**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-QSB**

** **

**(Mark One)**

 

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

** **

**Forthe quarterly period ended September 30, 2001.**

 

| **o** | **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 registrantas specified in its charter)

 

| **Delaware**                                                                        |   | **84-1280679**                        |
|-------------------------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization)                     |   | (I.R.S. Employer  Identification No.) |
|                                                                                |   |                                  |
| **145  Hudson Street, New York, New York**                                          |   | **10013**                             |
| (Address of principal  executive offices)                                           |   | (Zip Code)                            |
|                                                                                |   |                                  |
| **(917)  237-0500**                                                                 |
| (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) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.                      ý Yes     o No

 

**APPLICABLEONLY TO ISSUERS INVOLVED IN BANKRUPTCY**

**PROCEEDINGSDURING THE PRECEDING FIVE YEARS**:

 

Indicate by check mark whether the registrant hasfiled 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 ofsecurities under a plan confirmed by a court.  

                                                                                                                                o Yes     o No

 

**APPLICABLEONLY TO CORPORATE ISSUERS:**

 

State the number of shares outstanding of each of theissuer’s classes of common equity, as of the latest practicable date:

 

The number of shares of the Registrant’s Common Stock, par value $0.01(“Common Stock”), outstanding as of November 12, 2001 was 37,040,585.

 

Transitional Small Business Disclosure Format (Check one):     oYes     ýNo

 

** **

**Table of Contents**

 
| **PART I — FINANCIAL INFORMATION**                                                                              |
|----------------------------------------------------------------------------------------------------------------------|
|                                                                                                                 |   |
| Item  1.                                                                                                             | Unaudited  Condensed Consolidated Financial Statements. |
|                                                                                                                 |   |
| Condensed  Consolidated Balance Sheets at September 30, 2001 (Unaudited) and December  31, 2000                      |
| Unaudited  Condensed Consolidated Statements of Operations, Three and Nine Months Ended  September 30, 2001 and 2000 |
| Unaudited Condensed  Consolidated Statements of Cash Flows Nine Months Ended September 30, 2001  and 2000            |
| Notes to Unaudited Condensed  Consolidated Financial Statements                                                      |
|                                                                                                                 |   |
| Item 2.                                                                                                              | Management’s Discussion and  Analysis of Financial Condition and Results of Operations |
|                                                                                                                 |   |
| Item 3.                                                                                                              | Qualitative and  Quantitative Disclosures About Market Risk |
|                                                                                                                 |   |
| **PART II —  OTHER INFORMATION**                                                                                |
|                                                                                                                 |   |
| Item 1.                                                                                                              | Legal Proceedings |
|                                                                                                                 |   |
| Item 2.                                                                                                              | Changes in Securities |
|                                                                                                                 |   |
| Item 4.                                                                                                              | Submission of Matters to a Vote  of Security Holders |
|                                                                                                                 |   |
| Item 6.                                                                                                              | Exhibits and Reports on Form 8-K |
|                                                                                                                 |   |
| Signatures                                                                                                           |

 

**PART I — FINANCIAL INFORMATION**

 

Item 1.  Unaudited Condensed Consolidated FinancialStatements

 

**ON2TECHNOLOGIES, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

 
|                                             |   | **September  30, 2001** |      | **December 31, 2000** |   |
|--------------------------------------------------|--------|-------------------------|-----------|-----------------------|--------|
|                                             |   | **(unaudited)**         |      |                  |   |
| **ASSETS**                                       |   |                    |      |                  |   |
|                                             |   |                    |      |                  |   |
| Current assets:                                  |   |                    |      |                  |   |
| Cash  and cash equivalents                       |   | $                       | 575,956   |                  | $      | 1,561,495 |   |
| Accounts  receivable                             |   | 369,027                 |      | 392,943               |   |
| Prepaid  and other current assets                |   | 356,303                 |      | 566,540               |   |
|                                             |   |                    |      |                  |   |
| Total  current assets                            |   | 1,301,286               |      | 2,520,978             |   |
|                                             |   |                    |      |                  |   |
| Property  and equipment, net                     |   | 1,639,609               |      | 2,522,188             |   |
| Goodwill  and other intangible assets, net       |   | 3,844,819               |      | 5,747,842             |   |
| Other  assets                                    |   | 403,772                 |      | 419,049               |   |
|                                             |   |                    |      |                  |   |
| Total  assets                                    |   | $                       | 7,189,486 |                  | $      | 11,210,057 |   |
|                                             |   |                    |      |                  |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**   |   |                    |      |                  |   |
|                                             |   |                    |      |                  |   |
| Current  liabilities:                            |   |                    |      |                  |   |
| Accounts  payable                                |   | $                       | 448,277   |                  | $      | 1,509,401 |   |
| Accrued  expenses                                |   | 423,719                 |      | 769,221               |   |
| Notes  payable                                   |   | —                  |      | 251,311               |   |
| Deferred  revenue                                |   | 25,047                  |      | 72,604                |   |
| Capital  lease obligations                       |   | —                  |      | 26,100                |   |
|                                             |   |                    |      |                  |   |
| Total  current liabilities                       |   | 897,043                 |      | 2,628,637             |   |
| Convertible  debentures                          |   | 1,963,344               |      | —                |   |
|                                             |   |                    |      |                  |   |
| Commitments  and contingencies                   |   |                    |      |                  |   |
|                                             |   |                    |      |                  |   |
| Stockholders’  equity:                      |   |                    |      |                  |   |
| Preferred  stock                                 |   | 86,242                  |      | 50,528                |   |
| Common  stock                                    |   | 354,074                 |      | 276,842               |   |
| Additional  paid-in capital                      |   | 98,721,051              |      | 86,293,786            |   |
| Deferred  compensation                           |   | —                  |      | (47,410               | )      |
| Accumulated  other comprehensive loss            |   | (8,399                  | )         | (3,966                | )      |
| Accumulated  deficit                             |   | (94,823,869             | )         | (77,988,360           | )      |
|                                             |   |                    |      |                  |   |
| Total  stockholders’ equity                 |   | 4,329,099               |      | 8,581,420             |   |
|                                             |   |                    |      |                  |   |
| Total  liabilities and stockholders’ equity |   | $                       | 7,189,486 |                  | $      | 11,210,057 |   |

 

*Seeaccompanying notes to unaudited condensed consolidated financial statements*

 

**ON2TECHNOLOGIES, INC.**

**UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

 
|                                                          |   | **Three Months Ended September 30,** |       | **Nine Months Ended September 30,** |   |
|---------------------------------------------------------------|--------|--------------------------------------|------------|-------------------------------------|--------|
|                                                          |   | **2001**                             |       | **2000**                            |   | **2001** |   | **2000** |   |
|                                                          |   |                                 |       |                                |   |   |   |   |   |
| Revenues                                                      |   | $                                    | 497,556    |                                | $      | 289,750 |   | $ | 1,301,504 |   | $ | 618,724 |   |
|                                                          |   |                                 |       |                                |   |   |   |   |   |
| Operating  expenses:                                          |   |                                 |       |                                |   |   |   |   |   |
| Research  and development                                     |   | 1,132,045                            |       | 2,590,394                           |   | 4,526,418 |   | 8,715,055 |   |
| Sales  and marketing                                          |   | 332,787                              |       | 995,496                             |   | 1,744,598 |   | 5,386,091 |   |
| General  and administrative                                   |   | 1,513,803                            |       | 2,785,993                           |   | 5,163,082 |   | 8,054,912 |   |
| Impairment  charges                                           |   | 83,333                               |       | —                              |   | 533,333 |   | — |   |
| Restructuring  charges                                        |   | —                               |       | —                              |   | 293,200 |   | — |   |
| Non-cash  stock based compensation                            |   | 43,707                               |       | —                              |   | 143,707 |   | 11,557,883 |   |
|                                                          |   |                                 |       |                                |   |   |   |   |   |
| Total  operating expenses                                     |   | 3,105,675                            |       | 6,371,883                           |   | 12,404,338 |   | 33,713,941 |   |
|                                                          |   |                                 |       |                                |   |   |   |   |   |
| Loss  from operations                                         |   | (2,608,119                           | )          | (6,082,133                          | )      | (11,102,834 | ) | (33,095,217 | ) |
|                                                          |   |                                 |       |                                |   |   |   |   |   |
| Interest  and other income (expense):                         |   |                                 |       |                                |   |   |   |   |   |
| Interest  and other income                                    |   | 6,793                                |       | 72,703                              |   | 55,464 |   | 525,858 |   |
| Interest  and other expense                                   |   | (484,051                             | )          | (3,418                              | )      | (1,610,821 | ) | (30,414 | ) |
|                                                          |   |                                 |       |                                |   |   |   |   |   |
| Other  income (expense), net                                  |   | (477,258                             | )          | 69,285                              |   | (1,555,357 | ) | 495,444 |   |
|                                                          |   |                                 |       |                                |   |   |   |   |   |
| Loss  before provision for income taxes                       |   | (3,085,377                           | )          | (6,012,848                          | )      | (12,658,191 | ) | (32,599,773 | ) |
|                                                          |   |                                 |       |                                |   |   |   |   |   |
| Provision  for income taxes                                   |   | 16,652                               |       | 16,128                              |   | 47,502 |   | 84,140 |   |
|                                                          |   |                                 |       |                                |   |   |   |   |   |
| Net  loss                                                     |   | (3,102,029                           | )          | (6,028,976                          | )      | (12,705,693 | ) | (32,683,913 | ) |
|                                                          |   |                                 |       |                                |   |   |   |   |   |
| Non-cash  convertible preferred stock dividend                |   | 2,600,878                            |       | 292,624                             |   | 4,129,816 |   | 5,700,926 |   |
|                                                          |   |                                 |       |                                |   |   |   |   |   |
| Net  loss attributable to common  stockholders                |   | $                                    | (5,702,907 | )                                   | $      | (6,321,600 | ) | $ | (16,835,509 | ) | $ | (38,384,839 | ) |
|                                                          |   |                                 |       |                                |   |   |   |   |   |
| Basic  and diluted net loss per common share                  |   | $                                    | (0.16      | )                                   | $      | (0.24 | ) | $ | (0.53 | ) | $ | (1.50 | ) |
|                                                          |   |                                 |       |                                |   |   |   |   |   |
| Weighted  average basic and diluted common shares outstanding |   | 35,003,671                           |       | 26,896,160                          |   | 31,738,183 |   | 25,611,297 |   |

 

*Seeaccompanying notes to unaudited condensed consolidated financial statements*

 

**ON2TECHNOLOGIES, INC.**

**UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
|                                                                         |   | **Nine  Months Ended September 30,** |        |
|------------------------------------------------------------------------------|--------|--------------------------------------|-------------|
|                                                                         |   | **2001**                             |        | **2000** |   |
|                                                                         |   |                                 |        |   |   |
| Cash flows from  operating activities:                                       |   |                                 |        |   |   |
|                                                                         |   |                                 |        |   |   |
| Net loss                                                                     |   | $                                    | (12,705,693 | ) | $ | (32,683,913 | ) |
| Adjustments to reconcile net loss to net cash  used in operating activities: |   |                                 |        |   |   |
| Non-cash stock based compensation                                            |   | 143,707                              |        | 11,557,883 |   |
| Depreciation and amortization                                                |   | 2,387,135                            |        | 2,345,164 |   |
| Amortization of debt discount                                                |   | 1,603,397                            |        | — |   |
| Deferred compensation                                                        |   | 44,570                               |        | 37,075 |   |
| Restructuring and impairment charges                                         |   | 826,533                              |        | — |   |
| Impairment of equity investments                                             |   | 125,000                              |        | — |   |
| Reserve for bad debt                                                         |   | 92,666                               |        | — |   |
| Changes  in operating assets and liabilities, net of effect of acquisitions: |   |                                 |        |   |   |
| Accounts receivable, net                                                     |   | (118,751                             | )           | (64,755 | ) |
| Prepaid and other current assets                                             |   | 110,237                              |        | (283,395 | ) |
| Other assets                                                                 |   | 12,302                               |        | 26,675 |   |
| Accounts payable and accrued expenses                                        |   | (1,372,991                           | )           | (332,577 | ) |
| Deferred revenue                                                             |   | (47,557                              | )           | 185,604 |   |
|                                                                         |   |                                 |        |   |   |
| Net cash used in operating activities                                        |   | (8,899,445                           | )           | (19,212,239 | ) |
|                                                                         |   |                                 |        |   |   |
| Cash flows from  investing activities:                                       |   |                                 |        |   |   |
|                                                                         |   |                                 |        |   |   |
| Purchases of property and equipment                                          |   | (89,479                              | )           | (2,187,211 | ) |
| Proceeds from the sale of fixed assets                                       |   | 25,000                               |        | — |   |
| Advances to affiliates                                                       |   | —                               |        | (952,000 | ) |
| Cash paid for acquisitions, net of cash  acquired                            |   | (42,415                              | )           | (241,551 | ) |
|                                                                         |   |                                 |        |   |   |
| Net cash used in investing activities                                        |   | (106,894                             | )           | (3,380,762 | ) |
|                                                                         |   |                                 |        |   |   |
| Cash flows from financing activities:                                        |   |                                 |        |   |   |
|                                                                         |   |                                 |        |   |   |
| Principal payments on capital lease  obligations                             |   | (26,100                              | )           | (35,232 | ) |
| Principal payments on notes payable                                          |   | (251,311                             | )           | — |   |
| Principal payments on notes payable to  stockholders                         |   | —                               |        | (355,000 | ) |
| Proceeds from the issuance of Series C  Preferred Stock, net                 |   | —                               |        | 9,990,825 |   |
| Proceeds from the issuance of Series C-II Preferred  Stock, net              |   | —                               |        | 2,450,000 |   |
| Proceeds from the issuance of Series C-VI  Preferred Stock, net              |   | 2,000,000                            |        | — |   |
| Proceeds from the sale of common stock                                       |   | 4,289,140                            |        | — |   |
| Proceeds from the issuance of convertible  debentures                        |   | 2,000,000                            |        | — |   |
| Proceeds from exercise of common stock options  and warrants                 |   | 13,500                               |        | 494,451 |   |
|                                                                         |   |                                 |        |   |   |
| Net cash provided by financing activities                                    |   | 8,025,229                            |        | 12,545,044 |   |
| Effect of exchange rate changes on cash and  cash equivalents                |   | (4,429                               | )           | (3,599 | ) |
|                                                                         |   |                                 |        |   |   |
| Net change in cash and cash equivalents                                      |   | (985,539                             | )           | (10,051,556 | ) |
|                                                                         |   |                                 |        |   |   |
| Cash and cash equivalents, beginning of period                               |   | 1,561,495                            |        | 15,083,419 |   |
| Cash and cash equivalents, end of period                                     |   | $                                    | 575,956     |   | $ | 5,031,863 |   |

** **

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

** **
|                                              |   | **Nine  Months Ended September 30,** |   |
|---------------------------------------------------|--------|--------------------------------------|--------|
|                                              |   | **2001**                             |   | **2000** |   |
|                                              |   |                                 |   |   |   |
| Cash paid during the period for:                  |   |                                 |   |   |   |
| Interest                                          |   | $                                    | 7,620  |   | $ | 27,393 |   |
| Taxes                                             |   | $                                    | 30,862 |   | $ | 72,191 |   |
| Acquisition of fixed assets under capital  leases |   | $                                    | — |   | $ | 72,750 |   |

 

*Seeaccompanying notes to unaudited condensed consolidated financial statements*

 

**ON2 TECHNOLOGIES, INC.**

**NOTES TO UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

 

 

*(1)   Organization and Summary of SignificantAccounting Policies*

 

(a) Description of On2 Technologies, Inc.

 

On2 Technologies, Inc. (“On2” or the “Company”) hasdeveloped proprietary video compression and streaming technology that combinesthe classic elements of television with the interactivity of the Internet or consumerelectronic devices for delivery to broadband end users.  The Company’s business model is to providebroadband video encoding, streaming and hosting services, broadband consultingand engineering services and to license its proprietary broadband technologysolutions to owners of video content and consumer electronic devices who wantto distribute television quality video images to broadband end users.  On May 22, 2001, the Company’s shareholdersapproved changing the name of the Company from On2.com Inc. to On2Technologies, Inc.

 

The Company’s business is characterized by rapidtechnological change, new product development and evolving industrystandards.  Inherent in the Company’sbusiness model are various risks and uncertainties, including its limitedoperating history, unproven business model and the limited history of broadbandtechnology services on the Internet. The Company’s success may depend, in part, upon the emergence of theInternet as a communications medium, prospective product and servicedevelopment efforts, and the acceptance of the Company’s broadband technologysolutions by the marketplace.

 

(b) Basis of Presentation

 

The unaudited condensed consolidated financialstatements include the accounts of the Company and its wholly owned subsidiariesfrom their respective dates of acquisition. All significant intercompany balances and transactions have beeneliminated in consolidation.

 

The interimcondensed consolidated financial statements are unaudited. However, in theopinion of management, the interim data include all adjustments, consistingonly of normal, recurring adjustments, necessary for a fair presentation of theconsolidated results for the interim periods. The condensed consolidatedfinancial statements included herein have been prepared pursuant to the rulesand regulations of the Securities and Exchange Commission (“SEC”). Certaininformation and footnote disclosures normally included in consolidatedfinancial statements prepared in accordance with generally accepted accountingprinciples have been condensed or omitted pursuant to such rules andregulations. The Company believes that the disclosures included herein areadequate to make the information presented not misleading. These condensedconsolidated financial statements should be read in conjunction with the annualfinancial statements and notes thereto included in the Company's Form 10-KSBReport filed with the SEC on April 2, 2001.

 

(c)  Goodwill and OtherIntangible Assets

 

Goodwill and otherintangible assets primarily relate to the acquisitions of MetaVisual CreationsLimited (“Metavisual”) and Eight Cylinder Studios, Inc. (“8CS”). The underlyingworkforce related to the Metavisual acquisition is integral to the Company’sproduct development and revenue generating activities.  The Company is currently reviewing thedirection it will take with regards to the technology and applications acquiredwith its acquisition of 8CS during November 2000.  Management currently believes that the technology and assetsacquired in both acquisitions are realizable and in alignment with theCompany’s current business model.

 

 (d) Reclassifications

 

Certainreclassifications have been made to the prior year’s condensed consolidatedfinancial statements to conform to the current year’s presentation.

 

*(2)    Propertyand Equipment*

 
|                                           |   | **September  30, 2001** |      | **December  31, 2000** |   |
|------------------------------------------------|--------|-------------------------|-----------|------------------------|--------|
|                                           |   |                    |      |                   |   |
| Furniture and fixtures                         |   | $                       | 277,997   |                   | $      | 277,997 |   |
| Computer equipment                             |   | 2,846,494               |      | 2,775,296              |   |
| Leasehold improvements                         |   | 487,348                 |      | 527,348                |   |
| Licensed software                              |   | 907,388                 |      | 851,570                |   |
|                                           |   |                    |      |                   |   |
|                                           |   | 4,519,227               |      | 4,432,211              |   |
|                                           |   |                    |      |                   |   |
| Less accumulated depreciation and amortization |   | 2,879,618               |      | 1,910,023              |   |
|                                           |   |                    |      |                   |   |
| Total                                          |   | $                       | 1,639,609 |                   | $      | 2,522,188 |   |
|                                                |        |                         |           |                        |        |  |  |  |  |

 

As of September 30, 2001, property and equipment included assets undercapital leases of $90,721 with related accumulated depreciation of$54,176.  As of December 31, 2000,property and equipment included assets under capital leases of $90,721 withrelated accumulated depreciation of $33,289.

 

*(3)    Notes Payable*

 

In connection with its acquisition of Eight CylinderStudios, Inc. in November 2000, the Company assumed a note payable in theamount of $325,254.  Based upon theterms of the note, the Company paid $75,000 on December 15, 2000, at which timeinterest began to accrue at an annual rate of 9.50%.  The Company made payments of $65,000 on each of January 15, 2001,February 15, 2001 and March 15, 2001. Final payment of $62,889 was made on April 15, 2001 and included allunpaid principal and interest.

 

*(4)    Convertible Debentures*

 

In January 2001, the Company entered into a financingagreement with an existing shareholder of the Company whereby the Company wouldreceive up to $2,000,000 in exchange for Series A Convertible Debentures(“Debentures”) and warrants to purchase shares of Common Stock.  The timing of and the dollar value ofamounts received under this financing arrangement are required to equal amountsreceived and coincide with investments by others in the Company, up to amaximum of $2,000,000.

 

Under the terms of the agreement, the Debenturesconsist of 200 units, which are comprised of (1) $10,000 principal amount ofDebentures and (2) one warrant to purchase 6,667 shares of Common Stock at anexercise price of $1.68.  The principalamount of the Debentures can be converted into shares of Common Stock at aconversion price of $0.45.  Theprincipal amount of the Debentures are due 4 years from the date of issuanceand can be converted into shares of Common Stock six months after the date ofissuance at the discretion of the holder.

 

As of September 30, 2001, the Company had received thefull $2,000,000 under the Debenture agreement. The Company allocated the proceeds received to the principal amount ofthe Debentures and the warrants based upon the relative fair value method.  The difference between the relative fairvalue of the Debentures and the proceeds received was recorded as a debtdiscount.  The total amount of the debtdiscount is limited to the total proceeds received.  The initial amount of the debt discount recorded was$1,640,054.  Amortization of the debtdiscount included in interest expense for the three and nine months endedSeptember 30, 2001 was $484,051 and $1,603,397, respectively.

 

* (5)   Stockholders’ Equity*

 

(a)   PreferredStock

 

SeriesC Convertible Preferred Stock

 

The Travelers Indemnity Company (“Travelers”), theholders of the Series C Preferred Stock, was granted pricing protection on itsinvestment regarding certain subsequent investments in the Company.  These pricing protections were triggered bythe investments in the Series C-II and Series C-III Preferred Stock describedbelow and allows for the following:

 

Upon the earlier of (i) a change of control or (ii)December 31, 2001, the Company will (a) cancel the Series C Preferred and inits place issue 1,849,057 shares of Series C-IV Preferred Stock, par value$0.01 per share, with a conversion price of $2.65, and 4,099,678 shares ofSeries C-V Preferred Stock, par value $0.01 per share, with a conversion priceof $1.244, and (b) cancel the warrants issued in connection with the Series CPreferred Stock and in their place issue 462,264 warrants with an exerciseprice of $2.65 and 1,024,920 warrants with an exercise price of $1.14.  Travelers is not entitled to any furtherpricing protections.

 

Additionally, Travelers is entitled to certainanti-dilution protections.  Theanti-dilution provisions primarily adjust the conversion price of the SeriesC-IV and Series C-V Preferred Stock and the number and exercise price of thewarrants.  The anti-dilution provisionfor the Series C-IV and Series C-V Preferred Stock was triggered by certainsubsequent debt and equity financings consummated by the Company.  As of September 30, 2001, the conversionprice of the Series C-IV Preferred Stock was adjusted to $1.90, the Companywill issue 182,477 additional warrants and the exercise price of the warrantswill be reduced to $1.90.  Additionally,as of September 30, 2001, the conversion price of the Series C-V PreferredStock was adjusted to $0.9756, the Company will issue 271,543 additionalwarrants and the exercise price of the warrants will be reduced to$0.9012.  The Company recorded a deemednon-cash convertible preferred stock dividend for the three and nine monthsended September 30, 2001 of $410,281 and $1,160,032, respectively, to recognizethe additional benefit to be received by Travelers.

 

SeriesC-II Convertible Preferred Stock

 

The holders of the Series C-II Preferred Stock areentitled to certain anti-dilution protections, triggered by certain subsequentissuances of debt or equity by the Company. The anti-dilution provision primarily adjusts the conversion price ofthe Series C-II Preferred Stock and the number and exercise price of theoriginal warrants issued.  Theanti-dilution provision for the Series C-II Preferred Stock was triggered bycertain subsequent debt and equity financings consummated by the Company.  As of September 30, 2001, the conversionprice of the Series C-II Preferred Stock was adjusted to $1.90, the Companyissued an additional 156,334 warrants and the exercise price of the warrantswas reduced to $1.90.  The Companyrecorded a deemed non-cash convertible preferred stock dividend for the threeand nine months ended September 30, 2001 of $712,001 and $1,086,206,respectively, to record the additional benefit received by the Series C-IIInvestors.

 

SeriesC-III Convertible Preferred Stock

 

The holders of the Series C-III Preferred Stock areentitled to certain anti-dilution protections, triggered by certain subsequentissuances of debt or equity by the Company. The anti-dilution provision primarily adjusts the conversion price ofthe Series C-III Preferred Stock and the number and exercise price of theoriginal warrants issued.  Theanti-dilution provision for the Series C-III Preferred Stock was triggered bycertain subsequent debt and equity financings consummated by the Company.  As of September 30, 2001, the conversionprice of the Series C-III Preferred Stock was adjusted to $0.9756, the Companyissued an additional 168,357 warrants and the exercise price of the warrantswas reduced to $0.9012.  The Companyrecorded a deemed non-cash convertible preferred stock dividend for the threeand nine months ended September 30, 2001 of $551,262 and $956,244,respectively, to record the additional benefit received by the Series C-IIIInvestors.

 

SeriesC-VI Convertible Preferred Stock

 

On July 18, 2001, the Company entered into a UnitPurchase Agreement with Travelers whereby it sold an aggregate of 3,571,429units that consisted of one share of the Company’s Common Stock and a warrantto purchase 1.5 shares of the Company’s Common Stock.  The Company received net proceeds of $2,000,000.  On August 10, 2001, the Company entered intoa new agreement with Travelers, rescinding the Unit Purchase Agreement andproviding that Travelers receive 3,571,429 shares of preferred stock, whichwere not convertible into the Company’s Common Stock for a period of sixmonths.  Each share of Series C-VIPreferred Stock converts on a one-for-one basis into shares of the Company’sCommon Stock.  In addition, the Companyissued to Travelers a warrant to purchase 5,357,144 shares of the Company’sCommon Stock that cannot be exercised for a period of six months.  The exercise price of the warrant is $0.56and the warrant expires on July 18, 2005.

 

The Series C-VI Convertible Preferred Stock includes aliquidation preference. In the event of any liquidation, dissolution or windingup of the Company, either voluntary or involuntary, the holders of shares ofSeries C-VI Convertible Preferred Stock are entitled to receive an amount equalto $0.56 per share. The liquidationprice per share would be paid out of the assets of the Company available fordistribution prior to any payments made on any shares of the Company’s CommonStock or any other capital stock other than the Preferred Stock.

 

The aggregate fair market value of the Series C-VIPreferred on July 18, 2001 was $2,000,000, based upon the fair market value ofthe Company’s Common Stock on that date. Additionally, the fair market value of the warrants issued, ascalculated using the Black Scholes pricing model, was $1,729,027.  In accordance with EITF 98-5, the Companyallocated the net proceeds between the Series C-VI Preferred Stock and thewarrants based on the relative fair value method as described in APB No.14.  The Company allocated $1,072,666 tothe Series C-VI Preferred and recorded $927,334 of additional paid-in-capitalto account for the issuance of the warrants. The difference between the net proceeds allocated to, and the fairmarket value of, the Series C-VI Preferred on the closing date, which amountedto $927,334, was recorded as a non-cash convertible preferred stock dividend inaccordance with EITF 98-5.

 

(b)Common Stock

 

Equity-Line of Credit

 

In December 2000, the Company entered into a commonstock purchase agreement (“Stock Purchase Agreement”) with an accreditedinvestor (“Investor”), for the sale, from time to time, of the Company’s CommonStock.  Pursuant to the Stock PurchaseAgreement, the Investor has committed to purchase up to $23,000,000 of CommonStock over a 36 month period.  TheInvestor may be required to invest an additional $17,000,000 upon theattainment of certain trading volumes and weighted average market prices in theCompany’s Common Stock.  However, theCompany’s ability to procure funds through the Stock Purchase Agreement mayalso be limited or prohibited based on certain trading volumes and weightedaverage market prices in the Company’s Common Stock.

 

Under the Stock Purchase Agreement, shares of CommonStock are periodically sold to the Investor at a discount from market valueranging from 6%-10%, depending on the closing price of the Company’s CommonStock.  The amount of Common Stock soldis at the sole discretion of the Company and at no time throughout the term ofthe Stock Purchase Agreement is the Company obligated to sell its Common Stock,unless the Company issues a draw-down notice. The Company issued warrants to purchase 50,000 shares of the Company’sCommon Stock and incurred $25,000 of transaction costs in connection with theStock Purchase Agreement.  As ofSeptember 30, 2001, the Company had sold approximately 5,458,965 shares ofCommon Stock for net proceeds of $3,289,140 under the Stock Purchase Agreement.

 

On May 22, 2001, the Company’s shareholders approvedthe sale, at the sole discretion of the Company, of up to 15,500,000 shares ofCommon Stock in connection with the Stock Purchase Agreement.  The 15,500,000 shares include the shares ofCommon Stock issued to the Investor and outstanding as of September 30, 2001.

 

Investment byRealNetworks, Inc.

 

On July 18, 2001, the Company entered into aDevelopment and Services License Agreement and Common Stock Purchase Agreementwith RealNetworks, Inc. whereby RealNetworks invested in the Company andlicensed its proprietary VP4 compression technology.  Pursuant to the agreements, RealNetworks received 1,785,714shares of the Company’s Common Stock, subject to adjustments to preventdilution, and the Company received net proceeds of $1,000,000.  The shares were issued to RealNetworks, Inc.at the fair market value at the time of the transaction.

 

 *(6)   Restructuringand Impairment Charges*

 

In December 2000, in connection with certain costsaving and corporate restructuring initiatives, the Company’s Board ofDirector’s approved a plan that included the sale of certain content-related,non-strategic assets that would no longer be used in the operations of theCompany, closing the Company’s offices in San Francisco and Los Angeles and areduction in the Company’s workforce.

 

As a result of these initiatives, the Companyrecorded a non-cash restructuring charge of $293,200 in the first quarter of2001.  The non-cash restructuring chargewas comprised of the following: (1) $210,000 related to the termination of anemployment contract which was satisfied through the issuance of 150,000 sharesof Common Stock in February 2001 and (2) $83,200 related to the termination ofa commercial lease obligation in San Francisco which was satisfied through theissuance of 80,000 shares of Common Stock in March 2001.  The agreements were consummated subsequentto fiscal year end 2000 and the obligations of the Company could not bemeasured at December 31, 2000.

 

For three and nine months ended September 30, 2001,the Company recorded an impairment charge of $20,000 and $470,000,respectively, related to its Quickband content library.  The Company is actively pursuing the sale ofits Quickband content library and recorded the impairment charge to reflect thefair market value of the library as of September 30, 2001.

 

The Company recorded a charge of $63,333 related toa trademark that would no longer be used by the Company.  The write-off reflected the net book valueof the asset at the time it was no longer deemed to have value.

 

* (7)   2001**Employee**Stock Purchase Plan*

 

InFebruary 2001, the Board of Directors adopted the 2001 Employee Stock PurchasePlan (“ESPP”).  The ESPP will provideeligible employees of the Company the opportunity to apply a portion of theirafter tax compensation to the purchase of shares of the Company’s Common Stockat a 15% discount from market value. The Company will reserve 4,000,000 authorized but unissued shares of CommonStock for issuance under the ESPP.  TheESPP was approved at the Company’s Annual Meeting of Shareholders on May 22,2001.

 

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

 

This document contains forward-looking statementswithin the meaning of Section 27A of the Securities Act of 1933 and Section 21Eof the Securities Exchange Act of 1934. These statements relate to future events or our future financialperformance and are not statements of historical fact.  In some cases, you can identify forward-lookingstatements by terminology such as "may," "will,""should," "expect," "plan,""anticipate," "believe," "estimate,""predict," "potential," “objective,” “forecast,” “goal” or"continue," the negative of such terms, or other comparable terminology.  These statements are only predictions, andactual events or results may differ materially. Although we believe that theexpectations reflected in the forward-looking statements are reasonable, wecannot guarantee future results, levels of activity, performance orachievements, and in all cases, such statements are subject to the Company’sability to secure additional financing or to increase revenues to support itsoperations.  If the Company cannotsecure additional financing or increase its revenues to support its operations,the Company’s status as a going concern will remain in doubt. In this regard,the business and operations of the Company are subject to substantial risksthat increase the uncertainty inherent in the forward-looking statements containedin this Form 10-QSB.  In evaluating theCompany’s business, you should give careful consideration to the informationset forth herein.

 

The inclusion ofthe forward-looking statements should not be regarded as a representation bythe Company, or any other person, that such forward-looking statements will beachieved.  We undertake no duty toupdate any of the forward-looking statements, whether as a result of newinformation, future events or otherwise. In light of the foregoing, readers arecautioned not to place undue reliance on the forward-looking statementscontained in this report.

 

**Overview**

 

**The Company is a leading technology firm for videocompression.  We have developed aproprietary technology platform and video compression/decompression softwaretechnology (“codecs”) to deliver high quality video at the lowest possible datarates via the Internet and over closed area networks. We offer a suite ofproducts and services, including high-level video encoding, encodingworkstations, hosting, streaming, interface design, customized technicalsupport, and consulting services. In addition, we license our high qualityvideo codecs for use in closed area networks such as set-top boxes, electronicgaming devices and wireless applications.**

 

Founded in 1992 as The Duck Corporation, the Companyoriginally developed and marketed codecs that enabled developers of computervideo games, video games for dedicated video game consoles and multi-mediapresentations on computers to convert an analog video signal to a digital videosignal, and to compress the signal for storage and playback on the requireddevice. The Company also developed its own video streaming technology, enablingdelivery of high quality video signals over high bandwidth networks, andtechnology allowing for real-time capture, compression and storage of digitalvideo signals.

 

In June of 1999, The Duck Corporation was merged withand into a wholly owned subsidiary of Applied Capital Funding, Inc., a publiccompany whose name was later changed to On2.com Inc. On May 22, 2001, theCompany’s shareholders approved changing the name of the Company from On2.comInc. to On2 Technologies, Inc.  Throughthe first quarter of 2000, the Company devoted substantially all of its effortsto building a proprietary content network and developing the technology tooperate a broadband content site. In June of 2000, the Company made a strategicdecision to de-emphasize the development of its content site and redirected itsstrategic operating focus toward providing its proprietary broadband technologysolutions to customers requiring television quality video signals fordistribution over the broadband Internet or to consumer electronic devices.

 

In December 2000, the Company initiated certain costsavings initiatives that included a reduction in workforce, the closing ofcertain offices in San Francisco and Los Angeles and the sale of certaincontent-related, non-strategic assets associated with acquisitions made inconnection with the development of a broadband content site.  The Company’s strategic focus is to providethe highest level of broadband technology services and products to customersfor delivery of DVD quality video over the Internet and to consumer electronicdevices.  The Company believes that,subsequent to its restructuring and cost savings initiatives, its hassufficient personnel to continue its research and development efforts as wellas to create products and perform services that encompass its proprietarybroadband technologies.

 

In view of the rapidly evolving nature of its businessand its limited operating history, the Company has limited experienceforecasting its revenues and operating costs. Therefore, the Company believesthat period-to-period comparisons of financial results are not necessarilymeaningful and should not be relied upon as an indication of futureperformance.  To date, the Company hasincurred substantial costs to create technology products and services.  As of September 30, 2001, the Company had anaccumulated deficit of $94.8 million. The Company will continue to incur coststo develop, introduce and enhance products and services, build brand awarenessand grow the business. The Company may also incur significant additional costsrelated to technology, marketing or acquisitions of businesses and technologiesto respond to changes in this rapidly developing industry. These costs may notcorrespond with any meaningful increases in revenues in the near term, if atall.  As such, these costs may result innegative operating cash flows until such time as the Company generatessufficient revenue to offset such costs.

 

**Results of Operations**

 

*Revenues.* Revenues for the three months ended September 30, 2001 were $497,556 ascompared to $289,750 for the three months ended September 30, 2000.  Revenues for the three months endedSeptember 30, 2001 were derived primarily from engineering and consultingservices and the licensing of the Company’s products.  Revenues for the three months ended September 30, 2000 werederived primarily from historical licensing agreements, encoding services andthe sale of the Company’s legacy DVD assets. Revenues for the nine months ended September 30, 2001 were $1,301,504 ascompared to $618,724 for the nine months ended September 30, 2000.  Revenues for 2001 were primarily derivedfrom engineering fees, encoding services and licensing of the Company’stechnology and products.  Revenues for2000 were primarily derived from encoding services, licensing fees and the saleof the Company’s legacy DVD assets.  Theperiod-to-period increase is primarily attributable to certain engineering andconsulting projects as well as an increase in encoding services. The majorityof the Company’s current and future revenue is and will be derived frombroadband video encoding services, engineering and consulting services andlicensing its technology and products to video content owners who want to usethe Company’s technology to distribute television quality video images tobroadband end users.

 

*Operatingexpenses*

 

The Company's operating expenses consist of researchand development, sales and marketing, general and administrative expenses,impairment and restructuring charges and non-cash stock based compensation.

* *

*Researchand Development.*  Research and development expenses consistprimarily of salaries and related expenses for personnel and consulting feesassociated with the development and enhancement of the Company’s proprietarybroadband technology services and applications, hosting costs, depreciation andoperating leases for certain equipment. To date, all research and developmentcosts have been expensed as incurred because technological feasibility isgenerally not established until substantially all development is complete.  Research and development expenses for the threemonths ended September 30, 2001 were $1,132,045 as compared to $2,590,394 forthe three months ended September 30, 2000. Research and development expenses for the nine months ended September30, 2001 were $4,526,418 as compared to $8,715,055 for the nine months endedSeptember 30, 2000.  Theperiod-to-period decrease in absolute dollars is primarily attributable to adecrease in internal personnel and consulting fees associated with developingand enhancing the new technology and products. Additionally, as a result of certain cost-savings initiatives, theCompany disposed of certain non-strategic, content related assets thatdecreased certain personnel and production costs as well.  Moreover, research and development expensesfor the nine months ended September 30, 2000 included costs associated with thedevelopment of a broadband content Website and costs associated with producing,acquiring, processing and distributing content for it.  As a result of a strategic decision to focuson providing services and products that include its proprietary broadbandtechnology solutions, the Company did not incur content development anddistribution costs during 2001 nor does it expect to incur such costs in futureperiods.  The Company believes thatcontinued investments in research and development are necessary to maintain itscompetitive advantage and meet its strategic objectives.  Therefore, the Company will hire additionalengineers and consultants as necessary to develop and enhance its broadbandtechnology services and products.

 

*Salesand Marketing.*  Sales and marketing expenses consistprimarily of salaries and related costs of sales, business development andmarketing personnel, tradeshow expenses, advertising costs, marketing andpromotional costs incurred to create brand awareness and public relationsexpenses.  Sales and marketing expenseswere $332,787 for the three months ended September 30, 2001 as compared to$995,496 for the three months ended September 30, 2000. Sales and marketingexpenses were $1,744,598 for the nine months ended September 30, 2001 ascompared to $5,386,091 for the nine months ended September 30, 2000. Theperiod-to-period decrease is primarily attributable to a decrease in personnel,advertising costs and tradeshow costs associated with the Company’s cost savinginitiatives implemented in December 2000. However, the Company intends tocontinue to recruit and hire experienced personnel, as necessary, to sell andmarket its products and services.

 

*Generaland Administrative*.  General and administrative expenses consistprimarily of salaries and related personnel costs for general corporatefunctions including MIS, finance, human resources, legal and facilities,outside legal and professional fees, depreciation of fixed assets, amortizationof goodwill and other intangible assets, bad debt expense, impairment of equityinvestments and general operating overhead. General and administrative costswere $1,513,803 for the three months ended September 30, 2001 as compared to$2,785,993 for the three months ended September 30, 2000. General andadministrative costs were $5,163,082 for the nine months ended September 30,2001 as compared to $8,054,912 for the nine months ended September 30, 2000.The period-to-period decrease in absolute dollars is primarily attributable toa decrease is administrative personnel, rent, legal and professional fees andamortization of goodwill and intangible assets associated with the Company’scost saving initiatives implemented in December 2000.

 

*Impairment and Restructuring Charges.*  InDecember 2000, in connection with certain cost saving and corporaterestructuring initiatives, the Company’s Board of Director’s approved a planthat included the sale of certain content-related, non-strategic assets thatwould no longer be used in the operations of the Company, closing the Company’soffices in San Francisco and Los Angeles and a reduction in the Company’sworkforce.

 

As a result of these initiatives, the Companyrecorded a non-cash restructuring charge of $293,200 in the first quarter of2001.  The non-cash restructuring chargewas comprised of the following: (1) $210,000 related to the termination of anemployment contract which was satisfied through the issuance of 150,000 sharesof Common Stock in February 2001 and (2) $83,200 related to the termination ofa commercial lease obligation in San Francisco which was satisfied through theissuance of 80,000 shares of Common Stock in March 2001.  The agreements were consummated subsequentto fiscal year end 2000 and the obligations of the Company could not bemeasured at December 31, 2000.

 

For three and nine months ended September 30, 2001,the Company recorded an impairment charge of $20,000 and $470,000,respectively, related to its Quickband content library.  The Company is actively pursuing the sale ofits Quickband content library and recorded the impairment charge to reflect thefair market value of the library as of September 30, 2001.

 

The Company recorded a charge of $63,333 for thethree and nine months ended September 30, 2001 related to a trademark thatwould no longer be used by the Company. The write-off reflected the net book value of the asset at the time itwas no longer deemed to have value.

 

*Non-CashStock Based Compensation.*  Non-cash stock based compensationwas $43,707 for the three months ended September 30, 2001 as compared to $-0-for the three months ended September 30, 2000. Non-cash stock based compensation was $143,707 for the nine months endedSeptember 30, 2001 as compared to $11,557,883 for the nine months endedSeptember 30, 2000.  The non-cash stockbased charge for the three and nine months ended September 30, 2001 is a resultof shares of Common Stock issued to the Company’s Non-Executive Chairman inlieu of cash compensation and options to purchase shares of Common Stockgranted to certain consultants.  Aportion of the non-cash compensation for the three and nine months endedSeptember 30, 2000 is the result of cashless exercises of stock options grantedto employees under the Company’s 1999 Amended and Restated Stock Option Plan(the “1999 Plan”).  As the 1999 Plan wasself-administered between January 2000 and May 2000, generally acceptedaccounting principles required the Company to recognize the full fair marketvalue of all shares exercised under the cashless provision during thatperiod.  The non-cash stock based chargerelated to these cashless exercises for the three and nine months endedSeptember 30, 2000 was $-0- and $10,257,883, respectively.  The Company has now contracted with a thirdparty to administer all stock option exercises.  Thus, the Company does not anticipate non-cash charges fromcashless exercises in future periods. Additionally, for the nine months ended September 30, 2001, the Companyrecorded a non-cash stock based charge of $1,300,000 in connection with theissuance of a warrant to a business partner who agreed to sponsor the Company’sweb site.

 

*Interestand Other Income (Expense).*  Interest andother income (expense) primarily consists of interest income earned on theCompany’s cash and cash equivalents, interest expense incurred from theCompany’s capital lease obligations and note payables and the amortization ofdebt discounts.  Interest and otherincome (expense) was ($477,258) for the three months ended September 30, 2001as compared to $69,285 for the three months ended September 30, 2000.  Interest and other income (expense) was($1,555,357) for the nine months ended September 30, 2001 as compared to$495,444 for the nine months ended September 30, 2000. The period-to-perioddecrease is a result of a decrease in the average balance of our cash and cashequivalents, the amortization of a debt discount related to the Company’sconvertible debenture financing and the impairment of the Company’s equity investments.

 

*IncomeTaxes.*  Income taxes are based solely on state andlocal taxes on business and investment capital.  The Company does not pay, nor does it anticipate paying,significant state and local income taxes based on its investment capital.

 

**Liquidity and CapitalResources**

 

At September 30, 2001, the Company had cash and cash equivalents of$575,956 as compared to $1,561,495 at December 31, 2000.

 

Net cash used in operating activities was $8,899,445and $19,212,239 for the nine months ended September 30, 2001 and 2000,respectively.  The decrease in net cashused in operating activities is primarily attributable to a decrease in theCompany’s net operating losses, excluding depreciation and amortization, non-cashstock based charges, impairment and restructuring charges and the amortizationof debt discounts and a decrease in prepaid and other current assets.  These amounts were offset by a decrease inaccounts payable and accrued expenses and deferred revenue.

 

Net cash used in investing activities was $106,894 and$3,380,762 for the nine months ended September 30, 2001 and 2000,respectively.  The period-to-perioddecrease is primarily attributable to decreases in the purchases of propertyand equipment, advances to affiliates and cash paid for acquisitions, net ofcash acquired.

 

Net cash provided by financing activities was$8,025,229 and $12,545,044 for the nine months ended September 30, 2001 and2000, respectively.  Theperiod-to-period decrease is primarily attributable to a difference in theproceeds received from the issuance of Preferred Stock, Common Stock andconvertible debentures and a decrease in proceeds received from the exercise ofstock options.

 

The Company currently has no material commitmentsother than those under our operating lease arrangements.

 

The market for distribution of broadband technologyservices is highly competitive and may require significant capitalexpenditures.  The Company’s capitalrequirements depend on numerous factors, including market acceptance of its technologyand services, research and development costs and the resources it spends onmarketing and selling its technology and services.  Additionally, the Company continues to evaluate investments incomplementary businesses, products and services, some of which may besignificant.  The Company hasexperienced increases in its capital expenditures, consistent with the growthof its business, and significant operating losses and negative operating cashflows to date.

 

 The Companywill require additional funding during the next 12 months to finance the growthof its current operations and fulfillment of its strategic objectives.  Additionally, the Company may require morefinancing to fund acquisitions, develop new technologies or acquire strategicassets.

 

In December 2000, the Company entered into a commonstock purchase agreement (“Stock Purchase Agreement”) with an accreditedinvestor (“Investor”), for the sale, from time to time, of the Company’s CommonStock.  Pursuant to the Stock PurchaseAgreement, the Investor has committed to purchase up to $23,000,000 of CommonStock over a 36 month period.  TheInvestor may be required to invest an additional $17,000,000 upon theattainment of certain trading volumes and weighted average market prices in theCompany’s Common Stock.  However, theCompany’s ability to procure funds through the Stock Purchase Agreement mayalso be limited or prohibited based on certain trading volumes and weightedaverage market prices in the Company’s Common Stock.

 

In connection withagreements entered into with RealNetworks, Inc., the Company issued toRealNetworks 1,785,714 shares of its Common Stock in July 2001, and receivedproceeds of $1,000,000.  Also, in July2001, the Company entered into an agreement with Travelers, which agreement wasamended on August 10, 2001 to provide that Travelers would receive 3,571,429shares of preferred stock and warrants. Each share of preferred stock is convertible into one share of theCompany’s Common Stock after a period of six months, and each warrant isexerciseable into 1.5 shares of the Company’s Common Stock after a period ofsix months.  The exercise price of thewarrants is $0.56 per share.  TheCompany received proceeds of $2,000,000 from Travelers.

 

Notwithstanding the above, management is activelypursuing increases to cash flows and additional sources of financing andbelieves that such increases and additional financing will generate sufficientcash flow to fund the Company’s operations through fiscal year 2001.  Management’s plan to increase the Company’scash flows from operations relies significantly on increases in revenuegenerated from its broadband technology services, products and licenses anddecreases in operating expenses.  However,there are no assurances that such matters will be successfullyconsummated.  In such event, the Companycould reduce the development of its products and services, scale back currentoperations until such funds become available on terms acceptable to the Companyand could potentially result in a modification to the auditor’s report on theCompany’s December 31, 2001 financial statements.

 

**Impact of Recently IssuedAccounting Pronouncements**

 

During June 2001, the Financial Accounting StandardsBoard issued Statements of Financial Accounting Standards No.141, *Business Combination* (“SFAS No. 141”) andNo. 142 *Goodwill and Other Intangible Assets*(“SFAS No. 142”).  SFAS No. 141 changesthe accounting for business combinations, requiring that all businesscombinations be accounted for using the purchase method and that intangibleassets be recognized as assets apart from goodwill if they arise fromcontractual or other legal rights, or if they are separable or capable of beingseparated from the acquired entity and sold, transferred, licensed, rented orexchanged.  SFAS No.141 is effective forall business combinations initiated after June 30, 2001.  SFAS No. 142 specifies that financialaccounting and reporting for acquired goodwill and other intangibleassets.  Goodwill and intangible assetswith indefinite useful lives will not be amortized but rather will be tested atleast annually for impairment.  SFAS No.142 is effective for fiscal years beginning after December 15, 2001.

 

SFAS No. 142 requires that the useful lives ofintangible assets acquired on or before June 30, 2001 be reassessed and theremaining amortization periods adjusted accordingly.  Previously recognized intangible assets deemed to have indefinitelives shall be tested for impairment. Goodwill recognized on or before June 30, 2001, shall be assigned to oneor more reporting units and shall be tested for impairment as of the beginningof the fiscal year in which SFAS No. 142 is initially applied in its entirety.

 

The Company has not fully assessed the potentialimpact of the adoption of SFAS No. 142 which is effective for the Company as ofJanuary 1, 2002.  The reassessment ofintangible assets must be completed during the first quarter of 2002 and theassignment of goodwill to the reporting units, along with the completion of thefirst step of the transitional goodwill impairment tests, must be completedduring the first six months of 2002.

 

# **Item 3.  Qualitativeand Quantitative Disclosures About Market Risk**

 

*CollectionRisk.*  The Company’s accounts receivables aresubject, in the normal course of business, to collection risks.  Although the Company regularly assess theserisks and has policies and business practices to mitigate the adverse effectsof collection risks, significant losses may result due to the non-payment ofreceivables by its customers.

 

*InterestRate Risk.*  The Company’s return on its investments incash and cash equivalents is subject to interest rate risks.  The Company regularly assesses these risksand has established policies and business practices to manage the market riskof its cash and cash equivalents.

 

*ForeignCurrency Risk.*  The Company transacts business in the UnitedKingdom.  Accordingly, the Company maybe subject to exposure from the adverse movements in foreign currency exchangerates.  The effect of foreign currencyexchange rate fluctuations has not been material to date.  The Company does not use derivativefinancial instruments to limit its foreign currency risk exposure.

 

**PART II — OTHERINFORMATION**

 

**Item1. Legal Proceedings**

 

From time to time the Company isparty to various legal proceedings arising in the ordinary course ofbusiness.  In the opinion of management,the ultimate disposition of these matters will not have a material adverseeffect on the Company’s consolidated financial position, results of operationsor liquidity.

 

**Item 2. Changes in Securities**

 

Notes 4 and 5 to the interim consolidated financialstatements in Part I of this Form are hereby incorporated by reference.

 

**Item 4.  Submission ofMatters to a Vote of Security Holders**

 

None.

 

**Item6. Exhibits and Reports on Form 8-K.**

 

(a)    Exhibits

 

Exhibit Number                    Description

 

(b)   Reports on Form 8-K

 

On July 18, 2001, the Companyfiled a Form 8-K under Item 5 regarding a Common Stock Purchase agreemententered into with RealNetworks, Inc.

 

On July 20, 2001, the Companyfiled a Form 8-K under Item 5 regarding a Unit Purchase Agreement entered intowith Travelers Indemnity Company.

 

On August 9, 2001, the Companyfiled a Form 8-K under Item 5 regarding a Software License Agreement enteredinto with Media Commerce Solutions, Inc.

 

On August 23, 2001, the Companyfiled a Form 8-K/A amending its original Form 8-K, filed on July 20, 2001,regarding the Unit Purchase Agreement entered into with Travelers IndemnityCompany.

 

**SIGNATURES**

 

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

 
|               |   | On2 Technologies, Inc.                                                 |
|--------------------|--------|------------------------------------------------------------------------|
|               |   | (Registrant)                                                           |
|               |   |                                                                   |
|               |   |                                                                   |
| November 14,  2001 |   |   /s/ Mark J. Meagher                                             |
| (Date)             |   | (Signature)                                                            |
|               |   | Mark J. Meagher   Executive Vice President and Chief Financial Officer |