**UNITED
      STATES SECURITIES AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**


**Form 10-K/A**


**(Amendment
      No. 3)**





(Mark
                One)x
            
            **ANNUAL
                REPORT PURSUANT TO SECTION 13 OR15(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 oAccelerated
      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


The
        aggregate market value of the voting and non-voting common equity held by
        stockholders of the registrant as of October 8, 2007, was approximately
        $172,493,000.




**(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:
        117,342,165 shares as of October 8, 2007.









**EXPLANATORY
      NOTE**





This
      Amendment No. 3 on Form 10-K/A amends our Annual Report on Form 10-K for the
      year ended December 31, 2006 originally filed on March 23, 2007 (“Original
      Annual Report”) and our Amendment No. 1 to our Annual Report on Form 10-K/A
      filed on April 30, 2007 (“Amendment No. 1”). (This Amendment No. 3 on Form
      10-K/A does not amend our Amendment No. 2 to our Annual Report on Form 10-K/A
      filed on May 10, 2007.) The purpose of this Amendment No. 3 on Form 10-K/A
      is to
      make the following amendments to the Original Annual Report and to Amendment
      No.
      1:





·
            Original
                Annual Report, Item 1 (Description of Business): In the second
                introductory paragraph of the “*Our Technology, Products and
                Services*” section and
                in the Encoding Tools for Customer Formats segment of that section,
                we correct an error in the percentage of 2005 revenue accounted for
                by the
                licensing of our Flash® encoding products. In the introductory paragraph
                of the “*Services*” section, we correct an error in the percentage
                of 2005 revenue accounted for by the provision of engineering, consulting
                and support services.





·
            Original
                Annual Report, Item 5 (Market for Common Equity and Related Stockholder
                Matters): In the Equity Compensation Plan Information December 31,
                2006
                table, we correct an error in the weighted-average exercise price
                of
                outstanding options, warrants and rights for equity compensation
                plans
                approved by security holders (and in the total for equity compensation
                plans whether or not so approved).





·
            Original
                Annual Report, Item 6 (Selected Financial Data): In the Statements
                of
                Operations Data table, we correct an EDGAR conversion error made
                by a
                third party EDGAR service provider in the “Basic and diluted net loss
                attributable to common stockholders per common share” line. Specifically,
                a number of cells in the line were shifted leftward resulting in
                incorrect
                net loss entries for 2004, 2005 and 2006 and a blank net loss entry
                for
                2003.





·
            Original
                Annual Report, Item 7 (Management’s Discussion and Analysis of Financial
                Condition and Results of Operations): In the Revenue segment of the
                “*Results of Operations*” section (narrative and, where applicable,
                table), we correct errors in (i) 2005 VPx license revenue and Flix®
                license revenue (and the sum of the two), (ii) the percentage of
                2005
                total sales revenue accounted for by license revenue, (iii) the percentage
                of 2005 total sales revenue accounted for by engineering services
                and
                support revenue and (iv) 2004 license revenue. In the eighth paragraph
                of
                the “*Liquidity and Capital Resources*” section, we correct an
                error in the financing cost amount associated with warrants sold
                in August
                2006 and discussed in that paragraph. In the “*Tabular Disclosure of
                Contractual Obligations*” section, we correct an error in operating
                lease for office space payments due in less than one year (and the
                totals
                for all operating lease for office space payments, for all payments
                due in
                less than one year, and for all payments for contractual
                obligations).




·
            Amendment
                No. 1, Item 11 (Executive Compensation): In the Summary Compensation
                Table, we correct the dollar amounts recognized for financial statement
                purposes for the fair value of option awards made in 2006 to Anthony
                Principe, Eric L. Ameres, Matthew Frost and Timothy C. Reusing (and
                the
                resulting total 2006 compensation for each such individual), and
                we
                correct the dollar amount recognized for financial statement purposes
                for
                the fair value of all other compensation paid in 2006 to Douglas
                A.
                McIntyre (and the resulting total 2006 compensation for such individual).
                In
                the Outstandig Equity Awards at 2006 Fiscal Year-End table, we correct
                the
                option exercise price of options granted to Anthony Principe on August
                26,
                2002. In the “*Potential Payments Upon Termination*” section,
                within the table pertaining to Eric Ameres, we correct the total
                amount
                payable to Mr. Ameres in the event of a non-extension of the term
                of his
                employment agreement by the Company.In the Non-Management Director
                Compensation for Fiscal 2006 table, we correct the dollar amount
                recognized for financial statement purposes for the fair value of
                option
                awards made in 2006 to J. Allen
                Kosowsky.


In
          order
          to preserve the nature and character of the disclosures made in the Original
          Annual Report and Amendment No. 1, except as specifically discussed in
          this
          Amendment No. 3 to the Annual Report on Form 10-K/A, no attempt has been
          made in
          this amendment to modify or update such disclosures for events which occurred
          subsequent to the original filings. This
          Amendment No. 3 to the Annual Report on Form 10-K/A does not otherwise
          alter the
          disclosures set forth in the Original Annual Report or Amendment No. 1
          and, in
          particular, does not alter management’s conclusions set forth in Item 9A
          regarding 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/A for the fiscal
          year
          ended December 31, 2006.


2




**Table
      of Contents**


**PART
                  I**Item
                  1.
              
              Description
                  of Business
              4**PART
                  II**Item
                  5.
              
              Market
                  for Common Equity and Related Stockholder Matters
              17Item
                  6.
              
              Selected
                  Financial Data
              22Item
                  7.
              
              Management’s
                  Discussion and Analysis of Financial Condition and Results of Operations
              23**PART
                  III**Item
                  11.
              
              Executive
                  Compensation
              32




3




**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.




4




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.




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).




5




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


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.




6




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





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




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.




7




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 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* ”.




8




**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% 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  encoding
      products has accounted for 64% and 59% 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.




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.





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.




10




***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%,
        59%,
        and 0% 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).




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%, 4% and 14% of our revenue for the years
      ended December 31, 2006, 2005 and 2004, respectively. In particular, we offer
      the following services:




11




***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  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.





12




**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.




13




**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.





14




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.  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.





15




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.





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.





16




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.




**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.




17





Equity
                Compensation Plan Information December 31, 2006Plan
                category
            
            Number
                ofsecurities
              to
                be issued
              upon exercise of
              outstandingoptions,
              warrants
                andrights
            
            Weighted-average
              exercise price of
              outstandingoptions,
              warrants
                andrights
            
            Number
                ofsecurities
              remainingavailable
                for
              future
                issuanceunder
              equitycompensationplans
              (excludingsecurities
              reflected
                incolumn (a))(a)
            
            (b)
            
            (c)Equity
                compensation plans approved by security holders
            
            
            16,926,000
            
            $
            1.01
            
            
            1,012,000Equity
                compensation plans not approved by security holders
            
            
            0
            
            
            0
            
            
            0Total
            
            
            16,926,000
            
            $
            1.01
            
            
            1,012,000




18




**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.*




19


**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.





20




*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.




*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.


21


**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
              
              $
              (0.05
              )
              $
              (0.09
              )
              $
              (0.05
              )
              $$
              (0.04
              )
              
              (0.11
              )


22




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  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.





23




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




*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.




24




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





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





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.




*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.





25




**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
        84%
        in 2005, while engineering services and support decreased to 8% in 2006 from
        11%
        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 $1,858,000, of which the Company’s VPx
      licenses were $597,000 and Flix licenses were $1,261,000. For the year ended
      December 31, 2004 license revenue was $2,571,000.





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
              %
              
              84
              %
              
              85
              %Engineering
                  services and support
              
              
              8
              
              
              11
              
              
              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 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.




26




*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.




27





*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 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.




28





*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.




*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.





29




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 $52,000 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.




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
              
              
              497,000
              
              $
              165,000
              
              
              275,000
              
              $
              53,000
              
              $
              4,000Total
              
              $
              558,000
              
              $
              193,000
              
              $
              308,000
              
              $
              53,000
              
              $
              4,000




30




**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  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.




31




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





**EXECUTIVE
      COMPENSATION**




**Compensation
      Discussion and Analysis**





**Overview
      of our Compensation Program**





The
      Compensation Committee oversees our executive compensation plans and general
      compensation and employee benefit plans, including incentive and equity-based
      plans. Information concerning the Compensation Committee, the scope of its
      authority and responsibilities, and its processes and procedures are described
      in the “Compensation Committee” section of the corporate governance
      discussion.





The
      individuals who served as our chief executive officer and our chief financial
      officer during fiscal year ended December 31, 2006, as well as the other
      individuals included in the Summary Compensation Table, are referred to in
      this
      proxy statement as the “Named Executive Officers.”





**Compensation
      Philosophy and Objectives**





Our
      compensation program for the Named Executive Officers is intended to attract,
      retain, motivate and appropriately reward talented executives who can contribute
      significantly to our financial growth and success, and thereby build value
      for
      our stockholders over the long term. The program has the following specific
      goals:





·
            To
                offer a total compensation package to the Named Executive Officers
                that is
                competitive in the marketplace for executive
                talent.





·
            To
                motivate the Named Executive Officers to achieve our business objectives
                by providing incentive compensation awards that take into account
                our
                overall performance and that measure performance against those business
                objectives.





·
            To
                provide equity-based, long-term compensation arrangements that create
                meaningful incentives for the Named Executive Officers to maximize
                our
                near and long-term future performance, that align their interests
                with our
                shareholders', and encourage the Named Executive Officers to remain
                with
                the Company.





To
      achieve these objectives, the Compensation Committee is developing certain
      processes for setting Named Executive Officer compensation and is constructing
      an overall compensation program that consists of a number of elements, as
      described below.




32




**Setting
      Executive Compensation**





*General
      Processes*





In
      establishing compensation of Named Executives, the Compensation Committee has
      relied heavily on the terms of existing employment agreements with executive
      officers to establish executive compensation. Those agreements were entered
      into
      before the Company had articulated its current compensation philosophy, and
      thus, do not fully reflect the compensation principles that the Committee has
      since established. As we renew our executives’ employment agreements, we will
      work to ensure that the terms of the agreements dovetail with our compensation
      philosophy.





The
      Compensation Committee intends to use certain performance measures as the bases
      for determining annual cash incentive compensation. The Compensation Committee
      intends for annual cash incentive compensation to be linked to attainment of
      specific target performance measures. The specific target performance measure
      for 2007 will be cash flow. Further, the Named Executive Officers will not
      receive a bonus unless we have positive cash flow, and the payment of bonuses
      may not result in negative cash flow for us.




Generally,
      the bonus for each Named Executive Officer will be based on a percentage of
      his
      salary. The minimum amount of cash incentive compensation that Named Executive
      Officer can achieve will be $0 and will increase up to 20% of the Named
      Executive Officer’s salary on a schedule as our cash flow increases up to a
      pre-determined target amount. Thereafter, the cash incentive compensation will
      be based on performance toward a second, higher target amount, up to a maximum
      amount of cash incentive compensation equal to 50% of the Named Executive
      Officer’s salary, again on a schedule that links actual cash flow achieved with
      percentage of salary payable as bonus. The Compensation Committee will make
      subjective determinations as to the cash flow performance targets that must
      be
      attained for the Named Executive Officers to earn each of the two tiers of
      cash
      incentive compensation. In addition to this programmatic approach, the committee
      retains the discretion to grant cash bonuses as necessary to account for special
      circumstances or extraordinary individual or company performance.





The
      Compensation Committee intends annually to review and benchmark the total
      compensation program for the Named Executive Officers against relevant market
      data. The Compensation Committee anticipates retaining James Reda to assist
      in
      the benchmarking process, which will involve a comparison of various components
      of total compensation against a peer group of publicly traded companies (the
      “Peer Group”). The Compensation Committee has selected the Peer Group companies
      based on their similarities to us in revenue, earnings and capital and
      management structures, and the Board has adopted the Peer Group based on the
      Compensation Committee’s recommendation. The Compensation Committee included in
      the Peer Group some companies that, because of their recent acquisition or
      changes in ownership structure, have recently ceased to be publicly traded.
      The
      Peer Group will be reviewed periodically by the Compensation Committee and
      Board
      and updated as necessary to maintain comparability, including to remove those
      companies that have recently ceased to be publicly traded. The companies
      currently composing the Peer Group are:


·
              Audible
                  Inc.·
              Broadcaster
                  Inc.·
              CaminoSoft
                  Corp.·
              DG
                  FastChannel Inc.·
              DivX,
                  Inc.·
              eGames
                  Inc.·
              Global
                  Entertainment Holdings/Equities
  33
  ·
              Loudeye
                  Corp.·
              OpenTV
                  Corp.·
              SmartVideo
                  Technologies, Inc.·
              Sonic
                  Foundry, Inc.·
              SRS
                  Labs, Inc.·
              TouchStone
                  Software Corp.·
              VitalStream
                  Holdings, Inc.·
              Wizzard
                  Software Corp.


The
      Compensation Committee will compare its executive compensation programs as
      a
      whole to those maintained by the members of the Peer Group to determine whether
      our programs are reasonable in the aggregate. In addition, the Compensation
      Committee will compare the pay of its individual Named Executive Officers with
      that of executives of the Peer Group companies who hold functionally comparable
      positions.





*Allocating
      Between Different Types of Compensation*





The
      Compensation Committee believes that executive compensation should include
      a mix
      of different types of compensation and takes this consideration into account
      when structuring the total compensation for each Named Executive Officer. The
      allocation among different types of compensation is based on the employment
      agreement with the Named Executive Officer, where such agreements exist. Within
      the parameters set by the employment agreements, if any, the Compensation
      Committee intends to reward recent performance and create incentives for
      long-term enhancements in shareholder value. For example, the Compensation
      Committee allocates a portion of each Named Executive Officer’s total
      compensation to an annual variable compensation program that links the amount
      of
      bonus pay directly to the annual performance of On2. This is achieved through
      our annual cash incentive plan, which is further described below. In setting
      the
      amounts potentially payable under the annual cash incentive plan, the
      Compensation Committee takes into account other annual cash compensation payable
      to each Named Executive Officer and how that compensation compares to the amount
      of annual cash compensation paid by companies in the Peer Group. In setting
      the
      terms of the future employment agreements and when setting future compensation,
      the Compensation Committee anticipates setting total annual cash compensation
      in
      the middle percentile of the Peer Group for performance that meets our annual
      business objectives and between the 50 th and
      80 th percentile of the Peer Group for performance that substantially exceeds annual
      business objectives.




The
      Compensation Committee also seeks to allocate a portion of total compensation
      to
      long-term, equity-based compensation. Equity-based compensation is designed
      to
      motivate the creation of long-term shareholder value and simultaneously enhance
      executive retention. The Compensation Committee typically uses stock options
      because this form of equity compensation provides the executive with value
      only
      if the price of our stock when the option is exercised exceeds the option’s
      exercise price. This provides an incentive to increase stock price over the
      term
      of the option. To enhance retention goals and provide balance with stock
      options, the Compensation Committee may also grant restricted stock. The
      Compensation Committee anticipates that long-term, equity based compensation
      will constitute a larger percentage of each Named Executive Officer’s total
      compensation in future years as the Compensation Committee has additional
      opportunity to structure appropriately targeted awards of this
      type.





*Role
      of Executive Officers in Compensation Decisions*





Decisions
      on the compensation of the chief executive officer are made by the Compensation
      Committee. Compensation decisions on the other Named Executive Officers are
      made
      by the chief executive officer, pursuant to guidelines established by the
      Compensation Committee. Decisions regarding non-equity compensation of employees
      who are not Named Executive Officers are made by our chief executive officer
      in
      consultation with other members of management and the Compensation Committee.
      The chief executive officer, in consultation with the Compensation Committee,
      annually reviews the performance of the other Named Executive Officers. The
      Compensation Committee may exercise discretion to modify any recommended salary
      adjustment or award as it deems appropriate under the
      circumstances.


34


**2006
      Executive Compensation Components**





For
      the
      2006 fiscal year, the principal components of compensation for the Named
      Executive Officers were:





·
            base
                salary;





·
            performance-based
                incentive compensation; and





·
            long-term
                equity incentive compensation.





In
      addition, employment agreements with three of our Named Executive Officers
      provide for certain potential payments upon termination of employment for a
      variety of reasons, as well as certain payments and benefits during the
      executive’s employment. The Compensation Committee does not currently believe
      that perquisites, such as club memberships or automobile allowances, have a
      significant role to play in executive compensation. Each of the elements of
      the
      executive compensation program is discussed in the following paragraphs.





*Base
      Salary*





Base
      salaries are designed to compensate the Named Executive Officers for faithful
      execution of their individual responsibilities. The base salaries of the chief
      executive officer, executive vice president and chief technology officer, and
      the executive vice president and general counsel are set forth in the applicable
      employment agreement with the executive. The employment agreement of the chief
      executive officer will expire on May 1, 2008. The employment agreement of the
      executive vice president and general counsel will expire on February 8, 2008.
      The employment agreement of the executive vice president and chief technology
      officer will expire on September 15, 2009. When we enter into new or amended
      employment agreements with such Named Executive Officers, or if we enter into
      an
      employment agreement with another executive officer, the Compensation Committee
      will review the base salaries and adjust them based on a number of relevant
      factors. During its review of base salaries, the Compensation Committee
      primarily considers the following:





·
            relevant
                market data developed in connection with the benchmarking process
                described above;





·
            the
                executive’s role and
                responsibilities;





·
            and,
                in cases of renewal, the past performance of the
                executive.




35




Of
      the
      factors described above, primary consideration will be given to relevant market
      data in setting base salaries because the Compensation Committee believes that
      base compensation for executives should be close to the fiftieth percentile
      of
      the peer group and that upside potential in total compensation is achieved
      through the performance-based and long-term incentive compensation programs.
      Factors, other than those listed above, that may cause the Compensation
      Committee to deviate from the benchmarking salary data include an executive’s
      experience in a particular role, retention concerns, and the Compensation
      Committee’s judgment based on an executive’s leadership qualities, career with
      us, and long-term potential to enhance shareholder value.





Base
      salaries for other Named Executive Officers are set by the chief executive
      officer, within the guidelines established by the Compensation Committee. Those
      guidelines are based on the salaries set by the Compensation Committee for
      those
      Named Executive Officers that have employment agreements with us.




In
      setting base salaries for the chief executive officer in 2006, the Compensation
      Committee primarily relied upon the assistance of the executive search firm
      that
      assisted us in locating a suitable replacement for the chief executive officer
      who resigned in 2006. The data relied upon included the base salaries and total
      compensation for recently placed chief executive officers in technology business
      of similar size and lifestage.





*Annual
      Cash Incentive Compensation*





Our
      annual cash incentive plan is designed to reinforce the importance of both
      teamwork and individual initiative and effort, and to provide an incentive
      for
      employees to achieve and surpass targeted performance goals. As described below,
      bonuses to officers are based on a percentage of salary and are linked to
      metrics established by the Board. Bonuses to other employees are payable from
      a
      bonus pool that is budgeted for at the beginning of the fiscal year and are
      based on individual performance or achievement of technical goals. ****





For
      2007,
      the annual bonus amount for Named Executive Officers will be based on one or
      more Company-wide performance measures. The specific target performance measure
      for 2007 will be cash flow, that is, revenue minus operating expenses. Under
      the
      plan, Named Executive Officers will not receive a bonus unless we have positive
      cash flow, and the payment of bonuses may not result in negative cash flow
      for
      us.





Generally,
      the bonus for each Named Executive Officer will be based on a percentage of
      the
      participant’s base salary. This year, the minimum threshold for cash incentive
      compensation will be $0 and will increase up to 20% of the Employee/Named
      Executive Officer’s salary as our cash flow increases up to a pre-determined
      target amount. Thereafter, the cash incentive compensation will be based on
      performance toward a second, higher target amount, up to a maximum amount of
      cash incentive compensation equal to 50% of the Employee/Named Executive
      Officer’s salary.





Each
      year, the Compensation Committee will consider how to structure performance
      measures to ensure that the amount of the cash incentive potentially payable
      under the plan is properly aligned with our business objectives and strategic
      initiatives. As noted above, for 2007, the Compensation Committee has determined
      that cash flow is the primary financial measure that should be used to measure
      performance with regard to the annual cash incentive compensation plan.





The
      annual bonus amount paid in 2006 was for the 2005 year. Eric Ameres received
      a
      discretionary bonus of $9,000 and Tim Reusing received a discretionary bonus
      of
      $10,000. None of our other Named Executive Officers received annual cash
      incentive compensation during 2006 for their performance during the 2005 year.
      The amounts of the cash incentive compensation paid for the 2005 year reflected
      the Company’s continued negative cash flow situation.




36




Company-wide
      performance measures for the 2006 cash incentive plan were not defined prior
      to
      the end of 2006. The Compensation Committee intended to establish the target
      performance levels for 2006 based on a budget target. The 2006 plan funding
      was
      based on base salaries for all eligible employees as of December 31, 2006.
      The
      level of total funding for the plan for 2006 was determined during conversations
      between the Board and the Chief Executive Officer regarding the Company's
      performance in 2006.





*Long-Term
      Equity Incentive Compensation*





Consistent
      with our compensation philosophy, long-term equity incentives are an important
      component of each Named Executive Officer’s total compensation package. We have
      generally awarded stock options to the Named Executive Officers and other key
      management employees. These stock option awards are designed to:




·
            reward
                and encourage long-term contribution to the
                Company




·
            align
                executives' interests with the interests of
                shareholders;




·
            help
                achieve competitive levels of total
                compensation.





During
      2006, the Company only awarded long-term equity compensation only to Mr. Joll
      and Mr. Frost. Mr. Joll was awarded options to purchase 1,350,000 shares of
      common stock at an exercise price of $.90 per share. The options were issued
      to
      Mr. Joll in connection with the commencement of his employment with the Company.
      The options vested in one installment of 333, 334 shares on May 1, 2006, one
      installment of 333,333 shares on November 8, 2006, with the remainder to vest
      in
      one installment of 333,333 shares on May 8, 2007 and one installment of 500,000
      shares on May 8, 2008.





Mr.
      Frost
      was awarded options to purchase 75,000 shares of common stock at an exercise
      price of $0.82 per share. The options were issued to Mr. Frost in connection
      with his promotion to General Counsel. The options vested in one installment
      of
      37,500 shares on April 3, 2006 and one installment of 37,500 shares on February
      28, 2007.





The
      Compensation Committee intends to determine stock option award levels based
      on
      consideration of a number of factors, including discussions with the chief
      executive officer and other executives. For 2006, stock option awards were
      approved in the first quarter of 2007 and will be granted in the second quarter
      of 2007. However, newly appointed or promoted executives or management personnel
      may receive an additional stock grant at other times during the year.





Grants
      are not directly connected to an executive’s salary or bonus. Grants of stock
      options or restricted stock awards will usually be subject to less dramatic
      variation than cash incentive compensation. For instance, in a year when an
      executive’s performance evaluation was good, he might receive an equity award
      that is slightly larger than that received by other executives. But if, in
      that
      same year, our financial performance did not meet targets, then the executive
      would not receive a bonus. If, however, in the following year, the executive’s
      performance evaluation was again good and our financial performance exceeded
      targets, then the executive would receive an equity award that, while higher
      than other executives’, was approximately the same as in the previous year. On
      account of our financial performance in that year, however, he would also
      receive a bonus; like the award of equity, that bonus would also be adjusted
      upward because of the employee’s exceptional performance.





Grants
      will generally be awarded during the first quarter of the fiscal year in order
      to coincide with the timing of annual reviews and compensation determinations,
      and because our fiscal year-end results have generally been announced by this
      time. Equity awards are awarded under our 2005 Incentive Compensation Plan,
      which requires that the option exercise price be based on the average of the
      high and low price of our common stock on the trading day preceding the date
      the
      option is granted. The Compensation Committee does not grant options with an
      exercise price that is less than the fair market value of our common stock,
      as
      determined according to the 2005 Incentive Compensation Plan, or grant options
      which are priced on a date other than the grant date, unless for some reason
      the
      date proceeding the date is not a trading date, in which case the average of
      the
      high and low price of our common stock on the preceeding trading day is
      used.




37




*Retirement
      and Other Benefits*





We
      maintain a tax-qualified Section 401(k) savings plan available to all of our
      employees, including the Named Executive Officers. The plan provides a matching
      contribution equal to 100% of an employee’s contributions, up to a maximum
      contribution of $1,000. All contributions to the Section 401(k) savings plan,
      including the matching contributions, are fully-vested upon
      contribution.





Our
      other
      benefit plans primarily include medical and other health care benefits, group
      life insurance, disability and tuition assistance. The Compensation Committee
      has reviewed these other components of compensation in relation to the total
      compensation of the Named Executive Officers, and determined that they are
      reasonable and appropriate.





We
      do not
      maintain any defined benefit pension plans or any nonqualified deferred
      compensation arrangements.





*Perquisites
      and Other Personal Benefits*





We
      do not
      provide the Named Executive Officers with any perquisites or other similar
      personal benefits and the Compensation Committee does not currently believe
      that
      perquisites, such as club memberships or automobile allowances, have a
      significant role to play in executive compensation.





*Employment
      Agreements*





Mr.
      Joll,
      Mr. Ameres and Mr. Frost are parties to employment agreements with us. Each
      of
      these agreements provides for certain payments and other benefits if the
      executive’s employment terminates under specified circumstances, as well as
      certain payments and benefits during the executive’s employment. The
      Compensation Committee believed that these employment arrangements were an
      important part of our overall executive compensation program at that time
      because they served as a recruitment and retention device. However, the
      Compensation Committee has not determined that it is necessary to enter into
      employment agreements with other executives at this time. More information
      concerning these employment agreements is contained in the “Employment
      Agreements” section and in the “Potential Payments Upon Termination”
section.





**COMPENSATION
      COMMITTEE REPORT**





The
      Compensation Committee oversees On2’s executive compensation program on behalf
      of the Board. In fulfilling its oversight responsibilities, the Compensation
      Committee reviewed and discussed with On2 management the Compensation Discussion
      and Analysis set forth in this proxy statement. Based on such review and
      discussions, the Compensation Committee recommended to the Board that the
      Compensation Discussion and Analysis be included in this proxy
      statement.




James
                Meyer, ChairmanMichael
                Alfant




38




**SUMMARY
      COMPENSATION TABLE**





The
      following table provides summary information regarding compensation earned
      by
      the Named Executive Officers during the fiscal year ended December 31,
      2006.


**Name
                  and Principal**
                **Position**
              
              **Year**
              
              **Salary**
              
              **Bonus**
              
              **Option**
                **Awards****2**
              
              **All Other**
                **Compensation****3******
              
              **Total**Douglas
                  A. McIntyre
                Chief
                  Executive Officer,President
                  and Chairman, Former
              
              
              2006
              
              $
              36,000
              
              $
              175,000
              
              
              
              
              $
              56,0005
              
              $
              267,000James
                  Meyer
                Interim
                  Chief Executive Officer, Former4
              
              
              2006
              
              $
              109,000
              
              
              
              
              
              
              
              
              
              
              
              109,000Bill
                  Joll
                Chief
                  Executive Officer and President1
              
              
              2006
              
              $
              211,000
              
              
              
              
              $
              784,000
              
              
              
              
              
              995,000Anthony
                  Principe
                Executive
                  Vice President and Chief Financial Officer
              
              
              2006
              
              $
              120,000
              
              
              
              
              
              35,000
              
              
              1,000
              
              
              156,000Eric
                  L. Ameres
                Executive
                  Vice Presidentand
                  Chief Technology Officer
              
              
              2006
              
              $
              190,000
              
              $
              9,000
              
              
              63,000
              
              
              1,000
              
              
              263,000Matthew
                  Frost
                Executive
                  Vice President and General Counsel
              
              
              2006
              
              $
              179,000
              
              
              
              
              
              76,000
              
              
              1,000
              
              
              256,000Timothy
                  C. Reusing
                Executive
                  Vice President - Legal and Business Affairs, Former
              
              
              2006
              
              $
              233,000
              
              $
              10,000
              
              
              62,000
              
              
              1,000
              
              
              306,000




1 Mr. Joll
      commenced employment on May 8, 2006 at an annual base salary of $325,000. His
      salary for 2006 was prorated to reflect his employment for only the relevant
      portion of the year.





2 This
      column represents the dollar amount recognized for financial statement reporting
      purposes with respect to the 2006 fiscal year for the fair value of stock
      options granted to each of the Named Executive Officers in 2006 as well as
      prior
      fiscal years, determined in accordance with SFAS 123R. The amounts shown exclude
      the impact of estimated forfeitures related to service-based vesting conditions.
      For additional information on the valuation assumptions with respect to the
      2006
      grants, refer to note 1(k) of our financial statements in the Form 10-K for
      the
      year ended December 31, 2006, as filed with the SEC. See the Grants of
      Plan-Based Awards Table at page 12 for information on options granted in 2006.
      These amounts reflect our accounting expense for these awards, and do not
      correspond to the actual value that may be recognized by the Named Executive
      Officers. Options awarded to Mr. Joll during the 2006 fiscal year were granted
      on May 1, 2006. Options awarded to Mr. Frost during the 2006 fiscal year were
      granted on April 3, 2006.




39




3 See the
      All Other Compensation Table for additional information.





4 Mr.
      Meyer also received compensation in 2006 for his service on On2’s Board of
      Directors. See page 19.





5 Mr.
      McIntyre received this compensation for consulting services provided after
      termination of his employment as President, Chairman and Chief Executive
      Officer.





**All
      Other Compensation Table**





The
      All
      Other Compensation in the Summary Compensation Table reports the company
      matching contributions to the named executive’s section 401(k) savings plan
      account of up to $1,000 (subject to the limitations imposed by
      law).





**GRANTS
      OF PLAN-BASED AWARDS IN 2006**





The
      following table provides information about equity and non-equity awards granted
      to the Named Executive Officers in 2006. This information includes (1) the
      grant
      date of the award; (2) the estimated payouts under non-equity incentive plan
      awards, which consist of the potential payout levels under the 2006 annual
      performance-based incentive plan; (3) the number of shares underlying restricted
      stock awards; (4) the number of shares underlying stock option awards; (5)
      the
      exercise price of the stock option awards, based on closing price of our common
      stock on the date of grant and (6) the grant date fair value of each equity
      award, computed under SFAS 123R.




**Name**
            
            **Grant**
              **Date**
            
            **All Option Awards:**
              **Number of Securities**
              **Underlying Options**1
            
            **Exercise or Base**
              **Price of Option**
              **Awards)****2**
            
            **Grant Date Fair Value**
              **of Stock and Option**
              **Awards****3**Douglas
                A. McIntyre
            
            
            
            
            
            —James
                Meyer
            
            
            
            
            
            —Bill
                Joll
            
            
            May****9,****2006
            
            
            1,500,000
            
            $
            0.90
            
            $
            1,114,000Anthony
                Principe
            
            
            
            
            
            —Eric
                L. Ameres
            
            
            
            
            
            —Matthew
                Frost
            
            
            April****3,****2006
            
            
            75,000
            
            $
            0.82
            
            $
            51,000Timothy
                Reusing
            
            
            
            
            
            —




40




1 This
      column shows the number of stock options granted in 2006 to the Named Executive
      Officers. The 1,500,000 options issued to Mr. Joll vested in one installment
      of
      333, 334 shares on May 1, 2006, one installment of 333,333 shares on November
      8,
      2006, with the remainder to vest in one installment of 333,333 shares on May
      8,
      2007 and one installment of 500,000 shares on May 8, 2008. The options issued
      to
      Mr. Frost vested in one installment of 37,500 shares on April 3, 2006 and one
      installment of 37,500 shares on February 28, 2007.





2 This
      column shows the exercise price (per share) for the stock options granted,
      which
      was the average of the high and low prices of a share of our common
      stock **** on
      the
      last date on which our stock was traded prior to the date on which the
      Compensation Committee granted the options.





3 This
      column shows the full grant date fair value of stock options under SFAS 123R
      granted to each of the Named Executive Officers in 2006. Generally, the full
      grant date fair value is the amount that we would expense in our financial
      statements over the award’s vesting schedule. For stock options, fair value is
      calculated using the Black-Scholes option-pricing model which takes into account
      volatility in the price of our stock, the risk-free interest rate, the estimated
      life of the award, the closing market price of our stock on the date of grant
      and the exercise price. For additional information on the valuation assumptions,
      refer to note 1(k) of our financial statements in the Form 10-K for the year
      ended December 31, 2006, as filed with the SEC. These amounts reflect our
      accounting expense, and do not correspond to the actual value that may be
      recognized by the Named Executive Officers.





**Narrative
      to Summary Compensation Table and Plan-Based Awards Table**





*Employment
      Agreements.* During
      2006, Mr. Joll, Mr. Ameres and Mr. Frost were employed pursuant to employment
      agreements with us .
      Each
      agreement specifies the Named Executive Officer’s base salary, annual bonus
      opportunity, benefits during employment and post-termination benefits. The
      employment agreements also impose on each Named Executive Officer certain
      obligations following termination of their employment.





Mr. Joll’s
      employment agreement has an initial term that ends on May 7, 2008. The term
      will
      be automatically extended thereafter for a one-year term unless either party
      provides notice of non-extension at least ninety days prior to the expiration
      of
      the original term. Mr. Joll’s agreement provides for an initial base salary
      of $325,000. The agreement provides for a discretionary bonus for the fiscal
      year ending December 31, 2006, ranging from 33% of base salary based on
      attainment of an agreed-upon budget to 67% of base salary. A threshold budget
      was adopted by the Compensation Committee after the end of the 2006 fiscal
      year;
      the target budget specified under the Agreement that would have entitled Mr.
      Joll to receive the 67% bonus was achievement of positive earnings before
      interest, taxes, depreciation and amortization. We did not achieve positive
      earnings before interest, taxes, depreciation and amortization in fiscal 2006,
      so the discretionary bonus of 33% of base salary, $107,250, will be paid to
      Bill
      Joll based upon the budget adopted by the Compensation Committee at the end
      of
      the 2006 fiscal year.





Pursuant
      to the agreement with Mr. Joll, we granted to him options to purchase 1,500,000
      shares of our common stock at an exercise price of $.90 per share. The options
      vested in one installment of 333,334 shares on May 1, 2006, one installment
      of
      333,333 shares on November 8, 2006, with the remainder to vest in one
      installment of 333,333 shares on May 8, 2007 and one installment of 500,000
      shares on May 8, 2008. The exercise price of $0.90 for the stock options granted
      was the average of the high and low price of our common stock on April 28,
      2006,
      the trading day preceeding the date on which the Compensation Committee approved
      the grant of the options.





In
      addition, the agreement also entitles Mr. Joll to participate in employee
      benefit plans which are available to our other senior executives, annual
      vacation and reimbursement of reasonable travel and other business
      expenses.




41




Mr.
      Frost’s employment agreement has an initial term that ends on February 28, 2008.
      The term may be extended upon our agreement with Mr. Frost. Mr. Frost’s
      agreement provides for an annual base salary of $182,500 per year and an annual
      discretionary bonus pursuant to the bonus plan available to the most senior
      members of our management. Mr. Frost also received stock options to purchase
      75,000 shares of our common stock, to be granted under our 2005 Incentive
      Compensation Plan. One-half of the options vested on March 8, 2006, the date
      of
      grant, and the other half of the options vested on February 28, 2007. The
      exercise price was $0.82, which was the average of the high and low price of
      our
      common stock on March 31, 2006, the trading day preceeding the date on which
      the
      Compensation Committee granted the options. The agreement also provides that
      Mr.
      Frost is entitled to participate in employee benefit plans which are available
      to our other senior executives, annual vacation and reimbursement of reasonable
      business expenses.





Mr.
        Joll,
        Mr. Ameres and Mr. Frost are entitled to certain payments and benefits under
        their employment agreements if they are terminated by us without cause. For
        additional information concerning these payments and benefits, see Potential
        Payments Upon Termination on page 46.





*Salary
      and Cash Incentive Awards in Proportion to Total Compensation.* As noted
      in the Compensation Discussion and Analysis, the Compensation Committee believes
      that a portion of each Named Executive Officer’s compensation should be in the
      form of equity awards; however, the Compensation Committee awarded very little
      cash incentive compensation and long-term equity incentive compensation as
      a
      result of the Company’s continued negative cash flow in 2005. The following
      table sets forth the percentage of each Named Executive Officer’s total
      compensation that was paid in the form of base salary and cash incentive award
      under the 2006 performance-based incentive plan. The Compensation Committee
      anticipates that salary and cash incentive awards will constitute a smaller
      percentage of each Named Executive Officer’s total compensation in future years
      as the Compensation Committee has additional opportunity to structure
      appropriately targeted long-term equity-based incentive awards, such as stock
      options and restricted stock and the Company achieves
      profitability.




**Name**
            
            **Percentage of**
              **Total**
              **Compensation**Douglas
                A. McIntyre
            
            
            100
            %James
                Meyer
            
            
            100
            %Bill
                Joll
            
            
            21
            %Anthony
                Principe
            
            
            100
            %Eric
                Ameres
            
            
            100
            %Matthew
                Frost
            
            
            80
            %Timothy
                C. Reusing
            
            
            100
            %





As
      described above, we have moved from a practice of awarding cash bonuses and
      equity compensation at the end of a fiscal year to a practice of making such
      awards at the beginning of a fiscal year, based upon the previous year’s
      performance. Accordingly, the amount of equity compensation awarded to Named
      Executive Officers in 2006, other than to those officers who received promotions
      or were newly hired, is significantly lower than it has been in past years,
      or
      will likely be in the future.





42




**OUTSTANDING
      EQUITY AWARDS AT 2006 FISCAL YEAR-END**





The
      following table provides information about the stock option awards held by
      the
      Named Executive Officers as of December 31, 2006. This information includes
      unexercised and unvested stock options. Each equity award is separately shown
      for each Named Executive Officer. The vesting schedule for each stock option
      award is shown immediately following the table based on the date on which the
      stock option award was granted.


**Option Awards****Name**
                  
                  **Option**
                    **Grant Date**
                  
                  **Number of**
                    **Securities**
                    **Underlying**
                    **Unexercised**
                    **Options**
                    **Exercisable**
                  
                  **Number of**
                    **Securities**
                    **Underlying**
                    **Unexercised**
                    **Options**
                    **Unexercisable**
                  
                  **Equity**
                    **Incentive**
                    **Plan**
                    **Awards:**
                    **Number of**
                    **Securities**
                    **Underlying**
                    **Unexercised**
                    **Unearned**
                    **Options**
                  
                  **Option**
                    **Exercise**
                    **Price**
                  
                  **Option**
                    **Expiration**
                    **Date**
                  
                  **Option**
                    **Awards**
                    **Vesting**
                    **Schedule**Bill
                      Joll
                  
                  5/1/2006
                  
                  
                  666,667
                  
                  
                  333,333
                  
                  
                  
                  
                  $
                  0.90
                  
                  
                  5/1/2014
                  
                  33.34%
                      vests on 5/1/06; 33.33% vests on 11/8/06; 33.33% vests on
                      5/8/075/1/2006
                  
                  
                  
                  
                  
                  500,000
                  
                  
                  
                  
                  $
                  0.90
                  
                  
                  5/1/2014
                  
                  100%
                      vests on 5/8/08Anthony
                      Principe
                  
                  8/26/2002
                  
                  
                  12,500
                  
                  
                  
                  
                  
                  
                  
                  $
                  0.14
                  
                  
                  8/26/2012
                  
                  25%
                      immediately; 25% 1 year after grant; 25% 2 years after grant;
                      25% 3 years
                      after grant10/1/2002
                  
                  
                  10,000
                  
                  
                  
                  
                  
                  
                  
                  $
                  0.32
                  
                  
                  10/1/2012
                  
                  50%
                      in 6 months; 50% 1 year after grant11/15/2003
                  
                  
                  50,000
                  
                  
                  
                  
                  
                  
                  
                  $
                  1.25
                  
                  
                  11/15/2013
                  
                  50%
                      immediately; 50% 1 year after grant
  43
  5/13/2004
                  
                  
                  35,000
                  
                  
                  
                  
                  
                  
                  
                  $
                  0.66
                  
                  
                  5/13/2014
                  
                  50%
                      immediately; 50% 1 year after grant12/3/2004
                  
                  
                  40.000
                  
                  
                  
                  
                  
                  
                  
                  $
                  0.57
                  
                  
                  12/3/2014
                  
                  100%
                      1 year after grant6/27/2005
                  
                  
                  40,000
                  
                  
                  
                  
                  
                  
                  
                  $
                  0.59
                  
                  
                  6/27/2013
                  
                  50%
                      immediately; 50% 1 year after grant11/18/2005
                  
                  
                  100,000
                  
                  
                  
                  
                  
                  
                  
                  $
                  0.79
                  
                  
                  11/18/2013
                  
                  50%
                      immediately; 50% 1 year after grantEric
                      Ameres
                  
                  7/27/1999
                  
                  
                  50,000
                  
                  
                  
                  
                  
                  
                  
                  $
                  16.63
                  
                  
                  7/27/2009
                  
                  33%
                      1 year after grant; 33.33% 2 years after grant; 33.34% 3 years
                      after
                      grant5/17/2000
                  
                  
                  100,000
                  
                  
                  
                  
                  
                  
                  
                  $
                  11.81
                  
                  
                  5/17/2010
                  
                  33%
                      1 year after grant; 33.33% 2 years after grant; 33.34% 3 years
                      after
                      grant4/1/2003
                  
                  
                  100.000
                  
                  
                  
                  
                  
                  
                  
                  $
                  0.40
                  
                  
                  4/1/2013
                  
                  33%
                      1 year after grant; 33.33% 2 years after grant; 33.34% 3 years
                      after
                      grant8/9/2001
                  
                  
                  50,000
                  
                  
                  
                  
                  
                  
                  
                  $
                  0.80
                  
                  
                  8/9/2011
                  
                  50%
                      immediately; 50% 1 year after grant7/2/2004
                  
                  
                  200,000
                  
                  
                  
                  
                  
                  
                  
                  $
                  0.68
                  
                  
                  7/2/2014
                  
                  50%
                      immediately; 50% 1 year after grant5/5/2005
                  
                  
                  200,000
                  
                  
                  
                  
                  
                  
                  
                  $
                  0.57
                  
                  
                  5/5/2013
                  
                  100%
                      on 12/3/0511/18/2007
                  
                  
                  200,000
                  
                  
                  
                  
                  
                  
                  
                  $
                  0.79
                  
                  
                  11/18/2013
                  
                  50%
                      immediately; 50% 1 year after grant
  44
  Matthew
                    Frost
                
                12/15/2003
                
                
                75,000
                
                
                
                
                
                
                
                $
                1.36
                
                
                12/15/2013
                
                33.33%
                    immediately; 33.33% 1 year after grant; 33.34% 2 years after
                    grant5/13/2004
                
                
                35,000
                
                
                
                
                
                
                
                $
                0.66
                
                
                5/13/2014
                
                50%
                    immediately; 50% 1 year after grant12/3/2004
                
                
                140,000
                
                
                
                
                
                
                
                $
                0.57
                
                
                12/3/2014
                
                100%
                    1 year after grant11/18/2005
                
                
                100,000
                
                
                
                
                
                
                
                $
                0.79
                
                
                11/18/2013
                
                50%
                    immediately; 50% 1 year after grant4/3/2006
                
                
                37,500
                
                
                37,500
                
                
                
                
                $
                0.81
                
                
                4/3/2014Douglas
                    A. McIntyreJames
                    Meyer
                
                5/11/2005
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                100%
                    immediately11/18/2005
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                100%
                    immediatelyTimothy
                    Reusing
                
                4/1/2003
                
                
                33,334
                
                
                
                
                
                
                
                $
                0.40
                
                
                4/1/2013
                
                33%
                    1 year after grant; 33.33% 2 years after grant; 33.34% in 3
                    years11/5/2003
                
                
                84,000
                
                
                
                
                
                
                
                $
                1.25
                
                
                11/5/2013
                
                50%
                    immediately; 50% 1 year after grant7/2/2004
                
                
                200,000
                
                
                
                
                
                
                
                $
                0.68
                
                
                7/2/2014
                
                50%
                    immediately; 50% 1 year after grant6/15/2005
                
                
                200,000
                
                
                
                
                
                
                
                $
                0.57
                
                
                5/5/2013
                
                100%
                    on 12/3/0511/18/2005
                
                
                100,000
                
                
                
                
                
                
                
                $
                0.79
                
                
                11/18/2013
                
                100%
                    1 year after grant




**OPTION
      EXERCISES AND STOCK VESTED IN FISCAL 2006**





The
      following table provides information for the Named Executive Officers regarding
      stock options that were exercised during fiscal 2006.


**Option Awards**
              
              **Stock Awards****Name**
              
              **Number of**
                **Shares**
                **Acquired**
                **on Exercise**
              
              **Value**
                **Realized on**
                **Exercise**
              
              **Number of**
                **Shares**
                **Acquired**
                **on Vesting**
              
              **Value**
                **Realized on**
                **Vesting**Bill
                  JollAnthony
                  PrincipeEric
                  AmeresMatthew
                  FrostDouglas
                  A. McIntyre1
              
              
              1,475,000
              
              $
              1,138,433James
                  MeyerTimothy
                  C.Reusing2
              
              
              193,332
              
              $
              210,332




45




1 Douglas
      A. McIntyre exercised the following stock options in 2006:




·
            125,000
                stock options on May 16, 2006. The stock options had an exercise
                price of
                $28,250 and a market price of $98,750 on the date of
                exercise.·
            500,000
                stock options on May 26, 2006. The stock options had an exercise
                price of
                $165,000 and a market price of $385,000 on the date of
                exercise.


·
            356,700
                stock options on September 28, 2006. The stock options had an exercise
                price of $228,288 and a market price of $246,123 on the date of
                exercise.·
            243,300
                stock options on September 20, 2006. The stock options had an exercise
                price of $155,712 and a market price of $177,609 on the date of
                exercise.


·
            100,000
                stock options on November 2, 2006. The stock options had an exercise
                price
                of $64,000 and a market price of $86,000 on the date of
                exercise.·
            81,700
                stock options on December 15, 2006. The stock options had an exercise
                price of $64,543 and a market price of $80,066 on the date of
                exercise.


·
            68,300
                stock options on December 18, 2006. The stock options had an exercise
                price of $53,957 and a market price of $64,885 on the date of
                exercise.





2 Timothy
      C. Reusing exercised the following options in 2006:




·
            93,332
                stock options on December 14, 2006. The stock options had an exercise
                price of $47,533 and a market price of $93,332 on the date of
                exercise.·
            100,000
                stock options on December 21, 2006. The stock options had an exercise
                price of $79,000 and a market price of $117,000 on the date of
                exercise.





**POTENTIAL
      PAYMENTS UPON TERMINATION**





*Employment
      Agreements* *.* As
      explained in the Narrative to the Summary Compensation Table and Plan-Based
      Award Table on pages 11 and 12, we have entered into employment agreements
      with
      Mr. Joll, Mr. Ameres and Mr. Frost. The agreements provide for certain payments
      and other benefits if their employment with us is terminated under circumstances
      described in the agreements. The specific payments and benefits depend on the
      type of termination event. The standard definitions for the various types of
      termination events covered under the agreements are described below, although
      the exact definitions may vary by agreement and by Named Executive Officer.





·
            “Resignation
                for Good Reason” means a termination that the executive initiates if we,
                without the executive’s consent, fail to continue to employ him in his
                position; there is a material diminution in the nature or scope of
                his
                responsibilities, duties or authority; or we fail to make any payment
                or
                provide any benefit due under the agreement 15 days after notice
                of such
                has been made to us.





·
            “Resignation
                without Good Reason” means a termination initiated by the Named Executive
                Officer that is not a Resignation for Good
                Reason.





·
            “Termination
                for Cause” means termination of the Named Executive Officer’s employment
                by us due to his failure to satisfactorily perform material services
                required by the Board; conviction of a felony or any act of material
                fraud
                or dishonesty; willful misconduct or gross negligence in the performance
                of his duties; disregard or violation of the legal rights of our
                employees
                or of our written policy regarding harassment or discrimination;
                or a
                breach of any material provision of the executive’s employment
                agreement.




46




·
            “Termination
                without Cause” means a termination by us of the Named Executive Officer’s
                employment that is not a Termination for Cause.





·
            “Non-extension
                of Term by the Company” means termination initiated by us by providing
                notice to the Named Executive Officer that the current term of the
                agreement will not be automatically extended beyond its scheduled
                end
                date.





·
            “Disability
                Termination” means termination of the executive’s employment by us because
                of his failure to perform his material duties for a period of 26
                consecutive weeks or an aggregate of 40 weeks during any twelve month
                period, in the case of Bill Joll, or six consecutive weeks or an
                aggregate
                of twelve weeks during any twelve month period, in the case of Matt
                Frost
                as a result of disability or incapacity.·
            “Death
                Termination” means the automatic termination of the agreement upon the
                Named Executive Officer’s death.




Bill
      Joll
      is subject to non-competition and non-solicitation restrictions following
      termination of his employment for any reason. These restrictions apply for
      12
      months. In addition, Mr. Joll and Mr. Frost are entitled to continue coverage
      under company-sponsored group health plans following termination of employment
      for a period of six months.





The
      following tables describe the potential payments and benefits under each
      employment agreement. The agreements vary as to whether a particular type of
      termination event entitles the Named Executive Officer to any benefits or
      payments.




**Bill
      Joll**


**Chief
      Executive Officer**


**and
      President**


**Executive**
                  **Benefits and**
                  **Payments Upon**
                  **Separation****1**
                
                **Resignation**
                  **for Good**
                  **Reason**
                
                **Non-extension
                    of Term by the Executive**
                
                **Resignation
                    Without Good Reason**
                
                **Termination
                    for Cause**
                
                **Termination
                    without Cause**
                
                **Non-extension
                    of Term by the Company**
                
                **Disability
                    Termination**
                
                **Death
                    Termination****Compensation:**Severance2
                
                $
                341,700
                
                $
                0
                
                $
                0
                
                $
                0
                
                $
                341,700
                
                $
                162,500
                
                $
                27,083
                
                $
                0Bonus3
                
                $
                325,000
                
                $
                0
                
                $
                0
                
                $
                0
                
                $
                325,000
                
                $
                0
                
                $
                0
                
                $
                0**Benefits
                    & Perquisites:**4Health
                    Plan Continuation5
                
                $
                31,941
                
                $
                0
                
                $
                0
                
                $
                0
                
                $
                31,941
                
                $
                0
                
                $
                0
                
                $
                0**Total**
                
                $
                698,641
                
                $
                0
                
                $
                0
                
                $
                0
                
                $
                698,641
                
                $
                162,500
                
                $
                27,083
                
                $
                0





1 The
      amounts shown in this table were computed based on the following assumptions:
      the termination date is December 31, 2006; Mr. Joll’s base salary is $325,000;
      and Mr. Joll’s target percentage is 100% for purposes of our 2007 Cash Incentive
      plan.





2 For *Resignation
      for Good Reason or*  *Termination
      without Cause,* severance is one year of his base salary at termination and is paid in a single
      lump. For a *Non-extension
      of Term* by the
      Company, severance is continued payment of base salary for six (6) months
      following the date on which Mr. Joll receives the notice of non-renewal. For
      a *Disability
      Termination,* severance is continued payment of base salary for thirty (30) days following
      the
      notice of termination by us.




47




3 The
      bonus amount shown in the event of a *Resignation
      for Good Reason or*  *Termination
      without Cause* is an
      amount that the Board determines is their good-faith estimate of the pro rata
      amount of the bonus that would become payable for that year in which the
      termination or resignation occurs, based upon the goals agreed to by us and
      Mr.
      Joll for that year, payable at the end of the year.





**Eric
      Ameres**


**Executive
      Vice President and Chief Technical Officer**


**Executive**
                  **Benefits and**
                  **Payments**
                  **Upon**
                  **Separation****1**
                
                **Resignation**
                  **for Good**
                  **Reason**
                
                **Non-extension**
                  **of Term**
                  **by the**
                  **Executive**
                
                **Resignation**
                  **without**
                  **Good**
                  **Reason**
                
                **Termination**
                  **for Cause**
                
                **Termination**
                  **without**
                  **Cause**
                
                **Non-extension**
                  **of Term**
                  **by the**
                  **Company**
                
                **Disability**
                  **Termination**
                
                **Death**
                  **Termination****Compensation:**Severance2
                
                $
                0
                
                $
                0
                
                $
                0
                
                $
                1,800
                
                $
                96,250
                
                $
                0
                
                $
                1,800
                
                $
                1,800Bonus3
                
                $
                0
                
                $
                0
                
                $
                0
                
                $
                0
                
                $
                0
                
                $
                0
                
                $
                0
                
                $
                0**Benefits
                    & Perquisites:**4Health
                    Plan Continuation5
                
                $
                0
                
                $
                0
                
                $
                0
                
                $
                0
                
                $
                7,150
                
                $
                0
                
                $
                0
                
                $
                0**Total**
                
                $
                0
                
                $
                0
                
                $
                0
                
                $
                1,800
                
                $
                103,400
                
                $
                0
                
                $
                1,800
                
                $
                1,800





1 The
      amounts shown in the above tables were computed based on the following
      assumptions: the termination date was December 31, 2006; Mr. Ameres’s base
      salary was $190,000.





2 Severance is continuation
      of annual base salary for one (1) year from the date of termination in
      the
      event of a *Termination
      without Cause* .




**Matthew
      Frost**


**Executive
      Vice President and General Counsel**


**Executive**
                **Benefits and**
                **Payments**
                **Upon**
                **Separation****1**
              
              **Resignation**
                **for Good**
                **Reason**
              
              **Non-extension**
                **of Term**
                **by the**
                **Executive**
              
              **Resignation**
                **without**
                **Good**
                **Reason**
              
              **Termination**
                **for Cause**
              
              **Termination**
                **without**
                **Cause**
              
              **Non-extension**
                **of Term**
                **by the**
                **Company**
              
              **Disability**
                **Termination**
              
              **Death**
                **Termination****Compensation:**Severance2
              
              $
              212,000
              
              
              
              
              $
              0
              
              
              
              
              $
              0
              
              $
              9,600
              
              $
              91,250
              
              
              
              
              $
              0
              
              $
              9,600
              
              $
              9,600Bonus3
              
              $
              0
              
              
              
              
              $
              0
              
              
              
              
              $
              0
              
              $
              0
              
              $
              0
              
              
              
              
              $
              0
              
              $
              0
              
              $
              0**Benefits
                  & Perquisites:**4Health
                  Plan Continuation5
              
              $
              0
              
              
              
              
              $
              0
              
              
              
              
              $
              0
              
              $
              11,650
              
              $
              11,650
              
              
              
              
              $
              0
              
              $
              11,650
              
              $
              11,650**Total**
              
              $
              212,000
              
              
              
              
              $
              0
              
              
              
              
              $
              0
              
              $
              21,250
              
              $
              102,900
              
              
              
              
              $
              0
              
              $
              21,250
              
              $
              21,250




48




1 The
      amounts shown in the above tables were computed based on the following
      assumptions: the termination date was December 31, 2006; Mr. Frost’s base salary
      was $182,500.





2 Severance is continuation
      of annual base salary for one (1) year from the date of termination in
      the
      event of a *Termination
      without Cause* .





*Life
      Insurance Benefit* *.* If
      Mr.
      Joll had died on December 31, 2006, his survivor would have received $250,000
      under the supplemental term life insurance policy for which we annually
      reimburse premiums. If Mr. Ameres had died on December 31, 2006, his survivor
      would have received $190,004.88 under the supplemental term life insurance
      policy for which we annually reimburse premiums. If Mr. Frost had died on
      December 31, 2006, his survivor would have received $182,500.08 under the
      supplemental term life insurance policy for which we annually reimburse
      premiums. If Mr. Principe had died on December 31, 2006, his survivor would
      have
      received $138,450.24 under the supplemental term life insurance policy for
      which
      we annually reimburse premiums.





**NON-MANAGEMENT
      DIRECTOR COMPENSATION FOR FISCAL 2006**




We
      use a
      combination of cash and equity-based incentive compensation to attract and
      retain qualified candidates to serve as non-management directors on the Board.
      Director compensation is reviewed annually by the Compensation Committee and
      changes are made to the total director compensation package when the Board
      determines that such changes are appropriate. The Compensation Committee may
      from time to time engage independent compensation consultants to evaluate our
      director compensation program relative to the same Peer Group of companies
      that
      the Compensation Committee will consider in setting executive compensation,
      as
      described in the Compensation Discussion and Analysis on page 5. During the
      fiscal year ended December 31, 2006, each non-management director received
      an
      annual retainer fee of $10,000 for service on the Board and $5,000 for each
      committee on which they serve, except that non-management directors who are
      chairmen of committees shall $10,000 for their service on each such committee.
      In addition, a non-management chairman of the Board receives an annual cash
      retainer fee of $10,000 for service as chairman. All members of the Board are
      reimbursed for actual expenses incurred in connection with attendance at Board
      meetings and committee meetings.


**Name**
              
              **Fees**
                **Earned or**
                **Paid in**
                **Cash**
              
              **Option**
                **Awards**
              
              **Total**James
                  Meyer1
              
              $
              14,167.00
              
              
              
              
              $
              14,167.00William
                  Newman
              
              
              15,000.00
              
              
              
              
              $
              15,000.00Thomas
                  Weigman
              
              
              15,000.00
              
              
              
              
              $
              15,000.00J.
                  Allen Kosowsky
              
              
              40,000.00
              
              $
              72,000
              
              $
              112,000.00Mike
                  Kopetski
              
              
              15,000.00
              
              
              
              
              $
              15,000.00Mike
                  Alfant
              
              
              15,000.00
              
              
              
              
              $
              15,000.00Afsaneh
                  Naimollah
              
              
              17,917.00
              
              
              
              
              $
              17,917.00




1 Mr.
      Meyer also received compensation for his service as Interim Chief Executive
      Officer. See page 11. He did not receive a fee for his service on the Board
      during the term of his employment as Interim Chief Executive
      Officer.





49




**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
                JollBill Joll*Director, President*
              *and
                Chief Executive Officer*
              *(Principal
                Executive Officer)*


Date:  October 10, 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*Senior Vice President and Chief Financial Officer (Principal Financial and
                
                October
                      10, 2007/s/
                    Anthony Principe
                
                Accounting
                    Officer)(Anthony
                    Principe)/s/
                    J. Allen Kosowsky
                
                Chairman
                    of the Board and Director
                
                October
                      10, 2007(J.
                    Allen Kosowsky)/s/
                    William A. Newman
                
                Director
                
                October
                      10, 2007(William
                    A. Newman)/s/
                    Mike Kopetski
                
                Director
                
                October
                      10, 2007(Mike
                    Kopetski)/s/
                    Michael J. Alfant
                
                Director
                
                October
                      10, 2007(Michael
                    J. Alfant)/s/
                    Afsaneh Naimollah
                
                Director
                
                October
                      10, 2007(Afsaneh
                    Naimollah)/s/
                    James Meyer
                
                Director
                
                October
                    10, 2007(James
                    Meyer)
 50




**INDEX
      TO EXHIBITS**




**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, 2006




51




**Incorporated by Reference****Exhibit Number**
            
            **Exhibit Description**
            
            **Form**
            **Date Filed**
            **Filed Herewith**10.13
            
            Employment
                Agreement, dated as of February 28, 2006, by and between the Company
                and
                Matt Frost
            
            
            *21
            
            Subsidiaries
            
            10-K
            March
                31, 200323.1
            
            Consent
                of Eisner LLP
            
            
            *31.1
            
            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




*
      Previously Filed.





52