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 March 31, 2008.





 ̈  **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 a large accelerated filer, an
      accelerated filer, a non-accelerated filer or a smaller reporting company.
      See
      the definition of “accelerated filer”, “large accelerated filer” and “smaller
      reporting company” in Rule 12b-2 of the Exchange Act (Check one).





 ̈Large accelerated filer
              þAccelerated filer ̈Non-accelerated filer
               ̈Smaller reporting
                company




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.  p Yes   ̈ No





APPLICABLE
      ONLY TO CORPORATE ISSUERS:





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





The
      number of shares of the Registrant’s Common Stock, par value $0.01 (“Common
      Stock”), outstanding as of June 16, 2008, was 159,563,152 (this number does not
      include an additional 12,500,000 shares of the Registrant’s common stock that
      the Registrant is obligated to issue to the former shareholders of Hantro
      Products Oy, acquired by the Registrant in November 2007).




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          2
          -


**Explanatory
      Note**





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





The
      filing of this Form 10-Q for the quarter ended March 31, 2008 was delayed
      due to the independent review conducted by the Audit Committee of our Board
      of
      Directors concerning certain contracts with customers and the recognition of
      revenue that we had previously recognized as revenue in our quarterly filings
      for the quarters ended June 30, 2007 and September 30, 2007. The Audit
      Committee’s review commenced after the Audit Committee was informed by our
      management that certain documentation provided to us relating to two sales
      accounts for which revenue had been recognized in the third quarter of 2007
      had
      been falsified. Management made this discovery during the preparation of our
      2007 annual financial statements. The Audit Committee concluded, with respect
      to
      four accounts, including the two sales accounts previously mentioned, that
      we
      incorrectly recognized revenue of $185,000 for the second quarter of 2007 and
      $589,000 **** for
      third
      quarter of 2007. In addition, during the preparation of our 2007 annual
      financial statements and prior to discovery of the falsified documentation
      mentioned above, management determined that revenue of $42,000 had been
      incorrectly recognized in the third quarter of 2007. The revenue that was
      incorrectly recognized during these periods will be recognized on a cash basis
      when and if collected. As of the filing date of this report, only a portion
      of
      the amounts owed in connection with one of these accounts has been collected.
      When the Company filed its Current Report Form 8-K on May 27, 2008, we had
      preliminarily determined to establish a bad debt reserve of $383,000 in the
      fourth quarter of 2007 for certain sales to a fifth account.  Upon further
      examination of the facts and circumstances involved in sales to this account,
      we
      confirmed that sales had occurred to this account, that a reserve for $383,000
      was required, but that the reserve should have been established in the third
      quarter, rather than the fourth quarter, of 2007.  To establish that
      reserve we recorded a general charge to general and administrative expense
      of
      $383,000 which increased our net loss for the third quarter of 2007 by that
      amount (in addition to the $631,000 of revenue that was reversed in the
      period).  The establishment of the reserve also resulted in a reduction in
      accounts receivable, net of allowance for doubtful accounts on our balance
      sheet
      at September 30, 2007, by the same amount.





We
      restated our previously issued financial statements for the three and six months
      ended June 30, 2007 in Amendment No. 1 to our Quarterly Report on Form 10-Q/A
      for quarterly period ended June 30, 2007, to correct the incorrect recognition
      of revenue in the period relating to two of the sales accounts reviewed. We
      also
      restated our previously issued financial statements for the three and nine
      months ended September 30, 2007 in Amendment No. 1 to our Quarterly Report
      on
      Form 10-Q/A for the quarterly period ended September 30, 2007, to correct the
      incorrect recognition of revenue in the period relating to two other sales
      accounts, as well as the incorrect recognition in the period of an additional
      $42,000 and to establish an additional bad debt reserve in the period related
      the fifth sales account. A more complete discussion of the Audit Committee's
      review and determinations, and the restatement of our financial statements
      for
      the second and third quarters of 2007 and the related disclosure, can be found
      in the foregoing amendments to our Quarterly Reports on Form 10-Q.


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          3
          -





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




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          4
          -


**Table
      of Contents**




Page**PART
              I —
              FINANCIAL INFORMATION**Item
                1. Consolidated Financial Statements.
            6Condensed
                Consolidated Balance Sheets at March 31, 2008 (unaudited) and December
                31,
                2007
            6Unaudited
                Condensed Consolidated Statements of Operations, Three Months Ended
                March
                31, 2008 and 2007
            7Unaudited
                Condensed Consolidated Statements of Comprehensive loss, Three Months
                Ended March 31, 2008 and 2007
            8Unaudited
                Condensed Consolidated Statements of Cash Flows Three Months Ended
                March
                31, 2008 and 2007
            9Notes
                to Unaudited Condensed Consolidated Financial Statements
            11Item
                2. Management’s Discussion and Analysis of Financial Condition and Results
                of Operations
            15Item
                3. Quantitative and Qualitative Disclosures About Market
                Risk
            30Item
                4. Controls and Procedures
            30PART
                II — OTHER INFORMATIONItem
                1. Legal Proceedings
            34Item
                6. Exhibits and Reports on Form 8-K
            35Signatures
            36Certifications




-
          5
          -


**PART
      I — FINANCIAL INFORMATION**





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





**ON2
      TECHNOLOGIES, INC.**


**CONDENSED
      CONSOLIDATED BALANCE SHEETS**





**March 31,**
              **2008**
            
            **December 31,**
              **2007****(unaudited)****ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            2,684,000
            
            $
            9,573,000Short-term
                investments
            
            
            10,130,000
            
            
            5,521,000Accounts
                receivable
            
            
            5,173,000
            
            
            7,513,000Prepaid
                expenses and other current assets
            
            
            1,726,000
            
            
            1,492,000Total
                current assets
            
            
            19,713,000
            
            
            24,099,000Acquired
                software, net
            
            
            10,456,000
            
            
            10,333,000Other
                acquired intangibles, net
            
            
            7,454,000
            
            
            7,144,000Goodwill
            
            
            39,697,000
            
            
            37,023,000Property
                and equipment, net
            
            
            807,000
            
            
            751,000Other
                assets
            
            
            168,000
            
            
            175,000Total
                assets
            
            $
            78,295,000
            
            $
            79,525,000**LIABILITIES
                AND STOCKHOLDERS’ EQUITY**Current
                liabilities:Accounts
                payable
            
            $
            1,315,000
            
            $
            1,433,000Accrued
                expenses
            
            
            4,780,000
            
            
            4,820,000Deferred
                revenue
            
            
            3,498,000
            
            
            1,887,000Short-term
                borrowings
            
            
            185,000
            
            
            2,198,000Current
                portion of long-term debt
            
            
            392,000
            
            
            491,000Capital
                lease obligation
            
            
            25,000
            
            
            24,000Total
                current liabilities
            
            
            10,195,000
            
            
            10,853,000Capital
                lease obligation, excluding current portion
            
            
            12,000
            
            
            18,000Long-term
                debt
            
            
            3,306,000
            
            
            3,082,000Total
                liabilities
            
            
            13,513,000
            
            
            13,953,000Commitments
                and contingenciesStockholders’
                equity:Common
                stock
            
            
            1,705,000
            
            
            1,705,000Additional
                paid-in capital
            
            
            194,922,000
            
            
            194,453,000Treasury
                stock at costAccumulated
                other comprehensive income
            
            
            4,386,000
            
            
            906,000Accumulated
                deficit
            
            
            (136,231,000
            )
            
            (131,492,000
            )Total
                stockholders’ equity
            
            
            64,782,000
            
            
            65,572,000Total
                liabilities and stockholders’ equity
            
            $
            78,295,000
            
            $
            79,525,000




*See
      accompanying notes to unaudited condensed consolidated financial
      statements*


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          6
          -


**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**





**Three Months Ended March 31,****2008**
            
            **2007**Revenue
            
            $
            4,452,000
            
            $
            2,815,000Operating
                expenses:Cost
                of revenue (1)
            
            
            1,430,000
            
            
            423,000Research
                and development (2)
            
            
            2,808,000
            
            
            493,000Sales
                and marketing (2)
            
            
            1,889,000
            
            
            596,000General
                and administrative (2)
            
            
            2,479,000
            
            
            959,000Equity-based
                compensation:Research
                and development
            
            
            119,000
            
            
            1,000Sales
                and marketing
            
            
            38,000
            
            
            27,000General
                and administrative
            
            
            213,000
            
            
            120,000Total
                operating expenses
            
            
            8,976,000
            
            
            2,619,000Income
                (loss) from operations
            
            
            (4,5241,000
            )
            
            196,000Interest
                and other expense, net
            
            
            (130,000
            )
            
            (913,000
            )Loss
                before provision for income taxes
            
            
            (4,654,000
            )
            
            (717,000
            )Provision
                for income taxes
            
            
            85,000
            
            
            (4,000
            )Net
                loss
            
            $
            (4,739,000
            )
            $
            (721,000
            )Convertible
                preferred stock 8% dividend
            
            
            -
            
            
            54,000Net
                loss attributable to common stockholders
            
            $
            (4,676,000
            )
            $
            (775,000
            )Basic
                and diluted net loss attributable to common stockholders per common
                share
            
            $
            (0.03
            )
            $
            (0.01
            )Weighted
                average basic and diluted commonshares
                outstanding
            
            
            170,487,000
            
            
            103,599,000





(1)
            Includes
                equity-based compensation of $83,000 and $1,000 for the three months
                ended
                March 31, 2008 and 2007,
                respectively.


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





*See
      accompanying notes to unaudited condensed consolidated financial
      statements*


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          7
          -


**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS**





**Three
                Months Ended**
              **March
                31,****2008**
            
            **2007**Net
                loss
            
            $
            (4,739,000
            )
            $
            (721,000
            )Other
                Comprehensive income:Foreign
                currency translation adjustment
            
            
            3,480,000
            
            
            (2,000
            )Comprehensive
                loss
            
            $
            (1,259,000
            )
            $
            (723,000
            )




*See
      accompanying notes to unaudited condensed consolidated financial
      statements*




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          8
          -


**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**





**Three Months Ended March 31,****2008**
            
            **2007**Cash
                flows from operating activities:Net
                loss
            
            $
            (4,739,000
            )
            $
            (721,000
            )Adjustments
                to reconcile net loss to net cash used in, provided by operating
                activities:Equity
                based compensation
            
            
            453,000
            
            
            149,000Depreciation
                and amortization
            
            
            834,000
            
            
            86,000Amortization
                of debt discountRealized
                and unrealized loss on marketable equity securities
            
            
            -
            
            
            29,000Change
                in warrant derivative liability
            
            
            -
            
            
            914,000Changes
                in operating assets and liabilities:Accounts
                receivable, net
            
            
            2,792,000
            
            
            (735,000
            )Prepaid
                expenses and other current assets
            
            
            (161,000
            )
            
            (171,000
            )Other
                assets
            
            
            11,000Accounts
                payable and accrued expenses
            
            
            (503,000
            )
            
            539,000Deferred
                revenue
            
            
            1,521,000
            
            
            (4,000
            )Net
                cash provided by operating activities
            
            
            208,000
            
            
            86,000Cash
                flows from investing activities:Proceeds
                from the sale of marketable securities
            
            
            13,075,000
            
            
            113,000Purchases
                of marketable securities
            
            
            (17,684,000
            )Purchases
                of property and equipment
            
            
            (85,000
            )
            
            (77,000
            )Net
                cash (used in) provided by investing activities
            
            
            (4,694,000
            )
            
            36,000Cash
                flows from financing activities:Principal
                payments on capital lease obligations
            
            
            (6,000
            )
            
            (9,000
            )Principal
                payments on short-term borrowings
            
            
            (2,122,000
            )
            
            (33,000
            )Principal
                payments on debt
            
            
            (183,000
            )Proceeds
                from exercise of common stock options and warrants
            
            
            16,000
            
            
            400,000Purchase
                of treasury shares
            
            
            
            
            
            (158,000
            )Net
                cash (used in) provided by financing activities
            
            
            (2,295,000
            )
            
            200,000Net
                change in cash and cash equivalents
            
            
            (6,781,000
            )
            
            322,000Effect
                of exchange rate changes on cash and cash equivalents
            
            
            (108,000
            )
            
            (2,000
            )Cash
                and cash equivalents, beginning of period
            
            
            9,573,000
            
            
            4,961,000Cash
                and cash equivalents, end of period
            
            $
            2,684,000
            
            $
            5,281,000




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          9
          -





**ON2
      TECHNOLOGIES, INC.**


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





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




**Three Months Ended March 31,****2008**
            
            
            **2007**Cash
                paid during the period for:Interest
            
            $
            41,000
            
            $
            2,000Taxes
            
            $
            65,000
            
            $
            5,000Non-cash
                transactions:Acquisition
                of fixed assets under capital lease
            
            
            
            
            $
            6,000Cashless
                exercise of stock options
            
            
            
            
            $
            466,000Common
                stock issued for dividends on Series D Preferred Stock
            
            
            
            
            $
            61,000Conversion
                of Series C-IV Preferred Stock into common stock
            
            
            
            
            $
            19,000Conversion
                / redemption of Series D Convertible Preferred stock
            
            
            
            
            $
            1,194,000Decrease
                in accrued dividend on Series D Preferred Stock
            
            
            
            
            $
            (6,000
            )




*See
      accompanying notes to unaudited condensed consolidated financial
      statements*




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          10
          -





**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. In addition, the Company licenses its software products
      for
      use with video delivery platforms.





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





On
      November 1, 2007, the Company completed the acquisition of all of the share
      capital of Hantro Products Oy (“Hantro”), a Finnish corporation. Under the
      exchange agreement 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.





(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
      Company’s consolidated financial statements have been prepared assuming that it
      will continue as a going concern. The Company has incurred recurring operating
      losses and negative operating cash flows since its inception. At March 31,
      2008,
      the Company had cash and cash equivalents and short-term investments of
      $12,814,000 and working capital of $9,518,000. The Company believes that
      existing funds are sufficient to fund its operations through March 31, 2009.
      The
      Company plans to increase cash flows from operations principally from increases
      in revenue generated from its compression technology products and services.





The
      interim condensed consolidated financial statements are unaudited. However,
      in
      the opinion of management, such financial statements contain all adjustments
      necessary to present fairly the financial position of the Company and its
      results of operations and cash flows for the interim periods presented. The
      condensed consolidated financial statements included herein have been prepared
      pursuant to the rules and regulations of the Securities and Exchange Commission
      (“SEC”). Certain information and footnote disclosures normally included in
      consolidated financial statements prepared in accordance with accounting
      principles generally accepted in the United States of America have been
      condensed or omitted pursuant to such rules and regulations. The Company
      believes that the disclosures included herein are adequate to make the
      information presented not misleading. These condensed consolidated financial
      statements should be read in conjunction with the annual financial statements
      and notes thereto included in the Company's 2007 Form 10-K Report filed with
      the
      SEC on June 27, 2008. Results for the three months ended March 31, 2008 are
      not
      necessarily representative of the results that could be expected for the full
      year.




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          11
          -


(3)
      Stock-Based Compensation





The
      following table summarizes the activity of the Company’s stock options for the
      three months ended March 31, 2008:





**Shares**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**
            
            **Weighted**
              **Average**
              **Remaining
                Contractual**
              **Life**
            
            **Aggregate**
              **Intrinsic**
              **Value**Number
                of shares under option:Outstanding
                at January 1, 2008
            
            
            7,956,000
            
            $
            1.03Granted
            
            
            408,000
            
            
            .90Exercised
            
            
            (21,000
            )
            
            0.78Canceled
                or expired
            
            
            (0
            )
            
            0.00Outstanding
                at March 31, 2008
            
            
            8,343,000
            
            $
            1.02
            
            
            6.18
            
            $
            1,464,000Vested
                and expected to vest at March 31, 2008
            
            
            8,286,000
            
            $
            1.10
            
            
            6.39
            
            $
            1,462,000Exercisable
                at March 31, 2008
            
            
            4,828,000
            
            $
            1.17
            
            
            6.45
            
            $
            1,341,000





The
      aggregate intrinsic value of options exercised during the three months ended
      March 31, 2008 and 2007 was $6,000 and $2,145,000, respectively.





The
      following summarizes the activity of the Company’s non-vested stock options for
      the three months ended March 31, 2008:





**Shares**
            
            **Weighted**
              **Average Grant**
              **Date Fair**
              **Value**Non-vested
                at January 1, 2008
            
            
            3,108,000
            
            $
            0.58Granted
            
            
            408,000
            
            
            .90Cancelled
                or expired
            
            
            (0
            )
            
            0.00Vested
                during the period
            
            
            (1,000
            )
            
            1.48Non-vested
                at March 31, 2008
            
            
            3,515,000
            
            $
            0.62




As
      of
      March 31, 2008, there was $1,369,000 of total unrecognized compensation cost
      related to non-vested share-based compensation arrangements granted under
      existing stock option plans. This cost is expected to be recognized over a
      weighted-average period of 1.33 years. The total grant date fair value of shares
      vested during the three-months ended March 31, 2008 was $1,000.





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:


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          12
          -




**Three months
                ended**
              **March 31,**
              **2008**Weighted
                average fair value at date of grant for options granted during the
                period
            
            $
            .90Expected
                stock price volatility
            
            
            104
            %Expected
                life of options
            
            
            3
                yearsRisk
                free interest rates
            
            
            4.04
            %Expected
                dividend yield
            
            
            0
            %





The
      following summarizes the activity of the Company’s non-vested restricted common
      stock for the three months ended March 31, 2008:





**Shares**
            
            **Weighted**
              **Average Grant**
              **Date Fair**
              **Value**Non-vested
                at January 1, 2008
            
            
            1,053,000
            
            $
            0.49Granted
            
            
            75,000
            
            
            1.01Cancelled
                or expired
            
            
            (15,000
            )
            
            3.54Vested
                during the period
            
            
            (139,000
            )
            
            1.16Non-vested
                at March 31, 2008
            
            
            974,000
            
            $
            2.07





For
      the
      three months ended March 31, 2008, the Company recognized $281,000 in
      compensation expense related to restricted common stock and there was $1,728,000
      of unrecognized compensation cost.





(4)  Marketable Securities





As
      of
      March 31, 2008 the Company held $10,130,000 in short-term securities, $131,000
      in a certificate of deposit in a United States Bank and $9,999,000 in Federal
      Home Loan Bank Discount Notes. The Company does not accrue interest on the
      Federal Home Loan Bank Discount Notes; the interest is instead recorded at
      maturity. For the three months ended March 31, 2008, there was $3,000 of
      un-accrued interest on these Notes.





(5)
      Customer Concentration





For
      the
      three months ended March 31, 2008, one customer accounted for 13% of revenue.
      For the three months ended March 31, 2007, one customer accounted for 14% of
      the
      revenue.





(6)
      Effect of Recently Issued Accounting Pronouncements





On
      March
      19, 2008, the FASB issued SFAS Statement No. 161, *Disclosures
      about Derivative Instruments and Hedging Activities - an Amendment of FASB
      Statement 133.* Statement 161 enhances required disclosures regarding derivatives and hedging
      activities, including enhanced disclosures regarding how: ( *a* )
      an
      entity uses derivative instruments; ( *b* )
      derivative instruments and related hedged items are accounted for under FASB
      Statement No. 133, *Accounting
      for Derivative Instruments and Hedging Activities;* and
      ( *c* )
      derivative instruments and related hedged items affect an entity's financial
      position, financial performance, and cash flows. Specifically, Statement 161
      requires:


-
          13
          -




·
            Disclosure
                of the objectives for using derivative instruments be disclosed in
                terms
                of underlying risk and accounting designation;




·
            Disclosure
                of the fair values of derivative instruments and their gains and
                losses in
                a tabular format;




·
            Disclosure
                of information about credit-risk-related contingent features; and




·
            Cross-reference
                from the derivative footnote to other footnotes in which
                derivative-related information is
                disclosed.




Statement
      161 is effective for fiscal years and interim periods beginning after November
      15, 2008. Early application is encouraged.





The
      Company is currently evaluating the impact of adopting SFAS No. 161 on its
      financial position and results of operations.





In
      December 2007, the FASB issued SFAS No. 160, *“Non-controlling
      Interests in Consolidated Financial Statements - An Amendment of ARB No. 51.”* Statement
      160 establishes new accounting and reporting standards for the non-controlling
      interest in a subsidiary and for the deconsolidation of a subsidiary.
      Specifically, this Statement requires the recognition of a non-controlling
      interest (minority interest) as equity in the consolidated financial statements
      and separate from the parent's equity. The amount of net income attributable
      to
      the non-controlling interest will be included in consolidated net income on
      the
      face of the income statement. Statement 160 clarifies that changes in a parent's
      ownership interest in a subsidiary that do not result in deconsolidation are
      equity transactions if the parent retains its controlling financial interest.
      In
      addition, this Statement requires that a parent recognize a gain or loss in
      net
      income when a subsidiary is deconsolidated. Such gain or loss will be measured
      using the fair value of the non-controlling equity investment on the
      deconsolidation date. Statement 160 also includes expanded disclosure
      requirements regarding the interests of the parent and its non-controlling
      interest. Statement 160 is effective for fiscal years, and interim periods
      within those fiscal years, beginning on or after December 15, 2008. Earlier
      adoption of SFAS No. 160 is prohibited. Although
      the Company will continue to evaluate the application of SFAS 160, management
      does not currently believe adoption will have a material impact on the Company’s
      results of operations or financial position.




-
          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. Forward-looking statements include
      statements with respect to:




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





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




-
          15
          -


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 under the caption “ *Risk
      Factors That May Affect Future Operating Results* "
      in the
      Company's Form 10-K for the year ended December 31, 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, we caution readers not to place undue reliance on the forward-looking
      statements contained in this report.





**Costs
      Associated with Restatement of Financial Statements**





Since
      December 31, 2007, we have incurred legal and accounting and other costs related
      to the Audit Committee review and restatement of our financial statements
      described in this report under the caption “Explanatory Note,” of approximately
      $1,530,000, as of May 30, 2008, of which approximately $373,000 was expensed
      in
      the first quarter of 2008 and an additional $1,157,000 was incurred and will
      be
      expensed in the second quarter of 2008.  These costs are expensed in the
      period in which the legal, accounting and other services are provided and are
      recorded as general and administrative expenses. These costs will have a
      material adverse effect on our net loss for the period in which they are
      expensed and on our liquidity for the period in which they are paid. We
      anticipate that we will incur additional legal, accounting and other fees
      related to the Audit Committee review and restatement. We also will incur other
      fees and costs related to the execution of the remediation plan adopted by
      us
      after the conclusion of the Audit Committee review.  At this time, we
      cannot estimate the amount of additional legal, accounting and other fees and
      costs that may be incurred in the second quarter of 2008 and beyond to
      execute this remediation plan. The Company believes it continues to have
      sufficient cash and other resources available to meet working capital and other
      needs that might arise over the next twelve months.





**Overview**




On2
      Technologies is a developer of video compression technology and technology
      that
      enables multimedia in resource-limited environments, such as cellular networks
      transmitting to battery operated mobile handsets or High Definition (HD) video
      over the Internet. We have developed a proprietary technology platform and
      the
      TrueMotion® VPx family (e.g., VP6®, VP7TM) of video compression/decompression
      (“codec”) software to deliver high-quality video at the lowest possible data
      rates over proprietary networks and the Internet to personal computers, wireless
      devices, set-top boxes and other 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
      addition, through our wholly-owned subsidiary, On2 Finland (formerly Hantro),
      a
      Finnish corporation which we acquired on November 1, 2007, we license to chip
      and mobile handset manufacturers the hardware and software designs that make
      the
      encoding or decoding of video possible on devices such as mobile handsets,
      set
      top boxes, portable media players and cameras. On2 Finland’s headquarters and
      research and development teams are based in Oulu, Finland and it has a global
      sales network with satellite offices in Korea, Japan, Taiwan, Germany, Hong
      Kong
      and Mainland China. We also provide integration, customization and support
      services to enable high quality video on, and faster interoperability between
      devices.





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. Flash
      encoding has become an increasingly important part of our business. In addition,
      we have also dedicated significant resources to marketing customized software
      to
      device manufacturers that enable their devices to decode Flash content.




-
          16
          -


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




·
            Video
                codecs;





·
            Audio
                codecs; and





·
            Encoding
                and server software, for use with video delivery
                platforms.





We
      also
      offer the following suite of hardware and software products that incorporate
      our
      mobile video technology:





·
            TrueMotion
                VP6 and VP7 software video codec
                designs;





·
            MPEG-4,
                H.263, H.264 / AVC and VC-1 hardware and software video codec
                designs;





·
            Hardware
                and software JPEG codecs supporting up to
                16MP;





·
            AMR-NB
                and Enhanced aacPlusTM audio codecs;





·
            Pre-
                and post-processing technologies (such as cropping, rotation, scaling)
                implemented in both software and
                hardware;





·
            File
                format and streaming components;
                and





·
            Recorder
                and player application logic.





In
      addition, we offer the following services in connection with both our
      proprietary video compression technology and our mobile video
      technology:





·
            Customized
                engineering and consulting services;
                and





·
            Technical
                support.





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




-
          17
          -




**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
                surveillanceVideo
                and Audio Distribution over IP-based Networks (Internet)
            ·Video-on-demand
              ·Teleconferencing
                services
              ·Video
                instant messaging
              ·Video
                for Voice-over-IP (VOIP) servicesConsumer
                Electronic Devices
            ·Digital
                video players
              ·Digital
                video recorders
              ·Mobile
                TV
              ·Video
                Camera Recorder
              ·Mobile
                Video PlayerWireless
                Applications
            ·Delivery
                of video via satellite
              ·Providing
                video to web-enabled cell phones and PDAsUser-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





On2’s
      goal is to be a premier provider of video compression software and hardware
      technology and compression tools. We are striving to achieve that goal and
      the
      goal of building a stable base of quarterly revenues by implementing the
      following key strategies:




•
            Continuing
                our research and development efforts to improve our current codecs
                and
                developing new technologies that increase the quality of video technology
                and improve the experience of end users;•
            Continuing
                our research and development efforts to design hardware decoders
                and
                encoders that minimize the space used on a chip and to continue to
                improve
                the quality of those products;•
            Using
                the success of current customer implementations of our TrueMotion
                technology (e.g., Adobe® Flash 8, Skype) and other high-profile customers
                (e.g., Sun Microsystems) to increase our brand recognition, promote
                new
                business and encourage proliferation across platforms;•
            Updating
                and enhancing our existing consumer products, such as the Flix® line and
                embedded technologies;•
            Employing
                flexible licensing strategies to offer customers more attractive
                business
                terms than those available for competing technologies;




-
          18
          -





•
            Attempting
                to negotiate licensing arrangements with customers that provide for
                receipt of recurring revenue and/or that offer us the opportunity
                to
                market products that complement our customers implementations of
                our
                software; and•
            Using
                the expertise of our subsidiary, On2 Finland, to develop hardware
                designs
                of our TrueMotion codecs and optimizations for embedded processors
                that
                will allow those products to be easily implemented on
                devices.




We
      earn
      revenue chiefly through licensing our software technology and hardware designs
      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 and
      hardware **** products.
      The royalties may come in the form of either a fee for each unit of the
      customer’s products containing our software products or hardware designs 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 (e.g., minimum annual
      royalties) and/or maximum amounts (e.g., annual caps) that may vary
      substantially from deal to deal.




We
      also
      sell additional products and services that relate to our existing relationships
      with licensees of our TrueMotion codec products. 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 that customer’s 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.




We
      made
      the decision to acquire Hantro in large part because of our recognition of
      the
      strategic importance of implementing our TrueMotion codecs in hardware and
      developing highly optimized software libraries for operation on the digital
      signal processors (DSPs) used in embedded devices. The Hantro acquisition has
      allowed us to increase the resources devoted to improving the ease of
      implementation of our codecs across platforms. Prior to the acquisition, we
      did
      not have off-the-shelf optimized software that we could license to customers
      who
      were interested in implementing our codecs on devices. Those customers were
      therefore required to pay us to customize our software, or to perform the
      customizations themselves, or to hire third-party consultants to perform the
      customizations. The Hantro acquisition has given us access to experienced
      internal resources to enable us to develop hardware and software implementations
      that will allow customers to implement our codecs quickly and efficiently on
      embedded devices.




As
      part
      of our strategy to develop complementary products that could allow us to
      capitalize on our customers’ success, in 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 video engine for Flash 8 video,
      which 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 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. Following Adobe’s announcement in late 2007 of
      support for the H.264 codec in its Flash 9 player, we announced support for
      H.264 in our Flix products and have been adding support for additional codecs.
      These additional features have helped to make the Flix product line **** a
      more
      complete encoding solution for users.




-
          19
          -


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




Another
      factor that may affect our success is the relative complexity of our TrueMotion
      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. As referenced above,
      our license agreements with customers increasingly 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 114 employees competing in a market that offers a vast range
      of
      video-enabled devices, we do not have the product development or marketing
      resources to develop and market end-to-end video solutions. Instead, our codec
      software is primarily intended to be used as a building block for companies
      that
      are developing end-to-end video products and/or services.




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




-
          20
          -




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. 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 consumer generated
      content consisted primarily of text content and still photographs, the
      availability of relatively inexpensive digital video cameras and video-enabled
      mobile phones, the growth in the number of users with access to 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 have 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, and to UGC sites
      or
      to individual users of those services.




We
      have
      recently experienced an increased interest by UGC site operators and device
      manufacturers to allow users to access UGC content by means of mobile handsets,
      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 demand on two fronts: (1) demand
      to
      integrate Flash 8 video onto non-PC platforms, and (2) until most devices can
      play Flash 8 content, demand to provide transcoding software that allows Flash
      8
      content to be decoded and re-encoded into a format (such as the 3GPP standard)
      that is supported on devices. 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.




H.264
      continues to rise as a competitor in the video compression field. H.264 is
      a
      standards-based codec that is the successor to MPEG-4. We believe that our
      technology is superior to H.264, and that we can offer significantly more
      flexibility in licensing terms than customers get 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 has thus chosen
      H.264 for the current generation of video iPods. Finally, there is already
      a
      significant amount of professional content that has been encoded in H.264.
      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® TrueMotion video might require. In addition,
      there are certain customers that prefer to license standards-based codecs.
      In
      August 2007, our customer Adobe announced that the latest version of the Flash
      video player would support H.264. We continue to believe that VP6 will be an
      important part of the Flash video ecosystem for three reasons: (1) Adobe has
      in
      the past provided backwards compatibility with all generations of Flash video
      codecs; (2) VP6 has certain performance advantages over H.264 (e.g., HD VP6
      content may be played back on a lower-powered processor than HD H.264 content);
      and (3) there is a vast amount of existing VP6 content that consumers want
      on
      portable and mobile devices.




-
          21
          -


The
      market for digital media creation and delivery technology is constantly changing
      and becoming more 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, both in software and in hardware. Our
      acquisition of Hantro has significantly increased the resources that we can
      devote to these efforts. We have also increased the number of our engineers
      who
      integrate our codecs on chips, and we have cultivated relationships with chip
      companies to enable those companies to perform such integration. By increasing
      support for our technology on the chips that power embedded devices, we hope
      to
      encourage use by customers who want to develop video-enabled consumer products
      in a short timeframe.




A
      continuing trend in our business is the growing presence of Microsoft, Inc.
      as a
      significant competitor in the market for digital media creation and distribution
      technology. In 2007, Microsoft released SilverlightTM, a rich Internet
      application that allows users to integrate multimedia features, such as vector
      graphics, audio and video, into web applications. Silverlight may compete
      directly with Flash. If Silverlight gains market share at the expense of Flash,
      it could have a negative impact on our Flix business. In addition, Microsoft
      VC1
      format also competes in the marketplace with H.264 and our VPx technologies.
      We
      believe that our VPx technologies have the same advantages over VC1 as they
      do
      over H.264. 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 to, 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 financial resources and its competitive position in the computer
      industry to secure preferential or exclusive distribution, use and bundling
      contracts for its media delivery technologies, and products with third parties,
      such as ISPs, content delivery networks, content providers, entertainment and
      media companies, VARs and OEMs, including third parties with whom we have
      relationships.




The
      Microsoft® 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 could become more comfortable with using DRM technology produced
      by
      companies other than Microsoft.




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 like Microsoft and the MPEG consortium. We 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. We believe our ability to provide both our VPx codecs and standards
      based codecs has positioned us uniquely as a one stop shop for the
      implementation of multiple codecs on a variety of devices.




Another
      one of our primary businesses is the development and marketing of digital
      electronic hardware designs (known as register transfer level designs or RTL)
      of
      video and audio codecs to manufacturers of computer chips and multimedia
      devices. A licensee of our RTL design might use that product to implement a
      video decoder on the licensee’s chip, and the decoder would be built into the
      circuitry of the licensee’s chip. One of the factors affecting our hardware
      business is our ability to develop efficient RTL designs that minimize the
      physical area of a chip devoted to our designs. Increasing the surface area
      of a
      chip increases the manufacturer’s production costs. Our ability to produce RTL
      designs that require less surface area than our competitors’ designs results in
      lower production costs for our licensees and gives us a competitive advantage.




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          22
          -


Another
      factor affecting our hardware business is our reputation for producing reliable
      products that have been thoroughly tested, are accompanied by good
      documentation, and are supported by a strong technical support team. Chip and
      device manufacturers that are potential customers for our hardware products
      develop the products with which they will integrate our RTL designs. Our
      technology is hard-wired into chip circuitry rather than loaded as software.
      In
      connection with high volume chip production, the per-unit price of a specialized
      chip that has had multimedia support built into the chip can be substantially
      less than the costs of using a more powerful software-upgradable digital signal
      processor (DSP). However, any errors in the software operating on a DSP can
      be
      relatively easily corrected through a software upgrade or patch, while errors
      that have been hardwired into a circuit are more difficult, and may be
      impossible, to correct. Because customers for our RTL designs will invest a
      great deal of time and money into the designs, our reputation as a
      well-established provider of reliable, well-supported RTL designs is an
      important factor in our continuing success.




As
      multimedia content has proliferated on the Internet, manufacturers of mobile
      devices such as cell phones and personal media players (PMPs) have expanded
      their product lines to support playback and creation of that content. As noted
      above, in general, manufacturers have two options to add multimedia support
      to
      their devices. They can use either a specialized chip that has multimedia
      support hard-wired into it (RTL) or a more powerful DSP that can run software
      to
      provide the necessary multimedia functions. Hardware implementations that
      require RTL designs such as ours offer a number of advantages over DSPs with
      software layers:




·
            RTLs
                are cheaper to produce in high
                volumes;




·
            They
                use less energy, which prolongs battery life of mobile
                devices;




·
            They
                produce less heat, which has important implications for, among other
                things, circuit design; and




·
            They
                allow for simultaneous encoding and decoding of HD video
                content.




But
      there
      are also disadvantages to hardware implementations of multimedia
      tools:




·
            Initial
                implementation costs are high; and




·
            Hardware
                implementations are generally not
                upgradeable.




Similarly,
      software-upgradable DSPs offer certain advantages:




·
            Modifying
                software to operate on a DSP is easier and less expensive then
                implementing the software in hardware, reducing initial project costs
                and
                speeding deployment;




·
            DSPs
                do not require costly re-designs and re-tooling to operate new software;
                and




·
            They
                are more easily upgradeable.




But
      they
      also have certain disadvantages:




·
            Per-chip
                costs are higher than pure hardware solutions as volumes
                increase;




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          23
          -


·
            The
                increased processor power required to operate diverse software increases
                heat and power consumption.




Manufacturers
      that want to maintain the ability to upgrade mobile devices and PMPs to support
      new multimedia software may opt for DSPs rather than hardware solutions, which
      could impact our business of licensing hardware codecs. Nevertheless, we believe
      that even if manufacturers do choose to use DSPs in their devices, it is likely
      that many will continue to implement hardware codecs alongside the DSPs to
      take
      advantage of the efficiency of those hardware implementations. In addition,
      support for DSPs on multimedia devices would have the benefit of making those
      devices more easily upgraded to new generations of our TrueMotion codecs. We
      are
      continuing to monitor this trend and make the adjustments to our business model
      necessary to address changing markets.




**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. We have disclosed all significant accounting policies in Note 1
      to
      the consolidated financial statements included in our Form 10-K for the
      fiscal year ended December 31, 2007. The unaudited consolidated financial
      statements and the related notes thereto should be read in conjunction with
      the
      following discussion of our critical accounting policies. Our critical
      accounting policies and estimates are:





•
            Revenue
                recognition•
            Accounts
                receivable allowance•
            Acquisitions•
            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 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,” SOP 98-9, “MODIFICATION OF SOP 97-2 WITH
      RESPECT TO CERTAIN TRANSACTIONS” (“SOP 98-9”) and Staff
      Accounting Bulletin No. 104 (“SAB 104”) .
      Under
      each arrangement, revenues are recognized when a non-cancelable agreement has
      been signed and the customer acknowledges an unconditional obligation to pay,
      the products or applications have been delivered, there are no uncertainties
      surrounding customer acceptance, the fees are fixed and determinable, and
      collection is reasonably assured. Revenues recognized from multiple-element
      software arrangements are allocated to each element of the arrangement based
      on
      the fair values of the elements, such as product licenses, post-contract
      customer support, or training. The determination of the fair value is based
      on
      the vendor specific objective evidence available to us. If such evidence of
      the
      fair value of each element of the arrangement does not exist, we defer all
      revenue from the arrangement until such time that evidence of the fair value
      does exist or until all elements of the arrangement are delivered.




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          24
          -





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





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





*Accounts
      Receivable Allowance.* We
      perform ongoing credit evaluations of our customers and adjust credit limits,
      as
      determined by our review of current credit information. We continuously monitor
      collections and payments from our customers and maintain an allowance for
      doubtful accounts based upon our historical experience, our anticipation of
      uncollectible accounts receivable and any specific customer collection issues
      that we have identified. Our credit losses have historically been low and within
      our expectations.





*Acquisitions.* We are
      required to allocate the purchase price of acquired companies to the tangible
      and intangible assets acquired, liabilities assumed, as well as purchased
      in-process research and development (IPR&D) based on the estimated fair
      values. We use various models to determine the fair values of the assets
      acquired and liabilities assumed. These models include the discounted cash
      flow
      (DCF), the royalty savings method and the cost savings approach. The valuation
      requires management to make significant estimates and assumptions, especially
      with respect to long-lived and intangible assets.





Critical
      estimates in valuing certain of the intangible assets include, but are not
      limited to, future expected cash flows from customer contracts, customer lists,
      distribution agreements and acquired developed technologies and patents; the
      acquired company’s brand awareness and market position as well as assumptions
      about the period of time the brand will continue to be used in the combined
      company’s product portfolio; and discount rates. We derive our discount rates
      from our internal rate of return based on our internal forecasts and we may
      adjust the discount rate giving consideration to specific risk factors of each
      asset. Management’s estimates of fair value are based upon assumptions believed
      to be reasonable but which are inherently uncertain and unpredictable.
      Assumptions may be incomplete or inaccurate, and unanticipated events and
      circumstances may occur.


-
          25
          -





*Equity-Based
      Compensation.* The
      Company adopted the provisions of SFAS No. 123R effective January 1, 2006,
      using
      the modified prospective transition method. Under the modified prospective
      method, non-cash compensation expense is recognized under the fair value method
      for the portion of outstanding share based awards granted prior to the adoption
      of SFAS 123R for which service has not been rendered, and for any future share
      based awards granted or modified after adoption. Accordingly, periods prior
      to
      adoption have not been restated. 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.





*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
      No. 142”). SFAS 142 requires goodwill and other intangible assets to be
      tested for impairment at least annually, and written off when impaired, rather
      than being amortized as previously required.





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 March 31, 2008, we
      believe that no such impairment has occurred.





**Results
      of Operations**





*Revenue.*





Revenue
      for the three months ended March 31, 2008 was $4,452,000 as compared to
      $2,815,000 for the three months ended March 31, 2007. Revenue is derived
      primarily from the sale of software and RTL licenses and engineering and support
      services. The increase in revenue for the three months ended March 31, 2008
      as compared with 2007 is primarily due to a $1,547,000 revenue contribution
      from
      our subsidiary, On2 Finland (formerly Hantro), acquired in November 2007.





For
      the
      three months ended March 31, 2008, one customer accounted for 13% of revenue.
      For the three months ended March 31, 2007, one customer accounted for 14% of
      revenue.





*Operating
      expenses.*





The
      Company's operating expenses consist of cost of revenue, research and
      development, sales and marketing and general and administrative expenses.
      Operating expenses for the three months ended March 31, 2008, were $8,976,000
      as
      compared to $2,619,000 for the three months ended March 31, 2007. The increase
      in operating expenses for the three months ended March 31, 2008 as compared
      with
      the three months ended March 31, 2007 is primarily the result of the acquisition
      of On2 Finland (formerly Hantro).





*Cost
      of Revenue.* Cost of
      revenue includes personnel and related overhead expenses, royalties paid for
      software that is incorporated into the Company’s software, consulting
      compensation costs, operating lease costs and depreciation and amortization
      costs. Cost of revenue was $1,430,000 for the three months ended March 31,
      2008
      as compared to $423,000 for the three months ended March 31, 2007. The increase
      of $1,007,000 for the three months ended March 31, 2008 as compared with the
      three months ended March 31, 2007 is primarily attributable to an increase
      of
      $695,000 in amortization of the Hantro purchased technology, an increase in
      equity based compensation of $82,000 and an increase production and engineering
      costs associated with On2 Finland (formerly Hantro).




-
          26
          -





*Research
      and Development.* Research
      and development expenses, excluding equity-based compensation, primarily consist
      of personnel and related overhead expenses and consulting compensation costs
      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 March 31, 2008 were $2,808,000, as compared with
      $493,000 for the three months ended March 31, 2007. The increase of $2,315,000
      in 2008 is primarily a result of an increase of $1,897,000 in research and
      development costs incurred by our Finnish subsidiary that utilizes a greater
      portion of their engineers in research and development activities and a $418,000
      increase in research and development costs incurred by our US operations, that
      is a result of increases in personnel and related costs and an increase in
      the
      amount of hours that our engineering staff worked on development projects.





*Sales
      and Marketing.* Sales
      and marketing expenses, excluding stock-based compensation, consist primarily
      of
      salaries and commissions and related overhead costs, business development and
      marketing personnel, tradeshow costs, marketing and promotional costs incurred
      to create brand awareness and public relations expenses. Sales and marketing
      expenses for the three months ended March 31, 2008, were $1,889,000, as compared
      to $596,000 for the three months ended March 31, 2007. The increase of
      $1,293,000 is primarily a result sales and marketing personnel and related
      costs
      attributable to Hantro, which were partially offset by a slight decrease in
      costs from our US operation as a result of the elimination of certain
      duplication of costs.





*General
      and Administrative* .
      General
      and administrative expenses, excluding stock-based compensation, consist
      primarily of salaries and related personnel costs for general corporate
      functions, professional fees, insurance, rent and utilities and depreciation.
      General and administrative costs for the three months ended March 31, 2008,
      were
      $2,479,000, as compared with $959,000 for the three months ended March 31,
      2007.
      The $1,520,000 increase is primarily due to an increase of $604,000 from Hantro
      and an increase of $916,000 in the US. The $916,000 increase is primarily due
      to
      an increase in legal fees of $320,000 related to the Audit Committee’s review of
      certain 2007 sales contracts, **** a
      $283,000 increase in professional fees related to the implementation of Sarbanes
      Oxley Section 404, and other consulting fees and increases in insurance expense
      and travel and related expenses.





*Equity-based
      compensation.* The
      equity-based compensation expense for the three months ended March 31, 2008
      was
      $453,000, of which $83,000 is included in cost of revenue and $370,000 is shown
      separately, as compared with $149,000, of which $1,000 is included in cost
      of
      revenue and $148,000 is shown separately for the three months ended March 31,
      2007.





*Interest
      and Other Expense, Net.* Interest
      and other expense, net primarily consists of the change in the fair value of
      the
      derivative liability in connection with the warrants issued in August 2006,
      interest paid for capital lease obligations and long-term debt, interest earned
      on the Company’s invested cash balances, and realized losses on marketable
      securities. Interest and other expense, net was $130,000 for the three months
      ended March 31, 2008 as compared with $913,000 for the three months ended March
      31, 2007.





The
      decrease of $783,000 is primarily a result of the elimination of the derivative
      liability in the second quarter of 2007 partially offset **** by
      a net
      increase in interest income of $46,000. The warrant derivative liability was
      recorded in connection with the August 2006 sale of common stock and warrants
      to
      a group of investors led by Midsummer Capital.




-
          27
          -





**Liquidity
      and Capital Resources**





At
      March
      31, 2008, we had cash and cash equivalents and short-term investments of
      $12,814,000 as compared to $15,094,000 at December 31, 2007. At March 31, 2008
      the Company had working capital of $9,518,000 as compared with $13,393,000
      at
      December 31, 2007.





Net
      cash
      provided by operating activities was $208,000 and $86,000 for the three months
      ended March 31, 2008 and 2007, respectively. The increase in net cash used
      in
      operating activities is primarily attributable to an increase in non-cash
      expenses for depreciation and amortization of $748,000 as a result of the
      amortization of intangibles assets from the purchase of Hantro and an increase
      in equity based compensation of $304,000 due to an increase in stock options
      granted throughout 2007, a decrease in accounts receivable of $3,527,000, an
      increase in deferred revenue of $1,525,000 due to revenue recognition policies,
      partially offset by an increase in the net loss of $4,018,000, a decrease in
      accounts payable and accrued expenses of $1,042,000 due to the timing of
      payments, and a decrease in the warrant derivative liability of $914,000 due
      to
      the exercise of the remaining warrants in 2007.





Net
      cash
      (used in) provided by investing activities was $(4,694,000) and $36,000 for
      the
      three months ended March 31, 2008 and 2007, respectively. The decrease of
      $4,730,000 is a result of an $8,000 increase in the purchase of property and
      equipment and a $17,684,000 purchase of marketable securities, partially offset
      by $13,075,000 in proceeds from the sale of marketable
      securities.





Net
      cash
      (used in) provided by financing activities was $(2,295,000) and $200,000 for
      the
      three months ended March 31, 2008 and 2007, respectively. The $2,495,000
      decrease is primarily attributable to a $226,000 decrease in proceeds from
      the
      exercise of common stock options and warrants, net, a $180,000 increase in
      payments on long-term debt and capital lease obligations, and an increase in
      payments on short-term borrowings of $2,089,000.





We
      currently have material commitments for the next 12 months under our operating
      lease arrangements and borrowings. These arrangements consist primarily of
      lease
      arrangements for our office space in Clifton Park and Tarrytown, New York,
      Cambridge UK, and Oulu and Espoo, Finland. The aggregate required payments
      for
      the next 12 months under these arrangements are $880,000. 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 $2,300,000 per month in cash operating costs.





At
      March
      31, 2008, short-term borrowings consisted of the following:





A
      line of
      credit with a Finnish bank for $663,000 (450,000€ at March 31, 2008). The line
      of credit has no expiration date. Borrowings under the line of credit bear
      interest at EURIBOR plus 1.25% (total of 5.608% at March 31, 2008). The bank
      also requires a commission payable at .45% of the loan principal. Borrowings
      are
      collateralized by substantially all assets of Hantro and a guarantee by On2.
      The
      outstanding balance on the line of credit was $160,000 at March 31, 2008.





At
      March
      31, 2008, long-term debt consisted of the following:





Unsecured
      notes payable to a Finnish funding agency of $2,826,000, including interest
      at
      1.75%, due at dates ranging from January 2009 to December 2011; $283,000 to
      a
      Finnish bank, including interest at the 3-month EURIBOR (4.73% at March 31,
      2008) plus 1.1%, due March 2011, secured by a guarantee by On2, and the Finnish
      Government Organization, which also requires additional interest at 2.65% of
      the
      loan principal; and an unsecured note payable to a Finnish financing company
      of
      $198,000, including interest at the 6 month EURIBOR (4.73% at March 31, 2008)
      plus .5%, due March 2011.


-
          28
          -





The
      Company believes that existing funds are sufficient to fund its operations
      through March 31, 2009. The Company plans to increase cash flows from operations
      principally from increases in revenue generated from its compression technology
      products and services. 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, 2007, filed with the SEC on June
      ___, 2008





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.





Since
      December 31, 2007, we have incurred legal and accounting and other costs related
      to the Audit Committee review and restatement of our financial statements
      described in this report under the caption “Explanatory Note,” of approximately
      $1,530,000, as of May 30, 2008, of which approximately $373,000 was expensed
      the
      first quarter of 2008 and an additional $1,157,000 was incurred and will be
      expensed in the second quarter of 2008.  These costs are expensed in the
      period in which the legal, accounting and other services are provided and are
      recorded general and administrative expenses. These costs will have a material
      adverse effect on our net loss for the period in which they are expensed and
      on
      our liquidity for the period in which they are paid. We anticipate that we
      will
      incur additional legal, accounting and other fees related to the Audit Committee
      review and restatement. We also will incur other fees and costs related to
      the
      execution of the remediation plan adopted by us after the conclusion of the
      Audit Committee review.  At this time, we cannot estimate the amount of
      additional legal, accounting and other fees and costs that may be incurred
      in
      the second quarter of 2008 and beyond to execute this remediation plan. The
      Company believes it continues to have sufficient cash and other resources
      available to meet working capital and other needs that might arise over the
      next
      twelve months.





**Off-Balance
      Sheet Arrangements**





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





**Impact
      of Recently-Issued Accounting Pronouncements**





On
      March
      19, 2008, the FASB issued SFAS Statement No. 161, *Disclosures
      about Derivative Instruments and Hedging Activities - an Amendment of FASB
      Statement 133.* Statement 161 enhances required disclosures regarding derivatives and hedging
      activities, including enhanced disclosures regarding how: ( *a* )
      an
      entity uses derivative instruments; ( *b* )
      derivative instruments and related hedged items are accounted for under FASB
      Statement No. 133, *Accounting
      for Derivative Instruments and Hedging Activities;* and
      ( *c* )
      derivative instruments and related hedged items affect an entity’s financial
      position, financial performance, and cash flows. Specifically, Statement 161
      requires:


-
          29
          -





·
            Disclosure
                of the objectives for using derivative instruments be disclosed in
                terms
                of underlying risk and accounting designation;





·
            Disclosure
                of the fair values of derivative instruments and their gains and
                losses in
                a tabular format;





·
            Disclosure
                of information about credit-risk-related contingent features; and





·
            Cross-reference
                from the derivative footnote to other footnotes in which
                derivative-related information is
                disclosed.





Statement
      161 is effective for fiscal years and interim periods beginning after November
      15, 2008. Early application is encouraged.





The
      Company is currently evaluating the impact of adopting SFAS No. 161 on its
      financial position and results of operations.





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





The
      Company does not currently have any material exposure to interest rate risk,
      commodity price risk or other relevant market rate or price risks. However,
      the
      Company does have exposure to foreign currency rate fluctuations arising from
      maintaining offices in the U.K. and Finland for its wholly-owned subsidiaries
      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. The Finnish subsidiary conducts sales in both Euros and US
      dollars and pays its employees and other material obligations in Euros, and
      therefore can have a substantial impact translation gains and losses. 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.





**Item
      4. Controls and Procedures**





( a)
      Evaluation of Disclosure Controls and Procedures:





The
      term
      "disclosure controls and procedures," as defined in Rule 13a-15(e) and
      15d-15(e) under the Securities Exchange Act of 1934, or Exchange Act, means
      controls and other procedures of a company that are designed to ensure that
      information required to be disclosed in the reports that the company files
      or
      submits under the Exchange Act is recorded, processed, summarized and reported,
      within the time periods specified in the SEC's rules and forms. Disclosure
      controls and procedures include, without limitation, controls and procedures
      designed to ensure that information required to be disclosed by a company in
      the
      reports that it files or submits under the Exchange Act is accumulated and
      communicated to the company’s management, including its principal financial
      officers, as appropriate, to allow timely decisions regarding required
      disclosure. There are inherent limitations to the effectiveness of any system
      of
      disclosure controls and procedures, including the possibility of human error
      and
      the circumvention or overriding of the controls and procedures. Accordingly,
      even effective disclosure controls and procedures can only provide reasonable
      assurance of achieving their control objectives and management necessarily
      applies its judgment in evaluating the cost-benefit relationship of possible
      controls and procedures.


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          30
          -





In
      connection with the restatement of the Company’s financial statements for the
      second and third quarters of 2007, as described more fully in this report under
      the caption “Explanatory Note,” and the preparation of its Annual Report on Form
      10-K for the year ended December 31, 2007, management identified three material
      weaknesses in our internal control over financial reporting and reported those
      to our Audit Committee. The Public Company Accounting Oversight Board’s Auditing
      Standard No. 5 defines a material weakness as a deficiency, or combination
      of
      deficiencies, that result in a reasonable possibility that a material
      misstatement of the annual or interim financial statements will not be prevented
      or detected. Based on the identification of the material weaknesses in internal
      control over financial reporting described below, our Interim Chief Executive
      Officer and our Chief Financial Officer have concluded that, as of March 31,
      2008, our disclosure controls and procedures were not effective because of
      the
      following material weaknesses in our internal control over financial reporting
      that existed as of that date:




·
            *Revenue
                recognition procedures*–
                Our controls were not adequate to ensure that revenue was properly
                recognized when it was earned. Pursuant to American Institute of
                Certified
                Public Accountants’ Statement of Position (SOP) 97-2,*Software
                Revenue Recognition*(“SOP 97-2”) and Staff Accounting Bulletin No. 104 (“SAB 104”) one element
                of revenue recognition is consideration of whether the collectibility
                of
                sales revenue is reasonably assured (*i.e.*,
                whether the purchaser is creditworthy with respect to that transaction).We
                did not maintain effective procedures for the consideration of the
                probability that revenue is collectible. This control deficiency
                resulted
                in our incorrect recognition of revenue in our financial statements
                for
                the second and third quarters of
                2007.






·
            *Control
                environment*–
                We did not maintain an effective control environment, specifically
                relating to our tone at the top. This material weakness was evidenced
                by
                the control tone and control consciousness of our former Chief Executive
                Officer and resulted in the override and the possibility of override
                of
                controls or interference with our policies, procedures and internal
                control over financial reporting.






·
            *Allowance
                for Doubtful Account Procedures*–
                Effective controls were not designed and in place to ensure that
                an
                appropriate analysis of receivables from customers was conducted,
                reviewed, approved and documented in order to identify and estimate
                required allowance for doubtful accounts in accordance with generally
                accepted accounting principles. This material weakness resulted in
                a
                misstatement of accounts receivable, net of allowance for doubtful
                accounts on our balance sheet at the end of the third quarter of
                2007 and
                an understatement of our general and administrative expenses for
                the
                period.




(b)  Changes
      in Internal Controls:





There
      were no changes in our internal control
      over financial reporting identified in connection with the evaluation required
      by Rules 13a-15 and 15d-15 that occurred during the quarter ended March 31,
      2008
      that have materially affected,
      or are reasonably likely to materially affect, our internal control
      over financial reporting. However, in connection with the restatement of the
      Company’s financial statements for the second and third quarters of 2007, as
      described more fully in this report under the caption “Explanatory Note,” and
      the preparation of its Annual Report on Form 10-K for the year ended December
      31, 2007, management determined that the material weaknesses described above
      existed as of March 31, 2008. As a result,during
      the second quarter of 2008, we have taken certain steps to remediate these
      material weaknesses, discussed below, that will constitute changes inour
      internal control over financial reportingin that
      period that materially affect our internal control over financial reporting.
      In
      addition, we are in the process of finalizinga
      plan
      and timetable for the implementation of additional remediation measures, also
      discussed below,to
      further address these weakness, which will constitute additional changes inour
      internal control over financial reportingthat we
      anticipate will materially affect our internal control over financial reporting
      when implemented. We
      intend to implement these additional remediation measures as soon as practicable
      following finalization of our plan.


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          31
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**Remediation
      Initiatives**





In
      response to the identified material weaknesses, our management, with oversight
      from the Audit Committee, has taken certain actions related to their remediation
      during the second quarter of 2008, prior to the filing of this report. These
      actions have involved meetings among (i) our Chief Financial Officer, EVP,
      Legal
      and Business Affairs (and now Interim Chief Executive Officer and Chief
      Operating Officer) and certain members of our accounting staff and (ii) our
      Chief Financial Officer, EVP, Legal and Business Affairs (and now Interim Chief
      Executive Officer and Chief Operating Officer) and the Audit Committee.
      Representatives of our independent registered public accountants and our
      consultant on Sarbanes-Oxley compliance attended certain of these meetings.
      Due
      to the connection between our former Chief Executive Officer and the material
      weakness that we identified in our control environment, he has had limited
      involvement in our remediation actions. Prior
      to
      the filing of this report, we have taken certain steps to remediate these
      material weaknesses and are in the process of finalizing a
      plan
      and timetable for the implementation of additional remediation
      measures . As
      we
      continue to work to finalize our plan to improve our internal control over
      financial reporting, we may determine to take additional remediation measures
      or
      determine to modify, or in appropriate circumstances not to complete, certain
      of
      the remediation measures described below.





From
      a
      control environment and tone at the top perspective, during the second quarter
      of 2008, prior to the filing of this report, we have taken the following
      remedial steps: (i) our
      Board
      of Directors sought and obtained the resignation of our former Chief Executive
      Officer, Bill
      Joll, from all positions with us and our subsidiaries, including as an officer,
      employee and director, on June 11, 2008 (he will remain with us as an advisor
      to
      the chief executive officer until September 30, 2008 to effect a smooth
      transition of customer relationships and business development opportunities);
      (ii) also on June 10, 2008, our Board of Directors elected Matthew Frost,
      our EVP, Legal and Business Affairs, as Interim Chief Executive Officer and
      Chief Operating Officer; and (iii) we have segregated the duties of our
      accounting personnel from our non-accounting personnel other than those whose
      involvement in accounting-related matters is specifically authorized. At the
      time of the filing of this report, we anticipate that we will implement the
      following additional remediation measures with respect to this material weakness
      as soon as reasonably practicable: (i) establishing an independent third party
      ethics hotline so that employees can anonymously report
      violations of our Code of Ethics and other employee concerns, and educating
      employees about the hotline process; and (ii) revising our Code of Ethics to
      emphasize the importance of adherence to our policies and procedures relating
      to
      accounting and financial reporting and internal control of financial reporting
      and the availability of the ethics hotline for the reporting of violations
      of
      our Code of Ethics and other employee concerns.





The
      remedial steps we have taken during the second quarter of 2008 to address the
      material weakness in our revenue recognition procedures, specifically our
      procedures for assessing whether the collectibility of revenue is reasonably
      assured prior to recognition, are as follows: (i) we have revised the process
      that we and our operating subsidiary will follow in assessing whether the
      collectibilty of revenue is reasonably assured, as well as in determining that
      the other requirements for recognizing revenue have been met, so that this
      assessment occurs at the outset of the arrangement and is thereafter reviewed
      and confirmed in connection with our period end closing and financial statement
      preparation process; (ii) we have revised, formalized and expanded the
      documentation of the procedures we and our operating subsidiary will follow
      with
      respect to assessing reasonable assuredness of collectibility, as well as
      determining that the other requirements for recognizing revenue have been met;
      including, specifically, enhancing and documenting our policy with respect
      to
      the types of information that can be used in establishing creditworthiness;
      and
      (iii) we have added a position to our accounting staff and will fill this
      position as soon as possible. We also terminated the firm with which the sales
      agent who provided us falsified documents was affiliated. In addition, in the
      first quarter of 2008, we added a certified public accountant to our accounting
      and financial reporting staff. The addition of trained staff will both provide
      additional assistance in the accounting department and should allow other
      members of the accounting staff to devote additional time to responsibilities
      connected with financial reporting.




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With
      respect to addressing the material weakness in the design and operation of
      our
      procedures for estimating our allowance for doubtful accounts, prior to the
      filing of this report, we have enhanced, formalized and documented our
      procedures for analyzing our accounts receivable from customers so that we
      can
      appropriately estimate the collectibility of receivables at the end of a period
      based on aging categories and information related to collection efforts and
      formalized and documented timely review of that information, and sign
      off
      on the recommended allowance for doubtful accounts, by senior
      management.





At
      the
      time of the filing of this report, we anticipate that we will implement the
      following additional remediation measures as soon as reasonably practicable:
      (i)
      continued improvement to the documentation of the procedures we and our
      operating subsidiary will follow with respect to determining that the
      requirements for recognizing revenue have been met; (ii) Company-wide training
      (led by our Chief Financial Officer, with the assistance of our consultant
      on
      Sarbanes-Oxley compliance, our legal personnel and other accounting and
      financial reporting staff, as appropriate )
      to
      enhance awareness and understanding of standards and principles for accounting
      and financial reporting and
      internal control of financial reporting; and (iii) improve the
      processes and procedures around the completion and review of quarterly
      management representation letters .
      The
      training we plan to implement will deal specifically with revenue recognition
      requirements and requirements related to accounts receivable and allowance
      for
      doubtful accounts **** and
      will
      include appropriate programs for senior management to emphasize the importance
      of accounting and financial reporting integrity .
      This
      training will address all of the material weaknesses we have identified.





The
      Audit
      Committee has directed management to develop a detailed plan and timetable
      for
      the implementation of the foregoing remedial measures (to the extent not already
      completed) and will monitor their implementation. In addition, under the
      direction of the Audit Committee, management will continue to review and make
      necessary changes to the overall design of our internal control environment,
      as
      well as policies and procedures to improve the overall effectiveness of internal
      control over financial reporting. Our plan to remediate the material weaknesses
      in our internal control over financial reporting will be finalized and
      implemented as soon as reasonably practicable. We will continue to use external
      consultants to review our procedures and assist us in testing the effectiveness
      in our procedures on an on-going basis.





We
      believe that the steps we have heretofore taken have significantly improved
      our
      internal control over financial reporting. We are committed to remediating
      our
      material weaknesses and intend that, when finalized and fully implemented,
      our
      remediation measures will address the identified material weaknesses and will
      strengthen our overall internal control over financial reporting as well. We
      are
      committed to continuing to improve our internal control processes and will
      continue to diligently and vigorously review our financial reporting controls
      and procedures. As we continue to evaluate and work to improve our internal
      control over financial reporting, we may determine to take additional measures
      to address control deficiencies or determine to modify, or in appropriate
      circumstances not to complete, certain of the remediation measures described
      above.





Remediation
      generally requires making changes to how controls are designed and then adhering
      to those changes for a sufficient period of time such that the effectiveness
      of
      those changes is demonstrated with an appropriate amount of consistency. We
      believe that we have made significant improvements in our internal control
      over
      financial reporting and are committed to remediating our material
      weaknesses.


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**PART
      II — OTHER INFORMATION**




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





**2006
      Internal Investigation**





On
      March
      2, 2006, On2 filed a Form 8-K, which disclosed that it had voluntarily reported
      to the Securities and Exchange Commission (“SEC”) that On2 had undertaken an
      internal investigation into facts and circumstances concerning investor and
      other communications made by its former Chairman, Chief Executive Officer and
      President. On2 has completed its internal investigation, and, on May 5, 2006,
      the Company’s outside law firm submitted its final report to the Board of
      Directors. On2 subsequently delivered the report to the SEC and the American
      Stock Exchange on May 9, 2006. The Company has agreed to work with the SEC
      and
      the American Stock Exchange in connection with any investigations conducted
      by
      them. The Company has not uncovered any evidence of financial impropriety,
      and
      thus the Company continues to believe that the investigation will have no effect
      on previously filed financial statements or lead to any restatement of reported
      financial results.





**Beijing
      E-World**





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





·
            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.


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          34
          -





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




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          35
          -


**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.June
                27, 2008
            
            (Registrant)(Date)
            
            (Signature)
              Anthony
                Principe
              Senior
                Vice President and Chief Financial Officer
              (Principal
                Financial Officer)




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