**UNITED
      STATES** **SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**


**Form 10-K**





(Mark
                One)x
            
            **ANNUAL
                REPORT PURSUANT TO SECTION 13 OR 15(d)**
              **OF
                THE SECURITIES EXCHANGE ACT OF 1934****For
                the fiscal year ended December 31, 2007**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**
            
            **12065***(Address
                of principal executive offices)*
            
            *(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 o No x




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




Large
      Accelerated Filer  o Accelerated
      Filer x Non-Accelerated
      Filer o Smaller
      Reporting Company o




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
      non-affiliates of the registrant as of June 30, 2007, was approximately
      $356,827,000.




**(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: 159,563,152 shares as of June 16, 2008 (this number does not include
      an additional 12,500,000 shares of the Registrant’s common stock that the
      Registrant is obligated to issue to the former shareholders of Hantro Products
      Oy, acquired by the Registrant in November 2007).









**EXPLANATORY
      NOTE**





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





The
      filing of this Form 10-K for the year ended December 31, 2007 was
      delayed due to the independent review conducted by the Audit Committee of our
      Board of Directors concerning certain contracts with customers and the
      recognition of revenue that we had previously recognized as revenue in our
      quarterly filings for the quarters ended June 30, 2007 and September 30, 2007.
      The Audit Committee’s review commenced after the Audit Committee was informed by
      our management that certain documentation provided to us relating to two sales
      accounts for which revenue had been recognized in the third quarter of 2007
      had
      been falsified. Management made this discovery during the preparation of our
      2007 annual financial statements. The Audit Committee concluded, with respect
      to
      four accounts, including the two sales accounts previously mentioned, that
      we
      incorrectly recognized revenue of $185,000 for the second quarter of 2007 and
      $589,000 **** for
      third
      quarter of 2007. In addition, during the preparation of our 2007 annual
      financial statements and prior to discovery of the falsified documentation
      mentioned above, management determined that revenue of $42,000 had been
      incorrectly recognized in the third quarter of 2007. The revenue that was
      incorrectly recognized during these periods will be recognized on a cash basis
      when and if collected. As of the filing date of this report, only a portion
      of
      the amounts owed in connection with Account 4, defined below, has been
      collected. When the Company filed its Current Report Form 8-K on May 27, 2008,
      the Audit Committee had also preliminarily determined to establish a bad debt
      reserve of $383,000 in the fourth quarter of 2007 for certain sales to a fifth
      account. Upon further examination of the facts and circumstances involved in
      sales to this account, we confirmed that sales had occurred to this account,
      that a reserve for $383,000 was required, but that the reserve should have
      been
      established in the third quarter, rather than the fourth quarter, of 2007.
      To
      establish that reserve we recorded a general charge to general and
      administrative expense of $383,000 which increased our net loss for the third
      quarter of 2007 by that amount (in addition to the $631,000 of revenue that
      was
      reversed in the period). The establishment of the reserve also resulted in
      a
      reduction in accounts receivable, net of allowance for doubtful accounts on
      our
      balance sheet at September 30, 2007, by the same amount.





The
      foregoing correction to our financial statements for the second quarter of
      2007
      increased our net loss by $185,000. The foregoing corrections to our financial
      statements for the third quarter of 2007 increased our net loss by
      $1,014,000.





**Audit
      Committee Review**





On
      May
      26, 2008, the Audit Committee determined that the financial statements in the
      Company’s Quarterly Reports on Form 10-Q for the three months ended June 30 and
      September 30, 2007, should no longer be relied upon. The Audit Committee reached
      this determination based on its review of the Company’s sales to five accounts
      and its conclusion that the Company’s revenue recognition as to four of those
      accounts did not comply with applicable accounting principles. One account
      of
      $300,000 ($280,000 for software and $20,000 for post-contract support), of
      which
      $280,000 was recognized in the third quarter of 2007, which represented
      approximately 10.9% of the previously-reported revenues for that quarter
      (“Account 1”); a second account of $320,000 ($300,000 for software and $20,000
      for post-contract support), of which $300,000 was recognized in the third
      quarter of 2007, which represented approximately 11.7% of the
      previously-reported revenues for that quarter (“Account 2”); a third account of
      $150,000 ($125,000 for software and $25,000 for post-contract support), of
      which
      $125,000 was recognized in the second quarter of 2007, which represented
      approximately 4.9% of the previously-reported revenues for that quarter
      (“Account 3”); and a fourth account of $70,000 ($60,000 for software and $10,000
      for post-contract support), of which $60,000 was recognized in the second
      quarter of 2007, which represented approximately 2.4% of the previously-reported
      revenues for that quarter (“Account 4”). With respect to the fifth account
      (“Account 5”) reviewed by the Audit Committee, the Company established a bad
      debt reserve in the third quarter of 2007 in the amount of $383,000, which
      reflects an estimate of the uncollectibility of certain revenues that had
      previously been recognized in the first three quarters in 2007. The Company
      has
      restated its previously issued financial statements for the three and six months
      ended June 30, 2007, in Amendment No. 1 to its Quarterly Report on Form 10-Q
      for
      quarterly period ended June 30, 2007, to correct the incorrect recognition
      of
      revenue in the period relating to Account 3 and Account 4. The Company also
      restated its previously issued financial statements for the three and nine
      months ended September 30, 2007 in Amendment No. 1 to its Quarterly Report
      on
      Form 10-Q for the quarterly period ended September 30, 2007, to correct the
      incorrect recognition of revenue in the period relating to Account 1 and Account
      2, as well as the incorrect recognition in the period of an additional
      $42,000 (because the Company did not have sufficient evidence to establish
      the
      creditworthiness of the customer) and the establishment of a bad debt reserve
      relating to Account 5.


2





Pursuant
      to American Institute of Certified Public Accountants’ Statement of Position
      (SOP) 97-2, *Software
      Revenue Recognition* (“SOP
      97-2”) and Staff Accounting Bulletin No. 104 (“SAB 104”) one element of revenue
      recognition is consideration of whether the collectibility of sales revenue
      is
      reasonably assured ( *i.e.* ,
      whether
      the purchaser is creditworthy with respect to that transaction). During
      the 2007 year-end audit process, management learned that the creditworthiness
      of
      Account 1 and Account 2, both of which were European customers, had been
      assessed, and approximately $580,000 in revenue had been recognized in the
      third
      quarter of 2007, based upon falsified documentation that the Company
      received . The
      Company learned of the falsified documentation when the sales representative
      (the “Sales Representative”) responsible for Accounts 1, 2 and 4; and who was
      also involved with Account 3; who was employed by a European outsourcing company
      that the Company initially retained in 2006 (and to whom the Company paid
      commissions in connection with Accounts 1, 2, 3 and 4, but whom we terminated
      in
      April 2008 as a result of this review) admitted to the Company’s Executive
      Vice-President, Legal and Business Affairs, to falsifying documentation
      purporting to establish the creditworthiness of Account 1. The documentation
      purporting to establish the creditworthiness of Account 2 was subsequently
      determined to be false, although the identity of the person or persons
      responsible for falsifying such documentation was not ascertained during the
      Audit Committee review.





After
        determining that the documentation purporting to support the creditworthiness
        of
        Accounts 1 and 2 was false, management informed the Audit Committee, which
        then
        commenced its review. The Audit Committee’s review focused exclusively on the
        following issues: (1) whether the false documentation identified with respect
        to
        Accounts 1 and 2 was limited to those accounts, or whether it affected other
        accounts that were either affiliated with the Sales Representative or were
        deemed by management to be material to the quarter in 2007 in which revenue
        for
        those accounts had been recognized (Accounts 3, 4 and 5); (2) whether the
        Sales
        Representative falsified documentation for his own financial benefit and/or
        at
        the direction, or with the knowledge, of management; and (3) whether information
        obtained during the review indicated that Accounts 1 and 2 were not legitimate
        transactions.





The
      Audit
      Committee conducted its review of Accounts 1 through 5 with the assistance
      of
      Latham & Watkins LLP and FTI Consulting, and with the support and
      cooperation of management and personnel. The review was conducted over a period
      of approximately six weeks, and included collection and review of more than
      two
      million pages of documents, as well as interviews of eight members of management
      and sales force teams in the United States and the Sales Representative in
      Europe.





With
        respect to Account 1, with which the Company had no previous business
        relationship, the Audit Committee found that the Company paid a sales commission
        to the European outsourcing company upon execution of the contract with Account
        1, and that the Sales Representative received a commission from the outsourcing
        company in connection with Account 1, but found no evidence that the commission
        was affected by the Sales Representative’s falsification of documentation
        concerning the creditworthiness of Account 1. Although the Audit Committee
        found
        no evidence that the Sales Representative acted at the direction, or with
        the
        knowledge, of any member of management in falsifying documentation concerning
        the creditworthiness of Account 1, it found that the Sales Representative
        had
        been directed by senior management to obtain evidence of the creditworthiness
        of
        Account 1 so that revenue could be recognized in the third quarter of 2007.
        The
        Audit Committee also found that senior management did not adequately instruct
        the Sales Representative regarding (and the Company did not have a practice
        or
        policy regarding) the types of information that could be used in making a
        creditworthiness determination pursuant to the applicable revenue recognition
        accounting principles. In addition, the Audit Committee determined that,
        although sales revenue from Account 1 was recognized in the third quarter
        of
        2007, evidence relating to creditworthiness was not obtained until the fourth
        quarter of 2007, however, prior to the filing of the third quarter Form
        10-Q. The Audit Committee concluded that the sales revenue of $280,000 from
        Account 1, which was previously recognized in the third quarter of 2007,
        did not
        constitute a sale for which revenue could be recognized, and therefore no
        revenue should have been recognized in the third quarter of 2007 or any other
        period.


3




With
        respect to Account 2, with which the Company had no previous business
        relationship, the Audit Committee has been unable to determine the identity
        of
        the person or persons who falsified documentation concerning the
        creditworthiness of Account 2. Although the Audit Committee has found no
        evidence establishing that management directed or had knowledge of the
        falsification of any document, it has found that the Sales Representative
        had
        been directed by senior management to obtain evidence of the creditworthiness
        of
        Account 2 so that revenue could be recognized in the third quarter of 2007.
        The
        Audit Committee determined that, although sales revenue from Account 2 was
        recognized in the third quarter of 2007, evidence relating to creditworthiness
        was not obtained until the fourth quarter 2007, however, prior to the
        filing of the third quarter Form 10-Q. The Audit Committee also found that
        senior management did not adequately instruct the Sales Representative regarding
        (and the Company did not have a policy or practice regarding) the types of
        information that could be used in making a creditworthiness determination
        pursuant to the applicable revenue recognition accounting principles. The
        Audit
        Committee has concluded that the sales revenue of $300,000 from Account 2,
        which
        was previously recognized in the third quarter of 2007, did not constitute
        a
        sale for which revenue could be recognized, and therefore no revenue should
        have
        been recognized in the third quarter of 2007 or any other period. The revenue
        will be recognized on a cash basis when and if collected.





With
        respect to Accounts 3 and 4, with which the Company did not have previous
        business relationships, the Audit Committee did not find evidence of falsified
        documentation. The Audit Committee determined that the Company did not have
        sufficient evidence to establish the creditworthiness of Accounts 3 or 4
        when it
        recognized $125,000 and $60,000, respectively, in revenue in the second quarter
        2007, and that the Company did not have a practice or policy regarding the
        types
        of information that could be used in making such creditworthiness
        determinations. Neither Account 3 nor 4 has acknowledged its contract to
        the
        Company’s independent registered public accountants, and there is evidence that
        Account 3 disputes the terms of its contract with the Company. Account 3
        has
        made no payments to the Company. Account 4 has paid a portion of its outstanding
        receivable, which is now current. The Audit Committee concluded that the
        sales
        revenue of $185,000 from Accounts 3 and 4 was untimely recognized in the
        second
        quarter of 2007. Account 3 was determined not to constitute a sale for which
        revenue could be recognized in any period. The $60,000 of revenue from Account
        4
        was reclassified to deferred revenue in the second quarter of 2007 and revenue
        will be recognized as the payments are received. The Company received payments
        of $8,000 in the fourth quarter of 2007 and $30,000 in the first quarter
        of
        2008. The balance is not yet due. Additionally, the Company reversed $9,000
        of
        support revenue associated with Account 3 and 4 in the third quarter of
        2007.




With
      respect to Account 5, with which the Company had a prior business relationship,
      the Audit Committee did not find evidence of falsified documentation. The Audit
      Committee found that the creditworthiness of Account 5 was based on the past
      credit payment history with the Company. It also found that, when payments
      associated with Account 5 became past due in 2007, the Company continued selling
      to Account 5 without re-assessing its creditworthiness until September 2007,
      when the account was significantly past due. Further sales were suspended in
      the
      fourth quarter of 2007. The Audit Committee concurred with management’s
      recommendation that a bad debt reserve of $383,000 should be taken in the fourth
      quarter of 2007 in connection with its sales to Account 5.  Upon further
      examination of the facts and circumstances involved in Account 5, the Company
      confirmed that sales had occurred to Account 5, that a reserve for $383,000
      was
      required, but that the reserve should have been established in the third
      quarter, rather than the fourth quarter, of 2007.  To establish that
      reserve, the Company recorded a general charge to general and administrative
      expense of $383,000, which increased the Company’s net loss
      for the
      third quarter of 2007 by that amount (in addition to the $631,000 of revenue
      that was reversed in the period).  The establishment of the reserve also
      resulted in a reduction in accounts receivable, net of allowance for doubtful
      accounts on the Company’s balance sheet at September 30, 2007, by the same
      amount.





In
      addition, during the preparation of the Company’s 2007 annual financial
      statements and prior to discovery of the falsified documentation mentioned
      above, management determined that revenue of $42,000 had been incorrectly
      recognized in the third quarter of 2007 because of insufficient evidence to
      establish the creditworthiness of the customer.





Management
        also conducted a review of the Company’s sales to all accounts for which revenue
        was recognized in fiscal 2007, including the accounts of Hantro
        Products Oy, which the Company acquired in November 2007, for the purposes
        of
        determining that the criteria set forth in SOP 97-2 and SAB 104 were
        satisfied and that revenue was properly recognized for each account. Management
        concluded that, except for the accounts discussed above and the $42,000 that
        also was incorrectly recognized, the criteria set forth in SOP 97-2 and SAB
        104
        were satisfied and revenue was properly recognized for all of these
        accounts.


4




**Identification
      of Material Weaknesses in Internal Control over Financial
      Reporting**





As
        a
        result of the determination to restate the Company’s financial statements and in
        connection with the preparation of its Annual Report on Form 10-K for the
        year
        ended December 31, 2007, management identified three material weaknesses
        in our
        disclosure controls and procedures and internal control over financial reporting
        and reported those to our Audit Committee. Management identified a material
        weakness in our procedures for recognizing revenue, specifically with respect
        to
        our procedures for assessing whether  collectibility is reasonably assured.
        This material weakness resulted in the incorrect recognition of revenue in
        our
        financial statements for the second and third quarters of 2007. In addition,
        management identified a material weakness in our control environment,
        specifically relating to our tone at the top. This material weakness was
        evidenced by the control tone and control consciousness of our former Chief
        Executive Officer and resulted in the override and the possibility of override
        of controls or interference with our policies, procedures and internal control
        over financial reporting. Management also identified a material weakness
        in the
        design and operation of our procedures for determining the accuracy and
        completeness of our estimate of allowance for doubtful accounts. This material
        weakness resulted in a misstatement of accounts receivable, net of allowance
        for
        doubtful accounts on our balance sheet at the end of the third quarter of
        2007
        and an understatement of our general and administrative expenses for the
        period. **** Prior
        to
        the filing of this report, we have taken certain steps to remediate these
        material weaknesses and are in the process of finalizing a plan and timetable
        for the implementation of additional remediation measures to further address
        these material weaknesses. These material weaknesses and the remediation
        measures are further described below in Item 9A of this Form
        10-K.





We
      have
      amended our quarterly reports on Form 10-Q/A for the quarters ended June 30,
      2007 and September 30, 2007, to restate our unaudited condensed consolidated
      financial statements for those periods. For more information on these matters,
      please refer to Item 7 of this Form 10-K, Management’s Discussion and Analysis
      of Financial Condition and Results of Operations, Item 9Aof this Form 10-K,
      Controls and Procedures and Item 1A of this Form 10-K, Risk
      Factors.


5


**Table
      of Contents**





**PART
                I**Item
                1.
            Description
                of Business
            9Item
                1A.
            Risk
                Factors
            26Item
                1B.
            Unresolved
                Staff Comments
            38Item
                2
            Description
                of Property
            38Item
                3
            Legal
                Proceedings
            38Item
                4.
            Submission
                of Matters to a Vote of Security Holders
            39**PART
                II**Item
                5.
            Market
                for Common Equity and Related Stockholder Matters
            41Item
                6.
            Selected
                Financial Data
            44Item
                7.
            Management’s
                Discussion and Analysis of Financial Condition and Results of
                Operations
            45Item
                7A
            Quantitative
                and Qualitative Disclosures About Market Risk
            61Item
                8.
            Financial
                Statements and Supplementary Data
            61Item
                9.
            Changes
                In and Disagreements with Accountants on Accounting and Financial
                Disclosure
            61Item
                9A.
            Controls
                and Procedures
            61Item
                9B
            Other
                Information
            65**PART
                III**Item
                10.
            Directors,
                Executive Officers, Promoters and Control Persons; Compliance with
                Section 16(a) of the Exchange Act
            66Item
                11.
            Executive
                Compensation
            70Item
                12.
            Security
                Ownership Of Certain Beneficial Owners And Management and Related
                Stockholder Matters
            91Item
                13.
            Certain
                Relationships And Related Transactions
            94Item
                14.
            Principal
                Accounting Fees And Services
            94**PART
                IV**Item
                15.
            Exhibits
            96




6


**PART
      I**


**Forward-Looking
      Statements**




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





•
            future
                revenues, income taxes, net income per diluted share, acquisition
                costs
                and related amortization, and other measures of results of operations;•
            the
                effects of acquiring Hantro;•
            the
                effects of the restatement of our financial statements for the quarters
                ended June 30, 2007 and September 30, 2007;•
            costs
                associated with the independent review of the Audit Committee concerning
                certain contracts with customers and the recognition of revenue that
                we
                had previously recognized in 2007 regarding those
                contracts;•
            possible
                delisting of the Company’s shares of common stock from the American Stock
                Exchange;•
            risks
                associated with the ineffectiveness of the Company’s internal control over
                financial reporting and our ability to remediate material
                weaknesses;•
            plans,
                strategies and expected opportunities for growth, increased profitability
                and innovation in 2008 and future years;•
            the
                financial performance and growth of our business, including future
                international growth;•
            our
                financial position and the availability of resources;•
            our
                expectations regarding acquisition activity in 2008 and our focus
                on the
                integration of completed acquisitions;•
            future
                competition; and•
            the
                degree of seasonality in our
                revenue.




These
      statements are only predictions, and actual events or results may differ
      materially. The forward-looking statements are based on management’s beliefs and
      assumption using information available at the time. We cannot guarantee future
      results, levels of activity, performance or achievements. Factors that may
      cause
      actual results to differ are often presented with the forward-looking statements
      themselves. Additionally, other risks that may cause actual results to differ
      from predicted results are set forth, and in “Risk Factors” on page 26 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.


7




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





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





**Overview**





On2
      Technologies is a developer of video compression technology and technology
      that
      enables multimedia in resource-limited environments, such as cellular networks
      transmitting to battery operated mobile handsets or High Definition (HD) video
      over the Internet. We have developed a proprietary technology platform and
      the
      TrueMotionTM VPx family (e.g., 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 personal computers, wireless
      devices, set-top boxes and other devices. Unlike many other video codecs that
      are based on standard compression specifications set by industry groups (e.g.,
      MPEG-2 and H.264), our video compression/decompression technology is based
      solely on intellectual property that we developed and own ourselves. In
      addition, through our wholly-owned subsidiary, Hantro Products Oy, we license
      to
      chip and mobile handset manufacturers the hardware and software designs that
      make the encoding or decoding of video possible on devices such as mobile
      handsets, set top boxes, portable media players and cameras. We also provide
      integration, customization and support services to enable high quality video
      on,
      and faster interoperability between devices.





In
      2004,
      we licensed our video compression technology to Macromedia, Inc. (now Adobe
      Systems Incorporated) for use in the Flash® multimedia player. In anticipation
      of Adobe using our codec in the Flash platform, we launched our business of
      developing and marketing video encoding software for the Flash platform. Flash
      encoding has become an increasingly important part of our business. In addition,
      we have also dedicated significant resources to marketing customized software
      to
      device manufacturers that enable their devices to decode Flash content.





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





·
            Video
                codecs;





·
            Audio
                codecs; and





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





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





·
            TrueMotion
                VP6® and VP7TM software video codec
                designs;





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





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





·
            AMR-NB
                and Enhanced aacPlusTM audio codecs;





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





·
            File
                format and streaming components;
                and


8


·
            Recorder
                and player application logic.





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





·
            Customized
                engineering and consulting services;
                and





·
            Technical
                support.





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




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





**Hantro
      Acquisition**





On
      November 1, 2007, we completed the acquisition of all of the share capital
      of
      Hantro Products Oy (“Hantro”), a Finnish corporation. Under the exchange
      agreement pursuant to which the acquisition was completed, Hantro’s security
      holders each exchanged all of the outstanding capital shares of Hantro for
      a net
      total consideration of $6,608,102 in cash and 25,438,817 shares of our common
      stock. Because the closing share price was less than $1.50, we issued a set
      number of 25,438,817 shares, as specified in the share exchange agreement.
      The
      25,438,817 shares so issued represent approximately 22% of our outstanding
      common stock as of November 1, 2007. In addition, we are obligated to issue
      an
      additional 12,500,000 shares of our common stock to the Hantro security holders
      because Hantro’s net revenue for the fiscal year 2007 exceeded
€9,000,000.





Hantro,
      currently a wholly-owned subsidiary of On2, employs approximately 70 staff
      members and has a global sales network with satellite offices in Korea, Japan,
      Taiwan, Germany, Hong Kong and Mainland China. Hantro’s headquarters and
      research and development teams are based in Oulu, Finland.


9


**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 Results of Operations –
Company History”.





**Business
      Strategy**





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





•
            Continuing
                our research and development efforts to improve our current codecs
                and
                developing new technologies that increase the quality of video technology
                and improve the experience of end users;•
            Continuing
                our research and development efforts to design hardware decoders
                and
                encoders that minimize the space used on a chip and to continue to
                improve
                the quality of those products;•
            Using
                the success of current customer implementations of our TrueMotion
                technology (e.g., Adobe® Flash 8, Skype) and other high-profile customers
                (e.g., Sun Microsystems) to increase our brand recognition, promote
                new
                business and encourage proliferation across platforms;•
            Updating
                and enhancing our existing consumer products, such as the Flix® line and
                embedded technologies;•
            Employing
                flexible licensing strategies to offer customers more attractive
                business
                terms than those available for competing technologies;•
            Attempting
                to negotiate licensing arrangements with customers that provide for
                receipt of recurring revenue and/or that offer us the opportunity
                to
                market products that complement our customers implementations of
                our
                software; and•
            Using
                the expertise of the Hantro subsidiary to develop hardware designs
                of our
                TrueMotion codecs and optimizations for embedded processors that
                will
                allow those products to be easily implemented on devices.




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





We
      also
      sell additional products and services that relate to our existing relationships
      with licensees of our TrueMotion codec products. For instance, if a customer
      has
      licensed our software to develop its own proprietary video format and video
      players, we may sell encoding software to users who want to encode video for
      playback on that customer’s players, or we may provide engineering services to
      companies that want to modify our customer’s software for use on a specific
      platform, such as a cell phone. As with royalties or revenue share arrangements,
      complementary sales of encoding software or engineering services should allow
      us
      to participate in the success of our customers’ products. For instance, if a
      customer’s video platform does well commercially, we would expect there to be a
      market for encoding software and/or engineering services in support of that
      platform.





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


10




As
      part
      of our strategy to develop complementary products that could allow us to
      capitalize on our customers’ success, in 2005 we completed the acquisition from
      Wildform, Inc., of its Flix line of encoding software. The Flix software allows
      users to prepare video and other multimedia content for playback on the Adobe
      Flash player, which is one of the most widely distributed multimedia players.
      Adobe is currently using our VP6 software as the video engine for Flash 8 video,
      which is used in the Flash 8 and Flash 9 players. We therefore believed that
      there was an opportunity for us to sell Flash 8 encoding software to end users,
      such as video professionals and web designers, and to software development
      companies that wish to add Flash 8 encoding functionality to their software.
      We
      concluded that we could best take advantage of the anticipated success of Flash
      8 by taking the most up-to-date Flash 8 encoding software straight from the
      company that developed Flash 8 video and combining it with the already
      well-known Flix brand, which has existed since the advent of Flash video and
      has
      a loyal following among users. Following Adobe’s announcement in late 2007 of
      support for the H.264 codec in its Flash 9 player, we announced support for
      H.264 in our Flix products and have been adding support for additional codecs.
      These additional features have helped to make the Flix product line **** a
      more
      complete encoding solution for users.





A
      primary
      factor that will be critical to our success is our ability to improve
      continually on our current TrueMotion video compression technology, so that
      it
      streams the highest-quality video at the lowest transmission rates (bit rate).
      We believe that our video compression software is highly efficient, allowing
      customers to stream good quality video (as compared with that of our
      competitors) at low bit rates (i.e., over slow connections) and unsurpassed
      high-resolution video at higher bit rates (i.e., over broadband connections).
      As
      connection speeds increase, however, the advantage that our highly efficient
      software has over competing technology may decrease. Another
      factor that may affect our success is the relative complexity of our TrueMotion
      video compression software compared with other compression software producing
      comparable compression rates and image quality. Software with lower complexity
      can run on a computer chip that is less powerful, and therefore generally less
      expensive, than would be required to run software that is comparatively more
      complex. In addition, the process of getting software to operate on a chip
      is
      easier if the software is less complex. Increased compression rates frequently
      result in increased complexity. While potential customers desire software that
      produces the highest possible compression rates while producing the best
      possible decompressed image, they also want to keep production costs low by
      using the lowest-powered and accordingly least expensive chips that will still
      allow them to perform the processing they require. In addition, in some
      applications, such as mobile devices, constraints such as size and battery
      life
      rather than price issues limit the power of the chips embedded in such devices.
      Of course, in devices where a great deal of processing power can be devoted
      to
      video compression and decompression, the issue of software complexity is less
      important. In addition, in certain applications, savings in chip costs related
      to the use of low complexity software may be offset by increased costs (or
      reduced revenue) stemming from less efficient compression (e.g., increased
      bandwidth costs).




One
      of
      the most significant recent trends in our business is our increasing reliance
      on
      the success of the product deployments of our customers. As referenced above,
      our license agreements with customers increasingly provide for the payment
      of
      license fees that are dependent on the number of units of a customer’s product
      incorporating our software that are sold or the amount of revenue generated
      by a
      customer from the sale of products or services that incorporate our software.
      We
      have chosen this royalty-dependent licensing model because, as a company of
      approximately 114 employees (as of December 31, 2007) competing in a market
      that
      offers a vast range of video-enabled devices, we do not have the product
      development or marketing resources to develop and market end-to-end video
      solutions. Instead, our codec software is primarily intended to be used as
      a
      building block for companies that are developing end-to-end video products
      and/or services.





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


11




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




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




We
      have
      recently experienced an increased interest by UGC site operators and device
      manufacturers to allow users to access UGC content by means of mobile handsets,
      set-top boxes, and other devices. Many of the UGC sites use Flash 8 VP6 video,
      and while Flash 8 video is available on a vast number of PCs, it is just now
      beginning to become available on chip-based devices, such as mobile devices
      and
      set top boxes. We are therefore witnessing demand on two fronts: (1) demand
      to
      integrate Flash 8 video onto non-PC platforms, and (2) until most devices can
      play Flash 8 content, demand to provide transcoding software that allows Flash
      8
      content to be decoded and re-encoded into a format (such as the 3GPP standard)
      that is supported on devices. We are actively working to provide solutions
      for
      both of these demands and plan to continue to respond as necessary to the
      evolution and migration of Flash video.




H.264
      continues to rise as a competitor with the Company’s VPx product in the video
      compression field. H.264 is a standards-based codec that is the successor to
      MPEG-4. We believe that our technology is superior to H.264, and that we can
      offer significantly more flexibility in licensing terms than customers get
      when
      licensing H.264. H.264 has nevertheless gained significant adoption by potential
      customers because, as a standards-based codec, it has the advantage of having
      numerous developers who are programming to the H.264 standard and developing
      products based on that standard. In addition, a number of manufacturers of
      multimedia processors have done the work necessary to have H.264 operate on
      their chips, which makes H.264 attractive to potential customers who would
      like
      to enable video on devices. For example, Apple Inc. uses H.264 in its QuickTime®
player and has thus chosen H.264 for the current generation of video iPods.
      Finally, there is already a significant amount of professional content that
      has
      been encoded in H.264. These advantages may make H.264 attractive to potential
      customers and allow them to implement a solution based on H.264 with less
      initial development time and expense than a solution using On2® TrueMotion video
      might require. In addition, there are certain customers that prefer to license
      standards-based codecs. In August 2007, our customer Adobe announced that the
      latest version of the Flash video player would support H.264. We continue to
      believe that VP6 will be an important part of the Flash video ecosystem for
      three reasons: (1) Adobe has in the past provided backwards compatibility with
      all generations of Flash video codecs; (2) VP6 has certain performance
      advantages over H.264 (e.g., HD VP6 content may be played back on a
      lower-powered processor than HD H.264 content); and (3) there is a vast amount
      of existing VP6 content that consumers want on portable and mobile
      devices.




12


The
      market for digital media creation and delivery technology is constantly changing
      and becoming more competitive. Our strategy includes focusing on providing
      our
      customers with video compression/decompression technology that delivers the
      highest possible video quality at the lowest possible data rates. To do this,
      we
      devote a significant portion of our engineering capacity to research and
      development. We also are devoting significant attention to enabling our codecs
      to operate on a wide array of chips, both in software and in hardware. Our
      acquisition of Hantro has significantly increased the resources that we can
      devote to these efforts. We have also increased the number of our engineers
      who
      integrate our codecs on chips, and we have cultivated relationships with chip
      companies to enable those companies to perform such integration. By increasing
      support for our technology on the chips that power embedded devices, we hope
      to
      encourage use by customers who want to develop video-enabled consumer products
      in a short timeframe.




A
      continuing trend in our business is the growing presence of Microsoft, Inc.
      as a
      significant competitor in the market for digital media creation and distribution
      technology. In 2007, Microsoft released SilverlightTM, a rich Internet
      application that allows users to integrate multimedia features, such as vector
      graphics, audio and video, into web applications. Silverlight may compete
      directly with Flash. If Silverlight gains market share at the expense of Flash,
      it could have a negative impact on our Flix business. In addition, Microsoft
      VC1
      format also competes in the marketplace with H.264 and our VPx technologies.
      We
      believe that our VPx technologies have the same advantages over VC1 as they
      do
      over H.264. Microsoft’s practices have caused, and may continue to cause,
      pricing pressure on our revenue generating products and services and may affect
      usage of our competing products and formats. Microsoft’s marketing and licensing
      model has in some cases led to, and could continue to lead to, longer sales
      cycles, decreased sales, loss of existing and potential customers and reduced
      market share. In addition, we believe that Microsoft has used and may continue
      to use its financial resources and its competitive position in the computer
      industry to secure preferential or exclusive distribution, use and bundling
      contracts for its media delivery technologies, and products with third parties,
      such as ISPs, content delivery networks, content providers, entertainment and
      media companies, VARs and OEMs, including third parties with whom we have
      relationships.




The
      Microsoft® DRM (digital rights management) product, which prevents unauthorized
      copying and re-distribution of proprietary content, is widely accepted among
      movie studios and others in the content industry. Unfortunately, Microsoft’s DRM
      does not integrate well with non-Microsoft video and audio software, such as
      ours. We believe that the latest generation of codec technology, which includes
      VP7, is superior to Microsoft’s video compression software. We also believe that
      companies could become more comfortable with using DRM technology produced
      by
      companies other than Microsoft.




Although
      we expect that competition from Microsoft, H.264 developers, and others will
      continue to intensify, we expect that our video compression technology will
      remain competitive and that our relatively small size will allow us to innovate
      in the video compression field and respond to emerging trends more quickly
      than
      monolithic organizations like Microsoft and the MPEG consortium. We focus on
      developing relationships with customers who find it appealing to work with
      a
      smaller company that is not bound by complex and rigid standards-based licenses
      and fee structures and that is able to offer sophisticated custom engineering
      services. We believe our ability to provide both our VPx codecs and standards
      based codecs has positioned us uniquely as a one stop shop for the
      implementation of multiple codecs on a variety of devices.




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




13




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




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




·
            RTLs
                are cheaper to produce in high
                volumes;




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




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




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




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




·
            Initial
                implementation costs are high; and




·
            Hardware
                implementations are generally not
                upgradeable.




Similarly,
      software-upgradable DSPs offer certain advantages:




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




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




·
            They
                are more easily upgradeable.




But
      they
      also have certain disadvantages:




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




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




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




14


**Our
      Technology, Products and Services**




We
      have
      designed our software 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
      TrueMotion 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 1%, 19%, and 44% percent of our revenue for the fiscal years
      ended
      December 31, 2007, 2006 and 2005, 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 41%, 64%
      and 29% percent of our revenue for the fiscal years ended December 31, 2007,
      2006 and 2005, respectively.




Finally,
      our Hantro embedded product line consists of hardware (RTL) and software
      implementations of video and audio codecs that are largely intended to be
      operated on mobile cellular devices. The Hantro products are highly optimized
      and efficient designs aimed at minimizing both implementation costs and energy
      usage on devices.




***VP6
      Codec***




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




***VP7
      Codec***




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




***TrueMotion
      Encoder Products***





Our
      Encoder enables content owners to re-master and compress their assets
      efficiently into the VP6 or VP7 format at their own convenience. The Encoder
      is
      a key tool for users looking to develop content for our TrueMobileTM 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 develop jointly 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.




15




***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 the other 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
      of TrueMotion Codecs 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, mobile phones, set-top boxes 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, set-top boxes and other
      consumer device deployments where the availability of low-cost chips is
      important.




***Encoding
      Tools for Customer Formats***




In
      2005,
      we entered the business of selling video encoding software that allows users
      to
      encode video in the Adobe Flash 8 format, which uses On2’s TrueMotion VP6
      technology. The licensing of our Flash encoding tools accounted for 41%, 64%,
      and 29% of our revenue for the fiscal years ended December 31, 2007, 2006 and
      2005, respectively.


16




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 (SDKs) that allow customers to
      enable their products to encode in and decode from the Flash format. These
      products include our Flix SDK for DirectShow®, and our Flix SDK for Live Video.
      The SDKs can be integrated with our customers’ applications to enable file-based
      and live Flash video encoding directly with such applications.




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.




***HantroTM
      8170 Video Decoder***




The
      Hantro 8170 multi-format hardware provides format and resolution support to
      enable many types of video applications. The 8170 is significantly more power
      efficient than any commercially available DSP based solution and encompasses
      the
      latest in hardware design techniques to deliver improved performance and power
      utilization in a minimal silicon area. The 8170 utilizes dynamic clock gating,
      which de-activates the clock for functions when they are not required, thereby
      reducing power consumption. When combined with the Hantro
      6280 the 8170
      offers a full codec solution. The 8170 supports numerous formats, including
      the
      H.263, Spark, MPEG-4, H.264, VC-1 and JPEG. The 8170 supports resolutions from
      QCIF to 1080p.




***Hantro
      8190 Video Decoder***





The
      Hantro 8190 multi-format hardware provides format and resolution support to
      enable many types of video applications. The 8190 is significantly more power
      efficient than any commercially available DSP based solution and encompasses
      the
      latest in hardware design techniques to deliver improved performance and power
      utilization in a minimal silicon area. The 8190 utilizes dynamic clock gating,
      which de-activates the clock for functions when they are not required, thereby
      reducing power consumption. When combined with the Hantro 6280, the 8190 offers
      a full codec solution. The 8190 supports numerous formats including the H.263,
      Spark(r), MPEG-4, H.264, VP6, VC-1 and JPEG. The 8190 supports resolutions
      from
      QCIF to 1080p.




***Hantro
      7190 Video Decoder***




The
      Hantro 7190 multi-format hardware provides format and resolution support to
      enable many types of video applications. The 7190 is significantly more power
      efficient than any commercially available DSP based solution and encompasses
      the
      latest in hardware design techniques to deliver improved performance and power
      utilization in a minimal silicon area. The 7190 utilizes dynamic clock gating,
      which de-activates the clock for functions when they are not required, thereby
      reducing power consumption. When combined with the Hantro
      6280 ,
      the
      7190 offers a full codec solution. The 7190 supports numerous formats, including
      the H.263, Spark, MPEG-4, H.264, VC-1 and JPEG. The 7190 supports resolution
      forms QCIF to 720p.


17


***Hantro
      6280 Video Encoder***





The
      Hantro 6280 multi-format encoder core processes up to 1280 x 720 (720p)
      resolution video at 30 frames per second. The 6280 is designed for battery
      operated devices such as mobile phones and digital cameras. The 6280 combines
      ultra low power consumption with high resolution and broad format support.
      The
      6280 incorporates a proprietary indexed
      full search motion estimation algorithm,
      which reduces clock cycle requirement without affecting video quality. When
      combined with the Hantro
      8170 **** or
      the
      Hantro 7190 **,** the 6280
      offers a full codec solution. The 6280 supports numerous formats, including
      the
      H.263, MPEG-4, H.264 and JPEG and supports resolutions from QCIF to 720p.




***Hantro
      9100 Multi-Format Decoder***





The
      Hantro 9100 multi-decoder combines three of the most dominant video formats
      used
      to deploy video on the web. The 9100 is optimized for integration with ARM
      Powered® mobile handsets, providing chip and device manufacturers with a cost
      efficient off-the-shelf solution for supporting Flash video. The 9100 reduces
      the power required for video playback and saves battery life. The 9100 delivers
      CIF 30fps performance in approximately 100MHz on ARM9 CPUs for Spark based
      Flash
      video, and 170MHz in ARM11 for On2 VP6 and H.264 codecs. The 9100 multi-decoder
      achieves VGA resolution full motion playback by using the ARM NEON media
      processing extensions to the Cortex-A8.




***Hantro
      8100 Sorenson***





The
      Hantro 8100 is a fully optimized Sorenson Spark decoder for enabling Flash
      video
      playback in handheld devices. The 8100 is comparable to the Hantro 4100 H.263
      decoder in quality and performance but is mobile compatible for Flash 6 and
      Flash 7 based video content. As a standard ANSI C implementation, the 8100
      is
      available for various processor cores such as the ARM, Intel, MIPS and ARC,
      and
      the optimized versions are available for ARM11 (SIMD) and Intel PXA
      (MMX).




***Hantro
      7100 VC-1 Decoder***





The
      Hantro 7100 decoder enables support for capability classes from A to C at
      various IP-IRDs in ARM9 and ARM11 CPU based devices. The 7100, therefore,
      fulfills the requirements set by the upcoming DVB-H standard for mobile TV.
      In
      addition, the 7100 complies with the widely adopted Microsoft Windows Media
      Video (WMV) format and is suitable for implementing a full Windows Media player
      in a wireless handheld device. The 7100 is a pure ANSI C implementation,
      allowing portability to different processor cores such as Intel, ARC and MIPS.




***Hantro
      6200 H.264/AVC Encoder***





The
      Hantro 6200 encoder is fully optimized for ARM9 and ARM11 SIMD instruction
      sets.
      It may also be complied and further optimized for any typical mobile processor
      core such as Intel, ARC and MIPS when used as a pure ANSI C implementation
      the
      code. The 6200 supports four different encoding modes, allowing the optimal
      adaptation to available processing power. The 6200’s lowest encoding level has
      the least complexity and therefore places a minimal load on the CPU, whereas
      the
      highest level, providing the best video quality, has the highest requirement
      for
      CPU resources. The 6200 is delivered with Hantro's standard Application
      Programming Interface (API) or an operating system specific interface
      implementation such as Symbian MDF, Microsoft DirectShow, and OpenMax
      IL.




18




***Hantro
      6100 H.264/AVC Decoder***





The
      Hantro 6100 decoder is targeted for implementing 3GPP, DVB-H and DMB based
      video
      applications in a mobile handset. The 6100 is fully compliant with H.264
      Baseline profile and has been thoroughly tested for interoperability in IMTC
      and
      MPEGIF. Highly optimized code allows standard 3GPP services (QCIF, 15fps) to
      be
      implemented even low power ARM7 cores where as higher performance applications
      like DVB-H and DMB mobile TV playback can be implemented in existing
      handset based on the ARM9 family of processor cores. As a pure ANSI C
      implementation, the 6100 is portable to different processor cores such as Intel,
      ARC and MIPS.




***Hantro
      4200 MPEG-4 / H.263 Encoder***





The
      Hantro 4200 is fully compliant with 3GPP specifications and has been
      interoperability tested in IMTC and MPEGIF. The 4200 enables video applications
      like camcorder (MMS) and video telephony. As a standard ANSI C implementation,
      the 4200 is available for various processor cores such as the ARM, Intel, MIPS
      and ARC.




***Hantro
      4100 MPEG-4 / H.263 Decoder***





T he
      4100
      is fully compliant with 3GPP specifications and has been thoroughly
      interoperability tested in IMTC and MPEGIF. The 4100 enables video applications
      like realtime streaming, video telephony and local video playback. As a standard
      ANSI C implementation, the 4100 is available for various processor cores such
      as
      the ARM, Intel, MIPS and ARC.




***Hantro
      DirectShow***





Hantro
      DirectShow filters provide decode support for MPEG-4, H.263, Sorenson
      Spark, H.264/AVC and On2 VP6 video standards, GSM-AMR and AAC+ audio
      support, .3gp / .mp4 file format and 3GPP compliant streaming by enabling the
      fast deployment of multimedia applications in Windows based devices. As
      individual DirectShow compatible filters (DLL), these modules can be used
      alongside other formats and components, providing total flexibility for
      application development and aftermarket feature enhancement.




***Software
      AMR-NB Encoder and Decoder***





The
      AMR-NB audio encoder and decoder are targeted for mobile video messaging,
      streaming and telephony applications. These modules are available individually,
      as a full codec or incorporated as part of a complete multimedia solution.
      The
      modules are implemented in ANSI C, and may be ported to any processor
      environment.




***Enhanced
      aacPlus Codec (HE AAC v.2)***





Provided
      by Coding Technologies, the Enhanced aacPlus audio codec is utilized for
      embedded application in resource limited environments while maintaining quality,
      performance and optimization. MPEG-4 aacPlus is the combination of three MPEG
      technologies including Advanced Audio Coding (AAC), Coding Technologies'
      Spectral Band Replication (SBR) and Parametric Stereo (PS) technologies. SBR
      is
      a unique bandwidth extension technique which enables audio codecs to deliver
      the
      same quality at half the bit rate. PS significantly increases the codec
      efficiency a second time for low bit rate stereo signals. The supported
      platforms for the encoders include Win32, Linux, MacOS X, ARM, TI,
      Motorola and other DSPs.




***Multimedia
      Application Development Platform***





The
      Hantro development platform enables the fast deployment of applications such
      as:
      local video player, network streaming player and camcorder by speeding
      application development, device integration and upgrades. The platform features
      a completely modular design and offers high level application programming
      interfaces and wrapper interfaces for user interface development and device
      integration. Reference platforms are available for Windows CE, Pocket PC,
      Windows Mobile 5.0, Nucleus, Palm OS, eLinux, ARM Linux and uCos
      (MicroC/OSII).




19




***Application
      development for Freescale i.MX and MXC Processors***





Combining
      Hantro hardware video accelerators (integrated in i.MX and MXC processors)
      with
      additional technology modules and application logic, the application development
      platform enables high quality video with longer battery life. Available to
      license pre-ported off-the-shelf, it is interoperability proven and performance
      optimized.




***Hantro
      Embedded Development Services***





On2's
      Hantro Embedded Development Services combines knowledge of hardware codec cores
      and experience in solving the challenges of multimedia integration and software
      development to help minimize project risk and realize target revenues
      faster.




**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 6%, 8%, and 4% of our revenue for the years
      ended December 31, 2007, 2006 and 2005, respectively. In particular, we offer
      the following services:




***Custom
      Engineering and Consulting Services***




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




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





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





·
            evaluating
                potential customer implementations of our software;
                and





·
            providing
                technical support for existing customers.





***Encoding***




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




**Research
      and Development**




The
      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 and to improve the design, performance and quality of our digital
      electronic hardware. In addition, we devote significant research and development
      time 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, 2007, 2006 and
      2005
      were $3,833,000, $972,000, and $1,035,000, respectively.




20




**Distribution
      Methods**





Our
      business consists of developing and marketing our software-based technology
      products, our digital electronic hardware designs and related services. 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 we license our hardware video codec to companies that incorporate
      our technology into the semi-conductors and devices. Our software 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.




We
      generally sell our digital electronic hardware designs to manufacturers of
      computer chips and multimedia devices. We work closely with our embedded video
      customers to apply our hardware video codec to their application and license
      that embedded video solution to them. 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: hardware and software product licensing and professional
      services. Our sales and business development departments focus on engaging
      chip-set and device 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. We also seek to license our embedded video
      hardware technology to chip-set and device manufacturers. 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.




**International**





We
      believe that we are well positioned to selectively expand our business into
      other countries. 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 we 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, 2007, 2006 and 2005, foreign customers accounted
      for approximately 45%, 40%, and 27%, respectively, of total revenue. These
      customers were primarily located in Asia and increasingly in Europe after our
      acquisition of Hantro.




***Europe***





Prior
      to
      our acquisition of Hantro, we did not have the same success in Europe that
      we
      had in Asia. Hantro has a well established market position in Europe and has
      close customer and partnership relationships with major phone and OEM vendors
      in
      Europe, as well as with leading wireless operators. For the year ended December
      31, 2007, revenue, net of on-line sales and post contract customer support
      of
      approximately $1,600,000, generated from customers located in Europe and the
      Middle East was $2,230,000 with 29% from Finland, 36% from the UK and France
      and
      4% from Spain. 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, which includes two months of revenue from Hantro.
      For
      the year ended December 31, 2005, revenue generated from customers located
      in
      Europe was $25,000 all of which was from the Netherlands.




***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, 2007, revenue generated from customers located in Asia was
      $3,124,000, with 28% from Japan, 20% from Korea, 34% from Taiwan and 10% from
      China. 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. Furthermore, Hantro has a significant presence
      in
      North East Asia, with over 30 customers and several reputable System-On-Chip
      vendors. Asia contributed to over one-third of Hantro’s revenue for
      2007. ****




21




**Location
      of Assets and Operations**





Prior
      to
      the acquisition of Hantro, all of our assets and operations were based within
      the United States, except for two research and development employees located
      in
      the United Kingdom. Hantro has assets and operations located primarily in
      Finland, and has sales operations in Korea, Japan, Taiwan, Germany, Hong Kong,
      Mainland China, and the United States.




**Competition**





We
      believe that the principal competitive advantage of our code TrueMotion video
      compression technology 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.




We
      believe that the principal competitive advantage of our digital electronic
      hardware designs is our ability to produce designs that require less surface
      area than competitors’ designs. In addition, our reputation for producing
      reliable products with good documentation and strong technical support is
      important to our competitive advantage in the embedded technology
      market.




22




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 variants MPEG-4 and H.264. 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. Our embedded technology
      competes with companies such as Chips & Media, Inc., Techno Mathematical
      Co., LTD, and videantis GmbH.




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
      in the past we have not enjoyed. 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.





We
      enjoy
      several advantages in our business of marketing optimized standards-based codecs
      for the embedded market and, in particular, licensing RTL designs for hardware
      implementations of those codecs. We have a reputation for producing reliable,
      high-quality technology and providing high quality technical support for those
      products. Because of the high costs of developing embedded technology and the
      huge number of units that our customers may deploy containing, that reputation
      gives us a valuable competitive advantage. In addition, we develop very
      efficient embedded designs, which can reduce our customers costs of implementing
      our technology and can minimize increased power consumption for our customers’
products. Our continued ability to develop such efficient designs has in the
      past given us an additional advantage over our competitors.


23




**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 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 our Hantro embedded technology business, we
      generally market our products either to chip companies who will use our
      technology to develop multimedia-enabled chips to be sold to mobile and device
      manufacturers, or to the mobile and device manufacturers themselves. Finally,
      the customers for our engineering services are generally customers of our
      TrueMotion video compression technology or our Hantro embedded technology who
      need assistance customizing that technology 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.





For
      the
      year ended December 31, 2007, there were no customers that accounted for
      10% or more of the Company’s total revenue. For the year ended December 31,
      2006, one customer accounted for 10% of the Company’s total revenue. For the
      year ended December 31, 2005, two customers accounted for 20% and 11%,
      respectively, of the Company’s total revenue.





As
      of
      December 31, 2007, two customers accounted for 18% and 12% of gross
      accounts receivable. 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 eight U.S. patents and have four U.S. patent
      applications pending, five international patent applications pending, and two
      international patent applications published. Hantro currently has four U.S.
      patent applications pending, eight Finnish patents, two foreign (non-Finnish)
      patent applications pending, and four foreign (non-Finnish) patent applications
      published. 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 our intellectual property
      is
      maintained through these measures, there can be no assurance that steps we
      have
      taken and continue to take to protect our proprietary rights will be adequate
      or
      that third parties will not infringe on our intellectual property. In addition,
      there can be no assurance that third parties will not assert infringement claims
      against us which, even if not meritorious, could result in the expenditure
      of
      substantial resources and management effort.





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





Within
      the last two years, 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.


24


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, 2007, we had 114 full-time employees. Of the total employees,
      79 were engineering and product development personnel, 18 were sales and
      marketing personnel and 17 were general and administrative personnel.





Our
      employees located in Finland are represented by a labor union, and we consider
      our relationships with all of 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.





**Where
      You Can Find More Information About Us**





Our
      principal executive offices are located at 21 Corporate Drive, Suite 103,
      Clifton Park, New York 12065, and our telephone number at that location is
      (518)
      348-0099. We file reports with the Securities and Exchange Commission (SEC),
      including annual reports on Form 10-K, quarterly reports on Form 10-Q, current
      reports on Form 8-K and amendments to such reports. The public may read and
      copy
      any materials we file with the SEC at the SEC’s Public Reference Room at
      450 Fifth Street, N.W., Washington, DC 20549. The public may obtain
      information on the operation of the Public Reference Room by calling
      1-800-SEC-0330. The SEC also maintains an Internet site that contains reports
      and other information regarding issuers that file electronically with the SEC
      at*http://www.sec.gov*.
      Additionally, information about us, including our reports filed with the SEC,
      is
      available through our website at*http://www.on2.com*.
      Such
      reports are accessible at no charge through our web site and are made available
      as soon as reasonably practicable after such material is filed with or furnished
      to the SEC. The contents of our website are not incorporated by reference into
      this Form 10-K.


25


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





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





***Our
      recent acquisition of Hantro could expose us to new risks, disrupt our business,
      and adversely impact our results of operations.***





On
      November 1, 2007 we completed the acquisition of Hantro Products Oy (“Hantro”),
      a Finnish corporation. The integration of Hantro may divert the attention of
      management and other key personnel from other core business operations, which
      could adversely impact our financial performance in the near term. Moreover,
      the
      integration of Hantro’s operations into our company will require expansions to
      our system of internal controls over financial reporting. Any failure to
      successfully operate and integrate Hantro could have an adverse effect on our
      operations.





***Additional
      goodwill reported on our balance sheet as a result of our acquisition of Hantro
      may become impaired at a future date and accordingly require us to record a
      loss
      in the amount of the impairment in our results of operations.***





The
      valuation of the Hantro acquisition for accounting purposes has been completed.
      The asset allocation is as follows:





**Fair
                Value**Purchased
                Technology
            
            $
            10,214,000Customer
                Relationships
            
            
            4,074,000Trademarks
            
            
            2,991,000Goodwill
            
            
            36,075,000Net
                Tangible Liabilities Assumed
            
            
            (3,853,000
            )Purchase
                Price
            
            $
            49,501,000





Under
      generally accepted accounting principles, we will test the goodwill amount
      at
      regular intervals to determine whether the value of Hantro exceeds this amount.
      To the extent that it does not, we will be forced to make a corresponding
      reduction in the carrying value of its goodwill, and will also be required
      to
      take a corresponding charge against earnings for the period in which we recorded
      the impairment. The size of the impairment could be significant, and could
      have
      a material adverse effect on the business and financial position of us, as
      well
      as on the trading price of its shares.





***We
      may fail to realize the benefits expected from the business combination with
      Hantro, which could adversely affect the value of our common
      stock.***





The
      business combination involves the integration of On2 and Hantro, two companies
      that have previously operated independently. On2 and Hantro entered into the
      Share Exchange Agreement with the expectation that, among other things, the
      business combination would enable the combined company to consolidate support
      functions, leverage its research and development, patents and services across
      a
      larger base, and integrate its workforce, to create opportunities to achieve
      cost savings and to become a stronger and more competitive company. Although
      we
      expect significant benefits to result from the business combination, there
      can
      be no assurance that the combined company will actually realize these or any
      other anticipated benefits of the business combination.





The
      value
      of our common stock may be affected by our ability to achieve the benefits
      expected to result from the business combination. The combined company currently
      operates in several countries, with a combined workforce of approximately 114
      employees. Achieving the benefits of the business combination will depend in
      part upon meeting the challenges inherent in the successful combination and
      integration of global business enterprises of the size and scope of On2 and
      Hantro. The challenges involved in this integration include the following:


26





·
            demonstrating
                to our customers that the business combination has not and will not
                result
                in adverse changes to our ability to address the needs of customers,
                or
                the loss of attention or business focus;


·
            coordinating
                and integrating independent research and development teams across
                technologies and product platforms to enhance product development
                while
                reducing costs;


·
            Combining
                product offerings;


·
            Consolidating
                and integrating corporate, information technology, finance, and
                administrative infrastructures;


·
            coordinating
                sales and marketing efforts to effectively position the capabilities
                of
                the combined company and the direction of product development; and


·
            minimizing
                the diversion of management attention from important business objectives.





If
      we do
      not successfully manage these issues and the other challenges inherent in
      integrating businesses of the size and complexity of On2 and Hantro, then we
      may
      not achieve the anticipated benefits of the business combination and our
      revenues, expenses, operating results and financial condition could be
      materially adversely effected. For example, goodwill and other intangible assets
      could be determined to be impaired which could adversely impact our financial
      results. The successful integration of the combined company businesses is likely
      to require significant management attention both before and after the completion
      of the business combination, and may divert the attention of management from
      our
      business and operational issues.





***Uncertainties
      associated with the business combination may cause a loss of employees and
      may
      otherwise materially adversely affect our business and operations.***





Our
      future success will depend in part upon our ability to retain our key employees.
      In some of the fields in which we operate, there are only a limited number
      of
      people in the job market who possess the requisite skills. We have experienced
      difficulty in hiring and retaining sufficient numbers of qualified engineers
      in
      parts of our business. Current and prospective employees may experience
      uncertainty about their post-business combination roles with the combined
      company. This may materially adversely affect our ability to attract and retain
      key management, sales, marketing, technical and other personnel. In addition,
      key employees may depart because of issues relating to the uncertainty and
      difficulty of integration or a desire not to remain with the combined company
      following the share exchange. The loss of services of any key personnel or
      the
      inability to hire new personnel with the requisite skills could restrict our
      ability to develop new products or enhance existing products in a timely manner,
      to sell products to customers or to effectively manage our business.





***In
      May 2008, our management identified three material weaknesses in our internal
      control over financial reporting and, as a result, has concluded that our
      internal control over financial reporting and our disclosure controls and
      procedures were ineffective as of December31, 2007. Although we are attempting
      to remediate these material weaknesses, if we are unable to successfully do
      so,
      or if additional material weaknesses in our internal control over financial
      reporting are identified or develop, we may be unable to comply with our
      periodic reporting requirements, accurately report our financial results, detect
      fraud or comply with the requirements of Section 404 of the Sarbanes-Oxley
      Act
      which could have an adverse effect on our business and our stock
      price.***





As
      described in “Part II — Item 9A. Controls and Procedures” of this report, in May
      2008, we identified three material weaknesses in our internal control over
      financial reporting as a result of which our Interim CEO and CFO concluded
      that
      our disclosure controls and procedures were ineffective as of December 31,
      2007,
      due to the conditions that led to the identification of the material
      weaknesses. **** These
      material weaknesses were by identified by management during its assessment
      of
      the effectiveness of the Company’s internal control over financial reporting
      pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 in connection with
      the
      preparation of the Company’s Annual Report on Form 10-K for the year ended
      December 31, 2007. As a result of these material weaknesses, our Interim CEO
      and
      CFO also concluded that our internal control over financial reporting and our
      disclosure controls and procedures were ineffective as of December31, 2007,
      due
      to the conditions that led to the identification of the material weaknesses.
      Prior to the filing of this report, we have taken certain steps to remediate
      these material weaknesses and are in the process of finalizing, and will present
      to the Audit Committee, a final plan and timetable for the implementation of
      remediation measures to further these material weaknesses. The Audit Committee
      intends to monitor such implementation. Although we anticipate that these
      actions will remediate the material weaknesses we have identified and strengthen
      our internal control over financial reporting, we cannot assure you that the
      finalized measures that we implement will effectively address such material
      weaknesses.


27




In
      addition, we or our independent auditors may identify further material
      weaknesses or significant deficiencies in the future. If a material weakness
      exists as of a future period year-end (including a material weakness identified
      prior to year-end for which there is an insufficient period of time to evaluate
      and confirm the effectiveness of the corrections or related new procedures),
      our
      management will be unable to report favorably as of such future period year-end
      to the effectiveness of our internal control over financial reporting. If we
      are
      unable to assert that our internal control over financial reporting is effective
      in any future period, or if we continue to experience material weaknesses in
      our
      internal control over financial reporting, we could lose investor confidence
      in
      the accuracy and completeness of our financial reports, which could have an
      adverse effect on our stock price and potentially subject us to litigation.





Remedying
      the currently existing material weaknesses, as well as any additional
      significant deficiencies or material weaknesses that we or our independent
      auditors may identify in the future, may require us to incur significant costs
      and expend significant time and management resources.   If we fail to
      timely remedy any current or additional material weaknesses or significant
      deficiencies that we or our auditors may identify, we may be unable to comply
      with our periodic reporting requirements, accurately report our financial
      results, detect fraud or comply with the requirements of Section 404 of the
      Sarbanes-Oxley Act of 2002 all of which could result in a loss of investor
      confidence in the accuracy, timeliness and completeness of our financial
      reports. In addition, we can give no assurance that our independent auditors
      will agree with our management’s assessment of the effectiveness of our internal
      control over financial reporting at that time. If we cannot produce reliable
      financial reports, investors could lose confidence in our reported financial
      information, the market price of our common stock could decline significantly,
      we may be unable to obtain additional financing to operate and expand our
      business, and our business and financial condition could be harmed.





***Our
      failure to timely file certain periodic reports with the SEC poses significant
      risks to our business, each of which could materially and adversely affect
      our
      financial condition and results of operations.***





We
      did
      not timely file with the SEC this Annual Report on Form 10-K for the fiscal
      year
      ended December 31, 2007 or our Form 10-Q for the quarterly period ended March
      31, 2008. Consequently, we were not compliant with the reporting requirements
      under the Exchange Act. As a result of our inability to have timely filed our
      periodic reports with the SEC, we have not been eligible to use a registration
      statement to offer and sell freely tradable securities, which prevents us from
      accessing the public capital markets. We may also be subject to delisting of
      our
      common stock by the American Stock Exchange. On April 15, 2008, we submitted
      a
      proposed compliance plan to the AMEX, and on April 30, 2008, the AMEX granted
      an
      extension of the filing deadline of this 2007 10-K to June 30, 2008. While
      the
      compliance plan is in effect, On2 is required to advise the AMEX of new
      developments regarding the ongoing inquiry, progress with respect to initiatives
      of the plan and to respond to any particular questions the AMEX may raise.
      We
      may also be subject to enforcement action by the SEC or shareholder lawsuits.
      Any of these events could continue to materially and adversely affect our
      financial condition and results of operations. This 2007 Form 10-K filing
      is expected to be followed by the filing of our Form 10-Q for the quarterly
      period ended March 31, 2008. Upon the filing of this report and our quarterly
      report for the quarter ended March 31, 2008, we will be current with our SEC
      reporting requirements.





***We
      experienced additional risks and costs as a result of the restatement of our
      financial statements and the delayed filing of this annual report on Form 10-K.***





As
      a
      result of the restatement of our financial data for the quarters ended June
      30,
      2007 and September 30, 2007and the delayed filing of this annual report on
      Form
      10-K, we have become subject to a number of additional risks and uncertainties,
      including substantial unanticipated costs for accounting and legal fees in
      connection with or related to the restatement. It is possible that we will
      become involved in proceedings in the future in relation to these restatements.
      In connection with such potential proceedings, any incurred expenses not covered
      by available insurance or any adverse resolution could have a material adverse
      effect on us. Any such proceedings could be time consuming and distract our
      management from the conduct of our business. In addition, the restatement was
      time-consuming and required us to incur significant incremental expenses and
      affected management’s attention and resources. Further, the measures being
      implemented to strengthen our internal control over financial reporting continue
      to require and will likely require in the future greater management time,
      company resource and outside professional resources to implement and monitor.


28




***Our
      success depends upon the continuing service and capabilities of our management
      team. The failure to retain existing management could have a material adverse
      effect on our business.***




Our
      success will be dependent on our continued ability to attract, retain and
      motivate highly skilled employees. On June 11, 2008, Bill Joll resigned
      as our CEO
      and
      as a member of our Board of Directors. During his service as our CEO, Mr. Joll
      had established relationships with many of our customers the disruption of
      which, as a result of his resignation, could adversely affect our business.
      On
      June 10, 2008, the Board of Directors appointed Matthew Frost, our EVP, Legal
      and Business Affairs, to serve as Interim Chief Executive Officer and Chief
      Operating Officer upon the resignation of Mr. Joll. Mr. Joll will remain with
      us
      as an advisor to the chief executive officer until September 30, 2008 to effect
      a smooth transition of customer relationships and business development
      opportunities.The
      Board
      of Directors is currently conducting a search for a permanent CEO. Leadership
      transitions can be inherently difficult to manage and may cause disruption
      to
      our business or further turnover in our workforce or management team. The loss
      of services of one or more other members of senior management, or the inability
      to attract a qualified permanent CEO, would likely have a material adverse
      effect on our business. We are not protected by any key-man or similar life
      insurance for any of our executive officers.




***Our
      operating results may be adversely impacted by worldwide political and economic
      uncertainties and specific conditions in the markets we address, including
      the
      cyclical nature of and volatility in the semiconductor
      industry.*** **





We
      operate in the semiconductor industry, which is cyclical and subject to rapid
      change and evolving industry standards. From time to time, the semiconductor
      industry has experienced significant downturns. These downturns are
      characterized by decreases in product demand, excess customer inventories,
      and
      accelerated erosion of prices. These factors could cause substantial
      fluctuations in our revenue and in our results of operations. Any downturns
      in
      the semiconductor industry may be severe and prolonged, and any failure of
      the
      industry or wired and wireless communications markets to fully recover from
      downturns could seriously impact our revenue and harm our business, financial
      condition and results of operations. The semiconductor industry also
      periodically experiences increased demand and production capacity constraints,
      which may affect our ability to ship products. Accordingly, our operating
      results may vary significantly as a result of the general conditions in the
      semiconductor industry, which could cause large fluctuations in our stock price.





Additionally,
      in the last five years, general worldwide economic conditions have experienced
      a
      downturn due to slower economic activity, concerns about inflation and
      deflation, increased energy costs, decreased consumer confidence, reduced
      corporate profits and capital spending, adverse business conditions and
      liquidity concerns in the wired and wireless communications markets, the ongoing
      effects of the war in Iraq, recent international conflicts and terrorist and
      military activity, and the impact of natural disasters and public health
      emergencies. These conditions make it extremely difficult for our customers,
      our
      vendors and us to accurately forecast and plan future business activities,
      and
      they could cause U.S. and foreign businesses to slow spending on our products
      and services, which would delay and lengthen sales cycles. We cannot predict
      the
      timing, strength or duration of any economic recovery, worldwide, or in the
      wired and wireless communications markets. If the economy or the wired and
      wireless communications markets in which we operate do not continue at their
      present levels, our business, financial condition and results of operations
      will
      likely be materially and adversely affected.


29







***The
      current depressed general economic and market conditions could cause decreases
      in the demand for our products, which could negatively affect our revenue and
      operating results.***





Downturns
      in general economic and market conditions such as those being experienced at
      present may result in customers postponing or canceling hardware or software
      purchasing decisions. If demand for our products decreases, our revenues may
      decrease and operating results would be negatively impacted.





***As
      our international business expands, we are increasingly exposed to various
      legal, business, political and economic risks associated with our international
      operations.***





We
      derive
      a substantial portion of our revenue from sales of products shipped to locations
      outside of the United States. In addition, Hantro, our wholly-owned subsidiary,
      manufactures a significant portion of its products outside of the United States
      and will be dependent on non-U.S. suppliers for many parts and services. We
      may
      also pursue growth opportunities in sales, design and manufacturing outside
      of
      the United States. Operations outside of the United States are subject to a
      number of risks and potential costs that could adversely affect revenue and
      results of operations, including:





·
            political,
                social and economic instability;


·
            fluctuations
                in currency exchange rates;


·
            exposure
                to different legal standards, particularly with respect to intellectual
                property;


·
            natural
                disasters and public health emergencies;


·
            nationalization
                of business and blocking of cash flows;


·
            trade
                and travel restrictions;


·
            imposition
                of governmental controls and restrictions;


·
            burdens
                of complying with a variety of foreign laws;


·
            import
                and export license requirements and restrictions;


·
            unexpected
                changes in regulatory requirements;


·
            foreign
                technical standards;


·
            difficulties
                in staffing and managing international operations;


·
            international
                trade disputes;


·
            difficulties
                in collecting receivables from foreign entities or delayed revenue
                recognition;


·
            potentially
                adverse tax consequences;


·
            changes
                in taxation and tariffs; and


·
            fluctuations
                in currency exchange rates.





***We
      will face uncertainties related to the effectiveness of internal controls as
      a
      result of the business combination with Hantro.***





Public
      companies in the United States are required to review their internal controls
      over financial reporting under Section 404 of the Sarbanes-Oxley Act of 2002.
      It
      should be noted that any system of controls, however well designed and operated,
      can provide only reasonable, and not absolute, assurance that the objectives
      of
      the system are met. In addition, the design of any control system is based
      in
      part upon certain assumptions about the likelihood of future events. Because
      of
      these and other inherent limitations of control systems, there can be no
      assurance that any design will achieve its stated goal under all potential
      future conditions, regardless of how remote.





There
      can
      be no assurance that the integration of Hantro, and its internal control systems
      and procedures, will not result in or lead to a future material weakness in
      our
      internal controls, or that we or our independent registered public accounting
      firm will not identify a material weakness in our internal controls in the
      future. A material weakness in internal controls over financial reporting would
      require management and our independent public accounting firm to evaluate our
      internal controls as ineffective. If internal controls over financial reporting
      are not considered adequate, we may experience a loss of public confidence,
      which could have an adverse effect on its business and stock price.


30





***Fluctuations
      in foreign currency exchange rates could negatively impact our business, results
      of operations and financial condition.***





As
      an
      increasing proportion of our business may be denominated in currencies other
      than U.S. dollars, fluctuations in foreign currency exchange rates may have
      an
      adverse impact on our business, results of operations and financial condition.
      Our primary currency exposures are to the euro. These exposures may change
      over
      time as we change the geographic mix of our global business and as our business
      practices evolve. For instance, if we increase our presence in emerging markets,
      we may see an increase in our exposure to emerging market currencies, such
      as
      the Indian rupee. These currencies may be affected by internal factors and
      external developments in other countries. Also, our ability to enter into normal
      course derivative or hedging transactions in the future may be impacted by
      our
      current credit condition. Significant foreign exchange rate fluctuations could
      have material adverse effect to our business, results of operations and
      financial condition.





As
      a
      result of the strengthening Euro relative to the US dollar, during 2007 the
      revenue growth was 30% when presented in US dollars, whereas had the currency
      rates remained similar to those in 2006 it would have been 28%.




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





Since
      our
      inception, we have incurred significant losses and negative cash flow from
      operations, and as of December 31, 2007, we had an accumulated deficit of
      approximately $131.3 million. On December 31, 2007, we had cash and investment
      reserves of approximately $15.1 million. During fiscal 2008, we expect to meet
      our working capital obligations and other cash requirements with cash derived
      from the sale of our products and services and from our cash reserves. There
      can
      be no assurance, however, that cash derived from the sale of our products and
      services will be sufficient for our operating needs or that we will be able
      to
      achieve profitability on a consistent basis, if at all. In the event that cash
      used in operations is higher than anticipated and we are unable to secure
      additional funding, in order to preserve cash, we would be required to further
      reduce expenditures and effect further reductions in our corporate
      infrastructure, either of which could have a material adverse effect on our
      ability to continue our current level of operations. Even if we obtain
      additional working capital in the near future, to the extent that operating
      expenses increase or we need additional funds to make acquisitions, develop
      new
      technologies or acquire strategic assets, the need for additional funding may
      be
      accelerated, and there can be no assurances that any such additional funding
      can
      be obtained on terms acceptable to us, if at all.





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





Prior
      to
      our acquisition of Hantro, Hantro did not generate sufficient revenues to offset
      is operating costs and On2 has only generated sufficient revenues to offset
      its
      operating costs in two of the three most recent fiscal quarters. Moreover,
      as we
      continue to expand our product and service offerings to maintain our competitive
      advantage, we may be required to incur additional costs to hire and retain
      additional personnel, license complementary third party technology for use
      in
      our proprietary software or expand both our international and domestic presence
      to enter new markets. These costs may significantly increase our current level
      of monthly operating expenses. Failure to generate sufficient capital through
      both our revenue streams and financings may require us to execute additional
      corporate restructurings, scale back our product or service offerings or limit
      the markets into which we enter. Any of these items, or a combination thereof,
      could have a harmful effect on our operating results and our stock
      price.





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





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


31





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





Fluctuations
      in the market price of our common stock may adversely affect our access to
      capital and financing and our ability to attract and retain qualified personnel.
      Historically, our common stock price has fluctuated widely, with a 52-week
      range
      as of June 16, 2008 of $0.66 to $3.27. We expect fluctuations to continue in
      the
      future for a number of reasons, including:





·
            quarterly
                variations in our operating
                results;





·
            competitive
                announcements;





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





·
            news
                relating to trends in our markets;
                and





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





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





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





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





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





As
      part
      of our growth strategy, we may seek to acquire or invest in complementary
      businesses or technologies. Our goal is to make such acquisitions, integrate
      these acquired assets into our operations and expand the market for our products
      and services and possibly offer additional products or services. The process
      of
      integrating these acquired assets into our operations may result in unforeseen
      operating difficulties and expenditures, and may absorb significant management
      attention that would otherwise be available for the ongoing development of
      our
      business. We cannot be certain that the anticipated benefits of any acquisitions
      will be realized. Acquisitions also involve other risks, including entering
      geographic markets in which we have no or limited prior experience and the
      potential loss of key employees.





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


32





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





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





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





We
      currently hold over eight U.S. patents and have filed four additional U.S.
      patent applications. We have five international patent applications pending,
      and
      two international patent applications published. Hantro has four U.S. patent
      applications pending, eight Finnish patents, two foreign (non-Finnish) patent
      applications pending, and four foreign (non-Finnish) patent applications
      published. However, we cannot assure you that any additional patents will be
      issued. Even if a new patent is issued, the claims allowed may not be
      sufficiently broad to protect our technology. In addition, any of our existing
      or future patents may be challenged, invalidated or circumvented. As such,
      any
      rights granted under these patents may not provide us with meaningful
      protection. We may not have foreign patents or pending applications
      corresponding to our U.S. patents and patent applications. Even if foreign
      patents are granted, effective enforcement in foreign countries may not be
      available. If our patents do not adequately protect our technology, our
      competitors may be able to offer products similar to ours. Our competitors
      may
      also be able to develop similar technology independently or design around our
      patents. Some or all of our patents have in the past been licensed and likely
      will in the future be licensed to certain of our competitors through
      cross-license agreements. Moreover, because we have participated in developing
      various industry standards, we may be required to license some of our patents
      to
      others, including competitors, who develop products based on those standards.





Certain
      of our software (as well as that of our customers) may be derived from so-called
      “open source” software that is generally made available to the public by its
      authors and/or other third parties. Such open source software is often made
      available to us under licenses, such as the GNU General Public License, or
      GPL,
      which impose certain obligations on us in the event we were to distribute
      derivative works of the open source software. These obligations may require
      us
      to make source code for the derivative works available to the public, and/or
      license such derivative works under a particular type of license, rather than
      the forms of license customarily used to protect our intellectual property.
      In
      addition, there is little or no legal precedent for interpreting the terms
      of
      certain of these open source licenses, including the determination of which
      works are subject to the terms of such licenses. While we believe we have
      complied with our obligations under the various applicable licenses for open
      source software, in the event that the copyright holder of any open source
      software were to successfully establish in court that we had not complied with
      the terms of a license for a particular work, we could be required to release
      the source code of that work to the public and/or stop distribution of that
      work. With respect to our proprietary software, we generally license such
      software under terms that prohibit combining it with open source software as
      described above. Despite these restrictions, parties may combine our proprietary
      software with open source software without our authorization, in which case we
      might nonetheless be required to release the source code of our proprietary
      software.


33





We
      generally enter into confidentiality agreements with our employees, consultants
      and strategic partners. We also try to control access to and distribution of
      our
      technologies, documentation and other proprietary information. Despite these
      efforts, internal or external parties may attempt to copy, disclose, obtain
      or
      use our products, services or technology without our authorization. Also,
      current or former employees may seek employment with our business partners,
      customers or competitors, and we cannot assure you that the confidential nature
      of our proprietary information will be maintained in the course of such future
      employment. Additionally, current, departing or former employees or third
      parties could attempt to penetrate our computer systems and networks to
      misappropriate our proprietary information and technology or interrupt our
      business. Because the techniques used by computer hackers and others to access
      or sabotage networks change frequently and generally are not recognized until
      launched against a target, we may be unable to anticipate, counter or ameliorate
      these techniques. As a result, our technologies and processes may be
      misappropriated, particularly in countries where laws may not protect our
      proprietary rights as fully as in the United States.





We
      cannot
      assure you that our efforts to prevent the misappropriation or infringement
      of
      our intellectual property or the intellectual property of our customers will
      succeed. We have in the past been and currently are engaged in litigation to
      enforce or defend our intellectual property rights, protect our trade secrets,
      or determine the validity and scope of the proprietary rights of others,
      including our customers. Such litigation (and the settlement thereof) has been
      and will likely continue to be very expensive and time consuming. Additionally,
      any litigation can divert the attention of management and other key employees
      from the operation of the business, which could negatively impact our business
      and results of operations.





***Intellectual
      property risks and third party claims of infringement, misappropriation of
      proprietary rights or other claims against us could adversely affect our ability
      to market our products, require us to redesign our products or seek licenses
      from third parties, and seriously harm our operating results. In addition,
      the
      defense of such claims could result in significant costs and divert the
      attention of our management or other key employees.*** **





Companies
      in and related to the semiconductor, wireless and broadband industries often
      aggressively protect and pursue their intellectual property rights. There are
      often intellectual property risks associated with developing and producing
      new
      products and entering new markets, and we may not be able to obtain, at
      reasonable cost and upon commercially reasonable terms, licenses to intellectual
      property of others that is alleged to read on such new or existing products.
      From time to time, we may receive notices that claim we have infringed upon,
      misappropriated or misused other parties’ proprietary rights. Moreover, in the
      past we have been and we currently are engaged in litigation with parties that
      claim that we infringed their patents or misappropriated or misused their trade
      secrets. In addition, we or our customers may be sued by other parties that
      claim that our products have infringed their patents or misappropriated or
      misused their trade secrets, or which may seek to invalidate one or more of
      our
      patents. An adverse determination in any of these types of disputes could
      prevent us from manufacturing or selling some of our products, limit or restrict
      the type of work that employees involved in such litigation may perform for
      us,
      increase our costs of revenue and expose us to significant liability. Any of
      these claims may materially and adversely affect our business, financial
      condition and results of operations. For example, in a patent or trade secret
      action, a court could issue a preliminary or permanent injunction that would
      require us to withdraw or recall certain products from the market, redesign
      certain products offered for sale or under development, or restrict employees
      from performing work in their areas of expertise. We may also be liable for
      damages for past infringement and royalties for future use of the technology,
      and we may be liable for treble damages if infringement is found to have been
      willful. In addition, governmental agencies may commence investigations or
      criminal proceedings against our employees, former employees and/or the company
      relating to claims of misappropriation or misuse of another party’s proprietary
      rights. We may also have to indemnify some customers and strategic partners
      under our agreements with such parties if a third party alleges or if a court
      finds that our products or activities have infringed upon, misappropriated
      or
      misused another party’s proprietary rights. We have received requests from
      certain customers and strategic partners to include increasingly broad
      indemnification provisions in our agreements with them. These indemnification
      provisions may, in some circumstances, extend our liability beyond the products
      we provide to include liability for combinations of components or system level
      designs and for consequential damages and/or lost profits. Even if claims
      against us are not valid or successfully asserted, these claims could result
      in
      significant costs and diversion of the attention of management and other key
      employees to defend. Additionally, we may seek to obtain a license under a
      third
      party’s intellectual property rights and may grant a license to certain of our
      intellectual property rights to a third party in connection with a cross-license
      agreement or a settlement of claims or actions asserted against us. However,
      we
      may not be able to obtain a license under a third party’s intellectual property
      rights on commercially reasonable terms, if at all.


34





Our
      products may contain technology provided to us by other parties such as
      contractors, suppliers or customers. We may have little or no ability to
      determine in advance whether such technology infringes the intellectual property
      rights of a third party. Our contractors, suppliers and licensors may not be
      required to indemnify us in the event that a claim of infringement is asserted
      against us, or they may be required to indemnify us only up to a maximum amount,
      above which we would be responsible for any further costs or damages. In
      addition, we may have little or no ability to correct errors in the technology
      provided by such contractors, suppliers and licensors, or to continue to develop
      new generations of such technology. Accordingly, we may be dependent on their
      ability and willingness to do so. In the event of a problem with such
      technology, or in the event that our rights to use such technology become
      impaired, we may be unable to ship our products containing such technology,
      and
      may be unable to replace the technology with a suitable alternative within
      the
      time frame needed by our customers.





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





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





***With
      the acquisition of Hantro, we face intense competition in the semiconductor
      industry and the wired and wireless communications markets, which could reduce
      our market share in existing markets and affect our entry into new
      markets.*** **





The
      semiconductor industry and the wired and wireless communications markets are
      intensely competitive. We expect competition to continue to increase as industry
      standards become well known and as other competitors enter our target markets.
      We currently compete with a number of major domestic and international suppliers
      of integrated circuits and related applications in our target markets. In all
      of
      our target markets we also may face competition from newly established
      competitors, suppliers of products based on new or emerging technologies, and
      customers who choose to develop their own solutions. We expect to encounter
      further consolidation in the markets in which we compete.





Many
      of
      our competitors have longer operating histories and presence in key markets,
      greater name recognition, larger customer bases, and significantly greater
      financial, sales and marketing, manufacturing, distribution, technical and
      other
      resources than we do. These competitors may be able to adapt more quickly to
      new
      or emerging technologies and changes in customer requirements. They may also
      be
      able to devote greater resources to the promotion and sale of their products.
      In
      addition, current and potential competitors have established or may establish
      financial or strategic relationships among themselves or with existing or
      potential customers, resellers or other third parties. Accordingly, new
      competitors or alliances among competitors could emerge and rapidly acquire
      significant market share. Existing or new competitors may also develop
      technologies that more effectively address our markets with products that offer
      enhanced features and functionality, lower power requirements, greater levels
      of
      integration or lower cost. Increased competition has resulted in and is likely
      to continue to result in declining average selling prices, reduced gross margins
      and loss of market share in certain markets. We cannot assure you that we will
      be able to continue to compete successfully against current or new competitors.
      If we do not compete successfully, we may lose market share in our existing
      markets and our revenues may fail to increase or may decline.


35





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





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





***To
      remain competitive, we must keep pace with rapid technological change and
      evolving industry standards in the semiconductor industry and wired and wireless
      communications markets.*** **





Our
      future success will depend on our ability to anticipate and adapt to changes
      in
      technology and industry standards and our customers’ changing demands. We sell
      products in markets that are influenced by rapid technological change, evolving
      industry standards, frequent new product introductions, short product life
      cycles and increasing demand for higher levels of integration and smaller
      process geometries. Our past sales and profitability have resulted, to a large
      extent, from our ability to anticipate changes in technology and industry
      standards and to develop and introduce new and enhanced products incorporating
      the new standards and technologies. Our ability to adapt to these changes and
      to
      anticipate future standards, and the rate of adoption and acceptance of those
      standards, will be a significant factor in maintaining or improving our
      competitive position and prospects for growth. If new industry standards emerge,
      our products or our customers’ products could become unmarketable or obsolete,
      and we could lose market share. We may also have to incur substantial
      unanticipated costs to comply with these new standards. In addition, our target
      markets continue to undergo rapid growth and consolidation. A significant
      slowdown in any of these wired and wireless communications markets could
      materially and adversely affect our business, financial condition and results
      of
      operations. These rapid technological changes and evolving industry standards
      make it difficult to formulate a long-term growth strategy because the
      semiconductor industry and wired and wireless communications markets may not
      continue to develop to the extent or in the time periods that we anticipate.
      We
      have invested substantial resources in emerging technologies that did not
      achieve the market acceptance that we had expected. If new markets do not
      develop as we anticipate, or if our products do not gain widespread acceptance
      in these markets, our business, financial condition and results of operations
      could be materially and adversely affected.





***The
      complexity of our products could result in unforeseen delays or expenses and
      in
      undetected defects or bugs, which could damage our reputation with current
      or
      prospective customers, result in significant costs and claims, and adversely
      affect the market acceptance of new products.*** **





Highly
      complex products such as the products that we offer frequently contain defects
      and bugs when they are first introduced or as new versions are released. Our
      products have previously experienced, and may in the future experience, these
      defects and bugs. If any of our products contains defects or bugs, or has
      reliability, quality or compatibility problems, our reputation may be damaged
      and customers may be reluctant to buy our products, which could materially
      and
      adversely affect our ability to retain existing customers and attract new
      customers. In addition, these defects or bugs could interrupt or delay sales
      or
      shipment of our products to our customers. To alleviate these problems, we
      may
      have to invest significant capital and other resources. Although our products
      are tested by us, our subcontractors, suppliers and customers, it is possible
      that our new products will contain defects or bugs. If any of these problems
      are
      not found until after we have commenced commercial production of a new product,
      we may be required to incur additional development costs and product recall,
      repair or field replacement costs. These problems may divert our technical
      and
      other resources from other development efforts and could result in claims
      against us by our customers or others, including possible claims for
      consequential damages and/or lost profits. In addition, system and handset
      providers that purchase components may require that we assume liability for
      defects associated with products produced by their manufacturing subcontractors
      and require that we provide a warranty for defects or other problems which
      may
      arise at the system level. Moreover, we would likely lose, or experience a
      delay
      in, market acceptance of the affected product or products, and we could lose
      credibility with our current and prospective customers.


36





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





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





***Consolidation
      of customers of our embedded devices and RTL related business may lead to a
      reduction of the number of our deals and reduction of revenue in these
      businesses.***





We
      have
      recently seen consolidation of customers of our embedded devices and RTL related
      business. This may lead to a reduction in the number of deals and transactions
      we enter into as there may be fewer customers. In addition, one consolidated
      customer may use our products on more devices than it would have
      pre-consolidation, but it will not pay a proportionate increase in price for
      such increased usage.





***Changes
      in government regulation of the media and wireless communications industries
      may
      adversely effect our business.***





It
      is
      possible that a number of laws and regulations may be adopted in the United
      States and elsewhere that could restrict the media and wireless communications
      industries, including laws and regulations regarding customer privacy, taxation,
      content suitability, copyright, distribution and antitrust. Furthermore, the
      growth and development of the market for electronic commerce may prompt calls
      for more stringent consumer protection laws that may impose additional burdens
      on companies such as ours conducting business through wireless carriers. We
      anticipate that regulation of our industry will increase and that we will be
      required to devote legal and other resources to address this
      regulation.





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





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





·
            Discourage
                potential acquisition proposals;





·
            Delay
                or prevent a change in control; and





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





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


37





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





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





**Item
      1B.** ******  ***Unresolved
      Staff Comments***





None.





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





We
      do not
      own any real property. We lease approximately 7,000 square feet of space at
      21
      Corporate Dr., Suite 103, Clifton Park, New York where our principal executive,
      administrative and engineering offices are located, at an annual rental fee
      of
      approximately $106,000. This lease expires on February 1, 2009. In addition,
      we
      lease approximately 750 square feet of space for certain of our executives
      and
      certain IT and legal staff at 580 White Plains Road, Tarrytown, New York. We
      pay
      an annual rent of approximately $53,000 for this space. This lease
      expires **** January
      2011. We also lease small spaces in Cambridge, UK for an annual rental fee
      of
      $21,000 and in San Jose, California for an annual rental fee of $23,000.





The
      principal executive offices of Hantro, our subsidiary, are located in Oulu,
      Finland. Hantro leases approximately 17,000 square feet of space at
      Kiviharjunlenkki 1, Oulu, Finland, and pays an annual rental fee of
      approximately $460,000. This lease expires in November 2008. Hantro also leases
      office space in Finland for certain executives and certain sales managers in
      Kivenlahdenkatu 1, Espoo. Hantro pays an annual rent fee of approximately
      $25,000 for this 1,200 square feet space. This lease expires in August 2008.
      Hantro also leases small office spaces in Taiwan (for an annual rental fee
      of
      $19,000), Shanghai (for an annual rental fee of $18,000), Hong Kong (for an
      annual rental fee of $42,000), and Tokyo (for an annual rental fee of $63,000).





Management
      believes these facilities are all in usable condition and that these facilities
      are sufficient to meet our needs for the immediate future. Management also
      believes that these facilities are adequately covered by insurance.





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





**2006
      Internal Investigation**





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





**Beijing
      E-World**





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





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


38





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





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





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





Although
      almost three years have passed since the conclusion of the previous arbitration,
      the parties have nevertheless not completed the required porting of our software
      to two commercially available DSPs.


Our
      current arbitration claim alleges that, despite its obligations under the
      license agreements, Beijing E-World has:





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





·
            failed
                to use best reasonable efforts to have our video codec ported to
                a chip.





We
      have
      requested that the arbitrator award us approximately $5,690,000 in damages
      under
      the contract and grant us further relief as may be just and equitable.





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




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





On
      October 10, 2007, we held our annual stockholders meeting at the offices of
      McGuireWoods LLP, 1345 Avenue of the Americas, New York, NY 10105. Our
      stockholders approved all proposals presented at the annual meeting. The items
      considered and approved at the annual meeting are described in the proxy
      statement dated August 30, 2007. The record date for the annual meeting was
      July
      30, 2007. The meeting was called for the purpose of considering the following
      proposals:





1.
            to
                amend our bylaws to increase the number of members of our Board of
                Directors to nine (9) persons (Proposal
                #1);





2.
            to
                elect a board of nine (9) directors to serve until the next annual
                meeting
                of stockholders or until their successors are duly elected and qualified
                (Proposal #2);





3.
            to
                approve an amendment to our Certificate of Incorporation to increase
                the
                number of authorized shares of our common stock from 150,000,000
                to
                250,000,000 (Proposal #3);





4.
            to
                approve the issuance of shares of our common stock to be exchanged
                for all
                of the issued and outstanding equity securities of Hantro Products
                Oy, a
                corporation organized under the laws of Finland (“Hantro”), so that
                immediately after the share exchange Hantro will become a wholly-owned
                subsidiary of us (Proposal #4);





5.
            to
                authorize the Board of Directors, in its discretion, to amend our
                Certificate of Incorporation to effect a five-for-one reverse split
                of our
                outstanding shares of common stock (Proposal
                #5);




39




6.
            to
                approve an amendment to our Certificate of Incorporation to decrease
                the
                number of authorized shares of our common stock to 55,000,000 conditioned
                on the approval and implementation of Proposal No. 5 (Proposal
                #6);





7.
            to
                increase the number of authorized shares under our 2005 Incentive
                Compensation Plan to 20,000,000 shares (Proposal
                #7);





8.
            to
                ratify the election of Eisner LLP as our independent registered public
                accounting firm (Proposal #8); and





9.
            to
                transact any business as may properly come before the meeting and
                any
                adjournments thereof (Proposal #9).





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





All
      of
      the above proposals were approved at the annual meeting; however, Proposals
      5
      and 6 will not be implemented without additional shareholder approval. The
      votes
      received on the above proposals, including a separate tabulation with respect
      to
      each director nominee, were as follows:





**Proposal**
            
            **Number of Votes**
              **in Favor**
            
            **Number of Votes**
              **Against or Withheld**
            
            **Number of Abstentions**
              **and Broker Non-votes**Proposal #1
            
            
            85,004,181
            
            
            15,210,547
            
            
            1,097,169Proposal
                #2-Bill
                Joll
            
            
            60,835,676
            
            
            11,776,160-William
                A. Newman
            
            
            60,120,893
            
            
            12,490,943-Thomas
                Weigman
            
            
            66,171,987
            
            
            6,439,849-J.
                Allen Kosowsky
            
            
            66,324,603
            
            
            6,287,233-Mike
                Kopetski
            
            
            58,371,800
            
            
            14,240,036-Mike
                Alfant
            
            
            66,999,751
            
            
            5,612,085-Afsaneh
                Naimollah
            
            
            65,863,421
            
            
            6,748,415-James
                Meyer
            
            
            66,837,315
            
            
            5,774,521-Pekka
                Salonoja
            
            
            59,545,013
            
            
            13,066,823Proposal
                #3
            
            
            60,340,039
            
            
            11,200,030
            
            
            1,071,767Proposal
                #4
            
            
            55,389,419
            
            
            16,126,887
            
            
            1,095,530Proposal
                #5
            
            
            78,115,305
            
            
            22,009,941
            
            
            1,186,651Proposal
                #6
            
            
            81,575,163
            
            
            17,726,596
            
            
            2,010,138Proposal
                #7
            
            
            54,396,879
            
            
            17,050,969
            
            
            1,163,988Proposal
                #8
            
            
            95,180,236
            
            
            4,163,247
            
            
            1,968,414Proposal
                #9
            
            
            82,814,171
            
            
            15,978,100
            
            
            2,519,626


40





**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, 2006:





**High**
            
            **Low****Fiscal
                Year 2008**First
                Quarter
            
            $
            1.18
            
            $
            0.81Second
                Quarter (through June 16, 2008)
            
            $
            1.06
            
            $
            0.66**Fiscal
                Year 2007**First
                Quarter
            
            $
            1.65
            
            $
            1.02Second
                Quarter
            
            $
            3.99
            
            $
            1.57Third
                Quarter
            
            $
            3.05
            
            $
            1.00Fourth
                Quarter
            
            $
            1.71
            
            $
            0.75**Fiscal
                Year 2006**First
                Quarter
            
            $
            1.48
            
            $
            0.70Second
                Quarter
            
            $
            1.08
            
            $
            0.65Third
                Quarter
            
            $
            0.86
            
            $
            0.55Fourth
                Quarter
            
            $
            1.26
            
            $
            0.65





There
      were approximately 284 stockholders of record of our common stock as of June
      16,
      2008.





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.





**Equity Compensation Plan Information December 31, 2007****Plan category**
            
            **Number of securities**
              **to be issued**
              **upon exercise of**
              **outstanding options,**
              **warrants and rights**
            
            **Weighted-average**
              **exercise price of**
              **outstanding options,**
              **warrants and rights**
            
            **Number of securities**
              **remaining available for**
              **future issuance under**
              **equity compensation plans**
              **(excluding securities**
              **reflected in column (a))**(a)
            
            (b)
            
            (c)Equity
                compensation plans approved by security holders
            
            
            10,610,000
            
            $
            1.08
            
            
            10,452,000Equity
                compensation plans not approved by security holdersTotal
            
            
            10,610,00
            
            $
            1.08
            
            
            10,452,000


41


**Performance
      Graph**




The
      following graph compares the cumulative 5-year total return provided
      shareholders on our 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 December 31, 2002 to December
      31,
      2007.











12/02
            
            12/03
            
            12/04
            
            12/05
            
            12/06
            
            12/07On2
                Technologies, Inc.
            
            
            100.00
            
            
            436.67
            
            
            210.00
            
            
            353.33
            
            
            400.00
            
            
            340.00AMEX
                Composite
            
            
            100.00
            
            
            143.18
            
            
            175.20
            
            
            215.26
            
            
            257.04
            
            
            299.37RDG
                Software Composite
            
            
            100.00
            
            
            119.35
            
            
            130.16
            
            
            129.12
            
            
            149.07
            
            
            173.37





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


42





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




*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. On June 15, 2007, the exercise
      price was reduced to $0.69 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.





*Acquisition
      of Hantro*





On
      May
      22, 2007, we entered into a share exchange agreement with Nexit Ventures Oy,
      as
      the authorized representative of the holders of all outstanding equity
      securities, including outstanding share options, of Hantro. The share exchange
      was offered in reliance on the exemptions provided by Regulation S of the
      Securities Act and/or Section 4(2) of the Securities Act. The share exchange
      was
      completed in an “offshore transaction”, as defined in Rule 902(h) of Regulation
      S. We did not engage in any directed selling efforts, as defined in Regulation
      S, in the United States in connection with the share exchange. The investors
      were not U.S. persons, as defined in Regulation S, and were not acquiring the
      shares for the benefit of a US person. On November 1, 2007, we completed the
      acquisition of all of the share capital of Hantro. Hantro’s security holders
      each exchanged all of the outstanding capital shares of Hantro for a total
      consideration of $6,608,102 in cash and 25,438,817 shares of our common stock.
      In addition, we are obligated to issue an additional 12,500,000 shares of our
      common stock to the Hantro security holders because Hantro’s net revenue for the
      fiscal year 2007 exceeded €9,000,000. We filed a registration statement with the
      SEC on Form S-4 to register the exchange of all of the equity ownership of
      Hantro for shares of our common stock pursuant to the share exchange
      agreement.




43


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





The
      following selected consolidated historical financial and other data should
      be
      read in conjunction with “Management’s Discussion and Analysis of Financial
      Condition and Results of Operation” and the consolidated financial statements
      and the related notes thereto appearing elsewhere in this Form 10-K. The
      following selected consolidated historical financial and other data for the
      year
      ended December 31, 2007 includes the financial results of Hantro from November
      1, 2007 (the date of acquisition), consistent with generally accepted accounting
      principles, or GAAP.




**For
                  the years ended December 31,****Statements
                  of Operations Data**
              
              2007
              
              2006
              
              2005
              
              2004
              
              2003Revenue
              
              $
              13,237,000
              
              $
              6,572,000
              
              $
              2,208,000
              
              $
              3,028,000
              
              $
              3,302,000Total
                  operating expenses
              
              
              16,649,000
              
              
              10,162,000
              
              
              6,497,000
              
              
              6,518,000
              
              
              5,665,000Loss
                  from operations
              
              
              (3,412,000
              )
              
              (3,590,000
              )
              
              (4,289,000
              )
              
              (3,490,000
              )
              
              (2,363,000
              )Interest
                  and other income (expense), net
              
              
              (3,467,000
              )
              
              (1,226,000
              )
              
              (284,000
              )
              
              47,000
              
              
              (2,000
              )Provision
                  for income taxes
              
              
              25,000
              
              
              30,000
              
              
              32,000
              
              
              2,000
              
              
              10,000Net
                  loss
              
              
              (6,904,000
              )
              
              (4,846,000
              )
              
              (4,605,000
              )
              
              (3,445,000
              )
              
              (2,375,000
              )Convertible
                  preferred stock deemed dividend
              
              
              -
              
              
              68,000
              
              
              2,844,000
              
              
              120,000
              
              
              228,000Convertible
                  preferred stock 8% dividend
              
              
              82,000
              
              
              285,000
              
              
              325,000
              
              
              57,000
              
              
              -Accretion
                  of costs associated with the Series D Preferred Stock
              
              
              -
              
              
              -
              
              
              175,000
              
              
              14,000
              
              
              -Net
                  loss attributable to common stockholders
              
              $
              (6,986,000
              )
              $
              (5,199,000
              )
              $
              (7,949,000
              )
              $
              (3,636,000
              )
              $
              (2,603,000
              )Basic
                  and diluted net loss attributable to common stockholders per common
                  share
              
              $
              (0.06
              )
              $
              (0.05
              )
              $
              (0.09
              )
              $
              (0.05
              )
              $
              (0.04
              )


December
                31,**Balance
                Sheet Data**
            
            
            2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003Cash
                and cash equivalents
            
            $
            9,573,000
            
            $
            4,961,000
            
            $
            3,976,000
            
            $
            5,418,000
            
            $
            2,963,000Working
                capital
            
            
            13,246,000
            
            
            5,268,000
            
            
            4,179,000
            
            
            5,466,000
            
            
            3,520,000Total
                assets
            
            
            79,525,000
            
            
            7,887,000
            
            
            6,314,000
            
            
            6,610,000
            
            
            4,128,000Convertible
                debentures
            
            
            -
            
            
            -
            
            
            244,000
            
            
            330,000
            
            
            409,000Capital
                lease obligations
            
            
            42,000
            
            
            53,000
            
            
            26,000
            
            
            43,000
            
            
            -Series
                D redeemable convertible preferred stock
            
            
            -
            
            
            3,083,000
            
            
            3,790,000
            
            
            1,156,000
            
            
            -Convertible
                preferred stock
            
            
            -
            
            
            19,000
            
            
            19,000
            
            
            33,000
            
            
            56,000Common
                stock and APIC
            
            
            196,158,000
            
            
            125,566,000
            
            
            120,695,000
            
            
            115,663,000
            
            
            110,970,000Accumulated
                deficit and other comprehensive income(loss)
            
            
            (130,586,000
            )
            
            (124,552,000
            )
            
            (119,350,000
            )
            
            (111,400,000
            )
            
            (107,740,000
            )Total
                stockholders’ equity
            
            
            65,572,000
            
            
            1,033,000
            
            
            1,364,000
            
            
            4,296,000
            
            
            3,286,000


44


**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.





**Restatement
      of Financial Statements**





On
        April
        1, 2008, we announced the Audit Committee was conducting an independent review
        of certain contracts with customers and the recognition of revenue that the
        Company had previously recognized in 2007 regarding those contracts. Upon
        concluding its investigation and after consultation with and upon the
        recommendation of management and the Company’s independent registered accounting
        firm, the Audit Committee determined that revenue for certain of our customer
        contracts was recognized earlier than it should have been and that the financial
        statements for the affected periods should be restated. On May 28, 2008,
        we also
        announced that the Audit Committee had determined that our previously issued
        financial statements for the interim periods contained in the quarterly reports
        on Form 10-Q filed with respect to each of the quarterly periods ended June
        30
        and September 30, 2007 should not be relied upon. On June 27, 2008, we filed
        amendments to our Quarterly Reports for the fiscal quarters ended June 30
        and
        September 30, 2007 to restate the financial statements and related disclosures
        therein. The net effect at December 31, 2007 was to reduce and defer previously
        recognized revenue and gross profit of $829,000 and $837,000,
        respectively.





The
      restatement affected our previously reported financial results for the quarters
      ended June 30, 2007 and September 30, 2007 as follows:





**Three
                months ended**
              **June
                30, 2007**
            
            **Six
                months ended**
              **June
                30, 2007****(unaudited)**
            
            **(unaudited)****As Reported**
            
            **Adjustment**
            
            **As**
              **Restated**
            
            **As Reported**
            
            **Adjustment**
            
            **As**
              **Restated**Revenue
            
            $
            2,554,000
            
            $
            (185,000
            )
            $
            2,369,000
            
            $
            5,369,000
            
            $
            (185,000
            )
            $
            5,184,000Income
                (loss) from operations
            
            $
            (145,000
            )
            $
            (185,000
            )
            $
            (330,000
            )
            $
            51,000
            
            $
            (185,000
            )
            $
            (134,000
            )Net
                loss
            
            $
            (2,820,000
            )
            $
            (185,000
            )
            $
            (3,005,000
            )
            $
            (3,541,000
            )
            $
            (185,000
            )
            $
            (3,726,000
            )Net
                loss attributable to common shareholders
            
            $
            (2,838,000
            )
            $
            (185,000
            )
            $
            (3,023,000
            )
            $
            (3,612,000
            )
            $
            (185,000
            )
            $
            (3,797,000
            )Basic
                and diluted net loss attributable to common shareholders per common
                share
            
            $
            (0.03
            )
            $
            —
            
            $
            (0.03
            )
            $
            (0.03
            )
            $
            (0.01
            )
            $
            (0.04
            )




45





**Three
                months ended**
              **September
                30, 2007**
            
            **Nine
                months ended**
              **September
                30, 2007****(unaudited)**
            
            **(unaudited)****As Reported**
            
            **Adjustment**1
            
            **As**
              **Restated**
            
            **As Reported**
            
            **Adjustment**1
            
            **As**
              **Restated**Revenue
            
            $
            2,566,000
            
            $
            (631,000
            )
            $
            1,935,000
            
            $
            7,935,000
            
            $
            (816,000
            )
            $
            7,119,000Loss
                from operations
            
            $
            (486,000
            )
            $
            (1,014,000
            )
            $
            (1,500,000
            )
            
            (435,000
            )
            $
            (1,199,000
            )
            $
            (1,634,000
            )Net
                loss
            
            $
            (368,000
            )
            $
            (1,014,000
            )
            $
            (1,382,000
            )
            $
            (3,909,000
            )
            $
            (1,199,000
            )
            $
            (5,108,000
            )Net
                loss attributable to common shareholders
            
            $
            (375,000
            )
            $
            (1,014,000
            )
            $
            (1,389,000
            )
            $
            (3,987,000
            )
            $
            (1,199,000
            )
            $
            (5,186,000
            )Basic
                and diluted net loss attributable to common shareholders per common
                share
            
            $
            (0.00
            )
            $
            (0.01
            )
            $
            (0.01
            )
            $
            (0.04
            )
            $
            —
            
            $
            (0.05
            )





1
            Under
                the Company’s revenue recognition practice, revenue from post-contract
                support is recognized ratably over the period during which the Company
                is
                obligated to deliver support, which is usually a 12-month period.
                For
                Accounts 3 and 4, the Company previously recognized $6,000 and $3,000
                respectively in revenue for post-contract support in the third
                quarter.





The
      revenue that was incorrectly recognized during these periods will be recognized
      on a cash basis when and if collected.





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





Audit
      Committee Review





On
      May
      26, 2008, the Audit Committee determined that the financial statements in the
      Company’s Quarterly Reports on Form 10-Q for the three months ended June 30 and
      September 30, 2007, should no longer be relied upon. The Audit Committee reached
      this determination based on its review of the Company’s sales
      to five
      accounts and its conclusion that the Company’s revenue recognition as to four of
      those accounts did not comply with applicable accounting principles. One account
      of $300,000 ($280,000 for software and $20,000 for post-contract support),
      of
      which $280,000 was recognized in the third quarter of 2007, which represented
      approximately 10.9% of the previously-reported revenues for that quarter
      (“Account 1”); a second account of $320,000 ($300,000 for software and $20,000
      for post-contract support), of which $300,000 was recognized in the third
      quarter of 2007, which represented approximately 11.7% of the
      previously-reported revenues for that quarter (“Account 2”); a third account of
      $150,000 ($125,000 for software and $25,000 for post-contract support), of
      which
      $125,000 was recognized in the second quarter of 2007, which represented
      approximately 4.9% of the previously-reported revenues for that quarter
      (“Account 3”); and a fourth account of $70,000 ($60,000 for software and $10,000
      for post-contract support), of which $60,000 was recognized in the second
      quarter of 2007, which represented approximately 2.4% of the previously-reported
      revenues for that quarter (“Account 4”). With respect to the fifth account
      (“Account 5”) reviewed by the Audit Committee, the Company established a bad
      debt reserve in the third quarter of 2007 in the amount of $383,000, which
      reflects an estimate of the uncollectibility of certain revenues that had
      previously been recognized in the first three quarters in 2007. The Company
      has
      restated its previously issued financial statements for the three and six months
      ended June 30, 2007, in Amendment No. 1 to its Quarterly Report on Form 10-Q
      for
      quarterly period ended June 30, 2007, to correct the incorrect recognition
      of
      revenue in the period relating to Account 3 and Account 4. The Company also
      restated its previously issued financial statements for the three and nine
      months ended September 30, 2007 in Amendment No. 1 to its Quarterly Report
      on
      Form 10-Q for the quarterly period ended September 30, 2007, to correct the
      incorrect recognition of revenue in the period relating to Account 1 and Account
      2, as well as the incorrect recognition in the period of an additional $42,000
      (because the Company did not have sufficient evidence to establish the
      creditworthiness of the customer) and the establishment of a bad debt reserve
      relating to Account 5.


46





Pursuant
      to American Institute of Certified Public Accountants’ Statement of Position
      (SOP) 97-2, *Software
      Revenue Recognition* (“SOP
      97-2”) and Staff Accounting Bulletin No. 104 (“SAB 104”) one element of revenue
      recognition is consideration of
      whether the collectibility of sales revenue is reasonably assured ( *i.e.* ,
      whether
      the purchaser is creditworthy with respect to that transaction). During
      the 2007 year-end audit process, management learned that the creditworthiness
      of
      Account 1 and Account 2, both of which were European customers, had been
      assessed, and approximately $580,000 in revenue had been recognized in the
      third
      quarter 2007, based upon falsified documentation that the Company
      received . The
      Company learned of the falsified documentation when the sales representative
      (the “Sales Representative”) responsible for Accounts 1, 2 and 4; and who was
      also involved with Account 3; who was employed by a European outsourcing company
      that the Company initially retained in 2006 (and to whom the Company paid
      commissions in connection with Accounts 1, 2, 3 and 4, but whom we terminated
      in
      April 2008 as a result of this review) admitted to the Company’s Executive
      Vice-President, Legal and Business Affairs, to falsifying documentation
      purporting to establish the creditworthiness of Account 1. The documentation
      purporting to establish the creditworthiness of Account 2 was subsequently
      determined to be false, although the identity of the person or persons
      responsible for falsifying such documentation was not ascertained during the
      Audit Committee review.





After
        determining that the documentation purporting to support the creditworthiness
        of
        Accounts 1 and 2 was false, management informed the Audit Committee, which
        then
        commenced its review. The Audit Committee’s review focused exclusively on the
        following issues: (1) whether the false documentation identified with respect
        to
        Accounts 1 and 2 was limited to those accounts, or whether it affected other
        accounts that were either affiliated with the Sales Representative or were
        deemed by management to be material to the quarter in 2007 in which revenue
        for
        those accounts had been recognized (Accounts 3, 4 and 5); (2) whether the
        Sales
        Representative falsified documentation for his own financial benefit and/or
        at
        the direction, or with the knowledge, of management; and (3) whether information
        obtained during the review indicated that Accounts 1 and 2 were not legitimate
        transactions.





The
      Audit
      Committee conducted its review of Accounts 1 through 5 with the assistance
      of
      Latham & Watkins LLP and FTI Consulting, and with the support and
      cooperation of management and personnel. The review was conducted over a period
      of approximately six weeks, and included collection and review of more than
      two
      million pages of documents, as well as interviews of eight members of management
      and sales force teams in the United States and the Sales Representative in
      Europe.





With
        respect to Account 1, with which the Company had no previous business
        relationship, the Audit Committee found that the Company paid a sales commission
        to the European outsourcing company upon execution of the contract with Account
        1, and that the Sales Representative received a commission from the outsourcing
        company in connection with Account 1, but found no evidence that the commission
        was affected by the Sales Representative’s falsification of documentation
        concerning the creditworthiness of Account 1. Although the Audit Committee
        found
        no evidence that the Sales Representative acted at the direction, or with
        the
        knowledge, of any member of management in falsifying documentation concerning
        the creditworthiness of Account 1, it found that the Sales Representative
        had
        been directed by senior management to obtain evidence of the creditworthiness
        of
        Account 1 so that revenue could be recognized in the third quarter of 2007.
        The
        Audit Committee also found that senior management did not adequately instruct
        the Sales Representative regarding (and the Company did not have a practice
        or
        policy regarding) the types of information that could be used in making a
        creditworthiness determination pursuant to the applicable revenue recognition
        accounting principles. In addition, the Audit Committee determined that,
        although sales revenue from Account 1 was recognized in the third quarter
        of
        2007, evidence relating to creditworthiness was not obtained until the fourth
        quarter of 2007, however, prior to the filing of the third quarter Form
        10-Q. The Audit Committee concluded that the sales revenue of $280,000 from
        Account 1, which was previously recognized in the third quarter of 2007,
        did not
        constitute a sale for which revenue could be recognized, and therefore no
        revenue should have been recognized in the third quarter of 2007 or any other
        period.


47





With
        respect to Account 2, with which the Company had no previous business
        relationship, the Audit Committee has been unable to determine the identity
        of
        the person or persons who falsified documentation concerning the
        creditworthiness of Account 2. Although the Audit Committee has found no
        evidence establishing that management directed or had knowledge of the
        falsification of any document, it has found that the Sales Representative
        had
        been directed by senior management to obtain evidence of the creditworthiness
        of
        Account 2 so that revenue could be recognized in the third quarter of 2007.
        The
        Audit Committee determined that, although sales revenue from Account 2 was
        recognized in the third quarter of 2007, evidence relating to creditworthiness
        was not obtained until the fourth quarter 2007, however, prior to the
        filing of the third quarter Form 10-Q. The Audit Committee also found that
        senior management did not adequately instruct the Sales Representative regarding
        (and the Company did not have a policy or practice regarding) the types of
        information that could be used in making a creditworthiness determination
        pursuant to the applicable revenue recognition accounting principles. The
        Audit
        Committee has concluded that the sales revenue of $300,000 from Account 2,
        which
        was previously recognized in the third quarter of 2007, did not constitute
        a
        sale for which revenue could be recognized, and therefore no revenue should
        have
        been recognized in the third quarter of 2007 or any other period. The revenue
        will be recognized on a cash basis when and if collected.





With
        respect to Accounts 3 and 4, with which the Company did not have previous
        business relationships, the Audit Committee did not find evidence of falsified
        documentation. The Audit Committee determined that the Company did not have
        sufficient evidence to establish the creditworthiness of Accounts 3 or 4
        when it
        recognized $125,000 and $60,000, respectively, in revenue in the second quarter
        2007, and that the Company did not have a practice or policy regarding the
        types
        of information that could be used in making such creditworthiness
        determinations. Neither Account 3 nor 4 has acknowledged its contract to
        the
        Company’s independent registered public accountants, and there is evidence that
        Account 3 disputes the terms of its contract with the Company. Account 3
        has
        made no payments to the Company. Account 4 has paid a portion of its outstanding
        receivable, which is now current. The Audit Committee concluded that the
        sales
        revenue of $185,000 from Accounts 3 and 4 was untimely recognized in the
        second
        quarter of 2007. Account 3 was determined not to constitute a sale for which
        revenue could be recognized in any period. The $60,000 of revenue from Account
        4
        was reclassified to deferred revenue in the second quarter of 2007 and revenue
        will be recognized as the payments are received. The Company received payments
        of $8,000 in the fourth quarter of 2007 and $30,000 in the first quarter
        of
        2008. The balance is not yet due. Additionally, the Company reversed
        $9,000 of support revenue associated with Accounts 3 and 4 in the third quarter
        of 2007.





With
      respect to Account 5, with which the Company had a prior business relationship,
      the Audit Committee did not find evidence of falsified documentation. The Audit
      Committee found that the creditworthiness of Account 5 was based on the past
      credit payment history with the Company. It also found that, when payments
      associated with Account 5 became past due in 2007, the Company continued selling
      to Account 5 without re-assessing its creditworthiness until September 2007,
      when the account was significantly past due. Further sales were suspended in
      the
      fourth quarter of 2007. The Audit Committee concurred with management’s
      recommendation that a bad debt reserve of $383,000 should be taken in the fourth
      quarter of 2007 in connection with its sales to Account 5.  Upon further
      examination of the facts and circumstances involved in Account 5, the Company
      confirmed that sales had occurred to Account 5, that a reserve for $383,000
      was
      required, but that the reserve should have been established in the third
      quarter, rather than the fourth quarter, of 2007. To establish that reserve,
      the
      Company recorded a general charge to general and administrative expense of
      $383,000, which increased the Company’s net loss for the third quarter of
      2007 by that amount (in addition to the $631,000 of revenue that was reversed
      in
      the period). The establishment of the reserve also resulted in a reduction
      in
      accounts receivable, net of allowance for doubtful accounts on the Company’s
      balance sheet at September 30, 2007, by the same amount.


48





In
      addition, during the preparation of the Company’s 2007 annual financial
      statements and prior to discovery of the falsified documentation mentioned
      above, management determined that revenue of $42,000 had been incorrectly
      recognized in the third quarter of 2007 because of insufficient evidence to
      establish the creditworthiness of the customer.





Management
        also conducted a review of the Company’s sales to all accounts for which revenue
        was recognized in fiscal 2007, including the accounts of Hantro Products
        Oy,
        which the Company acquired in November 2007, for the purposes of determining
        that the criteria set forth in SOP 97-2 and SAB 104 were satisfied and that
        revenue was properly recognized for each account. Management concluded that,
        except for the accounts discussed above and the $42,000 that also was
        incorrectly recognized, the criteria set forth in SOP 97-2 and SAB 104 were
        satisfied and revenue was properly recognized for all of these
        accounts.





Identification
      of Material Weaknesses in Internal Control over Financial
      Reporting





As
        a
        result of the determination to restate the Company’s financial statements and in
        connection with the preparation of its Annual Report on Form 10-K for the
        year
        ended December 31, 2007, management identified three material weaknesses
        in our
        disclosure controls and procedures and internal control over financial reporting
        and reported those to our Audit Committee. Management identified a material
        weakness in our procedures for recognizing revenue, specifically with respect
        to
        our procedures for assessing whether collectibility is reasonably assured.
        This
        material weakness resulted in the incorrect recognition of revenue in our
        financial statements for the second and third quarters of 2007. In addition,
        management identified a material weakness in our control environment,
        specifically relating to our tone at the top. This material weakness was
        evidenced by the control tone and control consciousness of our former Chief
        Executive Officer and resulted in the override and the possibility of override
        of controls or interference with our policies, procedures and internal control
        over financial reporting. Management also identified a material weakness
        in the
        design and operation of our procedures for determining the accuracy and
        completeness of our estimate of allowance for doubtful accounts. This material
        weakness resulted in a misstatement of accounts receivable, net of allowance
        for
        doubtful accounts on our balance sheet at the end of the third quarter of
        2007
        and an understatement of our general and administrative expenses for the
        period. **** Prior
        to
        the filing of this report, we have taken certain steps to remediate these
        material weaknesses and are in the process of finalizing a plan and timetable
        for the implementation of additional remediation measures to further address
        these material weaknesses. These material weaknesses and the remediation
        measures are further described in Item 9A of this Form
        10-K.





**Overview**





We
      are a
      developer of video compression technology and technology for enabling multimedia
      in resource-limited environments such as battery operated mobile handsets.
      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. In addition, through our subsidiary Hantro Products,
      we license hardware and software design that makes mobile video possible to
      mobile handset manufacturers. We also provide integration, customization and
      support services to enable high quality video and faster interoperability
      between devices. We offer a suite of products and services based on our
      proprietary compression technology, multimedia server software and mobile video
      technology. 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 also license
      software that encodes video in the Adobe/Macromedia Flash 8 format; the Flash
      8
      format uses our VP6 video codec. We also license our hardware video codec to
      companies that incorporate our technology into the semi-conductors and devices.


49





**Hantro
      Acquisition**




On
      November 1, 2007, we completed the acquisition of all of the share capital
      of
      Hantro Products Oy (“Hantro”), a Finnish corporation. Under the exchange
      agreement, Hantro’s security holders exchanged all of the outstanding capital
      shares of Hantro for a total consideration of $6,608,102 (net of $233,673
      received in February 2008) in cash and 25,438,817 shares of our common stock.
      The number of shares issued was determined on the basis of the volume weighted
      average price of On2’s common stock during the ten business days prior to the
      closing, with an upper limit of $2.50 per share and a lower limit of $1.50
      per
      share. Because the closing share price as calculated pursuant to the foregoing
      formula was less than $1.50, we issued a set number of 25,438,817 shares, as
      specified in the share exchange agreement. The 25,438,817 shares so issued
      represent approximately 22% of our outstanding common stock as of November
      1,
      2007. In addition, we are obligated to issue an additional 12,500,000 shares
      of
      our common stock to the Hantro security holders because Hantro’s net revenue for
      the fiscal year 2007 exceeded €9,000,000. The 37,938,817 shares issued and
      issuable will result in 22% of our outstanding common stock as of December
      31,
      2007.





**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,
      a
      Delaware corporation. 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). On November 1, 2007, we acquired
      all of the issued and outstanding shares of capital stock of Hantro. Hantro
      develops technology for enabling multimedia in resource-limited environments
      such as battery operated mobile handsets.





To
      date,
      we have incurred substantial costs to create technology products and services.
      As of December 31, 2007, we had an accumulated deficit of $(131,492,000).
      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




50





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




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.





*Accounts
      Receivable Allowance* .
      We
      perform ongoing credit evaluations of our customers and adjust credit limits,
      as
      determined by our review of current credit information. We continuously monitor
      collections and payments from our customers and maintain an allowance for
      doubtful accounts based upon our historical experience, our anticipation of
      uncollectible accounts receivable and any specific customer collection issues
      that we have identified. While our credit losses have historically been low
      and
      within our expectations, we may not continue to experience the same credit
      loss
      rates that we have in the past.


51





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





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





*Equity-Based
      Compensation* .
      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.





*Accounting
      for Impairment of Goodwill* .
      During
      the fourth quarter of 2007, we assessed the fair value of the goodwill that
      resulted from the Wildform acquisition for impairment in accordance with SFAS
      142, Goodwill and Other Intangible Assets, which requires that goodwill be
      tested for impairment on a periodic basis. The process of evaluating the
      potential impairment of goodwill is highly subjective and requires significant
      management judgment to forecast future operating results, projected cash flows
      and current period market capitalization levels. In estimating the fair value
      of
      the business, we make estimates and judgments about the future cash flows.
      Although our cash flow forecasts are based on assumptions that are consistent
      with the plans and estimates we are using to manage our business, there is
      significant judgment in determining such future cash flows. We also consider
      market capitalization on the date we perform the analysis. Based on our annual
      impairment test performed for 2007, we concluded that there was no impairment
      of
      goodwill. However, there can be no assurance that we will not incur charges
      for
      impairment of goodwill in the future, which could adversely affect our
      earnings.





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, 2007,
      we
      believe that no such impairment has occurred.


52





**Results
      of Operations**





The
      discussion of our results of operations for the year ended December 31, 2007
      includes the financial results of Hantro from November 1, 2007 (the date of
      acquisition), consistent with generally accepted accounting principles, or
      GAAP.
      The inclusion of these results renders direct comparison with results for prior
      periods less meaningful. Accordingly, the discussion below addresses, where
      appropriate, trends we believe are significant, separate and apart from the
      impact of our merger with Hantro.





*Revenue* .
        Our
        revenue for the years ended December 31, 2007, 2006 and 2005 was
        $13,237,000, $6,572,000, and $2,208,000, respectively, and was derived from
        the
        sale of software and hardware licenses, engineering, consulting and support
        services, license royalties and other services. The revenue for 2007 consists
        of
        $9,102,000 from On2 USA and $4,135,000 from Hantro, our Finnish subsidiary,
        from
        November 1, 2007 (the date of acquisition). The fiscal 2007 revenue of Hantro
        for the full fiscal year was $13,250,000. The increase in revenue during
        the
        last quarter of fiscal 2007 of Hantro is the result of Hantro’s new products
        (6280 video decoder; 7190 and 8170 encoders) which covers the consumer device
        segment in addition to the mobile phone segment. Our combined revenue increased
        $6,810,000 for the year ended December 31, 2007 as compared with 2006. The
        increase is primarily attributable to an increase in license sales of our
        Hantro
        and Flix product lines and an increase in royalties earned. As a percent
        of
        total revenue, license revenue decreased to 78% in 2007 from 83% in 2006,
        engineering services and support decreased to 7% in 2007 from 8% in 2006.
        Royalties increased to 14% of revenue in 2007 from 9% in
        2006.





For
        the
        year ended December 31, 2007, license revenue was $10,445,000 of which our
        VPx
        licenses were $1,018,000, Flix licenses were $5,266,000 and Hantro licenses
        (from date of acquisition) were $4,161,000. 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 $651,000.





The
      following table sets forth the allocation of revenues, in terms of percentages,
      for the years ended December 31, 2007, 2006 and 2005:





**2007**
            
            **2006**
            
            **2005**Licenses
            
            
            78
            %
            
            83
            %
            
            84
            %Engineering
                services and support
            
            
            7
            %
            
            8
            %
            
            11
            %Royalties
            
            
            14
            %
            
            9
            %
            
            5
            %Other
            
            
            1
            %
            
            -
            
            
            -Total
            
            
            100
            %
            
            100
            %
            
            100
            %





For
      the
      years ended December 31, 2007, 2006 and 2005, 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 2007 versus 2006:***





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, 2007 were $16,649,000 compared with
      $10,162,000 for the year ended December 31, 2006.





*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 $2,549,000 for the year ended December 31, 2007, compared
      with $2,328,000 for the year ended December 31, 2006. Cost of revenue
      increased $221,000 for the year ended December 31, 2007 compared with 2006.
      The
      increase is primarily attributable to an increase of $482,000 in amortization
      of
      the Hantro purchased technology, partially offset by a decrease in engineering
      costs associated with products sold during the period.


53





*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 $3,833,000
        and
        $972,000 for the years ended December 31, 2007 and 2006, respectively. The
        increase of $2,861,000 is primarily attributed to $1,955,000 research and
        development expenses from Hantro coupled with a higher percentage of the
        US
        engineering time dedicated to research and development 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. We believe that the current rate of expenditures will
        remain consistent throughout 2008.





*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, 2007 were $4,272,000 compared with
        $1,093,000 for the year ended December 31, 2006. The increase of $3,179,000
        is a $1,281,000 increase from 2006 from the US operations and $1,898,000
        addition from Hantro. The $1,281,000 increase from the US operations is
        primarily attributable to an increase in commissions, personnel and related
        overhead expenses, consulting fees paid to independent sales representatives
        and
        marketing consultants, tradeshow fees, advertising and publicity costs. The
        $1,898,000 from Hantro is primarily from sales and marketing salaries and
        related benefits, commissions, tradeshow and publicity costs. We intend to
        continue to recruit and hire experienced personnel, as necessary, to sell
        and
        market our products and services. We believe that the current rate of
        expenditures will remain consistent throughout 2008.





*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 and
        transfer fees, board 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, 2007 were
        $5,200,000, compared with $4,384,000 for the year ended December 31, 2006.
        The increase of $816,000 is attributable to general and administrative costs
        from Hantro, our Finnish subsidiary, of approximately $800,000 and an increase
        in our bad debt reserve of $463,000. In addition, there were increases in
        consulting fees, audit fees and other professional fees, director’s fees, and
        Internet commerce fees. These increases were partially offset by a $839,000
        decrease in legal fees in the year ended December 31, 2007 as compared to
        the
        same period in 2006 as a result of the internal investigation of the Company’s
        former CEO. We believe that the current rate of expenditures will remain
        consistent throughout 2008.





At
      December 31, 2007, we had approximately 114 full-time employees as
      compared to approximately 37 full-time employees at December 31, 2006. This
      increase is primarily the result of the Hantro acquisition. We expect to hire
      employees as necessary in order to attain our strategic objectives.





*Equity-Based
      Compensation* .
      In
      December 2004, the FASB issued Statement of Financial Accounting Standards
      (“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 method. We adopted the provision of
      SFAS
      No. 123R effective January 1, 2006, using the modified prospective transition
      method. Under the modified prospective transition 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,
      2007 was $946,000, of which $151,000 is included in cost of revenue, $147,000
      is
      classified as research and development, $157,000 is classified as sales and
      marketing and $491,000 is classified as general and administrative. During
      the
      year ended December 31, 2007, we recognized expense of $362,000 related to
      stock
      options issued to employees and $584,000 related to 1,099,000 shares of
      restricted stock issued to directors and employees. 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.


54





*Interest
      and Other Income (Expense), Net* .
      Interest and other income (expense) was $(3,467,000) for the year ended December
      31, 2007, compared with $(1,226,000) for the year ended December 31, 2006.
      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 the increase in the incremental fair value of the warrant
      derivative liability. The $(3,467,000) in interest and other expense, net for
      the year ended December 31, 2007 consists primarily of other expense of
      $3,666,000, interest income of $333,000 and interest expense of $133,000.





Other
      expense of $3,666,000 consists primarily of an expense of $3,582,000 for the
      change in the fair value of the warrant derivative liability. During June 2007,
      the Company entered into a Letter Agreement with Midsummer Investments Ltd.
      and
      Rockmore Investment Master Fund where the parties agreed to place a $0.41 per
      share floor on the base share price for subsequent dilutive share issuances
      and
      received consideration in the form of a decrease in the warrant exercise price,
      from $0.77 to $0.69. The number of additional shares to be issued upon
      subsequent dilutive issuances is now finite and the Company will reserve for
      the
      issuance from its authorized common shares. The warrants were no longer
      considered a liability and the Company reclassified the warrant derivative
      liability of $5,911,000 to additional paid in capital.





Interest
      income of $333,000 was derived primarily from interest earned on our excess
      cash
      balances. The cash was invested in both money market accounts and short term
      fixed income securities.





Interest
      expense of $133,000 is primarily interest paid on capital leases, short-term
      borrowings and long-term debt.





*Income
      Taxes* .
      Income
      taxes reflect state and local franchise taxes and foreign withholding taxes.
      Income taxes were $25,000 and $30,000 for the years ended December 31, 2007
      and 2006, respectively.




***Year
      ended December 31, 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.





*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.


55





*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.





*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.


56





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.





**Liquidity
      and Capital Resources**





At
      December 31, 2007, we had cash and cash equivalents and short-term
      investments of $15,094,000, compared with $4,961,000 at December 31, 2006.
      The increase in cash and cash equivalents and short-term investments is
      primarily attributed to proceeds from the exercise of warrants and options
      of
      $6,901,000 and to the receipt of $13,903,000 of net proceeds from the sale
      of
      our common stock, of which $6,841,000 was paid to acquire Hantro. At
      December 31, 2007, we had working capital of $13,246,000, compared with
      $5,268,000 at December 31, 2006.





Net
      cash
      provided by (used in) operating activities was $357,000 and $(1,590,000) for
      the
      years ended December 31, 2007 and 2006, respectively. The net cash provided
      by
      operating activities during 2007 consisted principally of increases for
      depreciation and amortization of $867,000, the change of the fair value of
      the
      warrant derivative liability of $3,582,000, a realized loss on marketable
      securities of $27,000, equity-based compensation of $946,000, and increases
      in
      accounts payable and accrued expenses of $1,949,000, and other assets of $9,000,
      expense recognized for the extension of warrants of $90,000, a decrease in
      accounts receivable, net of $88,000 and increases in insurance expense financed
      with a term loan of $82,000, partially offset by decreases resulting from a
      net
      loss of $6,904,000, deferred revenue of $345,000, and an increase in prepaid
      expenses and other current assets of $34,000. 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.





Net
      cash
      used in investing activities was $15,014,000 and $76,000 for the years ended
      December 31, 2007 and 2006, respectively. The increase in 2007 is primarily
      due
      to the acquisition of Hantro Products Oy of $9,160,000, the purchase of
      short-term investments and increased purchases of property and equipment,
      partially offset by the net sale of marketable securities.





Net
      cash
      provided by financing activities was $19,272,000 and $2,654,000 for the years
      ended December 31, 2007 and 2006, respectively. The increase in 2007 is
      attributable to an increase in the net proceeds from the sale of common stock
      and proceeds from the exercise of common stock options and warrants, net,
      partially offset by principal payments on capital leases and debt.





The
      Company currently has commitments for the next 12 months under operating
      lease arrangements. These arrangements consist primarily of lease arrangements
      for our office space in New York, Cambridge, UK, Oulu and Espoo, Finland. The
      aggregate required payments for the next 12 months under these arrangements
      are $1,127,000. 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 2008, we anticipate incurring approximately $2,300,000 per
      month in cash operating costs.





In
      our
      acquisition of Hantro Products Oy we assumed $2.8 million in short-term
      borrowings and $3.5 million in long-term debt.


57





At
      December 31, 2007 short-term borrowings consisted of the following:





A
      line of
      credit with a Finnish bank for $736,000 (500,000€ at December 31, 2007). The
      line of credit expired in February 2008 and was paid in full. Borrowings under
      the line of credit bear interest at the Euro Interbank Offered Rate (EURIBOR)
      plus 1% (total of 5.288% at December 31, 2007). The bank also requires a
      commission payable at 1% of the loan principal. Borrowings are collateralized
      by
      substantially all assets of Hantro and a guarantee by On2. The borrowings is
      also 50% guaranteed by the Finnvera plc (Finnvera plc is a specialized financing
      company which offers financing services to promote the domestic operation of
      Finnish businesses and is owned by the Finnish government) , which requires
      a
      commission payable at 2.85% on 50% of the loan principal. The outstanding
      balance on the line of credit was $297,000 at December 31, 2007.





A
        line of
        credit with a Finnish bank for $663,000 (450,000€ at December 31, 2007). The
        line of credit has no expiration date. Borrowings under the line of credit
        bear
        interest at EURIBOR plus 1.25% (total of 5.538% at December 31, 2007). The
        bank
        also requires a commission payable at .45% of the loan principal. Borrowings
        are
        collateralized by substantially all assets of Hantro and a guarantee by On2.
        The
        outstanding balance on the line of credit was $352,000 at December 31, 2007.





A
      factoring line of credit with a Finnish bank for the lesser of $2,195,000
      (1,490,000€ at December 31, 2007) or 90% of eligible accounts receivable. The
      line of credit expired in February 2008 and was paid in full. Borrowings under
      the line of credit bear interest at EURIBOR plus .95% (total of 5.238% at
      December 31, 2007). The borrowings are collateralized by 90% of eligible
      accounts receivable. The borrowings also have a 100% guarantee by the Finnvera
      plc, which requires a commission payable at 2.15% to 2.95% of the loan
      principal. The outstanding balance on the line of credit was $1,500,000 at
      December 31, 2007. The carrying amount of accounts receivable of Hantro that
      serve as collateral for borrowings totaled $1,820,000 at December 31,
      2007.





At
      December 31, 2007 long-term debt consisted of the following:





Unsecured
      notes payable to a Finnish funding agency of $2,947,000, including interest
      at
      1.75%, due at dates ranging from January 2009 to December 2011; 368,000 to
      a
      Finnish bank, including interest at the 3-month EURIBOR (4.68% at December
      31,
      2007) plus 1.1%, due March 2011, secured by a guarantee by On2, and the Finnish
      Government Organization, which also requires additional interest at 2.65% of
      the
      loan principal; and an unsecured note payable to a Finnish financing company
      of
      $258,000, including interest at the 6 month EURIBOR (4.70% at December 31,
      2007)
      plus .5%, due March 2011.


We
          believe that existing funds are sufficient to fund our operations through
          2008.
          We plan to increase cash flows from operations principally from increases
          in
          revenue.





During
      October 2007, the Company sold 14,950,000 shares of our common stock to two
      institutional investors, led by ThinkEquity Partners LLC. We received net
      proceeds of $13,903,000 from this offering, of which $6,841,000 was used to
      acquire Hantro.


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 and
          video
          codec technology services and products. However, there are no assurances
          that we
          will be successful in effecting such increases. The market for distribution
          of
          compression and video codec technology services is highly competitive.
          Additionally, our capital requirements depend on numerous factors, including
          market acceptance of our technology and services, research and development
          costs
          and the resources we spend on marketing and selling our products and services.
          Additionally, we continue to evaluate investments in complementary businesses,
          products and services, some of which may be significant.




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


58





**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**





The
      following table summarizes our contractual obligations and other commitments
      as
      of December 31, 2007:




Total
            
            Less
                than
              1
                year
            
            1-3
                years
            
            4-5
                years
            
            After
                5
              yearsContractual
                ObligationsCapital
                lease obligations
            
            $
            42,000
            
            $
            24,000
            
            $
            16,000
            
            $
            2,000Long-term
                debt
            
            
            3,573,000
            
            
            491,000
            
            
            2,284,000
            
            
            798,000
            
            
            -Operating
                lease obligations
            
            
            1,844,000
            
            
            1,127,000
            
            
            444,000
            
            
            192,000
            
            
            81,000Total
                contractual obligations
            
            $
            5,459,000
            
            $
            1,642,000
            
            $
            2,744,000
            
            $
            992,000
            
            $
            81,000





**Impact
      of Recently Issued Accounting Pronouncements**




On
      January 1, 2007, the Company adopted the provisions of Financial Accounting
      Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in
      Income Taxes” (“FIN 48”), an interpretation of FASB Statement No. 109,
“Accounting for Income Taxes.” FIN 48 prescribes a recognition threshold and
      measurement attribute for the financial statement recognition and measurement
      of
      a tax position taken or expected to be taken in a tax return. The interpretation
      requires that the Company recognize the impact of a tax position in its
      financial statements if that position is more likely than not of being sustained
      on audit, based on the technical merits of the position. FIN 48 also provides
      guidance on derecognition, classification, interest and penalties, accounting
      in
      interim periods and disclosure. In accordance with the provisions of FIN 48,
      any
      cumulative effect resulting from the change in accounting principle is to be
      recorded as an adjustment to the opening balance of accumulated deficit. The
      adoption of FIN 48 had no material effects on the Company’s financial
      statements.





In
      February 2007, the FASB issued SFAS No. 159 “The Fair Value Option for Financial
      Assets and Financial Liabilities” (“SFAS 159”).  SFAS 159 permits entities
      to choose to measure many financial instruments and certain other items at
      fair
      value. 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 the Board’s long-term
      measurement objectives for accounting for financial instruments. This Statement
      is effective as of the beginning of an entity’s first fiscal year that begins
      after November 15, 2007. Early adoption is permitted as of the beginning of
      a
      fiscal year that begins on or before November 15, 2007, provided the entity
      also
      elects to apply the provisions of FASB Statement No. 157, “ *Fair
      Value Measurements”.* The Company is currently evaluating the impact of adopting SFAS 159 on its
      financial position and results of operations.


59




In
      September 2007, the FASB issued SFAS No. 157 “ *Fair
      Value Measurements* ”
(“SFAS
      157”).  SFAS 157 defines fair value, establishes a framework for measuring
      fair value in generally accepted accounting principles (GAAP), and expands
      disclosures about fair value measurements. This Statement applies under other
      accounting pronouncements that require or permit fair value measurements, the
      Board having previously concluded in those accounting pronouncements that fair
      value is the relevant measurement attribute. Accordingly, this Statement does
      not require any new fair value measurements. However, for some entities, the
      application of this Statement will change current practice.  This Statement
      is effective for financial statements issued for fiscal years beginning after
      November 15, 2007, and interim periods within those fiscal years. Earlier
      application is encouraged, provided that the reporting entity has not yet issued
      financial statements for that fiscal year, including financial statements for
      an
      interim period within that fiscal year. The Company is currently evaluating
      the
      impact of adopting SFAS 157 on its financial position and results of
      operations.





In
      December 2007, the FASB issued SFAS No. 141 (Revised 2007), *“Business
      Combinations”.* Statement 141R will significantly change the accounting for business
      combinations. Under Statement 141R, an acquiring entity will be required to
      recognize all the assets acquired and liabilities assumed in a transaction
      at
      the acquisition-date fair value with limited exceptions. Statement 141R will
      change the accounting treatment for certain specific items,
      including:





·
            Acquisition
                costs will be generally expensed as incurred;




·
            Non-controlling
                interests (formerly known as "minority interests" -- see Statement
                160
                discussion below) will be valued at fair value at the acquisition
                date;




·
            Acquired
                contingent liabilities will be recorded at fair value at the acquisition
                date and subsequently measured at either the higher of such amount
                or the
                amount determined under existing guidance for non-acquired contingencies;




·
            In-process
                research and development will be recorded at fair value as an
                indefinite-lived intangible asset at the acquisition date;




·
            Restructuring
                costs associated with a business combination will be generally expensed
                subsequent to the acquisition date; and




·
            Changes
                in deferred tax asset valuation allowances and income tax uncertainties
                after the acquisition date generally will affect income tax
                expense.




The
      Company is currently evaluating the impact of adopting SFAS 141R on its
      financial position and results of operations.





In
      December 2007, the FASB issued SFAS No. 160, *“Non-controlling
      Interests in Consolidated Financial Statements - An Amendment of ARB No.
      51”.* Statement 160 establishes new accounting and reporting standards for the
      non-controlling interest in a subsidiary and for the deconsolidation of a
      subsidiary. Specifically, this Statement requires the recognition of a
      non-controlling interest (minority interest) as equity in the consolidated
      financial statements and separate from the parent's equity. The amount of net
      income attributable to the non-controlling interest will be included in
      consolidated net income on the face of the income statement. Statement 160
      clarifies that changes in a parent's ownership interest in a subsidiary that
      do
      not result in deconsolidation are equity transactions if the parent retains
      its
      controlling financial interest. In addition, this Statement requires that a
      parent recognize a gain or loss in net income when a subsidiary is
      deconsolidated. Such gain or loss will be measured using the fair value of
      the
      non-controlling equity investment on the deconsolidation date. Statement 160
      also includes expanded disclosure requirements regarding the interests of the
      parent and its non-controlling interest. Statement 160 is effective for fiscal
      years, and interim periods within those fiscal years, beginning on or after
      December 15, 2008. Like Statement 141R discussed above, earlier adoption is
      prohibited. Although the Company will continue to evaluate the application
      of
      SFAS 160, management does not currently believe adoption will have a material
      impact on the Company’s results of operations or financial
      position.


60


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





At
      December 31, 2007, we had available net operating loss carry-forwards of
      $131,565,000 of which $95,688,000 is from the United States operations and
      $35,877,000 is from foreign operations. The net operating loss carry-forwards
      expire at various dates through 2027.





The
      Company performed an analysis of the limitations on the use of its net operating
      losses under Section 382 of the Internal Revenue Code. It was determined that
      on
      June 7, 2000, the Company experienced an ownership change to which Internal
      Revenue Code Section 382 applied. Of the current $95,688,000 in the Company’s
      United States, net operating loss carryforward, $33,800,000 was incurred prior
      to the June 7, 2000 change date. The annual Internal Revenue Code Section 382
      limitation is $14,000,000. Based on this limitation, the Company believes the
      entire pre-change net operating loss was available for use by 2004. However,
      because the Company’s ability to utilize these net operating losses is in doubt,
      the Company maintains a full valuation allowance against their total net
      operating loss carryforward.





As
      of
      December 31, 2007, no interest or penalties have been accrued or incurred.
      The
      Company files U.S. federal income tax returns, as well as filing various returns
      in states and applicable localities where it holds properties. The Company’s
      filed income tax returns are no longer subject to examination by taxing
      authorities for years before 2003.





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





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





We
      do not
      currently have any material exposure to interest rate risk, foreign currency
      risk, exchange rate risk, commodity price risk or other relevant market rate
      or
      price risks. However, we do have some exposure to foreign currency rate
      fluctuations arising from our operations in Finland, and to a lesser extent
      in
      other parts of Europe and Asia. Our operations in Finland transact business
      in
      the local functional currency. To date, we have not entered into any derivative
      financial instrument to manage foreign currency risk, and we are not currently
      evaluating the future use of any such financial instruments.





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





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




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





None.





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





**Evaluation
      of Disclosure Controls and Procedures**





Management,
      under the supervision and with the participation of our Chief Executive Officer
      and Chief Financial Officer, performed an evaluation of the effectiveness of
      our
      disclosure controls and procedures (as defined in Rules 13a-15(e) and
      15d-15(e) of the Securities Exchange Act of 1934 (the “Exchange Act”)) as of the
      end of the period covered by this Form 10-K for the fiscal year ended December
      31, 2007. The term “disclosure controls and procedures,” as defined in
      Rule 13a-15(e) and 15d-15(e) under the Exchange Act
      means controls and other procedures of a company that are designed to ensure
      that information required to be disclosed in the reports that the company files
      or submits under the Exchange Act is recorded, processed, summarized and
      reported, within the time periods specified in the SEC’s rules and forms.
      Disclosure controls and procedures include, without limitation, controls and
      procedures designed to ensure that information required to be disclosed by
      a
      company in the reports that it files or submits under the Exchange Act is
      accumulated and communicated to the company's management, including its
      principal financial officers, as appropriate, to allow timely decisions
      regarding required disclosure. There are inherent limitations to the
      effectiveness of any system of disclosure controls and procedures, including
      the
      possibility of human error and the circumvention or overriding of the controls
      and procedure s.
      Accordingly, even effective disclosure controls and procedures can only provide
      reasonable assurance of achieving their control objectives and management
      necessarily applies its judgment in evaluating the cost-benefit relationship
      of
      possible controls and procedures.


61





As
      described below, three material weaknesses were identified in our internal
      control over financial reporting. The Public Company Accounting Oversight
      Board’s Auditing Standard No. 5 defines a material weakness as a deficiency, or
      combination of deficiencies, that result in a reasonable possibility that a
      material misstatement of the annual or interim financial statements will not
      be
      prevented or detected. As a result of these material weaknesses, our Interim
      Chief Executive Officer and our Chief Financial Officer concluded that, as
      of
      December 31, 2007, the end of the period covered by this report, and as of
      the
      date of this filing, our disclosure controls and procedures were not effective
      at a reasonable assurance level.





**Internal
      Control over Financial Reporting**





(a)  *Management’s
      Annual Report on Internal Control Over Financial Reporting*





Management
      is responsible for establishing and maintaining adequate internal control over
      our financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under
      the
      Securities Exchange Act of 1934). Our internal control over financial reporting
      is designed to provide reasonable assurance regarding the reliability of
      financial reporting and the preparation of financial statements in accordance
      with accounting principles generally accepted in the United States of America.





Management,
      under the supervision and with the participation of our Interim Chief Executive
      Officer and Chief Financial Officer, assessed the effectiveness of our internal
      control over financial reporting as of December 31, 2007. In making this
      assessment, management used the framework established in a report entitled
      Internal Control-Integrated Framework issued by the Committee of Sponsoring
      Organizations of the Treadway Commission (“COSO”). Based upon that assessment,
      our management identified the following control deficiencies that constituted
      material weaknesses in our internal control over financial
      reporting:





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


62


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




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




As
      permitted by SEC rules and regulations, our management has excluded Hantro
      from
      its assessment of internal control over financial reporting as of December
      31,
      2007 because it was acquired in fiscal 2007. Total assets and total revenues
      of
      Hantro, our wholly-owned subsidiary, represented 80% and 30%, respectively,
      of
      the related Consolidated Financial Statement amounts as of and for the year
      ended December 31, 2007. Refer to Note 1 of our Consolidated Financial
      Statements included in Part II, Item 8 of this Annual Report on Form 10-K for
      more information about the acquisition of Hantro.





(b)  *Attestation
      Report of the Registered Public Accounting Firm*





Eisner
      LLP, our independent registered public accounting firm, has audited the
      effectiveness of our internal control over financial reporting as of December
      31, 2007, and has issued an attestation report, included elsewhere in this
      Annual Report on Form 10-K, which expresses an adverse opinion on the
      effectiveness of our internal controls. Eisner LLP has also excluded Hantro
      from
      its audit of internal control over financial reporting.





(c)  *Changes
      in Internal Control over Financial Reporting*





Other
      than the remediation measures discussed below, there were no changes in our
      internal controls over financial reporting, as defined in Rules 13a-15(f) and
      15d-15(f) of the Securities Exchange Act of 1934, during the fiscal quarter
      ended December 31, 2007, that have materially affected, or are reasonably likely
      to materially effect our internal control over financial reporting.




**Remediation
      Initiatives**





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





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


63





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





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





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





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


64





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





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





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





None.


65


**PART
      III**




**Item
                10.**
            ***Directors,
                Executive Officers and Corporate
                Governance***




**DIRECTORS
      AND EXECUTIVE OFFICERS**





The
      following sets forth the names, ages and title of the directors and the
      executive officers of On2:





**Name**
              
              **Age**
              
              **Title**Matthew
                  Frost
              
              40
              
              Interim
                  Chief Executive Officer, Chief Operating Officer and Executive
                  Vice
                  President and General CounselAnthony
                  Principe
              
              56
              
              Senior
                  Vice President and Chief Financial OfficerJames
                  Bankoski
              
              39
              
              Senior
                  Vice President of Core Technologies and Chief Technology
                  OfficerPaul
                  Wilkins
              
              44
              
              Senior
                  Vice President of Research and Development and Chief Technology
                  OfficerJ.
                  Allen Kosowsky
              
              60
              
              Chairman
                  of the Board of DirectorsEero
                  Kaikkonen
              
              44
              
              Chief
                  Marketing OfficerWilliam
                  A. Newman
              
              60
              
              DirectorThomas
                  Weigman
              
              60
              
              DirectorMike
                  Kopetski
              
              58
              
              DirectorMike
                  Alfant
              
              47
              
              DirectorAfsaneh
                  Naimollah
              
              49
              
              DirectorJames
                  Meyer
              
              49
              
              DirectorPekka
                  Salonoja
              
              50
              
              Director





No
      family
      relationship exists between any of the directors or executive officers of
      On2.





Mr.
      Frost
      has served as Interim Chief Executive Officer and Chief Operating Officer since
      June 2008 and as General Counsel since February 2006. From December 2003 to
      February 2006, he was Deputy General Counsel of the Company. Prior to working
      at
      the Company, Mr. Frost was associated with the law firms of Robison & Cole,
      LLP, from March 2003 to December 2003, and Pillsbury Winthrop LLP.




Mr.
      Principe has been the Company’s Chief Financial Officer since September 2003.
      Prior to that Mr. Principe served as the Company’s Corporate Controller from
      August 2002. Prior to that, Mr. Principe was the Corporate Controller for
      Wolf-tec, Inc. and the controller of Energy Answers Corp.





Mr.
      Bankoski has served as Senior Vice President of Core Technologies and Chief
      Technology Officer of the Company since July 2007. From 1998 until July 2007,
      he
      was Senior Vice President of Engineering of the Company.





Mr.
      Wilkins has served as Senior Vice President of Research and Development and
      Chief Technology Officer of the Company since July 2007. From 1999 until July
      2007, he was Senior Vice President of Research and Development of the
      Company.





Mr.
      Kosowsky has served as a Director of On2 since January 2003 and as the Chairman
      of the Board since February 2007, and is the Chairman of On2’s Audit Committee
      and its financial expert. Since 1992, Mr. Kosowsky has run J. Allen Kosowsky,
      CPA, P.C., a firm in Shelton, Connecticut that specializes in forensic
      accounting and analysis, business valuations, and interim management services.




Mr.
      Kaikkonen has served as Chief Marketing Officer of the Company since November
      2007. Prior to that, Mr. Kaikkonen was Chief Operating Officer of Hantro
      Products Oy from 1992 until November 2007. From 2004 until 2005, Mr. Kaikkonen
      served on the board of directors of Newtest Oy, a Finnish privately-held
      company.


66


Mr.
      Newman has served as a Director of On2 since August of 2000. From May 2008
      until
      the present, Mr. Newman has been associated with the law firm of Sullivan &
Worcester LLP. From November of 1999 until May 2008, Mr. Newman was a partner
      of
      the New York office of the law firm of McGuireWoods LLP.




Mr.
      Weigman has served as a Director of On2 since February 25, 2002. Since March
      2008, Mr. Weigman has been the Executive Vice President of Wireless Services,
      and since September 2006, he has been the Senior Vice President of Wireless
      Services at AirCell, a firm seeking to introduce Internet and communications
      services to the airline industry. Between September 2000 and September 2006,
      Mr.
      Weigman was a principal at two consulting practices Riverstone Weston and
      MCAworks -- aimed at providing marketing counsel to technology oriented
      companies. From September 2003 until January 2004, Mr. Weigman was the Chief
      Marketing Officer of Intuit Inc., a software development company. From February
      1999 until September 2003, Mr. Weigman was Senior Vice President, Consumer
      Strategy and Communications, of the Sprint Corporation. From October 2005 until
      June 2007, Mr. Weigman served on the board of directors of MDC Partners, a
      publicly-traded company.




Mr.
      Kopetski has served as a Director of On2 since August 2003. Mr. Kopetski has
      worked as an international trade consultant since January 1996. From 1991 to
      1995, he served as a member of the US House of Representatives from the 5th
      District of Oregon, where he served on the House Ways and Means
      Committee.




Mr.
      Alfant has served as a Director of On2 since May 2004.  Since September
      2004, Mr. Alfant has been the Group Chairman and Chief Executive Officer of
      Fusion Systems Japan.  Since March 2000, Mr. Alfant has worked as a founder
      and partner in Building2, a technology investment company located in Tokyo
      and
      Boston.  Prior to that, Mr. Alfant was president of Fusion Systems
      Japan.  Mr. Alfant has been a Vice President of the American Chamber of
      Commerce in Japan (ACCJ) since January 1998.  Since September 2004, Mr.
      Alftant has been a member of the board of directors of Fusion Systems
      Japan.




Ms.
      Naimollah has served as a Director of On2 since May 2005. From January of 2000
      until the present, Ms. Naimollah has been the Managing Partner of Chela
      Technology Partners, a mergers and acquisition advisory firm that she
      founded.




Mr.
      Meyer
      has been a Director of On2 since May of 2005. From May 6, 2006 until the
      present, he has served as CEO of Mindset Media, LLC, an Internet ad network,
      in
      Tarrytown, NY. From February 2006 to May 2006, he served as Interim President
      and Chief Executive Officer of On2. From March 2002 until January 2006, Mr.
      Meyer served as a managing director of Novantas, a consulting firm in New York,
      where he specialized in customer management, marketing strategy, and pricing.
      From 2001 through 2005, Mr. Meyer was a member of the board of directors of
      TheStreet.com, the online publisher of financial news and
      commentary.




Mr.
      Salonoja has been a Director of On2 since November 1, 2007. Mr. Salonoja
      has been a General Partner of Nexit Ventures Oy, a Finnish venture capital
      fund,
      since September 2003. He served as the Chairman of the Board of Hantro Products
      Oy from 2002 until November 1, 2007. Mr. Salonoja has also served as the
      Chairman of the Boards of Hybrid Graphics Oy and Fathammer Oy since 2003. From
      January 2002 through December 2003, Mr. Salonoja was a General Partner of
      Startupfactory. He is currently the Chairman of the Board of Gomm Oy, a private
      consulting company in Helsinki, Finland.




**SECTION
      16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE**





Section
      16(a) of the Securities Exchange Act of 1934 (the “Exchange Act”) requires our
      directors, executive officers and persons who own more than 10% of any class
      of
      our capital stock to file with the Securities and Exchange Commission initial
      reports of ownership and reports of changes in ownership and to provide copies
      of such reports to us. Based solely on a review of the copies of such reports
      furnished to us and written representations that no other reports were required
      to be filed during the fiscal year ended December 31, 2007, we believe that
      all filing requirements applicable to our officers, directors and beneficial
      owners of greater than 10% of our common stock have been complied with during
      the most recent fiscal year.


67


**CODE
      OF ETHICS**





We
      have
      adopted a Code of Ethics that applies to our principal executive officer,
      principal financial officer and principal accounting officer or any person
      performing similar functions (the “Code of Ethics”). The Code of Ethics is
      available on our website at www.on2.com .
      The
      Code of Ethics is also available in print to any stockholder by making a written
      request to Matthew Frost, Secretary, On2 Technologies, Inc., 21 Corporate Drive,
      Suite 103, Clifton Park, New York 12065. If we ever were to amend or waive
      any
      provision of our Code of Ethics, we intend to satisfy our disclosure obligations
      with respect to any such waiver or amendment by posting such information on
      our
      Internet website set forth above rather than by filing an 8-K.




**CORPORATE
      GOVERNANCE**





Our
      business and affairs are managed by our Board of Directors. Our Board of
      Directors consists of four standing committees; an audit committee, a
      compensation committee, a governance and nominating committee, and an executive
      committee. Each of the audit committee, governance and nominating committee,
      and
      the compensation committee operate under a written charter adopted by the Board
      of Directors. All of those committee charters are available on the our web
      site
      at www.on2.com.




As
      noted
      above, our Board has a standing Executive Committee. The Executive Committee
      operates as a committee of the Board. From time to time, the Board delegates
      certain matters to the Executive Committee and instructs the Executive Committee
      to operate within certain parameters set by the Board. The most recent matters
      delegated to the Executive Committee related to different issues arising out
      of
      the proposed share exchange with Hantro Products Oy. The Executive Committee
      has
      the ability to act quickly to carry out the duties of the Board when it is
      not
      practical or feasible for the entire Board to consider matters which require
      frequent and immediate attention. At no time does the Executive Committee
      exercise any functions that are reserved to the Audit Committee, the
      Compensation Committee or the Governance and Nominating Committee, that require
      action by independent directors exclusively, or that may otherwise not be
      designated to a committee of the Board. The Executive Committee consists of
      Messrs. Kosowsky, Kopetski, Newman, and Joll.




During
      the year ended December 31, 2007, our Board of Directors met nine times,
      including four regularly scheduled meetings and five special meetings. During
      2007, each of our directors attended at least 75% of the aggregate number of
      board and applicable committee meetings. Directors are invited but not required
      to attend annual meetings of our stockholders. Three of the directors attended
      the 2007 annual meeting of stockholders.




**Governance
      and Nominating Committee**





We
      have a
      standing Governance and Nominating Committee that nominates candidates for
      service on the Board of Directors.




There
      are
      currently three members of the Governance and Nominating Committee: J. Allen
      Kosowsky, Pekka Salonoja, and Mike Alfant. Each of members of the Governance
      and
      Nominating Committee has no material relationship with us and is independent
      within the meaning of our corporate governance guidelines, which adopt the
      statutory and American Stock Exchange rules regarding director independence.




The
      Board
      has adopted a charter for the Governance and Nominating Committee, which is
      available on our website at www.on2.com .
      The
      charter is also available in print to any stockholder by making a written
      request to Matthew Frost, Secretary, On2 Technologies, Inc., 21 Corporate Drive,
      Suite 103, Clifton Park, New York 12065.




**Audit
      Committee**




Our
      Board
      of Directors has a separately designated audit committee established in
      accordance with Section 3(a)(58)(A) of the Exchange Act. The Audit Committee
      consists of J. Allen Kosowsky, Thomas Weigman and Afsaneh Naimollah. The Audit
      Committee met eight times during 2007.


68


In
      addition, the composition of the Audit Committee, the attributes of its members,
      including the requirement that each be “financially literate” and have other
      requisite experience, and the responsibilities of the Audit Committee, as
      reflected in its charter, are intended to be in accordance with the applicable
      rules for corporate audit committees. The Board of Directors has determined
      that
      each of J. Allen Kosowsky, Thomas Weigman and Afsaneh Naimollah qualifies as
      “financially literate” as such term is defined by the rules of the Securities
      and Exchange Commission.




The
      Board
      of Directors designated J. Allen Kosowsky as the Audit Committee’s financial
      expert and has determined that he meets the qualifications of an “audit
      committee financial expert” in accordance with the SEC rules, and that he is
“independent” as defined for audit committee members in the listing standards of
      the American Stock Exchange.




**Compensation
      Committee**




The
      Compensation Committee was established by the Board to oversee our executive
      compensation plans and programs. The Compensation Committee consists of three
      non-employee Directors, James Meyer, Mike Alfant, and Pekka Salonoja. Each
      member of the committee has been determined by the Board to be independent
      under
      the American Stock Exchange’s listing requirements. The Board has adopted a
      charter for the Compensation Committee, which is available on our website at www.on2.com .
      The
      charter is also available in print to any stockholder by making a written
      request to Matthew Frost, Secretary, On2 Technologies, Inc., 21 Corporate Drive,
      Suite 103, Clifton Park, New York 12065.




The
      Compensation Committee’s responsibilities, which are discussed in detail in its
      charter, include the following:




·
            to
                recommend compensation philosophy and major compensation programs,
                and to
                administer particular programs for which the Compensation Committee
                is the
                designated administrator;




·
            to
                establish all components of the compensation of the Chief Executive
                Officer;




·
            to
                set aggregate guidelines for the compensation of all our other officers,
                and to consult with the Chief Executive Officer on the salary and
                total
                compensation of individual
                officers;




·
            to
                administer our 2005 Incentive Compensation
                Plan;




·
            with
                respect to stock option grants and other equity compensation, to
                establish
                maximum aggregate award levels, to set threshold levels for individual
                awards each year and to delegate to the Chief Executive Officer the
                authority to make individual awards at or below that threshold and
                to
                approve all individual awards above that threshold
                level;




·
            to
                determine whether a plan for bonuses to officers is desirable and,
                if so,
                to establish and administer such a plan or otherwise approve bonus
                grant
                to officers;




·
            to
                review and consider appropriate compensation for outside directors
                and
                make recommendations to the Board regarding Board compensation;
                and




·
            to
                review the Compensation Committee Charter annually and recommend
                any
                changes to the Board for approval.




In
      accordance with these responsibilities, the Compensation Committee makes
      decisions regarding the compensation for our Chief Executive Officer. Decisions
      regarding non-equity compensation of our other executives are made by our Chief
      Executive Officer pursuant to guidelines set by the Compensation Committee.


69





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





**COMPENSATION
      DISCUSSION AND ANALYSIS**





**Overview
      of our Compensation Program**




The
      Compensation Committee of the Board (“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 at page 69.




The
      individuals who served as our Chief Executive Officer and Chief Financial
      Officer during fiscal year ended December 31, 2007, as well as the other
      individuals included in the Summary Compensation Table on page 79, 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
      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; and




·
            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
                stockholders, and that encourage the Named Executive Officers to
                remain
                with us.




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




**Setting
      Executive Compensation**




*General
      Processe* *s*




In
      establishing compensation of Named Executive Officers, the Compensation
      Committee has relied heavily on the terms of existing employment agreements
      with
      such executives. Those agreements were entered into before On2 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.




In
      January 2007, the Compensation Committee engaged James F. Reda & Associates,
      LLC (“JFR&A”), an independent compensation consulting firm, to help On2
      identify a peer group of companies for reference purposes. This engagement
      was
      the first of a series of projects connected with a review of our total
      compensation program for executive officers. Since that initial engagement,
      JFR&A has provided continuing advice and counsel to the Compensation
      Committee and has assisted the Compensation Committee in developing an updated
      peer group of companies and benchmarking compensation for On2’s Named
      Executives. The Compensation Committee believes that it is important to obtain
      and consider executive compensation market data, particularly with regard to
      a
      relevant peer group of companies. The Compensation Committee further believes
      that an independent compensation consulting firm can best provide and
      objectively analyze and interpret such benchmark data. JFR&A reports
      directly to the Compensation Committee and the Compensation Committee approves
      the scope of JFR&A’s work and fees.


70


For
      2007,
      the Compensation Committee used certain performance measures as the bases for
      determining annual cash incentive compensation. In particular, the Compensation
      Committee linked annual cash incentive compensation to attainment of specific
      company-wide target performance measures; for 2007, the Compensation Committee
      identified cash flow as the appropriate measure. The Compensation Committee
      selected that metric of performance because cash flow has become an increasingly
      important financial measure used by management to make day-to-day operating
      decisions and appears to be an important factor to the investment community
      as a
      result of our limited operating history and inability to generate positive
      cash
      flow. A Named Executive Officer would not receive a bonus under the planned
      2007
      compensation plan unless we achieved positive cash flow, and the payment of
      bonuses should not have resulted in negative cash flow for us.




Generally,
      the 2007 compensation plan set the cash incentive compensation, or bonus, for
      each Named Executive Officer at a percentage of his salary. The minimum amount
      of cash incentive compensation that a Named Executive Officer could achieve
      was
      $0. If the Company achieved a pre-determined base target amount of net cash
      flow, the Chief Executive Officer would earn a bonus of 33% of his salary and
      all other Named Executive Officers would earn a bonus of 20% of their respective
      salaries. If the Company achieved a higher “stretch” target amount of net cash
      flow, the Chief Executive Officer would earn a bonus of 100% of his salary
      and
      all other Named Executive Officers would earn a bonus of 50% of their respective
      salaries, which was the maximum amount of cash incentive compensation available
      under the plan. If the Company achieved net cash flow that was greater than
      the
      base target amount but less than the “stretch” target amount, the Chief
      Executive Officer would earn a bonus of between 33% and 100% of his salary
      and
      all other Named Executive Officers would earn a bonus of between 20% and 50%
      of
      their respective salaries, according to a pre-set schedule. The Compensation
      Committee pegged the cash flow targets to align with On2’s strategic plan and
      budgeting expectations regarding our performance expectations. The Committee
      intends to set the threshold and stretch performance target levels so that
      the
      relative difficulty of achieving the target level is consistent from year to
      year. In particular, the performance measures:




·
            support
                On2’s plan for cash-based performance;




·
            establish
                measures that executives can
                influence;




·
            are
                readily capable of measurement and evaluation;




·
            establish
                an aggressive but achievable base target;
                and




·
            establish
                a challenging stretch targets that emphasizes the benefit and credibility
                of the program and encourages exceptional
                performance.




In
      addition to this programmatic approach, the committee retained the discretion
      to
      grant cash and equity bonuses as necessary to account for special circumstances
      or extraordinary individual or company performance.




Following
      the close of the 2007 financial year, the Compensation Committee evaluated
      the
      Company’s financial performance in comparison with the previously-established
      performance targets. Because the Company’s financial performance did not reach
      the base target, the Company’s executive officers were not entitled to bonus
      payments under the 2007 compensation plan. At the request of the CEO, the
      Committee considered nominal bonuses for the U.S. management team based on
      the
      need to retain key executives amidst the integration with the Company’s
      newly-acquired Finnish subsidiary, Hantro. The Committee accordingly approved
      an
      award of options to Anthony Principe, James Bankoski, Paul Wilkins, and Matthew
      Frost as well as other executives; the aggregate value of the award, based
      on
      the Black-Scholes valuation formula, was 10% of aggregate total end-of-year
      2007
      salaries of the relevant executives. The Committee agreed to leave the
      distribution of the options to the judgment of the CEO, but agreed to encourage
      him to base the distribution on individual performance in 2007 to the extent
      possible. The options have not yet been awarded to the relevant executives.


71


Beginning
      in 2008, the Compensation Committee intends to review and benchmark the total
      compensation program for the Named Executive Officers regularly using relevant
      market data and data from the peer group companies. JFR&A is expected to
      assist in the benchmarking process, which involves 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 Peer Group has been
      and will continued to 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.




·  Authentec,
      Inc.




·  California
      Micro Devices CP




·  DG
      FastChannel Inc.




·  DivX,
      Inc.




·  MIPS
      Technologies, Inc.




·  OpenTV
      Corp.




·  Sonic
      Foundry, Inc.




·  SRS
      Labs,
      Inc.




·  SupportSoft,
      Inc.




·  SoundBite
      Communications Inc.




·  Ceva,
      Inc.




·  QuickLogic
      Corporation




·  Techwell,
      Inc.




The
      Board
      first adopted a list of peer companies in 2007. The Board has since modified
      that list by removing certain companies and adding others to arrive at the
      current list. The Board made changes for a number of reasons, among which
      were:




·
            To
                remove companies that were no longer publicly traded or had been
                acquired;




·
            To
                respond to the acquisition of Hantro, which
                has




o
            made
                On2 larger in revenue and headcount, thus changing the relevant comparable
                ranges on market capitalization, revenue, and headcount; and




o
            expanded
                our comparable industries beyond software and services to include
                chips
                and hardware.




The
      current peer group now contains 14 companies, five of which are in the computer
      chip business and the remaining nine of which are in software and services.


72


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. For 2007, the Compensation Committee identified cash flow as the
      appropriate performance measure. The Compensation Committee selected that metric
      of performance because cash flow has become an increasingly important financial
      measure used by management to make day-to-day operating decisions and appears
      to
      be an important factor to the investment community as a result of our limited
      operating history and inability to generate positive cash flow. 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 the way in which 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. The Compensation Committee may also grant restricted stock to
      enhance retention goals, to provide balance with stock options, or to provide
      equity compensation in lieu of cash. In addition, when the number of equity
      units available for issuance under the Company’s equity compensation plans is
      limited, the Compensation Committee may grant restricted stock rather than
      stock
      options, because a single unit of restricted stock has greater economic value
      than an option to purchase a single share of 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.




**2007
      Executive Compensation Components**




For
      the
      2007 fiscal year, the principal components of compensation for the Named
      Executive Officers were:


73


·
            base
                salary;




·
            performance-based
                incentive compensation; and




·
            long-term
                equity incentive compensation.




In
      addition, employment agreements with certain 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 General Counsel, Senior Vice
      President of Research and Development and Chief Technology Officer and Senior
      Vice President of Core Technologies and Chief Technology Officer and are set
      forth in the applicable employment agreement with the executive. The employment
      agreement of Bill Joll, our former Chief Executive Officer, was terminated
      on
      June 11, 2008 upon his resignation as Chief Executive Officer and President
      of
      the Company. The employment agreement of the Executive Vice President and
      General Counsel will expire on February 8, 2011. The employment of the Senior
      Vice President of Research and Development and Chief Technology Officer will
      expire on July 30, 2010. The employment agreement of the Senior Vice President
      of Core Technologies and Chief Technology Officer will expire on July 30, 2010.
      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;




·
            regional
                salary and currency information;
                and




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




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.




Overall,
      the base salaries for the Named Executive Officers as a group were approximately
      28.3% lower than the base salaries of the Peer Group at the 50 th percentile. Based on this review process, including the comparisons to Peer
      Group data, the Compensation Committee approved the base salary adjustments
      in
      the table below for the Named Executive Officers:


74







**Name
                and Principal Position**
            
            **2006 Base**
              **Salary**
            
            **2007 Base**
              **Salary**
            
            **% Increase**Anthony
                Principe
              Senior
                Vice President and Chief Financial Officer
            
            $
            120,000
            
            $
            143,000
            
            
            19
            %Matthew
                Frost
              Executive
                Vice President and General Counsel
            
            $
            174,000
            
            $
            188,000
            
            
            8
            %




*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 Compensation Committee. Bonuses to other employees
      are payable from a bonus pool that is budgeted at the beginning of the fiscal
      year and are based on individual performance or achievement of technical goals.




The
      annual bonus amount for Named Executive Officers is based on one or more
      Company-wide performance measures. The specific target performance measure
      for
      2007 was cash flow, that is, revenue minus operating expenses. The 2007 cash
      flow targets link with On2’s strategic plan and are consistent with performance
      expectations of the Named Executive Officers in particular and the management
      of
      the Company in general. The Committee intends to set the threshold and stretch
      performance target levels so that the relative difficulty of achieving the
      target level is consistent from year to year. In particular, the performance
      measures:




·
            support
                On2’s plan for cash-based performance;




·
            establish
                measures that executives can
                influence;




·
            are
                readily capable of measurement and evaluation;




·
            establish
                an aggressive but achievable base target;
                and




·
            establish
                a challenging stretch targets that emphasizes the benefit and credibility
                of the program and encourages exceptional
                performance.




The
      Committee set the base and stretch target bonus by referring to threshold bonus
      amounts payable at other public companies and, in particular, among On2’s peer
      group. Because the performance metric in 2007 was positive cash flow, the
      corresponding performance targets were the financial results that would allow
      for the payment of bonuses without causing the Company to cease being cash-flow
      positive. A core tenet of the 2007 cash incentive plan was that it be
      self-funding, so that the Company’s financial performance in 2007 had to be
      sufficient to fund the bonuses without causing the Company to have negative
      cash
      flow.




Generally,
      the bonus for each Named Executive Officer was based on a percentage of the
      participant’s base salary. For our Chief Executive Officer, in 2007, the minimum
      threshold for cash incentive compensation was $0 and increased up to 33% of
      the
      Chief Executive Officer’s salary as our cash flow increased up to a
      pre-determined target amount. Thereafter, the cash incentive compensation was
      based on performance toward a second, higher target amount, up to a maximum
      amount of cash incentive compensation equal to 100% of Chief Executive Officer’s
      salary. For all other Named Executive Officers, in 2007, the minimum threshold
      for cash incentive compensation was $0 and increased up to 20% of the Named
      Executive Officer’s salary as our cash flow increased up to a pre-determined
      target amount. Thereafter, the cash incentive compensation was 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. As noted above, the Compensation Committee chose this structure for
      a
      number of reasons. The chosen metric lent itself to ease of measurement, and
      the
      Committee deemed it especially appropriate in light of On2’s history of negative
      cash flows. Finally, requiring that any payment of bonuses would not cause
      the
      Company to become cash-flow negative would ensure that payment of bonuses would
      not affect the Company’s goal of achieving, and maintaining, positive cash flow
      in 2007.




75


The
      specific target performance levels for 2007 established by the Committee, along
      with minimum and maximum performance targets, were:




**Cash Flow**
            
            **Funding % (Chief Executive**
              **Officer)**
            
            **Funding % (All**
              **Other Named**
              **Executive Officers)**Minimum
            
            
            0
            
            
            0
            
            
            0Target
            
            $
            245,000
            
            
            33
            %
            
            20
            %Maximum
            
            $
            666,000
            
            
            100
            %
            
            50
            %





The
      2007
      target award opportunities and actual payments for the Named Executive Officers,
      expressed as a percentage of annual base salary were as follows:




**Bill Joll**
            
            **Anthony**
              **Principe**
            
            **Paul Wilkins**
            
            **James**
              **Bankoski**
            
            **Matthew Frost**Target
            
            $
            108,000
            
            $
            30,000
            
            $
            36,000
            
            $
            31,000
            
            $
            40,000Actual
            
            
            0
            
            
            0
            
            
            0
            
            
            0
            
            
            0





Following
      the close of the 2007 financial year, the Compensation Committee evaluated
      the
      Company’s financial performance in comparison with the previously-established
      performance targets. Because the Company’s financial performance did not reach
      the base target, the Company’s executive officers were not entitled to bonus
      payments under the 2007 compensation plan.




At
      the
      request of the CEO, the Committee considered nominal bonuses for the U.S.
      management team based on the need to retain key executives amidst the
      integration with the Company’s newly-acquired Finnish subsidiary, Hantro. The
      Committee accordingly approved an award of options to Anthony Principe, James
      Bankoski, Paul Wilkins, and Matthew Frost as well as other executives; the
      aggregate value of the award, based on the Black-Scholes valuation formula,
      was
      10% of aggregate total end-of-year 2007 salaries of the relevant executives.
      The
      Committee agreed to leave the distribution of the options to the judgment of
      the
      CEO, but agreed to encourage him to base the distribution on individual
      performance in 2007 to the extent possible. The options have not yet been
      awarded to the relevant executives.




**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 On2;




·
            align
                executives’ interests with the interests of shareholders;
                and




·
            help
                achieve competitive levels of total
                compensation.




Annual
      equity grants are generally 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
      preceding trading day is used.


76


In
      2007,
      in addition to annual equity grants, we also issued shares of restricted stock
      in lieu of a cash bonus to certain of our Named Executive Officers. Because
      we
      would ordinarily make a cash bonus payment that was proportional to the
      executive’s salary, we also made the restricted stock grants proportional to the
      executive’s salary.




In
        2007,
        On2 awarded long-term equity compensation to Bill Joll, Anthony Principe,
        Matt
        Frost, James Bankoski and Paul Wilkins. These awards were for annual equity
        grants and bonuses for 2006. Bill Joll was awarded 107,629 shares of restricted
        stock as bonus payment for performance in 2006, and these shares will vest
        on September 30, 2008 in accordance with the terms of his Transition
        Agreement with the Company, dated June 10, 2008 .




Anthony
      Principe was awarded 10,848 shares of restricted stock as bonus payment for
      performance in 2006. These shares vest on November 13, 2008. Mr. Principe was
      also awarded an annual equity grant of 50,000 shares of restricted stock in
      accordance with On2’s compensation policy for services in 2007. These shares
      vest as follows: one-third of the grant amount on November 13, 2008, and
      one-sixth beginning on November 17, 2008 and every six months
      thereafter.




Matt
      Frost was awarded 16,182 shares of restricted stock as bonus payment for
      performance in 2006. These shares vest on November 13, 2008. Mr. Frost was
      also
      awarded an annual equity grant of 50,000 shares of restricted stock in
      accordance with On2’s compensation policy for services in 2007. These shares
      vest as follows: one-third of the grant amount on November 13, 2008, and
      one-sixth beginning on November 17, 2008 and every six months thereafter. These
      shares vest on November 13, 2008.




James
      Bankoski was awarded 11,628 shares of restricted stock as bonus payment for
      performance in 2006. These shares vested on May 18, 2008. Mr. Bankoski was
      also
      awarded an annual equity grant of 35,000 shares of restricted stock in
      accordance with On2’s compensation policy for services in 2007. These shares
      vest as follows: one-third of the grant amount on May 18, 2008, and one-sixth
      beginning on November 18, 2008 and every six months thereafter. In January
      2008,
      Mr. Bankoski was also awarded options to purchase 75,000 shares of common stock
      at an exercise price of $0.90 per share. These options were issued to Mr.
      Bankoski in connection with his promotion to Chief Technology Officer and Senior
      Vice President of Core Technologies in July 2007. The options will vest as
      follows: one-third of the grant amount on July 30, 2008, one-third of the grant
      amount on July 30, 2009, and one-third of the grant amount on July 30, 2010.




Paul
      Wilkins, a resident of the United Kingdom, was awarded a cash bonus in the
      amount of $20,000 for performance in 2006. This cash bonus was paid in lieu
      of a
      restricted stock bonus award due to tax laws in the United Kingdom. Mr. Wilkins
      was also awarded an annual equity grant of 42,500 cash-settled restricted stock
      units, in lieu of restricted stock due to tax laws in the United Kingdom, in
      accordance with On2’s compensation policy for services in 2007. The vesting
      schedule of the units is as follows: one-third of the units vested on May 18,
      2008, and one-sixth of the units will vest every six months thereafter. In
      January 2008, Mr. Wilkins was also awarded options to purchase 75,000 shares
      of
      common stock at an exercise price of $0.90 per share. These options were issued
      to Mr. Wilkins in connection with his promotion to Chief Technology Officer
      and
      Senior Vice President of Research and Development in July 2007. The options
      will
      vest as follows: one-third of the grant amount on July 30, 2008, one-third
      of
      the grant amount on July 30, 2009, and one-third of the grant amount on July
      30,
      2010.




*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.


77


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*




Messrs. Frost,
      Bankoski and Wilkins are parties to employment agreements with us. Mr. Joll,
      prior to his resignation, was also party to an employment agreement 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 on page 81 and in the “Potential Payments Upon
      Termination” section on page 86.




**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 annual report. Based on such review and
      discussions, the Compensation Committee recommended to the Board that the
      Compensation Discussion and Analysis be included in this annual
      report.


James
                Meyer, ChairmanMichael
                AlfantPekka
                Salonoja


78


**EXECUTIVE
      COMPENSATION**





**Summary
      Compensation Table**





The
      following table provides summary information regarding compensation earned
      by
      the Named Executive Officers during the fiscal year ended December 31,
      2007.




**Name
                and Principal Position**
            
            **Year**
            
            **Salary**
              **($)**
            
            **Bonus**
              **($)**
            
            **Stock**
              **Awards****1****($)**
            
            **Option**
              **Awards****2**
              **($)**
            
            **Non-Equity**
              **Incentive Plan**
              **Compen-**
              **sation********($)**
            
            **Change in**
              **Pension Value**
              **and**
              **Nonqualified**
              **Deferred**
              **Compensation**
              **Earnings ($)**
            
            **All Other**
              **Compen-**
              **sation****3**
              **($)**
            
            **Total ($)**Bill Joll4
              Chief
                Executive Officer and President
            
            
            2007
              2006
            
            $
              $
            325,000
              211,000
            
            
            
            
            $
            16,000
            
            $
              $
            267,000
              784,000
            
            
            
            
            
            
            
            
            
            
            $
              $
            608,000
              995,000Anthony
                Principe
              Senior
                Vice President and Chief Financial Officer
            
            
            2007
              2006
            
            $
              $
            143,000
              120,000
            
            $
            7,000
            
            $
            4,000
            
            
            
            
            
            
            
            
            
            
            $
              $
            1,000
              1,000
            
            $
              $
            155,000
              121,000Matthew
                Frost
              Executive
                Vice President and General Counsel
            
            
            2007
              2006
            
            $
              $
            190,000
              179,000
            
            $
            11,000
            
            $
            9,000
            
            $
            46,000
            
            
            
            
            
            
            
            $
              $
            1,000
              1,000
            
            $
              $
            211,000
              226,000James
                Bankoski**5**
              Senior
                Vice President of Core Technologies and Chief Technology
                Officer
            
            
            2007
            
            $
            141,000
            
            $
            8,000
            
            $
            51,000
            
            
            
            
            
            
            
            
            
            
            $
            1,000
            
            $
            201,000Paul
                Wilkins**6**
              Senior
                Vice President of Research and Development and Chief Technology Officer
            
            
            2007
            
            $
            172,000
            
            $
            20,000
            
            $
            4,000
            7
            
            
            
            
            
            
            
            
            
            $
            13,000
            
            $
            209,000





1
            This
                column represents the dollar amount recognized for financial statement
                reporting purposes with respect to the 2007 fiscal year for the fair
                value
                of restricted stock awards granted to each of the Named Executive
                Officers
                in 2007 as well as prior fiscal years, determined in accordance with
                Statement of Financial Accounting Standards Number 123, Share-Based
                Payment, as revised in 2004 (“SFAS 123R”). The amounts shown exclude the
                impact of estimated forfeitures related to service-based vesting
                conditions. The fair value is calculated using the closing price
                of
                Company common stock on the date the shares of restricted stock were
                granted. For additional information, refer to Note 1 of the Company’s
                financial statements in this Form 10-K for the year ended December
                31,
                2007. See the Grants of Plan-Based Awards Table at page 80 for
                additional information concerning the awards. These amounts reflect
                the
                Company’s accounting expense for the awards, and do not correspond to the
                actual value that may be recognized by the Named Executive Officers.





2
            This
                column represents the dollar amount recognized for financial statement
                reporting purposes with respect to the 2007 fiscal year for the fair
                value
                of stock options granted to each of the Named Executive Officers
                in 2007
                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 2007 grants, refer to Note
                1 of
                the Company’s financial statements in this Form 10-K for the year ended
                December 31, 2007. For information on the valuation assumptions with
                respect to grants made prior to 2007, refer to Note 1 of the Company
                financial statements in the Form 10-K for the year ended December
                31, 2006
                and Note 1 of the Company financial statements in the Form 10-K for
                the
                year ended December 31, 2005. See the Grants of Plan-Based Awards
                Table at
                page 80 for information on options granted in 2007. These amounts
                reflect the Company’s accounting expense for these awards, and do not
                correspond to the actual value that may be recognized by the Named
                Executive Officers.


79


3
            See
                the All Other Compensation below for additional information.





4
            Mr.
                Joll commenced employment with the Company on May 8, 2006 at an annual
                base salary of $325,000. His salary for 2006 was prorated to reflect
                his
                employment for only a portion of the year. Mr. Joll resigned as Chief
                Executive Officer and President of the Company on June 11,
                2008.





5
            James
                Bankoski was not a Named Executive Officer of our Company prior to
                2007.





6
            Paul
                Wilkins resides in the U.K. and was paid in the British Pound. The
                salary
                paid was £86,041 and the bonus paid in 2007, but earned in 2006 was
                £10,469. The December 31, 2007 conversion rate from the British Pound
                to
                the US Dollar was 1.9973. Paul Wilkins was not a Named Executive
                Officer
                of our Company prior to 2007.





7
            Represents
                an award of 42,500 shares of cash settled restricted stock units
                to Paul
                Wilkins. No shares of common stock will be issued pursuant to this
                award,
                as the award is settled in cash. See the Grants of Plan-Based Awards
                Table
                at page 80 for additional information concerning the cash-settled
                restricted stock units award.





**All
      Other Compensation**




The
      All
      Other Compensation in the Summary Compensation Table reports On2 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), with the exception of
      Paul Wilkins, whose pension payments of 6,600£ were paid in the U.K. The
      conversion rate at December 31, 2007 from the British Pound to the US Dollar
      was
      1.9973.




**GRANTS
      OF PLAN-BASED AWARDS IN 2007**





The
      following table provides information about equity and non-equity awards granted
      to the Named Executive Officers in 2007. This information includes (1) the
      grant
      date of the award; (2) the number of shares underlying each restricted stock
      award; and (3) the grant date fair value of each equity award, computed under
      SFAS 123R.




**Name**
            
            **Grant Date**
            
            **All Other Stock**
              **Awards: Number of**
              **Shares of Stock or**
              **Units (#)**1
            
            **Grant Date Fair Value**
              **of Stock and Option**
              **Awards**2Bill Joll
            
            
            11/13/2007
            
            
            107,629
            
            $
            118,000Anthony
                Principe
            
            
            11/13/2007
            
            
            60,848
            
            $
            66,000James
                Bankoski
            
            
            05/18/2007
            
            
            46,628
            
            $
            165,000Matthew
                Frost
            
            
            11/13/2007
            
            
            66,182
            
            $
            72,000Paul
                Wilkins
            
            
            11/13/2007
            
            
            42,5003
            
            $
            46,000


1
            This
                column shows the number of restricted stock awards granted in 2007
                to the
                Named Executive Officers. The 107,629 stock awards issued to Bill
                Joll
                vest on November 13, 2008. The 60,848 stock awards issued to Anthony
                Principe vest in one installment of 27,513 shares on November 13,
                2008,
                one installment of 8,335 shares on May 13, 2009, one installment
                of 8,335
                shares on November 13, 2009, one installment of 8,335 shares on May
                13,
                2010, and one installment of 8,330 shares on November 13, 2010. The
                46,628
                stock awards issued to Jim Bankoski vest in one installment of 23,293
                shares on May 18, 2008, one installment of 5,835 shares on November
                18,
                2008, one installment of 5,834 shares on May 18, 2009, 5,835 shares
                on
                November 18, 2009, and one installment on 5,831 shares on May 13,
                2010.
                The 66,182 stock awards issued to Matt Frost vest in one installment
                of
                32,847 shares on November 13, 2008, one installment of 8,335 shares
                on May
                13, 2009, one installment of 8,335 shares on November 13, 2009, one
                installment of 8,335 shares on May 13, 2010, and one installment
                of 8,330
                shares on November 13, 2010. The amount represented for Mr. Wilkins
                includes an award of cash-settled restricted units payable in cash.
                For
                more information regarding the award of cash-settled restricted stock
                units refer to Note 4 of this
                table.




80


2
            This
                column shows the full grant date fair value of each stock award under
                SFAS
                123R granted to each of the Named Executive Officers in 2007. 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 additional
                information on the valuation assumptions, refer to Note 1 of our
                financial
                statements in this Form 10-K for the year ended December 31, 2007.
                These amounts reflect our accounting expense, and do not correspond
                to the
                actual value that may be recognized by the Named Executive
                Officers.




3
            Paul
                Wilkins received an award of 42,500 shares of cash-settled restricted
                stock units in 2007. Each unit awarded represents a contractual right
                to
                receive an amount in cash equal to the fair market value of a share
                of our
                common stock on the settlement date. No shares of common stock will
                be
                issued pursuant to this award, as the award is settled in cash. The
                42,500
                cash-settled restricted stock units for financial reporting purposes
                vest
                in one installment of 14,167 shares on May 18, 2008, one installment
                of
                7,084 shares on November 18, 2008, one installment of 7,083 shares
                on May
                18, 2009, one installment of 7,083 shares on November 18, 2009, and
                one
                installment of 7,083 shares on May 10,
                2010.




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




*Employment
      Agreements*




During
      2007, Mr. Joll, Mr. Frost, Mr. Bankoski and Mr. Wilkins 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 had an initial term that ended on May 7, 2008. The
      term automatically extended thereafter for a one-year term. Mr. Joll’s
      employment agreement was terminated upon his resignation as Chief Executive
      Officer and President of the Company on June 11, 2008. Mr. Joll’s agreement
      provided for an initial base salary of $325,000. The agreement provided for
      a
      discretionary bonus for the fiscal year ending December 31, 2007, in
      accordance with a senior management bonus scheme tied to delivery of revenue
      and
      profitability objectives for such year, metrics and scales as agreed by the
      Compensation Committee in the fourth quarter of 2006 calendar year, with the
      achievable range between 33% of base salary and 100+% of base salary based
      upon
      actual performance against such goals. The amount of the bonus, if any, shall
      be
      increased or decreased, at the discretion of the Board of Directors, if the
      Company’s performance is better than or is less than the agreed-upon goals. In
      the absence of agreement between the Company and Mr. Joll of such goals, the
      goals shall be 135% of the goals metrics and scales set for the immediately
      preceding calendar year.




In
      2006,
      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 $0.90
      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 preceding the date on
      which the Compensation Committee approved the grant of the options.




In
      addition, the agreement also entitled 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.




Mr. Frost’s
      employment agreement has an initial term that ended on February 28, 2008.
      On April 24, 2008, we extended the term until February 28, 2011.
      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 preceding 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.


81


Mr.
      Bankoski’s employment agreement has an initial term that ends on July 30, 2010.
      The term may be extended upon our agreement with Mr. Bankoski. Mr. Bankoski’s
      agreement provides for an annual base salary of $152,500 per year and an annual
      discretionary bonus pursuant to the bonus plan available to the most senior
      members of our management. The agreement also provides that Mr. Bankoski 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.
      Wilkins’ employment agreement is with our wholly-owned subsidiary, On2
      Technologies (UK) Limited (f/k/a/ MetaVisual Creations Limited), and has an
      initial term that ends on July 30, 2010. The term may be extended upon our
      agreement with Mr. Wilkins. Mr. Wilkins’ agreement provides for an annual base
      salary of ₤90,000 per year and an annual discretionary bonus pursuant to the
      bonus plan available to the most senior members of our management. The agreement
      also provides that Mr. Wilkins is entitled to participate in employee benefit
      plans which are available to our other senior executives, annual vacation and
      reimbursement of reasonable business expenses.




Messers. Joll, Frost,
      Bankoski and Wilkins 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
      Paym ents
      Upon
      Termination on p age
      86.




*Salary
      and Cash Incentive Awards in Proportion to Total Compensation*




As
      noted
      in the Compensation Discussion and Analysis on page 70, the Compensation
      Committee believes that a portion of each Named Executive Officer’s compensation
      should be in the form of equity awards. 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 2007
      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 On2 achieves profitability.




**Name**
            
            **Percentage
                of Total**
              **Compensation**Bill
                Joll
            
            
            53
            %Anthony
                Principe
            
            
            97
            %Matthew
                Frost
            
            
            96
            %James
                Bankoski
            
            
            74
            %Paul
                Wilkins
            
            
            96
            %


82




**OUTSTANDING
      EQUITY AWARDS AT 2007 FISCAL YEAR-END**





The
      following table provides information about the stock option awards and stock
      awards held by the Named Executive Officers as of December 31, 2007. This
      information includes unexercised and unvested stock options, and unvested
      restricted stock awards. Each equity award is separately shown for each Named
      Executive Officer. The vesting schedule for each equity award is shown
      immediately following the table based on the date on which the stock option
      award was granted and based on whether it is a stock option award or a
      restricted stock award. The market value of restricted stock awards is based
      on
      the closing price of Company common stock as of December 31, 2007 (the last
      market trading date during the Company’s 2007 fiscal year), which was
      $1.02.


83


**Option
                  Awards**
              
              **Stock
                  Awards****Name**
              
              **Option Grant**
                **Date**
              
              **Number of**
                **Securities**
                **Underlying**
                **Unexercised**
                **Options**
                **Exercisable**
              
              **Number o****f**
                **Securities**
                **Underlying**
                **Unexercised**
                **Options**
                **Unexercisable**
              
              **Option**
                **Exercise**
                **Price ($)**
              
              **Option**
                **Expiration**
                **Date**
              
              **Stock**
                **Grant Date**
              
              **Number of**
                **Shares or**
                **Units of**
                **Stock That**
                **Have Not**
                **Vested (#)**
              
              **Market Value**
                **of Shares of**
                **Units of Stock**
                **That Have Not**
                **Vested ($)**
              
              **Equity**
                **Incentive Plan**
                **Awards:**
                **Number of**
                **Unearned**
                **Shares, Units**
                **or Other Rights**
                **That Have Not**
                **Vested (#)**
              
              **Equity**
                **Incentive Plan**
                **Awards: Market or**
                **Payout Value**
                **of Unearned**
                **Shares, Units**
                **or Other Rights**
                **That Have Not**
                **Vested ($)**Bill
                  Joll
              
              
              05/01/2006
              (a)
              
              1,000,000
              
              
              
              
              $
              0.90
              
              
              05/01/2014
              
              
              11/13/07
              
              
              107,629
              
              $
              110,00005/01/2006
              (b)
              
              
              
              
              500,000
              
              $
              0.90
              
              
              05/01/2014Anthony
                  Principe
              
              
              08/26/2002
              
              
              12,500
              
              
              
              
              $
              0.14
              
              
              08/26/2012
              
              
              11/13/07
              
              
              60,848
              
              $
              62,00010/01/2002
              
              
              10,000
              
              
              
              
              $
              0.32
              
              
              10/01/201211/15/2003
              
              
              50,000
              
              
              
              
              $
              1.25
              
              
              11/15/201305/13/2004
              
              
              35,000
              
              
              
              
              $
              0.66
              
              
              05/13/201412/03/2004
              
              
              40,000
              
              
              
              
              $
              0.57
              
              
              12/03/201406/27/2005
              
              
              40,000
              
              
              
              
              $
              0.59
              
              
              06/27/201311/18/2005
              
              
              100,000
              
              
              
              
              $
              0.79
              
              
              11/18/2013Matthew
                  Frost
              
              
              12/15/2003
              
              
              75,000
              
              
              
              
              $
              1.36
              
              
              12/15/2013
              
              
              11/13/07
              
              
              66,182
              
              $
              68,00005/13/2004
              
              
              35,000
              
              
              
              
              $
              0.66
              
              
              05/13/201412/03/2004
              
              
              140,000
              
              
              
              
              $
              0.57
              
              
              12/03/201411/18/2005
              
              
              100,000
              
              
              
              
              $
              0.79
              
              
              11/18/201304/03/2006
              
              
              75,000
              
              
              
              
              $
              0.81
              
              
              04/03/2014James
                  Bankoski
              
              
              08/08/2000
              
              
              25,000
              
              
              
              
              $
              3.38
              
              
              08/08/2010
              
              
              5/18/07
              
              
              46,628
              
              $
              48,000Paul
                  Wilkins
              
              
              11/22/2005
              
              
              40,000
              
              
              
              
              $
              .079
              
              
              11/22/2013
              
              
              11/13/07
              
              
              42,5001
              
              $
              43,000





1 Paul
      Wilkins received an award of 42,500 shares of cash-settled restricted stock
      units in 2007. Each unit awarded represents a contractual right to receive
      an
      amount in cash equal to the fair market value of a share of our common stock
      on
      the settlement date. No shares of common stock will be issued pursuant to this
      award, as the award is settled in cash.


84


**Option
      Awards Vesting Schedule**





Grant
                Date
            
            Vesting
                Schedule08/08/2000
            
            33.34%
                1 year after grant; 33.33% 2 years after grant; 33.33% 3 years after
                grant08/26/2002
            
            25%
                immediately; 25% 1 year after grant; 25% 2 years after grant; 25%
                3 years
                after grant10/01/2002
            
            50%
                in 6 months; 50% 1 year after grant11/15/2003
            
            50%
                immediately; 50% 1 year after grant12/15/2003
            
            33.33%
                immediately; 33.33% 1 year after grant; 33.34% 2 years after
                grant05/13/2004
            
            50%
                immediately; 50% 1 year after grant12/03/2004
            
            100%
                1 year after grant06/27/2005
            
            50%
                immediately; 50% 1 year after grant11/18/2005
            
            50%
                immediately; 50% 1 year after grant11/22/2005
            
            50%
                immediately; 50% in 1 year04/03/2006
            
            50%
                immediately; 50% on 02/28/0705/01/2006
                (a)
            
            33.34%
                vests on 05/01/06; 33.33% vests on 11/08/06; 33.33% vests on
                05/08/0705/01/2006
                (b)
            
            100%
                vests on 05/08/08





**Stock
      Awards Vesting Schedule**







Grant
                Date
            
            Vesting
                ScheduleBill
                Joll 11/13/07
            
            100%
                vests on 11/13/08Anthony
                Principe 11/13/07
            
            27,513
                shares on 11/13/08; 8,335 on 05/13/09; 8,335 on 11/13/09; 8,335 on
                05/13/10; 8,330 on 11/13/10Matthew
                Frost 11/13/07
            
            32,847
                on 11/13/08; 8,335-05/13/09; 8,335-11/13/09; 8,335-05/13/10;
                8,330-11/13/10James
                Bankowski 5/18/07
            
            23,293
                on 5/18/08; 5,835 on11/18/08; 5,834 on 5/18/09; 5,835 on11/18/09;
                5,831on
                5/18/10Paul
                Wilkins 11/13/07
            
            14,167
                on 5/18/08; 7,084 on11/18/08; 7,083 on 05/18/09; 7,083 on 11/18/09;
                7,083
                on 5/18/10




85


**OPTION
      EXERCISES AND STOCK VESTED IN FISCAL 2007**





The
      following table provides information for the Named Executive Officers regarding
      stock options that were exercised during fiscal 2007 and the vesting of stock,
      including restricted stock, during fiscal 2007.





Option
                Awards
            
            Stock
                AwardsName
            
            Number
                of Shares
              Acquired
                on
              Exercise
            
            Value
                Realized on
              Exercise
            
            Number
                of Shares
              Acquired
                on Vesting
            
            Value
                Realized on
              VestingBill
                Joll
            
            
            
            
            $
            
            
            
            
            
            $Anthony
                Principe
            
            
            
            
            $
            
            
            
            
            
            $Matthew
                Frost
            
            
            
            
            $
            
            
            
            
            
            $James
                Bankoski
            
            
            451,344
            
            $
            790,004
            
            
            
            
            $Paul
                Wilkins
            
            
            420,500
            
            $
            1,339,194
            
            
            
            
            $





**POTENTIAL
      PAYMENTS UPON TERMINATION**





**Employment
      Agreements**




As
      explained in the Narrative to the Summary Compensation Table and Plan-Based
      Award Table on page 81, we have entered into employment agreements with
      Mr. Joll, Mr. Frost and Mr. Bankoski. Our employment agreement with
      Mr. Joll terminated on June 11, 2008 upon his resignation from the Company
      as
      Chief Executive Officer and President. Our wholly-owned subsidiary, On2
      Technologies (UK) Limited (f/k/a MetaVisual Creations Limited), has entered
      into
      an employment agreement with Mr. Wilkins. **** 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 contained in these employment agreements 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.




·
            “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 On2 “ 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.




86


·
            “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 Messers.
                Frost, Bankoski and Wilkins 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
      was subject under his employment agreement to non-competition and
      non-solicitation restrictions following termination of his employment for any
      reason. These restrictions applied for 12 months. In addition, Mr. Joll was
      entitled under his employment agreement to continue coverage under
      company-sponsored group health plans following termination of employment for
      a
      period of six months. Mr. Frost is also 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 On2**
            
            **Disability**
              **Termination**
            
            **Death**
              **Termination****Compensation:**Severance
                2
            
            $
            325,000
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            325,000
            
            $
            162,500
            
            $
            27,083
            
            $
            0Bonus
                3
            
            $
            108,333
              to
              $325,000
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            108,333
              to
              $325,000
            
            $
            0
            
            $
            0
            
            $
            0**Benefits
                & Perquisites:**Health
                Plan Continuation
            
            $
            10,853
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            10,853
            
            $
            0
            
            $
            0
            
            $
            0**Total**
            
            $
            335,853
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            335,853
            
            $
            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, 2007; Mr. Joll’s base
                salary is $325,000.




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
                sum.
                For a Non-extension of Term by On2, severance is continued payment
                of base
                salary for six 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 30 days following the notice
                of
                termination by us.




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 the
                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. The range
                of
                the bonus is 33% to 100% of Mr. Joll’s base salary, which is determined by
                specific cash flow targets. For 2007, however, since the cash flow
                targets
                were not met, Mr. Joll was not awarded a
                bonus.


87


**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****4**
            
            **Non-extension of**
              **Term by**
              **On2**
            
            **Disability**
              **Termination**
            
            **Death**
              **Termination****Compensation:**Severance**2**
            
            $
            33,333
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            100,000
            
            $
            0
            
            $
            0
            
            $
            0Bonus**3**
            
            $
            0to
              $100,000
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            0to
              $100,000
            
            $
            0
            
            $
            0
            
            $
            0**Benefits
                & Perquisites:**Health
                Plan Continuation
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            13,023
            
            $
            13,023
            
            $
            0
            
            $
            13,023
            
            $
            13,023**Total**
            
            $
            33,333
            
            $
            0
            
            $
            0
            
            $
            13,023
            
            $
            113,023
            
            $
            0
            
            $
            13,023
            
            $
            13,023





1
            The
                amounts shown in the above table were computed based on the following
                assumptions: the termination date was December 31, 2007; Mr. Frost’s base
                salary was $200,000.




2
            Severance
                is continuation of annual base salary for 180 days from the date
                of
                termination in the event of a Termination without Cause, Disability
                Termination, or Death Termination.




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 the
                amount of the bonus that has become payable with respect to the completed
                2007 calendar year but not yet paid to Mr. Frost. The range of the
                bonus
                is 0 to 50% of Mr. Frost’s base salary, which is determined by specific
                cash flow targets.




4
            In
                the event of a Termination without Cause, the vesting of all of Mr.
                Frost’s outstanding options is accelerated.




**James
      Bankoski**


**Senior
      Vice President of Core Technologies and Chief Technology 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**4
            
            **Non-extension of**
              **Term by**
              **On2**
            
            **Disability**
              **Termination**
            
            **Death**
              **Termination****Compensation:**Severance**2**
            
            $
            76,250
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            76,250
            
            $
            0
            
            $
            0
            
            $
            0Bonus3
            
            $
            0to
              $76,250
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            0**Benefits
                & Perquisites:**Health
                Plan Continuation
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            7,158
            
            $
            0
            
            $
            0
            
            $
            0**Total**
            
            $
            76,250
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            83,408
            
            $
            0
            
            $
            0
            
            $
            0





1
            The
                amounts shown in the above table were computed based on the following
                assumptions: the termination date was December 31, 2007; Mr. Bankoski’s
                base salary was $152,500.




2
            Severance
                is continuation of annual base salary for 180 days from the date
                of
                termination in the event of a Termination without Cause, Disability
                Termination, or Death Termination.




88


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 the
                amount of the bonus that has become payable with respect to the completed
                2007 calendar year but not yet paid to Mr. Bankoski. The range of
                the
                bonus is 0 to 50% of Mr. Bankoski’s base salary, which is determined by
                specific cash flow targets.




4
            In
                the event of a Termination without Cause, the vesting of all of Mr.
                Bankoski’s outstanding options is accelerated.




**Paul
      Wilkins**


**Senior
      Vice President of Research and Development and Chief Technology 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**4
            
            **Non-extension of**
              **Term by**
              **On2**
            
            **Disability**
              **Termination**
            
            **Death**
              **Termination****Compensation:**Severance**2**
            
            $
            90,000
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            90,000
            
            $
            0
            
            $
            0
            
            $
            0Bonus3
            
            $
            0to
              $90,000
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            0**Benefits
                & Perquisites:**Health
                Plan Continuation
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            928
            
            $
            0
            
            $
            0
            
            $
            0**Total**
            
            $
            90,000
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            90,928
            
            $
            0
            
            $
            0
            
            $
            0





1
            The
                amounts shown in the above table were computed based on the following
                assumptions: the termination date was December 31, 2007; Mr. Wilkins’ base
                salary was $180,000. Mr. Wilkins is paid in his domestic currency
                which is
                the British Pound. For purposes of this table, we used the conversion
                rate
                at December 31, 2007.




2
            Severance
                is continuation of annual base salary for 180 days from the date
                of
                termination in the event of a Termination without Cause, Disability
                Termination, or Death Termination..




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 the
                amount of the bonus that has become payable with respect to the completed
                2007 calendar year but not yet paid to Mr. Wilkins. The range of
                the bonus
                is 0 to 50% of Mr. Wilkins’ base salary, which is determined by specific
                cash flow targets.




4
            In
                the event of a Termination without Cause, the vesting of all of Mr.
                Wilkins’ outstanding options is accelerated.




*Life
      Insurance Benefit* .
      If
      Mr. Joll had died on December 31, 2007, his survivor would have
      received $250,000 under the supplemental term life insurance policy for which
      we
      annually reimburse premiums. If Mr. Frost had died on December 31,
      2007, his survivor would have received $200,000 under the supplemental term
      life
      insurance policy for which we annually reimburse premiums. If Mr. Bankoski
      had
      died on December 31, 2007, his survivor would have received $152,500 under
      the
      supplemental term life insurance policy for which we annually reimburse
      premiums.




89




**NON-MANAGEMENT
      DIRECTOR COMPENSATION FOR FISCAL 2007**





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 70. During the
      fiscal year ended December 31, 2007, 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 the Audit and Compensation Committees shall receive $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 ($)**
            
            **Stock**
              **Awards**
              **($)**
            
            **Option**
              **Awards**
              **($)**
            
            **Non-Equity**
              **Incentive Plan**
              **Compensation**
              **($)**
            
            **Change in**
              **Pension Value**
              **and**
              **Nonqualified**
              **Deferred**
              **Compensation**
              **Earnings ($)**
            
            **All Other**
              **Compensation**
              **($)**
            
            **Total ($)**James
                Meyer
            
            $
            20,000
            
            $
            23,000
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            43,000William
                Newman
            
            $
            15,000
            
            $
            20,000
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            35,000Thomas
                Weigman
            
            $
            15,000
            
            $
            20,000
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            35,000J.
                Allen Kosowsky
            
            $
            35,000
            
            $
            44,000
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            79,000Mike
                Kopetski
            
            $
            15,000
            
            $
            20,000
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            35,000Mike
                Alfant
            
            $
            15,000
            
            $
            20,000
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            35,000Afsaneh
                Naimollah
            
            $
            15,000
            
            $
            20,000
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            35,000Pekka
                Salonoja


90





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




**SECURITY
      OWNERSHIP OF PRINCIPAL STOCKHOLDERS**




The
      following information with respect to beneficial ownership, as of June 16,
      2008,
      of shares of common stock is furnished with respect to (i) each director of
      our
      company, (ii) each Named Executive Officer of the our company, (iii) all current
      directors and Named Executive Officers as a group, and (iv) each person known
      by
      us to be a beneficial owner of more than 5% of our outstanding common stock,
      together with their respective percentages. All ownership information is based
      upon filings made by those persons with the Securities and Exchange Commission
      or upon information provided to us. To our knowledge, each of the holders of
      shares of common stock listed below has sole voting and investment power as
      to
      the shares owned by such holder, unless otherwise noted. Unless otherwise
      indicated below, the address of each person named in the table below is in
      the
      care of On2 Technologies, Inc., 21 Corporate Drive, Suite 103, Clifton Park,
      New
      York 12065.




**Amount and Nature of**
              **Beneficial Ownership**
              **(Number of Shares)****(1)****Name and Address of Beneficial Owner**
            
            **Title of Class**
            
            **Total**
            
            **Percent of**
              **Class**James
                Bankoski(2)
              Senior
                Vice President of Core Technologies and Chief Technology
                Officer
            
            
            Common
            
            
            137,426
            
            
            *Bill
                Joll(3)
              President
                and Chief Executive Officer
            
            
            Common
            
            
            1,607,629
            
            
            1.01
            %Matthew
                Frost(4)
              Executive
                Vice President, Legal and Business Affairs
            
            
            Common
            
            
            512,690
            
            
            *James
                Meyer(5)
              Director
            
            
            Common
            
            
            265,893
            
            
            *Anthony
                Principe(6)
              Senior
                Vice President and Chief Financial Officer
            
            
            Common
            
            
            377,548
            
            
            *Paul
                Wilkins(7)
              Senior
                Vice President of Research and Development and Chief Technology
                Officer
            
            
            Common
            
            
            103,597
            
            
            *William
                A. Newman(8)
              Director
            
            
            Common
            
            
            509,191
            
            
            *J.
                Allen Kosowsky(9)
              Director
            
            
            Common
            
            
            879,965
            
            
            *Michael
                Kopetski(10)
              Director
            
            
            Common
            
            
            385,531
            
            
            *Thomas
                Weigman(11)
              Director
            
            
            Common
            
            
            523,531
            
            
            *Michael
                J. Alfant(12)
              Director
            
            
            Common
            
            
            243,531
            
            
            *Afsaneh
                Naimollah(13)
              Director
            
            
            Common
            
            
            193,531
            
            
            *Pekka
                Salonoja(14)
              Director
            
            
            Common
            
            
            7,868,175
            
            
            4.93
            %All
                current directors and Named Executive Officers as a group (11
                persons)
            
            
            Common
            
            
            13,617,440
            
            
            8.53
            %Capman
                Capital Management Oy(15)
                (16) (17)
            
            
            Common
            
            
            10,284,042
            
            
            6.45
            %


91


*
            Represents
                less than one percent (1%) of outstanding shares of common
                stock.




(1)
            Pursuant
                to current regulations of the Securities and Exchange Commission,
                securities must be listed as “beneficially owned” by a person who directly
                or indirectly has or shares voting power or dispositive power with
                respect
                to the securities, whether or not the person has any economic interest
                in
                the securities. In addition, a person is deemed a beneficial owner
                if he
                has the right to acquire beneficial ownership within 60 days, whether
                upon
                the exercise of a stock option or warrant, conversion of a convertible
                security or otherwise.




(2)
            Includes
                37,426 shares of common stock and options to purchase 100,000 shares
                of
                common stock that are exercisable within 60
                days.




(3)
            Includes
                107,629 shares of common stock and options to purchase 1,500,000
                shares of
                common stock that are exercisable within 60
                days.




(4)
            Includes
                87,690 shares of common stock and options to purchase 425,000 shares
                of
                common stock that are exercisable within 60
                days.




(5)
            Includes
                85,893 shares of common stock, of which 113,952 shares are held directly,
                10,000 shares are held as trustee for the trust beneficially owned
                by Sara
                Meyer, and 9,000 shares are held indirectly by trust for his sons.
                Mr.
                Meyer disclaims beneficial ownership of the securities held in trust
                for
                his sons. Also includes options to purchase 180,000 shares of common
                stock
                that are exercisable within 60 days.****Does
                not include 47,059 restricted shares granted but not yet formally
                issued;
                these shares have not been included in the total number of our issued
                and
                outstanding shares.




(6)
            Includes
                90,048 shares of common stock and options to purchase 287,500 shares
                of
                common stock that are exercisable within 60 days.




(7)
            Includes
                options to purchase 87,500 shares of common stock that are exercisable
                within 60 days. Also includes 16,097 shares of common stock held
                indirectly as trustee for a trust for Mr. Wilkins’
                children.




(8)
            Includes
                44,191 shares of common stock and options to purchase 465,000 shares
                of
                common stock that are exercisable within 60 days. Does not include
                53,979
                restricted shares granted but not yet formally issued; these shares
                have
                not been included in the total number of our issued and outstanding
                shares.




(9)
            Includes
                369,965 shares of common stock and options to purchase 510,000 shares
                of
                common stock that are exercisable within 60 days. Does not include
                103,806
                restricted shares granted but not yet formally issued; these shares
                have
                not been included in the total number of our issued and outstanding
                shares.


92


(10)
            Includes
                68,531 shares of common stock and options to purchase 290,000 shares
                of
                common stock that are exercisable within 60 days. Does not include
                47,059
                restricted shares granted but not yet formally issued; these shares
                have
                not been included in the total number of our issued and outstanding
                shares.




(11)
            Includes
                83,531 shares of common stock and options to purchase 440,000 shares
                of
                common stock that are exercisable within 60 days. Does not include
                47,059
                restricted shares granted but not yet formally issued; these shares
                have
                not been included in the total number of our issued and outstanding
                shares.




(12)
            Includes
                43,531 shares of common stock and options to purchase 200,000 shares
                of
                common stock that are exercisable within 60 days. Does not include
                53,979
                restricted shares granted but not yet formally issued; these shares
                have
                not been included in the total number of our issued and outstanding
                shares.




(13)
            Includes
                43,531 shares of common stock and options to purchase 150,000 shares
                of
                common stock that are exercisable within 60 days. Does not include
                47,059
                restricted shares granted but not yet formally issued; these shares
                have
                not been included in the total number of our issued and outstanding
                shares.




(14)
            Includes
                76,650 shares of common stock held by Nexit Infocom 200 Limited,
                of which
                Mr. Salonoja is a director. Also includes 7,791,525 shares of common
                stock
                held by Nexit Ventures Oy, of which Mr. Salonoja is a director. Mr.
                Salonoja disclaims beneficial ownership of the securities held by
                these
                entities. Does not include 53,979 restricted shares granted but no
                yet
                formally issued; these shares have not been included in the total
                number
                of our issued and outstanding shares.




(15)
            The
                information with respect to this beneficial owner is according to
                such
                beneficial owner’s filings with the SEC. According to these filings, these
                shares were not acquired for the purpose of or having the effect
                of
                changing or influencing control of the company nor in connection
                with or
                as a participant in any transaction having such purpose or
                effect.




(16)
            The
                address of Capman Capital Management Oy is Korkeavuorenkatu 32, 00130
                Helsinki, Finland.




(17)
            According
                to Schedule 13G filed on March 14, 2008 by Capman Capital Management
                Oy
                (“Capman”), in its capacity as the general partner of Finnventure Rahasto
                V Ky (“Finnventure V”) and Finnventure Rahasto V ET Ky (“Finnventure V
                ET), Capman has sole dispositive and voting power with respect to
                such
                shares, of which 5,142,021 are directly held by Finnventure V and
                5,142,021 are directly held by Finnventure V ET. Finnventure V and
                Finnventure V ET are both limited partnerships in which Capman acts
                as the
                general partner.





**Equity
                Compensation Plan Information December 31, 2007****Plan
                category**
            
            **Number of securities**
              **to be issued**
              **upon exercise of**
              **outstanding options,**
              **warrants and rights**
            
            **Weighted-average**
              **exercise price of**
              **outstanding options,**
              **warrants and rights**
            
            **Number of securities**
              **remaining available for**
              **future issuance under**
              **equity compensation plans**
              **(excluding securities**
              **reflected in column (a))**Equity
                compensationplans
                approved bysecurity
                holders
            
            
            10,610,000
            
            $
            1.08
            
            
            10,452,000Equity
                compensationplans
                not approvedby
                security holdersTotal
            
            
            10,610,00
            
            $
            1.08
            
            
            10,452,000


93





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





**CERTAIN
      RELATIONSHIPS AND RELATED TRANSACTIONS**





We
      believe that the terms of each transaction described below are comparable to,
      or
      more favorable to us than the terms that would have been obtained in an arms’
length transaction with an unaffiliated party.




During
      the years ended December 31, 2007 and 2006, we retained McGuireWoods LLP to
      perform certain legal services on our behalf and incurred approximately
      $1,022,000 and $150,000 respectively for such legal services. William A. Newman,
      a director of our company, was a partner of McGuireWoods LLP until May,
      2008.




*Review,
      Approval or Ratification* ** *of
      Transactions with Related Persons*




We
      do not
      have a written policy concerning transactions between us and any director or
      executive officer, nominee for director, 5% stockholder or member of the
      immediate family of any such person. However, our policy is that such
      transactions shall be reviewed by our Board of Directors and found to be fair
      to
      On2 prior to entering into any such transaction, except for (i) executive
      officers’ participation in employee benefits which are available to all
      employees generally and (ii) compensation decisions with respect to executive
      officers other than the CEO, which are made by the Compensation Committee
      pursuant to recommendations of the CEO, as is described under “Compensation
      Discussion and Analysis” on page 70.




**Director
      Independence**





On
      the
      basis of information solicited from each director, the Board of Directors has
      affirmatively determined that each of J. Allen Kosowsky, Thomas Weigman, Michael
      Alfant Michael Kopetski, Afsaneh Naimollah, James Meyer, and Pekka Salonoja
      has
      no material relationship with On2 and is independent pursuant to American Stock
      Exchange director independence standards as currently in effect. In making
      this
      determination, the Board of Directors, with the assistance of On2’s general
      counsel, evaluated responses to a questionnaire completed annually by each
      director, the company and management. Bill Joll and William Newman are not
      independent pursuant to the American Stock Exchange independence standards.
      Bill
      Joll currently serves as our President and Chief Executive Officer. Until May
      2008, Mr. Newman was a partner in McGuireWoods, LLP, our outside law
      firm.




Further,
      the Board of Directors determined that each of the members of the audit
      committee, the compensation committee, and the governance and nominating
      committee has no material relationship with On2 and is independent within the
      meaning of our corporate governance guidelines, which adopt the statutory and
      American Stock Exchange independence standards applicable to audit committee
      members.




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





**AUDIT
      FEES**




Audit
        fees billed (or expected to be billed) to us by Eisner LLP for the audit
        of our
        annual financial statements included in our annual report on 10-K for the
        2007
        fiscal year and reviews of the quarterly financial statements included in
        our
        quarterly reports on Form 10-Q for the 2007 fiscal year totaled approximately
        $447,000. Audit fees billed to us by Eisner LLP for the audit of our annual
        financial statements included in our annual report on Form 10-K for the 2006
        fiscal year and reviews of the quarterly financial statements included in
        our
        quarterly reports on Form 10-Q for the 2006 fiscal year totaled approximately
        $117,000.




**AUDIT-RELATED
      FEES**




In
      the
      last two fiscal years, Eisner LLP did not bill us for any assurance and related
      services that are reasonably related to the performance of the audit or review
      of our financial statements.


94


**TAX
      FEES**




In
      the
      fiscal year ending December 31, 2007, Eisner LLP billed On2 approximately
      $17,000 for professional services for tax compliance, tax advice, and tax
      planning. In the fiscal year ending December 31, 2006, Eisner LLP billed
      On2 approximately $15,000 for professional services for tax compliance, tax
      advice, and tax planning.




**FINANCIAL
      INFORMATION SYSTEMS DESIGN AND IMPLEMENTATION FEES**




In
      the
      last two fiscal years, we did not engage Eisner LLP to provide advice to us
      regarding financial information systems design and implementation.




**ALL
      OTHER FEES**




In
      the
      fiscal year ending December 31, 2007, Eisner LLP billed us $122,000 for
      non-audit services. In the fiscal year ending December 31, 2006, Eisner LLP
      billed us approximately $0 for non-audit services.




**Pre-Approval
      of Audit and Non-Audit Services**




The
      audit
      committee’s policy is to pre-approve all audit services, audit-related services
      and other services permitted by law provided by the external auditors. During
      2007, On2 used Eisner LLP for non-audit services; and therefore, the audit
      committee was required to approve such services.


95


**PART
      IV**





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





*Exhibits*





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




**Incorporated
                by Reference****Exhibit**
              **Number**
            
            **Exhibit
                Description**
            
            **Form**
            
            **Date
                Filed**
            
            **Filed
                Herewith**2.1
            
            Share
                Exchange Agreement, dated as of May 21, 2007, by and among the Company
                and
                Nexit Ventures Oy, as the Authorized Representatives of the holders
                of all
                outstanding equity securities of Hantro Products Oy
            
            8-K
            
            May
                22, 20073.1
            
            Certificate
                of Incorporation of the Company
            
            10-K
            
            April
                2, 20013.2
            
            Bylaws
                of the Company
            
            
            
            
            
            X3.3
            
            Amendment
                to Certificate of Incorporation (to increase authorized shares to
                250,000,000)
            
            
            
            
            
            X3.4
            
            Amendment
                of Bylaws
            
            8-K
            
            June
                13, 20084.1
            
            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, 2003


96





**Incorporated
                by Reference****Exhibit**
              **Number**
            
            **Exhibit
                Description**
            
            **Form**
            
            **Date
                Filed**
            
            **Filed
                Herewith**4.12
            
            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
            
            8-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
            
            Securities
                Purchase Agreement, dated as of August 24, 2006
            
            8-K
            
            Aug.
                25, 200610.6
            
            Registration
                Rights Agreement, dated as of August 24, 2006
            
            8-K
            
            Aug.
                25, 200610.7
            
            Stockholder
                Voting Agreement
            
            8-K
            
            Aug.
                25, 200610.8
            
            Asset
                Purchase Agreement (Confidential Treatment Requested as to Redacted
                Portions)
            
            8-K/A
            
            Nov.
                17, 200610.9
            
            Exhibit
                B [sic] to Asset Purchase Agreement (Form of Escrow
                Agreement)
            
            8-K/A
            
            Nov.
                17, 200610.10
            
            Exhibit
                C [sic] to Asset Purchase Agreement (Form of Support and Maintenance
                Agreement)
            
            8-K/A
            
            Nov.
                17, 200610.11
            
            Exhibit
                D [sic] to Asset Purchase Agreement (Form of Registration Rights
                Agreement)
            
            8-K/A
            
            Nov.
                17, 200610.12
            
            Employment
                Agreement, dated as of February 28, 2006, by and between the Company
                and
                Matt Frost
            
            10-K
            
            March
                23, 200710.13
            
            Letter
                Agreement between the Company and Midsummer Investment, Ltd., dated
                May
                31, 2007
            
            8-K
            
            June
                20, 200710.14
            
            Letter
                Agreement between the Company and Rockmore Investment Master Fund,
                dated
                June 11, 2007
            
            8-K
            
            June
                20, 200710.15
            
            Form
                of Employment Agreement with Jim Bankoski
            
            8-K
            
            August
                3, 200710.16
            
            Form
                of Employment Agreement with Paul Wilkins
            
            8-K
            
            August
                3, 200710.17
            
            Underwriting
                Agreement, dated October 17, 2007, between the Company and ThinkEquity
                Partners LLC and Merriman Curhan Ford & Co.
            
            8-K
            
            October
                23, 2007


97




**Incorporated
                  by Reference****Exhibit**
                **Number**
              
              **Exhibit
                  Description**
              
              **Form**
              
              **Date
                  Filed**
              
              **Filed
                  Herewith**10.18
              
              Form
                  of Escrow Agreement, dated as of May 21, 2007 by and among the
                  Company,
                  Deutsche Bank and Nexit Ventures Oy, as authorized representative
                  of the
                  securityholders of Hantro Products Oy
              
              DEFR14A
              
              August
                  30, 200710.19
              
              Form
                  of Employment Agreement with Eero Kaikkonen
              
              DEFR14A
              
              August
                  30, 200710.20
              
              Transition
                  Agreement and General Release, dated June 10, 2008, between On2
                  Technologies, Inc. and Bill Joll
              
              8-K
              
              June
                  13, 200814
              
              Code
                  of Ethics
              
              
              
              
              
              X21
              
              Subsidiaries
              
              
              
              
              
              X23.1
              
              Consent
                  of Eisner LLP
              
              
              
              
              
              X31.1
              
              Certification
                  of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley
                  Action of 2002
              
              
              
              
              
              X31.2
              
              Certification
                  of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley
                  Action of 2002
              
              
              
              
              
              X32.1
              
              Certification
                  of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350,
                  as Adopted
                  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
              
              
              
              
              
              X32.2
              
              Certification
                  of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350,
                  as Adopted
                  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
              
              
              
              
              
              X


98


**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/
                  Matthew FrostMatthew
                  Frost*Interim
                  Chief Executive Officer**(Principal
                  Executive Officer)*Date:
                June 27, 2008





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





**Signature**
              
              **Title**
              
              **Date**/s/
                  Anthony Principe
              
              Senior
                  Vice President and Chief Financial Officer (Principal Financial
                  and
                  Accounting Officer)
              
              June
                  27, 2008(Anthony
                  Principe)/s/
                  J. Allen Kosowsky
              
              Chairman
                  of the Board and Director
              
              June
                    27, 2008(J.
                  Allen Kosowsky)/s/
                  William A. Newman
              
              Director
              
              June
                    27, 2008(William
                  A. Newman)/s/
                  Mike Kopetski
              
              Director
              
              June
                    27, 2008(Mike
                  Kopetski )/s/
                  Thomas Weigman
              
              Director
              
              June
                    27, 2008(Thomas
                  Weigman)/s/
                  Michael J. Alfant
              
              Director
              
              June
                    27, 2008(Michael
                  J. Alfant)/s/
                  Afsaneh Naimollah
              
              Director
              
              June
                    27, 2008(Afsaneh
                  Naimollah)/s/
                  James Meyer
              
              Director
              
              June
                    27, 2008(James
                  Meyer)/s/
                  Pekka Salonoja
              
              Director
              
              June
                    27, 2008(Pekka
                  Salonoja)




99




**INDEX
      TO CONSOLIDATED FINANCIAL STATEMENTS**





PageReports
                of Independent Registered Public Accounting Firm
            
            
            F-2Consolidated
                Balance Sheets as of December 31, 2007 and 2006
            
            
            F-5Consolidated
                Statements of Operations for the years ended December 31, 2007, 2006
                and
                2005
            
            
            F-6Consolidated
                Statements of Changes in Stockholders’ Equity for the years ended December
                31, 2007, 2006 and 2005
            
            
            F-7Consolidated
                Statements of Cash Flows for the years ended December 31, 2007, 2006
                and
                2005
            
            
            F-11Notes
                to Consolidated Financial Statements
            
            
            F-12


F-1


**Report
      of Independent Registered Public Accounting Firm**





Board
      of
      Directors and Stockholders


On2
      Technologies, Inc.





We
      have
      audited the accompanying consolidated balance sheets of On2 Technologies, Inc.
      and subsidiaries (the “Company”) as of December 31, 2007 and 2006 and the
      related consolidated statements of operations, changes in stockholders’ equity
      and cash flows for each of the years in the three-year period ended December
      31,
      2007. These financial statements are the responsibility of the Company’s
      management. Our responsibility is to express an opinion on these financial
      statements based on our audits.





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





In
      our
      opinion, the financial statements referred to above present fairly, in all
      material respects, the consolidated financial position of On2 Technologies,
      Inc.
      and subsidiaries as of December 31, 2007 and 2006, and the consolidated
      results of their operations and their consolidated cash flows for each of the
      years in the three-year period ended December 31, 2007 in conformity with U.S.
      generally accepted accounting principles.





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




In
      connection with our audits of the consolidated financial statements referred
      to
      above, we audited Schedule II – Valuation and Qualifying Accounts for each
      of the years in the three-year period ended December 31, 2007. In our opinion,
      this schedule, when considered in relation to the financial statements taken
      as
      a whole, present fairly, in all material respects, the information stated
      therein.




We
        have
        also audited, in accordance with the standards of the Public Company Accounting
        Oversight Board (United States), On2 Technologies, Inc.’s internal control over
        financial reporting as of December 31, 2007, based on criteria established
        in
        Internal Control - Integrated Framework issued by the Committee of Sponsoring
        Organizations of the Treadway Commission (COSO), and our report dated June
        27,
        2008 expressed an adverse opinion on the effectiveness of the Company’s internal
        control over financial reporting.


/s/
        Eisner LLP





New
      York,
      New York


June
        27,
        2008


F-2


**Report
          of Independent Registered Public Accounting Firm**
  Board
            of
            Directors and Stockholders
 On2
            Technologies, Inc.
 We
          have
          audited On2 Technologies, Inc.’s (the “Company” or “On2”) internal control over
          financial reporting as of December 31, 2007, based on criteria established
          in
          Internal Control - Integrated Framework issued by the Committee of Sponsoring
          Organizations of the Treadway Commission (COSO). The On2 Technologies,
          Inc.
          management is responsible for maintaining effective internal control over
          financial reporting, and for its assessment of the effectiveness of internal
          control over financial reporting, included in the accompanying management’s
          Annual Report on Internal Control over Financial Reporting. Our responsibility
          is to express an opinion on the company's internal control over financial
          reporting based on our audit.
 
 We
          conducted our audit in accordance with the standards of the Public Company
          Accounting Oversight Board (United States). Those standards require that
          we plan
          and perform the audit to obtain reasonable assurance about whether effective
          internal control over financial reporting was maintained in all material
          respects. Our audit included obtaining an understanding of internal control
          over
          financial reporting, assessing the risk that a material weakness exists,
          and
          testing and evaluating the design and operating effectiveness of internal
          control based on the assessed risk. Our audit also included performing
          such
          other procedures as we considered necessary in the circumstances. We believe
          that our audit provides a reasonable basis for our opinion.
 
 A
          company's internal control over financial reporting is a process designed
          to
          provide reasonable assurance regarding the reliability of financial reporting
          and the preparation of financial statements for external purposes in accordance
          with generally accepted accounting principles. A company's internal control
          over
          financial reporting includes those policies and procedures that (1) pertain
          to
          the maintenance of records that, in reasonable detail, accurately and fairly
          reflect the transactions and dispositions of the assets of the company;
          (2)
          provide reasonable assurance that transactions are recorded as necessary
          to
          permit preparation of financial statements in accordance with generally
          accepted
          accounting principles, and that receipts and expenditures of the company
          are
          being made only in accordance with authorizations of management and directors
          of
          the company; and (3) provide reasonable assurance regarding prevention
          or timely
          detection of unauthorized acquisition, use, or disposition of the company's
          assets that could have a material effect on the financial
          statements.
 
 Because
          of its inherent limitations, internal control over financial reporting
          may not
          prevent or detect misstatements. Also, projections of any evaluation of
          effectiveness to future periods are subject to the risk that controls may
          become
          inadequate because of changes in conditions, or that the degree of compliance
          with the policies or procedures may deteriorate.
 
 A
          material weakness is a deficiency, or a combination of deficiencies, in
          internal
          control over financial reporting, such that there is a reasonable possibility
          that a material misstatement of the company’s annual or interim financial
          statements will not be prevented or detected on a timely basis. The following
          material weaknesses have been identified and included in management’s
          assessment.
 
 F-3
 1.
                The
                    Company’s controls over the procedures for consideration of
                    creditworthiness or the assessment as to whether billings are
                    collectible
                    were not designed effectively to meet the Company’s revenue recognition
                    policy in accordance with generally accepted accounting
                    principles.
 
 2.
                The
                    Company did not maintain an effective control environment, specifically
                    relating to its tone at the top and the control consciousness
                    of the
                    former Chief Executive
                    Officer.
 
 3.
                Effective
                    controls were not designed to ensure that an appropriate analysis
                    of
                    receivables from customers was conducted, reviewed, approved
                    and
                    documented in order to reasonably estimate the allowance for
                    doubtful
                    accounts.
  These
          material weaknesses and their impact on the company’s financial statements are
          more fully described in the company’s Annual Report on Form
          10-K.
 
 The
          material weaknesses described above resulted in the restatement of On2’s interim
          June 30, 2007 and September 30, 2007 consolidated financial statements.
          Furthermore, these material weaknesses could result in other material
          misstatements in financial statement accounts and disclosures in the annual
          or
          interim On2 consolidated financial statements that would not be timely
          prevented
          or detected. These material weaknesses were considered in determining the
          nature, timing, and extent of audit tests applied in our audit of the 2007
          consolidated financial statements, and this report does not affect our
          report
          dated June 27, 2008, on those financial statements.
 
 In
          our
          opinion, because of the material weaknesses described above on the achievement
          of the objectives of the control criteria, On2 Technologies, Inc. has not
          maintained effective internal control over financial reporting as of December
          31, 2007, based on criteria established in COSO.
 
 We
          have
          also audited, in accordance with the standards of the Public Company Accounting
          Oversight Board (United States), the consolidated balance sheets as of
          December
          31, 2007 and 2006 of On2 Technologies, Inc. and the related consolidated
          statements of operations, changes in stockholders’ equity and cash flows for
          each of the years in the three-year period ended December 31, 2007 and
          our
          report dated June 27, 2008 included an explanatory paragraph in connection
          with
          the Company’s change in accounting principle for its method of accounting for
          stock-based compensation.
   /s/
          Eisner LLP
 
 New
          York,
          NY
 June
          27,
          2008
 
 F-4


**ON2
      TECHNOLOGIES, INC.**


**CONSOLIDATED
      BALANCE SHEETS**





December
                  31,2007
              
              2006ASSETSCurrent
                  assets:Cash
                  and cash equivalents
              
              $
              9,573,000
              
              $
              4,961,000Investments,
                  at market
              
              
              5,521,000
              
              
              154,000Accounts
                  receivable, less allowance for doubtful accounts of $519,000 and
                  $56,000
                  as of December 31, 2007 and 2006, respectively
              
              
              7,513,000
              
              
              1,335,000Prepaid
                  expenses and other current assets
              
              
              1,492,000
              
              
              231,000Total
                  current assets
              
              
              24,099,000
              
              
              6,681,000Acquired
                  software, net
              
              
              10,333,000
              
              
              467,000Other
                  acquired intangibles, net
              
              
              7,144,000
              
              
              108,000Goodwill
              
              
              37,023,000
              
              
              244,000Property
                  and equipment, net
              
              
              751,000
              
              
              157,000Other
                  assets
              
              
              175,000
              
              
              230,000Total
                  assets
              
              $
              79,525,000
              
              $
              7,887,000LIABILITIES
                  AND STOCKHOLDERS’ EQUITYCurrent
                  liabilities:Accounts
                  payable
              
              $
              1,433,000
              
              $
              194,000Accrued
                  expenses
              
              
              4,820,000
              
              
              454,000Deferred
                  revenue
              
              
              1,887,000
              
              
              708,000Current
                  portion of long-term debt
              
              
              491,000
              
              
              -Short-term
                  borrowings
              
              
              2,198,000
              
              
              33,000Capital
                  lease obligation
              
              
              24,000
              
              
              24,000Total
                  current liabilities
              
              
              10,853,000
              
              
              1,413,000Capital
                  lease obligation, excluding current portion
              
              
              18,000
              
              
              29,000Long-term
                  debt
              
              
              3,082,000
              
              
              -Warrant
                  derivative liability
              
              
              -
              
              
              2,329,000Total
                  liabilities
              
              
              13,953,000
              
              
              3,771,000Series
                  D redeemable convertible preferred stock, $0.01 par value; 3,083
                  and 3,790
                  shares issued and outstanding, (liquidation value of $3,083,000
                  at
                  December 31, 2006)
              
              
              -
              
              
              3,083,000Commitments
                  and contingencies (Note 10)Stockholders’
                  equity:Preferred
                  stock, $0.01 par value; 20,000,000 shares authorized; 1,849,000
                  convertible shares issued and outstanding at December 31, 2006
                  (aggregate of liquidation value of $5,110,000 as of December 31,
                  2006)
              
              
              -
              
              
              19,000Common
                  stock, $0.01 par value; 250,000,000 shares authorized; 170,475,000
                  shares
                  issed and issuable; 157,975,000 shares outstanding at December
                  31, 2007
                  and 101,258,000 shares issued and outstanding at December 31,
                  2006
              
              
              1,705,000
              
              
              1,012,000Additional
                  paid-in capital
              
              
              194,453,000
              
              
              124,554,000Accumulated
                  other comprehensive income (loss)
              
              
              906,000
              
              
              (46,000
              )Accumulated
                  deficit
              
              
              (131,492,000
              )
              
              (124,506,000
              )Total
                  stockholders’ equity
              
              
              65,572,000
              
              
              1,033,000Total
                  liabilities and stockholders’ equity
              
              $
              79,525,000
              
              $
              7,887,000





*See
      accompanying notes to consolidated financial statements*


F-5


**ON2
      TECHNOLOGIES, INC.**


**CONSOLIDATED
      STATEMENTS OF OPERATIONS**





Year Ended December 31,2007
            
            2006
            
            2005Revenue
            
            $
            13,237,000
            
            $
            6,572,000
            
            $
            2,208,000Operating
                expenses:Cost
                of revenue (1)
            
            
            2,549,000
            
            
            2,328,000
            
            
            1,919,000Research
                and development (2)
            
            
            3,833,000
            
            
            972,000
            
            
            1,035,000Sales
                and marketing (2)
            
            
            4,272,000
            
            
            1,093,000
            
            
            794,000General
                and administrative (2)
            
            
            5,200,000
            
            
            4,384,000
            
            
            2,749,000Equity-based
                compensation:Research
                and development
            
            
            147,000
            
            
            98,000
            
            
            -Sales
                and marketing
            
            
            157,000
            
            
            103,000
            
            
            -General
                and administrative
            
            
            491,000
            
            
            1,184,000
            
            
            -Total
                operating expenses
            
            
            16,649,000
            
            
            10,162,000
            
            
            6,497,000Loss
                from operations
            
            
            (3,412,000
            )
            
            (3,590,000
            )
            
            (4,289,000
            )Interest
                and other income (expense), net
            
            
            (3,467,000
            )
            
            (1,226,000
            )
            
            (284,000
            )Loss
                before income taxes
            
            
            (6,879,000
            )
            
            (4,816,000
            )
            
            (4,573,000
            )Income
                tax expense
            
            
            25,000
            
            
            30,000
            
            
            32,000Net
                loss
            
            
            (6,904,000
            )
            
            (4,846,000
            )
            
            (4,605,000
            )Convertible
                preferred stock deemed dividend
            
            
            -
            
            
            68,000
            
            
            2,844,000Convertible
                preferred stock 8% dividend
            
            
            82,000
            
            
            285,000
            
            
            325,000Accretion
                of costs associated with the Series D Preferred Stock
            
            
            -
            
            
            -
            
            
            175,000Net
                loss attributable to common stockholders
            
            $
            (6,986,000
            )
            $
            (5,199,000
            )
            $
            (7,949,000
            )Basic
                  and diluted net loss attributable to common stockholdersper common
                  share
            
            $
            (0.06
            )
            $
            (0.05
            )
            $
            (0.09
            )Weighted
                average basic and diluted common shares outstanding
            
            
            121,561,000
            
            
            96,642,000
            
            
            89,183,000





(1)  Includes
      equity-based compensation of $151,000 and $169,000 for the years ended December
      31, 2007 and 2006.


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





*See
      accompanying notes to consolidated financial statements*


F-6


**ON2
      TECHNOLOGIES, INC.**


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





AccumulatedConvertible
            
            
            
            Additional
            
            
            
            Other
            
            
            
            TotalPreferred Stock
            
            Common Stock
            
            Paid-in
            
            Treasury Stock
            
            Comprehensive
            
            Accumulated
            
            Stockholders’Shares
            
            Amount
            
            Shares
            
            Amount
            
            Capital
            
            Shares
            
            Amount
            
            Income (Loss)
            
            Deficit
            
            EquityBalance
                at January 1, 2005
            
            
            3,299,000
            
            $
            33,000
            
            
            80,328,000
            
            $
            803,000
            
            $
            114,860,000
            
            
            -
            
            $
            -
            
            $
            (42,000
            )
            $
            (111,358,000
            )
            $
            4,296,000Net
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (4,605,000
            )
            
            (4,605,000
            )Foreign
                currency translation adjustment
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (1,000
            )
            
            -
            
            
            (1,000
            )Comprehensive
                loss
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (4,606,000
            )Issuance
                of common stock in connection with the exercise of stock
                options
            
            
            -
            
            
            -
            
            
            116,000
            
            
            1,000
            
            
            41,000
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            42,000Issuance
                of common stock in connection with the exercise of
                warrants
            
            
            -
            
            
            -
            
            
            8,052,000
            
            
            81,000
            
            
            4,242,000
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            4,323,000Issuance
                of common stock in connection with the conversion of Series A secured
                convertible debentures
            
            
            -
            
            
            -
            
            
            893,000
            
            
            9,000
            
            
            91,000
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            100,000Issuance
                of common stock in connection with the conversion of Series C-V
                convertible preferred stock
            
            
            (1,450,000
            )
            
            (14,000
            )
            
            2,040,000
            
            
            21,000
            
            
            (7,000
            )
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Issuance
                of common stock in connection with the conversion of Series D convertible
                preferred stock
            
            
            -
            
            
            -
            
            
            300,000
            
            
            3,000
            
            
            207,000
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            210,000Issuance
                of common stock in connection with the payment of interest on the
                Series A
                secured convertible debentures
            
            
            -
            
            
            -
            
            
            28,000
            
            
            -
            
            
            18,000
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            18,000Issuance
                of common stock in connection with the payment of dividends and dividends
                accrued on the Series D convertible preferred stock
            
            
            -
            
            
            -
            
            
            538,000
            
            
            5,000
            
            
            320,000
            
            
            -
            
            
            -
            
            
            -
            
            
            (325,000
            )
            
            -


F-7


**ON2
      TECHNOLOGIES, INC.**


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





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


F-8


**ON2
      TECHNOLOGIES, INC.**


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





AccumulatedConvertible
            
            
            
            Additional
            
            
            
            Other
            
            
            
            TotalPreferred Stock
            
            Common Stock
            
            Paid-in
            
            Treasury Stock
            
            Comprehensive
            
            Accumulated
            
            Stockholders’Shares
            
            Amount
            
            Shares
            
            Amount
            
            Capital
            
            Shares
            
            Amount
            
            Income (Loss)
            
            Deficit
            
            EquityIssuance
                of common stock in connection with the payment of dividends and dividends
                accrued on the Series D convertible preferred stock
            
            
            -
            
            
            -
            
            
            387,000
            
            
            4,000
            
            
            287,000
            
            
            -
            
            
            -
            
            
            -
            
            
            (285,000
            )
            
            6,000Issuance
                of common stock in connection with sale of common stock and
                warrants
            
            
            -
            
            
            -
            
            
            3,070,000
            
            
            31,000
            
            
            398,000
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            429,000Deemed
                dividend on Series D convertible preferred stock
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            68,000
            
            
            -
            
            
            -
            
            
            -
            
            
            (68,000
            )
            
            -Expiration
                of January 2006 warrant extension
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            135,000
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            135,000December
                2006 warrant extension
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            106,000
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            106,000Compensation
                expense associated with the issuance and extension of stock options
                and
                restricted stock grants
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            1,538,000
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            1,538,000Balance
                at December 31, 2006
            
            
            1,849,000
            
            $
            19,000
            
            
            101,258,000
            
            $
            1,012,000
            
            $
            124,554,000
            
            
            -
            
            
            -
            
            $
            (46,000
            )
            $
            (124,506,000
            )
            $
            1,033,000Net
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (6,904,000
            )
            
            (6,904,000
            )Foreign
                currency translation adjustment
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            952,000
            
            
            -
            
            
            952,000Comprehensive
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (5,952,000
            )Proceeds
                from sale of common stock, net of offering costs of
                $1,048,000
            
            
            -
            
            
            -
            
            
            14,950,000
            
            
            150,000
            
            
            13,753,000
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            13,903,000Exercise
                of stock options
            
            
            -
            
            
            -
            
            
            2,139,000
            
            
            21,000
            
            
            1,407,000
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            1,428,000Cashless
                exercise of stock options
            
            
            -
            
            
            -
            
            
            1,840,000
            
            
            18,000
            
            
            1,223,000
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            1,241,000Cashless
                exercise of warrants
            
            
            -
            
            
            -
            
            
            27,000
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Exercise
                of warrants
            
            
            -
            
            
            -
            
            
            5,460,000
            
            
            55,000
            
            
            5,418,000
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            5,473,000Warrant
                amendments
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            90,000
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            90,000Deferred
                financing costs charged on exercise of extended
                warrant
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (106,000
            )
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (106,000
            )Issuance
                of restircted stock to employees and directors as
                compensation
            
            
            -
            
            
            -
            
            
            657,000
            
            
            7,000
            
            
            (7,000
            )
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Issuance
                of common stock in connection with the conversion of Series C-IV
                convertible preferred stock
            
            
            (1,849,000
            )
            
            (19,000
            )
            
            3,072,000
            
            
            31,000
            
            
            (12,000
            )
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -


F-9


**ON2
      TECHNOLOGIES, INC.**


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





AccumulatedConvertible
            
            
            
            Additional
            
            
            
            
            
            Other
            
            
            
            TotalPreferred Stock
            
            Common Stock
            
            Paid-in
            
            Treasury Stock
            
            Comprehensive
            
            Accumulated
            
            Stockholders’Shares
            
            Amount
            
            Shares
            
            Amount
            
            Capital
            
            Shares
            
            Amount
            
            Income (Loss)
            
            Deficit
            
            EquityIssuance
                of common stock in connection with the conversion of Series D convertible
                preferred stock
            
            
            -
            
            
            -
            
            
            3,891,000
            
            
            39,000
            
            
            3,044,000
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            3,083,000Issuance
                of common stock in connection with the payment of dividends and dividends
                accrued on the Series D convertible preferred stock
            
            
            -
            
            
            -
            
            
            78,000
            
            
            1,000
            
            
            101,000
            
            
            -
            
            
            -
            
            
            -
            
            
            (82,000
            )
            
            20,000Write
                off of the warrant
              derivative
                liability
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            5,911,000
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            5,911,000Issuance
                and shares issuable of common stock for the acquisition of the outstanding
                stock of Hantro Products Oy
            
            
            -
            
            
            -
            
            
            37,939,000
            
            
            379,000
            
            
            39,836,000
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            40,215,000Compensation
                expense associated with the issuance of stock options and restricted
                stock
                grants
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            946,000
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            946,000Purchase
                of treasury stock
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (836,000
            )
            
            (1,713,000
            )
            
            -
            
            
            -
            
            
            (1,713,000
            )Retirement
                of treasury stock
            
            
            -
            
            
            -
            
            
            (836,000
            )
            
            (8,000
            )
            
            (1,705,000
            )
            
            836,000
            
            
            1,713,000
            
            
            -
            
            
            -
            
            
            -Balance
                as of December 31, 2007
            
            
            -
            
            
            -
            
            
            170,475,000
            
            $
            1,705,000
            
            $
            194,453,000
            
            
            -
            
            $
            -
            
            $
            906,000
            
            $
            (131,492,000
            )
            $
            65,572,000





See
      accompanying notes to consolidated financial statements


F-10


**ON2
      TECHNOLOGIES, INC.**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**




Year Ended December 31,2007
            
            2006
            
            2005Cash
                flows from operating activities:Net
                loss
            
            $
            (6,904,000
            )
            $
            (4,846,000
            )
            $
            (4,605,000
            )Adjustments
                to reconcile net loss to net cash provided by (used in) operating
                activities:Equity-based
                compensation
            
            
            946,000
            
            
            1,554,000
            
            
            -Other
                expense recognized for amendments and extension of
                warrants
            
            
            90,000
            
            
            135,000
            
            
            -Common
                stock issued for debenture interest
            
            
            -
            
            
            5,000
            
            
            18,000Common
                stock issued to Wildform for Support and Services
                Agreement
            
            
            -
            
            
            126,000
            
            
            -Insurance
                expense financed with term loan
            
            
            82,000
            
            
            52,000
            
            
            -Depreciation
                and amortization
            
            
            867,000
            
            
            336,000
            
            
            236,000Change
                in fair value of warrant liability
            
            
            3,582,000
            
            
            1,078,000
            
            
            -Unrealized
                loss on marketable securities
            
            
            -
            
            
            46,000
            
            
            339,000Realized
                loss on marketable securities
            
            
            27,000
            
            
            -
            
            
            -Amortization
                of debt discount
            
            
            -
            
            
            6,000
            
            
            14,000Changes
                in operating assets and liabilities, net of acquisitions:Accounts
                receivable, net
            
            
            88,000
            
            
            (589,000
            )
            
            (497,000
            )Prepaid
                expenses and other current assets
            
            
            (34,000
            )
            
            (1,000
            )
            
            (30,000
            )Other
                assets
            
            
            9,000
            
            
            (95,000
            )
            
            51,000Accounts
                payable and accrued expenses
            
            
            1,949,000
            
            
            136,000
            
            
            79,000Deferred
                revenue
            
            
            (345,000
            )
            
            467,000
            
            
            88,000Net
                cash provided by (used in) operating activities
            
            
            357,000
            
            
            (1,590,000
            )
            
            (4,307,000
            )Cash
                flows from investing activities:Purchases
                of marketable securities
            
            
            (5,617,000
            )
            
            (94,000
            )
            
            (75,000
            )Sale
                of marketable securities
            
            
            223,000
            
            
            75,000
            
            
            -Purchases
                of the Flix software line
            
            
            -
            
            
            -
            
            
            (1,229,000
            )Acquisition
                of Hantro Products Oy
            
            
            (9,160,000
            )
            
            -
            
            
            -Purchases
                of property and equipment
            
            
            (460,000
            )
            
            (57,000
            )
            
            (116,000
            )Net
                cash used in investing activities
            
            
            (15,014,000
            )
            
            (76,000
            )
            
            (1,420,000
            )Cash
                flows from financing activities:Principal
                payments on capital lease obligations
            
            
            (25,000
            )
            
            (31,000
            )
            
            (17,000
            )Proceeds
                attributed to warrant derivative liability
            
            
            -
            
            
            1,251,000
            
            
            -Principal
                payments on debt
            
            
            (1,035,000
            )
            
            (63,000
            )
            
            (62,000
            )Net
                proceeds from the issuance of common stock
            
            
            13,903,000
            
            
            429,000
            
            
            -Taxes
                paid on cashless exercise of stock options
            
            
            (472,000
            )
            
            -
            
            
            -Proceeds
                from exercise of common stock options and warrants, net
            
            
            6,901,000
            
            
            1,068,000
            
            
            4,365,000Net
                cash provided by financing activities
            
            
            19,272,000
            
            
            2,654,000
            
            
            4,286,000Net
                change in cash and cash equivalents
            
            
            4,615,000
            
            
            988,000
            
            
            (1,441,000
            )Effect
                of exchange rate changes on cash and cash equivalents
            
            
            (3,000
            )
            
            (3,000
            )
            
            (1,000
            )Cash
                and cash equivalents, beginning of year
            
            
            4,961,000
            
            
            3,976,000
            
            
            5,418,000Cash
                and cash equivalents, end of year
            
            $
            9,573,000
            
            $
            4,961,000
            
            $
            3,976,000


F-11


**ON2
      TECHNOLOGIES, INC.**


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





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





Year Ended December 31,2007
              
              2006
              
              2005Cash
                  paid during the year for:Interest
              
              $
              107,000
              
              $
              8,000
              
              $
              7,000Taxes
              
              $
              26,000
              
              $
              19,000
              
              $
              25,000Non-cash
                  transactions:Acquisition
                  of fixed assets under capital leases
              
              $
              15,000
              
              $
              58,000Prepaid
                  insurance financed with term loan
              
              $
              82,000
              
              $
              44,000Conversion
                  of Series A, C-V and C-IV convertible preferred stock into common
                  stock
              
              $
              19,000
              
              
              
              
              $
              14,000Conversion
                  and redemption of Series D redeemable convertible preferred stock
                  into
                  common stock
              
              $
              3,
                  083,000
              
              $
              707,000
              
              $
              210,000Conversion
                  of debentures into common stock
              
              
              
              
              $
              250,000
              
              $
              100,000Common
                  stock issued for dividends and dividends accrued on Series D convertible
                  preferred stock
              
              $
              102,000
              
              $
              290,000
              
              $
              325,000Accrued
                  dividend on Series D convertible preferred stock
              
              $
              20,000
              
              $
              5,000Deferred
                  financing costs recorded for extension of warrants
              
              
              
              
              $
              106,000Stock
                  issued to Wildform associated with the Support and Services Agreement
                  for
                  prior year services
              
              
              
              
              $
              132,000Cashless
                  exercise of stock options
              
              $
              959,000Issuance
                  of restricted stock
              
              $
              7,000Retirement
                  of treasury stock
              
              $
              1,431,000Write
                  off of warrant derivative liability
              
              $
              5,911,000Acquisition
                  of Hantro
              
              $
              40,215,000Accretion
                  of costs associated with the issuance of Series D convertible preferred
                  stock
              
              
              
              
              
              
              
              $
              175,000Convertible
                  preferred stock deemed dividend
              
              
              
              
              $
              68,000
              
              $
              2,844,000





*See
      accompanying notes to consolidated financial statements*


F-12


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





(1)
      ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





*(a)
      Description of the Business*





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





Hantro
      Products Oy:





On2
      believes that the acquisition of Hantro Products Oy presents a unique
      opportunity to create a combined entity that will allow On2 to apply its
      proprietary TrueMotion® video technology across all platforms, from PCs to
      mobile devices to consumer devices, by implementing its technology in
      highly-efficient, low-cost video chipsets, and the share exchange should allow
      the combined company to deliver significant benefits to its customers and
      stockholders. The On2 board of directors and management team analyzed various
      alternative strategies and believes the acquisition will create a combined
      company that will be able to achieve strategic and financial
      benefits.





On
      November 1, 2007, the Company completed the acquisition of all of the share
      capital of Hantro Products Oy (“Hantro”), a Finnish corporation. Under the
      exchange agreement Hantro’s security holders each exchanged all of the
      outstanding capital shares, and all outstanding options to purchase capital
      shares, that together constituted all of the equity ownership of Hantro.





Accordingly,
      the Company acquired all of the issued and outstanding shares of capital stock
      of Hantro and in exchange, On2 paid at closing total consideration of $6,842,000
      in cash and 25,439,000 shares of On2’s common stock. Because the closing share
      price was less than $1.50, On2 issued the set number of 25,439,000 shares,
      as
      specified in the share exchange agreement. The 25,439,000 shares so issued
      represent approximately 22% of On2’s outstanding common stock as of November 1,
      2007.





The
        number of shares issued at closing is subject to an adjustment based on the
        difference between Hantro’s actual closing net deficit and a baseline of
        (€3,450,000). The actual closing net deficit was (€3,608,000) which was €158,000
        over the baseline, and the Hantro security holders will pay the net worth
        deficiency by cash or by returning On2’s common stock to On2 in such number
        equal to the net deficit deficiency divided by the deemed closing share
        price of $1.50. In February 2008, cash of $233,000 was received from the
        Hantro
        security holders to settle this deficiency.





Of
      the
      shares delivered to the Hantro security holders at the closing under the share
      exchange agreement, 2,000,000 shares were delivered into escrow for a period
      of
      one year from the closing date to secure the indemnification obligations of
      the
      Hantro security holders. These shares may be canceled if On2 makes a claim
      for
      indemnification in accordance with the applicable terms of the share exchange
      agreement and the claim is resolved in On2’s favor and monetary settlement is
      not made. At the end of the one-year period, the shares will be released from
      escrow and delivered to the Hantro security holders except for such portion
      having a value equal to the aggregate dollar amount of all the outstanding
      claims for indemnification unresolved at such time. Any dividends paid on the
      escrowed shares during the pendency of the escrow will be added to the property
      that the escrow agent holds and will be available for distribution under the
      escrow agreement.


F-13


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





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





*(a)
      Description of the Business (continued)*





In
      addition, under the share exchange agreement, On2 was obligated to issue
      additional shares of its common stock to the Hantro security holders if Hantro’s
      net revenue for the fiscal year 2007 exceeded €6,000,000. The


maximum
      additional shares which may be issued will be 12,500,000 shares if Hantro’s net
      revenue for 2007 exceeded €9,000,000. Hantro’s net revenue for the fiscal year
      2007 was calculated based on the net revenue of Hantro and its subsidiary as
      if
      Hantro had continued post-closing on a stand-alone basis independent of On2.
      Hantro’s actual net revenue for fiscal 2007 was €9,672,000 and therefore On2
      will issue (these shares have been reflected as issuable in the financial
      statements) 12,500,000 shares of its common stock to the Hantro security
      holders.





*Pro
      Forma Financial Information*





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





Twelve Months Ended December 31,2007
            
            2006Total
                revenues
            
            $
            23,189,000
            
            $
            15,546,000Net
                loss
            
            
            (9,264,000
            )
            
            (12,898,000
            )Net
                loss per share – basic and diluted
            
            
            (.06
            )
            
            (.09
            )





The
      Hantro acquisition costs are as follows:





Number of
              shares issued
              and issuable
            
            Fair valueCash,
                net of a $233,000 receivable
            
            
            
            
            $
            6,609,000Shares
                issued directly to Hantro security holders
            
            
            23,439,000
            
            
            24,845,000Shares
                issued into escrow
            
            
            2,000,000
            
            
            2,120,000Shares
                to be issued for the earn out
            
            
            12,500,000
            
            
            13,250,000Acquisition
                costs
            
            
            -
            
            
            2,677,00037,939,000
            
            $
            49,501,000





All
      the
      shares were valued at $1.06 which was the close price of the Company’s common
      stock on November 1, 2007, the closing date. There was $3,853,000 of net
      tangible liabilities assumed in the acquisition.


F-14


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





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





*(a)*
            *Description
                of business (continued)*





Based
      upon the purchase price of the acquisition, the preliminary purchase price
      allocation is as follows:




Current
                assets and other tangible assets:Cash
            
            $
            126,000Accounts
                receivable
            
            
            6,148,000Other
                current assets
            
            
            1,143,000Property
                and equipment
            
            
            273,000Goodwill
            
            
            36,075,000Amortizable
                intangible assets:Purchased
                technology
            
            
            10,214,000Customer
                relationships
            
            
            4,074,000Trademarks
            
            
            2,991,000Other
                assets
            
            
            58,000Deferred
                tax asset, net of valuation allowance of $3,401,000
            
            
            4,492,000Total
                assets acquired
            
            
            65,594,000Liabilities
                assumed:Short-term
                borrowings
            
            
            2,800,000Deferred
                revenues
            
            
            1,495,000Current
                liabilities
            
            
            3,802,000Deferred
                tax liabilities
            
            
            4,492,000Other
                long-term liabilities
            
            
            3,504,000Net
                assets acquired
            
            $
            49,501,000





The
      Company is required to allocate the preliminary purchase price of an acquired
      company to the tangible and intangible assets acquired, and liabilities assumed.
      The Company uses various models to determine the fair values of the assets
      acquired and liabilities assumed. These models include the discounted cash
      flow
      (DCF), the royalty savings method and the cost savings approach. The valuation
      requires management to make significant estimates and assumptions, especially
      with respect to long-lived and intangible assets.





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





Wildform
      Flix:





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


F-15


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





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





*(b)*
            *Basis
                of Presentation*





The
      consolidated financial statements include the accounts of the Company and its
      wholly owned subsidiaries.


All
      intercompany balances and transactions have been eliminated in consolidation.
      The operations of Hantro have been included from the date of acquisition.





The
        Company’s consolidated financial statements have been prepared assuming that it
        will continue as a going concern. The Company has incurred recurring operating
        losses and negative operating cash flows since its inception. At
        December 31, 2007 the Company had cash and cash equivalents and short-term
        investments of $15,094,000 and working capital of $13,246,000. The
        Company believes that existing funds are sufficient to fund its operations
        through 2008. The Company plans to increase cash flows from operations
        principally from increases in revenue generated from its compression technology
        services, products and licenses.The Company may also pursue additional
        financings. However, there are no assurances that such increases in revenues
        will be attained or that additional financings will be successfully
        consummated.





*(c)
      Cash and Cash Equivalents*





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





*(d)
      Revenue Recognition*





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





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





The
      Company assesses collectability based on a number of factors, including past
      transaction history with the customer and the credit-worthiness of the customer.
      If the Company determines the collection of a fee is not reasonably assured,
      the
      Company will recognize revenue at the time collection becomes reasonably
      assured, which is generally upon receipt of payment. If the Company determines
      that a fee is not fixed or determinable, the Company will recognize revenue
      as
      the fee becomes due.


F-16


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





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





*(d)
      Revenue Recognition (continued)*





Software
      Licenses





The
      Company’s software licensing arrangements typically consist of two elements: a
      software license and post-contract customer support (“PCS”). The Company
      recognizes software license revenue based on the residual method after all
      elements other than PCS have been delivered as prescribed by SOP 98-9. The
      Company recognizes PCS revenues over the term of the maintenance contract or
      on
      a “per usage” basis, whichever is stated in the contract. In accordance with
      SOP 97-2, vendor specific objective evidence of the fair value of PCS is
      determined by reference to the price the customer will have to pay for PCS
      when
      it is sold separately (i.e., the renewal rate). Each license agreement offers
      additional PCS at a stated price. Revenue is recognized on a per copy basis
      for
      licensed software when each copy of the licensed software purchased by the
      customer or reseller is delivered. The Company does not allow returns, exchanges
      or price protection for sales to its customers or its resellers nor does it
      allow its resellers to purchase software licenses under consignment
      arrangements.





Professional
      Services





Professional
      services consist of customized engineering and consulting services.





When
      customized engineering and consulting services are sold together with a software
      license, the arrangement typically requires customization and integration of
      the
      software into a third party hardware platform. In these arrangements, the
      Company requires the customer to pay a fixed fee for the engineering and
      consulting services and a licensing fee in the form of a per-unit royalty.
      The
      Company accounts for its engineering and consulting
      arrangements in accordance with SOP 81-1, *“Accounting
      for Performance of Construction Type and Certain Production Type
      Contracts”* .
      When
      reasonably dependable estimates are available for the costs and efforts
      necessary to complete the engineering or consulting services and those services
      do not include contractual milestones or other acceptance criteria, the Company
      accounts for the arrangements under the percentage of completion contract method
      pursuant to SOP 81-1 based upon input measures such as hours. When such
      estimates are not available, the completed contract method is utilized.





*(e)
      Accounts Receivable Allowance*





The
      Company maintains an allowance for doubtful accounts for estimated losses
      resulting from the inability of our customers to make payments when due or
      within a reasonable period of time thereafter. If the financial condition of
      our
      customers were to deteriorate, resulting in the inability to make required
      payments, additional allowances may be required. The allowance for doubtful
      accounts was $519,000 and $56,000 as of December 31, 2007 and 2006,
      respectively. Of the $519,000 as of December 31, 2007, $383,000 is a result
      of
      deteriorating financial condition of one customer, $36,000 is the result of
      a
      dispute with the customer as to whether the amount is actually due and $100,000
      is an estimated amount for additional potential write-offs based on past history
      from the remaining accounts that may become uncollectable.


F-17


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





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





*(f)
      Property and Equipment*





Property
      and equipment is stated at cost, net of accumulated depreciation and
      amortization. Property and equipment is depreciated using the straight-line
      method over the estimated useful lives of the related assets, generally three
      to
      five years for equipment and software and five to seven years for furniture
      and
      fixtures.





Leasehold
      improvements are amortized using the straight-line method over the shorter
      of
      the lease term or the estimated useful life of the asset. Equipment under
      capital leases is stated at the present value of the minimum lease payments
      and
      is depreciated using the straight-line method over the estimated useful life
      of
      the asset.





*(g)
      Impairment of Long-Lived Assets and Finite-Lived Intangible
      Assets*





Long-lived
      assets and identifiable intangibles with finite lives are reviewed for
      impairment whenever events or changes in circumstances indicate that the
      carrying amount of an asset may not be recoverable. Recoverability of assets
      to
      be held and used is measured by a comparison of the carrying amount of an asset
      to future undiscounted net cash flows expected to be generated by the asset.
      If
      such assets are considered to be impaired, the impairment recognized is measured
      by the amount by which the carrying amount of the assets exceeds the fair value
      of the assets. Assets to be disposed of are reported at the lower of the
      carrying amount or fair value less costs to sell.





*(h)
      Fair Value of Financial Instruments and Concentration of Credit
      Risk*





The
      fair
      values of accounts receivable and accounts payable approximate their carrying
      values based on the short-term nature of these financial instruments. The fair
      value of the Series D redeemable convertible preferred stock was approximately
      $0 at December 31, 2007 and $5,315,000 at December 31, 2006. The fair value
      is
      based on the quoted value of the underlying common stock of the Company.





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





*(i)
      Income Taxes*





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





On
      January 1, 2007, the Company adopted the provisions of Financial Accounting
      Standards Board (“FASB”) Interpretation No. 48, *“Accounting
      for Uncertainty in Income Taxes”* (“FIN
      48”), an interpretation of FASB Statement No. 109, *“Accounting
      for Income Taxes.”* FIN 48
      prescribes a recognition threshold and measurement


attribute
      for the financial statement recognition and measurement of a tax position taken
      or expected to be taken in a tax return. The interpretation requires that the
      Company recognize the impact of a tax position in its financial statements
      if
      that position is more likely than not of being sustained on audit, based on
      the
      technical merits of the position. FIN 48 also provides guidance on
      derecognition, classification, interest and penalties, accounting in interim
      periods and disclosure. In accordance with the provisions of FIN 48, any
      cumulative effect resulting from the change in accounting principle is to be
      recorded as an adjustment to the opening balance of accumulated deficit. The
      adoption of FIN 48 had no material effects on the Company’s financial
      statements.


F-18


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





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





*(i)
      Income Taxes (continued)*





The
      Company performed an analysis of the limitations on the use of its net operating
      losses under Section 382 of the Internal Revenue Code and determined that on
      June 7, 2000, the Company experienced an ownership change to which Internal
      Revenue Code Section 382 applied. Of the current $95,688,000 in the Company’s
      United States net operating loss carryforward, $33,800,000 was incurred prior
      to
      the June 7, 2000 change date. The annual net operating loss usage under the
      Internal Revenue Code Section 382 is limited to $14,000,000. Based on this
      limitation, the Company believes the entire pre-change net operating loss was
      available for use by 2004.





We
      intend
      to classify any future expense for income-tax related interest and penalties
      as
      a component of income tax expense. As of December 31, 2007, no interest or
      penalties have been accrued or incurred. The Company files U.S. federal income
      tax returns, as well as filing various returns in states and applicable
      localities where it holds properties. The Company’s filed income tax returns are
      no longer subject to examination by taxing authorities for years before 2003.
      The Company also has filings in the United Kingdom and Finland for its foreign
      locations.





*(j)
      Cost of Revenue*





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





*(k)
      Software Development Costs*





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





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


F-19


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





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





*(l)
      Equity-Based Compensation*





The
      Company adopted the provision of Statement of Financial Accounting Standards
      (SFAS) No. 123R effective January 1, 2006, using the modified prospective
      transition method. Under the modified prospective transition method, non-cash
      compensation expense is recognized under the fair value method for the portion
      of outstanding equity-based awards granted prior to the adoption of SFAS 123R
      for which service has not been rendered, and for any equity-based awards granted
      or modified after adoption. Accordingly, periods prior to adoption have not
      been
      restated. Prior to the adoption of SFAS 123R, the Company accounted for
      equity-based compensation using the intrinsic value method. The Company
      recognizes equity-based compensation cost associated with awards subject to
      graded vesting in accordance with the accelerated method specified in FASB
      Interpretation No. 28 pursuant to which each vesting tranche is treated as
      a
      separate award. The compensation cost associated with each vesting tranche
      is
      recognized as expense evenly over the vesting period of that
      tranche.





The
      following table illustrates the effect on net loss attributable to common
      stockholders and loss attributable to common stockholders per share if the
      fair
      value based method had been applied to the period prior to the adoption of
      SFAS
      123R:





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





Equity-based
      compensation expense recognized in the Statement of Operations was $946,000,
      $1,554,000 and $0 for the years ended December 31, 2007, 2006 and 2005,
      respectively. Equity-based compensation for the years ended December 31, 2007
      and 2006 reflects stock options and restricted stock granted to employees,
      directors and consultants and in 2006, includes $128,000 for the extension
      of
      stock options for the Company’s former president and chief executive officer.


F-20


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





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





*(l)
      Equity-Based Compensation (continued)*





The
      following table summarizes the activity of the Company’s stock options for the
      year ended December 31, 2007:




Shares
            
            Weighted
              Average
              Exercise
              Price
            
            Weighted
              Average
              Remaining
              Contractual
              Life
            
            Aggregate
              Intrinsic
              ValueNumber
                of shares under option:Outstanding
                at January 1, 2007
            
            
            9,497,000
            
            $
            1.07Granted
            
            
            2,567,000
            
            
            1.07Exercised
            
            
            (3,979,000
            )
            
            0.68Canceled
                or expired
            
            
            (129,000
            )
            
            12.94Outstanding
                at December 31, 2007
            
            
            7,956,000
            
            $
            1.03
            
            
            6.37
            
            $
            1,506,000Vested
                or expected to vest at December 31, 2007
            
            
            7,918,000
            
            $
            1.03
            
            
            6.33
            
            $
            1,489,000Exercisable
                at December 31, 2007
            
            
            4,848,000
            
            $
            1.03
            
            
            5.58
            
            $
            1,420,000




The
      aggregate intrinsic value of options exercised during the years ended December
      31, 2007 and 2006 was $6,491,000 and $942,000, respectively.





The
      following table summarizes the activity of the Company’s non-vested stock
      options for the year ended December 31, 2007:





Shares
            
            Weighted Average Grant
              Date Fair ValueNon-vested
                at January 1, 2007
            
            
            1,064,000
            
            $
            0.72Granted
            
            
            2,567,000
            
            
            0.54Cancelled
                or expired
            
            
            (3,000
            )
            
            0.59Vested
                during the period
            
            
            (520,000
            )
            
            0.67Non-vested
                at December 31, 2007
            
            
            3,108,000
            
            $
            0.58





As
      of
      December 31, 2007, there was $2,927,000 of total unrecognized compensation
      cost
      related to non-vested equity-based compensation arrangements granted under
      existing stock option plans. This cost is expected to be recognized over a
      weighted-average period of 2.18 years. The total grant date fair value of shares
      that vested during the year ended December 31, 2007 was
      $400,000.


F-21


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





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




*(l)
      Equity-Based Compensation (continued)*





The
      Company uses the Black-Scholes option-pricing model to determine the fair value
      of stock options. The weighted average grant date fair value of options granted
      during the years ended December 31, 2007, 2006 and 2005 at date of grant and
      the
      assumptions utilized to determine such values are indicated in the following
      table:





Year Ended December 31,2007
            
            2006
            
            2005Weighted
                average fair value at date of grant for options granted during the
                period
            
            $
            0.54
            
            $
            0.88
            
            $
            0.59Expected
                stock price volatility
            
            
            75
            %
            
            114
            %
            
            120
            %Expected
                life of options
            
            
            3
                years
            
            
            5
                years
            
            
            5
                yearsRisk
                free interest rates
            
            
            3.49
            %
            
            5.0
            %
            
            4.1
            %Expected
                dividend yield
            
            
            0
            %
            
            0
            %
            
            0
            %





The
      following table summarizes the activity of the Company’s non-vested restricted
      common stock for the year ended December 31, 2007:




Shares
            
            Weighted-
              average Grant
              Date Fair ValueNon-vested
                at January 1, 2007
            
            
            85,000
            
            $
            0.63Granted
            
            
            1,099,000
            
            
            2.10Cancelled
                or expired
            
            
            (46,000
            )
            
            3.54Vested
                during the period
            
            
            (85,000
            )
            
            0.63Non-vested
                at December 31, 2007
            
            
            1,053,000
            
            $
            2.04





During
      the year ended December 31, 2007, the Company granted shares of restricted
      common stock to its Board of Directors in which 139,000 shares vest on March
      12,
      2008 and 215,000 vest on November 6, 2008 and 745,000 shares of restricted
      common stock to its employees which vest over a three year period through
      November 2010. For the year ended December 31, 2007, the Company recognized
      $424,000 in compensation expense related to these grants and $1,569,000 of
      unrecognized compensation cost will be recognized through the November
      2010.





During
      the year ended December 31, 2007, the Company received proceeds of $1,428,000
      and issued 2,139,000 shares of its common stock for stock option exercises.
      In
      addition, during the year ended December 31, 2007, the Company issued 1,840,000
      shares of its common stock in cashless exercises of stock options and retained
      836,000 shares for payment of the options and related withholding
      taxes.





During
      the year ended December 31, 2007, the Company granted 2,567,000 stock options
      to
      employees that had an aggregate grant date fair value of
      $2,738,000.


F-22


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





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





*(m)Advertising
      costs*





The
      Company expenses advertising costs when incurred. Advertising expenses were
      $251,000, $135,000 and $115,000 for the years ended December 31, 2007, 2006
      and
      2005, respectively.





*(n)
      Net Loss Per Common Share*





The
      Company computes net loss per common share in accordance with SFAS No. 128, *“Earnings
      Per Share”* .
      In
      accordance with SFAS No. 128, basic earnings per share is computed using
      the weighted average number of common shares outstanding during the period.
      Potential common shares consist of the incremental common shares issuable upon
      the conversion of the preferred stock and convertible debentures (using the
      if-converted method) and shares issuable upon the exercise of stock options
      and
      warrants (using the Treasury Stock method). Diluted loss per share has not
      been
      presented separately since 10,610,000 potential common shares at
      December 31, 2007, 24,427,000 potential common shares at December 31,
      2006 and 26,891,000 potential common shares at December 31, 2005 are
      anti-dilutive for each of the periods presented. **





*(o)
      Use of Estimates*





The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States of America requires management to make
      estimates and assumptions that affect the reported amounts of assets and
      liabilities and the disclosure of contingent assets and liabilities at the
      date
      of the financial statements and the reported amounts of revenue and expenses
      during the reporting period. Actual results could differ from those estimates.
      Assumptions underlying the allowance for doubtful accounts, the estimated value
      of the warrant derivative liability and the recoverability of intangible assets
      represent sensitive estimates subject to change.





*(p)
      Segment Reporting and Customer Concentration*





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





The
      Company’s customers typically represent digital communication and media
      companies, entertainment companies, telecommunication companies and third party
      resellers. For the year ended December 31, 2007, there were no customers
      that accounted for 10% or more of the Company’s total revenue. For the year
      ended December 31, 2006, one customer accounted for 10% of the Company’s
      total revenue. For the year ended December 31, 2005, two customers
      accounted for 20% and 11% of the Company’s total revenue.





As
      of
      December 31, 2007, two customers accounted for 18% and 12% of total
      accounts receivable. As of December 31, 2006, four customers accounted for
      13%, 12%, 11% and 10% of total accounts receivable.


F-23


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





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





*(p)
      Segment Reporting and Customer Concentration (continued)*





The
      components of the Company’s revenue for the years ended December 31, 2007, 2006
      and 2005 are summarized as follows:


Year Ended December 31,2007
                  
                  2006
                  
                  2005License
                      software revenue
                  
                  $
                  10,299,000
                  
                  $
                  5,472,000
                  
                  $
                  1,947,000Engineering
                      services and support
                  
                  
                  928,000
                  
                  
                  496,000
                  
                  
                  155,000Royalties
                  
                  
                  1,935,000
                  
                  
                  604,000
                  
                  
                  106,000Other
                  
                  
                  75,000
                  
                  
                  -
                  
                  
                  -Total
                  
                  $
                  13,237,000
                  
                  $
                  6,572,000
                  
                  $
                  2,208,000
 For
        the
        years ended December 31, 2007, 2006 and 2005, foreign customers accounted
        for approximately 44%, 40% and 27%, respectively of the Company’s total revenue.
        These customers are primarily located in Europe and Middle East, and Asia.





Selected
      information by geographic location is a follows:




For the Year Ended December 31, 20072007
            
            2006
            
            2005Revenue
                from unaffiliated customers:United
                States Operations
            
            $
            9,102,000
            
            $
            6,572,000
            
            $
            2,208,000Finland
                Operations
            
            
            4,135,000
            
            
            -
            
            
            -Total
            
            $
            13,237,000
            
            $
            6,572,000
            
            $
            2,208,000Net
                Loss:United
                States Operations
            
            $
            (6,222,000
            )
            $
            (4,846,000
            )
            $
            (4,605,000
            )Finland
                Operations
            
            
            (682,000
            )
            
            -
            
            
            -Total
            
            $
            (6,904,000
            )
            $
            (4,846,000
            )
            $
            (4,573,000
            )





As of December 31, 20072007
            
            2006
            
            2005Identifiable
                assets:United
                States Operations
            
            $
            17,631,000
            
            $
            7,887,000
            
            $
            6,314,000Finland
                Operations
            
            $
            61,894,000
            
            
            -
            
            
            -Total
            
            $
            79,525,000
            
            $
            7,887,000
            
            $
            6,314,000




The
      Company also maintains an office in the United Kingdom. This office consists
      of
      two software engineers and does not generate any revenue.


F-24


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





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





*(q)
      Recently Issued Accounting Pronouncements*





In
      February 2007, the FASB issued SFAS No. 159, *“The
      Fair Value Option for Financial Assets and Financial
      Liabilities”* (“SFAS
      159”).  SFAS 159 permits entities to choose to measure many financial
      instruments and certain other items at fair value. 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 the Board’s long-term measurement
      objectives for accounting for financial instruments. This Statement is effective
      as of the beginning of an entity’s first fiscal year that begins after November
      15, 2007. Early adoption is permitted as of the beginning of a fiscal year
      that
      begins on or before November 15, 2007, provided the entity also elects to apply
      the provisions of FASB Statement No. 157, “ *Fair
      Value Measurements”.* The Company is currently evaluating the impact of adopting SFAS 159 on its
      financial position and results of operations.





In
      September 2007, the FASB issued SFAS No. 157 *“Fair
      Value Measurements”* (“SFAS
      157”).  SFAS 157 defines fair value, establishes a framework for measuring
      fair value in generally accepted accounting principles (GAAP), and expands
      disclosures about fair value measurements. This Statement applies under other
      accounting pronouncements that require or permit fair value measurements, the
      Board having previously concluded in those accounting pronouncements that fair
      value is the relevant measurement attribute. Accordingly, this Statement does
      not require any new fair value measurements. However, for some entities, the
      application of this Statement will change current practice.  This Statement
      is effective for financial statements issued for fiscal years beginning after
      November 15, 2007, and interim periods within those fiscal years. Earlier
      application is encouraged, provided that the reporting entity has not yet issued
      financial statements for that fiscal year, including financial statements for
      an
      interim period within that fiscal year. The Company is currently evaluating
      the
      impact of adopting SFAS 157 on its financial position and results of
      operations.





In
      December 2007, the FASB issued SFAS No. 141 (Revised 2007), *“Business
      Combinations”.* Statement 141R will significantly change the accounting for business
      combinations. Under Statement 141R, an acquiring entity will be required to
      recognize all the assets acquired and liabilities assumed in a transaction
      at
      the acquisition-date fair value with limited exceptions. Statement 141R will
      change the accounting treatment for certain specific items,
      including:




·
            Acquisition
                costs will be generally expensed as incurred;


·
            Non-controlling
                interests (formerly known as "minority interests" — see Statement 160
                discussion below) will be valued at fair value at the acquisition
                date;


·
            Acquired
                contingent liabilities will be recorded at fair value at the acquisition
                date and subsequently measured at either the higher of such amount
                or the
                amount determined under existing guidance for non-acquired  
                contingencies;


·
            In-process
                research and development will be recorded at fair value as an
                indefinite-lived intangible asset at the acquisition date;


·
            Restructuring
                costs associated with a business combination will be generally expensed
                subsequent to the acquisition date; and


·
            Changes
                in deferred tax asset valuation allowances and income tax uncertainties
                after the acquisition date generally will affect income tax
                expense.




The
      Company is currently evaluating the impact of adopting SFAS 141R on its
      financial position and results of operations.


F-25


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





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





*(q)
      Recently Issued Accounting Pronouncements (continued)*





In
        December 2007, the FASB issued SFAS No. 160, *“Non-controlling
        Interests in Consolidated Financial Statements - An Amendment of ARB No.
        51”.* Statement 160 establishes new accounting and reporting standards for the
        non-controlling interest in a subsidiary and for the deconsolidation of a
        subsidiary. Specifically, this Statement requires the recognition of a
        non-controlling interest (minority interest) as equity in the consolidated
        financial statements and separate from the parent's equity. The amount of
        net
        income attributable to the non-controlling interest will be included in
        consolidated net income on the face of the income statement. Statement 160
        clarifies that changes in a parent's ownership interest in a subsidiary that
        do
        not result in deconsolidation are equity transactions if the parent retains
        its
        controlling financial interest. In addition, this Statement requires that
        a
        parent recognize a gain or loss in net income when a subsidiary is
        deconsolidated. Such gain or loss will be measured using the fair value of
        the
        non-controlling equity investment on the deconsolidation date. Statement
        160
        also includes expanded disclosure requirements regarding the interests of
        the
        parent and its non-controlling interest. Statement 160 is effective for fiscal
        years, and interim periods within those fiscal years, beginning on or after
        December 15, 2008. Like Statement 141R discussed above, earlier adoption
        is
        prohibited. Although the Company
        will continue to evaluate the application of SFAS 160, management does not
        currently believe adoption will have a material impact on the Company’s results
        of operations or financial position.





*(r)
      Foreign Currency*





The
      functional currency of our foreign subsidiaries is their local currency. The
      balance sheet accounts of these subsidiaries are translated into U.S. dollars
      at
      the exchange rate as of the balance sheet date. Monthly revenues, costs and
      expenses are translated using the weighted-average rate for that month.
      Resulting exchange gains and losses are reported as a component of cumulative
      other comprehensive income within stockholders’ equity.





The
      Company’s Finland operations may conduct business in currencies other than their
      own functional currency, resulting in foreign exchange gains and losses. These
      foreign exchange gains and losses are included in interest and other income
      and
      (expense) on the Consolidated Statement of Operations. For the year ended
      December 31, 2007, the foreign exchange gains were $16,000.







(2)
      INVESTMENTS




As
      of
      December 31, 2007 the Company held short term bonds with maturities of less
      than
      90 days with a market value of $5,521,000.





As
      of
      December 31, 2006, the Company held 42,000 shares of a customer’s common stock
      with a market value of $60,000, which were received as payment of license fees.
      The Company classified these shares as trading securities and pursuant to SFAS
      No. 115, “ *Accounting
      for Certain Investments in Debt and Equity Securities* ”,
      unrealized gains and losses are included in the determination of net income
      (loss). Included in interest and other income (expense) are realized losses
      of
      $27,000 and unrealized losses of $46,000 for the year ended December 31, 2007
      and 2006, respectively. The Company’s former Chief Executive Officer (who was a
      director and shareholder of the Company) was a director of this
      customer.





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


F-26


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





(3)
      PROPERTY AND EQUIPMENT





Property
      and equipment are stated at cost, and consist of the following:


December
                  31,2007
              
              2006Furniture
                  and fixtures
              
              $
              130,000
              
              $
              92,000Machinery
                  and equipment
              
              
              691,000
              
              
              -Computer
                  equipment
              
              
              3,345,000
              
              
              2,538,000Leasehold
                  improvements
              
              
              28,000
              
              
              24,000Licensed
                  software
              
              
              687,000
              
              
              621,0004,881,000
              
              
              3,275,000Less:
                  accumulated depreciation and amortization
              
              
              4,130,000
              
              
              3,118,000Total
              
              $
              751,000
              
              $
              157,000





As
      of
      December 31, 2007, property and equipment included assets under capital
      leases of $230,000 with related accumulated depreciation of $186,000. As of
      December 31, 2006, property and equipment included assets under capital
      leases of $214,000 with related accumulated depreciation of $160,000.
      Depreciation expense was $158,000, $89,000 and $73,000 for the years ended
      December 31, 2007, 2006 and 2005, respectively.








(4)
      INTANGIBLE ASSETS AND GOODWILL





*(a)
      Acquisition of Hantro Products Oy*





The
      preliminary allocation to intangible assets recorded for the Hantro acquisition
      are as follows:





Purchased
                Technology
            
            $
            10,214,000Trademarks
            
            
            2,991,000Customer
                relationships
            
            
            4,074,000Goodwill
            
            
            36,075,000Total
                intangible assets acquired
            
            
            53,354,000





The
      asset
      recognized with respect to acquired purchased technology is being amortized
      over
      its estimated life of five years. The assets recognized with respect to
      trademarks and customer relationships are being amortized over their estimated
      lives of ten years. The weighted average amortization period is 7.04
      years. ** Amortization expense related to the Hantro intangible assets was $462,000 for
      the year ended December 31, 2007.


F-27


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





(4)
      INTANGIBLE ASSETS (continued)





*(b)
      Flix Acquisition*





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





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





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




The
      assets recognized with respect to acquired software, brand assets and the
      non-compete agreement are being amortized over their estimated lives of four
      years. Amortization expense related to these intangible assets was $246,000,
      $246,000 and $163,000 for the years ended December 31, 2007, 2006 and 2005,
      respectively. Accumulated amortization was $657,000, $410,000 and 164,000 at
      December 31, 2007, 2006 and 2005, respectively.





Based
      on
      the current amount of intangibles subject to amortization, the estimated future
      amortization expense related to our intangible assets at December 31, 2007
      is as
      follows:





FutureAmortization2008
            
            $
            3,049,0002009
            
            
            2,885,0002010
            
            
            2,803,0002011
            
            
            2,803,0002012
            
            
            2,456,000Thereafter
            
            
            3,481,000Total
            
            $
            17,477,000





The
      Company also entered into an eighteen-month agreement for support services
      from
      Wildform with respect to the Flix software.  Pursuant to such agreement,
      the Company paid $160,000 and issued 280,000 shares of common stock on April
      29,
      2006, which had a fair value of $258,000.  There are registration rights
      associated with the common stock, which contains liquidated damages if the
      Company fails to register such shares and maintain effectiveness of such
      registration.  The Company has determined that the fair value of the
      embedded derivative liability for the liquidated damages is nominal based on
      the
      expected probability of paying such damages.  The Company recognized
      expense over the eighteen-month term of the agreement, which ended in October
      2007, for the cash payment and common shares issued.


F-28


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





(5)
      ACCRUED EXPENSES





Accrued
      expenses consist of the following:





December
                31,2007
            
            2006Accrued
                compensation
            
            $
            3,369,000
            
            $
            112,000Accrued
                professional fees
            
            
            915,000
            
            
            231,000Other
                accrued expenses
            
            
            536,000
            
            
            111,000Total
            
            $
            4,820,000
            
            $
            454,000





(6)
      SHORT-TERM BORROWINGS




December
                31,2007
            
            2006Short-term
                borrowings
            
            $
            2,198,000
            
            $
            33,000





*(a)*  *Line
      of credit*




Hantro
      has available a line of credit with a Finnish bank for $736,000 (500,000€ at
      December 31, 2007). The line of credit expired in February 2008 and was paid
      in
      full. Borrowings under the line of credit bear interest at the Euro Interbank
      Offered Rate (EURIBOR) plus 1% (total of 5.288% at December 31, 2007). The
      bank
      also requires a commission payable at 1% of the loan principal. Borrowings
      are
      collateralized by substantially all assets of Hantro and a guarantee by On2.
      The
      borrowings is also 50% guaranteed by the Finnvera plc (Finnvera plc is a
      specialized financing company which offers financing services to promote the
      domestic operation of Finnish businesses and is owned by the Finnish government)
      , which requires a commission payable at 2.85% on 50% of the loan principal.
      The
      outstanding balance on the line of credit was $297,000 at December 31, 2007.





*(b)*   *Line
      of credit*




Hantro
        has available a line of credit with a Finnish bank for $663,000 (450,000€ at
        December 31, 2007). The line of credit has no expiration date. Borrowings
        under
        the line of credit bear interest at EURIBOR plus 1.25% (total of 5.538% at
        December 31, 2007). The bank also requires a commission payable at .45% of
        the
        loan principal. Borrowings are collateralized by substantially all assets
        of
        Hantro and a guarantee by On2. The outstanding balance on the line of credit
        was
        $352,000 at December 31, 2007.








*(c)*  *Factoring
      line of credit*




Hantro
      has available a line of credit with a Finnish bank for the lesser of $2,195,000
      (1,490,000€ at December 31, 2007) or 90% of eligible accounts receivable. The
      line of credit expired in February 2008 and was paid in full. Borrowings under
      the line of credit bear interest at EURIBOR plus .95% (total of 5.238% at
      December 31, 2007). The borrowings are collateralized by 90% of eligible
      accounts receivable. The borrowings also have a 100% guarantee by the Finnvera
      plc, which requires a commission payable at 2.15% to 2.95% of the loan
      principal. The outstanding balance on the line of credit was $1,500,000 at
      December 31, 2007. The carrying amount of accounts receivable of Hantro that
      serve as collateral for borrowings totaled $1,820,000 at December 31,
      2007.


F-29


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





(6)
      SHORT-TERM BORROWINGS (continued)





*(d)*  *Term
      loan*




During
      June 2007 the Company obtained unsecured financing in the amount of
      $143,000 to finance its directors’ and officers’ liability insurance. The
      financing arrangement is for nine months and ran through March 2008 and
      provided for interest at an effective interest rate of 8.032%. During
      June 2006 the Company obtained unsecured financing in the amount of $96,000
      to finance its directors’ and officers’ liability insurance. The financing
      arrangement was for nine months and ran through March of 2007 and provided
      for interest at an effective annual rate of 7.76%. The outstanding balance
      on
      the term loan was $49,000 and $33,000 at December 31, 2007 and December 31,
      2006, respectively





(7)
      INCOME TAXES




Loss
      before income taxes consisted of the following:





Year Ended December 31,2007
            
            2006
            
            2005U.S.
            
            $
            (5,658,000
            )
            $
            (4,400,000
            )
            $
            (4,166,000
            )Foreign
            
            
            (1,222,000
            )
            
            (416,000
            )
            
            (407,000
            )$
            (6,879,000
            )
            $
            (4,816,000
            )
            $
            (4,573,000
            )





The
      provision for income taxes consisted of the following:





Year
                Ended December 31,2007
            
            2006
            
            2005Current:Federal
            
            $
            -
            
            $
            -
            
            $
            -State
            
            
            15,000
            
            
            30,000
            
            
            32,000Foreign
            
            
            10,000
            
            
            -
            
            
            -$
            25,000
            
            $
            30,000
            
            $
            32,000Deferred:Federal
            
            $
            -
            
            $
            -
            
            $
            -State
            
            
            -
            
            
            -
            
            
            -Foreign
            
            
            -
            
            
            -
            
            
            -$
            25,000
            
            $
            30,000
            
            $
            32,000


F-30


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





(7)
      INCOME TAXES (continued)





The
      following is a reconciliation of the difference between the actual provision
      for
      income taxes and the provision computed by applying the federal statutory rate
      on income before income taxes:





Year Ended December 31,2007
            
            2006
            
            2005Tax
                provision computed at U.S. statutory rate
            
            $
            (2,175,000
            )
            $
            (1,523,000
            )
            $
            (1,446,000
            )State
                taxes
            
            
            (482,000
            )
            
            (337,000
            )
            
            (320,000
            )Limitation
                on utilization of U.S. losses and future deductions
            
            
            2,764,000
            
            
            1,837,000
            
            
            1,720,000Subsidiaries
                results subject to tax rates at rates other than U.S. statutory
                rates
            
            
            (241,000
            )
            
            (93,000
            )
            
            (64,000
            )Tax
                effect of acquisition related non-deductible goodwill and
                intangibles
            
            
            (33,000
            )Limitation
                on utilization of non-U.S. losses and future deductions
            
            
            192,000
            
            
            146,000
            
            
            142,000Income
                tax provision
            
            $
            25,000
            
            $
            30,000
            
            $
            32,000





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





Year Ended December 31,2007
            
            2006U.S.
                Federal & Foreign Net Operating Loss Carryforwards
            
            $
            43,702,000
            
            $
            36,034,000Depreciation,
                amortization, and other
            
            
            759,000
            
            
            930,000Stock-based
                compensation expense
            
            
            499,000
            
            
            622,000Unrealized
                loss on investments
            
            
            -
            
            
            154,000Accounts
                receivable reserves
            
            
            208,000
            
            
            22,000Accrued
                expenses
            
            
            9,000
            
            
            -Gross
                deferred tax assets
            
            
            45,177,000
            
            
            37,762,000Deferred
                tax assets valuation allowance
            
            
            (40,718,000
            )
            
            (37,762,000
            )Deferred
                tax assets, net of valuation allowance
            
            $
            4,459,000
            
            $
            -Deferred
                tax liability
            
            $
            -
            
            $
            -Acquired
                intangibles
            
            $
            (4,459,000
            )
            $
            -Deferred
                tax liability, net
            
            $
            (4,459,000
            )
            $
            -Total
                deferred tax assets (liabilities), net
            
            $
            -
            
            $
            -





We
      have
      recorded a valuation allowance against all of our deferred tax assets at
      December 31, 2007, and December 31, 2006. In accordance with SFAS 109 and based
      on all available evidence, including our historical results and the uncertainty
      of predicting our future income, the valuation allowance reduces the deferred
      tax assets to an amount that is more likely than not to be realized. The amount
      of valuation allowance can be attributable to U.S. federal, state and certain
      foreign deferred tax assets primarily consisting of reserves, net operating
      loss
      carryforwards, accrued expenses and other temporary differences. The valuation
      allowance increased by $2,923,000 and $1,983,000 for the years ended December
      31, 2007and 2006, respectively.


F-31


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





(7)
      INCOME TAXES (continued)





In
      accordance with SFAS 109, the Company recorded deferred tax liabilities of
      approximately $4,492,000 for the tax effect of the non-deductible amortizable
      intangible assets as part of the initial purchase price allocation for the
      Hantro acquisition on November 2007. The Company has also recorded deferred
      tax
      assets of $7,893,000 relating to acquired net operating losses in connection
      with the Hantro acquisition. These assets were subject to a valuation allowance
      of 3,401,000.





For
      U.S.
      federal income tax purposes, the Company has net operating loss, (“NOL”),
      carryforwards of approximately $95,688,000. These loss carry forwards will
      expire in various years through 2027, if not utilized. We also have
      approximately $35,877,000 of NOL carryforwards in various foreign jurisdictions.
      In event that we utilized these NOL carryforwards against our U.S. federal
      taxable income, we will release a portion of the valuation
      allowance.





Excess
      tax benefits from employee stock option exercises of approximately $1,554,000
      are included in the deferred tax asset balance at December 31, 2007 as a
      component of the Company’s net operating loss carryforwards. The deferred income
      tax assets for excess tax benefits has a full valuation allowance against them
      at December 31, 2007.





(8)
      CONVERTIBLE DEBENTURES





*Series
      A Secured Convertible Debentures*





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





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





As
      of
      December 31, 2006, the entire $650,000 of the Series A Secured Convertible
      Debentures were converted into 5,804,000 shares of the Company’s common stock.
      During 2005, 804,000 warrants were exercised and the Company received proceeds
      of $90,000. During 2004, 90,000 warrants were exercised and the Company received
      proceeds of $10,000. The amortization of the discount was $6,000, $14,000 and
      $21,000 for the years ended December 31, 2006, 2005 and 2004, respectively.
      During September 2007, 268,000 remaining warrants expired.


F-32




**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





(9)
      LONG-TERM DEBT





Long-term
      debt consists of the following at December 31, 2007:





Note
                payable to a Finnish funding agency in yearly installments of $35,350
                beginning in January 2007, including interest at the Finnish Bank
                Base
                rate less 3% (1.75% at December 31, 2007) with a 1% minimum, due
                January
                2009, secured by a guarantee by On2.
            
            $
            71,000Note
                payable to a Finnish funding agency in yearly installments of $129,016
                beginning in July 2007, including interest at the Finnish Bank Base
                rate
                less 3% (1.75% at December 31, 2007) with a 1% minimum, due July
                2009,
                secured by a guarantee by On2.
            
            
            258,000Note
                payable to a Finnish funding agency in yearly installments of $147,290
                beginning in September 2008, including interest at the Finnish Bank
                Base
                rate less 3% (1.75% at December 31, 2007) with a 1% minimum, due
                September
                2010, secured by a guarantee by On2.
            
            
            442,000Note
                payable to a Finnish funding agency in three yearly installments
                of
                $708,691 beginning in December 2009, including interest at the Finnish
                Bank Base rate less 3% (1.75% at December 31, 2007) with a 1% minimum,
                due
                December 2011, secured by a guarantee by On2.
            
            
            2,126,000Note
                payable to a Finnish funding agency payable out of distributable
                earnings
                as determined by the agreement. As of December 31, 2007 there were
                no
                distributions to pay down this debt, secured by a guarantee by
                On2.
            
            
            50,000Note
                payable to a Finnish bank in bi-annual installments of $52,604 beginning
                in September 2004, including interest at the 3-month EURIBOR (4.68%
                at
                December 31, 2007) plus 1.1%, due March 2011, secured by a guarantee
                by
                the Finnish Government Organization, which also requires additional
                interest at 2.65% of the loan principal.
            
            
            368,000Unsecured
                Note payable to a Finnish financing company in bi-annual installments
                of
                $36,823 beginning in September 2005, including interest at the 6
                month
                EURIBOR (4.70% at December 31, 2007) plus .5%, due March
                2011.
            
            
            258,000Total
                Debt
            
            
            3,573,000Less:
                Current Portion
            
            
            (491,000
            )Long-term
                debt, less current portion
            
            $
            3,082,000


F-33


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





(9)
      LONG-TERM DEBT (continued)





Future
      maturities of long-term debt are as follows as of December 31,
      2007:





2008
            
            $
            491,0002009
            
            
            1,249,0002010
            
            
            1,035,0002011
            
            
            798,000$
            3,573,000





(10)
      STOCKHOLDERS’ EQUITY





*(a)*
            *Preferred
                Stock*





The
      Company has 20,000,000 shares of preferred stock authorized for issuance and,
      through December 31, 2006, ten series of convertible preferred stock
      (collectively “Preferred Stock”) were issued. Pursuant to its Certificate of
      Incorporation, the Company may serially designate separate classes of preferred
      stock up to the aggregate of its authorized limit. Each class of the Preferred
      Stock is convertible into shares of the Company’s Common Stock based on a
      conversion rate and has rights and preferences which are generally more senior
      to the Company’s Common Stock and are more fully described in the Company’s
      Certificate of Incorporation.





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





Travelers
      Indemnity Company (“Travelers”) was granted pricing protection on its investment
      made in 2000 regarding certain subsequent investments in Preferred Stock.
      Accordingly, the Company issued 1,849,000 shares of Series C-IV
      Convertible Preferred Stock, (“Series C-IV Preferred”) par value $0.01 per
      share, with an initial conversion price of $2.65 per share with a liquidation
      preference of $4,900,000 plus accrued and unpaid dividends; and
      4,100,000 shares of Series C-V Convertible Preferred Stock (“Series
      C-V Preferred”), par value $0.01 per share, with a conversion price of $1.244
      per share, and cancelled the original Travelers Warrants and in their place
      issued 462,000 warrants with an exercise price of $2.65 per share and
      1,025,000 warrants with an exercise price of $1.14 per share. Travelers was
      not entitled to any further pricing protection.





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




As
      of
      December 31, 2003, the conversion price of the Series C-IV Preferred
      was adjusted to $1.7564 per share and the Company issued 236,000 additional
      warrants and the exercise price of the warrants was reduced to $1.7549 per
      share. As a result of the issuance of the Series D Convertible Preferred
      Stock in October 2004, the conversion price of the Series C-IV Preferred
      was further adjusted to $1.6412 per share. As a result of the sale of common
      stock and warrants in August 2006 to a group of investors led by Midsummer
      Investment Ltd., the conversion price of the Series C-IV Preferred was
      further adjusted to $1.595 per share. During the first quarter of 2007, all
      of
      the remaining 1,849,000 shares of Series C-IV Preferred were converted into
      3,072,000 shares of the Company’s common stock.


F-34


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





(10)
      STOCKHOLDERS’ EQUITY (continued)





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





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





As
      of
      December 31, 2003, the conversion price of the Series C-V Preferred
      was adjusted to $0.9062 per share, the Company issued 372,000 additional
      warrants and the exercise price of the warrants was reduced to $0.8363 per
      share. As a result of the issuance of the Series D Convertible Preferred
      Stock in October 2004, the conversion price of the Series C-V Preferred was
      further adjusted to $0.8839 per share.





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




**Series C-VI
      Convertible Preferred Stock**





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





**Series
      D Redeemable Convertible Preferred Stock**





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





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





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


F-35


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





(10)
      STOCKHOLDERS’ EQUITY (continued)





*(a)
      Preferred Stock (continued)*





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





The
      Series D Preferred includes a liquidation preference. In the event of any
      liquidation, dissolution or winding up of the Company, either voluntary or
      involuntary, the holders of shares of Series D Preferred are entitled to
      receive an amount equal to $1,000 per share. The liquidation price per share
      would be paid out of the assets of the Company available for distribution prior
      to any payments made on any shares of the Company’s junior securities. The
      registration right agreement provides for liquidated damages of 2% of the
      aggregate purchase price for the first month and 1% for each subsequent month
      if
      the Company failed to register the related common shares and maintain
      effectiveness of such registration. The aggregate fair value of the
      Series D Preferred was $4,000,000, based upon the redemption value of $0.70
      which exceeded the market value of the underlying Common Stock on the closing
      date. Additionally, the fair value of the warrants issued, as calculated using
      the Black Scholes pricing model, was $2,354,000. In accordance with Emerging
      Issues Task Force 00-27, the Company allocated the net proceeds between the
      Series D Preferred Stock and the warrants based on the relative fair value
      method as described in APB No. 14. The Company allocated $2,518,000 to the
      Series D Preferred and $1,482,000 to the warrants. The difference between
      the proceeds allocated to, and the fair value of the Series D Preferred, which
      amounted to $1,482,000 represents a beneficial conversion feature. The aggregate
      of the relative fair value of the Warrants and the beneficial conversion feature
      represents a convertible Preferred Stock deemed dividend. As of December 31,
      2004, the redemption value exceeded the market value of the common shares
      issuable upon conversion. Although the Series D Convertible Preferred Stock
      has
      stated redemption dates, the Company may, at its option, settle such redemptions
      by issuing common stock. Accordingly, $2,964,000 of deemed dividends and
      accretion of $189,000 of financing costs, (excluding $112,000 allocated to
      the
      warrants) were being recognized over the term of the Series D Preferred,
      including $120,000 and $14,000, respectively, in 2004. However, as of September
      30, 2005, the fair market value of the Company’s common stock exceeded the
      conversion price and as a result, the remaining unamortized balance was
      recognized as a deemed dividend. Additionally, the unamortized balance of
      financing costs has been recognized as accretion during the year ended December
      31, 2005. The aggregate convertible preferred stock deemed dividend and
      accretion of costs for the year ended December 31, 2005 were $2,844,000 and
      $175,000, respectively.





During
      the year ended December 31, 2007, all the remaining Series D Preferred was
      converted/redeemed as follows: 2,092 shares of the Series D Preferred were
      converted into 3,506,000 shares of the Company’s Common Stock and 991 shares of
      the Series D Preferred were redeemed into 385,000 shares of the Company’s Common
      Stock. During the year ended December 31, 2006, 523 shares of the Series D
      Preferred were converted into 750,000 shares of the Company’s Common Stock and
      184 shares of the Series D Preferred were redeemed into 267,000 shares of the
      Company’s Common Stock. During the year ended December 31, 2005, 210 shares of
      Series D Preferred were converted into 300,000 shares of the Company’s Common
      Stock.





During
      the year ended December 31, 2007, the Company recorded dividends of $82,000
      on
      the Series D Preferred and $103,000, including previously accrued dividends,
      was
      paid by issuing 78,000 shares of the Company’s Common Stock. During the year
      ended December 31, 2006, the Company recorded dividends of $285,000 on the
      Series D Preferred and $291,000 was paid, by issuing 387,000 shares of the
      Company’s Common Stock. During 2005, the Company recorded dividends of $325,000
      on the Series D Preferred of which $298,000 was paid, by issuing 538,000 shares
      of the Company’s Common Stock and $27,000 was accrued.





During
      the year ended December 31, 2007, Midsummer Investment Ltd. exercised all their
      five-year warrants issued in conjunction with the Series D Preferred and the
      Company received proceeds from the exercise in the amount of $1,422,000 and
      issued 1,886,000 shares of Common Stock. During the year ended December 31,
      2005, Midsummer Investment Ltd. and Islandia L.P. exercised all the one-year
      Series D Warrants and the Company received proceeds from the exercise in the
      amount of $1,886,000 (net of $60,000 of expenses) and issued 2,994,000 shares
      of
      Common Stock.





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


F-36


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





(10)
      STOCKHOLDERS’ EQUITY (continued)





*(a)
      Preferred Stock (continued)*





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





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





The
      following table summarizes the common stock issuable upon the exercise of
      warrants related to preferred stock at December 31, 2007:





Convertible
                Security
            
            Exercise Price per
              Share
            
            Shares of
              Common Stock
              Issuable upon
              ExerciseSeries
                D Warrant
            
            $
            0.7541
            
            
            1,132,000





There
      was
      no preferred stock outstanding at December 31, 2007.




*(b)
      August 2006 - Sale of Common Stock and Warrants*





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




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


F-37


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





(10)
      STOCKHOLDERS’ EQUITY (continued)





*(b)
      August 2006 - Sale of Common Stock and Warrants (continued)*





The
      warrants contained certain anti-dilution provisions and accordingly the Company
      accounted for the fair value of the warrants as a derivative liability (Warrant
      derivative liability) subject to SFAS No. 133. The fair value of the warrants
      issued, as calculated using the Black Scholes pricing model, was $1,251,000
      on
      August 24, 2006 and represents the portion of the proceeds from the financing
      that was attributed to the warrant derivative liability. The warrant fair value
      was revalued at each reporting date, using the Black Scholes pricing model,
      with
      changes in value recorded in the statement of operations as other income or
      expense. The warrant derivative fair value was $2,329,000 as of December 31,
      2006. On June 11, 2007, the Company entered into a Letter Agreement with
      Midsummer Investments Ltd. and Rockmore Investment Master Fund where the parties
      agreed to place a $0.41 per share floor on the base share price for subsequent
      dilutive share issuances and received consideration in the form of a decrease
      in
      the warrant exercise price, from $0.77 to $0.69. The number of additional shares
      to be issued upon subsequent dilutive issuances is finite and the Company will
      reserve for the issuance from its authorized common shares; the warrants were
      no
      longer considered a liability and the Company reclassified the warrant
      derivative liability of $5,911,000 on June 11, 2007 to additional paid in
      capital. The Company also recorded $86,000 in other expense related for the
      modification of the warrant. During the year ended December 31, 2007, the
      Company recorded charges of $3,582,000 to reflect the change in the fair value
      of the warrant derivative liability. The increase in value of the warrant from
      the date of issuance to December 31, 2006 of $1,078,000 is included as an
      expense in interest and other income (expense), net. The Company paid financing
      costs in the amount of $122,000 of which $52,000 is associated with the
      warrants, and is included in interest and other income (expense), net in the
      Company’s consolidated statement of operations for the year ended December 31,
      2006. During the year ended December 31, 2007, Midsummer Investment Ltd.
      exercised all their warrants issued in conjunction with the Sale of Common
      Stock
      and Warrants and the Company received proceeds from the exercise in the amount
      of $1,342,000 and issued 1,974,000 shares of Common Stock.





*(c)* October/November 2007 - Sale of Common Stock





On
      October 17, 2007, the Company entered into an Underwriting Agreement with
      ThinkEquity Partners LLC and Merriman Curhan Ford & Co. (collectively, the
“Underwriters”), pursuant to which the Company agreed to sell to the
      Underwriters, and the Underwriters agreed to purchase from the Company, in
      a
      firm commitment underwritten offering, 13,000,000 shares of the Company’s common
      stock at a purchase price of $1.00 per share. The Company also agreed to sell
      to
      the Underwriters up to an additional 1,950,000 shares of common stock at a
      purchase price of $1.00 per share at the option of the Underwriters to cover
      over-allotments, which option was required to be exercised within 30 days of
      the
      filing date of the Company’s prospectus covering the shares to be issued in the
      offering. The Company issued the 13,000,000 committed shares on October 23,
      2007, and the Company issued these option shares on November 9, 2007 after
      the
      Underwriters exercised their option to purchase the additional 1,950,000 shares.
      The 14,950,000 shares resulted in net proceeds of $13,903,000, net of
      underwriter commissions and offering costs.


F-38


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





(10)
      STOCKHOLDERS’ EQUITY (continued)





*(d)
      Warrants*





The
      Company issued common stock purchase warrants to various consultants, strategic
      partners and investors. The following table summarizes information about all
      common stock purchase warrants outstanding as of December 31, 2007,
      including those issued in connection with Common Stock, Preferred Stock and
      Convertible Debentures. All warrants were exercisable as of December 31,
      2007.





The
      following table summarizes the common stock issuable upon conversion of all
      outstanding warrants at December 31, 2007:





Range
                of
              Exercise
                Prices
            
            Number
                of Warrants Outstanding
            
            Weighted
              Average
              Exercise
                Price
            
            Expiration
                Dates$
                0.57 - $ 0.70
            
            
            470,000
            
            $
            0.659
            
            
            2009
                - 2011$
                0.71 - $ 0.76
            
            
            1,132,000
            
            $
            0.754
            
            
            20091,602,000
            
            $
            0.726
            
            
            2009
                -2011





In
      January 2006, the Company extended the expiration date of 1,600,000 warrants
      exercisable at $1.68 per share that were due to expire on January 29, 2006.
      As
      part of the agreement the expiration date was changed to December 31, 2006,
      and
      a provision was added to require the holder to exercise of the warrants if
      the
      volume weighted average price of the Company’s common stock for ten consecutive
      trading days equals or exceeds $1.93 or forfeit the warrants. In December 2006,
      the Company extended the expiration date of these warrants to December 31,
      2007
      and reduced the volume weighted average price requiring exercise to $1.83.
      There
      is no compensatory relationship with the warrant holder, who is also a common
      stockholder. The Company has accounted for the fair value of these modifications
      as financing costs. Accordingly, the Company had recognized an expense of
      $135,000 in December 2006 for the incremental fair value of the January 2006
      modification and has recorded a deferred financing cost of $106,000 as of
      December 31, 2006 for the incremental fair value of the December 2006
      modification. During 2007, all the warrants were exercised and the Company
      received $2,688,000 and issued 1,600,000 shares of its common stock and
      additional paid in capital was reduced by the $106,000 of deferred financing
      costs.





*(e)
      Stock Options*





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


F-39


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





(10)
      STOCKHOLDERS’ EQUITY (continued)





*(e)
      Stock Options (continued)*





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





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





In
      October 2007, the Company’s stockholders approved an additional 13,000,000
      options (for a total of 20,000,000 options) for grant under the Company’s 2005
      Plan.


F-40


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





(10)
      STOCKHOLDERS’ EQUITY (continued)





*(e)
      Stock Options (continued)*





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





Options
              Granted
            
            Weighted
              Average
              Exercise
                PriceOutstanding
                January 1, 2005
            
            
            5,832,000
            
            $
            1.18Granted
            
            
            4,778,000
            
            
            0.71Exercised
            
            
            (116,000
            )
            
            0.35Canceled
            
            
            (195,000
            )
            
            076Outstanding
                December 31, 2005
            
            
            10,299,000
            
            $
            0.98Granted
            
            
            1,820,000
            
            
            0.87Exercised
            
            
            (1,745,000
            )
            
            0.54Canceled
            
            
            (877,000
            )
            
            0.68Outstanding
                at December 31, 2006
            
            
            9,497,000
            
            $
            1.07Granted
            
            
            2,567,000
            
            
            1.07Exercised
            
            
            (3,979,000
            )
            
            0.68Canceled
            
            
            (129,000
            )
            
            12.94Outstanding
                at December 31, 2007
            
            
            7,956,000
            
            $
            1.03Exercisable
                at December 31, 2006
            
            
            8,433,000
            
            $
            1.09Exercisable
                at December 31, 2007
            
            
            4,848,000
            
            $
            1.03Options
                available for grant at December 31, 2007
            
            
            10,452,000





The
      following table summarizes information about stock options outstanding as of
      December 31, 2007





Options
                Outstanding
            
            Options
                ExercisableRange
                of Exercise
              Prices
            
            Number
              of
                Shares
            
            Weighted
              Average
              Exercise
              Price
            
            Weighted Average
              Remaining
              Contractual Life
              (in years)
            
            Number
              of
                Shares
            
            Weighted
              Average
              Exercise
              Price$
                0.14 - $ 0.70
            
            
            1,849,000
            
            $
            0.53
            
            
            5.6
            
            
            1,809,000
            
            $
            0.53$
                0.73 - $ 1.07
            
            
            5,387,000
            
            
            0.93
            
            
            6.9
            
            
            2,411,000
            
            
            0.84$
                0.14 - $ 1.61
            
            
            425,000
            
            
            1.37
            
            
            6.1
            
            
            345,000
            
            
            1.33$
                2.25 - $ 3.59
            
            
            207,000
            
            
            3.24
            
            
            2.8
            
            
            195,000
            
            
            3.26$
                3.60 - $ 25.00
            
            
            88,000
            
            
            9.94
            
            
            2.0
            
            
            88,000
            
            
            9.947,956,000
            
            $
            1.03
            
            
            6.4
            
            
            4,848,000
            
            $
            1.03


F-41


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





(10)
      STOCKHOLDERS’ EQUITY (continued)





*(e)
      Stock Options (continued)*





During
      the year ended December 31, 2007 options for 2,139,000 shares were exercised
      and
      the Company received $1,428,000 in proceeds. In addition, during the year ended
      December 31, 2007 certain employees exercised 1,840,000 stock options in
      cashless exercises and the Company retained 836,000 shares of common stock,
      and
      paid $472,000 in cash, for payroll withholding taxes. During the year ended
      December 31, 2006 options for 270,000 shares were exercised and the Company
      received $181,000 in proceeds.





During
      the year ended December 31, 2007 the Company granted 1,053,000 shares, of its
      restricted common stock, to its directors, officers and certain employees that
      had a fair value on the dates of grant of $2,067,000, of which no shares vested
      during 2007. The unrecognized compensation costs and intrinsic value of these
      shares at December 31, 2007 was $1,601,000 and $1,096,000, respectively. During
      the year ended December 31, 2006 the Company granted 110,000 shares of its
      restricted common stock to certain employees and consultants that had a fair
      value on the date of grant of $70,000, of which 25,000 shares vested in
      September 2006 and the remaining shares vested through August 2007. The
      unrecognized compensation costs and intrinsic value of these shares at December
      31, 2006 was $33,000 and $132,000, respectively.





*(f)
      Treasury Stock*





During
      the year ended December 31, 2007, certain employees of the Company exercised
      their stock options in cashless exercises. According to certain Stock Option
      Plans the Company is required to record all shares received in payment of the
      options and related withholding taxes as treasury stock. Accordingly, the
      Company received 836,000 shares of its common stock at a value of $1,431,000.
      The Company’s Board of Directors approved the retirement of all the shares
      received. The Company paid $472,000 in cash for employee’s withholding taxes on
      certain cashless exercises.





(11)
      COMMITMENTS AND CONTINGENCIES





*(a)*
            *Operating
                Leases*





The
      Company has entered into several non-cancelable leases, primarily related to
      the
      rental of certain equipment, automobiles and facilities. Future minimum lease
      payments, by year and in the aggregate, under material operating leases
      consisted of the following at December 31, 2007:





Year
                ended December 31,
            
            Amount2008
            
            $
            1,127,0002009
            
            
            294,0002010
            
            
            150,0002011
            
            
            118,0002012
            
            
            74,0002013
            
            
            65,0002014
            
            
            16,000Total
                minimum lease payments
            
            $
            1,844,000





Rent
      expense under operating leases was approximately $396,000, $221,000 and $202,000
      for the years ended December 31, 2007, 2006 and 2005,
      respectively.


F-42


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





(11)
      COMMITMENTS AND CONTINGENCIES (continued)




*(b)*
            *Employment
                Agreements*





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




*(c)*
            *Litigation*





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





*(d)*
            *Beijing
                E-world*





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





Although
      almost three years have passed since the conclusion of the previous arbitration,
      the parties have nevertheless not completed the required porting of our software
      to two commercially available DSPs.


Our
      current arbitration claim alleges that, despite its obligations under the
      license agreements, Beijing E-World has:





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





·
            failed
                to use best reasonable efforts to have our video codec ported to
                a chip.





We
      have
      requested that the arbitrator award us approximately $5,690,000 in damages
      under
      the contract and grant us further relief as may be just and equitable.





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


F-43


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





(12)
      RELATED PARTY TRANSACTIONS





During
      the years ended December 31, 2007, 2006 and 2005, the Company retained a
      law firm to perform certain legal services on its behalf and incurred
      approximately $1,022,000, $150,000 and $13,000, respectively, for such legal
      services. A member of the Company’s board of directors is a partner at the law
      firm. At December 31, 2007 the amount owed to this law firm was
      $51,000.





During
      the years ended December 31, 2007, 2006 and 2005, the Company retained a
      consulting firm to facilitate customer relationships in Asia and incurred
      approximately $0, $0 and $34,000, respectively, for such services. A consultant
      at the consulting firm became a director of the Company in August
      2003.





(13)
      SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)





Quarterly
      financial data for fiscal 2007, 2006 and 2005 is as follows:





Quarter
                Ended 2007March
                31,
            
            June
                30,
            
            September
                30,
            
            December
                31,Revenue
            
            $
            2,815,000
            
            $
            2,369,000
            
            $
            1,935,000
            
            $
            6,118,000Gross
                profit
            
            
            2,392,000
            
            
            1,980,000
            
            
            1,332,000
            
            
            4,984,000Net
                loss
            
            
            (721,000
            )
            
            (3,005,000
            )
            
            (1,382,000
            )
            
            (1,796,000
            )Net
                loss attributable to common stockholders
            
            
            (775,000
            )
            
            (3,023,000
            )
            
            (1,389,000
            )
            
            (1,799,000
            )Basic
                and diluted net loss attributable to common stockholders per
                share
            
            $
            (0.01
            )
            $
            (0.03
            )
            $
            (0.01
            )
            $
            (0.01
            )





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





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


F-44


**ON2
      TECHNOLOGIES, INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2007, 2006 AND 2005**





ON2
      TECHNOLOGIES, INC.


SCHEDULE
      II – VALUATION AND QUALIFYING ACCOUNTS





Description
            
            Balance
                at
              Beginning
              Of
                Period
            
            Charged
                to
              Costs
                and
              Expenses
            
            Charged
                to
              Other
              Accounts
            
            Deductions
            
            Balance
                at
              End
                of
              PeriodYear
                ended December 31, 2007 allowance for doubtful accounts
            
            $
            56,000
            
            $
            518,000
            
            $
            —
            
            $
            (55,000
            )
            $
            519,000Year
                ended December 31, 2006 allowance for doubtful accounts
            
            $
            13,000
            
            $
            117,000
            
            $
            —
            
            $
            (74,000
            )
            $
            56,000Year
                ended December 31, 2005 allowance for doubtful accounts
            
            $
            140,000
            
            
            
            
            $
            —
            
            $
            (127,000
            )
            $
            13,000


F-45