UNITED
      STATES


SECURITIES
      AND EXCHANGE COMMISSION


Washington,
      D.C. 20549





FORM
      10-Q





(Mark
      One)





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


For
      the
      quarterly period ended September 30, 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.)3
                Corporate Drive, Suite 100, 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.   ̈ Yes   ̈ No





APPLICABLE
      ONLY TO CORPORATE ISSUERS:





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





The
      number of shares of the Registrant’s Common Stock, par value $0.01 (“Common
      Stock”), outstanding, as of November 7, 2008, were 171,924,000





**Table
      of Contents**





Page**PART
              I — FINANCIAL INFORMATION**Item
                1. Consolidated Financial Statements.Condensed
                Consolidated Balance Sheets at September 30, 2008 (unaudited) and
                December
                31, 2007
            
            
            2Unaudited
                Condensed Consolidated Statements of Operations Three and Nine Months
                Ended September 30, 2008 and 2007
            
            
            3Unaudited
                Condensed Consolidated Statements of Comprehensive Income (Loss)
                Three and
                Nine Months Ended September 30, 2008 and 2007
            
            
            4Unaudited
                Condensed Consolidated Statements of Cash Flows Nine Months Ended
                September 30, 2008 and 2007
            
            
            5Notes
                to Unaudited Condensed Consolidated Financial Statements
            
            
            7Item
                2. Management’s Discussion and Analysis of Financial Condition and Results
                of Operations
            
            
            17Item
                3. Quantitative and Qualitative Disclosures About Market
                Risk
            
            
            33Item
                4. Controls and Procedures
            
            
            34**PART
                II — OTHER INFORMATION**Item
                1. Legal Proceedings
            
            
            37Item
                1A. Risk Factors
            
            
            38Item
                4. Submission of Matters to a Vote of Security Holders
            
            
            39Item
                6. Exhibits
            
            
            40Signatures
            
            
            41Certifications


-
          1
          -


**PART
      I — FINANCIAL INFORMATION**





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




**ON2
      TECHNOLOGIES, INC.**


**CONDENSED
      CONSOLIDATED BALANCE SHEETS**





**September 30,**
              **2008**
            
            **December 31,**
              **2007****(unaudited)****ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            4,491,000
            
            $
            9,573,000Short-term
                investments
            
            
            132,000
            
            
            5,521,000Accounts
                receivable, net of allowance for doubtful accounts of $535,000 at
                September 30, 2008 and $519,000 at December 31, 2007
            
            
            3,997,000
            
            
            7,513,000Prepaid
                and other current assets
            
            
            1,757,000
            
            
            1,492,000Total
                current assets
            
            
            10,377,000
            
            
            24,099,000Property
                and equipment, net
            
            
            1,509,000
            
            
            751,000Acquired
                software, net
            
            
            2,459,000
            
            
            10,333,000Other
                acquired intangibles, net
            
            
            6,445,000
            
            
            7,144,000Goodwill
            
            
            15,987,000
            
            
            37,023,000Other
                assets
            
            
            430,000
            
            
            175,000Total
                assets
            
            $
            37,207,000
            
            $
            79,525,000**LIABILITIES
                AND STOCKHOLDERS’ EQUITY**Current
                liabilities:Accounts
                payable
            
            $
            309,000
            
            $
            1,433,000Accrued
                expenses
            
            
            4,813,000
            
            
            4,820,000Deferred
                revenue
            
            
            3,324,000
            
            
            1,887,000Short-term
                borrowings
            
            
            109,000
            
            
            2,198,000Current
                portion of long-term debt
            
            
            481,000
            
            
            491,000Capital
                lease obligation
            
            
            262,000
            
            
            24,000Total
                current liabilities
            
            
            9,298,000
            
            
            10,853,000Long-term
                debt
            
            
            2,542,000
            
            
            3,082,000Capital
                lease obligation, excluding current portion
            
            
            485,000
            
            
            18,000Total
                liabilities
            
            
            12,325,000
            
            
            13,953,000Commitments
                and contingenciesStockholders’
                equity:Preferred
                stock, $0.01 par value; 20,000,000 authorized and -0-
                outstanding
            
            
            -
            
            
            -Common
                stock, $0.01 par value; 250,000,000 shares authorized; 171,924,000
                and
                170,475,000 shares issued and issuable, and outstanding at September
                30,
                2008 and December 31, 2007, respectively
            
            
            1,719,000
            
            
            1,705,000Additional
                paid-in capital
            
            
            195,851,000
            
            
            194,453,000Accumulated
                other comprehensive income (loss)
            
            
            (167,000
            )
            
            906,000Accumulated
                deficit
            
            
            (172,521,000
            )
            
            (131,492,000
            )Total
                stockholders’ equity
            
            
            24,882,000
            
            
            65,572,000Total
                liabilities and stockholders’ equity
            
            $
            37,207,000
            
            $
            79,525,000


*See
      accompanying notes to unaudited condensed consolidated financial statements*


-
          2
          -


**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**


**Three Months Ended**
                **September 30,**
              
              **Nine Months Ended**
                **September 30,****2008**
              
              **2007**
              
              **2008**
              
              **2007**Revenue
              
              $
              4,971,000
              
              $
              1,935,000
              
              $
              12,688,000
              
              $
              7,119,000Operating
                  expenses:Costs
                  of revenue (1)
              
              
              940,000
              
              
              603,000
              
              
              3,564,000
              
              
              1,415,000Research
                  and development (2)
              
              
              2,848,000
              
              
              445,000
              
              
              8,665,000
              
              
              1,500,000Sales
                  and marketing (2)
              
              
              2,018,000
              
              
              676,000
              
              
              5,782,000
              
              
              1,886,000General
                  and administrative (2)
              
              
              1,946,000
              
              
              1,532,000
              
              
              8,640,000
              
              
              3,478,000Asset
                  impairments
              
              
              26,245,000
              
              
              -
              
              
              26,245,000
              
              
              -Equity-based
                  compensation:Research
                  and development
              
              
              101,000
              
              
              46,000
              
              
              325,000
              
              
              66,000Sales
                  and marketing
              
              
              35,000
              
              
              34,000
              
              
              147,000
              
              
              88,000General
                  and administrative
              
              
              257,000
              
              
              102,000
              
              
              728,000
              
              
              330,000Total
                  operating expenses
              
              
              34,390,000
              
              
              3,438,000
              
              
              54,096,000
              
              
              8,763,000Loss
                  from operations
              
              
              (29,419,000
              )
              
              (1,503,000
              )
              
              (41,408,000
              )
              
              (1,644,000
              )Other
                  income (expense), netInterest
                  income (expense), net
              
              
              (27,000
              )
              
              118,000
              
              
              34,000
              
              
              229,000Other
                  income (expense), net
              
              
              331,000
              
              
              3,000
              
              
              345,000
              
              
              (3,693,000
              )Total
                  other income (expense)
              
              
              304,000
              
              
              121,000
              
              
              379,000
              
              
              (3,464,000
              )Net
                  loss
              
              $
              (29,115,000
              )
              $
              (1,382,000
              )
              $
              (41,029,000
              )
              $
              (5,108,000
              )Convertible
                  preferred stock 8% dividend
              
              
              -
              
              
              7,000
              
              
              -
              
              
              78,000Net
                  loss attributable to common stockholders
              
              $
              (29,115,000
              )
              $
              (1,389,000
              )
              $
              (41,029,000
              )
              $
              (5,186,000
              )Basic
                  and diluted net loss attributable to common stockholders per common
                  share
              
              $
              (0.17
              )
              $
              (0.01
              )
              $
              (0.24
              )
              $
              (0.05
              )Weighted-average
                  basic and diluted common shares outstanding
              
              
              171,613,000
              
              
              116,353,000
              
              
              171,028,000
              
              
              110,615,000





(1)  Includes
      equity-based compensation of $53,000 and $215,000 for the three and nine months
      ended September 30, 2008, respectively, and $48,000 and $63,000 for the three
      and nine months ended September 30, 2007, respectively.


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





*See
      accompanying notes to unaudited condensed consolidated financial
      statements*


-
          3
          -


**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
      (LOSS)**





**Three Months Ended**
              **September 30,**
            
            **Nine Months Ended**
              **September 30,****2008**
            
            **2007**
            
            **2008**
            
            **2007**Net
                loss
            
            $
            (29,115,000
            )
            $
            (1,382,000
            )
            $
            (41,029,000
            )
            $
            (5,108,000
            )Other
                comprehensive income (loss):Foreign
                currency translation
            
            
            4,497,000
            
            
            (1,000
            )
            
            1,073,000
            
            
            (6,000
            )Comprehensive
                income (loss)
            
            $
            24,618,000
            
            $
            (1,383,000
            )
            $
            (39,956,000
            )
            $
            (5,114,000
            )





*See
      accompanying notes to unaudited condensed consolidated financial
      statements*


-
          4
          -


**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**




**Nine Months Ended September 30,****2008**
            
            **2007**Cash
                flows from operating activities:Net
                loss
            
            $
            (41,029,000
            )
            $
            (5,108,000
            )Adjustments
                to reconcile net loss to net cash (used in) provided by operating
                activities:Equity-based
                compensation
            
            
            1,415,000
            
            
            547,000Other
                expense recognized for warrant amendment
            
            
            -
            
            
            86,000Depreciation
                and amortization
            
            
            2,630,000
            
            
            275,000Asset
                impairments
            
            
            26,245,000
            
            
            -Insurance
                expenses financed with term loan
            
            
            29,000
            
            
            -Loss
                on disposal of equipment
            
            
            1,000
            
            
            -Write
                off of fixed assets
            
            
            -
            
            
            (21,000
            )Loss
                on marketable securities
            
            
            -
            
            
            27,000Change
                in fair value of warrant liability
            
            
            -
            
            
            3,582,000Changes
                in operating assets and liabilities:Accounts
                receivable
            
            
            3,398,000
            
            
            (242,000
            )Prepaid
                expenses and other current assets
            
            
            (173,000
            )
            
            138,000Other
                assets
            
            
            (257,000
            )
            
            20,000Accounts
                payable and accrued expenses
            
            
            (1,007,000
            )
            
            969,000Deferred
                revenue
            
            
            1,460,000
            
            
            84,000Net
                cash (used in) provided by operating activities
            
            
            (7,288,000
            )
            
            357,000Cash
                flows from investing activities:Proceeds
                from the sale of short-term investments
            
            
            23,074,000
            
            
            223,000Purchase
                of short-term investments
            
            
            (17,685,000
            )
            
            (96,000
            )Deferred
                acquisition costs
            
            
            -
            
            
            (1,727,000
            )Deferred
                financing costs
            
            
            -
            
            
            (62,000
            )Purchases
                of property and equipment
            
            
            (313,000
            )
            
            (257,000
            )Proceeds
                from disposal of equipment
            
            
            1,000
            
            
            -Net
                cash provided by (used in) investing activities
            
            
            5,077,000
            
            
            (1,919,000
            )Cash
                flows from financing activities:Principal
                payments on capital lease obligations
            
            
            (141,000
            )
            
            (19,000
            )Principal
                payments on short-term borrowings
            
            
            (2,134,000
            )
            
            (81,000
            )Principal
                payments on long-term debt
            
            
            (561,000
            )
            
            -Proceeds
                from the exercise of common stock options and warrants
            
            
            50,000
            
            
            6,813,000Purchase
                of treasury stock
            
            
            (52,000
            )
            
            (472,000
            )Net
                cash (used in) provided by financing activities
            
            
            (2,838,000
            )
            
            6,241,000Effect
                of exchange rate changes on cash and cash equivalents
            
            
            (33,000
            )
            
            (6,000
            )Net
                (decrease) increase in cash and cash equivalents
            
            
            (5,082,000
            )
            
            4,673,000Cash
                and cash equivalents, beginning of period
            
            
            9,573,000
            
            
            4,961,000Cash
                and cash equivalents, end of period
            
            $
            4,491,000
            
            $
            9,634,000


-
          5
          -





**ON2
      TECHNOLOGIES, INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**


**(CONTINUED)**





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





Nine Months Ended September 30,2008
            
            2007Cash
                paid during the period for:Interest
            
            $
            138,000
            
            $
            6,000Acquisition
                of fixed assets under capital leases
            
            $
            846,000
            
            $
            6,000Insurance
                premium financed with a term-loan
            
            $
            140,000
            
            $
            143,000Conversion
                of preferred stock into shares of common stock
            
            
            -
            
            $
            3,102,000Common
                stock issued for accrued dividend on Series D Preferred
                Stock
            
            
            -
            
            $
            21,000Common
                stock issued for dividends on Series D Preferred Stock
            
            
            -
            
            $
            93,000Write
                off of warrant derivative liability
            
            
            -
            
            $
            5,911,000Deferred
                financing costs charged to paid-in-capital on exercise of
                warrants
            
            
            -
            
            $
            106,000Cashless
                exercise of options and warrants
            
            
            -
            
            $
            959,000Retirement
                of treasury stock
            
            $
            52,000
            
            $
            1,431,000





*See
      accompanying notes to unaudited condensed consolidated financial
      statements*


-
          6
          -


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**





(1)
      Description of On2 Technologies, Inc.





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





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





The
      Company has experienced significant operating losses and negative operating
      cash
      flows to date. At September 30, 2008, the Company had working capital of
      $1,079,000. For the nine months ended September 30, 2008, the Company incurred
      a
      net loss of $41,029,000 which included non-cash charges of $30,290,000. Cash
      used from operating activities was $7,288,000 for the nine months ended
      September 30, 2008.





The
      Company’s plan to increase cash flows from operations relies significantly on
      increases in revenue generated from our compression and video codec technology
      services and products. Additionally, in order to reduce operating costs,
      management has begun the implementation of a Company-wide cost savings plan.
      Given our cash and short-term investments of $4,623,000 at September 30, 2008,
      and the Company’s forecasted cash requirements, the Company’s management
      anticipates that the Company’s existing capital resources will be sufficient to
      satisfy our cash flow requirements for the next 12 months. We have based our
      forecasts on assumptions we have made relating to, among other things, the
      market for our products and services, economic conditions and the availability
      of credit to us and our customers. If these assumptions are incorrect, or if
      our
      sales are less than forecasted and/or expenses higher than expected, we may
      not
      have sufficient resources to fund our operations for this entire period,
      however. In that event, the Company may need to seek other sources of funds
      by
      issuing equity or incurring debt, or may need to implement further reductions
      of
      operating expenses, or some combination of these measures, in order for the
      Company to generate positive cash flows to sustain the operations of the
      Company. However, because of the recent tightening in global credit markets,
      we
      may not be able to obtain financing on favorable terms, or at all.





(2)
      Basis
      of Presentation





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





The
      interim condensed consolidated financial statements are unaudited. However,
      in
      the opinion of management, such financial statements contain all adjustments
      (consisting of normally recurring accruals) necessary to present fairly the
      financial position of the Company and its results of operations and cash flows
      for the interim periods presented. The condensed consolidated financial
      statements included herein have been prepared pursuant to the rules and
      regulations of the Securities and Exchange Commission (“SEC”). Certain
      information and footnote disclosures normally included in consolidated financial
      statements prepared in accordance with accounting 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 Form 10-K
      Annual Report for the fiscal year ended December 31, 2007, filed with the SEC
      on
      June 27, 2008.


-
          7
          -


*Reclassifications*





We
      have
      reclassified certain prior period amounts to conform with the current period
      presentation.





(3)
      Acquisitions





On
      November 1, 2007, the Company completed the acquisition of all of the share
      capital of Hantro Products Oy (“Hantro”), a Finnish corporation. The Hantro
      acquisition was structured as a share exchange transaction. In accordance with
      the exchange agreement that governed the exchange transaction, on November
      1,
      2007, Hantro’s security holders each transferred to On2 all of the outstanding
      capital shares, and all outstanding options to purchase capital shares, that
      together constituted all of the equity ownership of Hantro, in exchange for
      cash, shares of On2’s common stock and a commitment to issue additional shares
      of On2’s common stock in an amount to be determined in accordance with a formula
      for calculating contingent consideration.





*Pro
      Forma Financial Information*





The
      unaudited information in the table below summarizes the combined results of
      operations of On2 Technologies, Inc. and Hantro, on a pro forma basis, as though
      the companies had been combined as of the beginning of each of the periods
      presented. The pro forma financial information is presented for informational
      purposes only and is not indicative of the results of operations that would
      have
      been achieved if the acquisition had taken place at the beginning of each of
      the
      periods presented. The pro forma financial information for all periods presented
      includes the business combination accounting effect of historical Hantro
      revenues and amortization charges from acquired intangible assets.





Three Months
              Ended
              September 30,
              2007
            
            Nine Months
              Ended
              September 30,
              2007Total
                revenues
            
            $
            5,750,000
            
            $
            15,625,000Net
                loss
            
            
            (1,430,000
            )
            
            (7,008,000
            )Net
                loss per share – basic and diluted
            
            $
            (0.01
            )
            $
            (0.05
            )





(4)
      Recently Issued Accounting Pronouncements




In
      May
      2008, the FASB issued SFAS 162, *The
      Hierarchy of Generally Accepted Accounting Principles.* SFAS 162
      is intended to improve financial reporting by identifying a consistent
      framework, or hierarchy, for selecting accounting principles to be used in
      preparing financial statements that are presented in conformity with U.S.
      generally accepted accounting principles for nongovernmental entities. SFAS
      162
      is effective 60 days following the SEC's approval of the PCAOB amendments to
      AU
      Section 411. The Company is currently evaluating the impact of adopting SFAS
      162
      on its consolidated financial position and results of operations.





In
      March
      2008, the FASB issued SFAS 161, *Disclosures
      about Derivative Instruments and Hedging Activities - an Amendment of FASB
      Statement 133.* SFAS 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, SFAS 161
      requires:


-
          8
          -




·
            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.




SFAS
      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 consolidated financial position and
      results of operations.





(5)
      Stock-Based Compensation





The
      Company adopted the provision of SFAS No. 123R effective January 1, 2006, using
      the modified prospective transition method. Under this 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 share based awards granted
      or
      modified after adoption. Accordingly, periods prior to adoption have not been
      restated. Prior to the adoption of SFAS 123R, the Company accounted for stock
      based compensation using the intrinsic value method. The Company recognizes
      share-based compensation cost associated with awards subject to graded vesting
      in accordance with the accelerated method specified in FASB Interpretation
      No.
      28 pursuant to which each vesting tranche is treated as a separate award. The
      compensation cost associated with each vesting tranche is recognized as expense
      evenly over the vesting period of that tranche.





The
      following table summarizes the activity of the Company’s stock options for the
      nine months ended September 30, 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
            
            
            5,463,000
            
            
            0.44Exercised
            
            
            (71,000
            )
            
            0.70Canceled
                or expired
            
            
            (279,000
            )
            
            1.24Outstanding
                at September 30, 2008
            
            
            13,069,000
            
            $
            0.78
            
            
            7.31
            
            $
            6,000Vested
                and expected to vest at September 30, 2008
            
            
            12,920,000
            
            $
            0.78
            
            
            7.29
            
            $
            6,000Exercisable
                at September 30, 2008
            
            
            5,588,000
            
            $
            1.00
            
            
            5.07
            
            $
            6,000


-
          9
          -





Stock-based
      compensation expense recognized in the condensed consolidated statement of
      operations was $446,000 and $1,415,000 for the three and nine months ended
      September 30, 2008, respectively, which included $924,000 of compensation
      expense from restricted stock grants. Stock-based compensation expense
      recognized in the condensed consolidated statement of operations was $230,000
      and $547,000 for the three and nine months ended September 30, 2007,
      respectively, which included $176,000 of compensation expense from restricted
      stock grants.




The
      aggregate intrinsic value of options exercised during the nine months ended
      September 30, 2008 was $18,000.





The
      following table summarizes the activity of the Company’s non-vested stock
      options for the nine months ended September 30, 2008:





**Shares**
            
            **Weighted-**
              **average
                Grant**
              **Date Fair Value**Non-vested
                at January 1, 2008
            
            
            3,108,000
            
            $
            0.58Granted
            
            
            5,463,000
            
            
            0.24Cancelled
                or expired
            
            
            (331,000
            )
            
            0.56Vested
                during the period
            
            
            (759,000
            )
            
            0.65Non-vested
                at September 30, 2008
            
            
            7,481,000
            
            $
            0.32





As
      of
      September 30, 2008, there was $1,993,000 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 1.68 years. The total grant date fair value of shares
      vested during the nine-months ended September 30, 2008 was
      $493,000.





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:





**Three Months**
              **Ended**
              **September 30,**
              **2008**
            
            **Three Months**
              **Ended**
              **September 30,**
              **2007**Weighted
                average fair value at date of grant for options granted during the
                period
            
            $
            0.22
            
            $
            0.84Expected
                stock price volatility
            
            
            83
            %
            
            71
            %Expected
                life of options
            
            
            3
                years
            
            
            5
                yearsRisk
                free interest rates
            
            
            2.41
            %
            
            4.26
            %Expected
                dividend yield
            
            
            0
            %
            
            0
            %


-
          10
          -


The
      following table compares characteristics of the Company’s stock options granted
      during the nine months ended September 30, 2008 and September 30,
      2007:





**Nine Months**
              **Ended**
              **September 30,**
              **2008**
            
            **Nine Months**
              **Ended**
              **September 30,**
              **2007**Weighted-average
                fair value at date of grant for options granted during the
                period
            
            $
            0.24
            
            $
            1
                .31Expected
                stock price volatility
            
            
            83
            %
            
            94
            %Expected
                life of options
            
            
            3
                years
            
            
            5
                yearsRisk
                free interest rates
            
            
            2.40
            %
            
            4.95
            %Expected
                dividend yield
            
            
            0
            %
            
            0
            %





The
      following summarizes the activity of the Company’s non-vested restricted common
      stock for the nine months ended September 30, 2008:





**Shares**
            
            **Weighted-**
              **average**
              **Grant Date**
              **Fair Value**Non-vested
                at January 1, 2008
            
            
            1,053,000
            
            $
            2.04Granted
            
            
            1,065,000
            
            
            0.65Cancelled
                or expired
            
            
            (56,000
            )
            
            2.46Vested
                during the period
            
            
            (292,000
            )
            
            2.41Non-vested
                at September 30, 2008
            
            
            1,770,000
            
            $
            1.14





During
      the nine months ended September 30, 2008, the Company granted 486,000 shares
      of
      restricted common stock to its Board of Directors which vest in April and July
      2009, and 579,000 shares of restricted common stock to its employees which
      vest
      at various dates through March 2011. As of September 30, 2008, the Company
      recognized $208,000 in compensation expense related to these grants and there
      was $1,232,000 of unrecognized compensation cost which will be recognized
      through the second quarter of 2011.





(6)
      Cash
      and cash equivalents and short-term investments





As
      of
      September 30, 2008, the Company held $132,000 in short-term securities, all
      of
      which are in a certificate of deposit in a United States bank.





(7)
      Intangible Assets and Goodwill





In
      connection with the Company’s acquisition of Hantro on November 1, 2007 (as
      described in Note 3), the Company acquired intangible assets of $53,354,000
      and
      included goodwill in the amount of $36,075,000.





Goodwill
      represents the excess of the purchase price over the fair value of net assets
      acquired in a business combination. Goodwill is required to be tested for
      impairment at the reporting unit level on an annual basis and between annual
      tests when circumstances indicate that the recoverability of the carrying amount
      of such goodwill may be impaired. Application of the goodwill impairment test
      requires exercise of judgment, including the estimation of future cash flows,
      determination of appropriate discount rates and other important assumptions.
      Changes in these estimates and assumptions could materially affect the
      determination of fair value and/or goodwill impairment for each reporting
      unit.


-
          11
          -





During
      the quarter ended September 30, 2008, the global economy has dramatically
      weakened, which, along with other factors, has contributed to a continued
      underperformance of our Hantro business (now operated by our wholly-owned
      subsidiary, On2 Finland) and a decline in our overall market value.  Based
      on these circumstances, at September 30, 2008, the Company performed an
      impairment review of its goodwill and intangible assets related to its Hantro
      business.  The Company engaged an outside valuation specialist to perform
      the evaluation, utilizing management’s inputs and assumptions, by analyzing the
      expected future cash flows of the business.  Based on the results of the
      evaluation, the Company has determined that goodwill and other intangibles
      are
      impaired. Accordingly, the Company recorded an impairment charge during the
      quarter ended September 30, 2008, totaling $20,265,000 (goodwill) and $5,980,000
      (intangible assets) to reduce their carrying value to an amount that is expected
      to be recoverable.  Should the global economy continue to weaken,
      additional impairment charges may be necessary.





The
      assets recognized with respect to acquired software, trademarks, customer
      relationships and non-compete agreements are being amortized over their
      estimated lives. Amortization expense related to these intangible assets was
      $778,000 and $2,340,000 for the three and nine months ended September 30, 2008,
      respectively, and $62,000 and $185,000 for the three and nine months ended
      September 30, 2007, respectively. The intangible assets and goodwill, decreased
      by $ 4,877,000 and by $1,024,000 for the three and nine months ended September
      30, 2008, respectively, for the effects of the foreign currency translation
      adjustment. There were no other additions of intangible assets and goodwill
      during the nine months ended September 30, 2008.





Based
      on
      the current amount of intangibles subject to amortization, the estimated future
      amortization expense related to our intangible assets at September 30, 2008
      is
      as follows:





For
                the Year Ending
              September
                30,
            
            Future
              Amortization2009
            
            $
            1,424,0002010
            
            
            1,280,0002011
            
            
            1,280,0002012
            
            
            1,280,0002013
            
            
            754,000Thereafter
            
            
            2,886,000Total
            
            $
            8,904,000





(8)
      Short-Term Borrowings





At
      September 30, 2008, short-term borrowings consisted of the following:





A
      line of
      credit with a Finnish bank for $650,000 (€450,000 at September 30, 2008). The
      line of credit has no expiration date. Borrowings under the line of credit
      bear
      interest at one month EURIBOR plus 1.25% (total of 5.523% at September 30,
      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 $-0-
      at September 30, 2008.





Term-loan





During
      July 2008, the Company renewed its Directors and Officers Liability Insurance
      and financed the premium with a $140,000, nine-month term-loan that carries
      an
      effective annual interest rate of 4.75%. The balance at September 30, 2008
      was
      $109,000.


-
          12
          -





(9)
      Long-Term Debt





At
      September 30, 2008, long-term debt consisted of the following:





Unsecured
      notes payable to a Finnish funding agency of $2,584,000, including interest
      at
      1.75%, due at dates ranging from January 2009 to December 2011; $258,000 to
      a
      Finnish bank, including interest at the 3-month EURIBOR plus 1.1% (total of
      5.76% at September 30, 2008), due March 2011, secured by a guarantee by On2,
      and
      by 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 $181,000, including interest at the 6 month EURIBOR plus
      .5% (total of 5.465% at September 30, 2008), due March 2011.





Future
      maturities of long-term debt are as follows as of September 30,
      2008:





For
                the Year Ending September 30,2009
            
            $
            481,0002010
            
            
            1,064,0002011
            
            
            783,0002012
            
            
            695,000Total
            
            $
            3,023,000





(10)
      Common Stock





During
      the nine months ended September 30, 2008, the Company received $49,000 in
      proceeds and issued 71,000 shares of its common stock for stock option
      exercises. The Company cancelled 102,000 shares of restricted common stock
      grants from 2007 as a result of terminated employees and cancelled 53,000 shares
      of common stock resulting from the retirement of Treasury Stock, as outlined
      in
      Note 11 below.





(11)
      Treasury Stock





In
      April
      2007 the Company’s Board of Directors authorized that all the shares recorded as
      treasury stock be cancelled and that all subsequent shares received from
      cashless exercises be cancelled immediately after receipt. During the nine
      months ended September 30, 2008, the Company allowed its employees to relinquish
      shares from the vesting of a portion of restricted stock grants for payment
      of
      taxes. The Company received a total of 53,000 shares at a value of $52,000
      for
      payment of taxes.





(12)
      Geographical Reporting and Customer Concentration





The
      components of the Company’s revenue for the three and nine months ended
      September 30, 2008 and 2007 are summarized as follows:





For the three months ended
              September 302008
            
            2007License
                software revenue
            
            $
            3,415,000
            
            $
            1,278,000Engineering
                services and support
            
            
            576,000
            
            
            180,000Royalties
            
            
            961,000
            
            
            458,000Other
            
            
            19,000
            
            
            19,000Total
            
            $
            4,971,000
            
            $
            1,935,000


-
          13
          -





For the nine months ended
              September 302008
            
            2007License
                software revenue
            
            $
            8,417,000
            
            $
            5,193,000Engineering
                services and support
            
            
            1,638,000
            
            
            643,000Royalties
            
            
            2,576,000
            
            
            1,226,000Other
            
            
            57,000
            
            
            57,000Total
            
            $
            12,688,000
            
            $
            7,119,000





For
      the
      three and nine months ended September 30, 2008, foreign customers accounted
      for
      approximately 60% and 52%, respectively of the Company’s total revenue. For the
      three and nine months ended September 30, 2007 foreign customers accounted
      for
      approximately 31% and 43%, respectively of the Company’s total revenue. These
      customers are primarily located in Asia, Europe and the Middle East.





Selected
      information by geographic location is as follows:





For the three months ended
              September 302008
            
            2007Revenue
                from unaffiliated customers:United
                States Operations
            
            $
            3,489,000
            
            $
            1,935,000Finland
                Operations
            
            
            1,482,000
            
            
            -Total
            
            $
            4,971,000
            
            $
            1,935,000Net
                income (loss):United
                States Operations
            
            $
            508,000
            
            $
            (1,382,000
            )Finland
                Operations
            
            
            (29,623,000
            )
            
            -Total
            
            $
            (29,115,000
            )
            $
            (1,382,000
            )





For the nine months ended
              September 302008
            
            2007Revenue
                from unaffiliated customers:United
                States Operations
            
            $
            8,346,000
            
            $
            7,119,000Finland
                Operations
            
            
            4,342,000
            
            
            -Total
            
            $
            12,688,000
            
            $
            7,119,000Net
                loss:United
                States Operations
            
            $
            (4,510,000
            )
            $
            (5,108,000
            )Finland
                Operations
            
            
            (36,519,000
            )
            
            -Total
            
            $
            (41,029,000
            )
            $
            (5,108,000
            )


-
          14
          -





September 30,
            
            December 31,2008
            
            2007Identifiable
                assets:United
                States Operations
            
            $
            15,600,000
            
            $
            17,631,000Finland
                Operations
            
            
            21,607,000
            
            
            61,894,000Total
            
            $
            37,207,000
            
            $
            79,525,000




The
      Identifiable assets for the United States Operations include intangible assets,
      net of $387,000 at September 30, 2008 and $572,000 at December 30, 2007. The
      identifiable assets for the Finland operations include intangible assets, net
      of
      $24,504,000 at September 30, 2008 and $53,928,000 at December 30,
      2007.





For
      the
      three months ended September 30, 2008, there was one customer that accounted
      for
      11% of the Company’s revenue. For the nine months ended September 30, 2008,
      there were no customers that accounted for 10% or more of the Company's revenue.
      For the three and nine months ended September 30, 2007, there were no customers
      that accounted for 10% or more of the Company’s revenue.





Financial
      instruments that subject the Company to concentrations of credit risk consist
      primarily of cash and cash equivalents and accounts receivable. The company
      maintains all of its cash and cash equivalents in one financial institution.
      The
      Company performs periodic evaluations of the relative credit standing of the
      institution. The cash balances are insured by the FDIC, up to $250,000 per
      depositor. The company has cash balances in a money market fund and a checking
      account at September 30, 2008 that exceeds the limit in the amount of $3.9
      million.





(13)
      Net
      Loss Per Share





Basic
      net
      loss per share is computed by dividing the net loss applicable to common shares
      by the weighted average number of common shares outstanding during the
      period.  Diluted loss attributable to common shares adjusts basic loss per
      share for the effects of convertible securities, warrants, stock options and
      other potentially dilutive financial instruments, only in the periods in which
      such effect is dilutive.  The shares issuable upon the conversion of
      preferred stock, the exercise of stock options and warrants are excluded from
      the calculation of net loss per share as their effect would be
      anti-dilutive. ****





Securities
      that could potentially dilute earnings per share in the future, that had
      exercise prices below the market price at September 30, 2008 and 2007, were
      not
      included in the computation of diluted loss per share and consist of the
      following as of September 30:





**2008**
            
            **2007**Warrants
                to purchase common stock
            
            
            -
            
            
            1,601,000Options
                to purchase common stock
            
            
            102,500
            
            
            4,427,000Total
            
            
            102,500
            
            
            6,028,000





(14)
      Related Party Transactions





During
      the nine months ended September 30, 2008 and 2007, the Company retained
      McGuireWoods LLP to perform certain legal services on behalf of the Company
      and
      incurred costs of approximately $59,000 and $228,000 for the three and nine
      months ended September 30, 2008, respectively, and $308,000 and $845,000 for
      the
      three and nine months ended September 30, 2007, respectively, for such legal
      services. William A. Newman, a director of the Company, was a partner of
      McGuireWoods LLP until May 2008. In May 2008, Mr. Newman became a partner at
      Sullivan & Worcester LLP and the company incurred $27,000 in legal service
      fees to Sullivan & Worcester LLP for the nine months ended September 30,
      2008.


-
          15
          -


(15)
      Litigation




**Islandia**





On
      August
      14, 2008, Islandia, L.P. filed a complaint against On2 in the Supreme Court
      of
      the State of New York, New York County. Islandia was an investor in the
      Company’s October 2004 issuance of Series D Convertible Preferred Stock pursuant
      to which On2 sold to Islandia 1,500 shares of Series D Convertible Preferred
      Stock, raising gross proceeds for the Company from Islandia of $1,500,000.
      Islandia’s Series D Convertible Preferred Stock was convertible into On2 common
      stock at an effective conversion price of $0.70 per share of common stock.
      Pursuant to this transaction, Islandia also received two warrants to purchase
      an
      aggregate of 1,122,754 shares of On2 common stock.





The
      complaint asserts that, at various times in 2007, On2 failed to make monthly
      redemptions of the Series D Preferred Stock in a timely manner and that On2
      failed to deliver timely notice of its intention to make such redemptions using
      shares of On2’s common stock. The complaint also asserts that Islandia timely
      exercised its right to convert the Series D Preferred Stock into shares of
      On2
      common stock and that On2 failed to credit to Islandia such allegedly converted
      shares. The complaint further asserts that On2 failed to pay to Islandia certain
      Series D dividends to which it was entitled. The complaint seeks a total of
      $4,645,193 in damages plus interest and reasonable attorneys’ fees.




On
      October 8, 2008, On2 filed an answer in which it denied the material assertions
      of the complaint and asserted various affirmative defenses, including that
      (i)
      On2 made the required Series D redemptions in full and on the dates agreed
      upon
      by the parties, (ii) On2 provided timely notice that it would pay redemptions
      in
      On2 common stock and that Islandia accepted all of the redemption payments
      on
      the dates made without protest, (iii) Islandia failed to timely assert its
      conversion rights under the terms of the Series D agreements and (iv) On2 duly
      paid the dividends owed to Islandia under the terms of the Agreement and
      Islandia accepted all dividend payments without protest.





On2
      believes this lawsuit is without merit and intends to vigorously defend itself
      against Islandia’s complaint. As of September 30, 2008, the Company has not
      recorded any provision associated with this complaint.





**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 bestreasonableefforts to have On2’s video codec “ported” to (i.e., integrated with) a
                chip to be used in EVD players.


-
          16
          -





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




On2’s
      current arbitration claim alleges that, despite its obligations under the
      license agreements, 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.





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





**Forward-Looking
      Statements**





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 loss per share, acquisition costs and
                related
                amortization, and other measures of results of operations;•
            the
                effects of acquiring Hantro;•
            difficulties
                in controlling expenses, legal compliance matters or internal control
                over
                financial reporting review, improvement and
                remediation;•
            risks
                associated with the ineffectiveness of the Company’s internal control over
                financial reporting and our ability to remediate material
                weaknesses;


-
          17
          -





•
            the
                financial performance and growth of our business, including future
                international growth;•
            our
                financial position and the availability of resources;•
            the
                availability of credit and future debt and/or equity investment
                capital;•
            future
                competition; and•
            the
                degree of seasonality in our
                revenue.




These
      forward-looking statements are only predictions, and actual events or results
      may differ materially. The statements are based on management’s beliefs and
      assumption using information available at the time the statements were made.
      We
      cannot guarantee future results, levels of activity, performance or
      achievements. Factors that may cause actual results to differ are often
      presented with the forward-looking statements themselves. Additionally, other
      risks that may cause actual results to differ from predicted results are set
      forth in “ *Risk
      Factors That May Affect Future Operating Results* "
      in the
      Company's Annual Report on Form 10-K for the year ended December 31, 2007,
      as
      well as in Item 1A of Part II of this quarterly report on Form
      10-Q.




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. We have based our
      forecasts on assumptions we have made relating to, among other things, the
      market for our products and services, economic conditions and the availability
      of credit to us and our customers. If these assumptions are incorrect, we may
      not have sufficient resources to fund our operations for this entire
      period, however. Additional
      funds may also be required in order to pursue strategic opportunities or for
      capital expenditures. Because of the recent tightening in global credit markets,
      we may not be able to obtain financing on favorable terms, or at all. 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 under the caption “ *Risk
      Factors That May Affect Future Operating Results* "
      in the
      Company's Annual Report on Form 10-K for the year ended December 31, 2007 in
      addition to the other information set forth herein, including Item 1A of Part
      II
      of this quarterly report on Form 10-Q.




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





**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 for
      the second and third quarters of 2007. These restatements are set forth in
      Amendment No. 1 to our Quarterly Report on Form 10-Q, filed on June 27, 2008
      and
      Amendment No. 1 to our Quarterly Report on Form 10-Q for the period ended
      September 30, 2007, both filed on June 27, 2008, and are also described in
      our
      Annual Report on Form 10-K for the year ended December 31, 2007, filed on June
      28, 2008. In connection with this, we incurred costs of approximately
      $2,186,000, as of September 30, 2008, of which we expensed approximately
      $373,000 in the first quarter of 2008 and an additional $1,813,000 the second
      quarter of 2008.   We expensed these costs in the period in which the
      legal, accounting and other services were provided and we recorded these costs
      as general and administrative expenses. 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.


-
          18
          -


**Acquisition
      of Hantro Products Oy**




On
      May
      21, 2007, we entered into an exchange agreement with Nexit Ventures Oy, as
      the
      authorized representative of the holders of all outstanding equity securities
      (including outstanding share options) of Hantro to acquire all outstanding
      equity securities of Hantro in exchange for cash and common stock. We completed
      the acquisition on November 1, 2007 for a total purchase price of $49,501,000.
      Under the terms of the exchange agreement, On2 paid $6,608,102 in cash and
      issued 25,438,817 shares of the Company's common stock, par value $.01 per
      share, directly to the Hantro security holders, of which two million On2 shares
      are being held in escrow until the anniversary of the Hantro closing to secure
      the indemnification obligations of the shareholders of Hantro. At that time,
      Hantro and its subsidiary became wholly-owned subsidiaries of the Company.




The
      exchange agreement also required On2 to issue additional shares of common stock,
      depending on Hantro’s net revenue in 2007. Hantro’s 2007 net revenue exceeded
€9,000,000, and accordingly, the Company became obligated to issue to the former
      security holders of Hantro an additional 12,500,000 shares of On2 common stock
      (the maximum number of shares issuable as contingent payment). On July 8, 2008,
      the Company issued 11,100,440 of the shares due to the former Hantro security
      holders, and on August 28, 2008 issued the remaining 1,399,560
      shares.





**Asset
      Impairment**





During
      the quarter ended September 30, 2008, the global economy has dramatically
      weakened, which, among other factors, has contributed to the continued
      underperformance of our Hantro business and a decline in our overall market
      value.  Based on these circumstances, at September 30, 2008, the Company
      performed an impairment review of its goodwill and intangible assets related
      to
      its Hantro business.  The Company engaged an outside valuation specialist
      to perform the evaluation, utilizing management’s inputs and assumptions, by
      analyzing the expected future cash flows of the business.  Based on the
      results of the evaluation, the Company has determined that goodwill and other
      intangibles are impaired. Accordingly, the Company recorded an impairment charge
      during the quarter ended September 30, 2008, totaling $20,265,000 (goodwill)
      and
      $5,980,000 (intangible assets) to reduce their carrying value to an amount
      that
      is expected to be recoverable.  Should the global economy continue to
      weaken, additional impairment charges may be necessary.





**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 has its headquarters
      and research and development facility in Oulu, Finland and it has a global
      sales
      network with satellite offices in Korea, Japan, Taiwan, Germany, Hong Kong
      and
      Mainland China. Both On2 and On2 Finland also provide integration, customization
      and support services to enable high quality video on and faster interoperability
      between devices.




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


-
          19
          -


We
      offer
      the following suite of products and services 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 aacPlus 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.


-
          20
          -


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:




**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;


-
          21
          -





•
            Employing
                flexible licensing strategies to offer customers more attractive
                business
                terms than those available for competing technologies;•
            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 part to assist us in achieving our strategic
      goal 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 a broad
      selection of off-the-shelf optimized software that we could license to customers
      who were interested in implementing our codecs on devices. Those customers
      were
      therefore frequently 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.


-
          22
          -


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
      111employees 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.




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.


-
          23
          -


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, have sprung
      up
      and seen their popularity soar. Although consumer generated content initially
      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 has only
      recently become available on devices using DSPs, 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.




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.


-
          24
          -


A
      continuing trend in our business is the presence of Microsoft, Inc. as a
      significant competitor in the market for digital media creation and distribution
      technology. In 2007, Microsoft released Silverlight, 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.




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.


-
          25
          -


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;




·
            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.


-
          26
          -


**Critical
      Accounting Policies and Estimates**





This
      discussion and analysis of our financial condition and results of operations
      are
      based on our unaudited condensed consolidated financial statements that have
      been prepared under accounting principles generally accepted in the U.S. The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States of America requires our management
      to
      make estimates and assumptions that affect the reported amounts of assets and
      liabilities and the disclosure of contingent assets and liabilities at the
      date
      of the financial statements and the reported amounts of revenue and expenses
      during the reporting period. Actual results could materially differ from those
      estimates. The unaudited condensed consolidated financial statements and the
      related notes thereto should be read in conjunction with the discussion of
      our
      critical accounting policies and our annual report for the fiscal year ended
      December 31, 2007 on Form 10K, filed with the Securities and Exchange Commission
      on June 27, 2008. Our critical accounting policies and estimates
      are:





•
            Revenue
                recognition;•
            Accounts
                receivable allowance;•
            Acquisitions;•
            Equity-based
                compensation; and•
            Valuation
                of goodwill and intangible assets, including impairment, 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 management or estimates used 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
      collectibility is probable. Revenues recognized from multiple-element software
      arrangements are allocated to each element of the arrangement based on the
      fair
      values of the elements, such as product licenses, post-contract customer
      support, or training. The determination of the fair value is based on the vendor
      specific objective evidence available to us. If such evidence of the fair value
      of each element of the arrangement does not exist, we defer all revenue from
      the
      arrangement until such time that evidence of the fair value does exist or until
      all elements of the arrangement are delivered.




Our
      software licensing arrangements typically consist of two elements: a software
      license and post-contract customer support (“PCS”). We recognize license
      revenues based on the residual method after all elements other than PCS have
      been delivered as prescribed by SOP 98-9. We recognize PCS revenues over the
      term of the maintenance contract or on a “per usage” basis, whichever is stated
      in the contract. Vendor specific objective evidence of the fair value of PCS
      is
      determined by reference to the price the customer will have to pay for PCS
      when
      it is sold separately (i.e. the renewal rate). 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.


-
          27
          -





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.





*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. See the discussion of “Asset
      Impairment” below under “Results of Operations.”


-
          28
          -





**Results
      of Operations**





*Revenue.* Revenue
      for the three months ended September 30, 2008 was $4,971,000, as compared to
      $1,935,000 for the three months ended September 30, 2007. Revenue for the nine
      months ended September 30, 2008 was $12,688,000, as compared to $7,119,000
      for
      the nine months ended September 30, 2007. Revenue for the three and nine months
      ended September 30, 2008 and 2007 was derived primarily from the sale of
      software licenses, engineering and consulting services and royalties. The
      increase in revenue for the three and nine months ended September 30, 2008
      is
      primarily attributed to the revenue contribution of $1,482,000 and $4,342,000,
      respectively, from our subsidiary, On2 Finland (formerly Hantro), acquired
      in
      November 2007, and also increases in license software and royalty sales from
      On2
      US.





*Operating
      Expenses.* The
      Company's operating expenses consist of costs of revenue, research and
      development, sales and marketing, general and administrative expenses and equity
      based compensation. Operating expenses for the three months ended September
      30,
      2008 were $34,390,000 as compared to $3,438,000 for the three months ended
      September 30, 2007. Operating expenses were $54,096,000 for the nine months
      ended September 30, 2008 as compared to $8,763,000 for the nine months ended
      September 30, 2007.





*Costs
      of Revenue.* Costs 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. Costs of revenue for the three months ended September 30, 2008 was
      $940,000, as compared to $603,000 for the three months ended September 30,
      2007.
      Costs of revenue for the nine months ended September 30, 2008 was $3,564,000,
      as
      compared to $1,415,000 for the nine months ended September 30, 2007. The
      increase in expenses for the nine months ended September 30, 2008 as compared
      with the nine months ended September 30, 2007 is primarily attributable to
      an
      increase in production and engineering costs associated with On2 Finland of
      $2,708,000, of which $1,791,000 is amortization of the Hantro purchased
      technology, offset by a decrease in production and engineering costs for the
      US
      operations of $558,000 due to fewer hours allocated by our engineering
      staff.





*Research
      and Development.* Research
      and development expenses, excluding equity-based compensation, consist primarily
      of salaries and related expenses and consulting fees associated with the
      development and production of our products and services, operating lease costs
      and depreciation costs. Research and development expenses for the three months
      ended September 30, 2008 were $2,848,000 as compared to $445,000 for the three
      months ended September 30, 2007. The increase of $2,403,000 for the three months
      ended September 30, 2008 is primarily the result of an increase of $2,218,000
      in
      research and development costs incurred by our Finnish subsidiary, which uses
      a
      greater portion of their engineers in research and development activities ,
      and
      a $185,000 increase in research and development costs incurred by our US
      operations, which is a result of increases in personnel and related costs and
      an
      increase in the number of hours that our engineering staff worked on development
      projects. Research and development expenses for the nine months ended September
      30, 2008 were $8,665,000 as compared to $1,500,000 for the nine months ended
      September 30, 2007. The increase of $7,165,000 for the nine months ended
      September 30, 2008 as compared with September 30, 2007 is primarily a result
      of
      an increase of $6,249,000 in research and development costs incurred by our
      Finnish subsidiary, which utilizes a greater portion of their engineers in
      research and development activities and a $917,000 increase in research and
      development costs incurred by our US operations, which 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.


-
          29
          -





*Sales
      and Marketing.* Sales
      and marketing expenses, excluding equity-based compensation, consist primarily
      of salaries and related overhead costs, commissions, business development costs,
      trade show costs, marketing and promotional costs incurred to create brand
      awareness and public relations expenses. Sales and marketing expenses for the
      three months ended September 30, 2008 were $2,018,000, as compared to $676,000
      for the three months ended September 30, 2007. The increase of $1,342,000 for
      the three months ended September 30, 2008 is primarily a result of an increase
      of $1,509,000 in sales and marketing personnel and related costs attributable
      to
      our Finnish subsidiary and a $167,000 decrease in sales and marketing costs
      incurred by US operations that is a result of cost reductions that took effect
      during the third quarter. Sales and marketing expenses for the nine months
      ended
      September 30, 2008 were $5,782,000, as compared to $1,886,000 for the nine
      months ended September 30, 2007. The increase of $3,896,000 for the nine months
      ended September 30, 2008 is primarily a result of an increase of $3,693,000
      in
      sales and marketing personnel and related costs attributable to our Finnish
      subsidiary and a $533,000 increase in sales and business development costs,
      offset by a decrease in marketing costs of $305,000 incurred by US.




*General
      and Administrative* .
      General
      and administrative expenses excluding equity-based compensation, consist
      primarily of salaries and related overhead costs for general corporate functions
      including finance, human resources, legal, information technology, facilities,
      outside legal and professional fees and insurance. General and administrative
      expenses for the three months ended September 30, 2008 were $1,946,000, as
      compared with $1,532,000 for the three months ended September 30, 2007. The
      increase of $414,000 for the three months ended September 30, 2008 is primarily
      a result of an increase of $630,000 in general and administrative costs
      attributable to our Finnish subsidiary and a $216,000 decrease in general and
      administrative costs incurred by US operations that is a result of cost
      reductions that took effect during the third quarter. General and administrative
      expenses for the nine months ended September 30, 2008 were $8,640,000, as
      compared with $3,478,000 for the nine months ended September 30, 2007. The
      increase of $5,162,000 for the nine months ended September 30, 2008 is
      attributable to $1,904,000 of related general and administrative costs
      attributable to our Finnish subsidiary, increases in legal and accounting fees
      of $2,349,000 of which $2,186,000 is related to the Audit Committee’s review of
      certain 2007 sales contracts in connection with the restatement, increases
      in
      salaries and related benefit costs, consulting services related to the Company’s
      compliance with Sarbanes-Oxley Section 404 and professional fees associated
      with
      the Company’s proxy statement and annual report.





*Asset
      Impairment* .
      During
      the quarter ended September 30, 2008, the global economy has dramatically
      weakened, which, among other factors, has contributed to the continued
      underperformance of our Hantro business and a decline in our overall market
      value.  Based on these circumstances, at September 30, 2008, the Company
      performed an impairment review of its goodwill and intangible assets related
      to
      its Hantro business.  The Company engaged an outside valuation specialist
      to perform the evaluation, utilizing management’s inputs and assumptions, by
      analyzing the expected future cash flows of the business.  Based on the
      results of the evaluation, the Company has determined that goodwill and other
      intangibles are impaired. Accordingly, the Company recorded an impairment charge
      during the quarter ended September 30, 2008, totaling $20,265,000 (goodwill)
      and
      $5,980,000 (intangible assets) to reduce their carrying value to an amount
      that
      is expected to be recoverable.  Should the global economy continue to
      weaken, additional impairment charges may be necessary.





*Equity-Based
      Compensation.* Equity
      based compensation, which is presented separately, was $393,000 for the three
      months ended September 30, 2008, as compared with $182,000 for the three months
      ended September 30, 2007. Equity based compensation was $1,200,000 for the
      nine
      months ended September 30, 2008, as compared with $484,000 for the nine months
      ended September 30, 2007. The increase for the three and nine months ended
      September 30, 2008 is primarily due to the amortization of options granted
      in
      association with the acquisition of our Finnish subsidiary on November 1, 2007. Equity-based
      compensation of $53,000 and $48,000 is included in cost of revenue for the
      three
      months ended September 30, 2008 and 2007, respectively. Equity-based compensation of $215,000 and $63,000 is included in cost of revenue
      for the nine months ended September 30, 2008 and 2007,
      respectively.


-
          30
          -


*Other
      income (expense), net*





Interest
      income (expense), net primarily consists of interest incurred for capital lease
      obligations and long-term debt, offset by interest earned on the Company’s
      invested cash balances. Interest income (expense), net was $(27,000) and $34,000
      for the three and nine months ended September 30, 2008, respectively ,
      as
      compared to $118,000
      and $229,000 for the three and nine months ended September 30, 2007,
      respectively.





Other
      income (expense), net primarily consists of the change in the fair value of
      the
      warrant derivative liability and realized losses on marketable securities.
      The
      decrease in expense of $4,038,000 for the nine months ended September 30, 2008
      is primarily a result of the elimination of the derivative liability in the
      second quarter of 2007 which accounted for $3,582,000, the elimination of a
      one
      time fee for a warrant amendment which accounted for $86,000, the sale of
      marketable securities at a loss which accounted for $27,000 and income from
      a
      grant from our Finnish subsidiary for $331,000. 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.





**Liquidity
      and Capital Resources**





At
      September 30, 2008, the Company had cash and cash equivalents and short-term
      investments of $4,623,000, as compared to $15,094,000 at December 31, 2007.
      At
      September 30, 2008 the Company had working capital of $1,079,000, as compared
      with $13,246,000 at December 31, 2007.





Net
      cash
      (used in) provided by operating activities was $(7,288,000) and $357,000 for
      the
      nine months ended September 30, 2008 and 2007, respectively. The decrease in
      net
      cash used in operating activities is primarily related to a net loss of
      $41,029,000 and a decrease in accounts payable and accrued expenses of
      $1,007,000, partially offset by a decrease in accounts receivable of $3,398,000,
      an increase in deferred revenue of $1,460,000, an increase in depreciation
      and
      amortization of $2,630,000, an asset impairment of $26,245,000 and an increase
      in equity-based compensation of $1,415,000.





Net
      cash
      provided by (used in) investing activities was $5,077,000 and $(1,919,000)
      for
      the nine months ended September 30, 2008 and 2007, respectively. The increase
      in
      net cash used in investing activities is primarily a result of the sale of
      short-term investments during the first nine months of 2008 and a decrease
      in
      deferred acquisition costs associated with the then-pending Hantro acquisition,
      offset by increases in the purchase of short-term investments and property
      and
      equipment.





Net
      cash
      (used in) provided by financing activities was $(2,838,000) and $6,241,000
      for
      the nine months ended September 30, 2008 and 2007, respectively. The decrease
      is
      primarily attributable to a decrease in proceeds received from the exercise
      of
      common stock options and warrants and an increase in payments on short-term
      and
      long-term debt.





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, Tarrytown, and Manhattan,
      New
      York, Cambridge UK, and Oulu and Espoo, Finland. The aggregate required payments
      for the next 12 months under these arrangements are $901,000. 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.


-
          31
          -





At
      September 30, 2008, short-term borrowings consisted of the following:





A
      line of
      credit with a Finnish bank for $650,000 (€450,000 at September 30, 2008). The
      line of credit has no expiration date. Borrowings under the line of credit
      bear
      interest at one month EURIBOR plus 1.25% (total of 4.273% at September 30,
      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 $-0-
      at September 30, 2008.





Term-loan





During
      July 2008, the Company renewed its Directors and Officers Liability Insurance
      and financed the premium with a $140,000, nine-month term-loan that carries
      an
      effective annual interest rate of 4.75%.





At
      September 30, 2008, long-term debt consisted of the following:





Unsecured
      notes payable to a Finnish funding agency of $2,584,000, including interest
      at
      1.75%, due at dates ranging from January 2009 to December 2011; $258,000 to
      a
      Finnish bank, including interest at the 3-month EURIBOR plus 1.1% (total of
      5.76% at September 30, 2008), due March 2011, secured by a guarantee by On2
      and
      by 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 $181,000, including interest at the 6 month EURIBOR plus
      .5% (total of 5.465% at September 30, 2008), due March 2011.




The
      Company believes that existing funds are sufficient to fund its operations
      for
      the next 12 months. The Company plans to increase cash flows from operations
      principally from increases in revenue generated from its compression technology
      services and products. Our forecasts are predicated upon assumptions we have
      made as to, among other factors, the market for our products and services,
      global economic conditions, and the availability of credit affecting us and
      our
      customers. If those assumptions are incorrect, or if sales are less than
      projected and/or expenses higher than expected, we may not have sufficient
      resources to fund our operations for this entire period, however. The
      Company may also pursue additional financings, although current economic
      conditions may make it impossible for us to obtain financing on favorable terms,
      or at all. 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, as well as in Item 1A of
      Part II of this quarterly report on Form 10-Q.





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





**Off-Balance
      Sheet Arrangements**





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


-
          32
          -





**Impact
      of Recently-Issued Accounting Pronouncements**





In
      May
      2008 the FASB has issued SFAS Statement No. 162, *The
      Hierarchy of Generally Accepted Accounting Principles.* Statement 162 is intended to improve financial reporting by identifying a
      consistent framework, or hierarchy, for selecting accounting principles to
      be
      used in preparing financial statements that are presented in conformity with
      U.S. generally accepted accounting principles for nongovernmental entities.
      SFAS
      162 is effective 60 days following the SEC's approval of the PCAOB amendments
      to
      AU Section 411. The Company is currently evaluating the impact of adopting
      SFAS
      162 on its financial reporting **.**





On
      March
      19, 2008, the FASB issued SFAS Statement No. 161, *Disclosures
      about Derivative Instruments and Hedging Activities - an Amendment of FASB
      Statement 133.* SFAS 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, SFAS 161
      requires:





·
            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.





SFAS
      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 161 on its consolidated financial position and results
      of operations.





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





The
      Company does not currently have any material exposure to interest rate risk,
      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 transact business in the local functional currency. The U.K. based
      subsidiary does not conduct any sales and all its 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 be substantially impacted by currency 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.


-
          33
          -


**Item
      4.**  **Controls
      and Procedures**





(a)  Overview.





In
      connection with the restatement of the Company’s condensed consolidated
      financial statements for the second and third quarters of 2007, the Company’s
      management identified three material weaknesses in our internal control over
      financial reporting and reported those to our Audit Committee. The material
      weaknesses, detailed in the Company’s Annual Report on Form 10-K for the year
      ended December 31, 2007, are:




·
            *Revenue
                recognition procedures*–
                Our controls were not adequate to ensure that revenue was properly
                recognized when it was earned because we did not maintain effective
                procedures for the consideration of the probability that revenue
                is
                collectible.


·
            *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.




(b)
      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.





We
      carried out an evaluation, under the supervision and with the participation
      of
      our Chief Executive Officer and our Chief Financial Officer, of the
      effectiveness of the design and operation of our disclosure controls and
      procedures pursuant to Rule 13a-15(b) of the Exchange Act. Based on that
      evaluation, our Chief Executive Officer and our Chief Financial Officer
      concluded that our disclosure controls and procedures were not effective as
      of
      the end of the period covered by this report.





(c)  Changes
      in Internal Controls:





Except
      as
      noted below as part of our remediation initiatives, 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 September
      30,
      2008 that have materially affected,
      or are reasonably likely to materially affect, our internal control
      over financial reporting. However, as a result of our efforts beginning in
      the
      second quarter of 2008 to remediate the identified material weaknesses, we
      have
      taken certain steps set forth below to remediate the identified material
      weaknesses and are in the process of finalizing a plan and timetable for the
      implementation of additional remediation measures.****We
      believe that the actions we have taken will significantly improve our internal
      controls over financial reporting.


-
          34
          -





**Remediation
      Initiatives**





To
      improve our internal controls over financial reporting, we have taken the
      following measures:





During
      the second quarter of 2008, we took the following remedial steps to address
      the
      material weakness in internal controls relating to the maintenance of an
      effective control environment tone at the top: (i) our Board of Directors sought
      and on June 11, 2008, 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, although Mr. Joll served until September
      30, 2008 as an advisor to the interim chief executive officer to effect a smooth
      transition of customer relationships and business development opportunities;
      (ii) on June 10, 2008, our Board of Directors appointed Matthew Frost, our
      EVP, Legal and Business Affairs, as Interim Chief Executive Officer and Chief
      Operating Officer; and (iii) we segregated the duties of our accounting
      personnel from our non-accounting personnel other than those whose involvement
      in accounting-related matters is specifically authorized. During the third
      quarter of 2008, we took the additional remedial step of establishing an
      independent third party ethics hotline so that employees can anonymously report
      violations of our Code of Ethics and other employee concerns, and have
      communicated the hotline process to our employees. In addition, prior to the
      filing of this report, we took the following additional remedial steps with
      regard to this material weakness: (i) our third party consultant on
      Sarbanes-Oxley compliance conducted training for our Interim CEO, CFO, General
      Counsel and other legal and accounting staff on corporate governance matters,
      including corporate ethics, and revenue recognition; and (ii) we have revised
      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.





With
      regard to the identified material weakness in our revenue recognition
      procedures, specifically our procedures for assessing whether the collectibility
      of revenue is probable prior to recognition, we took the following remedial
      steps during the second quarter of 2008: (i) we revised the process that we
      and
      our operating subsidiary will follow in assessing whether the collectibilty
      of
      revenue is probable, 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; and (ii)
      we
      revised, formalized and expanded the documentation of the procedures we and
      our
      operating subsidiaries will follow with respect to assessing probability 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. In addition, prior to the filing of this
      report, we took the following additional remedial steps with regard to this
      material weakness: (i) our third party consultant on Sarbanes-Oxley compliance
      conducted training for our Interim CEO, CFO, General Counsel and other legal
      and
      accounting staff on revenue recognition; and (ii) we have adopted and
      communicated to our relevant staff a company policy setting forth acceptable
      customer payment terms and their importance in revenue recognition.





In
      addition, in the first quarter of 2008, we added a certified public accountant
      to our accounting and financial reporting staff and during the third quarter
      of
      2008, we filled a newly-added position to our accounting staff. The addition
      of
      trained staff will both provide further assistance in the accounting department
      and allow other members of the accounting staff to devote more time to
      responsibilities connected with financial reporting.


-
          35
          -





With
      respect to addressing the material weakness in the design and operation of
      our
      procedures for estimating our allowance for doubtful accounts, during the second
      quarter of 2008, we 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. During the third quarter
      of 2008, we implemented an accounting tool for use by our staff in quantifying
      the amount of a reserve to be taken with respect to doubtful accounts and prior
      to the filing of this report we communicated to our accounting staff the
      Company’s policies governing the calculation and recording of bad debt expenses.





To
      generally improve upon the quality of our financial reporting, we have
      implemented additional remediation measures that
      improve the
      processes and procedures around the completion and review of quarterly
      management representation letters .





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). The Audit Committee has approved our initial remediation efforts
      and
      the current timetable and will monitor the 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 intend to continue to review our procedures and test the effectiveness in
      our
      procedures on an on-going basis, whether through the use of third party
      consultants or internal staff.





We
      believe that the steps we have taken have significantly improved our internal
      control over financial reporting. We are committed to remediating our material
      weaknesses and, on an ongoing basis, repairing any internal control deficiencies
      that we identify, whether or not they rise to the level of a material weakness.
      We 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. As
      of
      the end of the third quarter, we have conducted preliminary testing of our
      internal controls related to the material weaknesses. Final testing of our
      internal controls to confirm that the identified material weaknesses have been
      remediated is expected to be performed by the end of the fourth quarter.


-
          36
          -





**PART
      II — OTHER INFORMATION**





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





**Islandia**





On
      August
      14, 2008, Islandia, L.P. filed a complaint against On2 in the Supreme Court
      of
      the State of New York, New York County. Islandia was an investor in the
      Company’s October 2004 issuance of Series D Convertible Preferred Stock pursuant
      to which On2 sold to Islandia 1,500 shares of Series D Convertible Preferred
      Stock, raising gross proceeds for the Company from Islandia of $1,500,000.
      Islandia’s Series D Convertible Preferred Stock was convertible into On2 common
      stock at an effective conversion price of $0.70 per share of common stock.
      Pursuant to this transaction, Islandia also received two warrants to purchase
      an
      aggregate of 1,122,754 shares of On2 common stock.





The
      complaint asserts that, at various times in 2007, On2 failed to make monthly
      redemptions of the Series D Preferred Stock in a timely manner and that On2
      failed to deliver timely notice of its intention to make such redemptions using
      shares of On2’s common stock. The complaint also asserts that Islandia timely
      exercised its right to convert the Series D Preferred Stock into shares of
      On2
      common stock and that On2 failed to credit to Islandia such allegedly converted
      shares. The complaint further asserts that On2 failed to pay to Islandia certain
      Series D dividends to which it was entitled. The complaint seeks a total of
      $4,645,193 in damages plus interest and reasonable attorneys’ fees.





On
      October 8, 2008, On2 filed an answer in which it denied the material assertions
      of the complaint and asserted various affirmative defenses, including that
      (i)
      On2 made the required Series D redemptions in full and on the dates agreed
      upon
      by the parties, (ii) On2 provided timely notice that it would pay redemptions
      in
      On2 common stock and that Islandia accepted all of the redemption payments
      on
      the dates made without protest, (iii) Islandia failed to timely assert its
      conversion rights under the terms of the Series D agreements and (iv) On2 duly
      paid the dividends owed to Islandia under the terms of the Agreement and
      Islandia accepted all dividend payments without protest.





On2
      believes this lawsuit is without merit and intends to vigorously defend itself
      against Islandia’s complaint. As of September 30, 2008, the Company has not
      recorded any provision associated with this complaint.





**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.


-
          37
          -





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




On2’s
      current arbitration claim alleges that, despite its obligations under the
      license agreements, 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.





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
      1A. Risk Factors.**





**On2
      has updated certain risk factors that it previously disclosed in its Form 10-K
      for the year ended December 31, 2007. The updated risk factors are set forth
      below.**





***Economic
      conditions may make it more difficult for us to achieve our sales and revenue
      projections.***


The
      economy in the US and internationally has deteriorated significantly during
      2008. We may encounter difficulties in achieving sales if demand for our
      products and services decreases as a result of the poor economy. For example,
      our customers may reduce or defer purchases of our goods and services due to
      economic pressures they encounter, and some of our customers’ businesses may
      fail. Customers may also elect to develop products and services internally
      rather than purchasing them from us. We may also be forced to reduce the amounts
      we charge for our goods and services as competition becomes more intense in
      a
      tight market. Pressure on our customers may also result in their delaying
      payments due to us as they attempt to manage their cash flows or cause them
      to
      default on payments that they owe us. Although we have taken economic factors
      into consideration when making our internal sales and revenue projections,
      if
      economic conditions and the effect on our sales and collections are worse than
      we have anticipated, we may be unable to meet our sales and revenue
      expectations. In this case, we may suffer a material adverse affect on our
      financial condition and results of operation.





***A
      lack of investment capital will make it more difficult for us to obtain from
      third parties funds we may need to support our
      operations.***


We
      are an
      emerging company and have experienced significant operating losses and negative
      cash flows to date. We have funded our operations with a series of equity
      financing transactions, credit facilities and our operating revenue as we have
      moved towards achieving profitability. Given the economic downturn, which has
      become more acute during the latter part of 2008, investor appetite for equity
      investments has been reduced, and investors who are willing to invest in
      emerging companies may demand terms offering greater returns than they had
      previously found acceptable. At the same time, credit markets have become more
      stringent, with fewer lenders making fewer loans, with more restrictive terms.
      Therefore, should we need further third party financing, it may not be available
      to us on acceptable terms, or at all. Should this occur, our financial condition
      and results of operation will likely be materially adversely
      affected .


-
          38
          -





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





On
      September 23, 2008, we held our annual stockholders meeting at the Company’s
      headquarters in Clifton Park, New York . Our stockholders re-elected our board
      of directors and approved all proposals presented at the annual meeting. The
      items considered and approved at the annual meeting are described in the proxy
      statement dated August 27, 2008. The record date for the annual meeting was
      August 1, 2008. The meeting was called for the purpose of considering the
      following proposals:





1.
            to
                elect eight (8) directors to serve on our Board of Directors for
                the term
                commencing immediately following the Annual Meeting;





2.
            to
                ratify the Board of Directors’ appointment of Marcum & Kliegman LLP as
                the Company’s independent registered public accounting firm for the fiscal
                year ending December 31, 2008; and





3.
            to
                transact any business as may properly come before the meeting and
                any
                adjournments thereof.





J.
      Allen
      Kosowsky, Mike Alfant, Mike Kopetski, James Meyer, Afsaneh Naimollah, William
      A.
      Newman, Pekka Salonoja, and Thomas Weigman were nominated by the Board of
      Directors for election to the Board of Directors at the annual meeting. All
      of
      the nominees were current directors and were elected at the last annual meeting
      of stockholders.





The
      votes
      received on the above proposals, including a separate tabulation with respect
      to
      each director nominee, were as follows:





**Proposal
      1: Election of Directors**


Director
            
            For
            
            %
                For
            
            Withheld
            
            %
                WithheldJ.
                Allen Kosowsky
            
            
            123,358,397
            
            
            72.14%
            
            
            16,327,458
            
            
            9.55%Mike
                Alfant
            
            
            124,984,208
            
            
            73.09%
            
            
            14,701,647
            
            
            8.60%Mike
                Kopetski
            
            
            123,810,911
            
            
            72.41%
            
            
            15,874,944
            
            
            9.28%James
                Meyer
            
            
            124,954,802
            
            
            73.08%
            
            
            14,731,053
            
            
            8.62%Afsaneh
                Naimollah
            
            
            124,860,615
            
            
            73.02%
            
            
            14,825,240
            
            
            8.67%William
                A. Newman
            
            
            123,864,580
            
            
            72.44%
            
            
            15,821,275
            
            
            9.25%Pekka
                Solonoja
            
            
            125,534,467
            
            
            73.42%
            
            
            14,151,388
            
            
            8.28%Thomas
                Weigman
            
            
            124,545,905
            
            
            72.84%
            
            
            15,139,950
            
            
            8.85%





**Proposal
      2: Ratification of the Selection of Marcum & Kliegman as the Company’s
      Independent Registered Public Accounting Firm**


For
            
            %
                For
            
            Against
            
            %
                Against
            
            Witheld
            
            %
                Witheld134,203,531
            
            
            78.49%
            
            
            2,512,104
            
            
            1.47%
            
            
            2,970,222
            
            
            1.74


-
          39
          -





**Proposal
      3: Transact such other business as may properly come before the meeting and
      any
      adjournments thereof**


For
            
            %
                For
            
            Against
            
            %
                Against
            
            Witheld
            
            %
                Witheld126,331,380
            
            
            73.88%
            
            
            9,496,274
            
            
            5.55%
            
            
            3,858,204
            
            
            2.26









**Item
      6. Exhibits.**





10.1  Employment
      Agreement, dated as of September 15, 2008, by and between the Company and Tim
      Reusing





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





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





32.1  Certification
      of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted
      Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.





32.2  Certification
      of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted
      Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


-
          40
          -


**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.November
                7, 2008
            
            (Registrant)
              
              
              /s/
                MATTHEW FROST(Date)
            
            (Signature)
              Matthew
                Frost
              Interim
                Chief Executive Officer





On2
                Technologies, Inc.November
                7, 2008
            
            (Registrant)
              
              
              /s/
                ANTHONY PRINCIPE(Date)
            
            (Signature)
              Anthony
                Principe
              Senior
                Vice President and Chief Financial Officer
              (Principal
                Financial Officer)


-
          41
          -