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

                                  FORM 10-KSB/A
      AMENDMENT NO. 1 TO THE ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
                     OF THE SECURITIES EXCHANGE ACT OF 1934

   (Mark One)

      [X]   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
            EXCHANGE ACT OF 1934
            FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004

      [_]   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
            EXCHANGE ACT OF 1934.

                         COMMISSION FILE NUMBER 1-15117.

                             ON2 TECHNOLOGIES, INC.
             (Exact name of registrant as specified in its charter)


                         DELAWARE                                84-1280679
              (State or other jurisdiction of                 (I.R.S. Employer
              incorporation or organization)                 Identification No.)
                     21 CORPORATE DR.                               12065
                         SUITE 103                               (Zip Code)
                     CLIFTON PARK, NY
         (Address of principal executive offices)


               REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:
                                 (518) 348-0099


           SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:

      TITLE OF EACH CLASS      NAME(S) OF EACH EXCHANGE ON WHICH LISTED
         Common Stock                   American Stock Exchange


           SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
                                      NONE


     Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 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.
                                                                  Yes [X] No [_]

     Check if there is no disclosure of delinquent filers in response to Item
405 of Regulation S-B contained in this form, and no disclosure will be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-KSB
or any amendment to this Form 10-KSB. [X]

     Issuer's revenues for the year ended December 31, 2004 were approximately
$3,028,000.

     The aggregate market value of the voting stock held by non-affiliates of
the registrant as of the last business day of the registrant's most recently
completed fiscal quarter was approximately $51,123,459.

     Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).   Yes [ ]   No [X]

                      APPLICABLE ONLY TO CORPORATE ISSUERS:

     State the number of shares outstanding of each of the issuer's classes of
common stock, $0.01 par value ("Common Stock"), as of the latest practicable
date:

    88,565,440 shares as of March 14, 2005.

                       DOCUMENTS INCORPORATED BY REFERENCE

     Items 9, 10, 11, and 12 of Part III are incorporated by reference from the
Company's definitive Proxy Statement for the Annual Meeting of Stockholders, to
be held on May 18, 2005. Registrant's definitive Proxy Statement will be filed
with the Securities and Exchange Commission on or before 120 days after December
31, 2004.

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

<PAGE>

                      AMENDMENT NO. 1 TO THE ANNUAL REPORT
                      FOR THE YEAR ENDED DECEMBER 31, 2004

                                EXPLANATORY NOTE

On2 Technologies, Inc. ("On2") is filing this Amendment No. 1 (this "Amendment")
to its Form 10-KSB for the fiscal year ended December 31, 2004 as filed on March
18, 2004 (the "Annual Report") to (i) include a consent from Eisner LLP (filed
as Exhibit 23.1 to this Amendment) that was omitted from the Annual Report and
(ii) add the signature of Eisner LLP to the Report of Independent Registered
Public Accounting Firm included at page F-2 of the Annual Report. Eisner LLP had
provided the consent and signed Report of Independent Registered Public
Accounting Firm to On2 prior to the filing of the Annual Report.

The complete text of the exhibit amended and of the consolidated financial
statements, including the signed Report of Independent Registered Public
Accounting Firm, are included in the Amendment pursuant to Rule 12b-15
promulgated under the Securities Exchange Act of 1934. This Amendment amends and
restates in their entirety only Exhibit 23.1, Part III, Item 13, which contains
the exhibit list, and the Report of Independent Registered Public Accounting
Firm and no changes have been made to the consolidated financial statements
other than the addition of the signature of Eisner LLP to the Report of
Independent Registered Public Accounting Firm. This Amendment does not affect
any other Items and Exhibits in the Annual Report, and those unaffected Items or
Exhibits are not included in this Amendment.

This Amendment continues to speak as of the date of the original Annual Report
and On2 has not updated the disclosure contained herein to reflect events that
have occurred since the filing of the original Annual Report. Accordingly, this
Form 10-KSB/A should be read in conjunction with On2's other filings made with
the Securities and Exchange Commission subsequent to the filing of the original
Annual Report, including any amendments to those filings.

<PAGE>

                                    PART III

ITEM 13.  EXHIBITS.

 Exhibits

The exhibits listed in the Index to Exhibits, which appears below, are filed as
a part of this annual report.

                                INDEX TO EXHIBITS

 EXHIBIT
    NO.                                  IDENTIFICATION OF EXHIBIT
---------                                -------------------------

 3.1****              Certificate of Incorporation of the Company

 3.2********          Bylaws of the Company

 4.1*                 Securityholders Agreement, dated as of December 1, 1999,
                      between the Company and thirteen securityholders party
                      thereto

 4.2*                 Form of Investor Rights Agreement, dated as of December 1,
                      1999,between the Company and each of nine investors

 4.3*                 Form of Warrant issued to the investors party to the
                      Investor Rights Agreement

 4.4***               Form of Investors' Rights Agreement between the Company
                      and the holders of Series C Preferred Stock, Series C-II
                      Preferred Stock and Series C-III Preferred Stock

 4.5****              Certificate of Designations for the Company's Series C
                      Preferred Stock

 4.6****              Certificate of Designations for the Company's Series C-II
                      Preferred Stock

 4.7****              Certificate of Designations for the Company's Series C-III
                      Preferred Stock

 4.8****              Form of Warrant issued to the holders of Series C, Series
                      C-II and Series C-III Preferred Stock

 4.9*****             Common Stock Purchase Agreement, dated as of July 18, 2001
                      by and between the Company and Real.

 4.10*****            Investor Rights Agreement, dated as of July 18, 2001,
                      between Real and the Company

 4.11**********       Indemnity Agreement, dated as of January 28, 2002, by and
                      among The Travelers Insurance Company, Travelers Indemnity
                      Company, and the Company

 4.12***********      Investor's Rights Agreement, dated as of January 29, 2001,
                      between the Company and Abanat Limited

10.1**                Employment Agreement with Douglas McIntyre

10.2***               Common Stock Purchase Agreement, dated as of December 1,
                      2000,between the Company and Crossover Ventures, Inc.

10.3****              Deferred Pricing Agreement, dated as of January 19, 2001,
                      between the Company and The Travelers Indemnity Company

10.4*****             Development Services and License Agreement dated July 18,
                      2001 between the Company and RealNetworks, Inc., subject
                      to an Order Granting Confidential Treatment under The
                      Securities Exchange Act of 1933 (CF #11815).

10.5******            Common Stock Purchase Agreement, dated as of November 21,
                      2001,between the Company and Crossover Ventures, Inc.

10.6*********         Lease Agreement, dated as of September 26, 2002 between
                      the Company and Sitterly Associates II, LLC.

10.7************      Source Code License and Software Distribution Agreement
                      (EVD Products) dated as of June 21, 2003 between On2
                      Technologies, Inc., Beijing E-World Technology Co. Ltd.
                      and Nature Talent Limited.

10.8************      Source Code License and Software Distribution Agreement
                      (Non-EVD Products) dated as of June 21, 2003 between On2
                      Technologies, Inc., Beijing E-World Technology Co. Ltd.
                      and Nature Talent Limited

10.9*************     Software Distribution Agreement, dated as of August 25,
                      2003, by and between the Company and Allied Telesis K.K.

10.10**************   Employment Agreement with Tim Reusing

10.11**************   Employment Agreement with Eric Ameres

10.12***************  Registration Rights Agreement, dated October 27, 2004

21*******             Subsidiaries

23.1                  Consent of Eisner LLP

31.1                  Certification of Chief Executive Pursuant to Section 302
                      of the Sarbanes-Oxley Act of 2002.

31.2                  Certification of 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.

 *                    Filed as an exhibit to the Company's Annual Report on Form
                      10-KSB for the fiscal year ended December 31, 1999 and
                      incorporated by reference herein.

**                    Filed as an exhibit to the Company's Quarterly Report on
                      Form 10-QSB for the period ended June 30, 2000 and
                      incorporated by reference herein.

***                   Filed as an exhibit to the Company Registration on Form
                      S-3, filed with the SEC on December 8, 2000 and
                      incorporated by reference herein.

****                  Filed as an exhibit to the Company's Annual Report on Form
                      10-KSB for the fiscal year ended December 31, 2000 and
                      incorporated by reference herein

*****                 Filed as an exhibit to the Company's Registration on Form
                      SB-2/A, filed with the SEC on September 13, 2001 and
                      incorporated by reference herein.


                                       26
<PAGE>

******                Filed as an exhibit to the Company's Registration on Form
                      SB-2, filed with the SEC on November 29, 2001 and
                      incorporated by reference herein.

*******               Filed as an exhibit to the Company's Annual Report on Form
                      10-KSB for the fiscal year December 31, 2002 and
                      incorporated herein by reference.

********              Filed as an Exhibit to the Company's Proxy Statement on
                      Schedule 14A, filed with the SEC on March 25, 2002.

*********             Filed as an Exhibit to the Company's Form 10-KSB for the
                      fiscal year ended December 31, 2002 and incorporated by
                      reference herein.

**********            Filed as an Exhibit to the Company's Registration
                      Statement on Form S-3, Registration No. 333-105795, and
                      incorporated by reference herein.

***********           Filed as an Exhibit to the Company's Registration
                      Statement on Form S-3, Registration No. 333-109355, and
                      incorporated by reference herein.

************          Filed as an Exhibit to the Company's Current Report on
                      Form 8-K, filed with the SEC on June 21, 2003, and
                      incorporated by reference herein.

*************         Filed as an Exhibit to the Company's Current Report on
                      Form 8-K, filed with the SEC on August 25, 2003, and
                      incorporated by reference herein.

**************        Filed as an Exhibit to the Company's Form 10-KSB for the
                      fiscal year ended December 31, 2003 and incorporated by
                      reference herein.

***************       Filed as an Exhibit to the Company's Registration
                      Statement on Form S-3, Registration No. 333-120801, and
                      incorporated by reference herein.

     (b) Reports filed on Form 8-K for the three months ended December 31, 2004.

The Company filed a Current Report on Form 8-K on February 26, 2004, containing
a press release announcing the Company's results of operations for the fourth
quarter ending December 31, 2003.

The Company filed a Current Report on Form 8-K on April 29, 2004 containing a
press release announcing the Company's results of operations for the first
quarter ending March 31, 2004.

The Company filed a Current Report on Form 8-K on July 22, 2004 containing a
press release announcing the Company's results of operations for the first
quarter ending June 30, 2004.

The Company filed a Current Report on Form 8-K on October 28, 2004 containing a
press release announcing the Company's results of operations for the first
quarter ending September 30, 2004.

The Company filed a Current Report on Form 8-K on October 28, 2004 announcing
that it had entered into a series of definitive agreements with two
institutional investors, led by MidSummer Investment Ltd., in connection with a
private placement of $4,000,000 of the Company's Series D Convertible Preferred
Stock (the "MidSummer Transaction").

The Company filed a Current Report on Form 8-K on November 11, 2004 announcing
that it had closed the MidSummer Transaction.


                                       27
<PAGE>

                                   SIGNATURES

     Pursuant to the requirements of  of the Securities Exchange Act of 1934, as
amended, the Company has duly caused this amended report to be signed on its
behalf by the undersigned, thereby duly authorized on March 22, 2005.

ON2 TECHNOLOGIES, INC.


By:  /s/ DOUGLAS A. MCINTYRE
     -------------------------------------------
     Douglas A. McIntyre
     Chairman, President and Chief Executive Officer



                                       28
<PAGE>




                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

                                                                            Page
                                                                            ----

Report of Independent Registered Public Accounting Firm...................  F-2

Consolidated Balance Sheets as of December 31, 2004 and 2003..............  F-3

Consolidated Statements of Operations for the years ended
    December 31, 2004 and 2003............................................  F-4

Consolidated Statements of Changes in Stockholders' Equity
    for the years ended December 31, 2004 and 2003........................  F-5

Consolidated Statements of Cash Flows for the years ended
    December 31, 2004 and 2003............................................  F-8

Notes to Consolidated Financial Statements................................  F-10


                                      F-1
<PAGE>

             REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


Board of Directors and Stockholders
On2 Technologies, Inc.

      We have audited the accompanying consolidated balance sheets of On2
Technologies, Inc. and subsidiaries (the "Company") as of December 31, 2004 and
2003 and the related consolidated statements of operations, changes in
stockholders' equity and cash flows for the years then ended. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

      We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.

      In our opinion, the financial statements enumerated above present fairly,
in all material respects, the consolidated financial position of On2
Technologies, Inc. and subsidiaries as of December 31, 2004 and 2003, and the
consolidated results of their operations and their consolidated cash flows for
the years then ended in conformity with U.S. generally accepted accounting
principles.


/s/ Eisner LLP
-------------------
Eisner LLP
New York, New York
January 21, 2005

With respect to Notes 2, 10(d) and 12
March 10, 2005


                                      F-2
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                           CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                                       December 31,
                                                                              ------------------------------
                                                                                   2004             2003
                                                                              -------------    -------------
<S>                                                                           <C>              <C>
                                  ASSETS

Current assets:
  Cash and cash equivalents ...............................................   $   5,418,000    $   2,963,000
  Marketable equity securities, at market .................................         445,000
  Accounts receivable, less allowance for doubtful
    accounts of $140,000 and $15,000 as of December 31,
    2004 and 2003, respectively ...........................................         249,000          826,000
  Prepaid expenses and other current assets ...............................         156,000          164,000
                                                                              -------------    -------------

       Total current assets ...............................................       6,268,000        3,953,000

Property and equipment, net ...............................................          87,000          149,000
Other assets ..............................................................          80,000           26,000
                                                                              -------------    -------------
       Total assets .......................................................   $   6,435,000    $   4,128,000
                                                                              =============    =============

                LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
  Accounts payable.........................................................   $     177,000    $     119,000
  Accrued expenses ........................................................         393,000          221,000
  Deferred revenue ........................................................         153,000           30,000
  Term-loan ...............................................................          62,000           63,000
  Capital lease obligation ................................................          17,000
                                                                              -------------    -------------
       Total current liabilities ..........................................         802,000          433,000

Capital lease obligation, excluding current portion .......................          26,000
Convertible debentures, net of debt discount of $20,000 and $41,000
   as of December 31, 2004 and 2003, respectively .........................         330,000          409,000
                                                                              -------------    -------------
       Total liabilities ..................................................       1,158,000          842,000
                                                                              -------------    -------------
Commitments and contingencies (Note 10)

Stockholders' equity:
   Preferred stock, $0.01 par value; 20,000,000 shares authorized;
       3,303,000 and 5,565,000 convertible shares issued and
       outstanding at December 31, 2004 and 2003, respectively
      (aggregate of liquidation value of $10,704,000 as of
      December 31, 2004 ...................................................          33,000           56,000
   Common stock, $0.01 par value; 150,000,000 shares
      authorized; 80,328,000 and 74,146,000 shares issued and
      outstanding at December 31, 2004 and 2003, respectively .............         803,000          741,000
   Additional paid-in capital .............................................     115,841,000      110,229,000
   Accumulated other comprehensive loss ...................................         (42,000)         (18,000)
   Accumulated deficit ....................................................    (111,358,000)    (107,722,000)
                                                                              -------------    -------------
       Total stockholders' equity .........................................       5,277,000        3,286,000
                                                                              -------------    -------------
       Total liabilities and stockholders' equity .........................   $   6,435,000    $   4,128,000
                                                                              =============    =============
</TABLE>

           See accompanying notes to consolidated financial statements


                                      F-3

<PAGE>

                             ON2 TECHNOLOGIES, INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
                                                                     Year Ended December 31,
                                                                  ----------------------------
                                                                      2004            2003
                                                                  ------------    ------------
<S>                                                               <C>             <C>
Revenue (1) ...................................................   $  3,028,000    $  3,302,000

Operating expenses:
      Cost of revenue (2) .....................................      1,437,000       1,506,000
      Research and development (3) ............................        884,000       1,124,000
      Sales and marketing (3) .................................        459,000         527,000
      General and administrative (3) ..........................      3,068,000       2,448,000
      Equity-based compensation:
            Research and development ..........................         68,000
            Sales and marketing ...............................         19,000
            General and administrative ........................        583,000          60,000
                                                                  ------------    ------------
Total operating expenses ......................................      6,518,000       5,665,000
                                                                  ------------    ------------
Loss from operations ..........................................     (3,490,000)     (2,363,000)

Interest and other income (expense), net ......................         47,000          (2,000)
                                                                  ------------    ------------
Loss before provision for income taxes ........................     (3,443,000)     (2,365,000)

Provision for income taxes ....................................          2,000          10,000
                                                                  ------------    ------------
Net loss ......................................................     (3,445,000)     (2,375,000)

Convertible preferred stock deemed dividend ...................        120,000         228,000
Convertible preferred stock 8% dividend .......................         57,000
Accretion of costs associated with the Series D Preferred Stock         14,000
                                                                  ------------    ------------
Net loss attributable to common stockholders ..................   $ (3,636,000)   $ (2,603,000)
                                                                  ============    ============

Basic and diluted net loss attributable to common stockholders
  per common share ............................................   $      (0.05)   $      (0.04)
                                                                  ============    ============

Weighted average basic and diluted common shares outstanding ..     77,187,000      64,654,000
                                                                  ============    ============
</TABLE>

(1) Includes $289,000 and $150,000 for the years ended December 31, 2004 and
    2003, respectively, from a related party.
(2) Includes equity-based compensation of $165,000 for the year ended December
    31, 2004.
(3) Excludes equity-based compensation, which is presented separately.



           See accompanying notes to consolidated financial statements


                                      F-4
<PAGE>

                             ON2 TECHNOLOGIES, INC.
           CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY

<TABLE>
<CAPTION>
                                                   Convertible
                                                 Preferred Stock                      Common Stock            Additional
                                           -------------------------         ---------------------------       Paid-in
                                               Shares        Amount              Shares          Amount        Capital
                                           -----------     ---------         ------------    -----------    -------------
<S>                                          <C>            <C>                <C>             <C>          <C>
Balance at January 1, 2003.................  9,920,000      $ 99,000           59,588,000      $ 596,000    $ 105,422,000
Net loss...................................
Foreign currency translation adjustment....

Comprehensive loss.........................

Issuance of common stock in connection                                          2,579,000         25,000        1,355,000
  with the exercise of stock options.......
Issuance of common stock in connection
  with the exercise of warrants............                                     1,503,000         15,000        1,710,000
Issuance of common stock in connection
  with the conversion of Series A secured
  convertible debentures...................                                     1,786,000         18,000          182,000
Issuance of common stock in
   connection with the equity line
   of credit ..............................                                     3,387,000         34,000        1,280,000
Issuance of common stock in
   connection with the conversion
   of Series C-V preferred stock........... (1,923,000)      (19,000)           2,644,000         26,000           (7,000)
Issuance of common stock in
   connection with the conversion
   of Series C-VI preferred stock.......... (2,432,000)      (24,000)           2,606,000         26,000           (2,000)
Issuance of common stock in
   connection with the payment of
   interest on the Series A secured
   convertible debentures..................                                        53,000          1,000           43,000
Warrants issued for consulting
   services................................                                                                        60,000
Purchase of warrants.......................                                                                       (42,000)
Warrants issued and discount recognized
  in connection with issuance of
  convertible debentures...................
Convertible preferred stock deemed
  dividends................................                                                                       228,000
                                           ------------------------------------------------------------------------------
Balance at December 31, 2003...............  5,565,000      $ 56,000           74,146,000      $ 741,000    $ 110,229,000
                                           ==============================================================================
</TABLE>

<TABLE>
<CAPTION>
                                            Accumulated
                                               Other                                        Total
                                           Comprehensive            Accumulated         Stockholders'
                                                Loss                  Deficit               Equity
                                           ---------------       --------------        ---------------
<S>                                        <C>                   <C>                     <C>
Balance at January 1, 2003.................$       (16,000)      $ (105,119,000)         $   982,000
Net loss...................................                          (2,375,000)          (2,375,000)
Foreign currency translation adjustment....         (2,000)                                   (2,000)
                                                                                        --------------
Comprehensive loss.........................                                               (2,377,000)
                                                                                        --------------
Issuance of common stock in connection                                                      1,380,000
  with the exercise of stock options.......
Issuance of common stock in connection
  with the exercise of warrants............                                                 1,725,000
Issuance of common stock in connection
  with the conversion of Series A secured
  convertible debentures...................                                                   200,000
Issuance of common stock in
   connection with the equity line
   of credit ..............................                                                 1,314,000
Issuance of common stock in
   connection with the conversion
   of Series C-V preferred stock...........                                                         0
Issuance of common stock in
   connection with the conversion
   of Series C-VI preferred stock..........                                                         0
Issuance of common stock in
   connection with the payment of
   interest on the Series A secured
   convertible debentures..................                                                    44,000
Warrants issued for consulting
   services................................                                                    60,000
Purchase of warrants.......................                                                   (42,000)
Warrants issued and discount recognized
  in connection with issuance of
  convertible debentures...................
Convertible preferred stock deemed
  dividends................................                           (228,000)                     0
                                           -----------------------------------------------------------
Balance at December 31, 2003...............$       (18,000)      $ (107,722,000)          $ 3,286,000
                                           ===========================================================
</TABLE>

           See accompanying notes to consolidated financial statements

                                      F-5
<PAGE>

                             ON2 TECHNOLOGIES, INC.
     CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (CONTINUED)

<TABLE>
<CAPTION>
                                                   Convertible
                                                 Preferred Stock                     Common Stock             Additional
                                           -------------------------         ---------------------------       Paid-in
                                               Shares        Amount              Shares          Amount        Capital
                                           -----------     ---------         ------------    -----------    --------------
<S>                                          <C>            <C>                <C>             <C>          <C>
Balance at December 31, 2003...............  5,565,000      $ 56,000           74,146,000      $ 741,000    $ 110,229,000
Net loss...................................
Foreign currency translation adjustment....

Comprehensive loss.........................

Issuance of common stock in connection                                            277,000          3,000           64,000
  with the exercise of stock options.......
Issuance of common stock in connection
  with the exercise of warrants............                                     1,435,000         14,000          749,000
Issuance of common stock in connection
  with the conversion of Series A secured
  convertible debentures...................                                       893,000          9,000           91,000
Issuance of common stock to
   employees and directors as
   compensation ...........................                                       870,000          9,000          826,000
Issuance of common stock in
   connection with the conversion
   of Series A preferred stock.............   (400,000)       (4,000)             400,000          4,000
Issuance of common stock in
   connection with the conversion
   of Series C-V preferred stock...........   (727,000)       (7,000)           1,000,000         10,000           (3,000)
Issuance of common stock in
   connection with the conversion
   of Series C-VI preferred stock.......... (1,139,000)      (12,000)           1,210,000         12,000
Issuance of common stock in
   connection with the payment of
   interest on the Series A secured
   convertible debentures..................                                        37,000              0           23,000
Issuance of common stock in
   connection with the payment of
   dividends on the Series D
   convertible preferred stock.............                                        60,000          1,000           29,000
Issuance of Series D convertible
   preferred stock.........................      4,000             0                                            3,699,000
Deemed dividend on Series D convertible
  preferred stock..........................                                                                       120,000
Accrued dividend on Series D convertible
  preferred stock..........................
Accretion of costs associated with the
  issuance of  the Series D convertible
  preferred stock..........................                                                                        14,000
                                           -------------------------------------------------------------------------------
Balance at December 31, 2004................ 3,303,000      $ 33,000           80,328,000      $ 803,000    $ 115,841,000
                                           ===============================================================================
</TABLE>

<TABLE>
<CAPTION>
                                            Accumulated
                                               Other                                        Total
                                           Comprehensive            Accumulated         Stockholders'
                                                Loss                  Deficit               Equity
                                           ---------------       --------------        ---------------
<S>                                        <C>                   <C>                     <C>
Balance at December 31, 2003...............$       (18,000)      $ (107,722,000)         $ 3,286,000
Net loss...................................                          (3,445,000)          (3,445,000)
Foreign currency translation adjustment....        (24,000)                                  (24,000)
                                                                                        -------------
Comprehensive loss.........................                                                (3,469,000)
                                                                                        -------------
Issuance of common stock in connection                                                         67,000
  with the exercise of stock options.......
Issuance of common stock in connection
  with the exercise of warrants............                                                   763,000
Issuance of common stock in connection
  with the conversion of Series A secured
  convertible debentures...................                                                   100,000
Issuance of common stock to
   employees and directors as
   compensation ...........................                                                   835,000
Issuance of common stock in
   connection with the conversion
   of Series A preferred stock.............                                                         0
Issuance of common stock in
   connection with the conversion
   of Series C-V preferred stock...........                                                         0
Issuance of common stock in
   connection with the conversion
   of Series C-VI preferred stock..........                                                         0
Issuance of common stock in
   connection with the payment of
   interest on the Series A secured
   convertible debentures..................                                                    23,000
Issuance of common stock in
   connection with the payment of
   dividends on the Series D
   convertible preferred stock.............                             (30,000)                    0
Issuance of Series D convertible
   preferred stock.........................                                                 3,699,000
Deemed dividend on Series D convertible
  preferred stock..........................                            (120,000)                    0
Accrued dividend on Series D convertible
  preferred stock..........................                             (27,000)              (27,000)
Accretion of costs associated with the
  issuance of  the Series D convertible
  preferred stock..........................                             (14,000)                    0
                                           -----------------------------------------------------------
Balance at December 31, 2004...............$       (42,000)      $ (111,358,000)         $ 5,277,000
                                           ===========================================================
</TABLE>

           See accompanying notes to consolidated financial statements

                                      F-6
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                                   Year Ended December 31,
                                                                                  --------------------------
                                                                                      2004           2003
                                                                                  -----------    -----------
<S>                                                                               <C>            <C>
Cash flows from operating activities:
  Net loss ....................................................................   $(3,445,000)   $(2,375,000)
    Adjustments to reconcile net loss to net cash used in operating activities:
      Equity-based compensation ...............................................       835,000         60,000
      Common stock issued for debenture interest ..............................        23,000         44,000
      Write-off of fixed assets ...............................................        20,000
      Depreciation and amortization ...........................................       115,000        706,000
      Marketable equity securities received as payment of license fee .........      (289,000)
      Unrealized gain on marketable equity securities .........................      (121,000)
      Realized loss on marketable equity securities ...........................        26,000
      Amortization of debt discount ...........................................        21,000         40,000
      Changes in operating assets and liabilities:
         Accounts receivable, net .............................................       427,000       (225,000)
         Prepaid expenses and other current assets ............................         8,000        (63,000)
         Other assets .........................................................       (54,000)       (17,000)
         Accounts payable and accrued expenses ................................       203,000       (180,000)
         Deferred revenue .....................................................       123,000         30,000
                                                                                  -----------    -----------
            Net cash used in operating activities .............................    (2,108,000)    (1,980,000)
                                                                                  -----------    -----------
Cash flows from investing activities:
  Proceeds from the sale of marketable equity securities ......................        89,000
  Purchases of property and equipment .........................................       (19,000)       (39,000)
                                                                                  -----------    -----------

            Net cash provided by (used in) investing activities ...............        70,000        (39,000)
                                                                                  -----------    -----------
  Cash flows from financing activities:
  Principal payments on capital lease obligations .............................       (11,000)        (9,000)
  Purchase of common stock warrants ...........................................                      (42,000)
  Proceeds from (principal payments on) term-loan, net ........................        (1,000)        63,000
  Net proceeds from the sale of common stock ..................................                    1,314,000
  Net proceeds from the issuance of Series D convertible Preferred Stock ......     3,699,000
  Proceeds from exercise of common stock options and warrants .................       830,000      3,105,000
                                                                                  -----------    -----------
            Net cash provided by financing activities .........................     4,517,000      4,431,000
                                                                                  -----------    -----------
Net change in cash and cash equivalents .......................................     2,479,000      2,412,000
Effect of exchange rate changes on cash and cash equivalents ..................       (24,000)        (2,000)
Cash and cash equivalents, beginning of year ..................................     2,963,000        553,000
                                                                                  -----------    -----------
Cash and cash equivalents, end of year ........................................   $ 5,418,000    $ 2,963,000
                                                                                  ===========    ===========
</TABLE>

                                      F-7
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)

Supplemental disclosure of cash flow information and non-cash transactions:

<TABLE>
<CAPTION>
                                                                                            Year Ended December 31,
                                                                                    ------------------------------------
                                                                                          2004                 2003
                                                                                    ---------------      ---------------
<S>                                                                                 <C>                  <C>
 Cash paid during the year for:
    Interest....................................................................... $        11,000      $        12,000
                                                                                    ===============      ===============
    Taxes.......................................................................... $         7,000      $        14,000
                                                                                    ===============      ===============
    Non-cash transactions:
    Acquisition of fixed assets under capital leases............................... $        54,000
                                                                                    ===============
    Conversion of Preferred Stock into Common Stock................................ $        23,000      $        43,000
                                                                                    ===============      ===============
    Conversion of debentures into common stock..................................... $       100,000      $       200,000
                                                                                    ===============      ===============
    Common stock issued for dividends on Series D Preferred Stock.................. $        30,000
                                                                                    ===============
    Accrued dividend on Series D Convertible Preferred Stock....................... $        27,000
                                                                                    ===============
    Accretion of costs associated with the issuance of Series D preferred stock.... $        14,000
                                                                                    ===============
    Convertible preferred stock deemed dividends................................... $       120,000      $       228,000
                                                                                    ===============      ===============
    Marketable equity securities received as consideration for account receivable.. $       150,000
                                                                                    ===============
</TABLE>


           See accompanying notes to consolidated financial statements

                                      F-8
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

(1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

      (a)  Description of the Business

     On2 Technologies, Inc. ("On2" or the "Company") is a video compression
technology firm. The Company has developed its proprietary technology platform
and video compression/decompression software ("codec") to deliver high quality
video at the lowest possible data rates to closed area networks, 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 consolidated financial statements have been prepared assuming
that it will continue as a going concern. The Company has incurred recurring
operating losses and negative operating cash flows since its inception. At
December 31, 2004 and 2003 the Company had cash and cash equivalents and working
capital of $5,418,000 and $2,963,000, respectively. The Company believes that
existing funds are sufficient to fund its operations through 2005. The Company
plans to increase cash flows from operations principally from increases in
revenue generated from its compression technology services, products and
licenses. The Company may also pursue additional financings. However, there are
no assurances that such increases in revenues will be attained or that
additional financings will be successfully consummated.

      (b)  Basis of Presentation

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

      (c) Cash and Cash Equivalents

      Cash equivalents consist of money market funds or other highly liquid debt
investments with original maturities of three months or less.

      (d)  Property and Equipment

     Property and equipment is stated at cost, net of accumulated depreciation
and amortization. Property and equipment is depreciated using the straight-line
method over the estimated useful lives of the related assets, generally three to
five years for equipment and software and five to seven years for furniture and
fixtures. Leasehold improvements are amortized using the straight-line method
over the shorter of the lease term or the estimated useful life of the asset.
Equipment under capital leases is stated at the present value of the minimum
lease payments and is depreciated using the straight-line method over the
estimated useful life of the asset.


                                      F-9
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

(1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

      (e)  Impairment of Long-Lived Assets and Finite-Lived Intangible Assets

     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.

      (f)  Fair Value of Financial Instruments and Concentration of Credit Risk

      The fair values of accounts receivable and accounts payable approximate
their carrying values based on the short-term nature of these financial
instruments.

     The Company performs ongoing credit evaluations of its customers' financial
condition and establishes an allowance for doubtful accounts based upon factors
surrounding the credit risk of customers, historical trends and other
information. Such losses have been within management's expectations.

      (g)  Income Taxes

     The Company accounts for income taxes using the asset and liability method.
Under this method, deferred tax assets and liabilities are recognized for the
future tax consequences attributable to differences between the consolidated
financial statement carrying amounts of existing assets and liabilities and
their respective tax bases and for operating loss and tax credit carry forwards.
Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in the
consolidated results of operations in the period that the tax change occurs.
Valuation allowances are established, when necessary, to reduce deferred tax
assets to the amount expected to be realized.

      (h)  Revenue Recognition

      The Company primarily generates revenue from the sale of its software
licenses and its professional service offerings.

     The Company's revenue recognition policies are in accordance with Statement
of Position ("SOP") 97-2, "Software Revenue Recognition", 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" and other authoritative guidance. Under each arrangement, revenues
are recognized when a non-cancelable agreement has been signed and the customer
acknowledges an unconditional obligation to pay, the products or applications
have been delivered, there are no uncertainties surrounding customer acceptance,
the fees are fixed and determinable, and collection is considered probable.
Revenues recognized from multiple-element software arrangements are allocated to
each element of the arrangement based on the fair values of the elements, such
as product licenses, post-contract customer support, or training. The
determination of the fair value is based on the vendor specific objective
evidence available to the Company. If such evidence of the fair value of each
element of the arrangement does not exist, all revenue from the arrangement is
deferred until such time that evidence of the fair value does exist or until all
elements of the arrangement are delivered.

                                      F-10
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

(1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

      (h)  Revenue Recognition  (continued)

      Software Licenses

     The Company's software licensing arrangements typically consist of two
elements: a software license and post-contract customer support ("PCS"). The
Company recognizes license revenue based on the residual method after all
elements other than PCS have been delivered as prescribed by SOP 98-9. The
Company recognizes PCS revenues over the term of the maintenance contract or on
a "per usage" basis, whichever is stated in the contract. In accordance with SOP
97-2, 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). Each license agreement offers 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. The Company does not allow returns, exchanges or price
protection for sales to its customers or its resellers nor does it allow its
resellers to purchase software licenses under consignment arrangements.

      Professional Services

      Professional services consist of customized engineering and consulting
services and encoding services.

     When customized 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, the Company requires 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. The Company accounts for its engineering and consulting
arrangements in accordance with SOP 81-1, "Accounting for Performance of
Construction Type and Certain Production Type Contracts". When reliable
estimates are available for the costs and efforts necessary to complete the
engineering or consulting services and those services do not include contractual
milestones or other acceptance criteria, the Company accounts for the
arrangements under the percentage of completion contract method pursuant to SOP
81-1 based upon input measures such as hours. When such estimates are not
available, the completed contract method is utilized.

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

      (i)  Cost of Revenues

     Cost of revenues primarily includes compensation costs for engineering and
consulting personnel, depreciation costs, licensing fees or royalties paid for
third party software products and the amortization of purchased technology.

                                      F-11
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

(1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

      (j)  Software Development Costs

     The Company recognizes costs associated with new software or product
development and/or significant enhancements to current software or products in
accordance with Statement of Financial Accounting Standards ("SFAS") SFAS No.
86, "Software Development Costs". Under SFAS No. 86, these costs are expensed
until technological feasibility has been established, at which time any
additional costs are capitalized. The Company essentially has completed its
software development concurrently with technological feasibility and,
accordingly, has not capitalized any software development costs.

     Software developed for internal use is recognized in accordance with SOP
98-1, "Accounting for the Cost of Computer Software Developed or Obtained for
Internal Use". SOP 98-1 requires all costs related to the development of
internal use software other than those incurred during the application
development stage to be expensed as incurred. It also provides guidance on the
capitalization of costs incurred during the application development stage for
computer software developed or obtained for internal use.

      (k)  Stock-Based Compensation

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

The following table illustrates the effect on net loss attributable to common
stockholders and loss attributable to common stockholders per share if the fair
value based method had been applied to all awards:

<TABLE>
<CAPTION>
                                                                   Year Ended December 31,
                                                                 --------------------------
                                                                     2004           2003
                                                                 -----------    -----------
<S>                                                              <C>            <C>
     Reported net loss attributable to common stockholders       $(3,636,000)   $(2,603,000)
     Stock-based employee compensation determined under the       (1,121,000)      (688,000)
                                                                 -----------    -----------
         fair value-based method

     Pro forma net loss attributable to common shareholders      $(4,757,000)   $(3,291,000)
                                                                 ===========    ===========

     Loss attributable to common stockholders per share (basic
       and diluted):
           As reported                                           $     (0.05)   $     (0.04)
                                                                 ===========    ===========
           Pro forma                                             $     (0.06)   $     (0.05)
                                                                 ===========    ===========
</TABLE>

      The proforma amounts disclosed above may not be representative of future
disclosures because the estimated fair value of stock options is amortized over
the vesting period and additional options may be granted in future years.

                                      F-12
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003


(1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

      (k)  Stock-Based Compensation  (continued)

         The fair value of each option grant on the date of grant is estimated
using the Black-Scholes option-pricing model reflecting the following:

                                                 Year Ended December 31,
                                              ----------------------------
                                                2004                2003
                                              --------            --------
         Volatility                               126%                138%
         Expected life of options             5 years             5 years
         Risk free interest rate                  3.6%                3.5%
         Dividend yield                             0%                  0%

         The weighted average grant date fair value of options granted during
the years ended December 31, 2004 and 2003 were $0.59 and $0.56, respectively.

         (l)  Net Loss Per Common Share

     The Company computes net loss per common share in accordance with SFAS No.
128, "Computation of Earnings Per Share". In accordance with SFAS No. 128, basic
earnings per share is computed using the weighted average number of common
shares outstanding during the period. Potential common shares consist of the
incremental common shares issuable upon the conversion of the preferred stock
and convertible debentures (using the if-converted method) and shares issuable
upon the exercise of stock options and warrants (using the Treasury Stock
method); potential common shares are excluded from the calculation if their
effect is anti-dilutive.

     Diluted loss per share has not been presented separately, as the
convertible preferred stock, convertible debentures and the outstanding stock
options and warrants (aggregating 33,047,000 potential common shares at December
31, 2004 and 24,540,000 at December 31, 2003) are anti-dilutive for each of the
periods presented.

         (m)  Use of Estimates

     The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
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 differ from those
estimates. Assumptions underlying revenue recognition represent sensitive
estimates subject to change.

         (n)  Segment Reporting

     The Company adopted the provisions of SFAS No. 131, "Disclosures About
Segments of an Enterprise and Related Information". The Company operates in one
business segment, the sale of video compression software and related services,
for which it receives revenues from its customers. The Company's Chief Operating
Decision Maker is the Company's Chief Executive Officer ("CEO"), who receives
consolidated financial information for purposes of evaluating the Company's
operational and financial performance.

                                      F-13
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

(1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)

         (n)  Segment Reporting  (continued)

     Our customers typically represent large digital communication and media
companies, entertainment companies, telecommunication companies and other global
corporations that operate within the digital media industry. For the year ended
December 31, 2004, one customer accounted for 47% of the Company's total
revenues. For the year ended December 31, 2003, three customers accounted for
35%, 19% and 11% of the Company's total revenue. As of December 31, 2004, two
customers accounted for 21% and 13% of total accounts receivable. As of December
31, 2003, two customers accounted for 59% and 18% of total accounts receivable.

      The components of the Company's revenue for the years ended December 31,
2004 and 2003 are summarized as follows:

                                                      December 31,
                                          --------------------------------------
                                                2004                   2003
                                          ---------------        ---------------

 License revenue.......................   $    2,571,000         $    2,637,000
 Engineering services and support......          414,000                633,000
 Royalties.............................           43,000                 32,000
                                          ---------------        ---------------

    Total..............................   $    3,028,000         $    3,302,000
                                          ===============        ===============

      For the year ended December 31, 2004, foreign customers accounted for
approximately 20% of total revenue. These customers are primarily located in
Asia. For the year ended December 31, 2003, foreign customers accounted for
approximately 67% of total revenue.

     The Company's assets and operations have been and are currently based
within in the United States, except for two research and development employees
located in the United Kingdom. There was no significant revenue generated from
the United Kingdom operations for the years ended December 31, 2004 and 2003.

      (o)  Recently Issued Accounting Pronouncements

     In December 2004, the FASB issued SFAS No. 123 (revised 2004) "Share-Based
Payment" ("SFAS 123(R)"). SFAS 123(R) addresses the accounting for transactions
in which an enterprise exchanges its equity instruments for employee services.
It also addresses transactions in which an enterprise incurs liabilities that
are based on the fair value of the enterprise's equity instruments or that may
be settled by the issuance of those equity instruments in exchange for employee
services. The cost of employee services received in exchange for equity
instruments, including employee stock options, is to be measured on the
grant-date fair value of those instruments. That cost will be recognized as
compensation expense over the service period, which would normally be the
vesting period. SFAS 123(R) is effective as of the first interim or annual
reporting period that begins after December 15, 2005. We are currently
evaluating the impact of adopting SFAS 123(R) on our financial position and
results of operations.

                                      F-14
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

(2) MARKETABLE EQUITY SECURITIES

      During the year ended December 31, 2004 the Company received 2,224,000
shares of a customer's common stock as payment of license fees pursuant to the
terms of an August 2004 license agreement and $289,000 of revenue was recognized
based on the market value of the stock. The Company also received 469,000 shares
of this customer's common stock pursuant to the terms of a license agreement for
a license fee of $150,000 that was recognized in 2003. During the year ended
December 31, 2004 the Company sold 574,000 shares for proceeds of $89,000 and
held 2,119,000 shares with a market value of $445,000 ($0.21 per share) as of
December 31, 2004. The market value of these securities was $0.12 per share as
of March 10, 2005. The Company classifies these shares as trading securities and
pursuant to SFAS No. 115, "Accounting for Certain Investments in Debt and Equity
Securities", unrealized gains and losses are included in the determination of
net income (loss). Other income for the year ended December 31, 2004 includes
$95,000 of net gain on these securities. The Company's Chief Executive Officer
(who is a director and shareholder of the Company) is a director of this
customer.

(3) PROPERTY AND EQUIPMENT

<TABLE>
<CAPTION>
                                                                 December 31,
                                                      --------------------------------
                                                           2004              2003
                                                      --------------    --------------
<S>                                                   <C>               <C>
 Furniture and fixtures............................   $      65,000     $     65,000
 Computer equipment................................       2,367,000        2,314,000
 Leasehold improvements............................          23,000           23,000
 Licensed software.................................         588,000          588,000
                                                      --------------    --------------

                                                          3,043,000        2,990,000

 Less accumulated depreciation and amortization....       2,956,000        2,841,000
                                                      --------------    --------------

    Total..........................................   $      87,000     $    149,000
                                                      ==============    ==============
</TABLE>

     As of December 31, 2004, property and equipment included assets under
capital leases of $156,000 with related accumulated depreciation of $118,000. As
of December 31, 2003, property and equipment included assets under capital
leases of $103,000 with related accumulated depreciation of $98,000.
Depreciation expense was $115,000 and $243,000 for the years ended December 31,
2004 and 2003, respectively.


(4) INTANGIBLE ASSETS

      Purchased technology of $2,509,000 became fully amortized in September
2003, including $463,000 of amortization expense in 2003.

                                      F-15
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

(5) ACCRUED EXPENSES

                                                      December 31,
                                           ----------------------------------
                                               2004                2003
                                           -------------      ---------------

    Accrued compensation................   $     41,000       $      28,000
    Accrued professional fees...........         80,000              65,000
    Other accrued expenses..............        272,000             128,000
                                           -------------      ---------------

           Total........................   $    393,000       $     221,000
                                           =============      ===============

(6) TERM LOAN

     During June 2004 the Company obtained unsecured financing in the amount of
$185,000 to finance their directors' and officers' liability insurance. The
financing arrangement is for nine months; runs through March of 2005 and bears
interest at an annual rate of 4.95%.

(7) INCOME TAXES

     The asset and liability method is used in accounting for income taxes.
Under this method, deferred tax assets and liabilities are determined based on
differences between the financial reporting and tax bases of assets and
liabilities and are measured using the enacted tax rates and laws that will be
in effect when the differences are expected to reverse.

   As of December 31, 2004, the Company has net operating loss carry forwards
for United States purposes of approximately $80,629,000 which expire at various
dates through 2024. As of December 31, 2004, the Company has a deferred tax
asset of approximately $33,917,000, principally representing the benefits of its
net operating loss carry forwards and certain expenses not currently deductible
for tax purposes. Past and future stock issuances may subject the Company to an
annual limitation on the utilization of its net operating loss under Section 382
of the Internal Revenue Code. At December 31, 2004 the principal timing
difference between tax and financial reporting was due to depreciation expense.
A full valuation allowance, which increased by $1,737,000 (the deferred tax
asset as of December 31, 2003, was $32,180,000) and $751,000 during the years
ended December 31, 2004 and 2003, respectively, has been recorded related to the
deferred tax asset as a result of management's uncertainty as to the realization
of such asset. Accordingly, no provision for federal income tax benefit has been
recognized. The tax provisions of $2,000 and $10,000 for the years ended
December 31, 2004 and 2003, respectively, relate primarily to various state and
local taxes.

 (8) CONVERTIBLE DEBENTURES

      Series A Secured Convertible Debentures

     In September 2002 the Company issued $650,000 principal amount, 5.75%,
four-year Series A Secured Convertible Debentures due in 2006 to a group of
existing investors and two former Board members who were members of the Board at
the time of issuance. The debentures are convertible into the Company's $0.01
par value common stock ("Common Stock") at $0.112. In addition, the Company
issued to the purchasers of the debentures, warrants to acquire the Company's
Common Stock. The Company sold sixty-five units with a principal amount of
$10,000 per unit and each unit contained one warrant to purchase 20% warrant
coverage shares of Common Stock at $0.112 per share. The debentures require
interest to be paid each November and May, which is payable in a number of
shares of common stock that is based on the average closing price of the stock
for the ten trading days prior to the payment date. The initial common share
equivalents for the debentures and the warrants were 5,804,000 and 1,161,000,
respectively.

                                      F-16
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

(8) CONVERTIBLE DEBENTURES (continued)

      Series A Secured Convertible Debentures (continued)

            The Company allocated the proceeds received to the principal amount
of the debentures and the warrants based upon the relative fair value method.
The fair value of the warrants was determined using the Black Scholes pricing
model. The difference between the proceeds allocated to, and the relative fair
value of the debentures, which amounted to $88,000, was recorded as debt
discount and additional paid-in capital. The discount is being amortized over
the life of the debentures, which resulted in an effective interest rate of
approximately 9%.

     An aggregate principal amount of $300,000, of the Series A Secured
Convertible Debentures, was converted into 2,679,000 shares the Company's common
stock as of December 31, 2004. During 2004, 90,000 warrants were exercised.

      The amortization of the discount was $21,000 and $40,000 for the years
ended December 31, 2004 and 2003, respectively.

(9) STOCKHOLDERS' EQUITY

     (a)    Preferred Stock

     The Company has 20,000,000 shares of preferred stock authorized for
issuance and, through December 31, 2004, nine series of convertible preferred
stock (collectively "Preferred Stock") were issued. Pursuant to its Certificate
of Incorporation, the Company may serially designate separate classes of
preferred stock up to the aggregate of its authorized limit. Each class of the
Preferred Stock is convertible into shares of the Company's Common Stock based
on a conversion rate and has rights and preferences which are generally more
senior to the Company's Common Stock and are more fully described in the
Company's Certificate of Incorporation.

      Series A Convertible Preferred Stock

      In 1999, the Company issued 2,000,000 preferred stock purchase units (the
"Units") for $7.50 per unit.

     Each Unit consisted of one share of Series A Convertible Preferred Stock,
$0.01 par value, and a warrant to purchase 1.114404 shares of Common Stock of
the Company at an exercise price of $3.14 per share. Each share of Series A
Preferred Stock is non-voting and may be converted at the holder's option, at
any time, into one share of Common Stock of the Company.

      The Series A Convertible Preferred Stock includes a liquidation
preference. In the event of any liquidation, dissolution or winding up of the
Company, either voluntary or involuntary, the holders of shares of Series A
Convertible Preferred Stock are entitled to receive an amount equal to $7.50 per
share. The liquidation price per share would be paid out of the assets of the
Company available for distribution prior to any payments made on any shares of
the Company's Common Stock or any other capital stock other than the Preferred
Stock.

     As of December 31, 2004, all of the Series A Preferred has been converted
into shares of the Company's Common Stock including the conversion of 400,000
shares during 2004.

                                      F-17
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

(9) STOCKHOLDERS' EQUITY (continued)

      (a) Preferred Stock (continued)

      Series C, C-IV and C-V Convertible Preferred Stock

     In 2000, the Company designated 4,286,000 shares of its authorized
preferred stock as Series C Preferred Stock, $0.01 par value ("Series C
Preferred") and completed a private placement of 1,644,000 shares of the Series
C Preferred with detachable warrants for an aggregate purchase price of
$10,000,000, in connection with an investment by The Travelers Indemnity Company
("Travelers"). The Company incurred transaction costs of $9,000 in connection
with the transaction. This investment was part of an aggregate financing of
$15,000,000. The original conversion price was $6.082. The additional $5,000,000
was received and satisfied through the issuance of the Company's Series C-II and
Series C-III Convertible Preferred Stock as described below. In the event of any
liquidation, dissolution or winding up of the Company, either voluntary or
involuntary, the holders of the Series C Preferred are entitled to receive a
liquidation amount of $6.082 per share. The liquidation price per share would be
paid out of the assets of the Company available for distribution prior to any
payments made on any shares of the Company's Common Stock or any other capital
stock that ranks junior to the Preferred Stock.

         In addition to the Series C Preferred, Travelers received detachable
warrants which provide them the right to purchase 206,000 shares of the
Company's Common Stock at an exercise price of $8.69 per share and 206,000
shares of the Company's Common Stock at an exercise price of $10.86 per share
(collectively "Travelers' Warrants").

      Concurrently with its investment in June 2000, Travelers was granted
pricing protection on its investment regarding the subsequent investments in the
Series C-II and Series C-III Preferred Stock. Accordingly, on December 31, 2001,
the Company canceled the Series C Preferred and issued in its place 1,849,000
shares of Series C-IV Convertible Preferred Stock, ("Series C-IV Preferred") par
value $0.01 per share, with a conversion price of $2.65 per share, and 4,100,000
shares of Series C-V Convertible Preferred Stock ("Series C-V Preferred"), par
value $0.01 per share, with a conversion price of $1.244 per share, and
cancelled the Travelers Warrants and in their place issued 462,000 warrants with
an exercise price of $2.65 per share and 1,025,000 warrants with an exercise
price of $1.14 per share. Travelers was not entitled to any further pricing
protections.

      Additionally, Travelers is entitled to certain anti-dilution protection on
its Series C-IV and C-V Preferred. The anti-dilution provisions primarily adjust
the conversion price of the Series C-IV and Series C-V Preferred and the number
and exercise price of the warrants. The anti-dilution provision for the Series
C-IV and Series C-V Preferred was triggered by certain subsequent debt and
equity financings consummated by the Company. Although the Series C-IV and C-V
Preferred was not issued until December 31, 2001, the Company recognized the
additional benefit to be received by Travelers as if the Series C-IV and C-V
Preferred had been issued in June 2000.

      As of December 31, 2002, the conversion price of the Series C-IV Preferred
was adjusted to $1.7549 per share, the Company issued 236,000 additional
warrants and the exercise price of the warrants was reduced to

                                      F-18
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

(9) STOCKHOLDERS' EQUITY (continued)

      (a) Preferred Stock (continued)

      Series C, C-IV and C-V Convertible Preferred Stock (continued)

$1.7549 per share. As a result of the issuance of the Series D Convertible
Preferred Stock in October 2004, the conversion price of the Series C-IV
Preferred was further adjusted to $1.6412 per share.

      Additionally, as of December 31, 2002, the conversion price of the Series
C-V Preferred was adjusted to $0.9047 per share, the Company issued 372,000
additional warrants and the exercise price of the warrants was reduced to
$0.8363 per share. As a result of the issuance of the Series D Convertible
Preferred Stock in October 2004, the conversion price of the Series C-V
Preferred was further adjusted to $0.8839 per share

     During the year ended December 31, 2003 the Company purchased 698,000
Warrants originally issued with the Series C-IV Preferred and 1,397,000 Warrants
originally issued with the Series C-V Preferred from a Company's shareholder for
$42,000 in cash. Both the Series C-IV and C-V Warrants were due to expire on
June 6, 2003. The Company recorded the transaction by decreasing additional
paid-in-capital.

     During the years ended December 31, 2004 and 2003, 727,000 and 1,923,000
shares of Series C-V Preferred were converted into 1,000,000 and 2,644,000
shares, respectively, of the Company's Common Stock.

      Series C-II Convertible Preferred Stock

     In September 2000, the Company designated 925,000 shares of its authorized
preferred stock as Series C-II Preferred Stock, $0.01 par value ("Series C-II
Preferred") and completed a private placement of 925,000 shares of the Series
C-II Preferred with detachable warrants for an aggregate purchase price of
$2,450,000 with three investors (the "Series C-II Investors"). The original
conversion price of the Series C-II Preferred was $2.65 per share. In the event
of any liquidation, dissolution or winding up of the Company, either voluntary
or involuntary, the holders of the Series C-II Preferred were entitled to
receive an amount equal to $2.65 per share. The liquidation price per share was
to be paid out of the assets of the Company available for distribution prior to
any payments made on any shares of the Company's Common Stock or any other
capital stock that ranks junior to the Preferred Stock.

     In addition to the Series C-II Preferred, the Series C-II Investors
received detachable warrants which provided them the right to purchase an
aggregate of 396,000 shares of the Company's Common Stock at an exercise price
of $2.65 per share.

     The holders of the Series C-II Preferred were entitled to certain
anti-dilution protection. The anti-dilution provision primarily adjusts the
conversion price of the Series C-II Preferred and the number and exercise price
of the original warrants issued. The anti-dilution provision for the Series C-II
Preferred was triggered by certain subsequent debt and equity financings
consummated by the Company. As of December 31, 2002 the conversion price of the
Series C-II Preferred was adjusted to $1.7549 per share, the Company issued an
additional 202,000 warrants and the exercise price of the warrants was reduced
to $1.7549 per share. All of the Series C-II Preferred was converted into shares
of the Company's Common Stock. During the year ended December 31, 2003 the
Company granted a cashless exercise right to a C-II Preferred Stock warrant
holder and recorded a deemed dividend of $85,000. During the year ended December
31, 2003, all of the C-II Preferred Warrants were exercised into 550,000 shares
of the Company's Common Stock and the Company received proceeds of $910,000 in
connection with their exercise.

                                      F-19
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

(9) STOCKHOLDERS' EQUITY (continued)

            (a) Preferred Stock (continued)

             Series C-III Convertible Preferred Stock

     In December 2000, the Company designated 2,050,000 shares of its authorized
preferred stock as Series C-III Preferred Stock, $0.01 par value ("Series C-III
Preferred") and completed a private placement of the 2,050,000 shares of the
Series C-III Preferred with detachable warrants for an aggregate purchase price
of $2,550,000 with two investors (the "Series C-III Investors"). The original
conversion price of the Series III Preferred was $1.244 per share. In the event
of any liquidation, dissolution or winding up of the Company, either voluntary
or involuntary, the holders of the Series C-III Preferred were entitled to
receive an amount equal to $1.244 per share. The liquidation price per share was
to be paid out of the assets of the Company available for distribution prior to
any payments made on any shares of the Company's Common Stock or any other
capital stock that ranks junior to the Preferred Stock.

     In addition to the Series C-III Preferred, the Series C-III Investors
received detachable warrants which provided them the right to purchase an
aggregate of 635,000 shares of the Company's Common Stock at an exercise price
of $1.14 per share.

     The holders of the Series C-III Preferred are entitled to certain
anti-dilution protection. The anti-dilution provision primarily adjusts the
conversion price of the Series C-III Preferred and the number and exercise price
of the original warrants issued. The anti-dilution provision for the Series
C-III Preferred was triggered by certain subsequent debt and equity financings
consummated by the Company. All of the Series C-III Preferred were converted
into 2,614,000 shares of the Company's Common Stock based on an adjusted
conversion price of $0.9756 per share. As of December 31, 2002 the Company
issued an additional 238,000 warrants and the exercise price of the warrants was
reduced to $0.8363 per share. During the year ended December 31, 2003, the
Company received proceeds of $730,000 in connection with the exercise of all of
the C-III Preferred Warrants into 873,000 shares of the Company's Common Stock.

      Series C-VI Convertible Preferred Stock

     In July 2001, the Company and completed a Unit Purchase Agreement with
Travelers whereby it sold an aggregate of 3,571,000 units that consisted of one
share of the Company's Common Stock and a warrant to purchase 1.5 shares of the
Company's Common Stock for an aggregate purchase price of $2,000,000. In August
2001, the Company entered into a new agreement with Travelers, rescinding the
Unit Purchase Agreement and providing that Travelers receive 3,571,000 shares of
preferred stock, which were not convertible into the Company's Common Stock for
a period of six months. Each share of Series C-VI Preferred Stock ("Series C-VI
Preferred") converts on a one-for-one basis into shares of the Company's Common
Stock. In addition, the Company issued to Travelers a warrant to purchase
5,357,000 shares of the Company's Common Stock that could not be exercised for a
period of six months. The exercise price of the warrant is $0.56 per share and
the warrant expires in August 2005.

      The Series C-VI Preferred includes a liquidation preference. In the event
of any liquidation, dissolution or winding up of the Company, either voluntary
or involuntary, the holders of shares of Series C-VI Preferred are

                                      F-20
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

(9) STOCKHOLDERS' EQUITY (continued)

            (a) Preferred Stock (continued)

             Series C-VI Convertible Preferred Stock (continued)

entitled to receive an amount equal to $0.56 per share. The liquidation price
per share would be paid out of the assets of the Company available for
distribution prior to any payments made on any shares of the Company's Common
Stock or any other capital stock other than the Preferred Stock.

     During the year ended December 31, 2003 the Company agreed to extend
certain anti-dilution rights to the holders of its Series C-VI Preferred,
retroactive to the issuance of such shares. The conversion price of the Series
C-VI Preferred has been adjusted to $0.5241 from $0.5601 per share as a result
of the retroactive treatment. The Company recorded deemed dividends of $143,000
during the year ended December 31, 2003 relating to this adjustment.

     During the years ended December 31, 2004 and 2003, 1,139,000 and 2,432,000
shares of Series C-VI Preferred were converted into 1,210,000 and 2,606,000
shares, respectively, of the Company's Common Stock. During 2004 the Company
received proceeds of $753,000 from the exercise of 1,345,000 warrants.

           Series D Convertible Preferred Stock

      In October 2004, the Company designated 4,000 shares of its authorized
preferred stock as Series D Convertible Preferred Stock, $0.01 par value
("Series D Preferred") and completed the sale of 4,000 shares of Series D
Preferred at $1,000 per share to two institutional investors, led by Midsummer
Investment Ltd., for net proceeds of $3,699,000. The Series D Convertible
Preferred is convertible at any time into common stock at an initial conversion
price of $0.70 per share of common stock.

      The Series D Preferred is mandatorally redeemable by the Company over an
18-month period beginning in October 2006 (42 months). Such redemptions can be
made in cash or Common Stock, at the Company's option. If redemptions are made
in Common Stock, the shares are valued at the average of the volume weighted
average trading price of the Common Stock for the 20 trading days immediately
prior to the redemption date.

      The Investors also received one-year warrants to purchase an aggregate of
2,994,000 shares of common stock at an exercise price of $0.65 per share and
five-year warrants to purchase an aggregate of 2,994,000 shares of Common Stock
at an exercise price of $0.76 per share. The Series D Preferred and warrants are
subject to certain anti-dilution protection for issuances of securities below
the conversion price. Holders of Series D Preferred are entitled to receive an
8% annual cumulative dividend, payable quarterly in cash or shares of Common
Stock at the Company's option, subject to the satisfaction of certain
conditions.

      The Series D Preferred includes a liquidation preference. In the event of
any liquidation, dissolution or winding up of the Company, either voluntary or
involuntary, the holders of shares of Series D Preferred are entitled to receive
an amount equal to $1,000 per share. The liquidation price per share would be
paid out of the assets of the Company available for distribution prior to any
payments made on any shares of the Company's junior securities. The aggregate
fair value of the Series D Preferred was $4,000,000, based upon the redemption
value of $0.70 which exceeded the market value the underlying Common Stock on
the closing date. Additionally, the fair value of the warrants issued, as
calculated using the Black Scholes pricing model, was $2,354,000. In accordance
with EITF 98-5, the Company allocated the net proceeds between the Series D
Preferred Stock and the warrants based on the relative fair value method as
described in APB No. 14. The Company allocated $2,518,000

                                      F-21
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

(9) STOCKHOLDERS' EQUITY (continued)

            (a) Preferred Stock (continued)

             Series D Convertible Preferred Stock (continued)

to the Series D Preferred and $1,482,000 to the warrants. The aggregate of the
relative fair value of the Warrants and the beneficial conversion feature of the
Series D Preferred represents a convertible Preferred Stock deemed dividend
which is limited to the proceeds allocated to the Series D Preferred. As of
December 31, 2004 the redemption value exceeded the market value of the common
shares issuable upon conversion. Accordingly, $2,518,000 of deemed dividends and
accretion of $301,000 of financing costs are being recognized over the 42-month
term of the Series D Preferred, including $120,000 and $14,000, respectively, in
2004. If the market value of the underlying Common Stock exceeds the redemption
value at a future reporting date the remaining amounts will be recognized at
that time.

      During 2004 the Company recorded dividends of $57,000 on the Series D
Preferred of which $30,000 was paid by issuing 60,000 shares of the Company's
Common Stock and $27,000 was accrued.

The following table summarizes the common stock issuable upon conversion of all
outstanding Preferred Stock and the exercise of related warrants at December 31,
2004:

                                                       Shares of
                                                      Common Stock
                                 Conversion or       Issuable upon
                                 Exercise Price       Conversion/
   Convertible Security            per Share            Exercise
---------------------------      --------------      --------------

Series C-IV Preferred Stock         $1.6412            2,986,000
Series C-V Preferred Stock          $0.8839            2,040,000
Series C-VI Warrants                $0.5600            4,012,000
Series D Preferred Stock            $0.7000            5,714,000
Series D Warrant                    $0.6500            2,994,000
Series D Warrant                    $0.7600            2,994,000


                                      F-22
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

(9) STOCKHOLDERS' EQUITY (continued)

      (b)   Common Stock

      Equity-Line of Credit

     In December 2000 and 2001, the Company entered into common stock purchase
agreements with an accredited investor for the sale, from time to time over 36
month terms, of the Company's Common Stock. During the year ended December 31,
2003, the Company issued 3,387,000 shares of its Common Stock and received
proceeds of $1,314,000 in connection with these agreements. As of December 31,
2004 these agreements have expired.

      (c)  Warrants

     The Company issued common stock purchase warrants to various consultants,
strategic partners and investors. The following table summarizes information
about all common stock purchase warrants outstanding as of December 31, 2004,
including those issued in connection with Preferred Stock and Convertible
Debentures. All warrants were exerciseable as of December 31, 2004.

                             Number of
           Range of           Warrants      Weighted Average
      Exercise Prices       Outstanding      Exercise Price     Expiration Dates
      ----------------      -----------     ----------------    ----------------
      $  0.11 - $ 0.39        1,114,000          $ 0.12           2005 - 2007
      $  0.43 - $ 0.76       10,486,000          $ 0.64           2005 - 2009
      $  1.43 - $ 1.68        1,650,000          $ 1.67           2006 - 2007
      $19.89                    100,000          $19.89           2005
                        ------------------

                             13,350,000          $ 0.87
                        ==================

      (d)  Stock Options

          Pursuant to the Company's 1999 Amended and Restated Incentive and
Nonqualified Stock Option Plan (the "1999 Plan") 5,500,000 shares of Common
Stock are reserved for issuance. The 1999 Plan provides for the issuance of
incentive stock options, which are intended to qualify under Section 422 of the
Internal Revenue Code, non-qualified stock options and restricted stock grants.
The granting of incentive stock options is subject to the limitations as set
forth in the 1999 Plan. Directors, officers, employees and consultants are
eligible to receive grants under the 1999 Plan. A committee selected by the
Company's Board of Directors has the authority to approve option grants and the
terms, which include the option price and the vesting terms. Options granted
under the 1999 Plan expire after a ten-year period and are subject to
acceleration upon the occurrence of certain events.

     Pursuant to the Company's 2000 Nonqualified Stock Option Plan (the "2000
Plan") 5,000,000 shares of the Company's Common Stock are reserved for issuance.
The 2000 Plan authorizes the Board of Directors to issue nonqualified stock
options as provided in section 422 of the Internal Revenue Code, restricted
stock and stock appreciation rights. Only employees, including officers, of the
Company and its subsidiaries are eligible to receive grants under the 2000 Plan.
A committee selected by the Company's Board of Directors has the authority to
approve option grants and the terms, which include the option price and the
vesting terms. Options granted under the 2000 Plan expire after a ten-year
period and are subject to acceleration upon the occurrence of certain events.


                                      F-23
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

(9) STOCKHOLDERS' EQUITY (continued)

      (d)  Stock Options  (continued)

      The following table summarizes the stock option activity under all plans:

<TABLE>
<CAPTION>
                                                                                     Weighted Average
                                                                Options Granted       Exercise Price
                                                             --------------------   ------------------
<S>                                                                   <C>             <C>
          Outstanding January 1, 2003........................         6,283,000       $    1.71

              Granted........................................         1,201,000            0.65
              Exercised......................................        (2,580,000)           0.54
              Canceled.......................................          (557,000)           6.63
                                                             ---------------------

          Outstanding December 31, 2003.......................        4,347,000            1.52

              Granted........................................         3,110,000            0.68
              Exercised......................................          (275,000)           0.24
              Canceled.......................................        (1,350,000)           1.30
                                                             ---------------------

          Outstanding at December 31, 2004...................         5,832,000       $    1.18
                                                             =====================

          Exercisable at December 31, 2003...................         3,477,000       $    0.73
                                                             =====================

          Exercisable at December 31, 2004...................         3,501,000       $    1.55
                                                             =====================

          Options granted in excess of shares available at
            December 31, 2004................................          (351,000)
                                                             =====================
</TABLE>

      The following table summarizes information about stock options outstanding
as of December 31, 2004:

<TABLE>
<CAPTION>
                                             Options Outstanding                                 Options Exercisable
                    --------------------------------------------------------------------- -------------------------------------
Range of Exercise        Number         Weighted Average     Weighted Average Remaining       Number         Weighted Average
Prices                  of Shares        Exercise Price     Contractual Life (in years)      of Shares        Exercise Price
------------------- --------------------------------------------------------------------- -------------------------------------
<C>                     <C>                <C>                         <C>                    <C>                <C>
$ 0.14 - $ 0.46         1,961,000          $  0.37                     7.6                    1,756,000          $  0.36
$ 0.55 - $ 0.69         2,522,000             0.61                     9.7                      540,000             0.67
$ 0.70 - $ 0.88           412,000             0.81                     5.6                      397,000             0.81
$ 1.25 - $ 2.25           522,000             1.48                     8.1                      395,000             1.50
$ 2.27 - $ 3.88           197,000             3.44                     5.6                      195,000             3.45
$10.63 - $11.81           157,000            11.59                     5.1                      157,000            11.59
$12.25 - $25.00            61,000            16.71                     4.6                       61,000            16.71
                    ----------------                                                      ---------------

                        5,832,000          $  1.18                     8.25                   3,501,000          $  1.55
                    ================                                                      ===============
</TABLE>

                                      F-24
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

(9) STOCKHOLDERS' EQUITY (continued)

      (d)  Stock Options  (continued)

       Equity based compensation of $835,000 and $60,000 were charged to
operations for the years ended December 31, 2004 and 2003, respectively. The
2004 compensation represents restricted stock granted to employees and directors
during 2004 that vested in December 2004. The 2003 compensation represents
warrants to purchase shares of Common Stock granted to certain consultants.

      In December 2004 the Company's Chief Executive Officer cancelled 1,300,000
of his stock options with exercise prices ranging from $0.74 to $2.50 per share
and the Company granted 1,440,000 stock options with an exercise price $0.57 per
share to other employees. As of December 31, 2004 the Company has granted
351,000 options in excess of shares available under its stock option plans,
which are not exercisable unless sufficient shares are added to the plans. The
measurement date for the compensation costs of the 351,000 options will be the
date on which sufficient shares are made available.

(10) COMMITMENTS AND CONTINGENCIES

(a)         Operating Leases

          The Company has entered into several non-cancelable leases, primarily
related to the rental of certain facilities. Future minimum lease payments, by
year and in the aggregate, under material operating leases. consisted of the
following at December 31, 2004:

            Year ended December 31,                        Amount
                                                         ----------
            2005......................................   $ 145,000
            2006......................................      16,000
                                                         ----------

                 Total minimum lease payments.........   $ 161,000
                                                         ==========

     Rent expense under operating leases was approximately $170,000 and $127,000
for the years ended December 31, 2004 and 2003, respectively.

(b)         Employment Agreements

     The Company maintains employment agreements, expiring at various intervals,
with three executives of the Company. The employment agreements provide for a
minimum salary, incentive compensation and certain benefits, among other items.

(c)         Litigation

      The Company received the final payment of $75,000 in 2003 in connection
with a 2002 settlement agreement with Ecoin Co. Ltd.

           From time to time the Company has been named in other claims arising
in the ordinary course of business. In the opinion of management, the ultimate
disposition of these matters will not have a material adverse effect on
Company's consolidated financial position, results of operations or liquidity.

                                      F-25
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

(10) COMMITMENTS AND CONTINGENCIES (continued)

(d)         Beijing E-world

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

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

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

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

     Beyond the licensing of the software, On2 will provide E-World with phone
and email source code porting, optimization and integration technical support
for a period of 24 months from the date of the agreement at no additional
charge. E-World can elect to receive an additional 12 months of technical
support for an additional $38,000 under each of the two arrangements. Deferred
revenue at December 31, 2004 includes $38,000 which will be recognized as
revenue over the remaining six months of technical support. Through December 31,
2004 the Company has recognized cumulative revenue of $262,000 in connection
with these agreements.

                                      F-26
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003


(10) COMMITMENTS AND CONTINGENCIES (continued)

(d)         Beijing E-world (continued)

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

      E-World has not made the minimum quarterly payments provided for under the
license agreements and in 2004 On2 commenced an arbitration proceeding seeking
damages for E-World's failure to perform. On2's arbitration claim alleged that
E-world had:

      o     Failed to make the quarterly payments;

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

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

On2 had requested that the arbitrator award it damages under the contract and
grant it further relief as may be just and equitable. E-world responded by
denying each of On2's claims and requested that the arbitrator find that E-world
complied with the terms of the license agreements.

On March 10, 2005, the decision of the arbitrator was released. The arbitrator
dismissed each of On2's claims and dismissed E-World's request for a declaration
regarding meaning of certain language under the contracts. In particular, the
arbitrator ruled that:

      o     E-World was not obligated to pay minimum royalty amounts beginning
            in the first quarter of 2004, because the parties had not ported VP6
            to a jointly-selected digital signal processor ("DSP");

      o     E-World was not yet required to pay the remaining license fee due
            under the contracts; and

      o     Because E-World had submitted On2's compression software to be made
            part of the People's Republic of China industrial standard for EVD
            prior to December 2003, E-World was not in breach of its obligation
            to have On2's software included as part of the EVD standard.

The arbitrator further found that:

      o     the contracts remain in effect; and

      o     the parties have a continuing obligation to work towards porting
            On2's software to two commercially-available DSPs.

Although the arbitrator found that E-world did include the VP5 and VP6 codecs as
part of its standards submissions to the Ministry of Information and China's
Standards Accreditation Committee, On2 does not know whether the standards
committee approved these recommendations or whether E-World will utilize the
Company's compression technology in a manner that will generate revenue for the
Company. In the event that E-World does begin to use VP5 or VP6 in its EVD
devices, there is no guarantee that the EVD standard will be widely adopted in
China or abroad or that we will receive any additional payments in connection
with these agreements. In addition, E-World and Chinese authorities may choose
to include other companies' video compression technologies in the EVD standard.

                                      F-27
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

(10) COMMITMENTS AND CONTINGENCIES (continued)

     (e)  Other Matters

     In July 2001, the Company entered into a Common Stock Purchase Agreement
with RealNetworks, Inc. ("Real") whereby Real purchased 1,786,000 shares of the
Company's Common Stock for net proceeds of $1,000,000 and entered into a
Software Development and License Agreement with Real as its exclusive delivery
platform for streamed content over the internet. The Company agreed to develop
software plug-ins in order to incorporate the technologies of the Company and
Real and to license its compression technology for use in Real's media delivery
products and services for a four-year term. In order for the Company to develop
the plug-ins described in the agreement, Real was to provide certain development
software and fulfill certain other obligations. The Company believes that Real
failed to deliver such software and perform such other obligations. During 2002,
the Company notified Real that it had terminated the agreement. Real has
disputed the Company's right to terminate the agreement and further claimed that
the Company was in breach of the agreement. The Company responded by reiterating
its position and has not had any subsequent contacts or discussions with Real.
The Company believes that it had the right to terminate the agreement based on
the nonperformance of Real. However, because the arrangement with Real was
exclusive in certain respects, should it be determined that the termination was
not effective, the Company could be restricted from supporting other software
platforms, including certain components of the Company's software platform which
have generated and are expected to continue to generate revenue under
arrangements with customers. The accompanying financial statements do not
include any provision for the outcome of this matter, which could have a
material adverse effect on the Company's business and financial condition.

(11) RELATED PARTY TRANSACTIONS

     During the years ended December 31, 2004 and 2003, the Company retained a
law firm to perform certain legal services on its behalf and incurred
approximately $38,000 and $56,000, respectively, for such legal services. A
member of the board of directors is a partner at the law firm.

     During the years ended December 31, 2004 and 2003, the Company retained a
consulting firm to facilitate customer relationships in Asia and incurred
approximately $122,000 and $108,000, respectively, for such services. A
consultant at the consulting firm became a director in August 2003.

      During the years ended December 31, 2004 and 2003, the Company's Chief
Executive Officer served as a director for one of the Company's customers. The
Company recognized revenue of $289,000 and $150,000 from this customer in 2004
and 2003, respectively.

                                      F-28
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2004 AND 2003

(12) SUBSEQUENT EVENTS

      Subsequent to December 31, 2004 Travelers exercised all of the remaining
Series C-VI Preferred Warrants and the Company received proceeds of $2,247,000
and issued 4,012,000 shares of Common Stock.

      Subsequent to December 31, 2004 Midsummer Investment Ltd. exercised all of
the one-year Series D Warrants and the Company received proceeds from the
exercise in the amount of $1,886,000 (net of $60,000 of expenses) and issued
2,994,000 shares of Common Stock.


                                      F-29