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

                                   FORM 10-KSB


(Mark One)

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

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

                         COMMISSION FILE NUMBER 1-15117.

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


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


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


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

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


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


     Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such
shorter period that the registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days. Yes [X] No __

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

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

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

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

                      APPLICABLE ONLY TO CORPORATE ISSUERS:

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

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

                       DOCUMENTS INCORPORATED BY REFERENCE

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

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

<PAGE>

                                TABLE OF CONTENTS

PART I
 ITEM 1.    DESCRIPTION OF BUSINESS                                            4
 ITEM 2.    DESCRIPTION OF PROPERTY                                           11
 ITEM 3.    LEGAL PROCEEDINGS                                                 12
 ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS               12

PART II
 ITEM 5.    MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS          12
 ITEM 6.    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
            RESULTS OF OPERATIONS                                             14
 ITEM 7.    FINANCIAL STATEMENTS                                              25
 ITEM 8.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
            FINANCIAL DISCLOSURE                                              25
 ITEM 8A.   CONTOLS AND PROCEDURES                                            25

PART III
 ITEM 9.    DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
            COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT                 25
 ITEM 10.   EXECUTIVE COMPENSATION                                            25
 ITEM 11.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT    25
 ITEM 12    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                    25
 ITEM 13    EXHIBITS                                                          26
 ITEM 14    PRINCIPAL ACCOUNTANT FEES AND SERVICES                            27

Signatures



                                       3
<PAGE>

                                     PART I


ITEM 1.         DESCRIPTION OF BUSINESS

FORWARD-LOOKING STATEMENTS

     This document contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. These statements relate to future events or our future
financial performance and are not statements of historical fact. In some cases,
you can identify forward-looking statements by terminology such as "may,"
"will," "should," "could," "would," "might," "expect," "plan," "anticipate,"
"project," "believe," "estimate," "predict," "foresee," "potential," "future,"
"objective," "forecast," "goal" or "continue," the negative of such terms, or
other comparable or derivative terminology. These statements are only
predictions, and actual events or results may differ materially. Although we
believe that the expectations reflected in the forward-looking statements are
reasonable, we cannot guarantee future results, levels of activity, performance
or achievements, and in all cases, such statements are subject to our ability to
secure sufficient financing or to increase revenues to support our operations.
In this regard, our business and operations 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 "Management's
Discussion and Analysis -- Risk Factors That May Affect Future Operating
Results," in addition to the other information set forth herein.

     The inclusion of the forward-looking statements should not be regarded as a
representation by us, or any other person, that such forward-looking statements
will be achieved. We undertake no duty to update any of the forward-looking
statements, whether as a result of new information, future events or otherwise.
In light of the foregoing, readers are cautioned not to place undue reliance on
the forward-looking statements contained in this report.

OVERVIEW

     We are a leading video compression technology firm. We have developed a
proprietary technology platform and video compression/decompression software
("codec") to deliver high-quality video at the lowest possible data rates over
proprietary networks and the Internet to devices such as set-top boxes, personal
computers, and wireless and other devices. We offer a suite of products and
services, centered around our VPx family of products (e.g., VP6, VP7), that
incorporate our proprietary compression technology. Our service offerings
include customized engineering, consulting, and encoding services and technical
support. In addition, we license our software products, which include video and
audio codecs and encoding, player and server software, for use with video
delivery platforms.

DEVELOPMENT OF OUR BUSINESS

We detail the history and evolution of our business under the section
"Management's Discussion and Analysis -- Risk Factors That May Affect Future
Operating Results - History".

BUSINESS STRATEGY

     Our strategy is to be the premier provider of video
compression/decompression software technology and compression tools. We are
striving to achieve our goals by implementing the following key strategies:

o     developing and expanding our expertise in and commercial applications for
      video compression and streaming software;

o     continuing our research and development efforts to increase the quality of
      video technology in order to improve the experience of end users;

o     leveraging our existing products and services to support new products and
      services and to expand our presence in multiple industries, including the
      Internet, wireless applications and consumer electronics; and

o     expanding into international markets by contracting with resellers of our
      products and services.


                                       4
<PAGE>

OUR TECHNOLOGY, PRODUCTS AND SERVICES

     We have designed our technology to deliver the highest-quality video at the
lowest possible data rates and to encode (compress) and decode (decompress)
video on comparatively low-powered chips suitable for consumer electronics
products. We currently license and develop 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.

TRUEMOTION(R) 2X (TM2X)

     Originally developed as our state-of-the-art video compression codec in
1998, the TM2X codec is optimized for hard-drive, Kiosk, or CD-ROM based video
playback. The TM2X video delivery algorithm was licensed for use in Sega's
Dreamcast and Saturn and has also been licensed to gaming developers and
manufacturers interested in high quality video on machines with limited
processing capabilities.

     At the time it was introduced, TM2X offered comparatively high resolutions
(320x240, 640x480) and high bit-rates that could play back smoothly on a wide
range of CPUs available at the time. The product was part of QuickTime and Video
for Windows and can be used in programs such as Adobe Premiere and Terran's
Media Cleaner Pro. It is also a cross-platform codec, with QuickTime working on
both Macintosh computers and personal computers.

TRUEMOTION VP3 SERIES

     Our TrueMotion VP3 series of codecs includes VP3, VP3.1 and VP3.2. VP3 was
introduced in January of 2000 and was the original codec used on our website at
data rates between 300 and 400 kbps. VP3.1 was launched in June of 2000 and
provided for full-motion, full-screen television quality video over the Internet
at data rates as low as 250 kbps, scaling dynamically to 500 kbps and more.
Introduced in August of 2000, VP3.2 is designed to offer high-quality video
transmission over broadband Internet connections and supply television-quality
video at data rates as low as 200 kbps. VP3 files are encoded in multiple bit
rates and at optimum frame rates (usually 29.97 fps) within a single file.

OPEN SOURCE VP3.2

     VP3.2 was made available to the open-source community on September 7, 2001,
so as to provide software developers an efficient, open source video codec with
no platform limitations or restrictive license fees. VP3 became the first true
common format that is open, documented and free. We created VP3-based plug-ins
for other media formats, such as Apple's QuickTime. With these plug-ins, users
can encode content using VP3 plug-in technology engineered to play that content
back through these other popular player-formats.

     In June 2002 the Company entered into an agreement with the Xiph.Org
Foundation, developers of Vorbis, the popular open-source audio codec, for Xiph
to be the prime source of support, distribution, and further development of VP3.
In addition, with On2's support, Xiph will integrate VP3 into its Ogg Multimedia
Framework, providing a full-featured, open-source, royalty-free alternative to
expensive solutions such as MPEG-4.

VP4 CODEC
     Released in the second quarter of 2001, VP4 was initially optimized for
set-top boxes and closed area environments, VP4 is widely recognized as being
among the most efficient video compression technologies available. VP4 achieves
near-DVD quality at 450 kbps and near-VHS quality at 150 kbps at full-screen and
full-motion. VP4 offers a 20% bandwidth reduction over some of our competitor's
technologies, allowing for greatly reduced costs for comparable quality video.


                                       5
<PAGE>

VP5 CODEC

     We made VP5 available for license in the second quarter of 2002. VP5 allows
a 50% reduction over the bandwidth required to show comparable quality video
using VP4. Additional features offered by VP5 include real-time encoding and the
ability to handle interlaced content, making it the first codec on the market to
offer true broadcast-quality, real-time compression of difficult live material
such as sports and action footage at sub-megabit data rates. The ability to
handle interlaced content set VP5 apart from the myriad of competitive video
codecs available at that time.

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. At the time of VP6's launch, we announced that
we would make the VP6 encoder free for personal use for individuals, developers,
and companies that register at the On2 website, although organizations or
developers who want to license the codec for commercial use must enter into a
commercial use license agreement with us. On2 has since ceased offering the VP6
encoder free for personal use. As with prior versions of our codec, VP6
represented a significant improvement over its predecessors, offering a 40%
image quality improvement over and 50% faster playback than VP5. VP6 improves
upon all the features contained in VP5 and supports real-time encoding at full
D1 resolution. It also consistently outperforms Windows Media 9 and H.264 based
on tests of Peak Signal-to-Noise Ratios 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. Despite the introduction of VP7, we expect to continue to license VP6
extensively for use with a wide variety of applications on numerous platforms.

VP7 CODEC

We introduced 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, H.264 and MPEG-4-compatible codecs, at data
rates ranging from dial-up (28.8 Kbps) to DVD and HD. As with VP6, VP7 also
supports real-time encoding at full D1 resolution. VP7 has been developed to run
on low-cost DSPs, and On2's engineers are currently working to port VP7 to a
number of DSPs.

AUDIO FOR VIDEO CODEC TECHNOLOGY (AVC)

     AVC is an advanced compression algorithm that is ideal for a variety of
audio sources, including music, human speech, film and broadcast television. AVC
can achieve very high quality audio at bit rates lower than current standards
such as MP3 or AC-3. This algorithm is designed for easy portability to embedded
devices and can be licensed for a lower per-unit cost than other audio codecs on
the market. AVC runs with the VP3, VP4, VP5, VP6, and VP7 video codecs, and this
combination can provide a seamless low-bit-rate multimedia experience. VP6 or
VP7 combined with AVC is comparable to MPEG-4 combined with AC-3, but with a
substantial data rate savings. It is ideal for VOD deployment over DSL or cable
networks. AVC also allows for less transfer time and storage space for
downloaded files.

ON2'S ENCODER PRODUCTS

     Our Encoder enables content owners to efficiently re-master and compress
their assets into the VP4, VP5, VP6, or VP7 format at their own convenience.
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 that wants exact
control over the optimization process. Once the raw file has been optimized, our
compression software has the capability of creating multiple data rate
compressed files.

     On2 recently began selling the NSV QuickTime Plugin for On2 Video, which
allows users to encode video in AOL's Nullsoft Video (.nsv) file format. The NSV
QuickTime Plugin is designed to work seamlessly with video processing
applications that support the QuickTime export component architecture, such as
Apple QuickTime Pro, Adobe Premiere Pro, and Discreet Cleaner XL. The NSV
QuickTime Plugin also includes aacPlus audio compression technology from Coding
Technologies.


                                       6
<PAGE>

ON2'S JAVA PLAYER

In 2004, On2 introduced its TrueMotion Streaming Java Applet 1.1, a VP6 video
player written in pure Java. The Applet takes advantage of Java's cross-platform
interoperability to allow display of On2 Video on Windows, MacOS, Linux, and
other environments. On2 believes that the Java Player will permit it to compete
with other "playerless" video delivery systems. Such systems are appearing with
increasing frequency in web-based video advertising, and we believe that the
introduction of our Java Applet will improve our ability to compete in this
growing market.

TRUECAST(R) SERVER SOFTWARE

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

     TrueCast comes optimized in two manners: one for transport using our own
proprietary protocol, TrueCast Transport Protocol (TTP), and one for RTSP/RTP to
various set-top box platforms. TrueCast and VP5/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 the first quarter of 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 the third quarter of 2003, we announced that we have added Microsoft
Windows CE to the family of operating systems supported by our TrueCast set-top
box solution.

     In addition, TrueCast 8.0 is able to stream content that is captured and
encoded directly from "live" video sources using the company's revolutionary
VP6, VP7 and earlier-generation On2real-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.

DIGITAL SIGNAL PROCESSOR (DSP) AND SERVER INTEGRATIONS

     VP4, VP5 and VP6 have been ported onto a variety of DSPs. The VP6 decoder
currently runs on a wide range of DSPs at various resolutions, and the VP6
encoder operates on several DSPs as well. We are also working to port the VP7
decoder and encoder to a number of DSPs. We believe that by porting to these
platforms, we will facilitate the use of On2's codec in set-top-box and other
consumer device deployments where the availability of low-cost chips is
important.

SERVICES

     In addition to licensing our software, we offer the following professional
services to our customers:

CUSTOM ENGINEERING AND CONSULTING SERVICES

     We provide custom engineering and consulting services designed to support
customers that are interested in porting and optimizing our technology platform
and algorithm libraries into set-top boxes, gaming and wireless devices and
other proprietary network applications.

ENCODING

     We provide encoding services for customers. These services consist of the
conversion of archival video and audio content into formats for delivery to
end-users.


                                       7
<PAGE>

RESEARCH AND DEVELOPMENT

     The focus of our research and development activities is to improve and
expand upon our core codec technology, which improves the video experience for
end users. 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). 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 for the year ended
December 31, 2004 were $884,000 as compared to $1,124,000 for the year ended
December 31, 2003.

DISTRIBUTION METHODS

    Our business consists of developing and marketing our software-based
technology products and related services. Because we generally sell our software
to companies that will integrate the software with their products or distribute
the software themselves in connection with their services, and until recently
have not regularly attempted to sell products directly to end users, we do not
distribute a high volume of individual copies of software. Our customers usually
download copies of software that they have purchased by online file transfer,
although we will send them a CD-ROM containing the software if they request.
While we have distributed tens of thousands of copies of VP3, VP4, and VP6 to
users for personal use, those users have also downloaded the software from our
web site. Other than temporary interruptions to Internet service, we therefore
do not generally suffer from delays in our distribution network. We usually
provide our engineering and consulting services and product support from our own
facilities.

SALES AND BUSINESS DEVELOPMENT

     Our sales and business development departments aim to build relationships
that fall into two basic categories: product licensing and professional
services. These departments focus on engaging chip-set manufacturers, global
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 their products with our codecs.
Additionally, our teams focus on selling encoding and streaming software
licenses to content providers who are delivering video over proprietary networks
and to IP-based end users. Our professional services are usually incident to our
product licensing and primarily focus on porting or optimizing our compression
technologies to multiple hardware platforms used in video delivery solutions by
manufacturers who have licensed our compression technology.

INTERNATIONAL

     We believe that we are well positioned to selectively expand our business
internationally. We have focused in particular on identifying and capitalizing
on opportunities in Asia and Europe.

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

ASIA

We believe that Asia, with its numerous broadband networks, is one of the
strongest markets for video-on-demand initiatives. Our international sales and
business development efforts have been primarily focused in this region to date.
Our predecessor corporation, The Duck Corporation, has significant name
recognition in Asia, especially among video game developers. Our TM2X software
was widely-distributed because of its inclusion in several popular video games,
such as Final Fantasy 7 for PC. We are currently involved with several Asian
entities that are considering using our video compression and server software in
set-top box deployments. We also aim to expand internationally by appointing
resellers of our products and services who purchase software licenses from us
and sell them in a designated international market. To date, we have signed
reseller agreements for both the Japanese and Korean markets.

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 the license agreements,
we granted E-World:

      o     A license to use our VP5 and VP6 video compression/decompression
            technology in E-World's Enhanced Versatile Disk (EVD) technology.
            EVD is a next-generation videodisk technology being developed by
            E-World to become the industrial standard for China for the
            recording and playback of video, audio and data;


                                       8
<PAGE>

      o     license to use our VP5 and VP6 video compression/decompression
            technology in a High Definition Television system being developed as
            a standard for China by E-World and others;

      o     exclusive rights to use VP5 and VP6 for EVD and HD TV in China,
            Macau, Hong Kong and Taiwan, and non-exclusive rights for the same
            products worldwide; and

      o     exclusive rights to use VP5 and VP6 in video compression products
            other than EVD and HD TV in China, Macau, Hong Kong and Taiwan,
            subject to certain exceptions, and non-exclusive rights to these
            products worldwide

In September, 2003, On2 and E-World amended the exclusivity provisions of the
license agreements so that, going forward, On2 and E-World split 50/50 all
royalties collected or received by On2 for products and devices sold in China
(by On2 or any third parties) that contain On2's VP5 or VP6 compression
software.

As discussed in "Legal Proceedings", 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 for a declaration as to the meaning of certain language in the contract.
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.

E-World has already launched the first generation EVD, which uses MPEG-2
compression technology. In the  event that E-World does begin to use VP5
or VP6 in its EVD devices, there is no guarantee that the EVD standard will be
widely adopted in China or abroad. In addition, E-World and Chinese authorities
may choose to include other companies' video compression technologies in the EVD
standard, and although the arbitrator found that E-World had submitted our
software for inclusion in the EVD standard, we do not know whether the Chinese
authorities ultimately included our software in the standard.

Moreover, one of the advantages that our compression technology has over other
companies' technologies is the high compression rates that our software
achieves, permitting a full-length, high-definition movie to be stored on a
single video disk. Because of the length of time that has elapsed since E-World
entered into the license agreements, other competing software- and
hardware-based technologies have emerged that could enable competitors (or
E-World) to achieve store a full-length, high-definition movie on a single video
disk without using On2's technology.

EUROPE

    We continue to pursue sales and business development opportunities in the
European market, although we have not yet had the success there that we have had
in Asia. We have had success with our U.K.-based partners TVZ Ltd. and QuickLink
Ltd. in powering newsgathering and dissemination applications for major news
organizations such as the BBC. Despite this, however, we have not yet
established the strong relationships with European customers and resellers that
we have in Asia, so we intend to continue to focus on increasing the visibility
of our compression products in Europe.

LOCATION OF ASSETS AND OPERATIONS

     All of the Company's assets and operations have been and are currently
based within the United States, except for two research and development
employees located in the United Kingdom. We did not generate any revenue from
our United Kingdom operations for the years ended December 31, 2004 and 2003.

COMPETITION

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

      o     lowering the amount of bandwidth that customers need,

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

      o     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:

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

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

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


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<PAGE>

     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, network quality, service offerings and the flexibility to adapt to
changing market conditions. We compete with companies such as Microsoft,
RealNetworks, and Apple and standards-based codec such as MPEG-2, H.264, MPEG-4
and several codecs that position themselves as "MPEG-4-based. In addition, we
increasingly compete with developers of "playerless" video delivery systems such
as Destiny Media Technologies, Inc. (Clipstream) and Eyewonder.

    The size of our company and the fact that we have developed a proprietary,
non-standards-based video codec both help and hinder our ability to compete.
Companies such as Microsoft and RealNetworks benefit from name recognition that
we do not enjoy. Microsoft is also able to use its market power to support
anti-competitive 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 is proceeding towards establishing a standard, dubbed
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 who 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:

      o     some customers do not want to license technology from Microsoft or a
            consortium of large western conglomerates (such as those that own
            the core intellectual property used in the proprietary codecs);

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

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

     We also compete with companies that provide encoding services and companies
that encode their content in-house. In establishing our business strategy, we
face a number of strong, firmly entrenched competitors who are currently
providing similar services to low-bandwidth and high-bandwidth users. These and
other companies are already providing broadband video-based services and
technology. In addition to competition from other 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.
Many of our existing competitors have, and some future competitors may have,
significantly greater financial and technical resources than we have. See the
section "Management's Discussion and Analysis -- Overview" for further
discussion of our competitors.

CUSTOMERS

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

INTELLECTUAL PROPERTY

     We regard much of our technology as proprietary and try to protect it by
relying on trademarks, copyrights, patents, trade secret laws and
confidentiality agreements. We view our copyrights, service marks, trademarks,
trade secrets, proprietary technology and similar intellectual property as
critical to our success. We currently hold several U.S. patents and have some
U.S. and international patent applications pending. We believe that the patents
that are currently issued are not material to our business. While we try to
ensure that the quality of the On2 brand is maintained through such 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, 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. Effective trademark, copyright and trade secret


                                       10
<PAGE>

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 a trade secrets for which government registration is not available.
We cannot be sure 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 go to court to either
enforce our intellectual property rights, to protect our trade secrets or to
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 incorporated
into some of our products and services. Although we do not currently have
material third party technology licenses, 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.

GOVERNMENT REGULATION

     We are not currently subject to direct regulation by any governmental
agency other than rules and regulations that apply to businesses generally,
except that certain U.S. export controls and import controls of other countries,
including controls on the use of encryption technologies, which 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 online content,
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.

     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. Although we try to mitigate this risk by
seeking indemnification from our customers and suppliers, we may still be
subject to liability if indemnification is not obtained, is contested or does
not provide us with enough resources to cover any potential liability.

EMPLOYEES

     As of December 31, 2004, we had approximately 30 full-time employees. Of
the total employees, 24 were engineering and product development personnel, 2
were sales and marketing personnel and 5 were general and administrative
personnel.

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

ITEM 2.  DESCRIPTION OF PROPERTY

     We do not own any real property. We lease approximately 7,246 square feet
of space at 21 Corporate Dr., Suite 103, Clifton Park, NY 12065 where our
principal executive, administrative and engineering offices are located at an
annual rental fee of approximately $108,690. This lease expires on January 31,
2006. In addition, we lease approximately 400 square feet of space for certain
of our executives and certain IT staff at 1560 Broadway, 10th Floor, New York,
New York 10036. We pay an annual rental fee of approximately $110,000. This
lease expires August 31, 2005. Management believes these facilities are all in
usable condition and that these facilities are sufficient to meet our needs for
the immediate future. Management also believes that both facilities are
adequately covered by insurance.

     We do not invest in real estate or interests in real estate, real estate
mortgages or securities of or interests in persons primarily engaged in real
estate. It is not our policy to acquire assets primarily for possible capital
gain or primarily for income, although during the year ended December 31, 2004
we received 2,224,000 shares of Powerlinx, Inc. common stock as payment of
license fees pursuant to the terms of an August 2004 license agreement and
$289,000 of revenue was recognized based on the market value of the stock. We
also received 469,000 shares of this customer's common stock pursuant to the
terms of a license agreement for a license fee of $150,000 that was recognized
in 2003. During the year ended December 31, 2004 the Company sold 574,000 shares
for proceeds of $89,000 and held 2,119,000 shares with a market value of
$445,000 ($0.21 per share) as of December 31, 2004. The market value of these
securities was $0.12 per share as of February 23, 2005. The Company's Chief
Executive Officer (who is a director and shareholder of the Company) is a
director of Powerlinx.


                                       11
<PAGE>

ITEM 3.  LEGAL PROCEEDINGS

On May 3, 2004, On2 commenced arbitration against its customer, Beijing E-World
relating to a dispute arising from two license agreements that On2 and E-World
entered into in June 2003. Under those agreements, On2 licensed the source code
to its video compression (codec) technology to E-World for use in E-World's
video disk (EVD) and high definition television (HDTV) products as well as for
other non-EVD/HDTV products. We believed that the license agreements imposed a
number of obligations on E-World, including the requirements that:

      o     Commencing in the first calendar quarter of 2004 and continuing
            through 2005, E-World pay to On2 certain minimum quarterly payments;

      o     E-World cause On2's software to be included in a new Chinese
            national standard for EVD by December 31, 2003; and

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

      On2's arbitration claim alleged that, despite its obligations under the
contracts, E-World had:

      o     Failed to pay On2 the quarterly payments of $1,232,000, which is
            currently due and owing;

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

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

On2 had requested that the arbitrator award it $4,992,000 in damages under the
contract and grant it further relief as may be just and equitable.

E-World responded by denying each of On2's claims and requesting that the
arbitrator rule as to the meaning of certain language in the agreements.

On March 10, 2005, the London Court of International Arbitration tribunal
released the decision of the arbitrator in On2's proceeding against its
licensee, Beijing E-World, for breach of the two source code licenses between
On2 and E-World. The arbitrator dismissed each of On2's claims and dismissed
E-World's request for a declaration regarding meaning of certain language under
the contracts. In particular, the arbitrator ruled that:

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

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

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

The arbitrator further found that:

      o     the contracts remain in effect; and

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

The arbitrator found that E-World did include the VP5 and VP6 codecs as part of
its standards submissions to the Ministry of Information and China's Standards
Accreditation Committee. On2 does not know whether the standards committee
approved these recommendations.

ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     None.

                                     PART II

ITEM 5.    MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

     Our common stock is traded on the American Stock Exchange under the symbol
"ONT". The following table sets forth for the fiscal periods indicated the high
and low bid prices of our common stock, as reported on the American Stock
Exchange, since January 1, 2003:


                                       12
<PAGE>

                                                          HIGH          LOW
FISCAL YEAR 2005                                          ----          ---
            First Quarter (through March 11, 2005)     $     1.28    $    0.62

FISCAL YEAR 2004
            First Quarter                              $     1.66    $    0.86
            Second Quarter                             $     1.24    $    0.59
            Third Quarter                              $     1.04    $    0.63
            Fourth Quarter                             $     0.76    $    0.50

FISCAL YEAR 2003
            First Quarter                              $     0.55    $    0.25
            Second Quarter                             $     1.39    $    0.37
            Third Quarter                              $     4.50    $    1.21
            Fourth Quarter                             $     2.22    $    1.20


     There were approximately 309 stockholders of record of our common stock as
of March 17, 2005.

     It is our present policy not to pay cash dividends and to retain future
earnings to support our growth. We do not anticipate paying any cash dividends
in the foreseeable future.


                                       13
<PAGE>

RECENT ISSUANCES OF UNREGISTERED SECURITIES AND USE OF PROCEEDS FROM
UNREGISTERED SECURITIES

Series A Convertible Debentures

     In September 2002, we issued $650,000 principal amount, 5.75%, four-year
Series A Secured Convertible Debentures due in 2006 to a group of existing
investors and two of our former board members (the "Series A Investors") who
were, at the time of issuance, members of our board. The Company received all of
the proceeds from the sale of the debentures. The debentures are convertible
into the our common stock at a price of $0.112. In addition, we issued to the
purchasers of the debentures warrants to acquire our common stock. We sold
sixty-five units with a principal amount of $10,000 per unit; each unit
contained one warrant to purchase 20% warrant coverage shares of our common
stock at $0.112 per share. The debentures require us to pay interest to the
debenture holders each November and May. The interest is payable in common stock
based on the average closing price of the stock for the ten trading days prior
to the payment date. The debentures are convertible into 5,804,000 shares of our
common stock. The warrants are convertible into 1,161,000 shares of our common
stock. We relied on Section (4)(2) of the Securities Act in issuing the
debentures and warrants without registration. To date, the Series A Investors
have converted an aggregate of $300,000 of the Series A Secured Convertible
Debentures into shares of our common stock.

Series D Convertible Preferred Stock

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

    On October 28, 2004, the Company issued to Wainwright 285,714 warrants (the
"Wainwright Warrants"); these warrants were further payment, in addition to the
$240,600 cash fee described above, for Wainwright's services as placement agent
in connection with the MidSummer Transaction. Warrants in this series are
convertible into Common Stock at an exercise price of $0.70 per share, expire on
October 27, 2009, and are subject to weighted-average anti-dilution protection
for issuances of securities below the conversion price.

  The Company has filed a registration statement with the SEC for resale of the
Common Stock issuable upon conversion of the Series D Preferred Stock, Series A
Warrants, Series B Warrants, and Wainwright Warrants. The Series D Investors
have since exercised all of the Series A Warrants and have paid the exercise
price of $1,946,000 to the Company. Upon receipt of the Series A Warrant
exercise fee, the Company paid Wainwright a cash fee of $60,000 as further
compensation for acting as placement agent on the MidSummer Transaction.

ITEM 6.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
         OF OPERATIONS

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

OVERVIEW

     We are a leading video compression technology firm. We have developed a
proprietary technology platform and video compression/decompression software
("codec") to deliver high quality video at the lowest possible data rates over
proprietary networks and the Internet to set-top boxes, personal computers and
wireless devices. We offer a suite of products and services that encompass our
proprietary compression technology. Our service offerings include customized


                                       14
<PAGE>

engineering, consulting services, technical support and high-level video
encoding. In addition, we license our software products, which include video and
audio codecs, encoding and server software, for use with video delivery
platforms.

COMPANY HISTORY

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

     In June of 1999, The Duck Corporation was merged with and into a wholly
owned subsidiary of Applied Capital Funding, Inc., a public company whose name
was concurrently changed to On2.com Inc. and subsequently changed to On2
Technologies, Inc. At that time, we had developed proprietary technology that
enabled the compression, storage and streaming of high quality video signals
over high bandwidth networks (i.e. broadband). We adopted a business model in
which we would develop our own broadband content network powered by our
proprietary technology. We intended to generate revenue through advertising
sales and electronic commerce. Through the first quarter of 2000, we devoted
substantially all of our efforts to building a content network and enhancing the
technology to operate it. In that time, we made three acquisitions: MetaVisual
Creations Limited ("Metavisual"), Celebrity Interviews ("CII") and Quickband
Networks, Inc. ("Quickband"). Metavisual was a compression technology firm
located in the United Kingdom and had developed its own video compression
technology. That technology is instrumental in the compression technology we
offer today. CII and Quickband were entities that had created, and had the
resources to continue to create, content that we had intended to incorporate
into our content network. Through CII and Quickband, we primarily acquired
produced content, certain distribution arrangements and certain production
personnel.

     By the second quarter of 2000, with the rapid decline in the Internet
industry and the lack of interest in content networks, we determined that
operating a content network would not be profitable for the foreseeable future.
This was evident through rapid declines in Internet advertising and electronic
commerce, the two areas in which we intended to generate our revenues. At no
time did we generate any revenues from the content network. Revenues generated
from any content related assets were the result of legacy arrangements in place
prior to our acquisitions of CII and Quickband. As such, we decided to cease
production on our content network and developed a strategic business model to
distribute our video compression technology to IP based clients as well as those
offering video through proprietary networks and consumer electronics and
wireless devices. This is the business model under which we currently operate.

     In view of the rapidly evolving nature of our business and our limited
operating history, we have limited experience forecasting our revenues and
operating costs. Therefore, we believe that period-to-period comparisons of
financial results are not necessarily meaningful and should not be relied upon
as an indication of our future performance. To date, we have incurred
substantial costs to create technology products and services. As of December 31,
2004, we had an accumulated deficit of $111.3 million. We will continue to incur
costs to develop, introduce and enhance products and services, build brand
awareness and grow 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. As such, these costs may 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-KSB.
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:

o    Revenue recognition
o    Equity-based compensation

     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.


                                       15
<PAGE>

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

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

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

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

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


                                       16
<PAGE>

RESULTS OF OPERATIONS

     Revenue. Revenue for the year ended December 31, 2004 were $3,028,000 as
compared to $3,302,000 for the year ended December 31, 2003. Revenue for the
years ended December 31, 2004 and 2003 were derived from engineering and
consulting services, the sale of software licenses and royalties. The following
table sets forth the allocation of revenues, in terms of percentages, for the
years ended December 31, 2004 and 2003:

                                                2004      2003
                                                ----      ----
     Licensing                                   85%       81%
     Engineering services and support            14%       19%
     Royalties                                    1%
                 Total                          100%      100%


For the years ended December 31, 2004 and 2003, engineering services and support
revenue and software licenses were the significant revenue streams and are
expected to be the significant future revenue streams 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. As we go forward, we expect our revenue from royalties to
become an increasing component of our licensing revenues.

OPERATING EXPENSES

     The Company's operating expenses consist of cost of revenues, research and
development, sales and marketing and general and administrative expenses.
Operating expenses for the year ended December 31, 2004 were $6,518,000 as
compared to $5,665,000 for the year ended December 31, 2003.

     Cost of Revenue. Cost of revenue includes personnel, related overhead
expenses, fees paid for licensed technology, depreciation costs and the
amortization of purchased technology. Cost of revenue was $1,437,000 for the
year ended December 31, 2004 as compared to $1,506,000 for the year ended
December 31, 2003. Cost of revenue decreased $69,000 for the year ended December
31, 2004, due to a $463,000 decrease in amortization of purchased technology,
offset by an increase of $165,000 in equity-based compensation and $235,000 in
additional personnel costs. Purchased technology was fully amortized in 2003.

     Research and Development. Research and development expenses primarily
consist of salaries and related expenses associated with the development and
production of our products and services, related overhead expenses and
depreciation costs. Research and development expenses were $884,000 and
$1,124,000 for the years ended December 31, 2004 and 2003, respectively. The
decrease is primarily attributed to a decrease in personnel and depreciation
associated with research and development. We believe that continued investments
in research and development are necessary to improve our competitive advantage
and we will continue to invest in such costs as considered necessary.

     Sales and Marketing. Sales and marketing expenses consist primarily of
salaries and related costs, tradeshow costs, marketing and promotional costs
incurred to create brand awareness and public relations expenses. Sales and
marketing expenses for the year ended December 31, 2004 were $459,000 as
compared with $527,000 for the year ended December 31, 2003. The decrease is
primarily attributable to a decrease in personnel and tradeshow 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 consist
primarily of salaries and related personnel costs for general corporate
functions including finance, human resources, outside legal and professional
fees, stock listing fees, reserve for uncollectible accounts receivable and
insurance. General and administrative costs for the year ended December 31, 2004
were $3,068,000 as compared with $2,448,000 for the year ended December 31,
2003. The increase is attributable to an increase in legal fees, stock listing
fees and an increase in the reserve for uncollectible accounts receivable
partially offset by decreases in depreciation and insurance costs.

   Equity-based Compensation, During 2004 the Company granted restricted stock
to its employees and directors as compensation. The company issued 870,000
shares of its common stock, with a fair value of $835,000. The related
compensation expense of $835,000 was recognized in 2004.


                                       17
<PAGE>

Interest and Other Income (Expense), Net. Interest and other income (expense)
was $47,000 for the year ended December 31, 2004 as compared with $(2,000) for
the year ended December 31, 2003. Interest and other income (expense) primarily
consists of net gains on marketable equity securities and interest earned on our
cash and cash equivalent balances, offset by interest on capital lease
obligations and indebtedness, and the amortization of debt discounts. The
increase in interest and other income for the year ended December 31, 2004, is
primarily a result of a net gain on marketable equity securities in 2004
partially offset by the E-Coin settlement received in 2003.

      Income Taxes. Income taxes reflect state and local taxes and for the year
ended December 31, 2004 were $2,000 as compared with $10,000 for the year ended
December 31, 2003.

      At December 31, 2004, we had approximately 30 full-time employees. We
expect to hire employees as necessary in order to attain our strategic
objectives.

LIQUIDITY AND CAPITAL RESOURCES

      At December 31, 2004, we had cash reserves of $5,418,000 as compared with
$2,963,000 at December 31, 2003. At December 31, 2004 we had working capital of
$5,466,000 as compared with $3,520,000 at December 31, 2003.

     Net cash used in operating activities was $2,108,000 and $1,980,000 for the
years ended December 31, 2004 and 2003, respectively. The increase in net cash
used in operating activities is primarily attributable to an increase in our net
loss, the receipt of marketable equity securities received as payment of a
license fee, and a decrease in depreciation and amortization, partially offset
by an increase in equity-based compensation, a decrease in accounts receivable
and an increase in accounts payable and accrued expenses.

      Cash flows from investing activities were $70,000 and ($39,000) for the
years ended December 31, 2004 and 2003, respectively. The increase is
attributable to proceeds from the sale of marketable equity securities.

      Net cash provided by financing activities was $4,517,000 and $4,431,000
for the years ended December 31, 2004 and 2003, respectively. The increase is
attributable to proceeds received from the issuance of Series D Preferred Stock
partially offset by decreases in proceeds from the sale of common stock and the
exercise of common stock options and warrants.

      The Company currently has no material commitments for the next 12 months
other than those under operating lease arrangements. These arrangements consist
primarily of lease arrangements for the Company's office space in Clifton Park
and New York City. The aggregate required payments for the next 12 months under
these arrangements are $145,000. 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 2005, we anticipate incurring approximately
$500,000 per month in cash operating costs.

      The Company believes that existing funds are sufficient to fund its
operations through 2005. The Company plans to increase cash flows from
operations principally from increases in revenue generated from its compression
technology services and products. The Company may also pursue additional
financings. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Risk Factors That May Affect Future Operating Results."

      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 mandatorily redeemable by the Company over an
18-month period beginning in October 2006. 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.


                                       18
<PAGE>

      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.

      In July 2001 the Company entered into a Software Development and License
Agreement with Real Networks, Inc. Under terms of the agreement, we agreed to
develop a software plug-in to RealPlayer that would allow consumers to play
files encoded in our VP4 and VP5 compression format using the RealPlayer. In
conjunction with the development of the codec software, we also agreed to
develop a software plug-in to the RealSystem Server that would enable
broadcasters to stream VP4 and VP5 encoded files and a software plug-in to the
RealProducer that would enable users of the RealProducer to encode content using
VP4 and VP5. In order for us to develop the plug-ins described in the
RealNetworks agreement, RealNetworks was required to provide us with certain
development software as well as fulfill certain other obligations. RealNetworks
failed to deliver such software and perform such other obligations. After
honoring the contract from its inception and attempting to resolve the situation
with RealNetworks for over 9 months through business discussions, in May 2002 we
notified RealNetworks that we were terminating the agreement. RealNetworks
responded and disputed our right to terminate the agreement and further claimed
that we were in breach of the agreement. We responded by reiterating our
positions. We have not had any contacts or discussions with RealNetworks since
delivering this response. As a result, we are not generating significant
revenues from the sale of RealNetworks related products.

      The Company believes that our May 2002 termination of the RealNetworks
agreement was effective. However, because the arrangement with RealNetworks was
exclusive in certain respects, should it hereafter be determined that such
termination was not effective, we could be restricted from supporting other
software platforms, including certain components of our own software platforms
and, although we do not believe that it would be the case, we might be found to
have breached the agreement with RealNetworks. Whether we might have liability
to RealNetworks depends on a variety of factors, including whether RealNetworks
met its obligations to us, whether it caused any breach that we might have
committed and whether it otherwise has liability to us in connection with the
agreement.

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

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

     IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

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

LIMITATION ON USE OF NET OPERATING LOSS AND OTHER TAX CREDIT CARRY-FORWARDS

     At December 31, 2004, the Company had available net operating loss
carry-forwards of approximately $80,629,000. The net operating loss
carry-forwards expire at various dates through 2024.

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


                                       19
<PAGE>

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

     The extent of the actual future use of our net operating loss
carry-forwards is subject to inherent uncertainty because it depends on the
amount of otherwise taxable income we may earn. We cannot give any assurance
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.

RISK FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS

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

WE MAY NEED TO OBTAIN ADDITIONAL CASH TO OPERATE OUR BUSINESS, AND TO BE ABLE TO
EXECUTE OUR BUSINESS PLAN AND MAY NOT ACHIEVE PROFITABILITY.

     Since our inception, we have incurred significant losses and negative cash
flow from operations, and as of December 31, 2004, we had an accumulated deficit
of approximately $111.4 million. On February 28, 2005, we had cash reserves of
approximately $8,700,000. During fiscal 2005, 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.

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

WE HAVE A HISTORY OF LOSSES AND NEGATIVE CASH FLOW FROM OPERATIONS AND
ANTICIPATE CONTINUED LOSSES.

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


                                       20
<PAGE>

BECAUSE WE CHANGED OUR STRATEGIC OPERATING MODEL, WE ARE A RELATIVELY NEW
COMPANY AND WE MAY BE UNABLE TO MAKE THE CHANGES NECESSARY TO OPERATE AS A NEW
COMPANY AND EXECUTE OUR BUSINESS PLAN.

     From June 1999 to April 2000, we were primarily engaged in the development
of interactive, broadband web channels with television-quality video. In April
2000, we implemented a new business plan focusing on the distribution of our
video compression technology for use over the Internet and in proprietary
networks, such as those networks, which include set-top boxes. As a result, our
company is a relatively new venture. In transitioning to our new business model,
we have substantially changed our business operations, sales and implementation
practices, customer service and support operations and management focus. If we
are not successful, we may not achieve profitability. To implement our business
plan and achieve profitability, we face new risks and challenges, including a
lack of meaningful historical financial data upon which to plan future budgets,
competition from a new range of sources, the need to develop strategic
relationships and other risks described below.

     Our ability to generate profits will depend on our ability:

      o     to attract customers to use our technology infrastructure and
            support services;

      o     to generate revenues from software licensing and sales, broadband
            streaming services and consulting and engineering services for
            customers wishing to deliver broadband content to end users; and

      o     to control costs.

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 February 23, 2005 of $0.51 to $1.18. We expect
fluctuations to continue in the future for a number of reasons, including:

      o     quarterly variations in our operating results;

      o     competitive announcements;

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

      o     news relating to trends in our markets; and

      o     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.

THE SALE OF SHARES ELIGIBLE FOR FUTURE SALE IN THE OPEN MARKET MAY CAUSE OUR
STOCK PRICE TO DECLINE AND COULD HINDER OUR FUTURE ABILITY TO RAISE CAPITAL.

     Sales of significant amounts of our common stock in the public market in
the future, the perception that sales will occur or the registration of shares
could significantly depress the market price of our common stock or hinder our
future ability to raise capital. We have granted some of the holders of those
securities demand registration rights and anti-dilution. We may also issue
additional shares in acquisitions and may grant additional stock options to our
employees, officers, directors and consultants under the stock option plans.

BECAUSE WE DEPEND ON THE GROWTH OF BROADBAND INTERNET USE, IF GROWTH FOR
BROADBAND DECLINES, OUR REVENUE MAY DECLINE AND WE MAY NOT ACHIEVE
PROFITABILITY.

     We derive, and expect to continue to derive substantially all of our
revenue from the sale of technology and services used over Internet connections
and proprietary networks that require broadband access. If the long-term growth


                                       21
<PAGE>

in demand for broadband access does not grow as we expect, the demand for many
of our products and services may decline or grow more slowly than we expect. As
a result, we may not be able to grow our business, and our revenue and
profitability may decline from current levels.

     Broadband web usage may be inhibited for a number of reasons, such as:

o    inadequate network infrastructure;
o    security concerns;
o    inconsistent quality of service; and
o    availability of cost-effective, high-speed service.

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. These factors would reduce profitability and the price of
our common stock.

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 sure that the steps we have
taken will prevent misappropriation of our proprietary information. In the
future, we may need to go to court to either enforce our intellectual property
rights, to protect our trade secrets or to 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.

     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 incorporated into some of our products
and services. As we continue to introduce new services that incorporate new
technologies, we may be required to license additional technology from others.
We cannot be sure that these third-party technology licenses will continue to be
available on commercially reasonable terms, if at all.

THE BROADBAND VIDEO SERVICES AND TECHNOLOGY MARKETS ARE HIGHLY COMPETITIVE, AND
OUR FAILURE TO COMPETE EFFECTIVELY COULD HURT OUR REVENUE AND REDUCE OUR GROSS
MARGINS AND PROFITABILITY.

     We face significant competition in the market for our technology and
services. In establishing our broadband strategy, we face a number of 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.


                                       22
<PAGE>

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.

POTENTIAL CUSTOMERS MAY NOT PURCHASE OUR TECHNOLOGY AND SERVICES AT ANTICIPATED
LEVELS IF INTERNET CAPACITY CONSTRAINTS CONTINUE TO IMPAIR THE ABILITY OF
CONSUMERS TO ACCESS OUR WEB SITE OR OUR CUSTOMER'S WEB SITES, WHICH COULD HINDER
OUR ABILITY TO GENERATE REVENUE.

     Our success will depend, in large part, upon a robust communications
industry and infrastructure for providing Internet access and carrying Internet
traffic. Lack of the necessary infrastructure or broadband capacity will limit
our ability to generate revenue from encoding and streaming services. The
Internet may ultimately not prove to be a viable commercial medium because of:

      o     inadequate development of the necessary infrastructure such as a
            reliable network backbone;

      o     failure to timely develop complementary products such as high speed
            modems that will enable broadband access for individuals;

      o     delays in the development or adoption of new standards and protocols
            required to handle increased levels of Internet activity; or

      o     increased government regulation.

     If the Internet continues to experience significant growth in the number of
users and the level of use, then the Internet infrastructure may not be able to
continue to support the demands placed on it.

A THIRD-PARTY COULD SEEK TO PREVENT US FROM SUPPORTING CERTAIN SOFTWARE
PLATFORMS, INCLUDING CERTAIN COMPONENTS OF OUR OWN SOFTWARE PLATFORMS.

     As a result of a dispute with RealNetworks, in May 2002 we notified
RealNetworks that we were terminating our July 2001 agreement with Real. Because
the arrangement with RealNetworks was exclusive in certain respects, should it
hereafter be determined that our termination of the agreement was not effective,
we could be restricted from supporting other software platforms, including
certain components of our own software platforms. In such event, we may
encounter difficulty in selling or licensing our products and achieving expected
revenue levels. For more information see "Management's Discussion and Analysis
of Financial Condition and Results of Operations -- Liquidity and Capital
Resources."

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 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.


                                       23
<PAGE>

WE MAY NEVER RECOVER THE MINIMUM ROYALTIES PROVIDED UNDER THE
E-WORLD CONTRACTS AND OUR SOFTWARE MAY NEVER BE INCLUDED IN THE EVD STANDARD.

In June 2003, we entered into two agreements with Beijing E-World. Under those
agreements, we licensed the source code to our video compression (codec)
technology to E-World for use in E-World's videodisk (EVD) and high definition
television (HDTV) products as well as for other non-EVD/HDTV products. We
believed that the license agreements imposed a number of obligations on E-World,
including the requirements that:

      o     Commencing in the first calendar quarter of 2004 and continuing
            through 2005, E-World pay to On2 certain minimum quarterly payments;

      o     E-World cause our software to be included in a new Chinese national
            standard for EVD by December 31, 2003; and

      o     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.

Our agreements with Beijing E-World provide for payment of minimum royalties for
the eight fiscal quarters beginning in the first quarter of 2004. The quarterly
payments are $410,500 for each quarter of 2004 and $837,500 for each quarter of
2005. In May 2004, we commenced arbitration against E-World for failing to pay
the quarterly minimums. In March, 2005, the arbitrator in our dispute with
E-World ruled that E-World was not obligated to pay the minimum quarterly
payments for the previous quarters, because the parties had not jointly
selected, and ported VP6, to a commercial digital signal processor (DSP) to use
in EVD players. The arbitrator's ruling does not clearly state whether we will
be entitled to receive eight quarters of minimum payments if the parties do port
VP6 to a DSP at some time in the future. It is therefore possible that E-World
will not have to pay us any of the minimums if VP6 is not ported by the end of
2005. In that event, since E-World would not be obligated to use our software in
its products, we might never receive any additional royalties, and the only
payment that we could receive under the agreements would be the $750,000 in
unpaid license fees due after the parties have completed the selection of and
porting VP6 to two DSPs. It is possible, however, that the parties will never
agree on the selection of two DSPs, in which case we might never receive any
additional license fees under the agreements.

In addition, the arbitrator ruled that, by submitting On2's software as part of
the proposed EVD standard, E-World had complied with its obligation to have our
software included in the EVD standard. We do not know, however, whether the
Chinese government has accepted On2's software for inclusion in the standard.
Accordingly, E-World may claim that it has no continuing obligation to attempt
to get On2's software included in the EVD standard, and it is therefore possible
that we may never be included in the EVD standard.

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:

      o     discourage potential acquisition proposals;

      o     delay or prevent a change in control; and

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

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

WE HAVE NEVER PAID COMMON STOCK DIVIDENDS AND DO NOT ANTICIPATE PAYING COMMON
STOCK DIVIDENDS IN THE FORESEEABLE FUTURE.

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


                                       24
<PAGE>

ITEM 7.    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 8.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
           FINANCIAL DISCLOSURE

   None.

ITEM 8A.   CONTROLS AND PROCEDURES

     (a)  Evaluation of Disclosure Controls and Procedures

     Our chief executive officer and chief financial officer have evaluated the
effectiveness of our disclosure controls and procedures (as defined in Rules
13a-14(c) and 15d-14(c) of the Securities Exchange Act of 1934), as of the end
of the period covered by this Form 10-KSB for the fiscal year ended December 31,
2004 (the "Evaluation Date"). They have concluded that, as of the Evaluation
Date, our disclosure controls and procedures were operating effectively.

     (b)  Changes in Internal Controls

    There have been no changes in our internal control over financial reporting,
as defined in Rule 13a-15(f) of the Securities Exchange Act, that occurred
during the fiscal quarter ended December 31, 2004, that have materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting.

                                    PART III

ITEM 9.   DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
          COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT

     The information required is incorporated by reference from the sections
entitled "Directors and Executive Officers", "The Board of Directors" and
"Compliance with Section 16(a) of the Exchange Act" contained in the Proxy
Statement for the Annual Meeting of Stockholders to be held on May 5, 2005 (the
"Proxy Statement"), which is to be filed with the Securities and Exchange
Commission.

ITEM 10.  EXECUTIVE COMPENSATION

     The information required is incorporated by reference from the section
entitled "Executive Compensation" contained in the Proxy Statement, which is to
be filed with the Securities and Exchange Commission.

ITEM 11.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
          RELATED STOCKHOLDER MATTERS

     The information required is incorporated by reference from the sections
entitled "Security Ownership of Principal Stockholders" and "Security Ownership
of Executive Officers and Directors" contained in the Proxy Statement, which is
to be filed with the Securities and Exchange Commission.

ITEM 12.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     The information required is incorporated by reference from the section
entitled "Certain Relationships and Related Transactions" contained in the Proxy
Statement, which is to be filed with the Securities and Exchange Commission.


                                       25
<PAGE>

ITEM 13.  EXHIBITS.

 Exhibits

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

                                INDEX TO EXHIBITS

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

 3.1****              Certificate of Incorporation of the Company

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

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

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

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

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

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

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

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

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

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

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

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

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

10.1**                Employment Agreement with Douglas McIntyre

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

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

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

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

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

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

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

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

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

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

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

21*******             Subsidiaries

23.1***************   Consent of Eisner LLP

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

31.2                  Certification of Chief Financial Officer Pursuant to
                      Section 302 of the Sarbanes-Oxley Act of 2002.

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

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

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

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

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

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

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


                                       26
<PAGE>

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


ITEM 14.    PRINCIPAL ACCOUNTANT FEES AND SERVICES

The information required is incorporated by reference from the section entitled
"Proposal To Ratify the Appointment of Eisner LLP" contained in the Proxy
Statement, which is to be filed with the Securities and Exchange Commission.


                                       27
<PAGE>

                                   SIGNATURES

     Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended, the Company has duly caused this report to be
signed on its behalf by the undersigned, thereby duly authorized on March 17,
2005.

ON2 TECHNOLOGIES, INC.


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


     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/ DOUGLAS A. MCINTYRE        Chairman, President and         March 17, 2005
---------------------------     Chief Executive Officer
  (Douglas A. McIntyre)         (Principal Executive Officer)

   /s/ ANTHONY PRINCIPE         Senior Vice President and       March 17, 2005
---------------------------     Chief Financial Officer
    (Anthony Principe)          (Principal Financial Officer)

    /s/ MIKE KOPETSKI           Director                        March 17, 2005
---------------------------
     (Mike Kopetski)

  /s/ WILLIAM A. NEWMAN         Director                        March 17, 2005
---------------------------
   (William A. Newman)

  /s/ J. ALLEN KOSOWSKY         Director                        March 17, 2005
---------------------------
   (J. Allen Kosowsky)

 /s/ DOUGLAS A. MCINTYRE        Director                        March 17, 2005
---------------------------
  (Douglas A. McIntyre)

    /s/ THOMAS WEIGMAN          Director                        March 17, 2005
---------------------------
     (Thomas Weigman)

  /s/ MICHAEL J. ALFANT         Director                        March 17, 2005
---------------------------
   (Michael J. Alfant)



                                       28
<PAGE>




                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

                                                                            Page
                                                                            ----

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

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

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

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

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

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


                                      F-1
<PAGE>

             REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


Board of Directors and Stockholders
On2 Technologies, Inc.

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

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

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


New York, New York
January 21, 2005

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


                                      F-2
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                           CONSOLIDATED BALANCE SHEETS

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

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

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

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

                LIABILITIES AND STOCKHOLDERS' EQUITY

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

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

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

           See accompanying notes to consolidated financial statements


                                      F-3

<PAGE>

                             ON2 TECHNOLOGIES, INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS

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

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

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

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

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

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

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

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



           See accompanying notes to consolidated financial statements


                                      F-4
<PAGE>

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

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

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

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

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

           See accompanying notes to consolidated financial statements

                                      F-5
<PAGE>

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

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

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

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

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

           See accompanying notes to consolidated financial statements

                                      F-6
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS

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

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

                                      F-7
<PAGE>

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

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

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


           See accompanying notes to consolidated financial statements

                                      F-8
<PAGE>

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

(1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

      (a)  Description of the Business

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

     The Company's consolidated financial statements have been prepared assuming
that it will continue as a going concern. The Company has incurred recurring
operating losses and negative operating cash flows since its inception. At
December 31, 2004 and 2003 the Company had cash and cash equivalents and working
capital of $5,418,000 and $2,963,000, respectively. The Company believes that
existing funds are sufficient to fund its operations through 2005. The Company
plans to increase cash flows from operations principally from increases in
revenue generated from its compression technology services, products and
licenses. The Company may also pursue additional financings. However, there are
no assurances that such increases in revenues will be attained or that
additional financings will be successfully consummated.

      (b)  Basis of Presentation

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

      (c) Cash and Cash Equivalents

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

      (d)  Property and Equipment

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


                                      F-9
<PAGE>

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

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

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

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

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

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

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

      (g)  Income Taxes

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

      (h)  Revenue Recognition

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

     The Company's revenue recognition policies are in accordance with Statement
of Position ("SOP") 97-2, "Software Revenue Recognition", as amended by SOP
98-4, "Deferral of the Effective Date of SOP 97-2, Software Revenue
Recognition", SOP 98-9, "Modification of SOP 97-2 with Respect to Certain
Transactions" and other authoritative guidance. Under each arrangement, revenues
are recognized when a non-cancelable agreement has been signed and the customer
acknowledges an unconditional obligation to pay, the products or applications
have been delivered, there are no uncertainties surrounding customer acceptance,
the fees are fixed and determinable, and collection is considered probable.
Revenues recognized from multiple-element software arrangements are allocated to
each element of the arrangement based on the fair values of the elements, such
as product licenses, post-contract customer support, or training. The
determination of the fair value is based on the vendor specific objective
evidence available to the Company. If such evidence of the fair value of each
element of the arrangement does not exist, all revenue from the arrangement is
deferred until such time that evidence of the fair value does exist or until all
elements of the arrangement are delivered.

                                      F-10
<PAGE>

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

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

      (h)  Revenue Recognition  (continued)

      Software Licenses

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

      Professional Services

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

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

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

      (i)  Cost of Revenues

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

                                      F-11
<PAGE>

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

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

      (j)  Software Development Costs

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

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

      (k)  Stock-Based Compensation

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

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

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

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

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

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

                                      F-12
<PAGE>

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


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

      (k)  Stock-Based Compensation  (continued)

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

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

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

         (l)  Net Loss Per Common Share

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

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

         (m)  Use of Estimates

     The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and the disclosure of contingent assets and liabilities
at the date of the financial statements and the reported amounts of revenue and
expenses during the reporting period. Actual results could differ from those
estimates. Assumptions underlying revenue recognition represent sensitive
estimates subject to change.

         (n)  Segment Reporting

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

                                      F-13
<PAGE>

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

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

         (n)  Segment Reporting  (continued)

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

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

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

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

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

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

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

      (o)  Recently Issued Accounting Pronouncements

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

                                      F-14
<PAGE>

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

(2) MARKETABLE EQUITY SECURITIES

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

(3) PROPERTY AND EQUIPMENT

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

                                                          3,043,000        2,990,000

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

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

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


(4) INTANGIBLE ASSETS

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

                                      F-15
<PAGE>

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

(5) ACCRUED EXPENSES

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

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

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

(6) TERM LOAN

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

(7) INCOME TAXES

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

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

 (8) CONVERTIBLE DEBENTURES

      Series A Secured Convertible Debentures

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

                                      F-16
<PAGE>

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

(8) CONVERTIBLE DEBENTURES (continued)

      Series A Secured Convertible Debentures (continued)

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

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

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

(9) STOCKHOLDERS' EQUITY

     (a)    Preferred Stock

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

      Series A Convertible Preferred Stock

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

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

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

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

                                      F-17
<PAGE>

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

(9) STOCKHOLDERS' EQUITY (continued)

      (a) Preferred Stock (continued)

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

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

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

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

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

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

                                      F-18
<PAGE>

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

(9) STOCKHOLDERS' EQUITY (continued)

      (a) Preferred Stock (continued)

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

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

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

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

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

      Series C-II Convertible Preferred Stock

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

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

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

                                      F-19
<PAGE>

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

(9) STOCKHOLDERS' EQUITY (continued)

            (a) Preferred Stock (continued)

             Series C-III Convertible Preferred Stock

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

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

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

      Series C-VI Convertible Preferred Stock

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

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

                                      F-20
<PAGE>

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

(9) STOCKHOLDERS' EQUITY (continued)

            (a) Preferred Stock (continued)

             Series C-VI Convertible Preferred Stock (continued)

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

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

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

           Series D Convertible Preferred Stock

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

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

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

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

                                      F-21
<PAGE>

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

(9) STOCKHOLDERS' EQUITY (continued)

            (a) Preferred Stock (continued)

             Series D Convertible Preferred Stock (continued)

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

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

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

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

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


                                      F-22
<PAGE>

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

(9) STOCKHOLDERS' EQUITY (continued)

      (b)   Common Stock

      Equity-Line of Credit

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

      (c)  Warrants

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

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

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

      (d)  Stock Options

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

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


                                      F-23
<PAGE>

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

(9) STOCKHOLDERS' EQUITY (continued)

      (d)  Stock Options  (continued)

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

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

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

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

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

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

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

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

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

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

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

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

                                      F-24
<PAGE>

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

(9) STOCKHOLDERS' EQUITY (continued)

      (d)  Stock Options  (continued)

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

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

(10) COMMITMENTS AND CONTINGENCIES

(a)         Operating Leases

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

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

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

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

(b)         Employment Agreements

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

(c)         Litigation

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

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

                                      F-25
<PAGE>

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

(10) COMMITMENTS AND CONTINGENCIES (continued)

(d)         Beijing E-world

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

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

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

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

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

                                      F-26
<PAGE>

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


(10) COMMITMENTS AND CONTINGENCIES (continued)

(d)         Beijing E-world (continued)

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

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

      o     Failed to make the quarterly payments;

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

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

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

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

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

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

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

The arbitrator further found that:

      o     the contracts remain in effect; and

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

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

                                      F-27
<PAGE>

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

(10) COMMITMENTS AND CONTINGENCIES (continued)

     (e)  Other Matters

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

(11) RELATED PARTY TRANSACTIONS

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

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

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

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<PAGE>

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

(12) SUBSEQUENT EVENTS

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

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


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