
            By:
            /s/ ANTHONY
              PRINCIPEAnthony
                Principe
              Senior Vice President and Chief Financial
                Officer
              (Principal Financial
                Officer)






-33-