**Table
          of Contents**





**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**FORM 10-K**





(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, 2006**o
            
            **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 incorporation or
                organization)*
            
            *(I.R.S.
                Employer Identification No.)***21
                Corporate Drive, Suite 103, Clifton Park, NY**
              *(Address
                of principal executive offices)*
            
            **12065**
              *(Zip
                Code)*






**Registrant’s
      telephone number, including area code:**


**(518) 348-0099**





**Securities
      to be 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**





Indicate
      by check mark if the registrant is a well-seasoned issuer, as defined in Rule
      405 of the Securities Act.


Yes o No
x




Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or Section 15(d) of the Act.


Yes
o No
x




Indicate
      by check mark whether the registrant (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
o




Indicate
      by check mark if disclosure of delinquent filers in response to Item 405 of
      Regulation S-K is not contained herein, and will not 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-K or
      any amendment to this Form 10-K. x




Indicate
      by check mark whether the registrant is a large accelerated filer, and
      accelerated filer, or a non-accelerated filer. (Check one):




Large
      Accelerated Filer o Accelerated
      Filer o Non-Accelerated
      Filer x




Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act.


Yes
o No
x





**Table
        of Contents**




The
      aggregate market value of the voting and non-voting common equity held by
      non-affiliates of the registrant as of March 21, 2007, was approximately
      $145,414,000.




**(APPLICABLE
      ONLY TO CORPORATE REGISTRANTS)**




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: 103,973,446 shares as of March 20, 2007.




**DOCUMENTS
      INCORPORATED BY REFERENCE**




Items 10,
      11, 12, 13 and 14 of Part III are incorporated by reference from the
      Company’s definitive Proxy Statement, to be filed with the Securities and
      Exchange Commission on or before 120 days after December 31, 2006.


-2-
 **Table
            of Contents**




**TABLE
      OF CONTENTS**




**PART
                I**Item
                1.
            
            Description
                of business
            
            4Item
                1A.
            
            Risk
                Factors
            
            15Item
                2
            
            Description
                of Property
            
            18Item
                3
            
            Legal
                Proceedings
            
            18Item
                4.
            
            Submission
                of Matters to a Vote of Security Holders
            
            19**PART
                II**Item
                5.
            
            Market
                for Common Equity and Related Stockholder Matters
            
            24Item
                6.
            
            SELECTED
                FINANCIAL DATA
            
            24Item
                7.
            
            Management’s
                Discussion and Analysis of Financial Condition
                and Results of Operations
            
            24Item
                7A
            
            Quantitative
                and Qualitative Disclosures About Market
                Risk
            
            32Item
                8.
            
            FINANCIAL
                STATEMENTS AND SUPPLEMENTARY DATA
            
            32Item
                9.
            
            Changes
                In and Disagreements with Accountants on Accounting
                and Financial Disclosure
            
            32Item
                9A.
            
            Controls
                and Procedures
            
            33Item
                9B
            
            Other
                Information
            
            33**PART
                III**Item
                10.
            
            Directors,
                Executive Officers, Promoters and Control
                Persons; Compliance with Section 16(a) of the Exchange Act
            
            33Item
                11.
            
            Executive
                Compensation
            
            33Item
                12.
            
            Security
                Ownership Of Certain Beneficial Owners And
                Management and Related Stockholder Matters
            
            33Item
                13.
            
            Certain
                Relationships And Related Transactions
            
            33Item
                14.
            
            Principal
                Accouting Fees And Services
            
            33Item
                15.
            
            Exhibits
            
            34





-3-
 **Table
            of Contents**




**PART
      I**





**Item
                1.*****Description
                of Business***





**Forward-Looking
      Statement**




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




These
      statements are only predictions, and actual events or results may differ
      materially. The forward-looking statements are based on management’s beliefs and
      assumption using information available at the time. We cannot guarantee future
      results, levels of activity, performance or achievements. Factors that may
      cause
      actual results to differ are often presented with the forward-looking statements
      themselves. Additionally, other risks that may cause actual results to differ
      from predicted results are set forth, and in “Risk Factors” on page 15 of this
      Form 10-K.




Many
      of
      the forward-looking statements are subject to additional risks related to our
      need to either secure additional financing or to increase revenues to support
      our operations or business or technological factors. We believe that between
      the
      funds we have on hand and the funds we expect to generate, we have sufficient
      funds to finance our operations for the next 12 months. However, additional
      funds may be required in order to pursue strategic opportunities or for capital
      expenditures. In addition, there is no assurance that additional funds will
      not
      be required to support our operations. In this regard, the business and
      operations of the Company are subject to substantial risks that increase the
      uncertainty inherent in the forward-looking statements contained in this Form
      10-K. In evaluating our business, you should give careful consideration to
      the
      information set forth below under the caption “ *Risk
      Factors* ,”
in
      addition to the other information set forth herein.




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




**Item
      1. Description of Business**




**Overview**




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




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


-4-
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          of Contents**




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




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





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




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




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




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




We
      have
      recently begun selling additional products and services that relate to our
      existing relationships with licensees. For instance, if a customer has licensed
      our software to develop its own proprietary video format and video players,
      we
      may sell encoding software to users who want to encode video for playback on
      our
      customers’ players or we may provide engineering services to companies that want
      to modify our customer’s software for use on a specific platform, such as a cell
      phone. As with royalties or revenue share arrangements, complementary sales
      of
      encoding software or  -5-
 **Table
            of Contents**


engineering
      services should allow us to participate in the success of our customers’
products. For instance, if a customer’s video platform does well commercially,
      we would expect there to be a market for encoding software and/or engineering
      services in support of that platform.




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




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




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




One
      of
      the most significant recent trends in our business is our increasing reliance
      on
      the success of the product deployments of our customers. As referenced above,
      an
      increasing number of our license agreements with customers provide for the
      payment of license fees that are dependent on the number of units of a
      customer’s product incorporating our software that are sold or the amount of
      revenue generated by a customer from the sale of products or services that
      incorporate our software. We have chosen this royalty-dependent licensing model
      because, as a company of only 37 employees and in light of the vast range of
      conceivable video-enabled devices, we do not have the product development or
      marketing resources to develop and market end-to-end video solutions. Instead,
      our codec software is primarily intended to be used as a building block for
      companies that are developing end-to-end video products and/or services.




Under
      our
      agreements with certain customers, we have retained the right to market products
      that complement those customer applications. These arrangements allow us to
      take
      advantage of our customers’ superior ability to produce and market end-to-end
      video products, while offering those customers the benefit of having us produce
      technologically-advanced products that should contribute to the success of
      their
      applications. As with arrangements in which we receive royalties, the ability
      to
      market complementary products can yield revenues in excess of any initial,
      one-time license fee. In instances where we have licensed our products to
      well-known customers, our right to sell complementary products may be very
      valuable. But unlike royalties, which we receive automatically without any
      additional effort on our part, the successful sale of complementary products
      requires that we effectively execute an end-user product development and
      marketing program. Until recently, we have generally produced software targeted
      at developers, who integrate our software into their products, and developing
      and marketing products aimed at end users is therefore a relatively new business
      for us.  -6-
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            of Contents**


We
      believe that we have adopted the licensing model most appropriate for a business
      of our size and expertise. However, a natural result of this licensing model
      is
      that the amount of revenue we generate is highly dependent on the success of
      our
      customers’ product deployments. In certain circumstances, we may decide to
      reduce the amount of up-front license fees and charge a higher per-unit royalty.
      If the products of customers with whom we have established per unit royalty
      or
      revenue sharing relationships or for which we expect to market complementary
      products do not generate significant sales, these revenues may not attain
      significant levels. Conversely, if one or more of such customers’ products are
      widely adopted, our revenues will likely be enhanced.




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




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




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




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




H.264
      is
      also a competitor in the video compression field. H.264 is a standards-based
      codec that is the successor to MPEG-4. We believe our technology is superior
      to
      H.264, and that we can offer significantly more flexibility in licensing terms
      than customers will receive when licensing H.264. H.264 has nevertheless gained
      significant adoption by potential customers because, as a standards-based codec,
      it has the advantage of having numerous developers who are programming to the
      H.264 standard and developing products based on that standard. In addition,
      a
      number of manufacturers of multimedia processors have done the work necessary
      to
      have H.264 operate on their chips, which makes H.264 attractive to potential
      customers who would like to enable video on devices. For example, Apple Inc.
      uses H.264 in its QuickTime® player and, as a result, has chosen H.264 for the
      current generation of video iPods®. These  -7-
 **Table
            of Contents**


advantages
      may make H.264 attractive to potential customers and allow them to implement
      a
      solution based on H.264 with less initial development time and expense than
      a
      solution using On2 Video might require. In addition, there are certain customers
      that prefer to license standards-based codecs.




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




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




**Development
      of Our Business**




We
      detail
      the history and evolution of our business under the section “ *Management’s
      Discussion and Analysis of Financial Condition and of Operation - Company 
- History* ”.




**Business
      Strategy**




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




•
            Continuing
                our research and development efforts to improve current codecs and
                developing new technology that increase the quality of video technology
                and improve the experience of end users;•
            Using
                the success of current customer implementations of our technology
                (e.g.,
                Adobe Flash 8, Skype) to increase our brand recognition, promote
                new
                business and encourage proliferation across platforms;•
            Updating
                and enhancing our existing products, such as the Flix
                line;•
            Employing
                flexible licensing strategies to offer customers more attractive
                business
                terms than those available for competing technologies;•
            Entering
                into licensing arrangements with customers that provide for receipt
                of
                recurring revenue and/or that offer us the opportunity to market
                products
                that complement our customers implementations of our software;
                and•
            Expanding
                into international markets by contracting with resellers of our products
                and services and by developing relationships with large, innovative
                customers.





**Our
      Technology, Products and Services**




We
      have
      designed our technology to deliver the highest-quality video at the lowest
      possible data rates and to encode (compress) and decode (decompress) video
      on
      comparatively low-powered chips suitable for consumer electronics products.
      We
      currently develop and license a number of products related to our TrueMotionTM
line of codecs and TrueCast® line of server and player products for proprietary
      networks, the Internet and consumer electronic industries. The licensing of
      our
      proprietary TrueMotion codec and TrueCast server technology has accounted for
      19%, 44%, and 99% percent of our revenue for the three fiscals years ended
      December 31, 2006, 2005 and 2004, respectively.




We
      also
      develop and license a number of products used for encoding video in the Adobe
      Flash 8 video format, which is used in the Flash 8 and Flash 9 video players.
      We
      market these products, which include software packages for end users and
      software development kits for use by developers, as part of our Flix® product
      line. The licensing of our Flash


-8-
 **Table
            of Contents**




encoding
      products has accounted for 64% and 29% percent of our revenue for the two fiscal
      years ended December 31, 2006 and December 1, 2005, respectively. Prior to
      2005,
      Macromedia did not use On2’s video compression technology in Flash.




***VP6
      Codec***




We
      launched the Beta version of our TrueMotion VP6 series of codecs in May 2003
      and
      the official version in October 2003, and we have since released updated
      versions VP6.1 and VP6.2. VP6 represented a significant improvement over its
      predecessors, offering a 40% image quality improvement over and 50% faster
      playback than the previous version of On2’s technology, VP5. VP6 improves upon
      all the features contained in VP5 and supports real-time encoding at full D1
      resolution. Because Adobe/Macromedia is currently using VP6 in its Flash 8
      video
      format, VP6 has become our most widely-deployed technology. Because of VP6’s
      broad use, and despite the fact that it is not our latest technology, we
      continue to make improvements to the VP6 technology. It also consistently
      outperforms Windows Media 9 based on tests of Peak Signal-to-Noise Ratios (PSNR)
      measured at data rates ranging from dial-up (28.8 Kbps) to DVD and HD (6 to
      8
      Mbps). Since our introduction of VP6, we have ported it to the following digital
      signal processors (DSPs) across a range of resolutions: Texas Instruments’
TMS320C64x, Analog Devices’ Blackfin, ARC International’s ARCTangent, Equator
      Technologies’ MAP-CA and the ARM 7 and ARM 9.




***VP7
      Codec***




We
      introduced the official version of our TrueMotion VP7 codec in early March
      2005.
      Like prior versions of the TrueMotion codecs, VP7 shows a marked improvement
      over its predecessors, producing up to a 30% image quality improvement over
      VP6.
      Like its predecessor, in objective PSNR tests, VP7 shows better performance
      than
      its main competitors, including Windows Media 9, Real 10, and MPEG-4-compatible
      codecs at data rates ranging from dial-up (28.8 Kbps) to DVD and HD. In
      addition, VP7 regularly outperforms all but the best implementations of H.264
      across data-rates and is highly competitive with the most advanced H.264
      implementations. As with VP6, VP7 also supports real-time encoding **** at
      full
      D1 resolution. We have made significant progress - much of it in 2006 - in
      having VP7 implemented on DSPs, and VP7 currently operates on a number of chips
      across a range of resolutions.




TrueMotion
      Encoder Products


Our
      Encoder enables content owners to re-master and compress their assets
      efficiently into the VP6 or VP7 format at their own convenience. The Encoder
      is
      a key tool for users looking to develop content for our TrueMobile video
      products. Beginning with capturing uncompressed video through high quality
      SDI
      inputs, users can create an optimized digital file using our proprietary
      re-mastering tools. These tools are geared toward the video professional who
      wants exact control over the optimization process. Once the raw file has been
      optimized, our compression software has the capability to create multiple data
      rate compressed files.




***TrueMobile
      Mobile Video Products***




On2’s
      partnership in late 2005 with China Transport Telecommunications Broadband
      Network Service Co., Ltd. (CTTnet) of Beijing, China to jointly develop mobile
      video products marked the launch of On2’s TrueMobile mobile video platform.
      Research and development that On2 did in the Symbian and Smartphone Mobile
      environments formed the foundation of the first commercial TrueMobile products,
      which are based on On2’s VP7 TrueMotion technology.




***TrueCast®
      Server Software***




TrueCast
      Server Software is designed to take full advantage of our industry-leading
      TrueMotion line of codecs and to guarantee the smoothest delivery of compelling
      multi-media presentations over private networks (e.g., set-top boxes), embedded
      platforms or the Internet.




TrueCast
      comes optimized in two manners: one for transport using our own proprietary
      protocol, TrueCast Transport Protocol (TTP), and one for RTSP/RTP to various
      set-top box platforms. TrueCast and VP6/VP7 are an ideal combination for
      low-bit-rate Video-On-Demand systems. Our TrueCast Servers and our encoder
      provide the necessary tools for high-quality video over low speed IP
      connections.


-9-
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            of Contents**




In
      2005,
      we released TrueCast version 8.0. This version of TrueCast provides support
      for
      multicast presentations and can simultaneously stream a single audio and video
      stream from a server, including HTTP-based Web servers, to thousands of users.
      It also permits local playback of AVI files from a user’s hard disk, and set-top
      box/DSP platforms from Texas Instruments, Equator Technologies and others.




In
      addition, TrueCast 8.0 is able to stream content that is captured and encoded
      directly from “live” video sources using our pioneering VP6, VP7 and
      earlier-generation On2 real-time encoders. This feature is ideal for
      time-critical applications, such as streaming live events, video conferencing,
      Digital Television over DSL and personal video recorders.




***Integrations
      on Chips***




VP6,
      VP7
      and earlier generations of On2’s TrueMotion codecs have been ported onto a
      variety of digital signal processing chips (DSPs) and other integrated circuits.
      DSPs, video chips (video ICs), and systems-on-a chip (SOCs) are the computer
      processing chips and components frequently used in consumer products such as
      DVDs, portable media players, cell phones, and personal digital assistants.
      The
      VP6 and VP7 decoders currently run on a wide range of **** DSPs
      at
      various resolutions, and the VP6 encoder operates on several DSPs as well.
      We
      and several third parties are also working to port the VP6 and VP7 decoders
      and
      encoders to a number of DSPs and other chips. Our recent high-profile
      implementations by Adobe/Macromedia, Skype and others have greatly increased
      the
      incentive for chip manufacturers to quickly implement our codecs on their chips.
      We believe that by porting to these platforms, we will facilitate the use of
      On2’s codec in mobile phones, portable media players and other consumer device
      deployments where the availability of low-cost chips is important.




***Encoding
      Tools for Customer Formats***




In
      2005,
      we entered the business of selling video encoding software that allows users
      to
      encode video in formats used by two of our customers, Adobe and AOL. Both
      Adobe’s Flash 8 multimedia player and AOL’s Nullsoft video (NSV) player use
      On2’s TrueMotion VP6 technology. Although we continue to offer Nullsoft encoding
      tools, that business constitutes a small fraction of our third-party encoding
      tool business. The licensing of our Flash encoding tools accounted for 64%,
      52%,
      and 0% percent of our revenue for the three fiscals years ended December 31,
      2006, 2005 and 2004, respectively. In 2004, we did license our VP6 technology
      to
      Adobe/Macromedia for use in its Flash multimedia player product.




We
      launched our encoding software business as part of our strategy to capitalize
      on
      our customers’ successful deployments of products that incorporate our
      technology. In particular, we believed that the inclusion of our technology
      in
      the widely-distributed Adobe Flash player represented a significant opportunity
      for us. We acquired the Flix® line of Flash encoding software from Wildform,
      Inc. to further our plan for rapidly establishing a significant business of
      marketing Flash encoding tools.




We
      sell
      two types of Flash encoding tools. We distribute end-user software, such as
      our
      desktop Flix encoding tools (Flix Pro and Flix Standard) and our Flix Engine
      software, which can operate in desktop or server environments. These products
      allow users to convert and/or encode video in Flash 6, 7 and 8 formats. We
      also
      sell Flash encoder software development kits that allow customers to enable
      their products to encode in the Flash format. These products range from
      low-level tools, such as our Flix 8 SDK for DirectShow®, to relatively
      high-level, more fully-featured tools, such our Flix Engine. The Flix Engine
      can
      be integrated with our customers’ applications, as well as being used as an
      off-the-shelf end user software product.




Our
      marketing efforts for our encoding tools for Flash are generally directed at
      three groups of customers. First, we offer our desktop Flix encoding tools
      (Flix
      Pro and Flix Standard) for purchase online by end users, both professional
      and
      non-professional. Second, we market our desktop and server products directly
      to
      enterprise customers, such as content providers and Internet advertising firms.
      Finally, we promote our Flix SDKs for Flash to software developers. Some
      developers use our SDKs to integrate our Flash encoder with their software
      products for sale to end users. Other developers will incorporate our Flash
      encoder into products that they will use in their own services (e.g., an online
      video search service might develop a Flash encoding tool for use internally
      or
      by its customers).


-10-
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            of Contents**




We
      believe that the prospects for our Flash encoding business are closely related
      to the success of Adobe’s Flash player and Flash authoring business. Although
      the increasing worldwide adoption of Flash players may not ensure the success
      of
      our Flash encoder business, the failure of Adobe’s Flash 8 and Flash 9
      initiatives would almost certainly have a serious, negative impact on our sales
      of Flash encoding software.




**Services**




In
      addition to licensing our software, we offer a variety of custom engineering
      and
      consulting services to our customers. Fees derived from engineering, consulting
      and support services accounted for 8%, 7% and 14% percent of our revenue for
      the
      years ended December 31, 2006, 2005 and 2004, respectively. In particular,
      we
      offer the following services:




***Custom
      Engineering and Consulting Services***




We
      provide custom engineering and consulting services designed to support customers
      or assist prospective customers in evaluating our software. Our engineering
      and
      consulting services generally consist of:




·
            customizing
                our software to add a feature, user interface or other function requested
                by a customer;


·
            porting
                and optimizing our technology platform and algorithm libraries onto
                chips
                and embedded devices, such as set-top boxes, mobile phones and other
                portable devices;


·
            evaluating
                potential customer implementations of our software;
                and


·
            providing
                technical support for existing customers.





***Encoding***




We
      provide encoding services for customers, although this business has
      significantly contracted as a component of our total revenue. These services
      consist of the conversion of archival video and audio content into formats
      for
      delivery to end-users.




**Research
      and Development**




We
      primary focus of our research and development activities is to advance and
      expand upon our core codec technology, which improves the video experience
      for
      end users. In addition, we devote significant research and development time
      to
      exploring new uses of our codecs, such as implementing our software on mobile
      platforms or in new operating environments. Our research and development efforts
      have enabled us to provide quality video compression and decompression at lower
      broadband data rates (e.g., DSL) and certain narrowband data rates (e.g.,
      dial-up and cell phone). Our research in new platforms or operating environments
      also regularly results in commercial products that may become a significant
      source of revenue. We believe that continued advances in our technology are
      key
      to the success of our business. Consequently, we devote a substantial portion
      of
      our resources to our research and development efforts. Research and development
      expenses, excluding equity-based compensation, for the years ended December
      31,
      2006, 2005 and 2004 were $972,000, $1,035,000 and $884,000,
      respectively.




**Distribution
                Methods**




Our
      business consists of developing and marketing our software-based technology
      products and related services. Because we generally sell our software to
      companies that will integrate the software with their products or distribute
      the
      software themselves in connection with their services, and until recently have
      not regularly attempted to sell products directly to end users, we do not
      distribute a high volume of individual copies of software. Our customers usually
      download copies of software that they have purchased by online file transfer,
      although we will send them a CD-ROM containing the software at their request.
      Other than temporary interruptions to Internet service, we do not generally
      suffer from delays in our distribution network. We usually provide our
      engineering and consulting services and our product support from our own
      facilities.





**Sales
                and Business Development**





Our
      sales
      and business development departments aim to build relationships that fall into
      two basic categories: product licensing and professional services. These
      departments focus on engaging chip-set manufacturers, cable and


-11-
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            of Contents**




telecommunication
      companies, manufacturers of hardware platforms for consumer electronic and
      wireless devices and manufacturers of video-enabled products targeted at
      commercial and government users. We seek to license our compression software
      to
      manufacturers of video or video-enabled equipment and providers of video
      services, and we seek to encourage developers of chip-sets and software
      platforms to integrate our codecs within their products. Additionally, our
      teams
      focus on selling licenses for our encoding and streaming software to content
      providers who are delivering video over proprietary networks and to IP-based
      end
      users. Our professional services are usually incident to our product licensing
      and primarily focus on porting or optimizing our compression technologies to
      multiple hardware platforms used in video delivery solutions by manufacturers
      who have licensed our compression technology.





**International**





We
      believe that we are well positioned to selectively expand our business
      internationally. We have focused in particular on identifying and capitalizing
      on opportunities in Asia and Europe. To that end, in the past year we have
      engaged a number of overseas sales consultants, support contractors and
      resellers and have thus significantly increased the number of staff focused
      on
      sales in Europe and Asia. In addition, we have dramatically increased our
      participation at international tradeshows and conferences.





For
      the
      years ended December 31, 2006, 2005 and 2004, foreign customers accounted
      for approximately 40%, 27%, and 20% respectively, of total revenue. These
      customers are primarily located in Asia.





***Asia***





We
      believe that Asia, with its numerous broadband networks and high penetration
      for
      mobile devices, is one of the strongest markets for our products. Our
      international sales and business development efforts have been primarily focused
      in this region to date. Our subsidiary, The Duck Corporation, has significant
      name recognition in Asia, especially among video game developers, and we
      continue to enjoy a favorable reputation in Asia based on our history in that
      market. We have recently significantly expanded the resources we are devoting
      to
      sales and marketing in Asia, particularly in Japan, Korea and China, by engaging
      regional marketing specialists and sales and support consultants and by seeking
      to increase the number of resellers we have operating in those territories.
      To
      date, we have signed reseller agreements for a number of Asian markets,
      including China, Japan, Korea, Hong Kong, Taiwan and Singapore. For the year
      ended December 31, 2006, revenue generated from customers located in Asia was
      $1,868,000, with 31% from Japan, 42% from Korea and 27% from China. For the
      year
      ended December 31, 2005, revenue generated from customers located in Asia was
      $551,000, with 48% from Japan, 23 % from Korea, 21 % from China and 9% from
      Singapore. For the year ended December 31, 2004, revenue generated from
      customers located in Asia was $518,000, with 49% from Japan, 29% from Korea
      and
      23% from China. ****




***CTTNet***




In
      January 2006, On2 and CTTnet entered into an agreement to jointly develop and
      distribute On2 TrueMobile mobile video software in China and the Asian markets.
      Under the terms of the Agreement, On2 granted CTTNet a license to On2’s VP6 and
      VP7 software as well as certain reseller rights for China and other Asian
      markets. On2’s TrueMobile implementation continues to be evaluated by Chinese
      mobile carriers as part of a lengthy trial process.




***Europe***





As
      part
      of our efforts to expand international sales, we have recently increased the
      number of sales and marketing resources focused on European customers.
      Historically we have not had the same success in Europe that we have had in
      Asia. We nevertheless believe that we have made strides in meeting our goal
      of
      increasing the visibility of our compression products in Europe and,
      specifically, in increasing name recognition and demand for our products in
      that
      region. For the year ended December 31, 2006, revenue generated from customers
      located in Europe was $266,000 with 80% from the Netherlands, 12% from Italy
      and
      8% from the UK. For the year ended December 31, 2005, revenue generated from
      customers located in Europe was $25,000 all of which was from the Netherlands.
      For the year ended December 31, 2004, revenue generated from customers located
      in Europe was $22,000, with 45% from the Finland and 55% from the
      UK.


-12-
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            of Contents**




**Location
      of Assets and Operations**





All
      of
      the Company’s assets and operations have been and are currently based within the
      United States, except for two research and development employees located in
      the
      United Kingdom. We did not generate any revenue from our United Kingdom
      operations for the years ended December 31, 2006, 2005 and 2004.





**Competition**





We
      believe that our principal competitive advantage is our ability to deliver
      video
      that is comparable or superior in quality to other compression technologies
      at
      significantly lower data rates. In the streaming video market, this attribute
      significantly reduces the amount of bandwidth necessary to deliver video of
      similar quality and allows our customers to realize a greater profit on their
      video delivery initiatives by either:





·
            lowering
                the amount of bandwidth that customers need to deliver video,


·
            allowing
                customers to deliver video to more users without increasing bandwidth,
                or


·
            permitting
                customers to deliver good-quality video at lower data rates than
                those at
                which other video codecs can operate
                effectively.





Increased
      compression offers similar advantages in storage of video files, enabling
      customers to:





·
            store
                video at a set resolution using less storage capacity than required
                by
                competitive compression software;


·
            store
                more video at a set resolution in a given storage space than competitive
                compression software; and


·
            store
                more video of a higher quality in a given storage space than competitive
                compression software.





Our
      position as a developer of proprietary video codecs also offers several
      significant pricing advantages. First, because we are not bound by the pricing
      constraints placed on the standards bodies, we are able to vary our business
      terms to respond to our customers’ requests. Second, because we can offer both a
      license to the intellectual property underlying our technology as well as a
      codec that implements that technology, our customers do not have to pay multiple
      layers of licensing fees. In contrast, licensees of MPEG compression technology
      generally must acquire a license to patents from the MPEG consortium and then
      either acquire a separate license to or develop at their own cost a codec
      implementation based on the intellectual property they have licensed.





Our
      business is highly competitive and affected by rapid change. We believe that
      the
      principal competitive factors in our business include technological innovation,
      versatility of products, pricing, availability of content, ease of integration
      with and availability of use on low-cost processors, customer service, service
      offerings and the flexibility to adapt to changing market conditions. Our video
      compression technology competes with that of companies such as Microsoft and
      RealNetworks and with standards-based codecs such as MPEG-2, H.264, MPEG-4
      and
      several codecs that position themselves as “MPEG-4-based”. Companies such as
      Apple, Inc. and DivX, Inc. also have popular players that they have derived
      from
      standards-based technology; Apple’s QuickTime® player is based on H.264, and
      DivX® uses a variant of MPEG-4. In the market for mobile video players, our
      newly-developed On2 TrueMobile products compete with products from companies
      such as MobiTV, Inc., GoTV, PacketVideo and SmartVideo. Our server technology
      faces competition from products marketed by RealNetworks, Microsoft and other
      companies and various open source server technology.





The
      size
      of our company and the fact that we have developed a proprietary,
      non-standards-based video codec both help and hinder our ability to compete.
      Companies such as Microsoft and RealNetworks benefit from name recognition
      that
      we do not enjoy. Microsoft is also able to use its market power to support
      aggressive pricing on its products that compete with ours. There are three
      major
      standards-based codecs - MPEG-2, H.264 and the less widely-adopted MPEG-4;
      in
      addition, Microsoft was instrumental in establishing a standard, named VC1,
      based on its Window Media 9 technology. With respect to standards-based codecs,
      there are numerous developers programming to those standards, and there are
      certain customers that prefer to license standards-based codecs. In addition,
      because of significant adoption of standards-based codecs and Windows Media
      9,
      there are a number of chip manufacturers that have designed low-cost chips
      designed to operate with those codecs. The availability of a range of chips
      means that potential customers of standards-based codecs or Windows Media 9
      may
      not have to incur added cost or experience delays if they choose to use those
      codecs in their products.


-13-
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            of Contents**




Nevertheless,
      we believe that our small size and proprietary products frequently are
      attractive to customers, especially overseas, that will seek to license our
      products not only because of their superior performance, but also because:





·
            our
                products do not come from Microsoft or a consortium of conglomerates
                (such
                as those that own the core intellectual property used in the proprietary
                codecs), and we offer highly responsive, customized service befitting
                a
                company of our size and culture;


·
            we
                offer flexible licensing terms that do not involve burdensome
                standards-based licenses and fee structures;


·
            we
                license both the intellectual property underlying our compression
                technology and a full-featured codec implementing that technology,
                which
                means that customers do not have to incur additional development
                and/or
                licensing costs to produce a working codec;
                and


·
            we
                are able to upgrade our technology regularly, because we do not have
                to
                submit proposed revisions to slow-acting standards
                committees.




**Customers**





Our
      customers, and the potential customers of our resellers, fall into several
      categories. The customers for our TrueMotion video compression technology and
      Flash encoding software development kits typically are either software or
      hardware developers who want to enable their products to store or transmit
      digital video, or providers of online services that want to add video
      capabilities to their services. The customers for our engineering services
      are
      generally customers of our video compression technology who need assistance
      customizing our software to work on a certain platform or need us to modify
      our
      software to work with their software. In addition, we have begun to provide
      a
      growing range of engineering services to customers who have requested
      customization of our Flash encoding software. Finally, the customers who
      purchase our Flix Flash encoding tools span the spectrum from individual users
      to business users, who range from small businesses to large enterprises, such
      as
      content providers, operators of UGC sites, and Internet advertising firms who
      may license single or multiple units of our end user products or copies of
      our
      SDKs for use in large-scale deployments.





For
      the
      year ended December 31, 2006, our Korean reseller, Ninelanes, Inc.
      accounted for 10% of the Company’s total revenue. For the year ended
      December 31, 2005, VideoEgg, Inc and our Japanese reseller, MCS KK,
      accounted for 20% and 11%, respectively, of the Company’s total revenue. For the
      year ended December 31, 2004, Macromedia (Adobe) accounted for 47% of the
      Company’s total revenue.





As
      of
      December 31, 2006, four customers accounted for 13%, 12%, 11% and 10% of
      total accounts receivable. As of December 31, 2005, four customers
      accounted for 18%, 20%, 11% and 11% of total accounts receivable.





**Intellectual
      Property**





We
      regard
      much of our technology as proprietary and try to protect it by relying on
      trademarks, copyrights, patents, trade secret laws and confidentiality
      agreements. We view our copyrights, service marks, trademarks, trade secrets,
      proprietary technology and similar intellectual property as critical to our
      success. We currently hold several U.S. patents and have several
      U.S. and international patent applications **** pending.
      We believe that the patents that are currently issued are material to our
      business and anticipate that our pending patents will also be of importance
      to
      us. While we try to ensure that the security of On2’s intellectual property is
      maintained through these measures, there can be no assurance that steps we
      have
      taken and continue to take to protect our proprietary rights will be adequate
      or
      that third parties will not infringe on our intellectual property. In addition,
      there can be no assurance that third parties will not assert infringement claims
      against us which, even if not meritorious, could result in the expenditure
      of
      substantial resources and management effort.





In
      connection with our software license agreements with third parties, we seek
      to
      control access to and distribution of our technology, documentation and other
      proprietary information. Even with all of these precautions, someone else could
      conceivably copy or otherwise obtain and use our proprietary information without
      our authorization, or could develop similar technology independently. Effective
      trademark, copyright and trade secret protection may not be available in every
      country in which our services are made available through the Internet, and
      policing unauthorized use of our proprietary information is difficult and
      expensive. In addition, some of our technology is protected as trade secrets
      for
      which government registration is not available. Our only means of protecting
      our
      trade secrets is to restrict scrupulously the disclosure of that
      information.


-14-
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            of Contents**




Within
      the last year, we have faced several efforts to produce open source versions
      of
      our software. These efforts involve attempts to evade our copyright and other
      intellectual property protection by developing software that works with our
      codec but that purports not to rely on our software code. The newly-developed
      software is then generally distributed under one of the common open source
      licenses, such as the GNU General Public License or Lesser Public License.
      Although open source software that has been reverse engineered from proprietary
      software in a clean room environment (i.e., without reference to the proprietary
      source code) may avoid violation of copyright protection, it nevertheless is
      generally viewed as not avoiding patent protection for techniques used in the
      software. In the face of these efforts, it has therefore become increasingly
      important for us to pursue patent protection for our technology, since we could
      demand that users of open source versions of our software acquire patent
      licenses from us.





We
      cannot
      be certain that the steps we have taken will prevent misappropriation of our
      proprietary information. Any misappropriation could have a material adverse
      effect on our business. In the future, we may need to initiate and maintain
      legal proceedings to enforce our intellectual property rights, protect our
      trade
      secrets or determine the validity and scope of the proprietary rights of others.
      That litigation might result in substantial costs and diversion of resources
      and
      management attention.





From
      time
      to time, we license from third parties technologies that are to be incorporated
      into some of our products and services. Historically, we have not required
      any
      material third party technology licenses. As we have entered into the Flash
      encoding business, however, we have found it necessary to license third-party
      software to allow us to decode and encode video and audio files in a variety
      of
      formats. We cannot be certain that these third-party technology licenses will
      continue to be available on commercially reasonable terms, if at all.





**Government
      Regulation**





We
      are
      not currently subject to direct regulation by any governmental agency other
      than
      rules and regulations that apply to businesses and publicly-traded companies
      generally, except that certain U.S. export controls and import controls of
      other
      countries, including controls on the use of encryption technologies, may apply
      to our products. Laws and regulations specifically pertaining to the Internet
      are new and developing. These laws or regulations govern matters such as
      intellectual property, user privacy, e-commerce, information security and
      taxation. In addition, the applicability of existing laws to the Internet is
      uncertain and evolving. As a result of this uncertainty, it is difficult to
      predict the impact, if any, that future regulation or changes in regulation
      may
      have on our operations.





**Employees**





As
      of
      December 31, 2006, we had 37 full-time employees. Of the total employees,
      24 were engineering and product development personnel, 4 were sales and
      marketing personnel and 9 were general and administrative personnel.





None
      of
      our employees is represented by a labor union, and we consider our relationships
      with our employees to be good. We supplement our work force from time to time
      with contractors, administrative personnel through employment agencies and
      part
      time employees.





**Item
                1A.*****Risk
                Factors***





In
      evaluating our business, prospective investors and shareholders should carefully
      consider the following risks in addition to the other information in this Form
      10-K or in the documents referred to in this Form 10-K. Any of the following
      risks could have a material adverse impact on our business, operating results
      and financial condition and result in a complete loss of your
      investment.




***We
        may need to obtain additional cash to operate our business and to execute
        our
        business*** ***plan,
        and we may not achieve profitability.***




Since
      our
      inception, we have incurred significant losses and negative cash flow from
      operations, and as of December 31, 2006, we had an accumulated deficit of
      approximately $124.5 million. On February 28, 2007, we had cash reserves of
      approximately $5,307,000. During fiscal 2007, we expect to meet our working
      capital obligations and other cash requirements with cash derived from the
      sale
      of our products and services and from our cash reserves. There can be no
      assurance, however, that cash derived from the sale of our products and services
      will be sufficient for our operating needs or that we will be able to achieve
      profitability on a consistent basis, if at all. In the event that cash used
      in
      operations is higher than anticipated and we are unable to secure additional
      funding, in order to preserve cash, we would be required to further reduce
      expenditures and effect further reductions in our corporate infrastructure,
      either of which


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            of Contents**





could
      have a material adverse effect on our ability to continue our current level
      of
      operations. Even if we obtain additional working capital in the near future,
      to
      the extent that operating expenses increase or we need additional funds to
      make
      acquisitions, develop new technologies or acquire strategic assets, the need
      for
      additional funding may be accelerated, and there can be no assurances that
      any
      such additional funding can be obtained on terms acceptable to us, if at
      all.




***If
        we cannot generate sufficient positive cash flows from our operations, our
        operating results and our*** ***stock
        price may be negatively impacted.***




We
      currently do not generate sufficient revenues to offset our operating costs.
      Moreover, as we continue to expand our product and service offerings to maintain
      our competitive advantage, we may be required to incur additional costs to
      hire
      and retain additional personnel, license complementary third party technology
      for use in our proprietary software or expand both our international and
      domestic presence to enter new markets. These costs may significantly increase
      our current level of monthly operating expenses. Failure to generate sufficient
      capital through both our revenue streams and financings may require us to
      execute additional corporate restructurings, scale back our product or service
      offerings or limit the markets into which we enter. Any of these items, or
      a
      combination thereof, could have a harmful effect on our operating results and
      our stock price.




***We
        have a history of losses and negative cash flow from operations and anticipate
        continued losses.***




We
      have
      not achieved profitability, and it is a possibility that we will continue to
      incur operating losses for the foreseeable future as we fund operating and
      capital expenditures in implementing our business plan. Our business model
      assumes that consumers will be attracted to and use broadband-specific video
      compression technology to access content available on customer Web sites or
      over
      proprietary networks that will, in turn, allow us to provide our technology
      solutions to customers. Our business model is not yet proven, and we cannot
      assure you that we will ever achieve or sustain profitability or that our
      operating losses will not increase in the future. Our business strategy may
      be
      unsuccessful, and we may not be able to adequately address all or any of these
      risks. Even if we are able to achieve profitability, we may be unable to sustain
      or increase our profitability. In either case, our operating results and
      liquidity would be harmed.




***Our
        stock price may fluctuate for reasons beyond our control, which could result
        in
        losses on your investment in our stock.***




Fluctuations
      in the market price of our common stock may adversely affect our access to
      capital and financing and our ability to attract and retain qualified personnel.
      Historically, our common stock price has fluctuated widely, with a 52-week
      range
      as of March 20, 2007 of $0.55 to $1.48. We expect fluctuations to continue
      in
      the future for a number of reasons, including:





·
            quarterly
                variations in our operating
                results;


·
            competitive
                announcements;


·
            the
                operating and stock price performance of other companies that investors
                may deem comparable to us;


·
            news
                relating to trends in our markets;
                and


·
            changes
                in financial estimates by securities analysts or failure to meet
                analyst
                estimates.





In
      addition, the stock market generally has experienced significant price and
      volume fluctuations, and the market prices of companies in our industry have
      been highly volatile. Due to the volatility of the stock market generally,
      the
      price of our common stock could fluctuate for reasons beyond our
      control.




***If
        we are unable to continue to attract, retain and motivate highly skilled
        employees, we may not be able to execute our business
        plan.***




Our
      ability to execute our growth plan and be successful depends on our continuing
      ability to attract, retain and motivate highly skilled employees. As we continue
      to grow, we will need to hire additional personnel in all operational areas.
      We
      may be unable to retain our key employees or attract, assimilate or retain
      other
      highly qualified employees in the future. We have from time to time in the
      past
      experienced, and we expect to continue to experience in the future, difficulty
      in hiring and retaining highly skilled employees with appropriate
      qualifications. If we do not succeed in attracting new personnel or retaining
      and motivating our current personnel, customers could experience delays in
      service, which could, in turn, adversely affect our operating results and
      revenue. Additionally, retention of highly skilled employees may require
      additional personnel costs or the issuance of certain equity compensation
      packages. These factors would reduce profitability and the price of our common
      stock.




***Strategic
        acquisitions could have a dilutive effect on your investment. Failure to
        make
        accretive acquisitions and successfully integrate them could adversely affect
        our future financial results.***




As
      part
      of our growth strategy, we may seek to acquire or invest in complementary
      businesses or technologies. Our goal is to make such acquisitions, integrate
      these acquired assets into our operations and expand the market for our products
      and services and possibly offer additional products or services. The process
      of
      integrating these acquired assets into our operations may result in unforeseen
      operating difficulties and expenditures, and may absorb significant management
      attention that would otherwise be available for the ongoing development of
      our
      business. We cannot be certain that the


-16-
 **Table
            of Contents**




anticipated
      benefits of any acquisitions will be realized. Acquisitions also involve other
      risks, including entering geographic markets in which we have no or limited
      prior experience and the potential loss of key employees.





In
      addition, future acquisitions by us could result in potentially dilutive
      issuances of equity securities, the incurrence of debt and contingent
      liabilities and amortization expenses related to goodwill and other intangible
      assets, any of which can materially and adversely affect our operating results
      and financial position. We cannot be certain that we will be able to obtain
      the
      capital necessary to consummate acquisitions or alliances on satisfactory terms,
      if at all. Further, any businesses that we acquire will likely have their own
      capital needs, which may be significant, which we could be called upon to
      satisfy independent of the acquisition price.




***Much
        of our technology relies on owned or licensed intellectual property, and
        if such
        rights are not protected from the use of others, including potential
        competitors, our business prospects may be
        harmed.***




The
      failure to protect our intellectual property could seriously harm our businesses
      and prospects because we believe that our technology is unique and that its
      proprietary nature is critical to our success. If our prospects are harmed,
      the
      price of our common stock may decline because we may be less attractive to
      investors. Our efforts to protect our intellectual property through trademarks,
      copyrights, patents, trade secret laws, access to information and
      confidentiality agreements may not be adequate to protect our proprietary
      rights. Even with all of these precautions, it could be possible for someone
      else to either copy or otherwise obtain and use our proprietary information
      without our authorization or to develop similar technology independently. In
      addition, effective trademark, copyright and trade secret protection may not
      be
      available in every country in which our products and services are made
      available, and policing unauthorized use of our proprietary information is
      difficult and expensive. We cannot be certain that the steps we have taken
      will
      prevent misappropriation of our proprietary information. In the future, we
      may
      need to initiate and maintain legal proceedings to enforce our intellectual
      property rights, to protect our trade secrets or to determine the validity
      and
      scope of the proprietary rights of others, which might result in substantial
      costs and diversion of resources and management attention.





Although
      we do not currently license material third party technologies the loss of which
      could adversely affect our business, we do from time to time license from third
      parties technologies that are to be incorporated into some of our products
      and
      services. As we continue to introduce new services that incorporate new
      technologies, we may be required to license additional technology from others.
      We cannot be sure that these third-party technology licenses will continue
      to be
      available on commercially reasonable terms, if at all.




***The
        broadband video services and technology markets are highly competitive, and
        our
        failure to compete effectively could hurt our revenue and reduce our gross
        margins and profitability.***




We
      face
      significant competition in the market for our technology and services from
      strong, firmly entrenched competitors, who are currently providing similar
      services to low-bandwidth users and high-bandwidth users and have greater
      financial, technical and marketing resources than us. These and other companies
      have announced plans to provide broadband video-based services and technology.
      In addition to competition from other Internet content and technology companies,
      well-established media distribution companies, particularly in the cable
      television and satellite markets, have established, and continue to seek to
      establish, interactive, on-demand digital services through the development
      of
      sophisticated digital set-top technology and related back-end server systems.
      Those competitors could cause us to lose customers and impair our ability to
      attract new customers.




***If
        we fail to keep pace with technological advances in our industry or if we
        pursue
        technologies that do not become commercially accepted, customers may not
        buy our
        products and our revenue and profitability may
        decline.***




Our
      future success depends, in large part, on our ability to use leading
      technologies effectively, to develop our technological expertise, to enhance
      our
      existing services and to develop new services that meet changing customer needs
      on a timely and cost-effective basis. We are unable to predict which
      technological developments will challenge our competitive position or the amount
      of expenditures that will be required to respond to a rapidly changing
      technological environment. Our failure to respond in a timely and effective
      manner to new and evolving technologies could have a negative impact on our
      operating results and financial condition.




***Regulatory
        changes in the internet industry involve uncertainties, and the resolution
        of
        these uncertainties could adversely affect our business by raising our costs
        or
        reducing potential revenues.***




Although
      we are not currently subject to direct regulation by any governmental agency
      other than rules and regulations that apply to businesses generally and any
      export and import controls which may apply to our products, laws and regulations
      specifically pertaining to the Internet and digital video distribution through
      other means are new and developing. These laws, when enacted may require us
      to
      comply with new procedures or limit the scope of our technology or services,
      which could raise our expenses or reduce our revenues. The developing laws
      and
      regulations govern matters such as online content, intellectual property, user
      privacy, e-commerce, information security and taxation. Moreover, we may be
      liable to third parties for any content that we encode, distribute or make
      available on our website if that content violates a third party’s intellectual
      property rights or violates any applicable laws, such as obscenity laws or
      defamation laws. In addition, the applicability of existing laws to the Internet
      is uncertain and evolving.


-17-
 **Table
          of Contents**




***Effects
        of anti-takeover provisions could inhibit potential investors or delay or
        prevent a change of control that may favor
        you.***




Some
      of
      the provisions of our certificate of incorporation, our bylaws and Delaware
      law
      could, together or separately:




·
            Discourage
                potential acquisition proposals;


·
            Delay
                or prevent a change in control; and


·
            Limit
                the price that investors might be willing to pay in the future for
                shares
                of our common stock.





In
      particular, our board of directors is authorized to issue up to 20,000,000
      shares of preferred stock (less any outstanding shares of preferred stock)
      with
      rights and privileges that might be senior to our common stock, without the
      consent of the holders of the common stock.




***We
        have never paid common stock dividends and do not anticipate paying common
        stock
        dividends in the foreseeable future.***




We
      currently intend to retain earnings, if any, to support our growth strategy.
      We
      do not anticipate paying dividends on our common stock in the foreseeable
      future.




***Item
                2.******Description
                of Property***





We
      do not
      own any real property. We lease approximately 7,000 square feet of space at
      21
      Corporate Dr., Suite 103, Clifton Park, New York where our principal executive,
      administrative and engineering offices are located, at an annual rental fee
      of
      approximately $106,000. This lease expires on February 1, 2009. In addition,
      we
      lease approximately 750 square feet of space for certain of our executives
      and
      certain IT staff at 580 White Plains Road, Tarrytown, New York. We pay an annual
      rent of approximately $53,000 for this space. This lease expires **** January
      2011. Management believes these facilities are all in usable condition and
      that
      these facilities are sufficient to meet our needs for the immediate future.
      Management also believes that both facilities are adequately covered by
      insurance.





We
      do not
      invest in real estate or interests in real estate, real estate mortgages or
      securities of or interests in persons primarily engaged in real
      estate.




***Item
                3.******Legal
                Proceedings***





**Internal
      Investigation**





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





**Beijing
      E-World**





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





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





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





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


-18-
 **Table
          of Contents**


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





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




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





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





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





On2
      has
      requested that the arbitrator award it approximately $5,690,00 in damages under
      the contract and grant it further relief as may be just and equitable.





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




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





None.




**PART
      II**





***Item
                5. Market
                for
                Common Equity and Related Stockholder
                Matters***





Our
      common stock is traded on the American Stock Exchange under the symbol “ONT”.
      The following table sets forth for the fiscal periods indicated the high and
      low
      bid prices of our common stock, as reported on the American Stock Exchange,
      since January 1, 2005:





**High**
            
            **Low****Fiscal
                Year 2007**First
                Quarter (through March, 2007)
            
            $
            1.55
            
            
            $
            1.02**Fiscal
                Year 2006**First
                Quarter
            
            $
            1.48
            
            
            $
            0.70Second
                Quarter
            
            $
            1.08
            
            
            $
            0.65Third
                Quarter
            
            $
            0.86
            
            
            $
            0.55Fourth
                Quarter
            
            $
            1.26
            
            
            $
            0.65**Fiscal
                Year 2005**First
                Quarter
            
            $
            1.28
            
            
            $
            0.62Second
                Quarter
            
            $
            0.70
            
            
            $
            0.52Third
                Quarter
            
            $
            0.94
            
            
            $
            0.52Fourth
                Quarter
            
            $
            1.20
            
            
            $
            0.55




There
      were approximately 266 stockholders of record of our common stock as of March
      22, 2007.





It
      is our
      current policy not to pay cash dividends and to retain future earnings to
      support our growth. Since our inception, we have not paid any cash dividends
      and
      we **** do
      not
      anticipate paying any cash dividends in the foreseeable future.


-19-
 **Table
          of Contents**





Equity
                Compensation Plan Information December 31, 2006Plan
                category
            
            Number
                of securities
              to
                be issued
              upon
                exercise of
              outstanding
                options,
              warrants
                and rights
            
            Weighted-average
              exercise
                price of
              outstanding
                options,
              warrants
                and rights
            
            Number
                of securities
              remaining
                available for
              future
                issuance under
              equity
                compensation plans
              (excluding
                securities
              reflected
                in column (a))(a)
            
            (b)
            
            (c)Equity
                compensationplans
                approved bysecurity
                holders
            
            
            16,925,000
            
            $
            1.00
            
            
            1,012,000Equity
                compensationplans
                not approvedby
                security holders
            
            
            0
            
            
            0
            
            
            0Total
            
            
            16,925,000
            
            $
            1.00
            
            
            1,012,000





-20-
 **Table
            of Contents**




**Performance
      Graph**





The
      following graph compares the cumulative 5-year total return provided
      shareholders on On2 Technologies, Inc.'s common stock relative to the cumulative
      total returns of the AMEX Composite index and the RDG Software Composite index.
      The graph tracks the performance of a $100 investment in our common stock and
      in
      each of the indexes (with the reinvestment of all dividends) from 12/31/2001
      to
      12/31/2006.







12/01
            
            12/02
            
            12/03
            
            12/04
            
            12/05
            
            12/06On2
                Technologies, Inc.
            
            
            100.00
            
            
            88.24
            
            
            385.29
            
            
            185.29
            
            
            311.76
            
            
            352.94AMEX
                Composite
            
            
            100.00
            
            
            100.08
            
            
            144.57
            
            
            178.46
            
            
            220.35
            
            
            262.17RDG
                Software Composite
            
            
            100.00
            
            
            69.77
            
            
            86.91
            
            
            97.48
            
            
            97.30
            
            
            107.31






*The
      stock price performance included in this graph is not necessarily indicative
      of
      future stock price performance.*


-21-
 **Table
            of Contents**




**Recent
      Issuances of Unregistered Securities and Use of Proceeds from Unregistered
      Securities**




*Series
      D Convertible Preferred Stock*




On
      October 28, 2004, we completed a private placement of its convertible securities
      (the “MidSummer Transaction”) to MidSummer Investment Ltd. and Islandia L.P (the
“Series D Investors”). The Company received gross proceeds of $4,000,000 and net
      proceeds of approximately $3,699,000. We paid a fee of $240,000 to H.C.
      Wainwright & Co., Inc. (“Wainwright”), and issued certain common stock
      warrants described below, for Wainwright’s services as placement agent in the
      MidSummer Transaction. In addition, we paid approximately $61,000 in additional
      fees relating to the MidSummer Transaction and registration for resale of the
      common stock issuable upon conversion of the securities issued in connection
      with the MidSummer Transaction. In exchange for the proceeds, the Company issued
      4,000 shares of a new Series D convertible preferred stock (the “Series D
      Preferred Stock”), which are convertible into an aggregate of 5,714,286 shares
      (at an initial conversion price of $0.70 per share) of our common stock, par
      value $0.01. The Series D Preferred Stock is subject to a guaranteed 8% annual
      dividend, payable quarterly, and is mandatorily redeemable by the Company over
      an eighteen-month period starting in October 2006. Such redemptions can be
      made
      in cash or shares of our common stock, at our option. If redemptions are made
      in
      common stock, the shares are valued at the average of the volume weighted
      average trading price of our common stock for the twenty trading days
      immediately prior to the redemption date. In addition, we granted the Investors
      a Series A Warrant and Series B Warrant, each of which is exercisable
      for 2,994,011
      shares of our common stock. The Series A Warrant, which has been exercised
      as
      described below, bore an exercise price of $0.65 and could be redeemed by us
      for
      $0.01 if our common stock trades at or above $0.845 for 10 consecutive trading
      days at any point after the shares of common stock underlying the Series A
      Warrant had been registered for resale. The Series B Warrant bears an exercise
      price of $0.76 and expires on October 27, 2009. The Series D Preferred Stock
      and
      warrants are subject to weighted-average anti-dilution protection for issuances
      of securities below the exercise price. We relied on Section (4)(2) of the
      Securities Act in issuing the debentures and warrants without
      registration.




On
      October 28, 2004, we issued to Wainwright 285,714 warrants (the “Wainwright
      Warrants”). These warrants were further payment, in addition to the $240,000
      cash fee described above, for Wainwright’s services as placement agent in
      connection with the MidSummer Transaction. Warrants in this series are
      exercisable for shares of our common stock at an exercise price of $0.70 per
      share, expire on October 27, 2009 and are subject to weighted-average
      anti-dilution protection for issuances of securities below the exercise
      price.





The
      Company has filed a registration statement with the SEC for resale of the common
      stock issuable upon conversion of the Series D Preferred Stock, Series A
      Warrants, Series B Warrants, and Wainwright Warrants. The Series D Investors
      have since exercised all of the Series A Warrants and have paid the exercise
      price of $1,946,000 to the Company. In addition, the Series D Investors have
      also converted 917 shares of the Series D Preferred Stock into 1,317,000 shares
      of our common stock. **** Upon
      receipt of the Series A Warrant exercise fee, we paid Wainwright a cash fee
      of
      $60,000 as further compensation for acting as placement agent on the MidSummer
      Transaction. In January 2006 Wainwright exercised 202,000 warrants, and we
      received $127,000 in cash for the exercise.





*Issuance
      of Common Stock in Connection with the Acquisition of the Flix
      Business*





On
      April
      29, 2005, we completed the acquisition of certain assets related to the “Flix”
software line of business of Wildform, Inc. (“Wildform”). In connection with the
      acquisition, On2 and Wildform entered a Support and Maintenance Agreement,
      dated
      as of April 29, 2005, under which Wildform agreed to perform certain software
      integration, technical support and marketing services. In consideration for
      the
      services, we agreed to pay Wildform $160,000 and 280,000 shares of common stock,
      issuable upon the anniversary of the closing date. Accordingly, we have issued
      the 280,000 shares to Wildform on April 28, 2006. We relied on Section (4)(2)
      of
      the Securities Act in agreeing to issue the Stock without registration. We
      have
      agreed to file a registration statement to register the shares of common stock
      issuable to Wildform.


-22-
 **Table
          of Contents**




*Issuance
      of Common Stock in August 2006*




In
      August
      2006, we completed the sale of 3,070,175 shares of our common stock at $0.57
      per
      share. The sale of common stock raised gross proceeds for us of $1,750,000.
      The
      purchasers of these shares also received a warrant to purchase an aggregate
      of
      2,302,632 additional shares of our common stock exercisable for a period of
      five
      years at an exercise price of $0.77 per share. The offering was exempt from
      registration under Section 4(2) of the Securities Act and Rule 506 of Regulation
      D promulgated thereunder. The common stock and warrants were offered and sold
      to
      Midsummer Investment and Rockmore Investment , both of which are two “accredited
      investors,” as that term is defined in Rule 501 of Regulation D, both of which
      are institutional investors, in compliance with Rule 506.





Kuhns
      Brothers, Inc. acted as private placement agent in the offering to Midsummer
      Investment and Rockmore Investment and earned commissions of $87,500. We also
      granted a warrant to Kuhns Brothers, Inc. to purchase 42,982 shares of our
      common stock at an exercise price of $0.57 per share. The offering was exempt
      from registration under Section 4(2) of the Securities Act of 1933 and Rule
      506
      of Regulation D promulgated thereunder. In connection with the offering, we
      also
      granted Gregory Dryer, a registered employee of Kuhns Brothers, Inc., a warrant
      to purchase 79,825 shares of our common stock at an exercise price of $0.57
      per
      share. The offering was exempt from registration under Section 4(2) of the
      Securities Act and Rule 506 of Regulation D promulgated thereunder. Both Kuhns
      Brothers and Mr. Dryer are “accredited investors,” as that term is defined in
      Rule 501 of Regulation D. We have filed a registration statement with the SEC
      for the resale of the Common Stock issued or issuable in connection with this
      private placement.


-23-
 **Table
            of Contents**




**Item
      6. *Selected
      Financial Data.***





For
                the years ended December 31,**Statements
                of Operations Data**
            
            2006
            
            2005
            
            2004
            
            2003
            
            2002Revenue
            
            $
            6,572,000
            
            $
            2,208,000
            
            $
            3,028,000
            
            $
            3,302,000
            
            $
            3,353,000Total
                operating expenses
            
            
            10,162,000
            
            
            6,497,000
            
            
            6,518,000
            
            
            5,665,000
            
            
            8,621,000Loss
                from operations
            
            
            (3,590,000
            )
            
            (4,289,000
            )
            
            (3,490,000
            )
            
            (2,363,000
            )
            
            (5,268,000
            )Interest
                and other income (expense), net
            
            
            (1,226,000
            )
            
            (284,000
            )
            
            47,000
            
            
            (2,000
            )
            
            (5,000
            )Provision
                for income taxes
            
            
            30,000
            
            
            32,000
            
            
            2,000
            
            
            10,000
            
            
            28,000Net
                loss
            
            
            (4,846,000
            )
            
            (4,605,000
            )
            
            (3,445,000
            )
            
            (2,375,000
            )
            
            (5,301,000
            )Convertible
                preferred stock deemed dividend
            
            
            68,000
            
            
            2,844,000
            
            
            120,000
            
            
            228,000
            
            
            668,000Convertible
                preferred stock 8% dividend
            
            
            285,000
            
            
            325,000
            
            
            57,000Accretion
                of costs associated with the Series D Preferred
              stock
            
            
            
            
            
            175,000
            
            
            14,000Net
                loss attributable to common stockholders
            
            $
            (5,199,000
            )
            $
            (7,949,000
            )
            $
            (3,636,000
            )
            $
            (2,603,000
            )
            $
            (5,969,000
            )Basic
                and diluted net loss attributable to common
              stockholders
                per common share
            
            $
            (0.09
            )
            $
            (0.05
            )
            $
            (0.04
            )
            $
            
            $
            
            (0.11
            )




December
                31,**Balance
                Sheet Data**
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003
            
            
            2002Cash
                and cash equivalents
            
            $
            4,961,000
            
            $
            3,976,000
            
            $
            5,418,000
            
            $
            2,963,000
            
            $
            553,000Working
                capital
            
            
            5,268,000
            
            
            4,179,000
            
            
            5,466,000
            
            
            3,520,000
            
            
            731,000Total
                assets
            
            
            7,887,000
            
            
            6,314,000
            
            
            6,610,000
            
            
            4,128,000
            
            
            2,080,000Convertible
                debentures
            
            
            
            
            
            244,000
            
            
            330,000
            
            
            409,000
            
            
            569,000Capital
                lease obligations
            
            
            53,000
            
            
            26,000
            
            
            43,000
            
            
            
            
            
            9,000Series
                D redeemable convertible preferred stock
            
            
            3,083,000
            
            
            3,790,000
            
            
            1,156,000Convertible
                preferred stock
            
            
            19,000
            
            
            19,000
            
            
            33,000
            
            
            56,000
            
            
            99,000Common
                stock and APIC
            
            
            125,566,000
            
            
            120,695,000
            
            
            115,663,000
            
            
            110,970,000
            
            
            106,018,000Accumulated
                deficit and other comprehensive loss
            
            
            (124,522,000
            )
            
            (119,350,000
            )
            
            (111,400,000
            )
            
            (107,740,000
            )
            
            (105,135,000
            )Total
                stockholders’ equity
            
            
            1,033,000
            
            
            1,364,000
            
            
            4,296,000
            
            
            3,286,000
            
            
            982,000


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





The
      following discussion and analysis of our financial condition and results of
      operations should be read in conjunction with the consolidated financial
      statements, including the notes thereto, appearing elsewhere in this report.





**Overview**





We
      are a
      leading video compression technology firm. We have developed a proprietary
      technology platform and video compression/decompression software (“codec”) to
      allow the efficient storage of high-quality video and delivery of that video
      at
      the lowest possible data rates over proprietary networks and the Internet to
      personal computers, wireless devices and set-top boxes. We offer a suite of
      products and services based on our proprietary compression technology and
      multimedia server software. Our service offerings include customized
      engineering, consulting services, technical support


-24-
 **Table
            of Contents**




and
      high-level video encoding. In addition, we license our software products, which
      include video and audio codecs and encoding and server software, for use with
      video delivery platforms. We have also recently begun to license software that
      encodes video in the Adobe/Macromedia Flash 8 format; the Flash 8 format uses
      our VP6 video codec.





**Company
      History**





Founded
      in 1992 as The Duck Corporation, a privately owned entity, we originally
      developed and marketed compression technology that enabled developers of
      computer video games, video games for dedicated video game consoles and
      multi-media presentations on computers to convert an analog video signal to
      a
      digital video signal, and to compress the signal for storage and playback on
      the
      required device.





In
      June
      of 1999, The Duck Corporation was merged with and into a wholly-owned subsidiary
      of Applied Capital Funding, Inc., a public company whose name was concurrently
      changed to On2.com Inc. and subsequently changed to On2 Technologies, Inc.
      At
      that time, we had developed proprietary technology that enabled the compression,
      storage and streaming of high quality video signals over high bandwidth networks
      (i.e. broadband). We adopted a business model in which we would develop our
      own
      broadband content network powered by our proprietary technology. We intended
      to
      generate revenue through advertising sales and electronic commerce. From June
      of
      1999, through the first quarter of 2000, we made three acquisitions: MetaVisual
      Creations Limited (“Metavisual”), Celebrity Interviews (“CII”) and Quickband
      Networks, Inc. (“Quickband”). Metavisual was a compression technology firm
      located in the United Kingdom and had developed its own video compression
      technology. That technology is instrumental in the compression technology we
      offer today.





By
      the
      second quarter of 2000, with the rapid decline in the Internet industry and
      the
      lack of interest in content networks, we determined that operating a content
      network would not be profitable for the foreseeable future. Based on market
      conditions, we decided to cease production on our content network and developed
      a strategic business model to distribute our video compression technology to
      IP-based clients as well as those offering video through proprietary networks,
      consumer electronics and wireless devices. This is the business model under
      which we currently operate.





In
      view
      of the rapidly evolving nature of our business and our limited operating
      history, we have limited experience forecasting our revenues and operating
      costs. Therefore, we believe that period-to-period comparisons of financial
      results are not necessarily meaningful and should not be relied upon as an
      indication of our future performance. To date, we have incurred substantial
      costs to create technology products and services. As of December 31, 2006,
      we had an accumulated deficit of $124.5 million. We will continue to incur
      costs to develop, introduce and enhance products and services, build brand
      awareness and expand our business. We may also incur significant additional
      costs related to technology, marketing or acquisitions of businesses and
      technologies to respond to changes in this rapidly developing industry. These
      costs may not correspond with any meaningful increases in revenues in the near
      term, if at all, and may therefore result in negative operating cash flows
      until
      such time as we generate sufficient revenues to offset such costs.




**Critical
      Accounting Policies and Estimates**





This
      discussion and analysis of our financial condition and results of operations
      are
      based on our consolidated financial statements that have been prepared under
      accounting principles generally accepted in the United States of America. The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States of America requires our management
      to
      make estimates and assumptions that affect the reported amounts of assets and
      liabilities and the disclosure of contingent assets and liabilities at the
      date
      of the financial statements and the reported amounts of revenue and expenses
      during the reporting period. Actual results could materially differ from those
      estimates. We have disclosed all significant accounting policies in note 1
      to
      the consolidated financial statements included in this Form 10-K. The
      consolidated financial statements and the related notes thereto should be read
      in conjunction with the following discussion of our critical accounting
      policies. Our critical accounting policies and estimates are:







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


-25-
 **Table
            of Contents**




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





We
      recognize revenue in accordance with SOP 97-2, “SOFTWARE REVENUE RECOGNITION”
(“SOP 97-2”), as amended by SOP 98-4, “DEFERRAL OF THE EFFECTIVE DATE OF SOP
      97-2, SOFTWARE REVENUE RECOGNITION” and SOP 98-9, “MODIFICATION OF SOP 97-2 WITH
      RESPECT TO CERTAIN TRANSACTIONS” (“SOP 98-9”). Under each arrangement, revenues
      are recognized when a non-cancelable agreement has been signed and the customer
      acknowledges an unconditional obligation to pay, the products or applications
      have been delivered, there are no uncertainties surrounding customer acceptance,
      the fees are fixed and determinable, and collection is considered probable.
      Revenues recognized from multiple-element software arrangements are allocated
      to
      each element of the arrangement based on the fair values of the elements, such
      as product licenses, post-contract customer support, or training. The
      determination of the fair value is based on the vendor specific objective
      evidence available to us. If such evidence of the fair value of each element
      of
      the arrangement does not exist, we defer all revenue from the arrangement until
      such time that evidence of the fair value does exist or until all elements
      of
      the arrangement are delivered.




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





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





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





*Equity-Based
      Compensation* In
      December 2004, the Financial Accounting Standards Board (“FASB”) issued
      Statement of Financial Accounting Standards (“SFAS”) No. 123R “Share-Based
      Payment” (“SFAS 123R”), which requires all share-based payments to
      employees, including grants of employee stock options, to be recognized in
      the
      statement of operations as an operating expense, based on their fair values
      on
      grant date. Prior to the adoption of SFAS 123R, we accounted for stock based
      compensation using the intrinsic value method. We adopted the provisions of
      SFAS
      No. 123R effective January 1, 2006, using the modified prospective transition
      method. Under the modified prospective method, non-cash compensation expense
      is
      recognized under the fair value method for the portion of outstanding share
      based awards granted prior to the adoption of SFAS 123R for which service has
      not been rendered, and for any future share based awards granted or modified
      after adoption. Accordingly, periods prior to adoption have not been restated.
      We recognize share-based compensation cost associated with awards subject to
      graded vesting in accordance with the accelerated method specified in FASB
      Interpretation No. 28 pursuant to which each vesting tranche is treated as
      a
      separate award. The compensation cost associated with each vesting tranche
      is
      recognized as expense evenly over the vesting period of that
      tranche.


-26-
 **Table
            of Contents**




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





Long-lived
      assets and identifiable intangibles with finite lives are reviewed for
      impairment whenever events or changes in circumstances indicate that the
      carrying amount of an asset may not be recoverable. Recoverability of assets
      to
      be held and used is measured by a comparison of the carrying amount of an asset
      to future undiscounted net cash flows expected to be generated by the asset.
      If
      such assets are considered to be impaired, the impairment recognized is measured
      by the amount by which the carrying amount of the assets exceeds the fair value
      of the assets. Assets to be disposed of are reported at the lower of the
      carrying amount or fair value less costs to sell. As of December 31, 2005,
      we
      believe that no such impairment has occurred.





**Results
      of Operations**





*Revenue.* Our
      revenue for the years ended December 31, 2006, 2005 and 2004 was
      $6,572,000, $2,208,000 and $3,028,000, respectively, and was derived from the
      sale of software licenses, engineering and consulting services and license
      royalties. Our revenue increased $4,364,000 for the year ended December 31,
      2006
      as compared with 2005. The increase is primarily attributable to an increase
      in
      license sales of our Flix product line and license royalties. As a percent
      of
      total sales, license revenue decreased to 83% in 2006 from 88% in 2005, while
      engineering services and support increased to 8% in 2006 from 7% in 2005.
      Royalties increased to 9% of sales in 2006 from 5% in 2005.





For
      the
      year ended December 31, 2006, license revenue was $5,472,000 of which our VPx
      licenses were $1,266,000 and Flix licenses were $4,206,000. For the year ended
      December 31, 2005, license revenue was $1,947,000, of which the Company’s VPx
      licenses were $1,296,000 and Flix licenses were $651,000. For the year ended
      December 31, 2004 license revenue was $2,578,000.





The
      following table sets forth the allocation of revenues, in terms of percentages,
      for the years ended December 31, 2006, 2005 and 2004:





**2006**
            
            **2005**
            
            **2004**Licenses
            
            
            83
            %
            
            88
            %
            
            85
            %Engineering
                services and support
            
            
            8
            
            
            7
            
            
            14Royalties
            
            
            9
            
            
            5
            
            
            1Total
            
            
            100
            %
            
            100
            %
            
            100
            %


For
      the
      years ended December 31, 2006, 2005 and 2004, software licenses were the
      significant revenue stream and are expected to be the significant future revenue
      stream as we continue to provide these services and products to clients who
      deliver high quality video to proprietary networks, consumer electronic devices,
      wireless applications and IP-based end users.




**OPERATING
      EXPENSES**





***Year
      ended December 2006 versus 2005:***





Our
      operating expenses consist of cost of revenues, research and development, sales
      and marketing and general and administrative expenses. Our operating expenses
      for the year ended December 31, 2006 were $10,162,000 compared with
      $6,497,000 for the year ended December 31, 2005.




*Cost
      of Revenue.* Cost
      of
      revenue includes personnel and related overhead expenses, rent and related
      energy costs, consulting costs, fees paid for licensed technology, depreciation,
      amortization of purchased technology and certain other operating expenses.
      Cost
      of revenue was $2,328,000 for the year ended December 31, 2006, compared
      with $1,919,000


-27-
 **Table
            of Contents**




for
      the
      year ended December 31, 2005. Cost of revenue increased $409,000 for the
      year ended December 31, 2006 compared with 2005. The increase is primarily
      attributable to an increase of approximately $80,000 in personnel and related
      overhead allocated to cost of revenue from the addition of one software
      engineer, an increase of $172,000 in equity-based compensation and an increase
      of $82,000 in amortization of the acquired Flix software assets.




*Research
      and Development.* Research
      and development expenses (excluding equity-based compensation), includes
      personnel and related overhead expenses, rent and related energy costs and
      depreciation, associated with the development and pre-production of our products
      and services. Research and development expenses were $972,000 and $1,035,000
      for
      the years ended December 31, 2006 and 2005, respectively. The decrease of
      $63,000 is primarily attributed to a higher percentage of our engineers working
      on customer projects. We believe that continued investments in research and
      development are necessary to improve our competitive advantage, and we will
      continue to invest in such costs as considered necessary.




*Sales
      and Marketing.* Sales
      and
      marketing expenses (excluding equity-based compensation), consist primarily
      of
      salaries and related overhead costs and increases in year end bonuses,
      commissions, tradeshow costs, marketing and promotional costs incurred to create
      brand awareness and public relations expenses. Our sales and marketing expenses
      for the year ended December 31, 2006 were $1,093,000 compared with $794,000
      for the year ended December 31, 2005. The increase of $299,000 is primarily
      attributable to an increase in personnel and related overhead expenses from
      the
      addition of two sales and two marketing people and an increase in tradeshow,
      advertising and promotional costs. We intend to continue to recruit and hire
      experienced personnel, as necessary, to sell and market our products and
      services.




*General
      and Administrative.* General
      and administrative expenses (excluding equity-based compensation), consist
      primarily of salaries and related overhead costs for general corporate functions
      including legal, finance, human resources and management information systems.
      Also included are outside legal and professional fees, stock-listing fees,
      reserve for uncollectible accounts receivable and general liability and
      directors and offices’ liability insurance. Our general and administrative costs
      for the year ended December 31, 2006 were $4,384,000, compared with
      $2,749,000 for the year ended December 31, 2005. The increase of $1,635,000
      is attributable to an increase in outside legal fees of $1,069,000 (including
      $1,010,000 associated with the investigation relating to the Company’s former
      President, Chief Executive Officer and Chairman), recruiting fees of $216,000
      associated with the selection, recruitment and relocation of the Company’s new
      CEO, increase in consulting fees increased $163,000 (including $107,000
      associated with our preparation for Sarbanes-Oxley Section 404), an increase
      in
      our bad debt provision of $117,000 and an increase in stock listing fees of
      $55,000.




*Equity-Based
      Compensation.* In
      December 2004, FASB issued SFAS 123R, which requires all share-based
      payments to employees, including grants of employee stock options, to be
      recognized in the statement of operations as an operating expense, based on
      their fair values on grant date. Prior to the adoption of SFAS 123R we had
      accounted for stock based compensation using the intrinsic value, if any. We
      adopted the provision of SFAS No. 123R effective January 1, 2006, using the
      modified prospective transition method. Under the modified prospective method,
      non-cash compensation expense is recognized for the portion of outstanding
      stock
      option awards granted prior to the adoption of SFAS 123R for which service
      has
      not been rendered, and for any future stock option grants. Accordingly, periods
      prior to adoption have not been restated. We recognize share-based compensation
      cost associated with awards subject to graded vesting in accordance with the
      accelerated method specified in FASB Interpretation No. 28 pursuant to which
      each vesting tranche is treated as a separate award. The compensation cost
      associated with each vesting tranche is recognized as expense evenly over the
      vesting period of that tranche. Equity-based compensation costs for the year
      ended December 31, 2006 was $1,554,000, of which $169,000 is included in
      cost of revenue, $98,000 is classified as research and development, $103,000
      is
      classified as sales and marketing and $1,184,000 is classified as general and
      administrative. During the year ended December 31, 2006, we recognized expense
      of $1,389,000 related to stock options issued to employees and $37,000 related
      to 110,000 shares of restricted stock issued to an employee and certain
      consultants. Additionally, for the year ended December 31, 2006 our former
      President, Chief Executive Officer and Chairman was granted extensions on stock
      options, and we recorded $128,000 of compensation expense related to those
      extensions. There was no equity-based compensation for the year ended December
      31, 2005. During 2004, we had granted restricted stock to its employees and
      directors as compensation. We issued 870,000 shares of our common stock, with
      a
      fair value of $835,000, which was recognized as compensation expense in
      2004.





*Interest
      and Other Income (Expense), Net.* Interest
      and other income (expense) was $(1,226,000) for the year ended
      December 31, 2006, compared with $(284,000) for the year ended
      December 31, 2005. Interest and other income (expense) primarily
      consist of net gains (losses) on marketable securities, interest earned on
      our
      cash and cash equivalent  -28-
 **Table
            of Contents**


balances,
      interest on capital lease obligations and indebtedness, the amortization of
      debt
      discounts and for 2006, the increase in the increase in the incremental fair
      value of the warrant derivative liability. The $1,226,000 in interest and other
      expense, net for the year ended December 31, 2006 consists primarily of other
      expense of $1,304,000, interest income of $95,000 and interest expense of
      $17,000.




Other
      expense of $1,304,000 consists primarily of $1,078,000 associated with the
      increase in the fair value of the warrant derivative liability at December
      31,
      2006 resulting from the increase in our stock price of $1.20 on December 31,
      2006, compared with $0.70 on September 30, 2006, and financing costs of
      $186,000, of which $135,000 is associated with the expiration of a warrant
      extension granted in January 2006.




Interest
      income of $95,000 was derived primarily from interest earned on our excess
      cash
      balances. The cash was invested in both a money market account and short term
      fixed income securities.




Interest
      expense of $17,000 is primarily interest paid on capital leases, the term loan
      used to finance our directors and officers liability insurance, interest paid
      in
      shares of our common stock to a holder of Series A Secured Convertible
      Debentures and amortization of debt discount.




*Income
      Taxes.* Income
      taxes reflect state and local franchise taxes and foreign withholding taxes.
      Income taxes were $30,000 and $32,000 for the years ended December 31, 2006
      and 2005, respectively.




***Year
      ended December 31, 2005 versus 2004:***





*Cost
      of Revenue.* Our
      cost
      of revenue includes personnel and related overhead expenses, rent and related
      energy costs, fees paid for licensed technology, depreciation, amortization
      of
      purchased intangible assets and certain other operating expenses. Our cost
      of
      revenue was $1,919,000 for the year ended December 31, 2005, compared with
      $1,437,000 for the year ended December 31, 2004. Cost of revenue increased
      $482,000 for the year ended December 31, 2005, compared with 2004. The increase
      is primarily attributable to an increase of approximately $124,000 in personnel
      and related overhead, $203,000 associated with the support of the Flix product
      line by Wildform in 2005 and $164,000 in amortization of the Flix software
      assets.





*Research
      and Development.* Our
      research and development expenses, excluding equity based compensation, includes
      personnel and related overhead expenses, rent and related energy costs and
      depreciation, associated with the development and pre-production of our products
      and services. Our research and development expenses were $1,035,000 and $884,000
      for the years ended December 31, 2005 and 2004, respectively. The increase
      of $151,000 is primarily from an increase of approximately $156,000 in personnel
      and related overhead attributed to research and development.





*Sales
      and Marketing.* Our *s* ales
      and
      marketing expenses, excluding equity based compensation, consist primarily
      of
      salaries and related overhead costs, tradeshow costs, marketing and promotional
      costs incurred to create brand awareness and public relations expenses. Our
      sales and marketing expenses for the year ended December 31, 2005 were
      $794,000, compared with $459,000 for the year ended December 31, 2004. The
      increase of $335,000 is primarily attributable to an increase in personnel
      and
      related overhead expenses and an increase in tradeshow and promotional
      costs.





*General
      and Administrative.* Our
      general and administrative expenses, excluding equity based compensation,
      consist primarily of salaries and related overhead costs for general corporate
      functions including legal, finance, human resources and management information
      systems. Also included are outside legal and professional fees, stock-listing
      fees, reserves for uncollectible accounts receivable and costs of liability
      and
      directors and offices’ insurance. General and administrative costs for the year
      ended December 31, 2005 were $2,749,000, compared with $3,068,000 for the
      year ended December 31, 2004. The decrease of $319,000 is attributable to a
      decrease in outside legal fees, stock listing fees and a decrease in the reserve
      for uncollectible accounts receivable partially offset by an increase in
      personnel and related overhead expenses as a result of increases in labor and
      related overhead rates.





*Equity-Based
      Compensation.* The
      Company had no equity based compensation expense in 2005. During 2004 we granted
      restricted stock to its employees and directors as compensation. We issued
      870,000 shares of our common stock, with a fair value of $835,000. The related
      compensation expense of $835,000 was recognized in 2004, including $165,000
      included in cost of revenue.


-29-
 **Table
            of Contents**




*Interest
      and Other Income (Expense), Net.* Interest
      and other income (expense) was $(284,000) for the year ended
      December 31, 2005 as compared with $47,000 for the year ended
      December 31, 2004. The $284,000 in interest and other expense, net for the
      year ended December 31, 2005 is primarily a result of a $339,000 unrealized
      loss
      on marketable equity securities, interest paid on debt of $39,000 partially
      offset by interest earned on our cash balances of $89,000 and $5,000 in other
      income.





At
      December 31, 2006, we had approximately 37 full-time employees. We
      expect to hire employees as necessary in order to attain our strategic
      objectives.





**Liquidity
      and Capital Resources**




At
      December 31, 2006, we had cash and cash equivalents of $4,961,000, compared
      with $3,976,000 at December 31, 2005. At December 31, 2006 we had
      working capital of $5,268,000, compared with $4,179,000 at December 31,
      2005.





Net
      cash
      used in operating activities was $1,590,000 and $4,307,000 for the years ended
      December 31, 2006 and 2005, respectively. The net cash used in operating
      activities during 2006 consisted principally of a net loss of $4,846,000 and
      an
      increase in accounts receivable, net of $589,000, partially offset by
      equity-based compensation of $1,554,000, an expense of $1,078,000 associated
      with an increase in the estimated fair value of the warrant derivative
      liability, an increase in accounts payable and accrued expenses of $136,000,
      an
      increase in deferred revenue of $467,000, depreciation and amortization of
      $336,000 and other equity-based charges of $261,000. The net cash used in
      operating activities during 2005 consisted principally of a net loss of
      $4,605,000 and an increase in accounts receivable, net of $497,000, partially
      offset by an unrealized loss on marketable equity securities of $339,000 and
      depreciation and amortization of $236,000.





Net
      cash
      used in investing activities was $76,000 and $1,420,000 for the years ended
      December 31, 2006 and 2005, respectively. The decrease in 2006 is primarily
      due
      to $1,229,000 of cash used in connection with the purchase of the Flix software
      line during 2005.





Net
      cash
      provided by financing activities was $2,654,000 and $4,286,000 for the years
      ended December 31, 2006 and 2005, respectively. The decrease is
      attributable a decrease in the proceeds from the exercise of common stock
      options and warrants, net, partially offset by an increase in proceeds
      attributed to the warrant derivative liability and the issuance of common
      stock.





The
      Company currently has no material commitments for the next 12 months other
      than those under operating lease arrangements. These arrangements consist
      primarily of lease arrangements for our office space in Clifton Park and
      Tarrytown, New York, and Cambridge, UK. The aggregate required payments for
      the
      next 12 months under these arrangements are $165,000. Additionally,
      notwithstanding the above, our most significant non-contractual operating costs
      for the next 12 months are compensation and benefit costs, insurance costs
      and general overhead costs such as telephone and utilities. During 2007, we
      anticipate incurring approximately $750,000 per month in cash operating costs.





We
      believe that existing funds are sufficient to fund our operations through 2007.
      We plan to increase cash flows from operations principally from increases in
      revenue generated from its compression technology services and products. We
      may
      also pursue additional financings. See Item 1A “Risk Factors”
above.





In
      August
      2006, we completed the sale of 3,070,000 shares of its common stock with
      detachable five-year warrants to purchase 2,303,000 shares of our common stock
      at an exercise price of $0.77 per share, to two institutional investors, led
      by
      Midsummer Investments Ltd., and received net proceeds of $1,628,000.





The
      warrants contain certain anti-dilution provisions and, accordingly, we accounted
      for the fair value of the warrants as a derivative liability (warrant derivative
      liability) subject to SFAS No. 133. The fair value of the warrants issued,
      as
      calculated using the Black Scholes pricing model, was $1,251,000 and represents
      the portion of the proceeds from the financing that was attributed to the
      warrant derivative liability. The warrant fair value will be revalued at each
      balance sheet date, using the Black Scholes pricing model, with changes in
      value
      recorded in the statement of operations as income or expense. On December 31,
      2006 the warrant derivative fair value was $2,329,000 and the increase in value
      of $1,078,000 is included as an expense in interest and other income (expense),
      net. We paid financing costs in the amount of $122,000 of which $51,000 is
      associated with the warrants, and is included in interest and other income
      (expense), net in our consolidated financial statements for the twelve months
      ended December 31, 2006.


-30-
 **Table
            of Contents**




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




**Off-Balance
      Sheet Arrangements**





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




**Tabular
      Disclosure of Contractual Obligations**





Payments
                due by periodContractual
                Obligations
            
            Total
            
            Less
                than
              1
                year
            
            1
                -
                3
              years
            
            3
                -
                5 years
            
            More
                than 5
              yearsCapital
                lease obligation
            
            $
            61,000
            
            $
            28,000
            
            $
            33,000Operating
                lease for office space
            
            
            493,000
            
            $
            156,000
            
            
            275,000
            
            $
            53,000
            
            $
            9,000Total
            
            $
            554,000
            
            $
            184,000
            
            $
            308,000
            
            $
            53,000
            
            $
            9,000


**Impact
      of Recently Issued Accounting Pronouncements**





In
      July
      2006, the FASB issued FASB Interpretation Number 48, *Accounting
      for Uncertainty in Income Taxes, an Interpretation of FASB Statement
      No. 109* ,
      (“FIN48”). FIN 48 prescribes a recognition threshold and measurement attribute
      for the financial statement recognition and measurement of a tax position taken
      in a tax return. We must determine whether it is “more-likely-than-not” that a
      tax position will be sustained upon examination, including resolution of any
      related appeals or litigation processes, based on the technical merits of the
      position. Once it is determined that a position meets the more-likely-than-not
      recognition threshold, the position is measured to determine the amount of
      benefit to recognize in the financial statements. FIN 48 applies to all tax
      positions related to income taxes subject to FASB Statement No. 109, *Accounting
      for Income Taxes.* We
      will
      adopt the provisions of this statement beginning in the first quarter of 2007.
      The cumulative effect of applying the provisions of FIN 48 will be reported
      as
      an adjustment to the opening balance of retained earnings on January 1,
      2007. We do not anticipate that the adoption of this statement will have a
      material effect on our financial position or results of operations.





In
      September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for
      Defined Benefit Pension and Other Postretirement Plans—an amendment of FASB
      Statements No. 87, 88, 106, and 132(R),” which requires employers to:
      (a) recognize in its statement of financial position an asset for a plan’s
      over funded status or a liability for a plan’s under-funded status;
      (b) measure a plan’s assets and its obligations that determine its funded
      status as of the end of the employer’s fiscal year; and (c) recognize
      changes in the funded status of a defined benefit postretirement plan in the
      year in which the changes occur. Those changes will be reported in comprehensive
      income of a business entity. The requirement to recognize the funded status
      of a
      benefit plan and the disclosure requirements are effective as of the end of
      the
      fiscal year ending after December 15, 2006, for entities with publicly
      traded equity securities. The requirement to measure plan assets and benefit
      obligations as of the date of the employer’s fiscal year-end statement of
      financial position is effective for fiscal years ending after December 15,
      2008. We currently have no Post Retirement Benefit Plan.





Also
      in
      September 2006, the FASB issued SFAS No. 157, “ *Fair
      Value Measurements’* ”
which
      defines fair value, establishes a framework for measuring fair value in
      generally accepted accounting principles and expands
      disclosures


-31-
 **Table
            of Contents**




about
      fair value measurements. This Statement is effective for financial statements
      issued for fiscal years beginning after November 15, 2007 and interim
      periods within those fiscal years. Earlier application is encouraged provided
      that the reporting entity has not yet issued financial statements for that
      fiscal year including financial statements for an interim period within that
      fiscal year. We believe that several accounts will be affected on the adoption
      of SFAS No. 157 statements.





In
      February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
      Financial Assets and Financial Liabilities,” which provides companies with an
      option to report selected financial assets and liabilities at their fair values.
      The objective is to improve financial reporting by providing entities with
      the
      opportunity to mitigate volatility in reported earnings caused by measuring
      related assets and liabilities differently without having to apply complex
      hedge
      accounting provisions. This Statement is expected to expand the use of fair
      value measurement, which is consistent with FASB’s  long-term
      measurement objectives for accounting for financial instruments. We are
      currently evaluating the effects of the adoption of SFAS No. 159.




**Limitation
      on Use of Net Operating Loss and Other Tax Credit Carry-Forwards**





At
      December 31, 2006, we had available net operating loss carry-forwards of
      approximately $90,083,000. The net operating loss carry-forwards expire at
      various dates through 2026.





Section 382
      of the Internal Revenue Code provides that when a corporation undergoes an
      “ownership change,” the corporation’s use of its net operating losses is limited
      in each subsequent year. An “ownership change” occurs when, as of any testing
      date, the sum of the increases in ownership of each shareholder that owns five
      percent or more of the value of a company’s stock as compared to that
      shareholder’s lowest percentage ownership during the preceding three-year period
      exceeds fifty percentage points. For purposes of this rule, certain shareholders
      who own less than five percent of a company’s stock are aggregated and treated
      as a single five-percent stockholder.





The
      merger of The Duck Corporation with and into a wholly-owned subsidiary of
      Applied Capital Funding, Inc. in 1999 may have involved an “ownership change,”
and thus we may be unable to use a material portion of our available net
      operating loss carry-forwards. Furthermore, in the ordinary course of our
      business operations we have and may continue to issue shares in conjunction
      with
      acquisitions or additional financing, to meet our growth objectives and
      liquidity constraints. In addition, the exercise of outstanding warrants and
      certain options to purchase shares of our common stock may require us to issue
      additional shares of common stock. Past and future issuances of shares of common
      stock may limit our ability to use a substantial amount of our available net
      operating loss carry-forwards to reduce future taxable income.





The
      extent of the actual future use of our net operating loss carry-forwards is
      subject to inherent uncertainty because it depends on the amount of otherwise
      taxable income we may earn. We cannot be certain that we will have sufficient
      taxable income in future years to use any of our net operating loss
      carry-forwards before they would otherwise expire.




**Item
                7A*****Quantitative
                and Qualitative Disclosures About Market
                Risk***




We
      do not
      currently have any material exposure to interest rate risk, foreign currency
      risk, exchange rate risk, commodity price risk or other relevant market rate
      or
      price risks. However, we do have some exposure to foreign currency rate
      fluctuations arising from maintaining an office for our U.K. based, wholly-owned
      subsidiary which transacts business in the local functional currency and from
      paying consulting fees to certain of its European-based sales contractors in
      Euros. Our U.K. based subsidiary does not conduct any sales and all their costs
      are funded in United States dollars. To date, we have not entered into any
      derivative financial instrument to manage foreign currency risk, and we are
      not
      currently evaluating the future use of any such financial
      instruments.




**Item 8.*****Financial
                Statements and Supplementary Data***




The
      consolidated financial statements are included herein and filed as a part of
      this report. See Index on page F-1.




**Item
                9.*****Changes
                In and Disagreements with Accountants on Accounting and Financial
                Disclosure***





None.  -32-
 **Table
            of Contents**




**Item
                9A.*****Controls
                and Procedures***





(a)
            *Evaluation
                of Disclosure Controls and Procedures*





Our
      chief
      executive officer and chief financial officer have evaluated the effectiveness
      of our disclosure controls and procedures (as defined in Rules 13a-14(c)
      and 15d-14(c) of the Securities Exchange Act of 1934) as of the end of the
      period covered by this Form 10-K for the fiscal year ended December 31, 2006.
      Based upon this evaluation process, our chief executive officer and chief
      financial officer have concluded that our disclosure controls and procedures
      are
      effective.





(b)
            *Changes
                in Internal Controls*





There
      have been no changes in our internal control over financial reporting, as
      defined in Rule 13a-15(f) of the Securities Exchange Act of 1934, that occurred
      during the fiscal quarter ended December 31, 2006, that have materially
      affected, or are reasonably likely to materially affect, our internal control
      over financial reporting.





**Item
                9B.*****Other
                Information***




None.




**PART
      III**




**Item
                10.*****Directors,
                Executive Officers, Promoters and Control Persons and Corporate
                Governance***




The
      information required is incorporated by reference from the sections entitled
      “Directors and Executive Officers”, “The Board of Directors” and “Compliance
      with Section 16(a) of the Exchange Act” contained in the 2007 Proxy
      Statement, which is to be filed with the Securities and Exchange Commission
      on
      or about April 16, 2007 (the “2007 Proxy Statement”).





**Item
                11.*****Executive
                Compensation***





The
      information required is incorporated by reference from the section entitled
      “Executive Compensation” contained in the 2007 Proxy Statement.




**Item
                12.*****Security
                Ownership of Certain Beneficial Owners and Management and Related
                Stockholder Matters***





The
      information required is incorporated by reference from the sections entitled
      “Security Ownership of Principal Stockholders” and “Security Ownership of
      Executive Officers and Directors” contained in the 2007 Proxy
      Statement.




**Item
                13.*****Certain
                Relationships and Related Transactions, and Director
                Independance***




The
      information required is incorporated by reference from the section entitled
      “Certain Relationships and Related Transactions” contained in the 2007 Proxy
      Statement.




**Item
                14.*****Principal
                Accounting Fees and Services.***




The
      information required is incorporated by reference from the section entitled
      “Proposal To Ratify the Appointment of Eisner LLP” contained in the 2007 Proxy
      Statement.


-33-
 **Table
          of Contents**




**PART
      IV**




**Item
                15.*****Exhibits.***





*Exhibits*





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




**Incorporated
                by Reference****Exhibit
                Number**
            
            **Exhibit
                Description**
            
            **Form**
            
            **Date
                Filed**
            
            **Filed
                Herewith**3.1
            
            Certificate
                of Incorporation of the Company
            
            10-K
            
            April
                2, 20013.2
            
            Bylaws
                of the Company
            
            8-K
            
            Feb.
                8, 20064.1
            
            Securityholders
                Agreement, dated as of Dec. 1, 1999, between the Company and thirteen
                securityholders party thereto
            
            10-K
            
            March
                30, 20004.2
            
            Form
                of Investor Rights Agreement, dated as of Dec. 1, 1999,between the
                Company and each of nine investors
            
            10-K
            
            March
                30, 20004.3
            
            Form
                of Warrant issued to the investors party to the Investor Rights Agreement
            
            10-K
            
            March
                30, 20004.4
            
            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
            
            S-3
            
            Dec.
                8, 20004.5
            
            Certificate
                of Designations for the Company’s Series C Preferred Stock
            
            10-K
            
            April
                2, 20014.6
            
            Certificate
                of Designations for the Company’s Series C-II Preferred Stock
            
            10-K
            
            April
                2, 20014.7
            
            Certificate
                of Designations for the Company’s Series C-III Preferred Stock
            
            10-K
            
            April
                2, 20014.8
            
            Form
                of Warrant issued to the holders of Series C, Series C-II and Series
                C-III Preferred Stock
            
            10-K
            
            April
                2, 20014.9
            
            Common
                Stock Purchase Agreement, dated as of July 18, 2001 by and between
                the Company and Real.
            
            SB-2/A
            
            Sept.
                13, 20014.10
            
            Investor
                Rights Agreement, dated as of July 18, 2001, between Real and the
                Company
            
            SB-2/A
            
            Sept.
                13, 20014.11
            
            Indemnity
                Agreement, dated as of January 28, 2002, by and among The Travelers
                Insurance Company, Travelers Indemnity Company, and the
                Company
            
            S-3
            
            July
                11, 20034.12
            
            Investor’s
                Rights Agreement, dated as of January 29, 2001, between the Company
                and
                Abanat Limited
            
            S-3
            
            Oct.
                1, 20034.13
            
            Common
                Stock Purchase Warrant, dated as of August 24, 2006
            
            10-K
            
            August
                25, 200610.1
            
            License
                Agreement by and between the Company and Bevmax Office Centers 1560,
                LLC
            
            10-K
            
            March
                15, 200610.2
            
            Restated
                Lease Agreement by and between the Company and Sitterly Associates
                II
            
            10-K
            
            March
                15, 200610.3
            
            Separation
                and Consultancy Agreement by and between the Company and Douglas
                A.
                McIntyre, dated as of February 2, 2006
            
            10-K
            
            March
                15, 200610.4
            
            Employment
                Agreement, dated May 1, 2006, by and between the Company and Bill
                Joll
            
            10-Q
            
            May
                5, 200610.5
            
            Amended
                and Restated Employment Agreement, dated May 1, 2006, by and between
                the
                Company and Tim Reusing
            
            10-Q
            
            Aug.
                2, 200610.6
            
            Securities
                Purchase Agreement, dated as of August 24, 2006
            
            8-K
            
            Aug.
                25, 200610.7
            
            Registration
                Rights Agreement, dated as of August 24, 2006
            
            8-K
            
            Aug.
                25, 200610.8
            
            Stockholder
                Voting Agreement
            
            8-K
            
            Aug.
                25, 200610.9
            
            Asset
                Purchase Agreement (Confidential Treatment Requested as to Redacted
                Portions)
            
            8-K/A
            
            Nov.
                17, 200610.10
            
            Exhibit
                B [sic] to Asset Purchase Agreement (Form of Escrow
                Agreement)
            
            8-K/A
            
            Nov.
                17, 200610.11
            
            Exhibit
                C [sic] to Asset Purchase Agreement (Form of Support and Maintenance
                Agreement)
            
            8-K/A
            
            Nov.
                17, 200610.12
            
            Exhibit
                D [sic] to Asset Purchase Agreement (Form of Registration Rights
                Agreement)
            
            8-K/A
            
            Nov.
                17, 200610.13
            
            Employment
                Agreement, dated as of February 28, 2006, by and between the Company
                and Matt Frost
            
            
            
            
            
            X21
            
            Subsidiaries
            
            10-K
            
            March
                31, 200323.1
            
            Consent
                of Eisner LLP
            
            
            
            
            
            X31.1
            
            Certification
                of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley
                Action of 2002
            
            
            
            
            
            X31.2
            
            Certification
                of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley
                Action of 2002
            
            
            
            
            
            X32.1
            
            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
            
            
            
            
            
            X32.2
            
            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
            
            
            
            
            
            X




-34-
 **Table
          of Contents**




**SIGNATURES**





Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
      1934, the registrant has duly caused this report to be signed on its behalf
      by
      the undersigned, thereunto duly authorized..




ON2
      TECHNOLOGIES, INC.




By: /s/
      Bill
      Joll


Bill
      Joll


*Director,
      President* *and
      Chief Executive Officer*


*(Principal
      Executive Officer)*




Date:
      March 23, 2007





Pursuant
      to the requirements of the Securities Exchange Act of 1934, as amended, this
      report has been signed by the following persons on behalf of the Company and
      in
      the capacities and on the dates indicated.




**Signature**
              
              **Title**
              
              **Date**/s/
                  Anthony Principe
              
              Senior
                  Vice President and Chief Financial Officer
              
              March
                  23, 2007(Anthony
                  Principe)
              
              (Principal
                Financial and Accounting Officer)/s/
                  J. Allen Kosowsky
              
              Chairman
                  of the Board and Director
              
              March
                  23, 2007(J.
                  Allen Kosowsky)/s/
                  William A. Newman
              
              Director
              
              March
                  23, 2007(William
                  A. Newman)/s/
                  Mike Kopetski
              
              Director
              
              March
                  23, 2007(Mike
                  Kopetski )/s/
                  Thomas Weigman
              
              Director
              
              March
                  23, 2007(Thomas
                  Weigman)/s/
                  Michael J. Alfant
              
              Director
              
              March
                  23, 2007(Michael
                  J. Alfant)/s/
                  Afsaneh Naimollah
              
              Director
              
              March
                  23, 2007(Afsaneh
                  Naimollah)/s/
                  James Meyer
              
              Director
              
              March
                  23, 2007(James
                  Meyer)





-35-
 **Table
            of Contents**




**INDEX
      TO CONSOLIDATED FINANCIAL STATEMENTS**




PageReport
                of Independent Registered Public Accounting Firm
            F-2Consolidated
                Balance Sheets as of December 31, 2006 and 2005
            F-3Consolidated
                Statements of Operations for the years endedDecember
                31, 2006, 2005 and 2004
            F-4Consolidated
                Statements of Changes in Stockholders’ Equityfor
                the years ended December 31, 2006, 2005 and 2004
            F-5Consolidated
                Statements of Cash Flows for the years endedDecember
                31, 2006, 2005 and 2004
            F-9Notes
                to Consolidated Financial Statements
            F-11




F-1
 **Table
          of Contents**




**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, 2006 and 2005 and the
      related consolidated statements of operations, changes in stockholders’ equity
      and cash flows for each of the years in the three-year period ended December
      31,
      2006. 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 referred to above present fairly, in all
      material respects, the consolidated financial position of On2 Technologies,
      Inc.
      and subsidiaries as of December 31, 2006 and 2005, and the consolidated
      results of their operations and their consolidated cash flows for each of the
      years in the three-year period ended December 31, 2006 in conformity with U.S.
      generally accepted accounting principles.




In
      connection with our audits of the consolidated financial statements referred
      to
      above, we audited Schedule II - Valuation and Qualifying Accounts for each
      of
      the years in the three-year period ended December 31, 2006. In our opinion,
      this
      schedule, when considered in relation to the financial statements taken as
      a
      whole, present fairly, in all material respects, the information stated
      herein.




As
      discussed in Note 1 to the consolidated financial statements, the Company
      changed the manner in which it accounts for share-based compensation effective
      January 1, 2006.





Eisner
      LLP





New
      York,
      New York


March **7** ,
      2007


F-2
 **Table
          of Contents**




**ON2
      TECHNOLOGIES, INC.**


**CONSOLIDATED
      BALANCE SHEETS**




December
                31,2006
            
            2005ASSETSCurrent
                assets:Cash
                and cash equivalents
            
            $
            4,961,000
            
            $
            3,976,000Marketable
                securities, at market
            
            
            154,000
            
            
            181,000Accounts
                receivable, less allowance for doubtful accounts of $56,000 and $13,000
                as
                of December 31, 2006 and 2005, respectively
            
            
            1,335,000
            
            
            746,000Prepaid
                expenses and other current assets
            
            
            231,000
            
            
            186,000Total
                current assets
            
            
            6,681,000
            
            
            5,089,000Acquired
                software, net
            
            
            467,000
            
            
            667,000Other
                acquired intangibles, net
            
            
            108,000
            
            
            154,000Goodwill
            
            
            244,000
            
            
            244,000Property
                and equipment, net
            
            
            157,000
            
            
            131,000Other
                assets
            
            
            230,000
            
            
            29,000Total
                assets
            
            $
            7,887,000
            
            $
            6,314,000LIABILITIES
                AND STOCKHOLDERS’ EQUITYCurrent
                liabilities:Accounts
                payable
            
            $
            194,000
            
            $
            41,000Accrued
                expenses
            
            
            454,000
            
            
            608,000Deferred
                revenue
            
            
            708,000
            
            
            241,000Term-loan
            
            
            33,000Capital
                lease obligation
            
            
            24,000
            
            
            20,000Total
                current liabilities
            
            
            1,413,000
            
            
            910,000Capital
                lease obligation, excluding current portion
            
            
            29,000
            
            
            6,000Warrant
                derivative liability
            
            
            2,329,000Convertible
                debentures, net of debt discount of $6,000 as of December 31,
                2005
            
            
            
            
            
            244,000Total
                liabilities
            
            
            3,771,000
            
            
            1,160,000Series
                D redeemable convertible preferred stock $0.01 par value; 3,083 and
                3,790
                shares issued and outstanding, (liquidation value of $3,083,000 and
                $3,790,000 at December 31, 2006 and 2005, respectively)
            
            
            3,083,000
            
            
            3,790,000Commitments
                and contingencies (Note 10)Stockholders’
                equity:Preferred
                stock, $0.01 par value; 20,000,000 shares authorized; 1,849,000
                convertible shares issued and outstanding at December 31, 2006 and
                2005 (aggregate of liquidation value of $5,110,000 as of December
                31, 2006
                and 2005)
            
            
            19,000
            
            
            19,000Common
                stock, $0.01 par value; 150,000,000 shares authorized; 101,258,000
                and
                92,295,000 shares issued and outstanding at December 31, 2006 and
                2005,
                respectively)
            
            
            1,012,000
            
            
            923,000Additional
                paid-in capital
            
            
            124,554,000
            
            
            119,772,000Accumulated
                other comprehensive loss
            
            
            (46,000
            )
            
            (43,000
            )Accumulated
                deficit
            
            
            (124,506,000
            )
            
            (119,307,000
            )Total
                stockholders’ equity
            
            
            1,033,000
            
            
            1,364,000Total
                liabilities and stockholders’ equity
            
            $
            7,887,000
            
            $
            6,314,000


*See
      accompanying notes to consolidated financial statements*


F-3
 **Table
            of Contents**




**ON2
      TECHNOLOGIES, INC.**


**CONSOLIDATED
      STATEMENTS OF OPERATIONS**




Year
                Ended December 31,2006
            
            2005
            
            2004Revenue
                (1)
            
            $
            6,572,000
            
            $
            2,208,000
            
            $
            3,028,000Operating
                expenses:Cost
                of revenue (2)
            
            
            2,328,000
            
            
            1,919,000
            
            
            1,437,000Research
                and development (3)
            
            
            972,000
            
            
            1,035,000
            
            
            884,000Sales
                and marketing (3)
            
            
            1,093,000
            
            
            794,000
            
            
            459,000General
                and administrative (3)
            
            
            4,384,000
            
            
            2,749,000
            
            
            3,068,000Equity-based
                compensation:Research
                and development
            
            
            98,000
            
            
            
            
            
            68,000Sales
                and marketing
            
            
            103,000
            
            
            
            
            
            19,000General
                and administrative
            
            
            1,184,000
            
            
            
            
            
            583,000Total
                operating expenses
            
            
            10,162,000
            
            
            6,497,000
            
            
            6,518,000Loss
                from operations
            
            
            (3,590,000
            )
            
            (4,289,000
            )
            
            (3,490,000
            )Interest
                and other income (expense), net
            
            
            (1,226,000
            )
            
            (284,000
            )
            
            47,000Loss
                before provision for income taxes
            
            
            (4,816,000
            )
            
            (4,573,000
            )
            
            (3,443,000
            )Provision
                for income taxes
            
            
            30,000
            
            
            32,000
            
            
            2,000Net
                loss
            
            
            (4,846,000
            )
            
            (4,605,000
            )
            
            (3,445,000
            )Convertible
                preferred stock deemed dividend
            
            
            68,000
            
            
            2,844,000
            
            
            120,000Convertible
                preferred stock 8% dividend
            
            
            285,000
            
            
            325,000
            
            
            57,000Accretion
                of costs associated with the Series D Preferred Stock
            
            
            
            
            
            175,000
            
            
            14,000Net
                loss attributable to common stockholders
            
            $
            (5,199,000
            )
            $
            (7,949,000
            )
            $
            (3,636,000
            )Basic
                and diluted net loss attributable to common stockholdersper
                common share
            
            $
            (0.05
            )
            $
            (0.09
            )
            $
            (0.05
            )Weighted
                average basic and diluted common shares outstanding
            
            
            96,642,000
            
            
            89,183,000
            
            
            77,187,000





(1)
            Includes
                $289,000 for the year ended December 31, 2004, from a related
                party.


(2)
            Includes
                equity-based compensation of $169,000 and $165,000 for the years
                ended
                December 31, 2006 and 2004.


(3)
            Excludes
                equity-based compensation, which is presented
                separately.




*See
      accompanying notes to consolidated financial statements*


F-4
 **Table
          of Contents**




**ON2
      TECHNOLOGIES, INC.**


**CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY**




AccumulatedConvertible
            
            
            
            
            
            Additional
            
            Other
            
            
            
            TotalPreferred
                Stock
            
            Common
                Stock
            
            Paid-in
            
            Comprehensive
            
            Accumulated
            
            Stockholders’Shares
            
            Amount
            
            Shares
            
            Amount
            
            Capital
            
            Loss
            
            Deficit
            
            EquityBalance
                at January 1, 2004
            
            
            5,565,000
            
            $
            56,000
            
            
            74,146,000
            
            $
            741,000
            
            $
            110,229,000
            
            $
            (18,000
            )
            $
            (107,722,000
            )
            $
            3,286,000Net
                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 with the exercise of stock
                options
            
            
            
            
            
            
            
            
            277,000
            
            
            3,000
            
            
            64,000
            
            
            
            
            
            
            
            
            67,000Issuance
                of common stock in connection with the exercise of
                warrants
            
            
            
            
            
            
            
            
            1,435,000
            
            
            14,000
            
            
            749,000
            
            
            
            
            
            
            
            
            763,000Issuance
                of common stock in connection with the conversion of Series A secured
                convertible debentures
            
            
            
            
            
            
            
            
            893,000
            
            
            9,000
            
            
            91,000
            
            
            
            
            
            
            
            
            100,000Issuance
                of common stock toemployees
                and directors ascompensation
            
            
            
            
            
            
            
            
            870,000
            
            
            9,000
            
            
            826,000
            
            
            
            
            
            
            
            
            835,000Issuance
                of common stock inconnection
                with the conversionof
                Series A convertiblepreferred
                stock
            
            
            (400,000
            )
            
            (4,000
            )
            
            400,000
            
            
            4,000
            
            
            
            
            
            
            
            
            
            
            
            0Issuance
                of common stock inconnection
                with the conversionof
                Series C-V convertiblepreferred
                stock
            
            
            (727,000
            )
            
            (7,000
            )
            
            1,000,000
            
            
            10,000
            
            
            (3,000
            )
            
            
            
            
            
            
            
            0Issuance
                of common stock inconnection
                with the conversionof
                Series C-VI convertiblepreferred
                stock
            
            
            (1,139,000
            )
            
            (12,000
            )
            
            1,210,000
            
            
            12,000
            
            
            
            
            
            
            
            
            
            
            
            0Issuance
                of common stock inconnection
                with the payment ofinterest
                on the Series A securedconvertible
                debentures
            
            
            
            
            
            
            
            
            37,000
            
            
            0
            
            
            23,000
            
            
            
            
            
            
            
            
            23,000Issuance
                of common stock inconnection
                with the payment ofdividends
                on the Series Dconvertible
                preferred stock
            
            
            
            
            
            
            
            
            60,000
            
            
            1,000
            
            
            29,000
            
            
            
            
            
            (30,000
            )
            
            0Discount
                on Series D convertiblepreferred
                stock for warrantsand
                beneficial conversionfeature
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            2,964,000
            
            
            
            
            
            
            
            
            2,964,000




F-5
 **Table
          of Contents**




**ON2
      TECHNOLOGIES, INC.**


**CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (CONTINUED)**




AccumulatedConvertible
            
            
            
            
            
            Additional
            
            Other
            
            
            
            TotalPreferred
                Stock
            
            Common
                Stock
            
            Paid-in
            
            Comprehensive
            
            Accumulated
            
            Stockholders’Shares
            
            Amount
            
            Shares
            
            Amount
            
            Capital
            
            Loss
            
            Deficit
            
            EquitySeries
                D convertible preferred stock financing costs allocated to
                warrants
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (112,000
            )
            
            
            
            
            
            
            
            (112,000
            )Deemed
                dividend on Series D convertible preferred stock
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (120,000
            )
            
            (120,000
            )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
            )
            
            (14,000
            )Balance
                at December 31, 2004
            
            
            3,299,000
            
            $
            33,000
            
            
            80,328,000
            
            $
            803,000
            
            $
            114,860,000
            
            $
            (42,000
            )
            $
            (111,358,000
            )
            $
            4,296,000Net
                loss
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (4,605,000
            )
            
            (4,605,000
            )Foreign
                currency translation adjustment
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (1,000
            )
            
            
            
            
            (1,000
            )Comprehensive
                loss
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (4,606,000
            )Issuance
                of common stock in connection with the exercise of stock
                options
            
            
            
            
            
            
            
            
            116,000
            
            
            1,000
            
            
            41,000
            
            
            
            
            
            
            
            
            42,000Issuance
                of common stock in connection with the exercise of
                warrants
            
            
            
            
            
            
            
            
            8,052,000
            
            
            81,000
            
            
            4,242,000
            
            
            
            
            
            
            
            
            4,323,000Issuance
                of common stock in connection with the conversion of Series A secured
                convertible debentures
            
            
            
            
            
            
            
            
            893,000
            
            
            9,000
            
            
            91,000
            
            
            
            
            
            
            
            
            100,000Issuance
                of common stock inconnection
                with the conversionof
                Series C-V convertiblepreferred
                stock
            
            
            (1,450,000
            )
            
            (14,000
            )
            
            2,040,000
            
            
            21,000
            
            
            (7,000
            )
            
            
            
            
            
            
            
            0Issuance
                of common stock inconnection
                with the conversionof
                Series D convertiblepreferred
                stock
            
            
            
            
            
            
            
            
            300,000
            
            
            3,000
            
            
            207,000
            
            
            
            
            
            
            
            
            210,000Issuance
                of common stock inconnection
                with the payment ofinterest
                on the Series A securedconvertible
                debentures
            
            
            
            
            
            
            
            
            28,000
            
            
            
            
            
            18,000
            
            
            
            
            
            
            
            
            18,000





F-6
 **Table
            of Contents**




**ON2
      TECHNOLOGIES, INC.**


**CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (CONTINUED)**





AccumulatedConvertible
            
            
            
            
            
            Additional
            
            Other
            
            
            
            TotalPreferred
                Stock
            
            Common
                Stock
            
            Paid-in
            
            Comprehensive
            
            Accumulated
            
            Stockholders’Shares
            
            Amount
            
            Shares
            
            Amount
            
            Capital
            
            Loss
            
            Deficit
            
            EquityIssuance
                of common stock inconnection
                with the payment ofdividends
                and dividendsaccrued
                on the Series Dconvertible
                preferred stock
            
            
            
            
            
            
            
            
            538,000
            
            
            5,000
            
            
            320,000
            
            
            
            
            
            (325,000
            )
            
            0Deemed
                dividend on Series D convertible preferred stock
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (2,844,000
            )
            
            (2,844,000
            )Accretion
                of costs associated with the issuance of the Series D convertible
                preferred stock
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (175,000
            )
            
            (175,000
            )Balance
                at December 31, 2005
            
            
            1,849,000
            
            $
            19,000
            
            
            92,295,000
            
            $
            923,000
            
            $
            119,772,000
            
            $
            (43,000
            )
            $
            (119,307,000
            )
            $
            1,364,000Net
                loss
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (4,846,000
            )
            
            (4,846,000
            )Foreign
                currency translation adjustment
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (3,000
            )
            
            
            
            
            (3,000
            )Comprehensive
                loss
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (4,849,000
            )Issuance
                of common stock in onnection with the exercise of stock
                options
            
            
            
            
            
            
            
            
            1,745,000
            
            
            17,000
            
            
            924,000
            
            
            
            
            
            
            
            
            941,000Issuance
                of common stock in
              connection
                with the exercise
              of
                warrants
            
            
            
            
            
            
            
            
            202,000
            
            
            2,000
            
            
            125,000
            
            
            
            
            
            
            
            
            127,000Issuance
                of common stock to employees and consultants as
                compensation
            
            
            
            
            
            
            
            
            25,000
            
            
            
            
            
            16,000
            
            
            
            
            
            
            
            
            16,000Issuance
                of common stock in connection with the Wildform Support and Services
                Agreement
            
            
            
            
            
            
            
            
            280,000
            
            
            3,000
            
            
            255,000
            
            
            
            
            
            
            
            
            258,000Issuance
                of common stock in connection with the conversion of Series A secured
                convertible debentures
            
            
            
            
            
            
            
            
            2,232,000
            
            
            22,000
            
            
            228,000
            
            
            
            
            
            
            
            
            250,000Issuance
                of common stock inconnection
                with the conversionand
                redemption of Series D convertible preferred stock
            
            
            
            
            
            
            
            
            1,017,000
            
            
            10,000
            
            
            697,000
            
            
            
            
            
            
            
            
            707,000Issuance
                of common stock inconnection
                with the payment ofinterest
                on the Series A securedconvertible
                debentures
            
            
            
            
            
            
            
            
            5,000
            
            
            
            
            
            5,000
            
            
            
            
            
            
            
            
            5,000





F-7
 **Table
            of Contents**




**ON2
      TECHNOLOGIES, INC.**


**CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (CONTINUED)**




AccumulatedConvertible
            
            
            
            
            
            Additional
            
            Other
            
            
            
            TotalPreferred
                Stock
            
            Common
                Stock
            
            Paid-in
            
            Comprehensive
            
            Accumulated
            
            Stockholders’Shares
            
            Amount
            
            Shares
            
            Amount
            
            Capital
            
            Loss
            
            Deficit
            
            EquityIssuance
                of common stock inconnection
                with the payment ofdividends
                and dividendsaccrued
                on the Series Dconvertible
                preferred stock
            
            
            
            
            
            
            
            
            387,000
            
            
            4,000
            
            
            287,000
            
            
            
            
            
            (285,000
            )
            
            6,000Issuance
                of common stock inconnection
                with sale ofcommon
                stock and warrants
            
            
            
            
            
            
            
            
            3,070,000
            
            
            31,000
            
            
            398,000
            
            
            
            
            
            
            
            
            429,000Deemed
                dividend on Series D convertible preferred stock
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            68,000
            
            
            
            
            
            (68,000
            )
            
            0Expiration
                of January 2006 warrant extension
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            135,000
            
            
            
            
            
            
            
            
            135,000December
                2006 warrant extension
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            106,000
            
            
            
            
            
            
            
            
            106,000Compensation
                expense associated with the issuance and extension of stock options
                and
                restricted stock grants
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,538,000
            
            
            
            
            
            
            
            
            1,538,000Balance
                at December 31, 2006
            
            
            1,849,000
            
            $
            19,000
            
            
            101,258,000
            
            $
            1,012,000
            
            $
            124,554,000
            
            $
            (46,000
            )
            $
            (124,506,000
            )
            $
            1,033,000






*See
      accompanying notes to consolidated financial statements*


F-8
 **Table
          of Contents**




**ON2
      TECHNOLOGIES, INC.**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**




Year
                Ended December 31,2006
            
            2005
            
            2004Cash
                flows from operating activities:Net
                loss
            
            $
            (4,846,000
            )
            $
            (4,605,000
            )
            $
            (3,445,000
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Equity-based
                compensation
            
            
            1,554,000
            
            
            
            
            
            835,000Other
                expense recognized for extension of warrants
            
            
            135,000Common
                stock issued for debenture interest
            
            
            5,000
            
            
            18,000
            
            
            23,000Common
                stock issued to Wildform for Support and Services
                Agreement
            
            
            126,000Insurance
                expense financed with term loan
            
            
            52,000Write-off
                of fixed assets
            
            
            
            
            
            
            
            
            20,000Depreciation
                and amortization
            
            
            336,000
            
            
            236,000
            
            
            115,000Change
                in fair value of warrant liability
            
            
            1,078,000Marketable
                equity securities received as payment of license fee
            
            
            
            
            
            
            
            
            (289,000
            )Unrealized
                loss (gain) on marketable equity securities
            
            
            46,000
            
            
            339,000
            
            
            (121,000
            )Realized
                loss on marketable equity securities
            
            
            
            
            
            
            
            
            26,000Amortization
                of debt discount
            
            
            6,000
            
            
            14,000
            
            
            21,000Changes
                 in operating assets and liabilities:Accounts
                receivable, net
            
            
            (589,000
            )
            
            (497,000
            )
            
            427,000Prepaid
                expenses and other current assets
            
            
            (1,000
            )
            
            (30,000
            )
            
            8,000Other
                assets
            
            
            (95,000
            )
            
            51,000
            
            
            (54,000
            )Accounts
                payable and accrued expenses
            
            
            136,000
            
            
            79,000
            
            
            203,000Deferred
                revenue
            
            
            467,000
            
            
            88,000
            
            
            123,000Net
                cash used in operating activities
            
            
            (1,590,000
            )
            
            (4,307,000
            )
            
            (2,108,000
            )Cash
                flows from investing activities:Purchases
                of marketable securities
            
            
            (94,000
            )
            
            (75,000
            )Sale
                of marketable securities
            
            
            75,000
            
            
            
            
            
            89,000Purchases
                of the Flix software line
            
            
            
            
            
            (1,229,000
            )Purchases
                of property and equipment
            
            
            (57,000
            )
            
            (116,000
            )
            
            (19,000
            )Net
                cash provided by (used in) investing activities
            
            
            (76,000
            )
            
            (1,420,000
            )
            
            70,000Cash
                flows from financing activities:Principal
                payments on capital lease obligations
            
            
            (31,000
            )
            
            (17,000
            )
            
            (11,000
            )Proceeds
                attributed to warrant derivative liability
            
            
            1,251,000Principal
                payments on term-loan
            
            
            (63,000
            )
            
            (62,000
            )
            
            (1,000
            )Net
                proceeds from the issuance of common stock
            
            
            429,000Net
                proceeds from the issuance of Series D redeemable convertible preferred
                stock
            
            
            
            
            
            
            
            
            3,699,000Proceeds
                from exercise of common stock options and warrants, net
            
            
            1,068,000
            
            
            4,365,000
            
            
            830,000Net
                cash provided by financing activities
            
            
            2,654,000
            
            
            4,286,000
            
            
            4,517,000Net
                change in cash and cash equivalents
            
            
            988,000
            
            
            (1,441,000
            )
            
            2,479,000Effect
                of exchange rate changes on cash and cash equivalents
            
            
            (3,000
            )
            
            (1,000
            )
            
            (24,000
            )Cash
                and cash equivalents, beginning of year
            
            
            3,
                976,000
            
            
            5,418,000
            
            
            2,963,000Cash
                and cash equivalents, end of year
            
            $
            4,961,000
            
            $
            3,976,000
            
            $
            5,418,000




F-9
 **Table
          of Contents**




**ON2
      TECHNOLOGIES, INC.**


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




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




Year
                Ended December 31,2006
            
            2005
            
            2004Cash
                paid during the year for:Interest
            
            $
            8,000
            
            $
            7,000
            
            $
            11,000Taxes
            
            $
            19,000
            
            $
            25,000
            
            $
            7,000Non-cash
                transactions:Acquisition
                of fixed assets under capital leases
            
            $
            58,000
            
            
            
            
            $
            54,000Prepaid
                insurance financed with term loan
            
            $
            44,000Conversion
                of Series A, C-V and C-IV convertible preferred stock intocommon
                stock
            
            
            
            
            $
            14,000
            
            $
            23,000Conversion
                and redemption of Series D redeemable convertible preferred stock
                intocommon
                stock
            
            $
            707,000
            
            $
            210,000Conversion
                of debentures into common stock
            
            $
            250,000
            
            $
            100,000
            
            $
            100,000Common
                stock issued for dividends and dividends accrued on Series Dconvertible
                preferred stock
            
            $
            290,000
            
            $
            325,000
            
            $
            30,000Accrued
                dividend on Series D convertible preferred stock
            
            $
            5,000
            
            
            
            
            $
            27,000Deferred
                financing costs recorded for extension of warrants
            
            $
            106,000Stock
                issued to Wildform associated with the Support and ServicesAgreement
                for prior year services
            
            $
            132,000Accretion
                of costs associated with the issuance of Series D convertible preferredstock
            
            
            
            
            $
            175,000
            
            $
            14,000Convertible
                preferred stock deemed dividend
            
            $
            68,000
            
            $
            2,844,000
            
            $
            120,000Marketable
                equity securities received as consideration for account
                receivable
            
            
            
            
            
            
            
            $
            150,000


*See
      accompanying notes to consolidated financial statements*


F-10
 **Table
          of Contents**


**ON2
        TECHNOLOGIES, INC.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**
   (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. In addition, the Company licenses its software products
      for
      use with video delivery platforms.




On
      April
      29, 2005 the Company acquired certain assets related to the Flix software
      product line of Wildform, Inc. (“Wildform”), pursuant to the terms of the Asset
      Purchase and Software License Agreement.





*(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.




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, 2006 the Company had cash and cash equivalents of $4,961,000
      and working capital of $5,268,000. The Company believes that existing funds
      are
      sufficient to fund its operations through 2007. 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.





*(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-11
 **Table
          of Contents**




**ON2
      TECHNOLOGIES, INC.**


**NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**


(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 fair
      value of the Series A secured convertible debentures was approximately
      $2,366,000 at December 31, 2005. The fair value of the Series D redeemable
      convertible preferred stock is approximately $5,315,000 and $5,739,000 at
      December 31, 2006 and 2005, respectively. The fair values are based on the
      quoted value of the underlying common stock of the Company.




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”* 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


F-12
 **Table
          of Contents**




**ON2
      TECHNOLOGIES, INC.**


**NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**


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





*(h)*
            *Revenue
                Recognition (continued)*





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.





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.





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
      reasonably dependable 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.





*(i)*
            *Cost
                of Revenue*





Cost
      of
      revenue primarily includes compensation costs for engineering and consulting
      personnel, equity-based compensation costs, overhead costs, depreciation costs,
      licensing fees or royalties paid for third party software products and the
      amortization of purchased technology recorded in connection with the Flix
      acquisition.


F-13
 **Table
          of Contents**




**ON2
      TECHNOLOGIES, INC.**


**NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**


(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”) No. 86, *“Software
      Development Costs”* .
      Under
      SFAS No. 86, these costs are expensed until technological feasibility
      has been established. 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*





In
      December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No.
      123R “Share-Based Payment” (“SFAS 123R”), which requires all share-based
      payments to employees, including grants of employee stock options, to be
      recognized in the statement of operations as an operating expense, based on
      their fair values on grant date. Prior to the adoption of SFAS 123R the Company
      accounted for stock based compensation using the intrinsic value method. The
      Company adopted the provision of SFAS No. 123R effective January 1, 2006, using
      the modified prospective transition method. Under the modified prospective
      method, non-cash compensation expense is recognized under the fair value method
      for the portion of outstanding share based awards granted prior to the adoption
      of SFAS 123R for which service has not been rendered, and for any share based
      awards granted or modified after adoption. Accordingly, periods prior to
      adoption have not been restated. The Company recognizes share based compensation
      cost associated with awards subject to graded vesting in accordance with the
      accelerated method specified in FASB Interpretation No. 28 pursuant to which
      each vesting tranche is treated as a separate award. The compensation cost
      associated with each vesting tranche is recognized as expense evenly over the
      vesting period of that tranche.




The
      following table 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 prior periods:





December
                31,2005
            
            2004Reported
                net loss attributable to common stockholders
            
            $
            (7,949,000
            )
            $
            (3,636,000
            )Stock-based
                employee compensation determined under the fair value-based method,
                prior
                to the adoption of SFAS 123R
            
            
            (2,766,000
            )
            
            (1,121,000
            )Pro
                forma net loss attributable to common shareholders
            
            $
            (10,715,000
            )
            $
            (4,757,000
            )Loss
                attributable to common stockholders per share (basic and
                diluted):As
                reported
            
            $
            (0.09
            )
            $
            (0.05
            )Pro
                forma
            
            $
            (0.12
            )
            $
            (0.06
            )





F-14
 **Table
            of Contents**




**ON2
      TECHNOLOGIES, INC.**


**NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**


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




*(k)*
            *Stock-Based
                Compensation (continued)*





Stock
      based compensation expense recognized in the Statement of Operations was
      $1,554,000, $0 and $835,000 for the years ended December 31, 2006, 2005 and
      2004, respectively. Stock based compensation for the year ended December 31,
      2006 reflects stock options and restricted stock granted to employees and
      consultants and includes $128,000 for the extension of stock options for the
      Company’s former president and chief executive officer. Stock based compensation
      expense for the year ended December 31, 2004 reflects restricted stock granted
      to employees and directors.




The
      following table summarizes the activity of the Company’s stock options for the
      year ended December 31, 2006:





Shares
            
            Weighted
                Average
              Exercise
                Price
            
            Weighted
                Average
              Remaining
              Contractual
                Life
            
            Aggregate
              Intrinsic
                ValueNumber
                of shares under option:Outstanding
                at January 1, 2006
            
            
            10,299,000
            
            $
            0.98Granted
            
            
            1,820,000
            
            
            0.88Exercised
            
            
            (1,745,000
            )
            
            0.48Canceled
                or expired
            
            
            (877,000
            )
            
            0.68Outstanding
                at December 31, 2006
            
            
            9,497,000
            
            $
            1.07
            
            
            6.92
            
            $
            4,405,000Vested
                or expected to vest at December 31, 2006
            
            
            8,974,000
            
            $
            1.01
            
            
            6.54
            
            $
            4,162,000Exercisable
                at December 31, 2006
            
            
            8,433,000
            
            $
            1.09
            
            
            6.65
            
            $
            4,029,000


The
      aggregate intrinsic value of options exercised during the year ended December
      31, 2006 was $942,000.





The
      following summarizes the activity of the Company’s non-vested stock options for
      the year ended December 31, 2006:




Shares
            
            Weighted
                Average
              Grant
                Date
              Fair
                ValueNon-vested
                at January 1, 2006
            
            
            2,035,000
            
            $
            0.69Granted
            
            
            1,820,000
            
            
            0.88Cancelled
                or expired
            
            
            (867,000
            )
            
            0.67Vested
                during the period
            
            
            (1,924,000
            )
            
            0.73Non-vested
                at December 31, 2006
            
            
            1,064,000
            
            $
            0.72





F-15
 **Table
            of Contents**




**ON2
      TECHNOLOGIES, INC.**


**NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**


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




*(k)*
            *Stock-Based
                Compensation (continued)*





As
      of
      December 31, 2006, there was $400,000 of total unrecognized compensation cost
      related to non-vested share-based compensation arrangements granted under
      existing stock option plans. This cost is expected to be recognized over a
      weighted-average period of 1.14 years. The total grant date fair value of shares
      that vested during the year ended December 31, 2006 was $1,256,000.




The
      Company uses the Black-Scholes option-pricing model to determine the fair value
      of stock options. The weighted average grant date fair value of options granted
      during the years ended December 31, 2006, 2005 and 2004 at date of grant and
      the
      assumptions utilized to determine such values are indicated in the following
      table:




Year
                Ended December 31,2006
            
            2005
            
            2004Weighted
                average fair value at date of grant for options granted during the
                period
            
            $
            0.88
            
            $
            0.59
            
            $
            0.59Expected
                stock price volatility
            
            
            114
            %
            
            120
            %
            
            126
            %Expected
                life of options
            
            
            5
                years
            
            
            5
                years
            
            
            5
                yearsRisk
                free interest rates
            
            
            5.0
            %
            
            4.1
            %
            
            3.6
            %Expected
                dividend yield
            
            
            0
            %
            
            0
            %
            
            0
            %




*(l)*
            *Advertising
                costs*





The
      Company expenses advertising cost when incurred. Advertising expenses were
      $135,000, $115,000 and $40,000 for the years ended December 31, 2006, 2005
      and
      2004, respectively.





*(m)*
            *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). Diluted loss per share has not
      been
      presented separately since 24,427,000 potential common shares at
      December 31, 2006, 26,891,000 potential common shares at December 31,
      2005 and 33,047,000 potential common shares at December 31, 2004 are
      anti-dilutive for each of the periods presented.


F-16
 **Table
          of Contents**




**ON2
      TECHNOLOGIES, INC.**


**NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**


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





*(n)*
            *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 the allowance for doubtful accounts, the estimated value
      of the warrant derivative liability and the recoverability of intangible assets
      represent sensitive estimates subject to change.





*(o)*
            *Segment
                Reporting and customer
                concentration*





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, from which it earns 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.




Our
      customers typically represent digital communication and media companies,
      entertainment companies, telecommunication companies and third party resellers.
      For the year ended December 31, 2006, one customer accounted for 10% of the
      Company’s total revenue. For the year ended December 31, 2005, two
      customers accounted for 20% and 11% of the Company’s total revenue. For the year
      ended December 31, 2004, one customer accounted for 47% of the Company’s
      total revenue.




As
      of
      December 31, 2006, four customers accounted for 13%, 12%, 11% and 10% of
      total accounts receivable. As of December 31, 2005, four customers
      accounted for 20%, 18%, 11% and 11% of total accounts receivable.




The
      components of the Company’s revenue for the years ended December 31, 2006, 2005
      and 2004 are summarized as follows:




Year
                Ended December 31,2006
            
            2005
            
            2004License
                revenue
            
            $
            5,472,000
            
            $
            1,947,000
            
            $
            2,571,000Engineering
                services and support
            
            
            496,000
            
            
            155,000
            
            
            414,000Royalties
            
            
            604,000
            
            
            106,000
            
            
            43,000Total
            
            $
            6,572,000
            
            $
            2,208,000
            
            $
            3,028,000





For
      the
      years ended December 31, 2006, 2005 and 2004 foreign customers accounted
      for approximately 40%, 27% and 20%, respectively of the Company’s total revenue.
      These customers are primarily located in Asia.




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 revenue generated from the United Kingdom
      operations for the years ended December 31, 2006, 2005 and
      2004.


F-17
 **Table
          of Contents**


**ON2
        TECHNOLOGIES, INC.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**


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





*(p)*
            *Recently
                Issued Accounting
                Pronouncements*





In
      July
      2006, the FASB issued FASB Interpretation Number 48, *Accounting
      for Uncertainty in Income Taxes, an Interpretation of FASB Statement
      No. 109* ,
      (“FIN48”). FIN 48 prescribes a recognition threshold and measurement attribute
      for the financial statement recognition and measurement of a tax position taken
      in a tax return. The Company must determine whether it is “more-likely-than-not”
that a tax position will be sustained upon examination, including resolution
      of
      any related appeals or litigation processes, based on the technical merits
      of
      the position. Once it is determined that a position meets the
      more-likely-than-not recognition threshold, the position is measured to
      determine the amount of benefit to recognize in the financial statements. FIN
      48
      applies to all tax positions related to income taxes subject to FASB Statement
      No. 109, *Accounting
      for Income Taxes.* The
      Company will adopt the provisions of this statement beginning in the first
      quarter of 2007. The cumulative effect of applying the provisions of FIN 48
      will
      be reported as an adjustment to the opening balance of retained earnings on
      January 1, 2007. The Company does not anticipate that the adoption of this
      statement will have a material effect on our financial position or results
      of
      operations.




In
      September 2006, the Financial Accounting Standards Board (FASB) issued SFAS
      No. 158, “Employers’ Accounting for Defined Benefit Pension and Other
      Postretirement Plans—an amendment of FASB Statements No. 87, 88, 106, and
      132(R),” which requires employers to: (a) recognize in its statement of
      financial position an asset for a plan’s over funded status or a liability for a
      plan’s under-funded status; (b) measure a plan’s assets and its obligations
      that determine its funded status as of the end of the employer’s fiscal year;
      and (c) recognize changes in the funded status of a defined benefit
      postretirement plan in the year in which the changes occur. Those changes will
      be reported in comprehensive income of a business entity. The requirement to
      recognize the funded status of a benefit plan and the disclosure requirements
      are effective as of the end of the fiscal year ending after December 15,
      2006, for entities with publicly traded equity securities. The requirement
      to
      measure plan assets and benefit obligations as of the date of the employer’s
      fiscal year-end statement of financial position is effective for fiscal years
      ending after December 15, 2008. The Company currently has no Post
      Retirement Benefit Plan.




Also
      in
      September 2006, FASB issued SFAS No. 157, “ *Fair
      Value Measurements’* ”
which
      defines fair value, establishes a framework for measuring fair value in
      generally accepted accounting principles and expands disclosures about fair
      value measurements. This Statement is effective for financial statements issued
      for fiscal years beginning after November 15, 2007 and interim periods
      within those fiscal years. Earlier application is encouraged provided that
      the
      reporting entity has not yet issued financial statements for that fiscal year
      including financial statements for an interim period within that fiscal year.
      The Company believes that several accounts will be affected on the adoption
      of
      SFAS No. 157.




In
      February 2007, FASB issued SFAS No. 159, “The Fair Value Option for Financial
      Assets and Financial Liabilities” which provides companies with an option to
      report selected financial assets and liabilities at their fair values. The
      objective is to improve financial reporting by providing entities with the
      opportunity to mitigate volatility in reported earnings caused by measuring
      related assets and liabilities differently without having to apply complex
      hedge
      accounting provisions. This statement is effective as of January 1, 2008 for
      the
      Company. This Statement is expected to expand the use of fair value measurement.
      The Company is currently evaluating the affects of the adoption of SFAS No.
      159.


F-18
 **Table
            of Contents**




**ON2
      TECHNOLOGIES, INC.**


**NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**


(2)
            MARKETABLE
                SECURITIES





As
      of
      December 31, 2005 the Company held 2,119,000 shares of a customer’s common stock
      with a market value of $106,000, which were received as payment of license
      fees.
      On March 22, 2006 there was a 50/1 reverse stock split and the number of shares
      was reduced to 42,000. As of December 31, 2006, the market value of these shares
      decreased to $60,000 ($1.42 per share). 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). Included in interest and other income (expense) are unrealized losses
      of
      $46,000 and $339,000 for the years ended December 31, 2006 and 2005,
      respectively and a net gain on these securities of $95,000 for the year ended
      December 31, 2004. The Company’s former Chief Executive Officer (who was a
      director and shareholder of the Company) was a director of this
      customer.




In
      2006
      and 2005, the Company purchased short-term investments in the amounts of $94,000
      and $75,000, respectively. The fair value at December 31, 2006 and 2005 for
      these investments were the same as the carrying value. These investments are
      accounted for as held to maturity securities.





(3)
            PROPERTY
                AND EQUIPMENT





Property
      and equipment consists of the following:




December
                31,2006
            
            2005Furniture
                and fixtures
            
            $
            92,000
            
            $
            92,000Computer
                equipment
            
            
            2,538,000
            
            
            2,437,000Leasehold
                improvements
            
            
            24,000
            
            
            24,000Licensed
                software
            
            
            621,000
            
            
            607,0003,275,000
            
            
            3,160,000Less
                accumulated depreciation and amortization
            
            
            3,118,000
            
            
            3,029,000Total
            
            $
            157,000
            
            $
            131,000





As
      of
      December 31, 2006, property and equipment included assets under capital
      leases of $214,000 with related accumulated depreciation of $160,000. As of
      December 31, 2005, property and equipment included assets under capital
      leases of $156,000 with related accumulated depreciation of $136,000.
      Depreciation expense was $89,000, $73,000 and $115,000 for the years ended
      December 31, 2006, 2005 and 2004, respectively.




During
      the year ended December 31, 2006 the Company entered into a capital lease for
      $58,000 to purchase certain computer equipment and software. The lease has
      a
      three-year term with a $1.00 buyout, an effective interest rate of 9.25% and
      is
      secured by a certificate of deposit for $65,000 held by the leasing
      bank.


F-19
 **Table
          of Contents**




**ON2
      TECHNOLOGIES, INC.**


**NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**


(4)
            INTANGIBLE
                ASSETS




*Flix
      Acquisition*





On
      April
      29, 2005 the Company acquired certain assets related to the Flix software line
      of Wildform, pursuant to the terms of the Asset Purchase And Software License
      Agreement. Pursuant to the terms of the agreement, the Company acquired certain
      assets related to the Flix software and received a perpetual, irrevocable,
      royalty-free, sub-licensable license to use certain other intellectual property
      (the “Licensed Flix IP”) related to the Flix software. The Company also received
      a perpetual, irrevocable, royalty-free license to use certain web sales software
      (“E-Commerce Software”). In addition, the Company granted Wildform a perpetual
      license to use the purchased Flix assets and new versions of the Flix software
      in certain new software products being developed by Wildform in exchange for
      a
      payment of a royalty to the Company by Wildform.




In
      consideration for the purchased Flix assets and the license of the Licensed
      Flix
      IP and E-Commerce Software, the Company paid Wildform $1,215,000, $200,000
      of
      which was deposited in an escrow account that was maintained until April 30,
      2006, the one-year anniversary of the Closing Date as security for Wildform’s
      obligations under the Purchase Agreement and incurred $14,000 in associated
      costs.




The
      total
      acquisition cost of $1,229,000 was allocated as follows:


Acquired
                software
            
            $
            800,000Brand
                assets
            
            
            160,000Non-compete
                agreement
            
            
            25,000Goodwill
            
            
            244,000Total
            
            $
            1,229,000




The
      assets recognized with respect to acquired software, brand assets and the
      non-compete agreement are being amortized over their estimated lives of four
      years. Amortization expense related to these intangible assets was $246,000
      and
      $163,000 for the years ended December 31, 2006 and 2005,
      respectively.




The
      Company also entered into an eighteen-month agreement for support services
      from
      Wildform with respect to the Flix software.  Pursuant to such agreement,
      the Company paid $160,000 and issued 280,000 shares of common stock on April
      29,
      2006, which had a fair value of $258,000.  There are registration rights
      associated with the common stock, which contains liquidated damages if the
      Company fails to register such shares and maintain effectiveness of such
      registration.  The Company has determined that the fair value of the
      embedded derivative liability for the liquidated damages is nominal based on
      the
      expected probability of paying such damages.  The Company recognized
      expense over the eighteen-month term of the agreement, which ended in October
      2006, for the cash payment and common shares issued.




Had
      the
      Company acquired the Flix assets as of January 1, 2005 there would have been
      a
      nominal effect on revenue and expenses for the twelve months ended December
      31,
      2005 other than additional amortization of acquired intangibles of approximately
      $83,000.


F-20
 **Table
            of Contents**


**ON2
        TECHNOLOGIES, INC.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**


(5)
            ACCRUED
                EXPENSES





Accrued
      expenses consist of the following:




December
                31,2006
            
            2005Accrued
                compensation
            
            $
            112,000
            
            $
            243,000Accrued
                professional fees
            
            
            231,000
            
            
            80,000Other
                accrued expenses
            
            
            111,000
            
            
            285,000Total
            
            $
            454,000
            
            $
            608,000




(6)
            TERM
                LOAN





During
      June 2006 the Company obtained unsecured financing in the amount of $96,000
      to finance its directors’ and officers’ liability insurance. The financing
      arrangement is for nine months and runs through March of 2007 and provides
      for interest at an effective annual rate of 7.76%.




(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, 2006, the Company had net operating loss carry forwards for
      United States income tax purposes of approximately $87,827,000, and
      approximately $2,256,000 for United Kingdom purposes, which expire at various
      dates through 2026. As of December 31, 2006 and 2005, the Company had a deferred
      tax asset of approximately $37,762,000 and $35,779,000, respectively,
      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, 2006 and 2005 the principal timing difference
      between tax and financial reporting was due to certain compensation expenses
      not
      currently deductable for income tax purposes and depreciation and amortization
      expense. A full valuation allowance, which increased by $1,983,000, $1,862,000
      and $1,737,000 during the years ended December 31, 2006, 2005 and 2004,
      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
      income tax benefit has been recognized. The tax provisions of $30,000, $32,000
      and $2,000 for the years ended December 31, 2006, 2005 and 2004,
      respectively, relate primarily to various state and local taxes.


F-21
 **Table
          of Contents**




**ON2
      TECHNOLOGIES, INC.**


**NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**







(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 Secured 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 were secured by all property interests
      in
      the Company. The debentures were 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 required interest to be paid
      each November and May, which was 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.




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 fair value of the
      debentures, which amounted to $88,000, was recorded as debt discount and
      additional paid-in capital. The discount was amortized over the life of the
      debentures, which resulted in an effective interest rate of approximately
      9%.




As
      of
      December 31, 2006 the entire $650,000 of the Series A Secured Convertible
      Debentures were converted into 5,804,000 shares of the Company’s common stock.
      During 2005, 804,000 warrants were exercised and the Company received proceeds
      of $90,000. During 2004, 90,000 warrants were exercised and the Company received
      proceeds of $10,000. The amortization of the discount was $6,000, $14,000 and
      $21,000 for the years ended December 31, 2006, 2005 and 2004,
      respectively.





(9)
            STOCKHOLDERS’
                EQUITY





*(a)*
            *Preferred
                Stock*





The
      Company has 20,000,000 shares of preferred stock authorized for issuance and,
      through December 31, 2006, ten 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.


F-22
 **Table
          of Contents**




**ON2
      TECHNOLOGIES, INC.**


**NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**


(9)
            STOCKHOLDERS’
                EQUITY (continued





*(a)*
            *Preferred
                Stock (continued)*





**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 (the “Series A Preferred”), $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 was non-voting
      and was convertible at the holder’s option, at any time, into one share of
      Common Stock of the Company.




All
      of
      the Series A Preferred has been converted into shares of the Company’s Common
      Stock.





**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 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 an initial conversion price of
      $2.65 per share with a liquidation preference of $4,900,000 plus accrued and
      unpaid dividends; 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 protection.


F-23
 **Table
            of Contents**


**ON2
        TECHNOLOGIES, INC.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**


(9)
            STOCKHOLDERS’
                EQUITY (continued)





*(a)*
            *Preferred
                Stock (continued)*





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





Additionally,
      Travelers was provided with 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, 2003, the conversion price of the Series C-IV Preferred
      was adjusted to $1.7564 per share and the Company issued 236,000 additional
      warrants and the exercise price of the warrants was reduced to $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. As a result of the sale of common
      stock and warrants in August 2006 to a group of investors led by Midsummer
      Investment Ltd., the conversion price of the Series C-IV Preferred was
      further adjusted to $1.595 per share.




As
      of
      December 31, 2003, the conversion price of the Series C-V Preferred
      was adjusted to $0.9062 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.




At
      December 31, 2003, 2,177,000 shares of Series C-V Preferred Stock were
      outstanding. During the year ended December 31, 2004, 727,000 shares of
      Series C-V Preferred were converted into 1,000,000 shares of the Company’s
      Common Stock. During the year ended December 31, 2005 the remaining
      1,450,000 shares of Series C-V Preferred were converted into 2,040,000
      shares of the Company’s Common Stock.




**Series
      C-II Convertible Preferred Stock**




In
      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
      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.




All
      of
      the Series C-II Preferred has been converted into shares of the Company’s
      Common Stock.


F-24
 **Table
          of Contents**




**ON2
        TECHNOLOGIES, INC.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**


(9)
            STOCKHOLDERS’
                EQUITY (continued)





*(a)*
            *Preferred
                Stock (continued)*





**Series C-III
      Convertible Preferred Stock**





In
      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
      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, which was triggered by certain subsequent debt and equity financings
      consummated by the Company. All of the Series C-III Preferred has been
      converted into 2,614,000 shares of the Company’s Common Stock based on an
      adjusted conversion price of $0.9756 per share.




**Series C-VI
      Convertible Preferred Stock**




In
      2001,
      the Company 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 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”) was originally convertible on a one-for-one basis into shares
      of the Company’s Common Stock and subsequently due to anti-dilution the
      conversion price was reduced from $0.56 to $0.52. In addition, the Company
      issued to Travelers a warrant to purchase 5,357,000 shares of the Company’s
      Common Stock, at $0.56 per share, that could not be exercised for a period
      of
      six months.




At
      December 31, 2003, 1,139,000 shares of Series C-VI Preferred Stock were
      outstanding. During the year ended December 31, 2004 the remaining
      1,139,000 shares of Series C-VI Preferred were converted into 1,210,000
      shares of the Company’s Common Stock. During the year ended December 31,
      2004, the Company received proceeds of $753,000 from the exercise of 1,345,000
      warrants. During the year ended December 31, 2005, the Company received
      proceeds of $2,247,000 from the exercise of the remaining 4,012,000
      warrants.




**Series
      D Redeemable 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.


F-25
 **Table
          of Contents**




**ON2
      TECHNOLOGIES, INC.**


**NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**


(9)
            STOCKHOLDERS’
                EQUITY (continued)





*(a)*
            *Preferred
                Stock (continued)*




**Series
      D Redeemable Convertible Preferred Stock (continued)**





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
      registration right agreement provides for liquidated damages of 2% of the
      aggregate purchase price for the first month and 1% for each subsequent month
      if
      the Company failed to register the related common shares and maintain
      effectiveness of such registration. 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 of 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 00-27, 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 to the
      Series D Preferred and $1,482,000 to the warrants. The difference between
      the proceeds allocated to, and the fair value of the Series D Preferred, which
      amounted to $1,482,000 represents a beneficial conversion feature. The aggregate
      of the relative fair value of the Warrants and the beneficial conversion feature
      represents a convertible Preferred Stock deemed dividend. As of December 31,
      2004 the redemption value exceeded the market value of the common shares
      issuable upon conversion. Although the Series D Convertible Preferred Stock
      has
      stated redemption dates, the Company may, at its option, settle such redemptions
      by issuing common stock. Accordingly, $2,964,000 of deemed dividends and
      accretion of $189,000 of financing costs, (excluding $112,000 allocated to
      the
      warrants) were being recognized over the term of the Series D Preferred,
      including $120,000 and $14,000, respectively, in 2004. However as of September
      30, 2005, the fair market value of the Company’s common stock exceeded the
      conversion price and as a result, the remaining unamortized balance was
      recognized as a deemed dividend. Additionally, the unamortized balance of
      financing costs has been recognized as accretion during the year ended December
      31, 2005. The aggregate convertible preferred stock deemed dividend and
      accretion of costs for the year ended December 31, 2005 were $2,844,000 and
      $175,000, respectively.




During
      the year ended December 31, 2006, 523 shares of the Series D Preferred were
      converted into 750,000 shares of the Company’s Common Stock and 184 shares of
      the Series D Preferred were redeemed into 267,000 shares of the Company’s Common
      Stock. During the year ended December 31, 2005, 210 shares of Series D Preferred
      were converted into 300,000 shares of the Company’s Common
      Stock.


F-26
 **Table
            of Contents**


**ON2
        TECHNOLOGIES, INC.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**


(9)
            STOCKHOLDERS’
                EQUITY (continued)





*(a)*
            *Preferred
                Stock (continued)*




**Series
      D Redeemable Convertible Preferred Stock (continued)**





During
      the year ended December 31, 2006, the Company recorded dividends of $285,000
      on
      the Series D Preferred of which $264,000 was paid, by issuing 387,000 shares
      of
      the Company’s Common Stock and $5,000 was accrued. During 2005, the Company
      recorded dividends of $325,000 on the Series D Preferred of which $298,000
      was
      paid, by issuing 538,000 shares of the Company’s Common Stock and $27,000 was
      accrued.




During
      the year ended December 31, 2005, Midsummer Investment Ltd. and Islandia L.P.
      exercised all 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.




As
      a
      result of the sale of common stock and warrants in August 2006 to a group of
      investors led by Midsummer Investment Ltd., the conversion price of the
      Series D Preferred was adjusted to $0.6960 per share and the Company issued
      23,000 additional warrants and the exercise price of the warrants was reduced
      to
      $0.7541 per share.




The
      number of common shares issuable upon redemption is dependent upon a volume
      weighted average trade price of the Company’s common stock which is currently
      indeterminable and may exceed the number authorized at such time. Since
      obtaining stockholder approval to increase the authorized shares is not under
      the control of the Company, the Series D Preferred has been classified as
      temporary equity (mezzanine).




The
      Company accounts for the registration rights agreement as a separate
      freestanding instrument and accounts for the liquidated damages provision as
      a
      derivative liability subject to SFAS No. 133. The estimated fair value of the
      derivative liability is based on estimates of the probability and costs of
      cash
      penalties expected to be incurred and such estimates are revalued at each
      balance sheet date with changes in value recorded in other income. As of
      December 31, 2006 and 2005 the Company has estimated the fair values of these
      derivative liabilities to be nominal and accordingly no liability has been
      recorded. There were no changes to the estimated fair value during the years
      ended December 31, 2006, 2005 and 2004.




The
      following table summarizes the common stock issuable upon conversion of all
      outstanding Preferred Stock and the exercise of related warrants at
      December 31, 2006:




Convertible
                Security
            
            Conversion
                or Exercise Price per Share
            
            Shares
                of Common Stock Issuable upon Conversion/
              ExerciseSeries
                C-IV Preferred Stock
            
            $
            1.5950
            
            
            3,072,000Series
                D Preferred Stock
            
            $
            0.6960
            
            
            4,429,000Series
                D Warrant
            
            $
            0.7541
            
            
            3,017,000Total
            
            
            
            
            
            10,518,000





F-27
 **Table
            of Contents**




**ON2
      TECHNOLOGIES, INC.**


**NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**


(9)
            STOCKHOLDERS’
                EQUITY (continued)





*(b)*
            *Sale
                of CommonStock
                and Warrants*





In
      August
      2006, the Company completed the sale of 3,070,000 shares of its common stock
      with detachable, five-year warrants to purchase 2,303,000 shares of the
      Company’s common stock at an exercise price of $0.77, to two institutional
      investors, led by Midsummer Investments Ltd., and received net proceeds of
      $1,628,000.




In
      connection with the offering, the parties entered into a registration rights
      agreement. The registration rights agreement requires that the Company file
      a
      registration statement registering the securities sold in the offering and
      use
      its best efforts to have the registration statement declared effective on or
      before the date that is ninety days after the date on which the parties entered
      into the agreement. The registration rights agreement also provides for
      liquidated damages of 2% of the aggregate purchase price for the first month
      and
      1% for each subsequent month if the Company failed to register the related
      common shares and maintain effectiveness of such registration. The Company
      filed
      a registration statement with the Securities and Exchange Commission (“SEC”) on
      September 25, 2006 and an amendment thereto on October 30, 2006. The Company
      accounts for the registration rights agreement as a separate freestanding
      instrument and accounts for the liquidated damages provision as a derivative
      liability subject to SFAS No. 133. The estimated fair value of the derivative
      liability is based on estimates of the probability and costs of cash penalties
      expected to be incurred and such estimates are revalued at each balance sheet
      date with changes in value recorded in other income. As of December 31, 2006
      the
      Company has estimated the fair values of these derivative liabilities to be
      nominal and accordingly no liability has been recorded.




The
      warrants contain certain anti-dilution provisions and accordingly the Company
      accounted for the fair value of the warrants as a derivative liability (Warrant
      derivative liability) subject to SFAS No. 133. The fair value of the warrants
      issued, as calculated using the Black Scholes pricing model, was $1,251,000
      and
      represents


the
      portion of the proceeds from the financing that was attributed to the warrant
      derivative liability. The warrant fair value will be revalued at each balance
      sheet date, using the Black Scholes pricing model, with changes in value
      recorded in the statement of operations as income or expense. On December 31,
      2006 the warrant derivative fair value was $2,329,000 and the increase in value
      of $1,078,000 is included as an expense in interest and other income (expense),
      net. The Company paid financing costs in the amount of $122,000 of which $52,000
      is associated with the warrants, and is included in interest and other income
      (expense), net in the Company’s consolidated financial statements for the year
      ended December 31, 2006.


F-28
 **Table
          of Contents**




**ON2
      TECHNOLOGIES, INC.**


**NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**


(9)
            STOCKHOLDERS’
                EQUITY (continued)





*(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, 2005,
      including those issued in connection with Common Stock, Preferred Stock and
      Convertible Debentures. All warrants were exercisable as of December 31,
      2006.





Range
                of
              Exercise
                Prices
            
            Number
                of Warrants Outstanding
            
            Weighted
                Average Exercise Price
            
            Expiration
                Dates$
                0.11
            
            
            268,000
            
            $
            0.11
            
            
            2007$
                0.69 - $ 0.77
            
            
            5,511,000
            
            $
            0.76
            
            
            2009
                - 2011$
                1.43 - $ 1.68
            
            
            1,650,000
            
            $
            1.67
            
            
            20077,429,000
            
            $
            0.94
            
            
            2007
                -2011





In
      January 2006 the Company extended the expiration date of 1,600,000 warrants
      exercisable at $1.68 per share that were due to expire on January 29, 2006.
      As
      part of the agreement the expiration date was changed to December 31, 2006
      and a
      provision was added to require the holder to exercise of the warrants if the
      volume weighted average price of the Company’s common stock for ten consecutive
      trading days equals or exceeds $1.93 or forfeit the warrants. In December 2006
      the Company extended the expiration date of these warrants to December 31,
      2007
      and reduced the volume weighted average price requiring exercise to $1.83.
      There
      is no compensatory relationship with the warrant holder, who is also a common
      stockholder. The Company has accounted for the fair value of these modifications
      as financing costs. Accordingly, the Company has recognized an expense of
      $135,000 in December 2006 for the incremental fair value of the January 2006
      modification and has recorded a deferred financing cost of $106,000 as of
      December 31, 2006 for the incremental fair value of the December 2006
      modification.




During
      the year ended December 31, 2006 the Company received proceeds of $127,000
      and
      issued 202,000 shares of its common stock for the exercise of
      warrants.


F-29
 **Table
          of Contents**




**ON2
      TECHNOLOGIES, INC.**


**NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**


(9)
            STOCKHOLDERS’
                EQUITY (continued)





(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.




In
      May
      2005, the Company’s stockholders approved the On2 Technologies, Inc. 2005
      Incentive Compensation Plan (the “2005 Plan”). Pursuant to the Company’s 2005
      Plan, 7,000,000 shares of the Company’s Common Stock are reserved for issuance,
      as Performance Grants, Restricted Stock, Goal-Based Stock options, or Stock
      Appreciation rights. Options granted under the 2005 Plan may be incentive Stock
      Options or Nonstatutory Stock Options. Employees, including officers, of the
      Company and its subsidiaries are eligible to receive grants under the 2005
      Plan.
      The 2005 Plan also permits the award of only Nonstatutory Stock Options and
      Restricted Stock to directors on the On2 Board, if such directors are not
      employees of On2 and individuals who are consultants or advisors to On2. The
      2005 Plan is administered by the Compensation Committee, of the Board for all
      present and future employees of the Company and its subsidiaries. The Board
      will
      administer the 2005 Plan for outside directors and consultants, based upon
      recommendations by the Compensation Committee. The Compensation Committee has
      the authority to approve option grants and the terms, which include the option
      price and the vesting terms. Options granted under the 2005 Plan expire after
      an
      eight-year period


F-30
 **Table
          of Contents**




**ON2
      TECHNOLOGIES, INC.**


**NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**


(9)
            STOCKHOLDERS’
                EQUITY (continued)





(d)
            *Stock
                Options*(continued)





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





Options
                Granted
            
            Weighted
                Average
              Exercise
                PriceOutstanding
                January 1, 2004
            
            
            4,347,000
            
            $
            1.52Granted
            
            
            3,110,000
            
            
            0.68Exercised
            
            
            (275,000
            )
            
            0.24Canceled
            
            
            (1,350,000
            )
            
            1.30Outstanding
                December 31, 2004
            
            
            5,832,000
            
            $
            1.18Granted
            
            
            4,778,000
            
            
            0.71Exercised
            
            
            (116,000
            )
            
            0.35Canceled
            
            
            (195,000
            )
            
            076Outstanding
                at December 31, 2005
            
            
            10,299,000
            
            $
            0.98Granted
            
            
            1,820,000
            
            
            0.87Exercised
            
            
            (1,745,000
            )
            
            0.54Canceled
            
            
            (877,000
            )
            
            0.68Outstanding
                at December 31, 2006
            
            
            9,497,000
            
            $
            1.07Exercisable
                at December 31, 2005
            
            
            8,264,000
            
            $
            1.05Exercisable
                at December 31, 2006
            
            
            8,433,000
            
            $
            1.09Options
                available for grant at December 31, 2006
            
            
            1,012,000


F-31
 **Table
            of Contents**
  **ON2
        TECHNOLOGIES, INC.**
 **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**


(9)
            STOCKHOLDERS’
                EQUITY (continued)





(d)
            *Stock
                Options*(continued)





The
      following table summarizes information about stock options outstanding as of
      December 31, 2006





Options
                Outstanding
            
            Options
                ExercisableRange
                of Exercise Prices
            
            Number
              of
                Shares
            
            Weighted
                Average Exercise Price
            
            Weighted
                Average Remaining Contractual Life (in years)
            
            Number
              of
                Shares
            
            Weighted
                Average Exercise Price$
                0.14 - $ 0.46
            
            
            1,201,000
            
            $
            0.40
            
            
            5.8
            
            
            1,201,000
            
            $
            0.40$
                0.55 - $ 0.69
            
            
            3,249,000
            
            
            0.61
            
            
            7.2
            
            
            3,062,000
            
            
            0.61$
                0.70 - $ 0.88
            
            
            4,126,000
            
            
            0.83
            
            
            7.5
            
            
            3,249,000
            
            
            0.81$
                1.25 - $ 2.25
            
            
            512,000
            
            
            1.48
            
            
            6.1
            
            
            512,000
            
            
            1.48$
                2.27 - $ 3.88
            
            
            193,000
            
            
            3.44
            
            
            3.6
            
            
            193,000
            
            
            3.44$10.63
                - $ 11.81
            
            
            156,000
            
            
            11.58
            
            
            3.1
            
            
            156,000
            
            
            11.58$12.25
                - $ 25.00
            
            
            60,000
            
            
            16.60
            
            
            2.6
            
            
            60,000
            
            
            16.609,497,000
            
            $
            1.06
            
            
            6.9
            
            
            8,433,000
            
            $
            1.09







In
      December 2004, the Company’s then 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 of $0.57
      per
      share to other employees.




On
      May 2,
      2006, the Company entered into an agreement with Douglas A. McIntyre, the
      Company’s former Chairman, President and CEO, under which the parties agreed to
      extend the expiration date of 1,475,000 vested options to purchase the common
      stock of the Company, from May 2, 2006 to September 30, 2006. On September
      30,
      2006, the Company entered into a second agreement with Mr. McIntyre under which
      the parties agreed to extend the expiration date of the remaining 250,000 vested
      options to purchase the common stock of the Company, held by Mr. McIntyre from
      September 30, 2006 to March 30, 2007. The Company recorded a charge of $129,000
      related to the option extensions. The incremental fair value of the extensions
      were calculated using the Black-Scholes model.




The
      Agreements also contain a number of restrictions on Mr. McIntyre’s ability to
      exercise the Options and sell shares of Common Stock received upon such
      exercise, including an undertaking from Mr. McIntyre not to sell, or cause
      to be
      sold, more than a fixed number of shares of Common Stock in any one-week period,
      including by means of direct sales, acquisitions of put options, or other
      transactions with the effect of a short transaction.




The
      second Agreement contained a mandatory exercise provision providing that if,
      prior to the expiration of the Agreement if the volume weighted average price
      of
      the stock, for five consecutive trading days, equals or exceeds the price that
      is $0.15 greater than the exercise price of either option. During the year
      ended
      December 31, 2006, Mr. McIntyre exercised all of the 1,475,000 stock options
      and
      the Company received $760,000 in proceeds.


F-32
 **Table
          of Contents**




**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2006, 2005 AND 2004**





(9)
            STOCKHOLDERS’
                EQUITY (continued)





(d)
            *Stock
                Options*(continued)




In
      addition, during the year ended December 31, 2006 certain employees and former
      employees exercised 270,000 stock options and the Company received $181,000
      in
      proceeds.




On
      May 1,
      2006 the Company’s new CEO was granted 1,500,000 options to purchase the
      Company’s common stock at an exercise price of $0.90 per share. The options vest
      on various dates beginning on May 1, 2006 through May 8, 2008.




During
      the year ended December 31, 2006 the Company granted 110,000 shares of its
      restricted common stock to certain employees and consultants that had a fair
      value on the date of grant of $70,000, of which 25,000 shares vested in
      September 2006 and the remaining shares vest through August 2007. The
      unrecognized compensation costs and intrinsic value of these shares at December
      31, 2006 was $33,000 and $132,000, respectively.





(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, 2006:





Year
                ended December 31,
            
            Amount2007
            
            $
            165,0002008
            
            
            159,0002009
            
            
            62,0002010
            
            
            53,0002011
            
            
            53,0002012
            
            
            5,000Total
                minimum lease payments
            
            $
            497,000





Rent
      expense under operating leases was approximately $221,000, $202,000 and $170,000
      for the years ended December 31, 2006, 2005 and 2004,
      respectively.




*(b)*
            *Employment
                Agreements*





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


F-33
 **Table
          of Contents**




**ON2
      TECHNOLOGIES, INC.**


**NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**


(10)
            COMMITMENTS
                AND CONTINGENCIES (continued)




*(c)*
            *Litigation*




From
      time
      to time the Company has been named in 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.





*(d)*
            *Beijing
                E-world*





In
      June
      2003, we announced that we had licensed our VP5 and VP6 codecs to Beijing
      E-World Technology Co. Ltd. (E-World), a consortium of several Chinese consumer
      electronics manufacturers. Under the terms of two license agreements with
      E-world, we granted E-World a license to use our codecs in E-World’s Enhanced
      Versatile Disk (EVD) technology as well as other video products. E-world is
      developing EVD as a next-generation videodisk technology that is hoped will
      become the industrial standard for China for the recording and playback of
      video, audio and data. E-World did not pay certain minimum quarterly payments
      that we believed were due under its license agreements with us, and we commenced
      an arbitration proceeding seeking damages for E-World’s failure to perform. In a
      ruling issued March 10, 2005, the arbitrator rejected our claims that E-World
      had breached the agreements and also denied a request by E-World to declare
      that
      it had complied with its obligations under the agreements. The arbitrator
      further noted that agreements remained in effect and that the parties had a
      continuing obligation to work to jointly select and port On2’s software to two
      commercial DSPs for use in the EVD players. Despite the arbitrator’s
      expectations regarding completion of the porting work, On2 and E-world have
      not
      made significant progress on the porting.




(11)
            RELATED
                PARTY TRANSACTIONS





During
      the years ended December 31, 2006, 2005 and 2004, the Company retained a
      law firm to perform certain legal services on its behalf and incurred
      approximately $150,000, $13,000 and $38,000, respectively, for such legal
      services. A member of the Company’s board of directors is a partner at the law
      firm.




During
      the years ended December 31, 2006, 2005 and 2004, the Company retained a
      consulting firm to facilitate customer relationships in Asia and incurred
      approximately $0, $34,000 and $122,000, respectively, for such services. A
      consultant at the consulting firm became a director of the Company in August
      2003.




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




(12)
            SUBSEQUENT
                EVENTS





Subsequent
      to December 31, 2006, 562 shares of Series D Preferred were converted and
      redeemed into 683,000 shares of the Company’s Common Stock.




Subsequent
      to December 31, 2006, Travelers Indemnity Company converted 925,000 shares
      of
      the Series C-IV
      Preferred Stock into 1,536,000 shares of the Company’s common
      stock.


F-34
 **Table
          of Contents**




**ON2
      TECHNOLOGIES, INC.**


**NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**


(13)
            SELECTED
                QUARTERLY FINANCIAL DATA
                (UNAUDITED)





Quarterly
      financial data for fiscal 2006 and 2005 is as follows:




Quarter
                Ended 2006March
                31,
            
            June
                30,
            
            September
                30,
            
            December
                31,Revenue
            
            $
            1,217,000
            
            $
            1,535,000
            
            $
            1,703,000
            
            $
            2,117,000Gross
                profit
            
            
            634,000
            
            
            830,000
            
            
            1,174,000
            
            
            1,606,000Net
                loss
            
            
            (1,179,000
            )
            
            (1,549,000
            )
            
            (608,000
            )
            
            (1,510,000
            )Net
                loss attributable to common stockholders
            
            
            (1,252,000
            )
            
            (1,622,000
            )
            
            (750,000
            )
            
            (1,575,000
            )Basic
                and diluted net loss attributable to common stockholders per
                share
            
            $
            (0.01
            )
            $
            (0.02
            )
            $
            (0.01
            )
            $
            (0.02
            )






Quarter
                Ended 2005March
                31,
            
            June
                30,
            
            September
                30,
            
            December
                31,Revenue
            
            $
            353,000
            
            $
            346,000
            
            $
            507,000
            
            $
            1,002,000Gross
                profit (loss)
            
            
            (16,000
            )
            
            (64,000
            )
            
            37,000
            
            
            332,000Net
                loss
            
            
            (1,302,000
            )
            
            (1,141,000
            )
            
            (1,044,000
            )
            
            (1,118,000
            )Net
                loss attributable to common stockholders
            
            
            (1,585,000
            )
            
            (1,424,000
            )
            
            (3,742,000
            )
            
            (1,198,000
            )Basic
                and diluted net loss attributable to common stockholders per
                share
            
            $
            (0.02
            )
            $
            (0.02
            )
            $
            (0.04
            )
            $
            (0.01
            )




F-35
 **Table
          of Contents**




**ON2
      TECHNOLOGIES, INC.**


**NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **DECEMBER
        31, 2006, 2005 AND 2004**


ON2
      TECHNOLOGIES, INC.


SCHEDULE
      II - VALUATION AND QUALIFYING ACCOUNTS





Description
            
            Balance
                at
              Beginning
              Of
                Period
            
            Charged
                to
              Costs
                and
              Expenses
            
            Charged
                to
              Other
              Accounts
            
            Deductions
            
            Balance
                at
              End
                of
              PeriodYear
                ended December 31, 2006 allowance for doubtful accounts
            
            $
            13,000
            
            $
            117,000
            
            $
            —
            
            $
            (74,000
            )
            $
            56,000Year
                ended December 31, 2005 allowance for doubtful accounts
            
            $
            140,000
            
            
            
            
            $
            —
            
            $
            (127,000
            )
            $
            13,000Year
                ended December 31, 2004 allowance for doubtful accounts
            
            $
            15,000
            
            $
            125,000
            
            $
            —
            
            
            
            
            $
            140,000






F-36