UNITED
      STATES SECURITIES AND EXCHANGE COMMISSIONWashington,
      D.C. 20549Form
      10-K
  (Mark
      One)x
                  ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d)
                    OF
      THE SECURITIES EXCHANGE ACT OF 1934For
      the fiscal year ended December 31, 2008o
                  TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d)
                    OF
      THE SECURITIES EXCHANGE ACT OF 1934.
 
 Commission
      file number 1-15117On2
      Technologies, Inc.(Exact
      name of registrant as specified in its
charter)
 
 Delaware
                    84-1280679(State
      or other jurisdiction of incorporation or organization)
                    (I.R.S.
      Employer Identification No.)3
      Corporate Drive, Suite 100, Clifton Park, NY
                    12065(Address
      of principal executive offices)
                    (Zip
      Code)
  Registrant’s
telephone number, including area code:
 (518)
348-0099
  Securities
to be Registered Pursuant to Section 12(b) of the Act:
 Title
      of Each Class
                Name(s)
      of Each Exchange on Which ListedCommon
      Stock
                NYSE
      Alternext US, Inc.
  Securities
Registered Pursuant to Section 12(g) of the Act:
 NONE
 Indicate
      by check mark if the registrant is a well-known seasoned issuer, as
      defined in Rule 405 of the Securities Act.Yes
      oNo x
  Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act. Yes oNo x
  Indicate
by check mark whether the registrant (1) filed all reports required to be filed
by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for
such shorter period that the registrant was required to file such reports), and
(2) has been subject to such filing requirements for the past 90 days. Yes x o
  Indicate
by check mark if disclosure of delinquent filers in response to Item 405 of
Regulation S-K is not contained herein, and will not will be contained, to the
best of registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this Form
10-K. o
  Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
definition of “accelerated filer,” “large accelerated filer,” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act (Check one):
 Large
      Accelerated Filer o
              Accelerated
      Filer x
              Non-Accelerated
      Filer o
              Smaller
      Reporting Company o
  Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).
  Yes oNo x
  The
aggregate market value of the voting and non-voting common equity held by
non-affiliates of the registrant as of June 30, 2008, was approximately
$88,353,000.
  (APPLICABLE
ONLY TO CORPORATE REGISTRANTS)
  State
the number of shares outstanding of each of the issuer’s classes of common
stock, $0.01 par value (“Common Stock”), as of the latest practicable date:
172,926,115 shares as of February 28, 2009.
  
 
  Table
of Contents
 PART
      IItem
      1.
              
              Business
              
              4Item
      1A.
              
              Risk
      Factors
              
              22Item
      1B.
              
              Unresolved
      Staff Comments
              
              35Item
      2
              
              Properties
              
              35Item
      3
              
              Legal
      Proceedings
              
              35Item
      4.
              
              Submission
      of Matters to a Vote of Security Holders
              
              37PART
      IIItem
      5.
              
              Market
      for Registrant’s Common Equity, Related Stockholder Matters and
      IssuerPurchases
      of Equity Securities
              
              37Item
      6.
              
              Selected
      Financial Data
              
              40Item
      7.
              
              Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
              
              41Item
      7A.
              
              Quantitative
      and Qualitative Disclosures About Market Risk
              
              53Item
      8.
              
              Financial
      Statements and Supplementary Data
              
              53Item
      9.
              
              Changes
      In and Disagreements with Accountants on Accounting and Financial
      Disclosure
              
              53Item
      9A.
              
              Controls
      and Procedures
              
              54Item
      9B
              
              Other
      Information
              
              59PART
      IIIItem
      10.
              
              Directors,
      Executive Officers, and Corporate Governance
              
              60Item
      11.
              
              Executive
      Compensation
              
              60Item
      12.
              
              Security
      Ownership Of Certain Beneficial Owners and Management and Related
      Stockholder Matters
              
              60Item
      13.
              
              Certain
      Relationships and Related Transactions, and Director
      Independence
              
              60Item
      14.
              
              Principal
      Accounting Fees And Services
              
              60PART
      IVItem
      15.
              
              Exhibits
      and Financial Statement Schedules
              
              61
  2
  PART
I
  Forward-Looking
Statements
  This
document contains forward-looking statements concerning our expectations, plans,
objectives, future financial performance and other statements that are not
historical facts. These statements are “forward-looking statements” within the
meaning of the Private Securities Litigation Reform Act of 1995. In most cases,
you can identify forward-looking statements by terminology such as “may,”
“might,” “will,” “would,” “can”, “could,” “should,” “expect,” “foresee,” “plan,”
“anticipate,” “assume,” “believe,” “estimate,” “predict,” “potential,”
“objective,” “forecast,” “goal” or “continue,” the negative of such terms, their
cognates, or other comparable terminology. Forward-looking statements include
statements with respect to:
 ●
                      future
      revenues, income taxes, net income per diluted share, acquisition costs
      and related amortization, and other measures of results of
      operations;●
                      the
      effects of acquiring On2 Finland;●
                      difficulties
      in controlling expenses related to legal compliance matters or internal
      control over financial reporting review, improvement and
      remediation;●
                      possible
      delisting of the Company’s shares of common stock from the American Stock
      Exchange;●
                      risks
      associated with the ineffectiveness of the Company’s internal control over
      financial reporting and our ability to remediate material
      weaknesses;●
                      plans,
      strategies and expected opportunities for growth, increased profitability
      and innovation in 2009 and future years;●
                      the
      financial performance and growth of our business, including future
      international growth;●
                      our
      financial position and the availability of resources;●
                      our
      expectations regarding acquisition activity in 2009 and our focus on the
      integration of completed acquisitions;●
                      the
      availability of credit and future debt and/or equity investment
      capital;●
                      the
      impact of the current global recession on our results from operations and
      financial condition;●
                      future
      competition; and●
                      the
      degree of seasonality in our
revenue.
  These
statements are only predictions, and actual events or results may differ
materially. The forward-looking statements are based on management’s beliefs and
assumptions using information available at the time. We cannot guarantee future
results, levels of activity, performance or achievements. Factors that may cause
actual results to differ are often presented with the forward-looking statements
themselves. Additionally, other risks that may cause actual results to differ
from predicted results are set forth in Item 1A, “Risk Factors” in this Form
10-K.
  Many
of the forward-looking statements are subject to additional risks related to our
need to either secure additional financing or to increase revenues to support
our operations or business or technological factors. We believe that between the
funds we have on hand and the funds we expect to generate, we have sufficient
funds to finance our operations for the next 12 months. We have based our
forecasts on assumptions we have made relating to, among other things, the
market for our products and services, economic conditions and the availability
of credit to us and our customers. If these assumptions are incorrect, we may
not have sufficient resources to fund our operations for this entire period,
however. Additional funds may also be required in order to pursue strategic
opportunities or for capital expenditures. Because of the continuing tightness
in global credit markets, we may not be able to obtain financing on favorable
terms, or at all. In this regard, the business and operations of the Company are
subject to substantial risks that increase the uncertainty inherent in the
forward-looking statements contained in this Form 10-K. In evaluating our
business, you should give careful consideration to the information set forth
below under the caption “Risk
Factors,” in addition to the other information set forth
herein.
  3
  We
undertake no duty to update any of the forward-looking statements, whether as a
result of new information, future events or otherwise. In light of the
foregoing, we caution readers not to place undue reliance on the forward-looking
statements contained in this report.
 Item
      1.
                Business
  Overview
  On2
Technologies is a developer of video compression technology and technology that
enables the creation, transmission, and playback of multimedia in
resource-limited environments, such as cellular networks transmitting to battery
operated mobile handsets or High Definition (HD) video transmitted over the
Internet. We have developed a proprietary technology platform and the On2® Video
VPx family (e.g., VP6, VP7, and VP8) of video compression/decompression
(“codec”) software to deliver high-quality video at the lowest possible data
rates over proprietary networks and the Internet to personal computers, wireless
devices, set-top boxes and other devices. Unlike many other video codecs that
are based on standard compression specifications set by industry groups (e.g.,
MPEG-2 and H.264), our video compression/decompression technology is based
solely on intellectual property that we developed and own ourselves. In
addition, through our wholly-owned subsidiary, On2 Technologies Finland Oy, we
license to chip and mobile handset manufacturers, and other developers of
multimedia consumer products the hardware and software designs that make the
encoding or decoding of video possible on mobile handsets, set top boxes,
portable media players, cameras and other devices. We also provide integration,
customization and support services to enable high quality video on, and faster
interoperability between devices.
  In
2004, we licensed our video compression technology to Macromedia, Inc. (now
Adobe Systems Incorporated) for use in the Adobe ® Flash® multimedia player. In
anticipation of Adobe using our codec in the Flash platform, we launched our
business of developing and marketing video encoding software for the Flash
platform. Flash encoding has become an increasingly important part of our
business. In December 2008, we entered into a license agreement with Sun
Microsystems for the use of our video compression technology in the JavaFX®
platform and anticipate further growth for our encoding and transcoding
businesses as a result of this transaction.
  In
addition, we have also dedicated significant resources to marketing customized
software to device manufacturers that enable their devices to decode Flash and
JavaFx content.
  We
offer the following suite of products that incorporate our proprietary
compression technology:
 ●
                Video
      codecs, including On2 VP6®, VP7TM and VP8TM;●
                Flix®
      Pro – an application targeted at web developers for encoding and
      transcoding video for delivery over the Internet to either Flash or JavaFX
      players.●
                Flix
      Publisher – a set of web browser plug-ins that enable live capture,
      encoding, and transcoding of video along with posting on web sites or live
      streaming via the Adobe Flash Media Server;●
                Flix
      Engine – a backend server side transcoding platform used by a large number
      of video sites to repurpose their video for playback over the internet and
      devices; and●
                Flix
      DirectShow SDK – a set of libraries that enable software vendors to
      create, edit, and deliver video content for Flash or
    JavaFX;
  4
  We
also offer the following suite of hardware and software products that
incorporate our mobile video technology:
 ●
                On2
      VP6, VP7 and VP8 software video codec designs;●
                MPEG-4,
      H.263, H.264 / AVC and VC-1 hardware and software video codec
      designs;●
                Hardware
      and software JPEG codecs supporting up to 16MP;●
                AMR-NB
      and Enhanced aacPlusTM audio codecs;●
                Pre-
      and post-processing technologies (such as cropping, rotation, scaling)
      implemented in both software and hardware;●
                File
      format and streaming components; and●
                Recorder
      and player application logic.In
      addition, we offer the following services in connection with both our
      proprietary video compression technology and our mobile video
      technology:●
                Customized
      engineering and consulting services;●
                On2
      Flix Cloud, our pay-as-you go encoding service; and●
                Technical
      support.
  Most
of our customers are hardware and software developers who use our products and
services chiefly to provide the following video-related products and services to
end users:
 TYPE
      OF CUSTOMER
                  APPLICATION
                
                EXAMPLESVideo
      and Audio Distribution over Proprietary Networks
                ●
                Providing
      video-on-demand services to residents in multi-dwelling units
      (MDUs)●
                Video
      surveillanceVideo
      and Audio Distribution over IP- based Networks (Internet)
                ●
                Video-on-demand●
                Teleconferencing
      services●
                Video
      instant messaging●
                Video
      for Voice-over-IP (VOIP) servicesConsumer
      Electronic Devices
                ●
                Digital
      video players●
                Digital
      video recorders●
                Mobile
      TV●
                Video
      Camera Recorder●
                Mobile
      Video PlayerWireless
      Applications
                ●
                Delivery
      of video via wireless networks, e.g., satellite, WLAN, WIMAX, and
      cellular●
                Providing
      video record and playback capability to battery-operated handsets such as
      mobile phones, MIDs, PDAs, and
PMPs
  5
  User-Generated
      Content (“UGC”) Sites
                  ●
                  Providing
      video encoding software for use on UGC site operators’
    servers●
                  Providing
      encoding software for users who are creating UGC●
                  Providing
      transcoding software to allow UGC site operators to convert video from one
      format to another
  On2
Finland Acquisition
  On
November 1, 2007, we completed the acquisition of all of the share capital of
Hantro Products Oy (now On2 Technologies Finland Oy and hereinafter “On2
Finland”), a Finnish corporation. Under the exchange agreement pursuant to which
the acquisition was completed, On2 Finland’s security holders each exchanged all
of the outstanding capital shares of On2 Finland for a net total consideration
of $6,608,102 in cash and 25,438,817 shares of our common stock. Because the
closing share price was less than $1.50, we issued a set number of 25,438,817
shares, as specified in the share exchange agreement. The 25,438,817 shares so
issued represented approximately 22% of our outstanding common stock as of
November 1, 2007. In addition, in July and August of 2008 we issued an
additional 12,500,000 shares of our common stock to the On2 Finland security
holders as required in the exchange agreement because On2 Finland’s net revenue
for the fiscal year 2007 exceeded €9,000,000.
  On2
Finland, currently a wholly-owned subsidiary of On2, employs 68 staff members
and has a global sales network with satellite offices in Taiwan and China. On2
Finland’s headquarters and research and development teams are based in Oulu,
Finland.
  Development
of Our Business
  We
detail the history and evolution of our business under the section “Management’s
Discussion and Analysis of Financial Condition and Results of Operations –
Company History.”
  Business
Strategy
  Our
goal is to be a premier provider of video compression software and hardware
technology and compression tools. We are striving to achieve that goal and the
goal of building a stable base of quarterly revenues by implementing the
following key strategies:
 ●
                Using
      the success of current customer implementations of our On2 Video
      technology (e.g., Adobe Flash, Skype, Move Networks) and other
      high-profile customers (e.g., Sun Microsystems) to increase our brand
      recognition, promote new business and encourage proliferation across
      platforms;●
                Continuing
      our research and development efforts to improve our current codecs and
      developing new technologies that increase the quality of video technology
      and improve the experience of end users;●
                Continuing
      our research and development efforts to design hardware decoders and
      encoders that minimize the space used on a chip and to continue to improve
      the quality of those products;●
                Updating
      and enhancing our existing consumer products, such as the Flix line and
      embedded technologies;●
                Providing
      pay-as-you-go encoding in our Flix Cloud software-as-a-service offering
      using Amazon EC2®;●
                Employing
      flexible licensing strategies to offer customers more attractive business
      terms than those available for competing
  technologies;
  6
  ●
                  Attempting
      to negotiate licensing arrangements with customers that provide for
      receipt of recurring revenue and/or that offer us the opportunity to
      market products that complement our customers’ implementations of our
      software; and●
                  Using
      the expertise of On2 Finland to develop hardware designs of our
      proprietary codecs and optimizations for embedded processors that will
      allow those products to be easily implemented on
  devices.
  We
earn revenue chiefly through licensing our software technology and hardware
designs and providing specialized software engineering and consulting services
to customers. In addition to up-front license fees, we often require that
customers pay us royalties in connection with their use of our software and
hardware products. The royalties may come in the form of either a fee for each
unit of the customer’s products containing our software products or hardware
designs that are sold or distributed or payments based on a percentage of the
revenues that the customer earns from any of its products or services that use
our software. Royalties may be subject to guaranteed minimum amounts (e.g.,
minimum annual royalties) and/or maximum amounts (e.g., annual caps) that may
vary substantially from deal to deal.
  We
also sell additional products and services that relate to our existing
relationships with licensees of our video codec products. For instance, if a
customer has licensed our software to develop its own proprietary video format
and video players, we may sell encoding software to users who want to encode
video for playback on that customer’s players, or we may provide engineering
services to companies that want to modify our customer’s software for use on a
specific platform, such as a cell phone. As with royalties or revenue share
arrangements, complementary sales of encoding software or engineering services
should allow us to participate in the success of our customers’ products. For
instance, if a customer’s video platform does well commercially, we would expect
there to be a market for encoding software and/or engineering services in
support of that platform.
  We
recognize the strategic importance of implementing our proprietary VPx video
codecs in hardware and developing highly optimized software libraries for
operation on the digital signal processors (DSPs) used in embedded devices. The
On2 Finland acquisition has allowed us to increase the resources devoted to
making it easier for our customers to implement our codecs across platforms.
Prior to the acquisition, we had a limited selection of off-the-shelf optimized
software that we could license to customers who were interested in implementing
our codecs on devices. We therefore regularly required customers to pay us to
customize our software, or to perform the customizations themselves, or to hire
third-party consultants to perform the customizations. The On2 Finland
acquisition has given us access to additional experienced internal resources to
help us to develop hardware and software implementations that will allow
customers to implement our codecs quickly and efficiently on embedded
devices.
  As
part of our strategy to develop complementary products that could allow us to
capitalize on our customers’ success, in 2005 we completed the acquisition from
Wildform, Inc., of its Flix line of encoding software. The Flix software allows
users to prepare video and other multimedia content for playback on the Adobe
Flash player, which is one of the most widely distributed multimedia players.
Adobe is currently using our VP6 software as the video engine for Flash 8 video,
which is used in the Flash 8 player and all of the subsequent Flash players that
have been released to date. We believed that there was an opportunity for us to
sell Flash encoding software to end users, such as video professionals and web
designers, and to software development companies that wish to add Flash encoding
functionality to their software. We concluded that we could best take advantage
of the anticipated success of Flash by taking the most up-to-date Flash encoding
software straight from the company that developed VP6 video and combining it
with the already well-known Flix brand, which has existed since the advent of
Flash video and has a loyal following among users. Following Adobe’s
announcement in late 2007 of support for the H.264 codec in its Flash 9 player,
we announced support for H.264 in our Flix products and have been adding support
for additional codecs. These additional features have helped to make the Flix
product line a more complete encoding solution for users.
  A
primary factor that will be critical to our success is our ability to improve
continually on our current proprietary video compression technology, so that it
streams the highest-quality video at the lowest transmission rates (bit rate).
We believe that our video compression software is highly efficient, allowing
customers to stream good quality video (as compared with that of our
competitors) at low bit rates (i.e., over slow connections) and unsurpassed
high-resolution video at higher bit rates (i.e., over broadband
connections).
  7
  Another
factor that may affect our success is the relative complexity of our proprietary
video compression software compared with other compression software producing
comparable compression rates and image quality. Software with lower complexity
can run on a computer chip that is less powerful, and therefore generally less
expensive, than would be required to run software that is comparatively more
complex. In addition, the process of getting software to operate on a chip is
easier if the software is less complex. Increased compression rates frequently
result in increased complexity. While potential customers desire software that
produces the highest possible compression rates while producing the best
possible decompressed image, they also want to keep production costs low by
using the lowest-powered and accordingly least expensive chips that will still
allow them to perform the processing they require. We believe that the encoding
and decoding functions of our video compression software are less complex than
our competitors. In addition, in some applications, such as mobile devices,
constraints such as size and battery life rather than price issues limit the
power of the chips embedded in such devices. Of course, in devices where a great
deal of processing power can be devoted to video compression and decompression,
the issue of software complexity is less important. In addition, in certain
applications, savings in chip costs related to the use of low complexity
software may be offset by increased costs (or reduced revenue) stemming from
less efficient compression (e.g., increased bandwidth costs).
  One
of the most significant recent trends in our business is our increasing reliance
on the success of the product deployments of our customers. As referenced above,
our license agreements with customers increasingly provide for the payment of
license fees that are dependent on the number of units of a customer’s product
incorporating our software that are sold or the amount of revenue generated by a
customer from the sale of products or services that incorporate our software. We
have chosen this royalty-dependent licensing model because, as a small company
competing in a market that offers a vast range of video-enabled devices, we do
not have the product development or marketing resources to develop and market
end-to-end video solutions. Instead, our codec software is primarily intended to
be used as a building block for companies that are developing end-to-end video
products and/or services.
  Under
our agreements with certain customers, we have retained the right to market
products that complement those customers’ applications. These arrangements allow
us to take advantage of our customers’ superior ability to produce and market
end-to-end video products, while offering those customers the benefit of having
us produce technologically-advanced products that should contribute to the
success of their applications. As with arrangements in which we receive
royalties, the ability to market complementary products can yield revenues in
excess of any initial, one-time license fee. In instances where we have licensed
our products to well-known customers, our right to sell complementary products
may be very valuable. But unlike royalties, which we receive automatically
without any additional effort on our part, the successful sale of complementary
products requires that we effectively execute an end-user product development
and marketing program.
  We
believe that we have adopted the licensing model most appropriate for a business
of our size and expertise. However, a natural result of this licensing model is
that the amount of revenue we generate is highly dependent on the speed with
which our customers deploy products containing our technology and the success of
those deployments. In certain circumstances, we may decide to reduce the amount
of up-front license fees and charge a higher per-unit royalty. If the products
of customers with whom we have established per unit royalty or revenue sharing
relationships or for which we expect to market complementary products do not
generate significant sales, these revenues may not attain significant levels.
Conversely, if one or more of such customers’ products are widely adopted, our
revenues will likely be enhanced.
  We
are continuing to participate in the trend towards the proliferation of user
generated video content on the web. As Internet use has grown worldwide and
Internet connection speeds have increased, sites such as MySpace, Facebook, and
YouTube, which allow visitors to create and view user generated content (“UGC”),
have sprung up and seen their popularity soar. Although initially consumer
generated content consisted primarily of text content and still photographs, the
availability of relatively inexpensive digital video cameras and video-enabled
mobile phones, the growth in the number of users with access to broadband
Internet connections, and improvements in video compression technology have
contributed to a rapid rise in consumer-created video content. Weblogs (blogs)
and podcasts (broadcasts of audio content to iPod® and MP3 devices) have evolved
to include video content. The continued proliferation of UGC video on the
Internet and the popularity of Adobe Flash video on the web have had a positive
effect on our business and have given us the opportunity to license Flash
encoding tools for use in video blogs, video podcasts, and to UGC sites or to
individual users of those services.
  8
  We
continue to experience an increased interest by UGC site operators and device
manufacturers to allow users to access UGC content by means of mobile handsets,
set-top boxes, and other devices. Many of the UGC sites use Flash VP6 video, and
while VP6 video is available on a vast number of PCs, it is still only available
on a limited number of chip-based devices, such as mobile devices and set top
boxes. We are therefore witnessing demand on two fronts: (1) demand to integrate
Flash 8 video onto non-PC platforms, and (2) until most devices can play Flash 8
content, demand to provide transcoding software that allows Flash 8 content to
be decoded and re-encoded into a format (such as the 3GPP standard) that is
supported on devices. We are actively working to provide solutions for both of
these demands and plan to continue to respond as necessary to the evolution and
migration of Flash video.
  H.264
continues to rise as a competitor with the Company’s VPx products in the video
compression field. H.264 is a standards-based codec that is the successor to
MPEG-4. We believe that our technology is superior to H.264, and that we can
offer significantly more flexibility in licensing terms than customers get when
licensing H.264. H.264 has nevertheless gained significant adoption by potential
customers because, as a standards-based codec, it has the advantage of having
numerous developers who are programming to the H.264 standard and developing
products based on that standard. In addition, a number of manufacturers of
multimedia processors have done the work necessary to have H.264 operate on
their chips, which makes H.264 attractive to potential customers who would like
to enable video on devices. For example, Apple Inc. uses H.264 in its QuickTime®
player and has thus chosen H.264 for the current generation of video iPods.
Finally, there is already a significant amount of professional content that has
been encoded in H.264. These advantages may make H.264 attractive to potential
customers and allow them to implement a solution based on H.264 with less
initial development time and expense than a solution using On2’s proprietary
video codecs might require. In addition, there are certain customers that prefer
to license standards-based codecs. We continue to believe that VP6 will be an
important part of the Flash video ecosystem for three reasons: (1) Adobe has in
the past provided backwards compatibility with all generations of Flash video
codecs; (2) VP6 has certain performance advantages over H.264 (e.g., HD VP6
content may be played back on a lower-powered processor than HD H.264 content);
and (3) there is a vast amount of existing VP6 content that consumers want on
portable and mobile devices.
  The
market for digital media creation and delivery technology is constantly changing
and becoming more competitive. Our strategy includes focusing on providing our
customers with video compression/decompression technology that delivers the
highest possible video quality at the lowest possible data rates. To do this, we
devote a significant portion of our engineering capacity to research and
development. We also are devoting significant attention to enabling our codecs
to operate on a wide array of chips, both in software and in hardware. We
continue to cultivate relationships with chip companies to enable those
companies to integrate our codecs on chips. By increasing support for our
technology on the chips that power embedded devices, we hope to encourage use by
customers who want to develop video-enabled consumer products in a short
timeframe.
  A
continuing trend in our business is the growing presence of Microsoft
Corporation as a significant competitor in the market for digital media creation
and distribution technology. In 2007, Microsoft released SilverlightTM, a rich
Internet application that allows users to integrate multimedia features, such as
vector graphics, audio and video, into web applications. Silverlight may compete
directly with Flash. If Silverlight gains market share at the expense of Flash,
it could have a negative impact on our Flix business. In addition, Microsoft VC1
format also competes in the marketplace with H.264 and our VPx technologies. We
believe that our VPx technologies have the same advantages over VC1 as they do
over H.264.
  Although
we expect that competition from Microsoft, H.264 developers, and others will
continue to intensify, we expect that our video compression technology will
remain competitive and that our relatively small size will allow us to innovate
in the video compression field and respond to emerging trends more quickly than
monolithic organizations like Microsoft and the MPEG consortium. We focus on
developing relationships with customers who find it appealing to work with a
smaller company that is not bound by complex and rigid standards-based licenses
and fee structures and that is able to offer sophisticated custom engineering
services. Moreover, as broadcast networks, web portal operators and others
distribute ever-increasing amounts of high-resolution video over the Internet,
the cost savings arising from the use of our high quality video should offer an
increasing advantage over lower quality competitive technology.
  9
  Another
one of our primary businesses is the development and marketing of digital
electronic hardware designs (known as register transfer level designs or RTL) of
video and audio codecs to manufacturers of computer chips and multimedia
devices. A licensee of our RTL design might use that product to implement a
video decoder on the licensee’s chip, and the decoder would be built into the
circuitry of the licensee’s chip. One of the factors affecting our hardware
business is our ability to develop efficient RTL designs that minimize the
physical area of a chip devoted to our designs. Increasing the surface area of a
chip increases the manufacturer’s production costs. Our ability to produce RTL
designs that require less surface area than our competitors’ designs results in
lower production costs for our licensees and gives us a competitive
advantage.
  Another
factor affecting our hardware business is our reputation for producing reliable
products that have been thoroughly tested, are accompanied by good
documentation, and are supported by a strong technical support team. Chip and
device manufacturers that are potential customers for our hardware products
develop the products with which they will integrate our RTL designs. Our
technology is hard-wired into chip circuitry rather than loaded as software. In
connection with high volume chip production, the per-unit price of a specialized
chip that has had multimedia support built into the chip can be substantially
less than the costs of using a more powerful software-upgradable digital signal
processor (DSP). However, any errors in the software operating on a DSP can be
relatively easily corrected through a software upgrade or patch, while errors
that have been hardwired into a circuit are more difficult, and may be
impossible, to correct. Because customers for our RTL designs will invest a
great deal of time and money into the designs, our reputation as a
well-established provider of reliable, well-supported RTL designs is an
important factor in our continuing success.
  As
multimedia content has proliferated on the Internet, manufacturers of mobile
devices such as cell phones and personal media players (PMPs) have expanded
their product lines to support playback and creation of that content. As noted
above, in general, manufacturers have two options to add multimedia support to
their devices. They can use either a specialized chip that has multimedia
support hard-wired into it (RTL) or a more powerful DSP that can run software to
provide the necessary multimedia functions. Hardware implementations that
require RTL designs such as ours offer a number of advantages over DSPs with
software layers:
 ●
                RTLs
      are cheaper to produce in high volumes;●
                They
      use less energy, which prolongs battery life of mobile
      devices;●
                They
      produce less heat, which has important implications for, among other
      things, circuit design; and●
                They
      allow for simultaneous encoding and decoding of HD video
      content.But
      there are also disadvantages to hardware implementations of multimedia
      tools:●
                Initial
      implementation costs are high; and●
                Hardware
      implementations are generally not upgradeable.Similarly,
      software-upgradable DSPs offer certain advantages:●
                Modifying
      software to operate on a DSP is easier and less expensive then
      implementing the software in hardware, reducing initial project costs and
      speeding deployment;●
                DSPs
      do not require costly re-designs and re-tooling to operate new software;
      and●
                They
      are more easily upgradeable.
  10
  But they
also have certain disadvantages:
 ●
                Per-chip
      costs are higher than pure hardware solutions as volumes increase;
      and●
                The
      increased processor power required to operate diverse software increases
      heat and power consumption.
  Manufacturers
that want to maintain the ability to upgrade mobile devices and PMPs to support
new multimedia software may opt for DSPs rather than hardware solutions, which
could impact our business of licensing hardware codecs. Nevertheless, we believe
that even if manufacturers do choose to use DSPs in their devices, it is likely
that many will continue to implement hardware codecs alongside the DSPs to take
advantage of the efficiency of those hardware implementations. In addition,
support for DSPs on multimedia devices would have the benefit of making those
devices more easily upgraded to new generations of our proprietary codecs. We
are continuing to monitor this trend and make the adjustments to our business
model necessary to address changing markets.
  Our
Technology, Products and Services
  We
have designed our software technology to deliver the highest-quality video at
the lowest possible data rates and to encode (compress) and decode (decompress)
video on comparatively low-powered chips suitable for consumer electronics
products. We currently develop and license a number of products related to our
video codecs.
  We
also develop and license a number of products used for encoding video in the
Adobe Flash video format, which is used in Flash video players. We market these
products, which include software packages for end users and software development
kits for use by developers, as part of our Flix product line. The licensing of
our Flash encoding products has accounted for 27%, 41%, and 64% of our revenue
for the fiscal years ended December 31, 2008, 2007, and 2006,
respectively.
  Finally,
our On2 Finland embedded product line consists of hardware (RTL) and software
implementations of video and audio codecs that are largely intended to be
operated on mobile cellular devices. The On2 Finland products are highly
optimized and efficient designs aimed at minimizing both implementation costs
and energy usage on devices.
  VP6
Codec
  We
launched the Beta version of our VP6 series of codecs in May 2003 and the
official version in October 2003, and we have since released updated versions
VP6.1 and VP6.2. VP6 represented a significant improvement over its
predecessors, offering a 40% improvement in image quality and a 50% increase in
playback speed over the previous version of On2’s technology, VP5. VP6 improved
upon all the features contained in VP5 and supports real-time encoding at full
D1 resolution. Because Adobe/Macromedia is currently using VP6 in its Flash 8
video format, VP6 has become our most widely-deployed technology. Because of
VP6’s broad use, and despite the fact that it is not our latest technology, we
continue to make improvements to the VP6 technology. It also consistently
outperforms Windows Media 9 based on tests of Peak Signal-to-Noise Ratios (PSNR)
measured at data rates ranging from dial-up (28.8 Kbps) to DVD and HD (6 to 8
Mbps). Since our introduction of VP6, we have ported it to the following digital
signal processors (DSPs) across a range of resolutions: Texas Instruments’
TMS320C64x, Analog Devices’ Blackfin, ARC International’s ARCTangent, Equator
Technologies’ MAP-CA and the ARM 7 and ARM 9.
  VP7
Codec
  We
introduced the official version of our VP7 codec in early March 2005. Like prior
versions of the codecs, VP7 shows a marked improvement over its predecessors,
producing up to a 30% image quality improvement over VP6. Like its predecessor,
in objective PSNR tests, VP7 shows better performance than its main competitors,
including Windows Media 9, Real 10, and MPEG-4-compatible codecs at data rates
ranging from dial-up (28.8 Kbps) to DVD and HD. In addition, VP7 regularly
outperforms all but the best implementations of H.264 across data-rates and is
highly competitive with the most advanced H.264 implementations. As with VP6,
VP7 also supports real-time encoding at full D1 resolution. We have made
significant progress – much of it in 2006 – in having VP7 implemented on DSPs,
and VP7 currently operates on a number of chips across a range of
resolutions.
  11
  VP8
Codec
  In
September, 2008 we introduced the newest version of our codecs – VP8. Like its
predecessors, VP8 offers considerable advances in our codecs with increased
quality and lower complexity than VP7. VP8 is designed specifically to be easily
implemented in hardware and on ARM processors that are commonly used in mobile
handsets. It efficiently uses all the cores available on today’s multi-core
systems and extends our performance advantage over all of our main competitors,
including Windows Media 9, Real 10, and all of the MPEG-4-compatible codecs at
data rates ranging from dial-up (28.8 Kbps) to DVD and HD.
  Integrations
of On2 Codecs on Chips
  VP6,
VP7 and earlier generations of On2’s codecs have been ported onto a variety of
digital signal processing chips (DSPs) and other integrated circuits. DSPs,
video chips (video ICs), and systems-on-a chip (SOCs) are the computer
processing chips and components frequently used in consumer products such as
DVDs, portable media players, mobile phones, set-top boxes and personal digital
assistants. The VP6 and VP7 decoders currently run on a wide range of DSPs at
various resolutions, and the VP6 encoder operates on several DSPs as well. We
and several third parties are also working to port the VP6 and VP7 decoders and
encoders to a number of DSPs and other chips. Our recent high-profile
implementations by Adobe/Macromedia, Skype and others have greatly increased the
incentive for chip manufacturers to quickly implement our codecs on their chips.
We believe that by porting to these platforms, we will facilitate the use of
On2’s codec in mobile phones, portable media players, set-top boxes and other
consumer device deployments where the availability of low-cost chips is
important. Because we only recently released VP8, we have not yet ported it to
the same range of chips as we have our VP6 and VP7 technologies. We have
successfully ported VP8 to the ARM 9 processor, however, and anticipate that we
can take advantage of much of the work we have done in porting VP7 to numerous
chips, thus potentially reducing the time required to port VP8 to those
chips.
  Flix
Product Lines and Services
  In
2005, we entered the business of selling video encoding software that allows
users to encode video in the Adobe Flash 8 format, which uses On2’s VP6
technology. The licensing of our Flash encoding tools accounted for 27%, 41%,
and 64% of our revenue for the fiscal years ended December 31, 2008, 2007, and
2006, respectively.
  We
launched our encoding software business as part of our strategy to capitalize on
our customers’ successful deployments of products that incorporate our
technology. In particular, we believed that the inclusion of our technology in
the widely-distributed Adobe Flash player represented a significant opportunity
for us. We acquired the Flix line of Flash encoding software from Wildform, Inc.
to further our plan for rapidly establishing a significant business of marketing
Flash encoding tools. We now license the following applications targeted at
different market segments:
 ●
                Flix
      Pro – an application targeted at web developers for encoding and
      transcoding video for delivery over the Internet to either Flash or JavaFX
      players;●
                Flix
      Publisher – a set of web browser plug-ins that enable live capture,
      encoding, and transcoding of video along with posting on web sites or live
      streaming via the Adobe ® Flash® Media Server;●
                Flix
      Engine – a backend server side transcoding platform used by a large number
      of video sites to repurpose their video for playback over the Internet and
      devices;●
                Flix
      DirectShow SDK – a set of libraries that enable software vendors to create
      edit and deliver video content for Flash or JavaFX;
  and
  12
 
 ●
                  Flix
      Cloud, our pay-as-go hosted service that enables broadcasters, UGC sites,
      content owners and providers to encode their video
  files.
  We
believe that the prospects for our Flix encoding business are closely related to
the success of Adobe’s Flash player and Sun’s JavaFX player. Although the
increasing worldwide adoption of Flash and JavaFX players may not ensure the
success of our Flash encoder business, the failure of either of these
initiatives would almost certainly have a serious, negative impact on our sales
of encoding software.
  HantroTM8190 Video
Decoder
  The
Hantro 8190 multi-format hardware provides format and resolution support to
enable many types of video applications. The 8190 is significantly more power
efficient than any commercially available DSP based solution and encompasses the
latest in hardware design techniques to deliver improved performance and power
utilization in a minimal silicon area. The 8190 utilizes dynamic clock gating,
which de-activates the clock for functions when they are not required, thereby
reducing power consumption. When combined with the Hantro 6280, the 8190 offers
a full codec solution. The 8190 supports numerous formats including the H.263,
SparkTM, MPEG-4, H.264, VC-1 and JPEG. The 8190 supports resolutions from QCIF to
1080p.
  Hantro
7190 Video Decoder
  The
Hantro 7190 multi-format hardware provides format and resolution support to
enable many types of video applications. The 7190 is significantly more power
efficient than any commercially available DSP based solution and encompasses the
latest in hardware design techniques to deliver improved performance and power
utilization in a minimal silicon area. The 7190 utilizes dynamic clock gating,
which de-activates the clock for functions when they are not required, thereby
reducing power consumption. When combined with the Hantro 6280, the 7190 offers
a full codec solution. The 7190 supports numerous formats, including the H.263,
Spark, MPEG-4, H.264, VC-1 and JPEG. The 7190 supports resolution forms QCIF to
720p.
  Hantro 7280 Video
Encoder
  The
Hantro 7280 multi-format encoder core processes up to SXGAresolution video at 30
frames per second. The 6280 is designed for battery operated devices such as
mobile phones and digital cameras. The 7280 combines ultra low power consumption
with high resolution and broad format support. The 7280 incorporates a
proprietary indexed full search motion estimation algorithm, which reduces clock
cycle requirement without affecting video quality. When combined with the Hantro
8190 or the Hantro 7190, the 7280 offers a full codec solution. The 7280
supports numerous formats, including the H.263, MPEG-4, H.264 and JPEG and
supports resolutions from QCIF to 720p.
  Hantro 8270 Video
Encoder
  The
Hantro 8270 H.264 encoder core processes up to 1080p resolution video at 30
frames per second. The 8270 is designed for devices such as mobile phones,
digital cameras, web cameras, and surveillance solutions. The 8270 incorporates
a proprietary indexed full search motion estimation algorithm, which reduces
clock cycle requirement without affecting video quality. When combined with the
Hantro 8190 or the Hantro 7190, the 8270 offers a full codec solution. The 8270
supports H.264 simple, main and high profiles and JPEG still
images.
  Hantro
9100 Multi-Format Decoder
  The
Hantro 9100 multi-decoder combines three of the most dominant video formats used
to deploy video on the web. The 9100 is optimized for integration with ARM
Powered® mobile handsets, providing chip and device manufacturers with a cost
efficient off-the-shelf solution for supporting Flash video. The 9100 reduces
the power required for video playback and saves battery life. The 9100 delivers
CIF 30fps performance in approximately 100MHz on ARM9 CPUs for Spark based Flash
video, and 170MHz in ARM11 for On2 VP6 and H.264 codecs. The 9100 multi-decoder
achieves VGA resolution full motion playback by using the ARM NEON media
processing extensions to the Cortex-A8.
  13
  Hantro 8100
Sorenson
  The
Hantro 8100 is a fully optimized Sorenson Spark decoder for enabling Flash video
playback in handheld devices. The 8100 is comparable to the Hantro 4100 H.263
decoder in quality and performance but is mobile compatible for Flash 6 and
Flash 7 based video content. As a standard ANSI C implementation, the 8100 is
available for various processor cores such as the ARM, Intel, MIPS and ARC, and
the optimized versions are available for ARM11 (SIMD) and Intel PXA
(MMX).
  Hantro
7100 VC-1 Decoder
  The
Hantro 7100 decoder enables support for capability classes from A to C at
various IP-IRDs in ARM9 and ARM11 CPU based devices. The 7100, therefore,
fulfills the requirements set by the upcoming DVB-H standard for mobile TV. In
addition, the 7100 complies with the widely adopted Microsoft Windows Media
Video (WMV) format and is suitable for implementing a full Windows Media player
in a wireless handheld device. The 7100 is a pure ANSI C implementation,
allowing portability to different processor cores such as Intel, ARC and
MIPS.
  Hantro
6200 H.264/AVC Encoder
  The
Hantro 6200 encoder is fully optimized for ARM9 and ARM11 SIMD instruction sets.
It may also be complied and further optimized for any typical mobile processor
core such as Intel, ARC and MIPS when used as a pure ANSI C implementation the
code. The 6200 supports four different encoding modes, allowing the optimal
adaptation to available processing power. The 6200’s lowest encoding level has
the least complexity and therefore places a minimal load on the CPU, whereas the
highest level, providing the best video quality, has the highest requirement for
CPU resources. The 6200 is delivered with On2 Finland’s standard Application
Programming Interface (API) or an operating system specific interface
implementation such as Symbian MDF, Microsoft DirectShow, and OpenMax
IL.
  Hantro
6100 H.264/AVC Decoder
  The
Hantro 6100 decoder is targeted for implementing 3GPP, DVB-H and DMB based video
applications in a mobile handset. The 6100 is fully compliant with H.264
Baseline profile and has been thoroughly tested for interoperability in IMTC and
MPEGIF. Highly optimized code allows standard 3GPP services (QCIF, 15fps) to be
implemented even low power ARM7 cores where as higher performance applications
like DVB-H and DMB mobile TV playback can be implemented in existing handset
based on the ARM9 family of processor cores. As a pure ANSI C implementation,
the 6100 is portable to different processor cores such as Intel, ARC and
MIPS.
  Hantro 4200 MPEG-4 / H.263
Encoder
  The
Hantro 4200 is fully compliant with 3GPP specifications and has been
interoperability tested in IMTC and MPEGIF. The 4200 enables video applications
like camcorder (MMS) and video telephony. As a standard ANSI C implementation,
the 4200 is available for various processor cores such as the ARM, Intel, MIPS
and ARC.
  Hantro
4100 MPEG-4 / H.263 Decoder
  The
4100 is fully compliant with 3GPP specifications and has been thoroughly
interoperability tested in IMTC and MPEGIF. The 4100 enables video applications
like realtime streaming, video telephony and local video playback. As a standard
ANSI C implementation, the 4100 is available for various processor cores such as
the ARM, Intel, MIPS and ARC.
  14
  Hantro
DirectShow
  Hantro
DirectShow filters provide decode support for MPEG-4, H.263, Sorenson
Spark, H.264/AVC and On2 VP6 video standards, GSM-AMR and AAC+ audio
support, .3gp / .mp4 file format and 3GPP compliant streaming by enabling the
fast deployment of multimedia applications in Windows based devices. As
individual DirectShow compatible filters (DLL), these modules can be used
alongside other formats and components, providing total flexibility for
application development and aftermarket feature enhancement.
  Software
AMR-NB Encoder and Decoder
  The
AMR-NB audio encoder and decoder are targeted for mobile video messaging,
streaming and telephony applications. These modules are available individually,
as a full codec or incorporated as part of a complete multimedia solution. The
modules are implemented in ANSI C, and may be ported to any processor
environment.
  Enhanced
aacPlus Codec (HE AAC v.2)
  Provided
by Coding Technologies, the Enhanced aacPlus audio codec is utilized for
embedded application in resource limited environments while maintaining quality,
performance and optimization. MPEG-4 aacPlus is the combination of three MPEG
technologies including Advanced Audio Coding (AAC), Coding Technologies’
Spectral Band Replication (SBR) and Parametric Stereo (PS) technologies. SBR is
a unique bandwidth extension technique which enables audio codecs to deliver the
same quality at half the bit rate. PS significantly increases the codec
efficiency a second time for low bit rate stereo signals. The supported
platforms for the encoders include Win32, Linux, MacOS X, ARM, TI,
Motorola and other DSPs.
  Multimedia
Application Development Platform
  The
On2 Finland development platform enables the fast deployment of applications
such as: local video player, network streaming player and camcorder by speeding
application development, device integration and upgrades. The platform features
a completely modular design and offers high level application programming
interfaces and wrapper interfaces for user interface development and device
integration. Reference platforms are available for Windows CE, Pocket PC,
Windows Mobile 5.0, Nucleus, Palm OS, eLinux, ARM Linux and uCos
(MicroC/OSII).
  On2
Finland Embedded Development Services
  On2
Finland’s Embedded Development Services combines knowledge of hardware codec
cores and experience in solving the challenges of multimedia integration and
software development to help minimize project risk and realize target revenues
faster.
  Services
  In
addition to licensing our software, we offer a variety of custom engineering and
consulting services to our customers. Fees derived from engineering, consulting
and support services accounted for 14%, 6%, and 8% of our revenue for the years
ended December 31, 2008, 2007, and 2006, respectively. In particular, we offer
the following services:
  Custom
Engineering and Consulting Services
  We
provide custom engineering and consulting services designed to support customers
or assist prospective customers in evaluating our software. Our engineering and
consulting services generally consist of:
 ●
                customizing
      our software to add a feature, user interface or other function requested
      by a customer;●
                porting
      and optimizing our technology platform and algorithm libraries onto chips
      and embedded devices, such as set-top boxes, mobile phones and other
      portable devices;
  15
  ●
                  evaluating
      potential customer implementations of our software; and●
                  providing
      technical support for existing
customers.
  Encoding
  In
November 2008, we announced our partnership with Zencoder, LLC to deliver an
on-demand video encoding service based on the Amazon EC2® virtual computing
platform. This service, known as On2 Flix Cloud, combines web application
components from Zencoder LLC with On2 Flix Engine SDK software to create an easy
to use “pay as you go” service for broadcasters, UGC sites and content owners
and providers. The service is designed to reduce cost barriers for customers who
need enterprise-grade video transcoding but can’t or don’t want to invest
thousands of dollars in the necessary physical infrastructure. Flix Cloud
enables us to expand into the growing web services market, thereby expanding
adoption of our video encoders and formats.
  Research
and Development
  Our
research and development activities are primarily focused on advancing and
expanding our core codec technology, improving the design, performance and
quality of our digital electronic hardware, and improving on and expanding on
our encoding and transcoding solutions. We devote significant research and
development time implementing our software on various embedded processors and
platforms and in new operating environments. These efforts have enabled us to
provide quality video compression and decompression at lower broadband data
rates (e.g., DSL) and narrowband data rates (e.g., dial-up and cell phone). Our
research in new platforms or operating environments also regularly results in
commercial products that may become a significant source of revenue. We believe
that continued advances in our technology are key to the success of our
business. Consequently, we devote a substantial portion of our resources to our
research and development efforts. Research and development expenses, excluding
equity-based compensation, for the years ended December 31, 2008, 2007, and 2006
were $10,736,000, $3,833,000, and $972,000, respectively.
  Distribution
Methods
  Our
business consists of developing and marketing our software-based technology
products, our digital electronic hardware designs and related services. We
generally license our software to companies that will integrate the software
with their products or distribute the software themselves in connection with
their services, and we license our hardware video codec to companies that
incorporate our technology into semi-conductors and devices. Our software
customers usually download copies of software that they have purchased by online
file transfer, although we will send them a CD-ROM containing the software at
their request.
  We
generally license our digital electronic hardware designs to manufacturers of
computer chips and multimedia devices. We work closely with our embedded video
customers to apply our hardware video codec to their application and license
that embedded video solution to them. We usually provide our engineering and
consulting services and our product support from our own
facilities.
  Sales
and Business Development
  Our
sales and business development departments aim to build relationships that fall
into two basic categories: hardware and software product licensing and
professional services. Our sales and business development departments focus on
engaging chip-set and device manufacturers, cable and telecommunication
companies, manufacturers of hardware platforms for consumer electronic and
wireless devices and manufacturers of video-enabled products targeted at
commercial and government users. We seek to license our compression software to
manufacturers of video or video-enabled equipment and providers of video
services, and we seek to encourage developers of chip-sets and software
platforms to integrate our codecs within their products. We also seek to license
our embedded video hardware technology to chip-set and device manufacturers.
Additionally, our teams focus on selling licenses for our encoding and streaming
software to content providers who are delivering video over proprietary networks
and to IP-based end users. Our professional services are usually incident to our
product licensing.
  16
  International
  We
believe that we are well positioned to selectively expand our business into
other countries. We have focused in particular on identifying and capitalizing
on opportunities in Asia and Europe. To that end, in the past year we continued
engagements with a number of overseas sales staff, contract agents, pre-sale
support contractors and resellers, thus maintaining a significant number of
staff focused on sales in Europe and Asia. In addition, we have continued to
participate at international tradeshows and conferences. Despite our ongoing
commitment to increase international sales, as part of our cost containment
initiatives undertaken in 2008, we have reduced the number of sales and sales
support staff located internationally and anticipate having a smaller presence
or no presence at all at certain international tradeshows. While it is possible
that these cost containment measures could have an impact on international
sales, we believe that in the current operating environment we can continue to
improve our international sales without maintaining regional sales resources or
participating in certain regional tradeshows and other marketing
events.
  For
the years ended December 31, 2008, 2007, and 2006, foreign customers
accounted for approximately 57%, 45%, and 40%, respectively, of total revenue.
These customers were primarily located in Asia and increasingly in Europe and
the Middle East after our acquisition of On2 Finland in late 2007.
  For
the years ended December 31, 2008, 2007 and 2006 revenue for on-line sales and
post contract customer support was approximately $1,060,000, $1,600,000 and
$1,008,000, respectively
  Europe
  Prior
to our acquisition of On2 Finland, we did not have the same success in Europe
that we had in Asia. On2 Finland has a well established market position in
Europe and has close customer and partnership relationships with major phone and
OEM vendors in Europe, as well as with leading wireless operators. For the year
ended December 31, 2008, revenue generated from customers located in Europe and
the Middle East was $3,257,000 with 46% from Finland, 9% from Luxemburg, and 7%
from France. For the year ended December 31, 2007, revenue generated from
customers located in Europe and the Middle East was $2,230,000 with 29% from
Finland, 36% from the UK and France and 4% from Spain, and includes two months
of revenue from On2 Finland. For the year ended December 31, 2006, revenue
generated from customers located in Europe was $266,000 with 80% from the
Netherlands, 12% from Italy and 8% from the UK.
  Asia
Pacific
  We
believe that Asia, with its large populations of consumers and widespread
adoption of mobile devices, is one of the strongest markets for our products.
Our international sales and business development efforts have historically been
primarily focused in this region. Our acquisition of On2 Finland resulted in a
significant expansion of the resources we are devoting to sales and marketing in
Asia, particularly in Japan, Korea, Taiwan and China, by giving us access to On2
Finland’s existing sales and pre-sales engineering support employees and
consultants. In addition, over the past several years we have engaged regional
marketing specialists and resellers operating in those territories. To date, we
have signed reseller agreements for a number of Asian markets, including China,
Japan, Korea, Hong Kong, and Taiwan. For the year ended December 31, 2008,
revenue generated from customers located in Asia and the Pacific was $4,396,000,
with 46% from Taiwan, 21% from Japan, 18% from South Korea and 8% from China.
For the year ended December 31, 2007, revenue generated from customers located
in Asia was $3,124,000, with 34% from Taiwan, 28% from Japan, 20% from South
Korea, and 10% from China. For the year ended December 31, 2006, revenue
generated from customers located in Asia was $1,868,000, with 31% from Japan,
42% from South Korea and 27% from China.
  Location
of Assets and Operations
  Prior
to the acquisition of On2 Finland, all of our assets and operations were based
within the United States, except for a research and development office located
in the United Kingdom. On2 Finland has assets and operations located primarily
in Finland, and has sales operations in Taiwan, China, and the United
States.
  17
  Competition
  We
believe that the principal competitive advantage of our code video compression
technology is our ability to deliver video that is comparable or superior in
quality to other compression technologies at significantly lower data rates. In
the streaming video market, this attribute significantly reduces the amount of
bandwidth necessary to deliver video of similar quality and allows our customers
to realize a greater profit on their video delivery initiatives by:
 ●
                lowering
      the amount of bandwidth required to deliver video;●
                delivering
      video to more users without increasing bandwidth; and●
                delivering
      good-quality video at lower data rates than those at which other video
      codecs can operate
effectively.
  Increased
compression offers similar advantages in storage of video files, enabling
customers to:
 ●
              store
      video at a set resolution using less storage capacity than required by
      competitive compression software;●
              store
      more video at a set resolution in a given storage space than competitive
      compression software; and●
              store
      more video of a higher quality in a given storage space than competitive
      compression software.
  Our
position as a developer of proprietary video codecs also offers several
significant pricing advantages. First, because we are not bound by the pricing
constraints placed on the standards bodies, we are able to vary our business
terms to respond to our customers’ requests. Second, because we can offer both a
license to the intellectual property underlying our technology as well as a
codec that implements that technology, our customers do not have to pay multiple
layers of licensing fees. In contrast, licensees of MPEG compression technology
generally must acquire a license to patents from the MPEG consortium and then
either acquire a license for a video codec or perform the codec implementation
themselves at their own cost.
  We
believe that the principal competitive advantage of our digital electronic
hardware designs is that they require less power and less surface area than our
competitors’ designs. In addition, our reputation for producing reliable
products with good documentation and strong technical support is important to
our competitive advantage in the embedded technology market.
  Our
business is highly competitive and affected by rapid change. We believe that the
principal competitive factors in our business include technological innovation,
versatility of products, pricing, availability of content, ease of integration
with and availability of use on low-cost processors, customer service, service
offerings and the flexibility to adapt to changing market conditions. Our video
compression technology competes with that of companies such as Microsoft and
RealNetworks and with standards-based codecs such as MPEG-2, H.264, MPEG-4 and
several codecs that position themselves as “MPEG-4-based.” Companies such as
Apple, Inc. and DivX, Inc. also have popular players that they have derived from
standards-based technology; Apple’s QuickTime® player is based on H.264, and
DivX® uses a variant MPEG-4 and H.264.
  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.
  On
the one hand, companies such as Microsoft and RealNetworks benefit from name
recognition that we do not enjoy. Microsoft is also able to use its market power
to support aggressive pricing on its products that compete with ours. There are
a number of standards-based codecs with significant adoption, among them MPEG-2,
H.264 and the less widely-adopted MPEG-4. In addition, Microsoft was
instrumental in establishing a standard, named VC1, based on its Window Media 9
technology. 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, chip manufacturers 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.
  18
  On
the other hand, we believe that our small size and proprietary products
frequently are attractive to customers, especially overseas, that will seek to
license our products not only because of their superior performance, but also
because:
 ●
                our
      products do not come from Microsoft or a consortium of conglomerates (such
      as those that own the core intellectual property used in the
      standards-based codecs), and we offer highly responsive, customized
      service befitting a company of our size and culture;●
                we
      offer flexible licensing terms that do not involve burdensome
      standards-based licenses and fee structures;●
                we
      license both the intellectual property underlying our compression
      technology and a full-featured codec implementing that technology, which
      means that customers do not have to incur additional development and/or
      licensing costs to produce a working codec; and●
                we
      are able to upgrade our technology regularly, because we do not have to
      submit proposed revisions to slow-acting standards
    committees.
  Customers
  Our
customers, and the potential customers of our resellers, fall into several
categories. The customers for our video compression technology and Flix encoding
software development kits typically are either software or hardware developers
who want to enable their products to store or transmit digital video, or
providers of online services that want to add video capabilities to their
services. The customers who purchase our Flix encoding tools span the spectrum
from individual users to business users, who range from small businesses to
large enterprises, such as content providers, operators of UGC sites, and
Internet advertising firms who may license single or multiple units of our end
user products or copies of our SDKs for use in large-scale deployments. For our
On2 Finland embedded technology business, we generally market our products
either to chip companies who will use our technology to develop
multimedia-enabled chips to be sold to mobile and device manufacturers, or to
the mobile and device manufacturers themselves. Finally, the customers for our
engineering services are generally customers of our video compression technology
or our On2 Finland embedded technology who need assistance customizing that
technology to work on a certain platform or need us to modify our software to
work with their software. In addition, we have begun to provide a growing range
of engineering services to customers who have requested customization of our
Flix encoding software.
  For
the year ended December 31, 2008 and 2007, there were no customers that
accounted for more than 10% of the Company’s revenues. For the year ended
December 31, 2006, one customer accounted for 10% of our
revenue.
  As
of December 31, 2008, one customer accounted for 29% of our gross accounts
receivable. As of December 31, 2007, two customers accounted for 18% and
12% of gross accounts receivable. As of December 31, 2006, four customers
accounted for 13%, 12%, 11% and 10% of total accounts receivable.
  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 proprietary technology and intellectual property as
critical to our success. We currently hold nine U.S. patents and have nine
U.S. patent applications pending, and six international patent applications
pending. On2 Finland currently has five U.S. patent applications pending, eight
Finnish patents, one Finnish patent application pending, and six foreign
(non-Finnish and non-U.S.) patent applications pending. We believe that the
patents that are currently issued are material to our business and anticipate
that our pending patents will also be important to us. While we try to ensure
that the security of our intellectual property is maintained through these
measures, there can be no assurance that our efforts 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 that, even if not meritorious,
could be expensive and time-consuming for us and disruptive to our
business.
  19
  In
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 these precautions, someone else could conceivably copy or
otherwise obtain and use our proprietary information without our authorization,
or could develop similar technology independently. Effective trademark,
copyright, trade secret and patent protection may not be available in every
country in which our services are made available through the Internet, and
policing unauthorized use of our proprietary information is difficult and
expensive. In addition, some of our technology is protected as trade secrets for
which government registration is not available. Our only means of protecting our
trade secrets is to restrict scrupulously the disclosure of that
information.
  In
recent years, we have faced several efforts to produce open source versions of
our software. These efforts involve attempts to evade our copyright and other
intellectual property protection by developing software that works with our
codec but that purports not to rely on our software code. The newly-developed
software is then generally distributed under one of the common open source
licenses, such as the GNU General Public License or Lesser General Public
License. Although open source software that has been reverse engineered from
proprietary software in a clean room environment (i.e., without reference to the
proprietary source code) may shield the developer from liability for copyright
infringement, it nevertheless may infringe a third party’s patent covering
techniques used in the proprietary software. It has therefore become
increasingly important for us to pursue patent protection for our technology,
since we could demand that users of open source versions of our software acquire
patent licenses from us.
  We
cannot be certain that the steps we have taken will prevent misappropriation of
our proprietary information. Any misappropriation could have a material adverse
effect on our business. In the future, we may need to initiate and maintain
legal proceedings to enforce our intellectual property rights, protect our trade
secrets or determine the validity and scope of the proprietary rights of others.
That litigation might result in substantial costs and diversion of resources and
management attention.
  From
time to time, we license from third parties technologies that are to be
incorporated into some of our products and services. Historically, we have not
required any material third party technology licenses. As we have entered into
the Flash encoding business, however, we have found it necessary to license
third-party software and patent rights to allow us to decode and encode video
and audio files in a variety of formats. We cannot be certain that these
third-party technology licenses will continue to be available on commercially
reasonable terms, if at all.
  Government
Regulation
  We
are not currently subject to direct regulation by any governmental agency other
than rules and regulations that apply to businesses and publicly-traded
companies generally, except that certain U.S. export controls and import
controls of other countries, including controls on the use of encryption
technologies, may apply to our products. Laws and regulations specifically
pertaining to the Internet are new and developing. These laws or regulations
govern matters such as intellectual property, user privacy, e-commerce,
information security and taxation. In addition, the applicability of existing
laws to the Internet is uncertain and evolving. As a result of this uncertainty,
it is difficult to predict the impact, if any, that future regulation or changes
in regulation may have on our operations.
  Employees
  As
of December 31, 2008, we had 106 full-time employees. Of that total, 73
were engineering and product development personnel, 13 were sales and marketing
personnel and 20 were general and administrative personnel.
  20
  Our
employees located in Finland are represented by a labor union, and we consider
our relationships with all of our employees to be good. We supplement our work
force from time to time with contractors, administrative personnel furnished
through employment agencies and part time employees.
  Where
You Can Find More Information About Us
  Our
principal executive offices are located at 3 Corporate Drive, Suite 100, Clifton
Park, New York 12065, and our telephone number at that location is (518)
348-0099. We file reports with the Securities and Exchange Commission (SEC),
including annual reports on Form 10-K, quarterly reports on Form 10-Q, current
reports on Form 8-K and amendments to such reports. Copies of our publicly-filed
reports may be obtained by written request to our Secretary at the address given
above. The public may also read and copy any materials we file with the SEC at
the SEC’s Public Reference Room at 100 F Street N.E., Washington, DC 20549. The
public may obtain information on the operation of the Public Reference Room by
calling 1-800-SEC-0330. The SEC also maintains an Internet site that contains
reports and other information regarding issuers that file electronically with
the SEC at http://www.sec.gov. Additionally, information about us, including our
reports filed with the SEC, is available through our website at
http://www.on2.com. Such reports are accessible at no charge through our web
site and are made available as soon as reasonably practicable after such
material is filed with or furnished to the SEC. The contents of our website are
not incorporated by reference into this Form 10-K.
  21
 
 Item
      1A.
                    Risk
      Factors
  In
evaluating our business, prospective investors and shareholders should carefully
consider the following risks in addition to the other information in this Form
10-K or in the documents referred to in this Form 10-K. Any of the following
risks could have a material adverse impact on our business, operating results
and financial condition and result in a complete loss of your
investment.
  Our
recent acquisition of On2 Finland could expose us to new risks, disrupt our
business, and adversely impact our results of operations.
  On
November 1, 2007 we completed the acquisition of On2 Finland. The integration of
On2 Finland may divert the attention of management and other key personnel from
other core business operations, which could adversely impact our financial
performance in the near term. Moreover, the integration of On2 Finland’s
operations into our company will require expansions to our system of internal
controls over financial reporting. Any failure to successfully operate and
integrate On2 Finland could have an adverse effect on our
operations.
  Additional
goodwill and other intangible assets reported on our balance sheet as a result
of our acquisition of On2 Finland may become impaired at a future date and
accordingly require us to record a loss in the amount of the impairment in our
results of operations.
  During
2008, the global economy dramatically weakened, which, among other factors, has
contributed to the continued underperformance of our On2 Finland business and a
decline in our overall market value. Based on these circumstances, at September
30, 2008, the Company performed impairment reviews of its goodwill and
intangible assets related to its On2 Finland business. The Company performed an
analysis of the expected future cash flows of the business and based on the
results of this evaluation, the Company determined that goodwill and other
intangibles are impaired. Accordingly, the Company recorded an impairment charge
during the quarter ended September 30, 2008, totaling $20,265,000 (goodwill) and
$5,980,000 (intangible assets), to reduce their carrying value to an amount that
is expected to be recoverable. During the quarter ended December 31, 2008, the
global economy continued to weaken, which necessitated an additional impairment
analysis. Based on the results of the additional evaluation, the Company has
determined that goodwill and other intangibles are further impaired.
Accordingly, the Company recorded an impairment charge during the quarter ended
December 31, 2008, totaling $6,216,000 (goodwill) and $807,000 (intangible
assets), to reduce their carrying value to an amount that is expected to be
recoverable.
  Under
generally accepted accounting principles, we will test the goodwill and other
intangible asset amounts at regular intervals to determine whether the value of
On2 Finland exceeds this amount. To the extent that it does not, we will be
forced to make an additional corresponding reduction in the carrying value of
its goodwill or other intangible assets, and will also be required to take a
corresponding charge against earnings for the period in which we recorded the
impairment. The size of any additional impairment could be significant, and
could have a material adverse effect on the business and financial position of
us, as well as on the trading price of its shares.
  We
may fail to realize the benefits expected from the business combination with On2
Finland, which could adversely affect the value of our common
stock.
  The
business combination involves the integration of On2 and On2 Finland, two
companies that have previously operated independently. On2 and On2 Finland
entered into the Share Exchange Agreement with the expectation that, among other
things, the business combination would enable the combined company to
consolidate support functions, leverage its research and development, patents
and services across a larger base, and integrate its workforce, to create
opportunities to achieve cost savings and to become a stronger and more
competitive company. There can be no assurance that the combined company will
actually realize these or any other anticipated benefits of the business
combination.
  22
  The
value of our common stock may be affected by our ability to achieve the benefits
expected to result from the business combination. The combined company currently
operates in several countries, with a combined workforce of approximately 106
employees. Achieving the benefits of the business combination will depend in
part upon meeting the challenges inherent in the successful combination and
integration of global business enterprises of the size and scope of On2 and On2
Finland. The challenges involved in this integration include the
following:
 ●
                demonstrating
      to our customers that the business combination has not and will not result
      in adverse changes to our ability to address the needs of customers, or
      the loss of attention or business focus;●
                coordinating
      and integrating independent research and development teams across
      technologies and product platforms to enhance product development while
      reducing costs;●
                combining
      product offerings;●
                consolidating
      and integrating corporate, information technology, finance, and
      administrative infrastructures;●
                coordinating
      sales and marketing efforts to effectively position the capabilities of
      the combined company and the direction of product development;
      and●
                minimizing
      the diversion of management attention from important business
      objectives.
  The
fact that we are integrating On2 and On2 Finland during a period of economic
decline, market volatility, and credit market constriction may make these
challenges even more difficult to manage. If we do not successfully manage these
issues and the other challenges inherent in integrating businesses of the size
and complexity of On2 and On2 Finland, then we may not achieve the anticipated
benefits of the business combination and our revenues, expenses, operating
results and financial condition could be materially adversely affected. For
example, goodwill and other intangible assets could be determined to be further
impaired which could adversely impact our financial results. The successful
integration of the combined company businesses is likely to require significant
management attention both before and after the completion of the business
combination, and may divert the attention of management from our business and
operational issues.
  Uncertainties
associated with the business combination may cause a loss of employees and may
otherwise materially adversely affect our business and operations.
  Our
future success will depend in part upon our ability to retain our key employees.
In some of the fields in which we operate, there is only a limited number of
people in the job market who possess the requisite skills. We have experienced
difficulty in hiring and retaining sufficient numbers of qualified engineers in
parts of our business. Current and prospective employees may experience
uncertainty about their post-business combination roles with the combined
company. This may materially adversely affect our ability to attract and retain
key management, sales, marketing, technical and other personnel. In addition,
key employees may depart because of issues relating to the uncertainty and
difficulty of integration or a desire not to remain with the combined company
following the share exchange. The loss of services of any key personnel or the
inability to hire new personnel with the requisite skills could restrict our
ability to develop new products or enhance existing products in a timely manner,
to sell products to customers or to effectively manage our
business.
  We
will face uncertainties related to the effectiveness of internal controls as a
result of the business combination with On2 Finland.
  Public
companies in the United States are required to review their internal controls
over financial reporting under Section 404 of the Sarbanes-Oxley Act of 2002. It
should be noted that any system of controls, however well designed and operated,
can provide only reasonable, and not absolute, assurance that the objectives of
the system are met. In addition, the design of any control system is based in
part upon certain assumptions about the likelihood of future events. Because of
these and other inherent limitations of control systems, there can be no
assurance that any design will achieve its stated goal under all potential
future conditions, regardless of how remote.
  23
  There
can be no assurance that the integration of On2 Finland, and its internal
control systems and procedures, will not result in or lead to a future material
weakness in our internal controls, or that we or our independent registered
public accounting firm will not identify a material weakness in our internal
controls in the future. A material weakness in internal controls over financial
reporting would require management and our independent public accounting firm to
evaluate our internal controls as ineffective. If internal controls over
financial reporting are not considered adequate, we may experience a loss of
public confidence, which could have an adverse effect on its business and stock
price.
  In
May 2008, our management identified three material weaknesses in our internal
control over financial reporting and, as a result, has concluded that our
internal control over financial reporting and our disclosure controls and
procedures were ineffective as of December 31, 2007. Although we believe that we
have remediated these material weaknesses, if that assessment proves to be
incorrect, or if additional material weaknesses in our internal control over
financial reporting are identified or develop, we may be unable to comply with
our periodic reporting requirements, accurately report our financial results,
detect fraud or comply with the requirements of Section 404 of the
Sarbanes-Oxley Act which could have an adverse effect on our business and our
stock price.
  Management,
under the supervision and with the participation of our Chief Executive Officer
and Chief Financial Officer, assessed the effectiveness of our internal control
over financial reporting as of December 31, 2008. In making this assessment,
management used the framework established in a report entitled Internal
Control-Integrated Framework issued by the Committee of Sponsoring Organizations
of the Treadway Commission (“COSO”). Based upon that assessment, our management
concluded that our internal control over financial reporting was
effective.
  As
described in “Part II — Item 9A. Controls and Procedures” of this report, in May
2008, we identified three material weaknesses in our internal control over
financial reporting as a result of which our CEO and CFO concluded that our
disclosure controls and procedures were ineffective as of December 31, 2007, due
to the conditions that led to the identification of the material weaknesses.
These material weaknesses were identified by management during its assessment of
the effectiveness of the Company’s internal control over financial reporting
pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 in connection with the
preparation of the Company’s Annual Report on Form 10-K for the year ended
December 31, 2007. As a result of these material weaknesses, our CEO and CFO
also concluded that our internal control over financial reporting and our
disclosure controls and procedures were ineffective as of December 31, 2007, due
to the conditions that led to the identification of the material
weaknesses.
  We
have taken certain steps to remediate the identified material weaknesses.
However, these steps may prove ineffective or we or our independent auditors may
identify further material weaknesses or significant deficiencies in the future.
If a material weakness exists as of a future period year-end (including a
material weakness identified prior to year-end for which there is an
insufficient period of time to evaluate and confirm the effectiveness of the
corrections or related new procedures), our management will be unable to report
favorably as of such future period year-end to the effectiveness of our internal
control over financial reporting. If we are unable to assert that our internal
control over financial reporting is effective in any future period, or if we
continue to experience material weaknesses in our internal control over
financial reporting, we could lose investor confidence in the accuracy and
completeness of our financial reports, which could have an adverse effect on our
stock price and potentially subject us to litigation.
  Remedying
any additional significant deficiencies or material weaknesses that we or our
independent auditors may identify in the future may require us to incur
significant costs and expend significant time and management resources. If we
fail to timely remedy any additional material weaknesses or significant
deficiencies that we or our auditors may identify, we may be unable to comply
with our periodic reporting requirements, accurately report our financial
results, detect fraud or comply with the requirements of Section 404 of the
Sarbanes-Oxley Act of 2002 all of which could result in a loss of investor
confidence in the accuracy, timeliness and completeness of our financial
reports. In addition, we can give no assurance that our independent auditors
will agree with our management’s assessment of the effectiveness of our internal
control over financial reporting at that time. If we cannot produce reliable
financial reports, investors could lose confidence in our reported financial
information, the market price of our common stock could decline significantly,
we may be unable to obtain additional financing to operate and expand our
business, and our business and financial condition could be
harmed.
  24
  Our
failure to timely file certain periodic reports with the SEC poses significant
risks to our business, each of which could materially and adversely affect our
financial condition and results of operations.
  We
did not timely file with the SEC this Annual Report on Form 10-K for the fiscal
year ended December 31, 2007 or our Form 10-Q for the quarterly period ended
March 31, 2008. Consequently, we were not compliant with the reporting
requirements under the Exchange Act. Should we again be unable to timely file
our periodic reports with the SEC, we may not be eligible to use a registration
statement to offer and sell freely tradable securities, which prevents us from
accessing the public capital markets. We could also be subject to delisting of
our common stock by the NYSE Alternext US, Inc. (formerly known as the American
Stock Exchange) or enforcement action by the SEC or shareholder lawsuits. Any of
these events could continue to materially and adversely affect our financial
condition and results of operations.
  We
may face additional risks and costs as a result of the restatement of our
financial statements and the delayed filing of our annual report on Form 10-K
for the fiscal year ending December 31, 2007.
  As
a result of the restatement of our financial data for the quarters ended June
30, 2007 and September 30, 2007 and the delayed filing of our annual report on
Form 10-K for the period ending December 31, 2007 and our quarterly report on
Form 10-Q for the quarter ended March 30, 2008, we incurred substantial
unanticipated costs for accounting and legal fees in connection with or related
to the restatement. It is possible that we will become involved in proceedings
in the future in relation to these restatements. In connection with such
potential proceedings, any incurred expenses not covered by available insurance
or any adverse resolution could have a material adverse effect on us. Any such
proceedings could be time consuming and distract our management from the conduct
of our business. Further, the measures we have implemented to strengthen our
internal control over financial reporting continue to require and will likely
require in the future greater management time, company resource and outside
professional resources to implement and monitor.
  Our
success depends upon the continuing service and capabilities of our management
team. The failure to retain existing management could have a material adverse
effect on our business.
  Our
success will be dependent on our continued ability to attract, retain and
motivate highly skilled employees. Effective June 11, 2008, Bill Joll resigned
as our CEO and as a member of our Board of Directors. On June 10, 2008, the
Board of Directors appointed Matthew Frost, our EVP, Legal and Business Affairs,
to serve as Interim Chief Executive Officer and Chief Operating Officer upon the
resignation of Mr. Joll. The Board of Directors is currently conducting a search
for a permanent CEO. Leadership transitions can be inherently difficult to
manage and may cause disruption to our business or further turnover in our
workforce or management team. The loss of services of one or more other members
of senior management, or the inability to attract a qualified permanent CEO,
would likely have a material adverse effect on our business. We are not
protected by any key-man or similar life insurance in respect of any of our
executive officers.
  If
we are unable to continue to attract, retain and motivate highly skilled
employees, we may not be able to execute our business plan.
  Our
ability to execute our growth plan and be successful depends on our continuing
ability to attract, retain and motivate highly skilled employees. As we continue
to grow, we will need to hire additional personnel in all operational areas. We
may be unable to retain our key employees or attract, assimilate or retain other
highly qualified employees in the future. We have from time to time in the past
experienced, and we expect to continue to experience in the future, difficulty
in hiring and retaining highly skilled employees with appropriate
qualifications. If we do not succeed in attracting new personnel or retaining
and motivating our current personnel, customers could experience delays in
service, which could, in turn, adversely affect our operating results and
revenue. Additionally, retention of highly skilled employees may require
additional personnel costs or the issuance of certain equity compensation
packages. These factors would reduce profitability and the price of our common
stock.
  25
  Our
operating results may be adversely impacted by worldwide political and economic
uncertainties and specific conditions in the markets we address, including the
cyclical nature of and volatility in the semiconductor industry.
  We
operate in the semiconductor industry, which is cyclical and subject to rapid
change and evolving industry standards. From time to time, the semiconductor
industry has experienced significant downturns. These downturns are
characterized by decreases in product demand, excess customer inventories, and
accelerated erosion of prices. These factors could cause substantial
fluctuations in our revenue and in our results of operations. Any downturns in
the semiconductor industry may be severe and prolonged, and any failure of the
industry or wired and wireless communications markets to fully recover from
downturns could seriously impact our revenue and harm our business, financial
condition and results of operations. The semiconductor industry also
periodically experiences increased demand and production capacity constraints,
which may affect our ability to ship products. Accordingly, our operating
results may vary significantly as a result of the general conditions in the
semiconductor industry, which could cause large fluctuations in our stock
price.
  Additionally,
the current worldwide downturn makes it extremely difficult for our customers,
our vendors and us to accurately forecast and plan future business activities,
and has caused U.S. and foreign businesses to slow spending on our products and
services, which could delay and lengthen sales cycles. We cannot predict the
timing, strength or duration of any economic recovery, worldwide, or in the
wired and wireless communications markets. If the economy or the wired and
wireless communications markets in which we operate continue to decline, our
business, financial condition and results of operations will likely be
materially and adversely affected.
  Our
hardware designs involve extended product development efforts and require that
we make judgments regarding future customer demand and industry trends. A
prolonged downturn in the semiconductor industry may cause our customers to make
decisions regarding the architecture and fabrication of their chips that may
undercut some of the advantages of our hardware designs. Because our key
customers include many of the world’s largest semiconductor designers and
manufacturers that use the latest chip technology and fabrication plants, we may
make certain design decisions in anticipation that the majority of our customers
will use such advanced technology. A continued decline in the semiconductor
industry may discourage customers from making investments in new technologies,
thus potentially impacting the performance they can achieve with our designs or
making our designs unacceptable for their semiconductor products.
  The
current depressed general economic and market conditions could cause decreases
in the demand for our products, which could negatively affect our revenue and
operating results.
  Downturns
in general economic and market conditions such as those being experienced at
present may result in customers postponing or canceling hardware or software
purchasing decisions. If demand for our products decreases, our revenues may
decrease and our operating results would be negatively impacted.
  As
our international business expands, we are increasingly exposed to various
legal, business, political and economic risks associated with our international
operations.
  We
derive a substantial portion of our revenue from sales of products shipped to
locations outside of the United States. In addition, On2 Finland, our
wholly-owned subsidiary, manufactures a significant portion of its products
outside of the United States and will be dependent on non-U.S. suppliers for
many parts and services. We may also pursue growth opportunities in sales,
design and manufacturing outside of the United States. Operations outside of the
United States are subject to a number of risks and potential costs that could
adversely affect revenue and results of operations, including:
 ●
                political,
      social and economic instability;●
                fluctuations
      in currency exchange rates;●
                exposure
      to different legal standards, particularly with respect to intellectual
      property;
  26
  ●
                  natural
      disasters and public health emergencies;●
                  nationalization
      of business and blocking of cash flows;●
                  trade
      and travel restrictions;●
                  imposition
      of governmental controls and restrictions;●
                  burdens
      of complying with a variety of foreign laws;●
                  import
      and export license requirements and restrictions;●
                  unexpected
      changes in regulatory requirements;●
                  foreign
      technical standards;●
                  difficulties
      in staffing and managing international operations;●
                  international
      trade disputes;●
                  difficulties
      in collecting receivables from foreign entities or delayed revenue
      recognition;●
                  potentially
      adverse tax consequences;●
                  changes
      in taxation and tariffs; and●
                  fluctuations
      in currency exchange
rates.
  Fluctuations
in foreign currency exchange rates could negatively impact our business, results
of operations and financial condition.
  As
an increasing proportion of our business may be denominated in currencies other
than U.S. dollars, fluctuations in foreign currency exchange rates may have an
adverse impact on our business, results of operations and financial condition.
Our primary currency exposures are to the euro. These exposures may change over
time as we change the geographic mix of our global business and as our business
practices evolve. For instance, if we increase our presence in emerging markets,
we may see an increase in our exposure to emerging market currencies, such as
the Indian rupee. These currencies may be affected by internal factors and
external developments in other countries. Also, our ability to enter into normal
course derivative or hedging transactions in the future may be impacted by our
current credit condition. Significant foreign exchange rate fluctuations could
have a material adverse effect on our business, results of operations and
financial condition.
  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.
  27
  We
may need to obtain additional cash to operate our business and to execute our
business plan, and we may not achieve profitability.
  Since our
inception, we have incurred significant losses and negative cash flow from
operations, and as of December 31, 2008, we had an accumulated deficit of
approximately $183 million. On December 31, 2008 we had cash and investment
reserves of approximately $4.3 million. During 2008, the company implemented a
restructuring program, including a reduction of its workforce, a reduction in
overhead costs, and the identification of one time charges for professional
fees. Additionally, on January 28, 2009 the company notified its employees at
On2 Finland that it intends to further reduce its personnel costs there through
furloughs, terminations and/or moving some full-time employees to part-time. In
accordance with Finnish law and the collective bargaining agreement covering
most On2 Finland employees, the details of this plan to further reduce personnel
costs in Finland are subject to final negotiations with the On2 Finland employee
representative. Management estimates that the 2009 savings related to these
cost-cutting measures and one time charges approximate $11.9 million. Although
sales levels were weakened in the fourth quarter of 2008, we are continuing to
focus our efforts on marketing our compression and video technology to
strengthen the demand for our product and services.
  Additionally,
On2 Finland may borrow funds up to a maximum of €450,000 ($634,000) under a line
of credit as of December 31, 2008. To date, On2 Finland has not borrowed under
the line. Given our cash and short-term investments of $4,289,000 at December
31, 2008, and the Company’s forecasted cash requirements, the Company’s
management anticipates that the Company’s existing capital resources will be
sufficient to satisfy our cash flow requirements for the next 12 months. We have
based our forecasts on assumptions we have made relating to, among other things,
the market for our products and services, economic conditions and the
availability of credit to us and our customers. If these assumptions are
incorrect, or if our sales are less than forecasted and/or expenses higher than
expected, we may not have sufficient resources to fund our operations for this
entire period. In that event, the Company may need to seek other sources of
funds by issuing equity or incurring debt, or may need to implement further
reductions of operating expenses, or some combination of these measures, in
order for the Company to generate positive cash flows to sustain the operations
of the Company. However, because of the recent tightening in global credit
markets, we may not be able to obtain financing on favorable terms, or at
all.
  Our
cost-cutting initiatives may be insufficient to ensure our continuing viability
and may have a detrimental effect on our operations.
  During
2008, the company implemented a restructuring program, including a reduction of
its workforce, a reduction in overhead costs and the identification of one time
charges for professional fees. Additionally, in January 2009 the company
notified its employees at On2 Finland that it intends to further reduce its
personnel costs there through furloughs, terminations and/or moving some
full-time employees to part-time. In accordance with Finnish law and the
collective bargaining agreement covering most On2 Finland employees, the details
of this plan to further reduce personnel costs in Finland are subject to final
negotiations with the On2 Finland employee representative. Management estimates
that the 2009 savings related to these cost-cutting measures and one time
charges approximate $11.9 million. While we are confident that these measures
will help improve the company’s cash flow, they may be insufficient to achieve
the results that we expect, particularly in light of the current global economic
conditions, and we may need to make even further reductions in costs. In
addition, while we have attempted to identify cost reductions that have the
least possible impact on our operations, we can’t offer any assurances that
these reductions will not have a negative impact on our results of
operations.
  If
we cannot generate sufficient positive cash flows from our operations, our
operating results and our stock price may be negatively impacted.
  Prior
to our acquisition of On2 Finland, On2 Finland did not generate sufficient
revenues to offset its operating costs and On2 did not generate sufficient
revenues to offset its operating costs during the period ended December 31,
2008. 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.
  28
  A
lack of investment capital will make it more difficult for us to obtain from
third parties funds we may need to support our operations.
  We
are an emerging company and have experienced significant operating losses and
negative cash flows to date. We have funded our operations with a series of
equity financing transactions, credit facilities and our operating revenue as we
have moved towards achieving profitability. Given the economic downturn, which
became more acute during the latter part of 2008, investor appetite for equity
investments has been reduced, and investors who are willing to invest in
emerging companies may demand terms offering greater returns than they had
previously found acceptable. At the same time, credit markets have become more
stringent, with fewer lenders making fewer loans, with more restrictive terms.
Therefore, should we need further third party financing, it may not be available
to us on acceptable terms, or at all. Should this occur, our financial condition
and results of operation will likely be materially adversely
affected.
  Our
stock price may fluctuate, 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 16, 2009 of $0.18 to $1.16. We expect fluctuations to continue in
the future for a number of reasons, including:
 ●
                quarterly
      variations in our operating results;●
                competitive
      announcements;●
                the
      operating and stock price performance of other companies that investors
      may deem comparable to us;●
                news
      relating to trends in our markets; and●
                changes
      in financial estimates by securities analysts or failure to meet analyst
      estimates.
  In
addition, the stock market generally has experienced significant price and
volume fluctuations, and the market prices of companies in our industry have
been highly volatile. Due to the volatility of the stock market generally, the
price of our common stock could fluctuate for reasons beyond our
control.
  Strategic
acquisitions could have a dilutive effect on your investment. Failure to make
accretive acquisitions and successfully integrate them could adversely affect
our future financial results.
  As
part of our growth strategy, we may seek to acquire or invest in complementary
businesses or technologies. Our goal is to make such acquisitions, integrate
these acquired assets into our operations and expand the market for our products
and services and possibly offer additional products or services. The process of
integrating these acquired assets into our operations may result in unforeseen
operating difficulties and expenditures, and may absorb significant management
attention that would otherwise be available for the ongoing development of our
business. We cannot be certain that the anticipated benefits of any acquisitions
will be realized. Acquisitions also involve other risks, including entering
geographic markets in which we have no or limited prior experience and the
potential loss of key employees.
  In
addition, future acquisitions by us could result in potentially dilutive
issuances of equity securities, the incurrence of debt and contingent
liabilities and amortization expenses related to goodwill and other intangible
assets, any of which can materially and adversely affect our operating results
and financial position. We cannot be certain that we will be able to obtain the
capital necessary to consummate acquisitions or alliances on satisfactory terms,
if at all. Further, any businesses that we acquire will likely have their own
capital needs, which may be significant, which we could be called upon to
satisfy independent of the acquisition price.
  29
  Much
of our technology relies on owned or licensed intellectual property, and if such
rights are not protected from the use of others, including potential
competitors, our business prospects may be harmed.
  The
failure to protect our intellectual property could seriously harm our businesses
and prospects because we believe that our technology is unique and that its
proprietary nature is critical to our success. If our prospects are harmed, the
price of our common stock may decline because we may be less attractive to
investors. Our efforts to protect our intellectual property through trademarks,
copyrights, patents, trade secret laws, access to information and
confidentiality agreements may not be adequate to protect our proprietary
rights. Even with all of these precautions, it could be possible for someone
else to either copy or otherwise obtain and use our proprietary information
without our authorization or to develop similar technology independently. In
addition, effective trademark, copyright and trade secret protection may not be
available in every country in which our products and services are made
available, and policing unauthorized use of our proprietary information is
difficult and expensive. We cannot be certain that the steps we have taken will
prevent misappropriation of our proprietary information. In the future, we may
need to initiate and maintain legal proceedings to enforce our intellectual
property rights, to protect our trade secrets or to determine the validity and
scope of the proprietary rights of others, which might result in substantial
costs and diversion of resources and management attention.
  We
currently hold nine U.S. patents and have nine additional U.S. patent
applications and six international patent applications pending. On2 Finland has
five U.S. patent applications pending, eight Finnish patents, one Finnish and
six foreign (non-Finnish) patent applications pending. However, we cannot assure
you that any additional patents will be issued. Even if a new patent is issued,
the claims allowed may not be sufficiently broad to protect our technology. In
addition, any of our existing or future patents may be challenged, invalidated
or circumvented. As such, any rights granted under these patents may not provide
us with meaningful protection. We may not have foreign patents or pending
applications corresponding to our U.S. patents and patent applications.
Even if foreign patents are granted, effective enforcement in foreign countries
may not be available. If our patents do not adequately protect our technology,
our competitors may be able to offer products similar to ours. Our competitors
may also be able to develop similar technology independently or design around
our patents. Some or all of our patents have in the past been licensed and
likely will in the future be licensed to certain of our competitors through
cross-license agreements. Moreover, because we have participated in developing
various industry standards, we may be required to license some of our patents to
others, including competitors, who develop products based on those
standards.
  We
generally enter into confidentiality agreements with our employees, consultants
and strategic partners. We also try to control access to and distribution of our
technologies, documentation and other proprietary information. Despite these
efforts, internal or external parties may attempt to copy, disclose, obtain or
use our products, services or technology without our authorization. Also,
current or former employees may seek employment with our business partners,
customers or competitors, and we cannot assure you that the confidential nature
of our proprietary information will be maintained in the course of such future
employment. Additionally, current, departing or former employees or third
parties could attempt to penetrate our computer systems and networks to
misappropriate our proprietary information and technology or interrupt our
business. Because the techniques used by computer hackers and others to access
or sabotage networks change frequently and generally are not recognized until
launched against a target, we may be unable to anticipate, counter or ameliorate
these techniques. As a result, our technologies and processes may be
misappropriated, particularly in countries where laws may not protect our
proprietary rights as fully as in the United States.
  We
cannot assure you that our efforts to prevent the misappropriation or
infringement of our intellectual property or the intellectual property of our
customers will succeed. We have in the past been engaged in litigation to
enforce or defend our intellectual property rights, protect our trade secrets,
or determine the validity and scope of the proprietary rights of others,
including our customers. Such litigation (and the settlement thereof) can be
very expensive and time consuming. Additionally, any litigation can divert the
attention of management and other key employees from the operation of the
business, which could negatively impact our business and results of
operations.
  30
  We
may be unable to attain required third party licenses.
  We
occasionally license from third parties technologies that are to be incorporated
into some of our products and services. As we continue to introduce new services
that incorporate new technologies, we may be required to license additional
technology from others. We cannot be sure that these third-party technology
licenses will continue to be available on commercially reasonable terms, if at
all.
  Our
use of open source software exposes us to certain risks.
  Certain
of our software (as well as that of our customers) may be derived from so-called
“open source” software that is generally made available to the public by its
authors and/or other third parties. Such open source software is often made
available to us under licenses, such as the GNU General Public License, or GPL,
which impose certain obligations on us in the event we were to distribute
derivative works of the open source software. These obligations may require us
to make source code for the derivative works available to the public, and/or
license such derivative works under a particular type of license, rather than
the forms of license customarily used to protect our intellectual property. In
addition, there is little or no legal precedent for interpreting the terms of
certain of these open source licenses, including the determination of which
works are subject to the terms of such licenses. While we believe we have
complied with our obligations under the various applicable licenses for open
source software, in the event that the copyright holder of any open source
software were to successfully establish in court that we had not complied with
the terms of a license for a particular work, we could be required to release
the source code of that work to the public and/or stop distribution of that
work. With respect to our proprietary software, we generally license such
software under terms that prohibit combining it with open source software as
described above. Despite these restrictions, parties may combine our proprietary
software with open source software without our authorization, in which case we
might nonetheless be required to release the source code of our proprietary
software.
  Intellectual
property risks and third party claims of infringement, misappropriation of
proprietary rights or other claims against us could adversely affect our ability
to market our products, require us to redesign our products or seek licenses
from third parties, and seriously harm our operating results. In addition, the
defense of such claims could result in significant costs and divert the
attention of our management or other key employees.
  Companies
in and related to the semiconductor, wireless and broadband industries often
aggressively protect and pursue their intellectual property rights. There are
often intellectual property risks associated with developing and producing new
products and entering new markets, and we may not be able to obtain, at
reasonable cost and upon commercially reasonable terms, licenses to intellectual
property of others that is alleged to read on such new or existing products.
From time to time, we may receive notices that claim we have infringed upon,
misappropriated or misused other parties’ proprietary rights. In addition, we or
our customers may be sued by other parties that claim that our products have
infringed their patents or misappropriated or misused their trade secrets, or
which may seek to invalidate one or more of our patents. An adverse
determination in any of these types of disputes could prevent us from
manufacturing or selling some of our products, limit or restrict the type of
work that employees involved in such litigation may perform for us, increase our
costs of revenue and expose us to significant liability.
  Any
of these claims may materially and adversely affect our business, financial
condition and results of operations. For example, in a patent or trade secret
action, a court could issue a preliminary or permanent injunction that would
require us to withdraw or recall certain products from the market, redesign
certain products offered for sale or under development, or restrict employees
from performing work in their areas of expertise. We may also be liable for
damages for past infringement and royalties for future use of the technology,
and we may be liable for treble damages if infringement is found to have been
willful. In addition, governmental agencies may commence investigations or
criminal proceedings against our employees, former employees and/or the company
relating to claims of misappropriation or misuse of another party’s proprietary
rights.
  31
  We
may also have to indemnify some customers and strategic partners under our
agreements with such parties if a third party alleges or if a court finds that
our products or activities have infringed upon, misappropriated or misused
another party’s proprietary rights. We have received requests from certain
customers and strategic partners to include increasingly broad indemnification
provisions in our agreements with them. These indemnification provisions may, in
some circumstances, extend our liability beyond the products we provide to
include liability for combinations of components or system level designs and for
consequential damages and/or lost profits. Even if claims against us are not
valid or successfully asserted, these claims could result in significant costs
and diversion of the attention of management and other key employees to defend.
Additionally, we may seek to obtain a license under a third party’s intellectual
property rights and may grant a license to certain of our intellectual property
rights to a third party in connection with a cross-license agreement or a
settlement of claims or actions asserted against us. However, we may not be able
to obtain a license under a third party’s intellectual property rights on
commercially reasonable terms, if at all.
  Our
products may contain technology provided to us by other parties such as
contractors, suppliers or customers. We may have little or no ability to
determine in advance whether such technology infringes the intellectual property
rights of a third party. Our contractors, suppliers and licensors may not be
required to indemnify us in the event that a claim of infringement is asserted
against us, or they may be required to indemnify us only up to a maximum amount,
above which we would be responsible for any further costs or damages. In
addition, we may have little or no ability to correct errors in the technology
provided by such contractors, suppliers and licensors, or to continue to develop
new generations of such technology. Accordingly, we may be dependent on their
ability and willingness to do so. In the event of a problem with such
technology, or in the event that our rights to use such technology become
impaired, we may be unable to ship our products containing such technology, and
may be unable to replace the technology with a suitable alternative within the
time frame needed by our customers.
  With
the acquisition of On2 Finland, we face intense competition in the semiconductor
industry and the wired and wireless communications markets, which could reduce
our market share in existing markets and affect our entry into new
markets.
  The
semiconductor industry and the wired and wireless communications markets are
intensely competitive. We expect competition to continue to increase as industry
standards become well known and as other competitors enter our target markets.
We currently compete with a number of major domestic and international suppliers
of integrated circuits and related applications in our target markets. In all of
our target markets we also may face competition from newly established
competitors, suppliers of products based on new or emerging technologies, and
customers who choose to develop their own solutions. We expect to encounter
further consolidation in the markets in which we compete.
  Many
of our competitors have longer operating histories and presence in key markets,
greater name recognition, larger customer bases, and significantly greater
financial, sales and marketing, manufacturing, distribution, technical and other
resources than we do. These competitors may be able to adapt more quickly to new
or emerging technologies and changes in customer requirements. They may also be
able to devote greater resources to the promotion and sale of their products. In
addition, current and potential competitors have established or may establish
financial or strategic relationships among themselves or with existing or
potential customers, resellers or other third parties. Accordingly, new
competitors or alliances among competitors could emerge and rapidly acquire
significant market share. Existing or new competitors may also develop
technologies that more effectively address our markets with products that offer
enhanced features and functionality, lower power requirements, greater levels of
integration or lower cost. Increased competition has resulted in and is likely
to continue to result in declining average selling prices, reduced gross margins
and loss of market share in certain markets. We cannot assure you that we will
be able to continue to compete successfully against current or new competitors.
If we do not compete successfully, we may lose market share in our existing
markets and our revenues may fail to increase or may decline.
  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.
  32
  To
remain competitive, we must keep pace with rapid technological change and
evolving industry standards in the semiconductor industry and wired and wireless
communications markets.
  Our
future success will depend on our ability to anticipate and adapt to changes in
technology and industry standards and our customers’ changing demands. We sell
products in markets that are influenced by rapid technological change, evolving
industry standards, frequent new product introductions, short product life
cycles and increasing demand for higher levels of integration and smaller
process geometries. Our past sales and profitability have resulted, to a large
extent, from our ability to anticipate changes in technology and industry
standards and to develop and introduce new and enhanced products incorporating
the new standards and technologies. Our ability to adapt to these changes and to
anticipate future standards, and the rate of adoption and acceptance of those
standards, will be a significant factor in maintaining or improving our
competitive position and prospects for growth. If new industry standards emerge,
our products or our customers’ products could become unmarketable or obsolete,
and we could lose market share. We may also have to incur substantial
unanticipated costs to comply with these new standards. In addition, our target
markets continue to undergo rapid growth and consolidation. A significant
slowdown in any of these wired and wireless communications markets could
materially and adversely affect our business, financial condition and results of
operations. These rapid technological changes and evolving industry standards
make it difficult to formulate a long-term growth strategy because the
semiconductor industry and wired and wireless communications markets may not
continue to develop to the extent or in the time periods that we anticipate. We
have invested substantial resources in emerging technologies that did not
achieve the market acceptance that we had expected. If new markets do not
develop as we anticipate, or if our products do not gain widespread acceptance
in these markets, our business, financial condition and results of operations
could be materially and adversely affected.
  The
complexity of our products could result in unforeseen delays or expenses and in
undetected defects or bugs, which could damage our reputation with current or
prospective customers, result in significant costs and claims, and adversely
affect the market acceptance of new products.
  Highly
complex products such as the products that we offer frequently contain defects
and bugs when they are first introduced or as new versions are released. Our
products have previously experienced, and may in the future experience, these
defects and bugs. If any of our products contains defects or bugs, or has
reliability, quality or compatibility problems, our reputation may be damaged
and customers may be reluctant to buy our products, which could materially and
adversely affect our ability to retain existing customers and attract new
customers. In addition, these defects or bugs could interrupt or delay sales or
shipment of our products to our customers. To alleviate these problems, we may
have to invest significant capital and other resources. Although our products
are tested by us, our subcontractors, suppliers and customers, it is possible
that our new products will contain defects or bugs. If any of these problems are
not found until after we have commenced commercial production of a new product,
we may be required to incur additional development costs and product recall,
repair or field replacement costs. These problems may divert our technical and
other resources from other development efforts and could result in claims
against us by our customers or others, including possible claims for
consequential damages and/or lost profits. In addition, system and handset
providers that purchase components may require that we assume liability for
defects associated with products produced by their manufacturing subcontractors
and require that we provide a warranty for defects or other problems which may
arise at the system level. Moreover, we would likely lose, or experience a delay
in, market acceptance of the affected product or products, and we could lose
credibility with our current and prospective customers.
  Regulatory
changes in the Internet industry involve uncertainties, and the resolution of
these uncertainties could adversely affect our business by raising our costs or
reducing potential revenues.
  Although
we are not currently subject to direct regulation by any governmental agency
other than rules and regulations that apply to businesses generally and any
export and import controls which may apply to our products, laws and regulations
specifically pertaining to the Internet and digital video distribution through
other means are new and developing. These laws, when enacted may require us to
comply with new procedures or limit the scope of our technology or services,
which could raise our expenses or reduce our revenues. The developing laws and
regulations govern matters such as online content, intellectual property, user
privacy, e-commerce, information security and taxation. Moreover, we may be
liable to third parties for any content that we encode, distribute or make
available on our website if that content violates a third party’s intellectual
property rights or violates any applicable laws, such as obscenity laws or
defamation laws. In addition, the applicability of existing laws to the Internet
is uncertain and evolving.
  33
  Consolidation
of customers of our embedded devices and RTL related business may lead to a
reduction of the number of our deals and reduction of revenue in these
businesses.
  We
have recently seen consolidation of customers of our embedded devices and RTL
related business. This may lead to a reduction in the number of deals and
transactions we enter into as there may be fewer customers. In addition, one
consolidated customer may use our products on more devices than it would have
pre-consolidation, but it will not pay a proportionate increase in price for
such increased usage.
  Changes
in government regulation of the media and wireless communications industries may
adversely affect our business.
  It
is possible that a number of laws and regulations may be adopted in the United
States and elsewhere that could restrict the media and wireless communications
industries, including laws and regulations regarding customer privacy, taxation,
content suitability, copyright, distribution and antitrust. Furthermore, the
growth and development of the market for electronic commerce may prompt calls
for more stringent consumer protection laws that may impose additional burdens
on companies such as ours conducting business through wireless carriers. We
anticipate that regulation of our industry will increase and that we will be
required to devote legal and other resources to address this
regulation.
  Effects
of anti-takeover provisions could inhibit potential investors or delay or
prevent a change of control that may favor you.
  Some
of the provisions of our certificate of incorporation, our bylaws and Delaware
law could, together or separately:
 ●
                Discourage
      potential acquisition proposals;●
                Delay
      or prevent a change in control; and●
                Limit
      the price that investors might be willing to pay in the future for shares
      of our common stock.
  In
particular, our Board of Directors is authorized to issue up to 20,000,000
shares of preferred stock (less any outstanding shares of preferred stock) with
rights and privileges that might be senior to our common stock, without the
consent of the holders of the common stock.
  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.
  Economic
conditions may make it more difficult for us to achieve our sales and revenue
projections.
  The
economy in the US and internationally deteriorated significantly during 2008. We
may encounter difficulties in achieving sales if demand for our products and
services decreases as a result of the poor economy. For example, our customers
may reduce or defer purchases of our goods and services due to economic
pressures they encounter, and some of our customers’ businesses may fail.
Customers may also elect to develop products and services internally rather than
purchasing them from us. We may also be forced to reduce the amounts we charge
for our goods and services as competition becomes more intense in a tight
market. Pressure on our customers may also result in their delaying payments due
to us as they attempt to manage their cash flows or cause them to default on
payments that they owe us. Although we have taken economic factors into
consideration when making our internal sales and revenue projections, if
economic conditions and the effect on our sales and collections are worse than
we have anticipated, we may be unable to meet our sales and revenue
expectations. In this case, we may suffer a material adverse effect on our
financial condition and results of operation.
  34
 
 Item
      1B.
                  Unresolved Staff
      Comments
  None.
 Item
      2.
                Properties
  We
do not own any real property. We lease approximately 14,000 square feet of space
at 3 Corporate Dr., Suite 100, Clifton Park, New York where our principal
executive, administrative and engineering offices are located, at an annual
rental fee of approximately $195,000. This lease expires on August 31, 2014. We
also lease small spaces in Cambridge, UK for an annual rental fee of $19,630 and
in New York, New York for an annual rental fee of $16,500.
  The
principal executive offices of On2 Finland, our subsidiary, are located in Oulu,
Finland. On2 Finland leases approximately 17,000 square feet of space in Oulu,
Finland, and pays an annual rental fee of approximately $392,000. This lease
expires in January 2011. On2 Finland also leases office space in Finland for
certain executives and certain sales managers in Espoo, Finland. On2 Finland
pays an annual rent fee of approximately $26,000 for this 1,200 square feet
space. This lease expired in August 2008 and we renewed it through April 2009,
at which time it will terminate. On2 Finland also leases small office spaces in
Taiwan for an annual rental fee of $19,000 and in Hong Kong for an annual rental
fee of $41,000.
  Management
believes these facilities are all in usable condition and that these facilities
are sufficient to meet our needs for the immediate future and that we do not
need to replace our facility in Espoo, Finland when our lease there terminates
in April 2009. Management also believes that these facilities are adequately
covered by insurance.
 Item
      3.
                Legal
      Proceedings
  Islandia
  On
August 14, 2008, Islandia, L.P. filed a complaint against On2 in the Supreme
Court of the State of New York, New York County. Islandia was an investor in the
Company’s October 2004 issuance of Series D Convertible Preferred Stock pursuant
to which On2 sold to Islandia 1,500 shares of Series D Convertible Preferred
Stock, raising gross proceeds for the Company from Islandia of $1,500,000.
Islandia’s Series D Convertible Preferred Stock was convertible into On2 common
stock at an effective conversion price of $0.70 per share of common stock.
Pursuant to this transaction, Islandia also received two warrants to purchase an
aggregate of 1,122,754 shares of On2 common stock.
  The
complaint asserts that, at various times in 2007, On2 failed to make monthly
redemptions of the Series D Preferred Stock in a timely manner and that On2
failed to deliver timely notice of its intention to make such redemptions using
shares of On2’s common stock. The complaint also asserts that Islandia timely
exercised its right to convert the Series D Preferred Stock into shares of On2
common stock and that On2 failed to credit to Islandia such allegedly converted
shares. The complaint further asserts that On2 failed to pay to Islandia certain
Series D dividends to which it was entitled. The complaint seeks a total of
$4,645,193 in damages plus interest and reasonable attorneys’ fees.
  On
October 8, 2008, On2 filed an answer in which it denied the material assertions
of the complaint and asserted various affirmative defenses, including that (i)
On2 made the required Series D redemptions in full and on the dates agreed upon
by the parties, (ii) On2 provided timely notice that it would pay redemptions in
On2 common stock and that Islandia accepted all of the redemption payments on
the dates made without protest, (iii) Islandia failed to timely assert its
conversion rights under the terms of the Series D agreements and (iv) On2 duly
paid the dividends owed to Islandia under the terms of the Agreement and
Islandia accepted all dividend payments without protest. As of the date of this
filing, the case was in the discovery phase of litigation.
  35
  On2
believes this lawsuit is without merit and intends to vigorously defend itself
against Islandia’s complaint. As of December 31, 2008, the Company has not
recorded any provision associated with this complaint.
  Beijing
E-World
  On
March 31, 2006, we commenced arbitration against our customer, Beijing E-World,
relating to a dispute arising from two license agreements that On2 and Beijing
E-World entered into in June 2003.
  Under
those agreements, we licensed the source code to our video compression (codec)
technology to Beijing E-World for use in Beijing E-World’s video disk (EVD) and
high definition television (HDTV) products as well as for other non-EVD/HDTV
products. We believe that the license agreements impose a number of obligations
on Beijing E-World, including the requirements that:
 ●
                Beijing
      E-World pay to On2 certain minimum quarterly payments;
  and●
                Beijing
      E-World use best reasonable efforts to have our video codec “ported” to
      (i.e., integrated with) a chip to be used in EVD
  players.
  On2
has previously commenced arbitration regarding the license agreements with
Beijing E-World. In March 2005, the London Court of International Arbitration
tribunal released the decision of the arbitrator, in which he dismissed our
claims in the prior arbitration, as well as Beijing E-World’s counterclaims, and
ruled that the license agreements remained in effect, and that the parties had a
continuing obligation to work towards porting On2’s software to two
commercially-available DSPs.
  Although
a substantial amount of time has passed since the conclusion of the previous
arbitration, the parties have nevertheless not completed the required porting of
our software to two commercially available DSPs.
  On2’s
current arbitration claim alleges that, despite its obligations under the
license agreements, Beijing E-World has:
 ●
                failed
      to pay On2 the quarterly payments of $1,232,000, which On2 believes are
      currently due and owing; and●
                failed
      to use best reasonable efforts to have On2’s video codec ported to a
      chip.
  On2
has requested that the arbitrator award us approximately $5,690,000 in damages
under the contract and grant it further relief as may be just and
equitable.
  Beijing
E-World has appeared in the arbitration, although it has not yet filed any
responses to On2’s filings in the proceeding. Following Beijing E-World’s
appearance, it entered into an agreement with On2 pursuant to which Beijing
E-World agreed by November 30, 2006 to pay On2 an amount in settlement equal to
approximately 25% of the remaining unpaid portion of the license fees set forth
in the license agreements. Upon payment of the settlement payment, the parties
will terminate the arbitration, the license agreements will terminate, and On2
will release Beijing E-World from all liability arising from the matters
underlying the arbitration. As of the date of filing, Beijing E-World has not
paid the amount agreed for settlement.
  36
 
 Item
      4.
                  Submission of Matters
      to a Vote of Security
Holders
  None
  PART
II
 Item
      5.
                Market for
      Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity
Securities
  Our
common stock is traded on the NYSE Alternext US, Inc. (formerly known as the
American Stock Exchange, or AMEX) 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 NYSE Alternext US since January 1,
2006:
 High
                  
                  LowFiscal
      Year 2008First
      Quarter
                  
                  $
                  1.18
                  
                  
                  $
                  0.81Second
      Quarter
                  
                  $
                  1.06
                  
                  
                  $
                  0.56Third
      Quarter
                  
                  $
                  0.70
                  
                  
                  $
                  0.31Fourth
      Quarter
                  
                  $
                  0.41
                  
                  
                  $
                  0.11Fiscal
      Year 2007First
      Quarter
                  
                  $
                  1.65
                  
                  
                  $
                  1.02Second
      Quarter
                  
                  $
                  3.99
                  
                  
                  $
                  1.57Third
      Quarter
                  
                  $
                  3.05
                  
                  
                  $
                  1.00Fourth
      Quarter
                  
                  $
                  1.71
                  
                  
                  $
                  0.75Fiscal
      Year 2006First
      Quarter
                  
                  $
                  1.48
                  
                  
                  $
                  0.70Second
      Quarter
                  
                  $
                  1.08
                  
                  
                  $
                  0.65Third
      Quarter
                  
                  $
                  0.86
                  
                  
                  $
                  0.55Fourth
      Quarter
                  
                  $
                  1.26
                  
                  
                  $
                  0.65
  There
were approximately 287 stockholders of record of our common stock as of February
16, 2009.
  It
is our current policy not to pay cash dividends and to retain future earnings to
support our growth. Since our inception, we have not paid any cash dividends and
we do not anticipate paying any cash dividends in the foreseeable
future.
 Equity
      Compensation Plan Information December 31, 2008Plan
      category
                
                Number
      of securities
                  to
      be issued
                  upon
      exercise of
                  outstanding
      options,
                  warrants
      and rights
                
                Weighted-average
                  exercise
      price of
                  outstanding
      options,
                  warrants
      and rights
                
                Number
      of securities
                  remaining
      available for
                  future
      issuance under
                  equity
      compensation plans
                  (excluding
      securities
                  reflected
      in column (a))(a)
                
                
                
                (b)
                
                
                
                (c)Equity
      compensation plans approved by security holders
                
                
                13,000
                
                
                $
                0.14
                
                
                
                4,732,000Equity
      compensation plans not approved by security
    holders
                
                
                —
                
                
                
                —
                
                
                
                —Total
                
                
                13,000
                
                
                $
                0.14
                
                
                
                4,732,000
  37
  Performance
Graph
  The
following graph compares the cumulative 5-year total return provided
shareholders on On2 Technologies, Inc.’s common stock relative to the cumulative
total returns of the AMEX Composite index and the RDG Software Composite index.
An investment of $100 (with reinvestment of all dividends) is assumed to have
been made in our common stock and in each of the indexes on 12/31/2003 and its
relative performance is tracked through 12/31/2008.
  COMPARISON
OF 5 YEAR CUMULATIVE TOTAL RETURN*
 Among On2
Technologies, Inc., The AMEX Composite Index
 And The
RDG Software Composite Index
  
  * $100
invested on 12/31/03 in stock & index-including reinvestment of
dividends.
 Fiscal
year ending December 31.
  12/03
                
                12/04
                
                12/05
                
                12/06
                
                12/07
                
                12/08On2
      Technologies, Inc.
                
                
                100.00
                
                
                48.09
                
                
                80.92
                
                
                91.60
                
                
                77.86
                
                
                15.27AMEX
      Composite
                
                
                100.00
                
                
                124.13
                
                
                155.00
                
                
                184.30
                
                
                217.52
                
                
                132.72RDG
      Software Composite
                
                
                100.00
                
                
                110.69
                
                
                109.48
                
                
                125.50
                
                
                146.24
                
                
                86.68
  The
stock price performance included in this graph is not necessarily indicative of
future stock price performance.
  38
  Recent
Issuances of Unregistered Securities and Use of Proceeds from Unregistered
Securities
  Issuance
of Common Stock in August 2006
  In
August 2006, we completed the sale of 3,070,175 shares of our common stock at
$0.57 per share. The sale of common stock raised gross proceeds for us of
$1,750,000. The purchasers of these shares also received a warrant to purchase
an aggregate of 2,302,632 additional shares of our common stock exercisable for
a period of five years at an exercise price of $0.77 per share. On June 15,
2007, the exercise price was reduced to $0.69 per share. The offering was exempt
from registration under Section 4(2) of the Securities Act and Rule 506 of
Regulation D promulgated thereunder. The common stock and warrants were offered
and sold to Midsummer Investment and Rockmore Investment, both of which are
“accredited investors,” as that term is defined in Rule 501 of Regulation D,
both of which are institutional investors, in compliance with Rule
506.
  Kuhns
Brothers, Inc. acted as private placement agent in the offering to Midsummer
Investment and Rockmore Investment and earned commissions of $87,500. We also
granted a warrant to Kuhns Brothers, Inc. to purchase 42,982 shares of our
common stock at an exercise price of $0.57 per share. The offering was exempt
from registration under Section 4(2) of the Securities Act of 1933 and Rule 506
of Regulation D promulgated thereunder. In connection with the offering, we also
granted Gregory Dryer, a registered employee of Kuhns Brothers, Inc., a warrant
to purchase 79,825 shares of our common stock at an exercise price of $0.57 per
share. The offering was exempt from registration under Section 4(2) of the
Securities Act and Rule 506 of Regulation D promulgated thereunder. Both Kuhns
Brothers and Mr. Dryer are “accredited investors,” as that term is defined in
Rule 501 of Regulation D. We have filed a registration statement with the SEC
for the resale of the Common Stock issued or issuable in connection with this
private placement.
  Acquisition
of On2 Finland
  On
May 22, 2007, we entered into a share exchange agreement with Nexit Ventures Oy,
as the authorized representative of the holders of all outstanding equity
securities, including outstanding share options, of On2 Finland. The share
exchange was offered in reliance on the exemptions provided by Regulation S of
the Securities Act and/or Section 4(2) of the Securities Act. The share exchange
was completed in an “offshore transaction”, as defined in Rule 902(h) of
Regulation S. We did not engage in any directed selling efforts, as defined in
Regulation S, in the United States in connection with the share exchange. The
investors were not U.S. persons, as defined in Regulation S, and were not
acquiring the shares for the benefit of a US person. On November 1, 2007, we
completed the acquisition of all of the share capital of On2 Finland. On2
Finland’s security holders each exchanged all of the outstanding capital shares
of On2 Finland for a total consideration of $6,608,102 in cash and 25,438,817
shares of our common stock. In addition, we became obligated to issue an
additional 12,500,000 shares of our common stock to the On2 Finland security
holders because On2 Finland’s net revenue for the fiscal year 2007 exceeded
€9,000,000. We issued these shares in July and August 2008. We filed a
registration statement with the SEC on Form S-4 to register the exchange of all
of the equity ownership of On2 Finland for shares of our common stock pursuant
to the share exchange agreement.
  39




Item
      6.
                Selected
      Financial Data.




The
following selected consolidated historical financial and other data should be
read in conjunction with “Management’s Discussion and Analysis of Financial
Condition and Results of Operation” and the consolidated financial statements
and the related notes thereto appearing elsewhere in this Form 10-K. The
discussion of our results of operations for the year ended December 31, 2008
includes a full year of financial results of On2 Finland, and is consistent with
generally accepted accounting principles, or GAAP. The discussion of our results
of operations for the year ended December 31, 2007 includes the financial
results of On2 Finland from November 1, 2007 (the date of acquisition), and is
consistent with GAAP. The inclusion of these results renders direct comparison
with results for prior periods less meaningful.


For
      the years ended December 31,(in
      thousands, except per share data)Statements
      of Operations Data
                    
                    2008
                    
                    
                    2007
                    
                    
                    2006
                    
                    
                    2005
                    
                    
                    2004Revenue
                    
                    $
                    16,268
                    
                    
                    $
                    13,237
                    
                    
                    $
                    6,572
                    
                    
                    $
                    2,208
                    
                    
                    $
                    3,028Total
      operating expenses
                    
                    
                    68,144
                    
                    
                    
                    16,649
                    
                    
                    
                    10,162
                    
                    
                    
                    6,497
                    
                    
                    
                    6,518Loss
      from operations
                    
                    
                    (51,876
                    )
                    
                    
                    (3,412
                    )
                    
                    
                    (3,590
                    )
                    
                    
                    (4,289
                    )
                    
                    
                    (3,490
                    )Interest
      and other income (expense), net
                    
                    
                    670
                    
                    
                    
                    (3,467
                    )
                    
                    
                    (1,226
                    )
                    
                    
                    (284
                    )
                    
                    
                    47Provision
      for income taxes
                    
                    
                    —
                    
                    
                    
                    25
                    
                    
                    
                    30
                    
                    
                    
                    32
                    
                    
                    
                    2Net
      loss
                    
                    
                    (51,206
                    )
                    
                    
                    (6,904
                    )
                    
                    
                    (4,846
                    )
                    
                    
                    (4,605
                    )
                    
                    
                    (3,445
                    )Convertible
      preferred stock deemed dividend
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    68
                    
                    
                    
                    2,844
                    
                    
                    
                    120Convertible
      preferred stock 8% dividend
                    
                    
                    —
                    
                    
                    
                    82
                    
                    
                    
                    285
                    
                    
                    
                    325
                    
                    
                    
                    57Accretion
      of costs associated with the Series D Preferred Stock
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    —
                    
                    
                    
                    175
                    
                    
                    
                    14Net
      loss attributable to common stockholders
                    
                    $
                    (51,206
                    )
                    
                    $
                    (6,986
                    )
                    
                    $
                    (5,199
                    )
                    
                    $
                    (7,949
                    )
                    
                    $
                    (3,636
                    )Basic
      and diluted net loss attributable to common stockholders per common
      share
                    
                    $
                    (0.30
                    )
                    
                    $
                    (0.06
                    )
                    
                    $
                    (0.05
                    )
                    
                    $
                    (0.09
                    )
                    
                    $
                    (0.05
                    )





December
      31,Balance
      Sheet Data
              
              2008
              
              
              2007
              
              
              2006
              
              
              2005
              
              
              2004Cash
      and cash equivalents
              
              $
              4,157
              
              
              $
              9,573
              
              
              $
              4,961
              
              
              $
              3,976
              
              
              $
              5,418Working
      capital
              
              
              (1,866
              )
              
              
              13,246
              
              
              
              5,268
              
              
              
              4,179
              
              
              
              5,466Total
      assets
              
              
              25,876
              
              
              
              79,525
              
              
              
              7,887
              
              
              
              6,314
              
              
              
              6,610Convertible
      debentures
              
              
              —
              
              
              
              —
              
              
              
              —
              
              
              
              244
              
              
              
              330Capital
      lease obligations
              
              
              692
              
              
              
              42
              
              
              
              53
              
              
              
              26
              
              
              
              43Long-term
      debt
              
              
              2,950
              
              
              
              3,082
              
              
              
              —
              
              
              
              —
              
              
              
              —Series
      D redeemable convertible preferred stock
              
              
              —
              
              
              
              —
              
              
              
              3,083
              
              
              
              3,790
              
              
              
              1,156Convertible
      preferred stock
              
              
              —
              
              
              
              —
              
              
              
              19
              
              
              
              19
              
              
              
              33Common
      stock and APIC
              
              
              198,089
              
              
              
              196,158
              
              
              
              125,566
              
              
              
              120,695
              
              
              
              115,663Accumulated
      deficit and other comprehensive income (loss)
              
              
              (183,771
              )
              
              
              (130,586
              )
              
              
              (124,552
              )
              
              
              (119,350
              )
              
              
              (111,400
              )Total
      stockholders’ equity
              
              
              14,318
              
              
              
              65,572
              
              
              
              1,033
              
              
              
              1,364
              
              
              
              4,296


40





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




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




Overview




On2
Technologies is a developer of video compression technology and technology for
enabling multimedia in resource-limited environments such as battery operated
mobile handsets. We have developed a proprietary technology platform and video
compression/decompression software (“codec”) to allow the efficient storage of
high-quality video and delivery of that video at the lowest possible data rates
over proprietary networks and the Internet to personal computers, wireless
handsets, set-top boxes and other devices. In addition, through our subsidiary
On2 Finland, we license hardware and software design that makes mobile video
possible to mobile handset manufacturers. We also provide integration,
customization and support services to enable high quality video and faster
interoperability between devices. We offer a suite of products and services
based on our proprietary compression technology and mobile video technology. Our
service offerings include customized engineering, consulting services, technical
support and high-level video encoding. In addition, we license our software
products, which include video and audio codecs and encoding software, for use
with video delivery platforms. We also license software that encodes video in
the Adobe/Macromedia Flash 8 format; the Flash 8 format uses our VP6 video
codec. We also license our hardware video codec to companies that incorporate
our technology into the semi-conductors and devices.




On2
Finland Acquisition




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




During
2008, the weakening global economy, continued underperformance of our On2
Finland business and a decline in our overall market value necessitated that we
review whether the value of our goodwill and intangible assets had been
impaired. As a result of this review, the Company determined that impairment had
occurred and recorded impairment charges in the third and fourth quarters of
2008 totaling $26,481,000 (goodwill) and $6,787,000 (intangible
assets).




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 Delaware corporation and 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). On November 1,
2007, we acquired all of the issued and outstanding shares of capital stock of
On2 Finland, which thereby became a wholly-owned subsidiary of On2. On2 Finland
develops technology for enabling multimedia in resource-limited environments
such as battery operated mobile handsets.


41




To
date, we have incurred substantial costs to create technology products and
services. As of December 31, 2008, we had an accumulated deficit of
$182,698,000. We will continue to incur costs to develop, introduce and enhance
products and services, build brand awareness and expand our business. We may
also incur significant additional costs related to technology, marketing or
acquisitions of businesses and technologies to respond to changes in this
rapidly developing industry. These costs may not correspond with any meaningful
increases in revenues in the near term, if at all, and may therefore result in
negative operating cash flows until such time as we generate sufficient revenues
to offset such costs.




Critical
Accounting Policies and Estimates




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


●
              Revenue
      recognition●
              Accounts
      receivable allowance●
              Equity-based
      compensation●
              Acquisition●
              Impairment
      of goodwill and other intangible
assets




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




We
recognize revenue in accordance with SOP 97-2, “SOFTWARE REVENUE RECOGNITION”
(“SOP 97-2”), as amended by SOP 98-4, “DEFERRAL OF THE EFFECTIVE DATE OF SOP
97-2, SOFTWARE REVENUE RECOGNITION” and SOP 98-9, “MODIFICATION OF SOP 97-2 WITH
RESPECT TO CERTAIN TRANSACTIONS” (“SOP 98-9”) and Staff Accounting Bulletin No.
104 (“SAB 104”). Under each arrangement, revenues are recognized when a
non-cancelable agreement has been signed and the customer acknowledges an
unconditional obligation to pay, the products or applications have been
delivered, there are no uncertainties surrounding customer acceptance, the fees
are fixed and determinable, and collection is reasonably assured. Revenues
recognized from multiple-element software arrangements are allocated to each
element of the arrangement based on the fair values of the elements, such as
product licenses, post-contract customer support, or training. The determination
of the fair value is based on the vendor specific objective evidence available
to us. If such evidence of the fair value of each element of the arrangement
does not exist, we defer all revenue from the arrangement until such time that
evidence of the fair value does exist or until all elements of the arrangement
are delivered.


42




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.




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




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




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




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


43




Impairment of Goodwill and Other
Intangible Assets. We assess goodwill for impairment in accordance with
SFAS 142, Goodwill and Other Intangible Assets, which requires that goodwill be
tested for impairment on a periodic basis. The process of evaluating the
potential impairment of goodwill is highly subjective and requires significant
management judgment to forecast future operating results, projected cash flows
and current period market capitalization levels. In estimating the fair value of
the business, we make estimates and judgments about the future cash flows.
Although our cash flow forecasts are based on assumptions that are consistent
with the plans and estimates we are using to manage our business, there is
significant judgment in determining such future cash flows. We also consider
market capitalization on the date we perform the analysis.




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.




Results
of Operations




The
discussion of our results of operations for the year ended December 31, 2008
includes a full year of financial results of On2 Finland, and is consistent with
generally accepted accounting principles, or GAAP. The discussion of our results
of operations for the year ended December 31, 2007 includes the financial
results of On2 Finland from November 1, 2007 (the date of acquisition), and is
consistent with GAAP. The inclusion of these results renders direct comparison
with results for prior periods less meaningful. Accordingly, the discussion
below addresses, where appropriate, trends we believe are significant, separate
and apart from the impact of our acquisition of On2 Finland.




Revenue. Our revenue for the
years ended December 31, 2008, 2007 and 2006 was $16,268,000, $13,237,000, and
$6,572,000, respectively, and was derived from the sale of software and hardware
licenses, engineering, consulting and support services, license royalties and
other services. The revenue for 2008 consists of $10,625,000 from On2 USA and
$5,643,000 from On2 Finland. The fiscal year 2007 revenue of On2 Finland for the
full fiscal year was $13,250,000 and $4,135,000 for November 1, 2007 to December
31, 2007. The decrease of the twelve month revenue is primarily attributable to
an overall decrease in the market for RTL code. Our combined revenue increased
$3,031,000 for the year ended December 31, 2008 as compared with 2007. The
increase is primarily attributable to an increase in royalties earned of
$1,462,000 and a full year of our Finland subsidiary which accounted for
$1,508,000. As a percent of total revenue, license revenue decreased to 65% in
2008 from 78% in 2007, engineering services and support increased to 14% in 2008
from 7% in 2007. Royalties increased to 21% of revenue in 2008 from 14% in
2007.




For
the year ended December 31, 2008, license revenue was $10,494,000 of which our
VPx licenses were $1,910,000, Flix licenses were $4,406,000 and On2 Finland
licenses were $4,178,000. For the year ended December 31, 2007, license revenue
was $10,445,000 of which our VPx licenses were $1,018,000, Flix licenses were
$5,266,000 and On2 Finland licenses were $4,161,000 for November 1, 2007 to
December 31, 2007.




The
following table sets forth the allocation of revenues, in terms of percentages,
for the years ended December 31, 2008, 2007 and 2006:


2008
                
                
                2007
                
                
                2006Licenses
                
                
                65
                %
                
                
                78
                %
                
                
                83
                %Engineering
      services and support
                
                
                14
                %
                
                
                7
                %
                
                
                8
                %Royalties
                
                
                21
                %
                
                
                14
                %
                
                
                9
                %Other
                
                
                —
                
                
                
                1
                %
                
                
                —Total
                
                
                100
                %
                
                
                100
                %
                
                
                100
                %


44




For
the years ended December 31, 2008, 2007 and 2006, software licenses were the
significant revenue stream and are expected to be our significant future revenue
stream as we continue to provide these services and products to clients who
deliver high quality video to proprietary networks, consumer electronic devices,
wireless applications and IP-based end users.




OPERATING
EXPENSES




Year
ended December 2008 versus 2007:




Our
operating expenses consist of cost of revenues, research and development, sales
and marketing, general and administrative, asset impairment and equity-based
compensation expenses. Our operating expenses for the year ended December 31,
2008 were $68,144,000 compared with $16,649,000 for the year ended December 31,
2007.




Cost of Revenue. Cost of
revenue includes personnel and related overhead expenses, rent and related
energy costs, consulting costs, fees paid for licensed technology, depreciation,
amortization of purchased technology and certain other operating expenses. Cost
of revenue was $4,154,000 for the year ended December 31, 2008, compared with
$2,549,000 for the year ended December 31, 2007. Cost of revenue increased
$1,605,000 for the year ended December 31, 2008 compared with 2007. The increase
is primarily attributable to an increase of $2,546,000 for a full year of On2
Finland amortization and engineering costs as compared with two months in 2007,
of which an increase in amortization accounted for $1,655,000 and an increase in
engineering costs accounted for $891,000, partially offset by a decrease in the
US engineering costs of $941,000 associated with a lower percentage of
engineering time associated with products sold during the period.




Research and Development.
Research and development expenses (excluding equity-based compensation),
includes personnel and related overhead expenses, rent and related energy costs
and depreciation, associated with the development and pre-production of our
products and services. Research and development expenses were $10,736,000 and
$3,833,000 for the years ended December 31, 2008 and 2007, respectively.
Research and development expenses increased $6,903,000 for the year ended
December 31, 2008 compared with 2007. The increase is primarily attributable to
an increase of $5,694,000 for a full year of On2 Finland research and
development expenses as compared with two months in 2007, coupled with a higher
percentage of the US engineering time dedicated to research and development
projects, which amounted to $1,209,000. We believe that continued investments in
research and development are necessary to improve our competitive advantage, and
we will continue to invest in such costs as considered necessary.




Sales and Marketing. Sales
and marketing expenses (excluding equity-based compensation), consist primarily
of salaries and related overhead costs and increases in year end bonuses,
commissions, tradeshow costs, marketing and promotional costs incurred to create
brand awareness and public relations expenses. Our sales and marketing expenses
for the year ended December 31, 2008 were $7,095,000 compared with $4,272,000
for the year ended December 31, 2007. The increase of $2,823,000 is attributable
to the sales and marketing costs from a full year of On2 Finland, as compared
with two months in 2007, which accounted for $2,710,000 of the current year
increase, and an increase of $113,000 from the US operations. We intend to
continue to recruit and hire experienced personnel, as necessary, to sell and
market our products and services.




General and Administrative.
General and administrative expenses (excluding equity-based compensation),
consist primarily of salaries and related overhead costs for general corporate
functions including legal, finance, human resources and management information
systems. Also included are outside legal and professional fees, stock-listing
and transfer fees, board fees, reserve for uncollectible accounts receivable and
general liability and directors and officers’ liability insurance. Our general
and administrative costs for the year ended December 31, 2008 were $11,228,000,
compared with $5,200,000 for the year ended December 31, 2007. The increase of
$6,028,000 is attributable to the general and administrative costs from a full
year of On2 Finland, as compared with two months in 2007, which accounted for
$2,195,000 of the current year increase, increases in legal and accounting fees
of $2,623,000, of which $2,186,000 is related to the Audit Committee’s review of
certain 2007 sales contracts in connection with the restatement, increase in
consulting fees of $764,000 related to the Company’s compliance with
Sarbanes-Oxley Section 404, and increases in salaries and related benefit
costs.


45




At
December 31, 2008, we had approximately 106 full-time employees, as compared to
approximately 114 full-time employees at December 31, 2007. This decrease is
primarily the result of the cost savings implementation which was instituted in
the 3rd quarter
of 2008. We expect to hire employees as necessary in order to attain our
strategic objectives.




Asset Impairment. During
2008, the global economy dramatically weakened, which, among other factors, has
contributed to the continued underperformance of our On2 Finland business and a
decline in our overall market value. Based on these circumstances, at September
30, 2008, the Company performed impairment reviews of its goodwill and
intangible assets related to its On2 Finland business. The Company performed an
analysis of the expected future cash flows of the business and based on the
results of this evaluation, the Company determined that goodwill and other
intangibles are impaired. Accordingly, the Company recorded an impairment charge
during the quarter ended September 30, 2008, totaling $20,265,000 (goodwill) and
$5,980,000 (intangible assets), to reduce their carrying value to an amount that
is expected to be recoverable. During the quarter ended December 31, 2008, the
global economy continued to weaken, which necessitated an additional impairment
analysis. Based on the results of the additional evaluation, the Company has
determined that goodwill and other intangibles are further impaired.
Accordingly, the Company recorded an impairment charge during the quarter ended
December 31, 2008, totaling $6,216,000 (goodwill) and $807,000 (intangible
assets), to reduce their carrying value to an amount that is expected to be
recoverable.




Equity-Based Compensation. In
December 2004, the FASB issued Statement of Financial Accounting Standards
(“SFAS”) 123R, which requires all share-based payments to employees, including
grants of employee stock options, to be recognized in the statement of
operations as an operating expense, based on their fair values on grant date.
Prior to the adoption of SFAS 123R, we had accounted for stock based
compensation using the intrinsic value method. We adopted the provision of SFAS
No. 123R effective January 1, 2006, using the modified prospective transition
method. Under the modified prospective transition method, non-cash compensation
expense is recognized for the portion of outstanding stock option awards granted
prior to the adoption of SFAS 123R for which service has not been rendered, and
for any future stock option grants. Accordingly, periods prior to adoption have
not been restated. We recognize share-based compensation cost associated with
awards subject to graded vesting in accordance with the accelerated method
specified in FASB Interpretation No. 28 pursuant to which each vesting tranche
is treated as a separate award. The compensation cost associated with each
vesting tranche is recognized as expense evenly over the vesting period of that
tranche. Equity-based compensation costs for the year ended December 31, 2008
was $1,951,000, of which $288,000 is included in cost of revenue, $433,000 is
classified as research and development, $204,000 is classified as sales and
marketing and $1,026,000 is classified as general and administrative. During the
year ended December 31, 2008, we recognized expense of $820,000 related to stock
options issued to employees and $1,131,000 related to shares of restricted stock
issued to directors and employees. Additionally, for the year ended December 31,
2008 our former President, Chief Executive Officer and Chairman was granted
extensions on stock options, and we recorded $81,000 of compensation expense
related to those extensions. Equity-based compensation costs for the year ended
December 31, 2007 was $946,000, of which $151,000 is included in cost of
revenue, $147,000 is classified as research and development, $157,000 is
classified as sales and marketing and $491,000 is classified as general and
administrative. During the year ended December 31, 2007, we recognized expense
of $362,000 related to stock options issued to employees and $584,000 related to
1,099,000 shares of restricted stock issued to directors and
employees.




Other income (expense),
net




Interest
income (expense), net primarily consists of interest incurred for capital lease
obligations and long-term debt, offset by interest earned on the Company’s
invested cash balances. Interest income (expense), net was $13,000 and $200,000
for the year ended December 31, 2008 and 2007, respectively. The decrease of
$187,000 is primarily attributable to less cash on hand and a full year of
results for On2 Finland, which carries more debt than the US.




Other income (expense), net primarily consists of the change in the fair value
of the warrant derivative liability, realized losses on marketable securities,
and grant income. Other income (expense), net was $657,000 and $(3,666,000) for
the years ended December 31, 2008 and 2007, respectively. The decrease in
expense of $4,323,000 for the year ended December 31, 2008 is primarily a result
of the elimination of the derivative liability in the second quarter of 2007
which accounted for $3,582,000, the elimination of a one-time fee for a warrant
amendment in 2007, which accounted for $86,000, the sale of marketable
securities at a loss in 2007, which accounted for $27,000, and income from a
grant in 2008 from On2 Finland, which accounted for $663,000. The warrant
derivative liability was recorded in connection with the August 2006 sale of
common stock and warrants to a group of investors led by Midsummer
Capital.


46




Year
ended December 2007 versus 2006:




Our
operating expenses consist of cost of revenues, research and development, sales
and marketing, general and administrative and equity-based compensation
expenses. Our operating expenses for the year ended December 31, 2007 were
$16,649,000 compared with $10,162,000 for the year ended December 31,
2006.




Cost of Revenue. Cost of
revenue includes personnel and related overhead expenses, rent and related
energy costs, consulting costs, fees paid for licensed technology, depreciation,
amortization of purchased technology and certain other operating expenses. Cost
of revenue was $2,549,000 for the year ended December 31, 2007, compared with
$2,328,000 for the year ended December 31, 2006. Cost of revenue increased
$221,000 for the year ended December 31, 2007 compared with 2006. The increase
is primarily attributable to an increase of $482,000 in amortization of the On2
Finland purchased technology, partially offset by a decrease in engineering
costs associated with products sold during the period.




Research and Development.
Research and development expenses (excluding equity-based compensation),
includes personnel and related overhead expenses, rent and related energy costs
and depreciation, associated with the development and pre-production of our
products and services. Research and development expenses were $3,833,000 and
$972,000 for the years ended December 31, 2007 and 2006, respectively. The
increase of $2,861,000 is primarily attributed to $1,955,000 in research and
development expenses from On2 Finland coupled with a higher percentage of the US
engineering time dedicated to research and development projects. We believe that
continued investments in research and development are necessary to improve our
competitive advantage, and we will continue to invest in such costs as we
consider necessary.




Sales and Marketing. Sales
and marketing expenses (excluding equity-based compensation), consist primarily
of salaries and related overhead costs and increases in year end bonuses,
commissions, tradeshow costs, marketing and promotional costs incurred to create
brand awareness and public relations expenses. Our sales and marketing expenses
for the year ended December 31, 2007 were $4,272,000, compared with $1,093,000
for the year ended December 31, 2006. The increase of $3,179,000 is a $1,281,000
increase from 2006 from the US operations and $1,898,000 addition from On2
Finland. The $1,281,000 increase from the US operations is primarily
attributable to an increase in commissions, personnel and related overhead
expenses, consulting fees paid to independent sales representatives and
marketing consultants, tradeshow fees, advertising and publicity costs. The
$1,898,000 from On2 Finland is primarily from sales and marketing salaries and
related benefits, commissions, tradeshow and publicity costs. We intend to
continue to recruit and hire experienced personnel, as necessary, to sell and
market our products and services.




General and Administrative.
General and administrative expenses (excluding equity-based compensation),
consist primarily of salaries and related overhead costs for general corporate
functions including legal, finance, human resources and management information
systems. Also included are outside legal and professional fees, stock-listing
and transfer fees, board fees, reserve for uncollectible accounts receivable and
general liability and directors and officers’ liability insurance. Our general
and administrative costs for the year ended December 31, 2007 were $5,200,000,
compared with $4,384,000 for the year ended December 31, 2006. The increase of
$816,000 is attributable to general and administrative costs from On2 Finland,
our Finnish subsidiary, of approximately $800,000 and an increase in our bad
debt reserve of $463,000. In addition, there were increases in consulting fees,
audit fees and other professional fees, director’s fees, and Internet commerce
fees. These increases were partially offset by a $839,000 decrease in legal fees
in the year ended December 31, 2007 as compared to the same period in 2006 as a
result of the internal investigation of the Company’s former
CEO.


47




At
December 31, 2007, we had approximately 114 full-time employees as compared to
approximately 37 full-time employees at December 31, 2006. This increase is
primarily the result of the On2 Finland acquisition. We expect to hire employees
as necessary in order to attain our strategic objectives.




Equity-Based Compensation. In
December 2004, the FASB issued Statement of Financial Accounting Standards
(“SFAS”) 123R, which requires all share-based payments to employees, including
grants of employee stock options, to be recognized in the statement of
operations as an operating expense, based on their fair values on grant date.
Prior to the adoption of SFAS 123R, we had accounted for stock based
compensation using the intrinsic value method. We adopted the provision of SFAS
No. 123R effective January 1, 2006, using the modified prospective transition
method. Under the modified prospective transition method, non-cash compensation
expense is recognized for the portion of outstanding stock option awards granted
prior to the adoption of SFAS 123R for which service has not been rendered, and
for any future stock option grants. Accordingly, periods prior to adoption have
not been restated. We recognize share-based compensation cost associated with
awards subject to graded vesting in accordance with the accelerated method
specified in FASB Interpretation No. 28 pursuant to which each vesting tranche
is treated as a separate award. The compensation cost associated with each
vesting tranche is recognized as expense evenly over the vesting period of that
tranche. Equity-based compensation costs for the year ended December 31, 2007
was $946,000, of which $151,000 is included in cost of revenue, $147,000 is
classified as research and development, $157,000 is classified as sales and
marketing and $491,000 is classified as general and administrative. During the
year ended December 31, 2007, we recognized expense of $362,000 related to stock
options issued to employees and $584,000 related to 1,099,000 shares of
restricted stock issued to directors and employees. Equity-based compensation
costs for the year ended December 31, 2006 was $1,554,000, of which $169,000 is
included in cost of revenue, $98,000 is classified as research and development,
$103,000 is classified as sales and marketing and $1,184,000 is classified as
general and administrative. During the year ended December 31, 2006, we
recognized expense of $1,389,000 related to stock options issued to employees
and $37,000 related to 110,000 shares of restricted stock issued to an employee
and certain consultants. Additionally, for the year ended December 31, 2006 our
former President, Chief Executive Officer and Chairman was granted extensions on
stock options, and we recorded $128,000 of compensation expense related to those
extensions.




Interest and Other Income
(Expense), Net. Interest and other income (expense) was $(3,467,000) for
the year ended December 31, 2007, compared with $(1,226,000) for the year ended
December 31, 2006. Interest and other income (expense) primarily consist of net
gains (losses) on marketable securities, interest earned on our cash and cash
equivalent balances, interest on capital lease obligations and indebtedness, the
amortization of debt discounts and the increase in the incremental fair value of
the warrant derivative liability. The $(3,467,000) in interest and other
expense, net for the year ended December 31, 2007 consists primarily of other
expense of $3,666,000, interest income of $333,000 and interest expense of
$133,000.




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




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




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




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


48




Liquidity
and Capital Resources




At
December 31, 2008, we had cash and cash equivalents and short-term investments
of $4,289,000, compared with $15,094,000 at December 31, 2007. The decrease in
cash and cash equivalents and short-term investments is primarily attributed to
cash used in operations of $7,153,000, of which $2,186,000 was from the Audit
Committee’s review of certain 2007 sales contracts in connection with the
restatement, payments on short-term debt of $2,299,000 and payments on long-term
debt and capital leases of $694,000. At December 31, 2008, we had negative
working capital of $1,866,000, compared with positive working capital of
$13,246,000 at December 31, 2007.




Net
cash (used in) provided by operating activities was $(7,153,000) and $357,000
for the years ended December 31, 2008 and 2007, respectively. The net cash used
in operating activities during 2008 consisted principally of a net loss of
$51,206,000, increase in other assets of $258,000, a decrease in accounts
payable and accrued expenses of $314,000, offset by increases for depreciation
and amortization of $3,233,000, equity-based compensation of $1,951,000, an
asset impairment of $33,268,000, a decrease in accounts receivable, net of
$4,537,000, an increases in insurance expense financed with a term loan of
$73,000, a decrease in prepaid expenses and other current assets of $1,108,000
and an increase in deferred revenue of $309,000. The net cash provided by
operating activities during 2007 consisted principally of increases for
depreciation and amortization of $867,000, the change of the fair value of the
warrant derivative liability of $3,582,000, a realized loss on marketable
securities of $27,000, equity-based compensation of $946,000, and increases in
accounts payable and accrued expenses of $1,949,000, and other assets of $9,000,
expense recognized for the extension of warrants of $90,000, a decrease in
accounts receivable, net of $88,000 and increases in insurance expense financed
with a term loan of $82,000, partially offset by decreases resulting from a net
loss of $6,904,000, deferred revenue of $345,000, and an increase in prepaid
expenses and other current assets of $34,000.




Net
cash provided by (used in) investing activities was $5,026,000 and $(15,014,000)
for the years ended December 31, 2008 and 2007, respectively. The increase in
2008 is primarily due to disposition of short-term investments of $23,074,000,
offset by purchases of short-term investments of $17,685,000 and fixed asset
purchases of $364,000. The net use in 2007 is primarily attributable to the
acquisition of On2 Finland of $9,160,000, the purchase of short-term investments
of $5,617,000 and increased purchases of property and equipment of $460,000,
partially offset by the proceeds from the sale of marketable securities of
$223,000.




Net
cash (used in) provided by financing activities was $(3,014,000) and $19,272,000
for the years ended December 31, 2008 and 2007, respectively. The decrease in
2008 is primarily attributable to payments on short-term debt of $2,299,000 and
payments on long-term debt and capital leases of $694,000. The net proceeds in
2007 is attributable to the net proceeds from the sale of common stock of
$13,903,000 and proceeds from the exercise of common stock options and warrants,
net of $6,901,000, and partially offset by principal payments on capital leases
and debt of $1,060,000.




The
Company currently has commitments for the next 12 months under operating lease
arrangements. These arrangements consist primarily of lease arrangements for our
office space in Clifton Park, Tarrytown and New York, NY, Cambridge, UK, Oulu
and Espoo, Finland, Taiwan, and China. The aggregate required payments for the
next 12 months under these arrangements are $724,000. 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.




In
our 2007 acquisition of On2 Finland we assumed $2.8 million in short-term
borrowings and $3.5 million in long-term debt.




At
December 31, 2008 short-term borrowings consisted of the following:




A
line of credit with a Finnish bank for $736,000 (€500,000 at December 31, 2007).
The line of credit expired in February 2008 and was paid in full and not
renewed. Borrowings under the line of credit carried interest at the Euro
Interbank Offered Rate (EURIBOR) plus 1% (total of 5.288% at December 31, 2007).
The bank also required a commission payable at 1% of the loan principal.
Borrowings were collateralized by substantially all assets of On2 Finland. The
borrowings were also 50% guaranteed by the Finnvera plc (Finnvera plc is a
specialized financing company which offers financing services to promote the
domestic operation of Finnish businesses and is owned by the Finnish
government), which required a commission payable at 2.85% on 50% of the loan
principal. The outstanding balance on the line of credit was $-0- and $297,000
at December 31, 2008 and 2007, respectively.


49




A
line of credit with a Finnish bank for $634,000 (€450,000 at December 31, 2008).
The line of credit has no expiration date. Borrowings under the line of credit
bear interest at EURIBOR plus 1.25% (total of 4.243% at December 31, 2008). The
bank also requires a commission payable at .45% of the loan principal.
Borrowings are collateralized by substantially all assets of the On2 Finland.
The outstanding balance on the line of credit was $-0- and $352,000 at December
31, 2008 and 2007.




A
factoring line of credit with a Finnish bank for the lesser of $2,195,000
(€1,490,000 at December 31, 2007) or 90% of eligible accounts receivable. The
line of credit expired in February 2008 and was paid in full and not renewed.
Borrowings under the line of credit carried interest at EURIBOR plus .95% (total
of 5.238% at December 31, 2007). The borrowings were collateralized by 90% of
eligible accounts receivable. The borrowings also had a 100% guarantee by the
Finnvera plc, which required a commission payable at 2.15% to 2.95% of the loan
principal. The outstanding balance on the line of credit was $-0- and $1,500,000
at December 31, 2008 and 2007, respectively. The carrying amount of accounts
receivable of On2 Finland that served as collateral for borrowings totaled
$1,820,000 at December 31, 2007.




At
December 31, 2008 long-term debt consisted of the following:




Secured
notes payable to a Finnish funding agency of $2,522,000, including interest at
1.75% (calculated as the Finnish bank base rate less 3%, minimum 1%), due at
dates ranging from January 2009 to December 2011; $252,000 to a Finnish bank,
including interest at the 3-month EURIBOR (3.29% at December 31, 2008) plus
1.1%, due March 2011, secured by a guarantee by the Finnish Government
Organization, which also requires additional interest at 2.65% of the loan
principal; and an unsecured note payable to a Finnish financing company of
$176,000, including interest at the 6 month EURIBOR (3.37% at December 31, 2007)
plus .5%, due March 2011.




We
have experienced significant operating losses and negative operating cash flows
to date. We plan to increase cash flows from operations principally from
increases in revenue. The Company’s plan to increase cash flows from operations
relies significantly on increases in revenue generated from our compression and
video codec technology services and products. During 2008, the company
implemented a restructuring program, including a reduction of its workforce, a
reduction in overhead costs, and the identification of one time charges for
professional fees. Additionally, on January 28, 2009 the company notified its
employees at On2 Finland that it intends to further reduce its personnel costs
there through furloughs, terminations and/or moving some full-time employees to
part-time. In accordance with Finnish law and the collective bargaining
agreement covering most On2 Finland employees, the details of this plan to
further reduce personnel costs in Finland are subject to final negotiations with
the On2 Finland employee representative. Management estimates that the 2009
savings related to these cost-cutting measures and one time charges approximate
$11.9 million. Although sales levels were weakened in the 4th quarter
of 2008, we are continuing to focus our efforts on marketing our compression and
video technology to strengthen the demand for our product and
services.




Additionally,
On2 Finland may borrow funds up to a maximum of €450,000 ($634,000) under a line
of credit as of December 31, 2008. To date, On2 Finland has not borrowed under
the line. Given our cash and short-term investments of $4,289,000 at December
31, 2008, and the Company’s forecasted cash requirements, the Company’s
management anticipates that the Company’s existing capital resources will be
sufficient to satisfy our cash flow requirements for the next 12 months. We have
based our forecasts on assumptions we have made relating to, among other things,
the market for our products and services, economic conditions and the
availability of credit to us and our customers. If these assumptions are
incorrect, or if our sales are less than forecasted and/or expenses higher than
expected, we may not have sufficient resources to fund our operations for this
entire period. In that event, the Company may need to seek other sources of
funds by issuing equity or incurring debt, or may need to implement further
reductions of operating expenses, or some combination of these measures, in
order for the Company to generate positive cash flows to sustain the operations
of the Company. However, because of the recent tightening in global credit
markets, we may not be able to obtain financing on favorable terms, or at
all.


50




Off-Balance
Sheet Arrangements




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




Tabular
Disclosure of Contractual Obligations




The
following table summarizes our contractual obligations and other commitments as
of December 31, 2008:


Contractual
      Obligations
                        
                        Total
                        
                        
                        Less
      than 1
                          year
                        
                        
                        1-3
      years
                        
                        
                        4-5
      years
                        
                        
                        After
      5
                          yearsCapital
      lease obligations
                        
                        $
                        692,000
                        
                        
                        $
                        260,000
                        
                        
                        $
                        323,000
                        
                        
                        $
                        109,000
                        
                        
                        
                        —Long-term
      debt
                        
                        
                        2,950,000
                        
                        
                        
                        1,148,000
                        
                        
                        
                        1,802,000
                        
                        
                        
                        —
                        
                        
                        
                        —Operating
      lease obligations
                        
                        
                        2,894,000
                        
                        
                        
                        1,169,000
                        
                        
                        
                        1,400,000
                        
                        
                        
                        325,000
                        
                        
                        
                        —Total
      contractual obligations
                        
                        $
                        6,536,000
                        
                        
                        $
                        2,577,000
                        
                        
                        $
                        3,525,000
                        
                        
                        $
                        434,000
                        
                        
                        
                        —




Impact
of Recently Issued Accounting Pronouncements




In
September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS
No. 157”). This Statement defines fair value, establishes a framework for
measuring fair value and expands disclosure of fair value measurements. SFAS No.
157 applies under other accounting pronouncements that require or permit fair
value measurements and accordingly, does not require any new fair value
measurements. SFAS No. 157 is effective for financial statements issued for
fiscal years beginning after November 15, 2007. The implementation of SFAS No.
157 did not have a material effect on the Company’s consolidated financial
position and results of operations.




In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities” (“SFAS No. 159”). SFAS No. 159
provides companies with an option to report selected financial assets and
liabilities at fair value. SFAS No. 159’s objective is to reduce both complexity
in accounting for financial instruments and the volatility in earnings caused by
measuring related assets and liabilities differently. SFAS No. 159 also
establishes presentation and disclosure requirements designed to facilitate
comparisons between companies that choose different measurement attributes for
similar types of assets and liabilities. SFAS No. 159 requires companies to
provide additional information that will help investors and other users of
financial statements to more easily understand the effect of the company’s
choice to use fair value on its earnings. It also requires entities to display
the fair value of those assets and liabilities for which the company has chosen
to use fair value on the face of the balance sheet. SFAS No. 159 is effective as
of the beginning of an entity’s first fiscal year beginning after November 15,
2007. The implementation of SFAS No. 159 did not have a material effect on the
Company’s consolidated financial position and results of
operations.




In
December 2007, the FASB issued Statement of Financial Accounting Standards
No. 141R, Business Combinations (“SFAS 141R”), which replaces SFAS No. 141,
Business Combinations. SFAS 141R establishes principles and requirements for
determining how an enterprise recognizes and measures the fair value of certain
assets and liabilities acquired in a business combination, including
noncontrolling interests, contingent consideration, and certain acquired
contingencies. SFAS 141R also requires acquisition-related transaction expenses
and restructuring costs be expensed as incurred rather than capitalized as a
component of the business combination. SFAS 141R will be applicable
prospectively to business combinations for which the acquisition date is on or
after the beginning of the first annual reporting period beginning on or after
December 15, 2008. SFAS 141R would have an impact on accounting for any
businesses acquired after the effective date of this
pronouncement.


51




In
December 2007, the FASB issued Statement of Financial Accounting Standards
No.160, Noncontrolling
Interests in Consolidated Financial Statements – An Amendment of ARB
No. 51 (“SFAS 160”). SFAS 160 establishes accounting and reporting
standards for the noncontrolling interest in a subsidiary (previously referred
to as minority interests). SFAS 160 also requires that a retained noncontrolling
interest upon the deconsolidation of a subsidiary be initially measured at its
fair value. Upon adoption of SFAS 160, the Company would be required to report
any noncontrolling interests as a separate component of consolidated
stockholders’ equity. The Company would also be required to present any net
income allocable to noncontrolling interests and net income attributable to the
stockholders of the Company separately in its consolidated statements of
operations. SFAS 160 is effective for fiscal years, and interim periods within
those fiscal years, beginning on or after December 15, 2008. SFAS 160 requires
retroactive adoption of the presentation and disclosure requirements for
existing minority interests. All other requirements of SFAS 160 shall be applied
prospectively. SFAS 160 would have an impact on the presentation and disclosure
of the noncontrolling interests of any non wholly-owned businesses acquired in
the future.




In
March 2008, the FASB issued SFAS 161, Disclosures about Derivative
Instruments and Hedging Activities - an Amendment of FASB Statement 133.
SFAS 161 enhances required disclosures regarding derivatives and hedging
activities, including enhanced disclosures regarding how: (a) an entity uses derivative
instruments; (b)
derivative instruments and related hedged items are accounted for under FASB
Statement No. 133, Accounting
for Derivative Instruments and Hedging Activities; and (c) derivative instruments and
related hedged items affect an entity’s financial position, financial
performance, and cash flows. Specifically, SFAS 161 requires:


●
              Disclosure
      of the objectives for using derivative instruments be disclosed in terms
      of underlying risk and accounting designation;●
              Disclosure
      of the fair values of derivative instruments and their gains and losses in
      a tabular format;●
              Disclosure
      of information about credit-risk-related contingent features;
      and●
              Cross-reference
      from the derivative footnote to other footnotes in which
      derivative-related information is
disclosed.




SFAS 161
is effective for fiscal years and interim periods beginning after November 15,
2008. Early application is encouraged. The Company is currently evaluating the
impact of adopting SFAS No. 161 on its consolidated financial position and
results of operations.




In
May 2008, the FASB issued SFAS 162, The Hierarchy of Generally Accepted
Accounting Principles. SFAS 162 is intended to improve financial
reporting by identifying a consistent framework, or hierarchy, for selecting
accounting principles to be used in preparing financial statements that are
presented in conformity with U.S. generally accepted accounting principles for
nongovernmental entities. SFAS 162 is effective November 15, 2008. The Company
is currently evaluating the impact of adopting SFAS 162 on its consolidated
financial position and results of operations.




In
June 2008, the EITF reached a consensus in Issue No. 07-5,
“Determining Whether an Instrument (or Embedded Feature) Is Indexed to an
Entity’s Own Stock” (“EITF 07-5”). This Issue addresses the determination of
whether an instrument (or an embedded feature) is indexed to an entity’s own
stock, which is the first part of the scope exception in paragraph 11(a) of SFAS
133. EITF 07-5 is effective for fiscal years beginning after December 15,
2008, and interim periods within those fiscal years. Early application is not
permitted. The Company is currently in the process of evaluating the impact of
the adoption of EITF 07-5 on its consolidated financial position and results of
operations.




In
October 2008, The FASB issued FSP 157-3 “Determining Fair Value of a Financial
Asset in a Market That is Not Active” (FSP 157-3). FSP 157-3 classified the
application of SFAS No. 157 in an inactive market. It demonstrated how the fair
value of a financial asset is determined when the market for that financial
asset is inactive. FSP 157-3 was effective upon issuance, including prior
periods for which financial statements had not been issued. The implementation
of FSP 157-3 did not have a material effect on the Company’s consolidated
financial position and results of operations.


52




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




At
December 31, 2008, we had available net operating loss carry-forwards of
$137,184,000 of which $96,543,000 is from the United States operations and
$40,641,000 is from foreign operations. The net operating loss carry-forwards
expire at various dates through 2028.




The
Company performed an analysis of the limitations on the use of its net operating
losses under Section 382 of the Internal Revenue Code. It was determined that on
June 7, 2000, the Company experienced an ownership change to which Internal
Revenue Code Section 382 applied. Of the current $96,543,000 in the Company’s
United States net operating loss carryforwards, $33,800,000 was incurred prior
to the June 7, 2000 change date. The Company believes the entire pre-change net
operating loss is available for use as of December 31, 2008. However, because
the Company’s ability to utilize these net operating losses is in doubt, the
Company maintains a full valuation allowance against their total net operating
loss carryforward.




As
of December 31, 2008, no interest or penalties have been accrued or incurred.
The Company files U.S. federal income tax returns, as well as filing various
returns in states and applicable localities where it holds properties. The
Company’s filed income tax returns are no longer subject to examination by
taxing authorities for years before 2004.




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


Item 7A.
              Quantitative and
      Qualitative Disclosures About Market
Risk




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


Item
      8.
              Financial Statements
      and Supplementary Data




The
consolidated financial statements required by this item are included in Item 15
of this report.


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




On
July 28, 2008, the Audit Committee of our Board of Directors determined to
dismiss Eisner LLP (“Eisner”) as On2’s independent accountant and to engage
Marcum & Kliegman, LLP (“Marcum”) as On2’s independent account as successor
to Eisner.




Accordingly,
acting through and with the approval of the Audit Committee, on July 31, 2008,
we dismissed Eisner as our independent accountant, effective July 31, 2008, and
engaged Marcum as our independent accountant, also effective July 31,
2008.




Eisner’s
reports regarding our financial statements for the 2006 and 2007 fiscal years
did not contain an adverse opinion or disclaimer of opinion, nor were such
reports qualified or modified as to uncertainty, audit scope or accounting
principles.


53




During
the period from January 1, 2006 through July 31, 2008, we had no disagreements
with Eisner on any matter of accounting principles or practices, financial
statement disclosure or auditing scope or procedure that we and Eisner did not
resolve. During the period from January 1, 2006 through July 31, 2008, no
reportable events (as that term is defined in Regulation S-K, Item 304(a)(1)(v)
promulgated by the Securities and Exchange Commission) occurred, except as
follows:




As
we disclosed in On2’s 2007 Annual Report on Form 10-K (the “2007 Annual
Report”), in the course of preparing our 2007 financial statements, certain
information came to the attention of On2 (and through us to Eisner, in
connection with its 2007 audit) that prompted us to initiate an independent
review, conducted by the Audit Committee, concerning certain contracts with
customers and the recognition of revenue that we had previously recognized in
our financial statements for the quarters ended June 30, 2007 and September 30,
2007. This review (i) necessitated that we and Eisner delay completion of our
2007 audit and finalization of our 2007 Annual Report, (ii) led us to restate
our quarterly financial statements for the quarters ended June 30, 2007 and
September 30, 2007 and (iii) led us to identify three material weaknesses in our
disclosure controls and procedures and internal control over financial reporting
and prompted us to develop and implement appropriate remedial
measures.




The
Audit Committee’s review and findings and the actions we have taken in response
to the Audit Committee’s review are detailed in the 2007 Annual Report under
Items 7, 9A and 1A, Amendment No. 1 to our Quarterly Report on Form 10-Q for
quarterly period ended June 30, 2007, Amendment No. 1 to our Quarterly Report on
Form 10-Q for the quarterly period ended September 30, 2007, our Quarterly
Report on Form 10-Q for the quarterly period ended March 30, 2008 and our
Current Report on Form 8-K dated May 27, 2008, each of which is hereby
incorporated into this Report on Form 10-K.


Item
      9A.
              Controls and
      Procedures




Disclosure
Controls and Procedures


(a)
              Overview.




In
connection with the restatement of the Company’s condensed consolidated
financial statements for the second and third quarters of 2007, the Company’s
management identified three material weaknesses in our internal control over
financial reporting and reported those to our Audit Committee. The material
weaknesses, detailed in the Company’s Annual Report on Form 10K for the year
ended December 31, 2007, were:


●
                Revenue recognition
      procedures – Our controls were not adequate to ensure that revenue
      was properly recognized when it was earned because we did not maintain
      effective procedures for the consideration of the probability that revenue
      is collectible.●
                Control environment –
      We did not maintain an effective control environment, specifically
      relating to our tone at the top. This material weakness was evidenced by
      the control tone and control consciousness of our former Chief Executive
      Officer and resulted in the override and the possibility of override of
      controls or interference with our policies, procedures and internal
      control over financial reporting.●
                Allowance for Doubtful Account
      Procedures – Effective controls were not designed and in place to
      ensure that an appropriate analysis of receivables from customers was
      conducted, reviewed, approved and documented in order to identify and
      estimate required allowance for doubtful accounts in accordance with
      generally accepted accounting
principles.




(b)
Evaluation of Disclosure Controls and Procedures:




The
term “disclosure controls and procedures,” as defined in Rule 13a-15(e) and
15d-15(e) under the Securities Exchange Act of 1934, or Exchange Act, means
controls and other procedures of a company that are designed to ensure that
information required to be disclosed in the reports that an issuer files or
submits under the Exchange Act is recorded, processed, summarized and reported,
within the time periods specified in the SEC’s rules and forms. Disclosure
controls and procedures include, without limitation, controls and procedures
designed to ensure that information required to be disclosed by a company in the
reports that it files or submits under the Exchange Act is accumulated and
communicated to the issuer’s management, including its principal financial
officers, as appropriate, to allow timely decisions regarding required
disclosure. There are inherent limitations to the effectiveness of any system of
disclosure controls and procedures, including the possibility of human error and
the circumvention or overriding of the controls and procedures. Accordingly,
even effective disclosure controls and procedures can only provide reasonable
assurance of achieving their control objectives and management necessarily
applies its judgment in evaluating the cost-benefit relationship of possible
controls and procedures.


54




Based
on management’s evaluation, our chief executive officer and chief financial
officer concluded that, as of December 31, 2008, our disclosure controls and
procedures are designed at a reasonable assurance level and are effective to
provide reasonable assurance that information we are required to disclose in
reports that we file or submit under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified in SEC rules and
forms, and that such information is accumulated and communicated to our
management, including our chief executive officer and chief financial officer,
as appropriate, to allow timely decisions regarding required
disclosure.




(c)
Changes in Internal Controls over Financial Reporting:




Except
as noted below as part of our remediation initiatives, there were no changes in
our internal control over financial reporting identified in connection with the
evaluation required by Rules 13a-15 and 15d-15 that occurred during the quarter
ended December 31, 2008 that have materially affected, or are reasonably likely
to materially affect, our internal control over financial
reporting.




(d)
Remediation of Material Weakness in Internal Control over Financial
Reporting




As
a result of our efforts beginning in the second quarter of 2008 to remediate the
identified material weaknesses, we have taken certain steps set forth below to
remediate the identified material weaknesses and have completed the
implementation of our remediation measures. We believe that the actions we have
taken have significantly improved our internal controls over financial
reporting.




To
improve our internal controls over financial reporting, we have taken the
following remediation measures:




During
the second quarter of 2008, we took the following remedial steps to address the
material weakness in internal controls relating to the maintenance of an
effective control environment tone at the top: (i) our Board of Directors sought
and effective June 11, 2008, obtained the resignation of our former Chief
Executive Officer, Bill Joll, from all positions with us and our subsidiaries,
including as an officer, employee and director, although Mr. Joll served until
September 30, 2008 as an advisor to the interim chief executive officer to
effect a smooth transition of customer relationships and business development
opportunities; (ii) on June 10, 2008, our Board of Directors appointed
Matthew Frost, our EVP, Legal and Business Affairs, as Interim Chief Executive
Officer and Chief Operating Officer; and (iii) we segregated the duties of our
accounting personnel from our non-accounting personnel other than those whose
involvement in accounting-related matters is specifically authorized. During the
third quarter of 2008, we took the additional remedial step of establishing an
independent third party ethics hotline so that employees can anonymously report
violations of our Code of Ethics and other employee concerns, and communicated
the hotline process to our employees. During the fourth quarter of 2008, we took
the following additional remedial steps with regard to this material weakness:
(i) our third party consultant on Sarbanes-Oxley compliance conducted training
for our Interim CEO, CFO, General Counsel and other legal and accounting staff
on corporate governance matters, including corporate ethics, and revenue
recognition; and (ii) we revised our Code of Ethics to emphasize the importance
of adherence to our policies and procedures relating to accounting and financial
reporting and internal control of financial reporting and the availability of
the ethics hotline for the reporting of violations of our Code of Ethics and
other employee concerns.




With
regard to the identified material weakness in our revenue recognition
procedures, specifically our procedures for assessing whether the collectibility
of revenue is probable prior to recognition, we took the following remedial
steps during the second quarter of 2008: (i) we revised the process that we and
our operating subsidiary will follow in assessing whether the collectibilty of
revenue is probable, as well as in determining that the other requirements for
recognizing revenue have been met, so that this assessment occurs at the outset
of the arrangement and is thereafter reviewed and confirmed in connection with
our period end closing and financial statement preparation process; and (ii) we
revised, formalized and expanded the documentation of the procedures we and our
operating subsidiaries will follow with respect to assessing probability of
collectibility, as well as determining that the other requirements for
recognizing revenue have been met; including, specifically, enhancing and
documenting our policy with respect to the types of information that can be used
in establishing creditworthiness. During the fourth quarter of 2008, we took the
following additional remedial steps with regard to this material weakness: (i)
our third party consultant on Sarbanes-Oxley compliance conducted training for
our Interim CEO, CFO, General Counsel and other legal and accounting staff on
revenue recognition; and (ii) we adopted and communicated to our relevant staff
a company policy setting forth acceptable customer payment terms and their
importance in revenue recognition.


55




In
addition, in the first quarter of 2008, we added a certified public accountant
to our accounting and financial reporting staff and during the third quarter of
2008, we filled a newly-added position to our accounting staff. The addition of
trained staff has provided further assistance in the accounting department and
has allowed other members of the accounting staff to devote more time to
responsibilities connected with financial reporting.




With
respect to addressing the material weakness in the design and operation of our
procedures for estimating our allowance for doubtful accounts, during the second
quarter of 2008, we enhanced, formalized and documented our procedures for
analyzing our accounts receivable from customers so that we can appropriately
estimate the collectibility of receivables at the end of a period based on aging
categories and information related to collection efforts and formalized and
documented timely review of that information, and sign off on the recommended
allowance for doubtful accounts, by senior management. During the third and
fourth quarters of 2008, we implemented an accounting tool for use by our staff
in quantifying the amount of a reserve to be taken with respect to doubtful
accounts and communicated to our accounting staff the Company’s policies
governing the calculation and recording of bad debt expenses.




To
generally improve upon the quality of our financial reporting, we have
implemented additional remediation measures that improve the processes and
procedures around the completion and review of quarterly management
representation letters.




At
the direction of the Audit Committee, management in 2008 developed a detailed
plan and timetable for the implementation of the foregoing remedial measures.
The Audit Committee approved our remediation efforts and has monitored the
implementation. As of the filing of this Report, our plan to remediate the
material weaknesses in our internal control over financial reporting has been
implemented. Under the direction of the Audit Committee, management will
continue to review and test the effectiveness in our procedures on an on-going
basis, and make necessary changes to the overall design of our internal control
environment, as well as policies and procedures to improve the overall
effectiveness of internal control over financial reporting.




We
believe that the steps we have taken have significantly improved our internal
control over financial reporting. We are committed on an ongoing basis to
repairing any internal control deficiencies that we identify, whether or not
they rise to the level of a material weakness. We believe that with our
remediation measures now finalized and fully implemented, we have addressed and
corrected the identified material weaknesses and improved the overall
effectiveness of our internal control over financial reporting. We are committed
to continuing to improve our internal control processes and will continue to
diligently and vigorously review our financial reporting controls and
procedures. As we continue to evaluate and work to improve our internal control
over financial reporting, we may determine to take additional measures to
address control deficiencies or determine to modify, or in appropriate
circumstances discontinue, certain of the remediation measures described
above.




Remediation
generally requires making changes to how controls are designed and then adhering
to those changes for a sufficient period of time such that the effectiveness of
those changes is demonstrated with an appropriate amount of consistency. As of
the filing of this Report, we have completed final testing of our internal
controls relating to the identified material weaknesses.


56




Internal
Control over Financial Reporting


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




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




We
maintain disclosure controls and procedures that are designed to ensure that
information required to be disclosed in our Exchange Act reports is recorded,
processed, summarized and reported within the time periods in the Securities and
Exchange Commission’s rules and forms and that such information is accumulated
and communicated to our management, including our Chief Executive Officer and
Chief Financial Officer, as appropriate to allow for timely decisions regarding
required disclosure. In designing and evaluating the disclosure controls and its
internal control over financial reporting procedures, management recognizes that
any controls and procedures, no matter how well designed and operated, can
provide only reasonable assurance of achieving the desired control objectives,
and management is required to apply its judgment in evaluating the cost-benefit
relationship of possible controls and procedures.




Management,
under the supervision and with the participation of our Chief Executive Officer
and Chief Financial Officer, assessed the effectiveness of our internal control
over financial reporting as of December 31, 2008. In making this assessment,
management used the framework established in a report entitled Internal
Control-Integrated Framework issued by the Committee of Sponsoring Organizations
of the Treadway Commission (“COSO”). Based upon that assessment, our management
concluded that our internal control over financial reporting was effective.
Management reviewed the results of the assessment with our Audit
Committee


(b)
            Attestation
      Report of the Registered Public Accounting
Firms




REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING FIRM




To the
Audit Committee of


The Board
of Directors and Stockholders of


On2
Technologies, Inc.




We have
audited On2 Technologies, Inc.’s (the “Company”) internal control over financial
reporting as of December 31, 2008, based on criteria established in Internal
Control – Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission. The Company’s management is
responsible for maintaining effective internal control over financial reporting,
and for its assessment of the effectiveness of internal control over financial
reporting, included in the accompanying “Management’s Annual Report on Internal
Control over Financial Reporting.” Our responsibility is to express an opinion
on the Company’s internal control over financial reporting based on our
audit.




We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. Our audit of internal control over financial reporting included
obtaining an understanding of internal control over financial reporting,
assessing the risk that a material weakness exists, and testing and evaluating
the design and operating effectiveness of internal control based on the assessed
risk. Our audit also included performing such other procedures as we considered
necessary in the circumstances. We believe that our audit provides a reasonable
basis for our opinion.


57




A
company’s internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company’s internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company’s
assets that could have a material effect on the financial
statements.




Because
of the inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that degree of compliance with
the policies or procedures may deteriorate.




In our
opinion, On2 Technologies, Inc. maintained, in all material respects, effective
internal control over financial reporting as of December 31, 2008, based on
criteria established in Internal Control – Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission.




We have
also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated balance sheet of On2
Technologies, Inc. as of December 31, 2008, and the related consolidated
statements of operations, changes in stockholders’ equity and cash flows for the
year then ended and our report, dated March 10, 2009, expressed an unqualified
opinion on those consolidated financial statements and financial statement
schedule.




/s/
Marcum & Kliegman LLP




Marcum
& Kliegman LLP


New York,
New York


March 10,
2009


58




Item
      9B.
              Other
      Information




None.


59




PART
III


Item
      10.
              Directors, Executive
      Officers and Corporate
Governance




The
information as to directors, executive officers and corporate governance
required by Items 401, 405 and 407(c)(3), (d)(4), and (d)(5) of Regulation S-K
is set forth in the Company’s definitive Proxy Statement to be filed with the
Securities and Exchange Commission pursuant to Regulation 14A within 120 days
after the end of the fiscal year covered by this Form 10-K and is incorporated
in this Form 10-K by reference.




Code
of Ethics




We
have adopted a Code of Ethics that applies to our principal executive officer,
principal financial officer and principal accounting officer or any person
performing similar functions (the “Code of Ethics”). The Code of Ethics is
available on our website at www.on2.com. The Code of Ethics is also available in
print to any stockholder by making a written request to Tim Reusing, Secretary,
On2 Technologies, Inc., 3 Corporate Drive, Suite 100, Clifton Park, New York
12065. If we ever were to amend or waive any provision of our Code of Ethics, we
intend to satisfy our disclosure obligations with respect to any such waiver or
amendment by posting such information on our Internet website set forth above
rather than by filing a Current Report on Form 8-K with the SEC.


Item
      11.
              Executive
      Compensation




The
information as to executive compensation required by Item 402 and paragraphs
e(4) and e(5) of Item 407 of Regulation S-K is set forth in the Company’s
definitive Proxy Statement to be filed with the Securities and Exchange
Commission pursuant to Regulation 14A within 120 days after the end of the
fiscal year covered by this Form 10-K and is incorporated in this Form 10-K by
reference.


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




The
information as to security ownership of certain beneficial owners and management
and related stockholder matters required by Item 201(d) Item 403 of Regulation
S-K is set forth the Company’s definitive Proxy Statement to be filed with the
Securities and Exchange Commission pursuant to Regulation 14A within 120 days
after the end of the fiscal year covered by this Form 10-K and is incorporated
in this Form 10-K by reference.


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




The
information as certain relationships and related transactions and director
independence required by item 404 and Item 407(a) of Regulation S-K is set forth
the Company’s definitive Proxy Statement to be filed with the Securities and
Exchange Commission pursuant to Regulation 14A within 120 days after the end of
the fiscal year covered by this Form 10-K and is incorporated in this Form 10-K
by reference.


Item
      14.
              Principal Accounting
      Fees and Services.




The
information as to principal accounting fees and services required by Item 9(e)
of Schedule 14A is set forth the Company’s definitive Proxy Statement to be
filed with the Securities and Exchange Commission pursuant to Regulation 14A
within 120 days after the end of the fiscal year covered by this Form 10-K and
is incorporated in this Form 10-K by reference.


60




PART
IV




Item 15. Exhibits,
Financial Statement Schedules.


(a)
              1.
              Consolidated
      Financial Statements:See
      Index to Consolidated Financial Statements on page F-1.2.
              Consolidated
      Financial Statement Schedules:See
      Index to Consolidated Financial Statements on page F-1.3.
              Exhibits:




Exhibits




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


Incorporated
      by ReferenceExhibit
              Number
            
            Exhibit
      Description
            
            Form
            
            Date
      Filed
            
            Filed
              Herewith2.1
            
            Share
      Exchange Agreement, dated as of May 21, 2007, by and among the Company and
      Nexit Ventures Oy, as the Authorized Representatives of the holders of all
      outstanding equity securities of On2 Finland Products Oy
            
            8-K
            
            May
      22, 20073.1
            
            Certificate
      of Incorporation of the Company
            
            10-K
            
            April
      2, 20013.2
            
            Bylaws
      of the Company
            
            10-K
            
            June
      27, 20083.3
            
            Amendment
      to Certificate of Incorporation (to increase authorized shares to
      250,000,000)
            
            10-K
            
            June
      27, 20083.4
            
            Amendment
      of Bylaws
            
            8-K
            
            June
      13, 20084.1
            
            Securityholders
      Agreement, dated as of Dec. 1, 1999, between the Company and thirteen
      securityholders party thereto
            
            10-K
            
            March
      30, 20004.2
            
            Form
      of Investor Rights Agreement, dated as of Dec. 1, 1999,between the
      Company and each of nine investors
            
            10-K
            
            March
      30, 20004.3
            
            Form
      of Warrant issued to the investors party to the Investor Rights
      Agreement
            
            10-K
            
            March
      30, 20004.4
            
            Form
      of Investors’ Rights Agreement between the Company and the holders of
      Series C Preferred Stock, Series C-II Preferred Stock and
      Series C-III Preferred Stock
            
            S-3
            
            Dec.
      8, 20004.5
            
            Certificate
      of Designations for the Company’s Series C Preferred
      Stock
            
            10-K
            
            April
      2, 20014.6
            
            Certificate
      of Designations for the Company’s Series C-II Preferred
      Stock
            
            10-K
            
            April
      2, 20014.7
            
            Certificate
      of Designations for the Company’s Series C-III Preferred
      Stock
            
            10-K
            
            April
      2, 20014.8
            
            Form
      of Warrant issued to the holders of Series C, Series C-II and Series
      C-III Preferred Stock
            
            10-K
            
            April
      2, 2001




61





Incorporated
      by ReferenceExhibit
                Number
              
              Exhibit
      Description
              
              Form
              
              Date
      Filed
              
              Filed
                Herewith4.9
              
              Common
      Stock Purchase Agreement, dated as of July 18, 2001 by and between
      the Company and Real.
              
              SB-2/A
              
              Sept.
      13, 20014.10
              
              Investor
      Rights Agreement, dated as of July 18, 2001, between Real and the
      Company
              
              SB-2/A
              
              Sept.
      13, 20014.11
              
              Indemnity
      Agreement, dated as of January 28, 2002, by and among The Travelers
      Insurance Company, Travelers Indemnity Company, and the
      Company
              
              S-3
              
              July
      11, 20034.12
              
              Investor’s
      Rights Agreement, dated as of January 29, 2001, between the Company and
      Abanat Limited
              
              S-3
              
              Oct.
      1, 20034.13
              
              Common
      Stock Purchase Warrant, dated as of August 24, 2006
              
              8-K
              
              August
      25, 200610.1
              
              License
      Agreement by and between the Company and Bevmax Office Centers 1560,
      LLC
              
              10-K
              
              March
      15, 200610.2
              
              Restated
      Lease Agreement by and between the Company and Sitterly Associates
      II
              
              10-K
              
              March
      15, 200610.3
              
              Separation
      and Consultancy Agreement by and between the Company and Douglas A.
      McIntyre, dated as of February 2, 2006
              
              10-K
              
              March
      15, 200610.4
              
              Employment
      Agreement, dated May 1, 2006, by and between the Company and Bill
      Joll
              
              10-Q
              
              May
      5, 200610.5
              
              Securities
      Purchase Agreement, dated as of August 24, 2006
              
              8-K
              
              Aug.
      25, 200610.6
              
              Registration
      Rights Agreement, dated as of August 24, 2006
              
              8-K
              
              Aug.
      25, 200610.7
              
              Stockholder
      Voting Agreement
              
              8-K
              
              Aug.
      25, 200610.8
              
              Asset
      Purchase Agreement (Confidential Treatment Requested as to Redacted
      Portions)
              
              8-K/A
              
              Nov.
      17, 200610.9
              
              Exhibit
      B [sic] to Asset Purchase Agreement (Form of Escrow
    Agreement)
              
              8-K/A
              
              Nov.
      17, 200610.10
              
              Exhibit
      C [sic] to Asset Purchase Agreement (Form of Support and Maintenance
      Agreement)
              
              8-K/A
              
              Nov.
      17, 200610.11
              
              Exhibit
      D [sic] to Asset Purchase Agreement (Form of Registration Rights
      Agreement)
              
              8-K/A
              
              Nov.
      17, 200610.12
              
              Employment
      Agreement, dated as of February 28, 2006, by and between the Company and
      Matt Frost
              
              10-K
              
              March
      23, 200710.13
              
              Letter
      Agreement between the Company and Midsummer Investment, Ltd., dated May
      31, 2007
              
              8-K
              
              June
      20, 200710.14
              
              Letter
      Agreement between the Company and Rockmore Investment Master Fund, dated
      June 11, 2007
              
              8-K
              
              June
      20, 200710.15
              
              Form
      of Employment Agreement with Jim Bankoski
              
              8-K
              
              August
      3, 2007




62





Incorporated
      by ReferenceExhibit
                  Number
                
                Exhibit
      Description
                
                Form
                
                Date
      Filed
                
                Filed
                  Herewith10.16
                
                Form
      of Employment Agreement with Paul Wilkins
                
                8-K
                
                August
      3, 200710.17
                
                Underwriting
      Agreement, dated October 17, 2007, between the Company and ThinkEquity
      Partners LLC and Merriman Curhan Ford & Co.
                
                8-K
                
                October
      23, 200710.18
                
                Form
      of Escrow Agreement, dated as of May 21, 2007 by and among the Company,
      Deutsche Bank and Nexit Ventures Oy, as authorized representative of the
      securityholders of Hantro Products Oy
                
                DEFR14A
                
                August
      30, 200710.19
                
                Form
      of Employment Agreement with Eero Kaikkonen
                
                DEFR14A
                
                August
      30, 200710.20
                
                Transition
      Agreement and General Release, dated June 10, 2008, between On2
      Technologies, Inc. and Bill Joll
                
                8-K
                
                June
      13, 200810.21
                
                Employment
      Agreement dated September 15, 2008 between On2 Technologies, Inc. and Tim
      Reusing
                
                10-Q
                
                November
      7, 200810.22
                
                Employment
      Agreement dated October 17, 2008 between On2 Technologies, Inc. and
      Matthew C. Frost
                
                8-K
                
                October
      22, 200810.23
                
                Transition
      Agreement and General Release, dated January 16, 2009, between On2
      Technologies, Inc. and Eero Kaikkonen
                
                8-K
                
                January
      22, 200914
                
                Code
      of Ethics
                
                
                
                
                
                X21
                
                Subsidiaries
                
                
                
                
                
                X23.1
                
                Consent
      of Marcum & Kliegman LLP
                
                
                
                
                
                X23.2
                
                Consent
      of Eisner LLP
                
                
                
                
                
                X31.1
                
                Certification
      of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley
      Action of 2002
                
                
                
                
                
                X31.2
                
                Certification
      of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley
      Action of 2002
                
                
                
                
                
                X32.1
                
                Certification
      of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted
      Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
                
                
                
                
                
                X32.2
                
                Certification
      of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted
      Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
                
                
                
                
                
                X




63




SIGNATURES




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


ON2
      TECHNOLOGIES, INC.By:
                /s/
      Matthew FrostMatthew
      FrostInterim
      Chief Executive Officer(Principal
      Executive Officer)Date:
      March 12, 2009




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


Signature
            
            Title
            
            Date/s/
      Anthony Principe
            
            Senior
      Vice President and Chief Financial Officer (Principal Financial and
      Accounting Officer)
            
            March
      12, 2009(Anthony
      Principe)/s/
      J. Allen Kosowsky
            
            Chairman
      of the Board and Director
            
            March
      12, 2009(J.
      Allen Kosowsky)/s/
      Mike Kopetski
            
            Director
            
            March
      12, 2009(Mike
      Kopetski)/s/
      Thomas Weigman
            
            Director
            
            March
      12, 2009(Thomas
      Weigman)/s/
      Michael J. Alfant
            
            Director
            
            March
      12, 2009(Michael
      J. Alfant)/s/
      Afsaneh Naimollah
            
            Director
            
            March
      12, 2009(Afsaneh
      Naimollah)/s/
      James Meyer
            
            Director
            
            March
      12, 2009(James
      Meyer)




64




INDEX
TO CONSOLIDATED FINANCIAL STATEMENTS
 PageReports
      of Independent Registered Public Accounting Firms
                            F-2Consolidated
      Balance Sheets as of December 31, 2008 and 2007
                            F-4Consolidated
      Statements of Operations for the years ended
                              December
      31, 2008, 2007 and 2006
                            F-5Consolidated
      Statements of Changes in Stockholders’ Equity
                              for
      the years ended December 31, 2008, 2007 and 2006
                            F-6Consolidated
      Statements of Cash Flows for the years ended
                              December
      31, 2008, 2007 and 2006
                            F-9Notes
      to Consolidated Financial Statements
                            F-11Schedule
      II – Valuation and Qualifying Accounts for the year ended
                              December
      31, 2008, 2007 and 2006
                            F-43
  F-1
  REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING FIRM
  To the
Audit Committee of
 The Board
of Directors and Stockholders of
 On2
Technologies, Inc.
  We have
audited the accompanying consolidated balance sheet of On2 Technologies, Inc.
(the “Company”) as of December 31, 2008, and the related consolidated statements
of operations, changes in stockholders’ equity and cash flows for the year then
ended. Our audit also included the consolidated financial statement schedule as
of December 31, 2008 listed in the Index at Item 15(a). These consolidated
financial statements and financial statement schedule are the responsibility of
the Company’s management. Our responsibility is to express an opinion on these
consolidated financial statements and financial statement schedule based on our
audit.
  We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the
consolidated financial statements are free of material misstatement. An audit
also includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
  In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the consolidated financial position of On2
Technologies, Inc. as of December 31, 2008, and the consolidated results of its
operations and its cash flows for the year then ended in conformity with United
States generally accepted accounting principles. Also, in our opinion, the
related consolidated financial statement schedule, when considered in relation
to the basic consolidated financial statements taken as a whole, presents
fairly, in all material respects, the information set forth
therein.
  We have
also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), On2 Technologies, Inc.’s internal control over
financial reporting as December 31, 2008, based on the criteria established in
Internal Control – Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission and our report, dated March 10, 2009,
expressed an unqualified opinion on the effectiveness of the Company’s internal
control over financial reporting.
  /s/
      Marcum & Kliegman LLPMarcum
      & Kliegman LLPNew
      York, New YorkMarch
      10, 2009
  F-2
  REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
  Board of
Directors and Stockholders
 On2
Technologies, Inc.
  We have
audited the accompanying consolidated balance sheet of On2 Technologies, Inc.
and subsidiaries (the “Company”) as of December 31, 2007 and the related
consolidated statements of operations, changes in stockholders’ equity and cash
flows for each of the years in the two-year period ended December 31, 2007.
These financial statements are the responsibility of the Company’s management.
Our responsibility is to express an opinion on these financial statements based
on our audits.
  We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
  In our
opinion, the financial statements referred to above present fairly, in all
material respects, the consolidated financial position of On2 Technologies, Inc.
and subsidiaries as of December 31, 2007, and the consolidated results of their
operations and their consolidated cash flows for each of the years in the
two-year period ended December 31, 2007 in conformity with U.S. generally
accepted accounting principles.
  In
connection with our audits of the consolidated financial statements referred to
above, we audited Schedule II - Valuation and Qualifying Accounts for each of
the years in the two-year period ended December 31, 2007. In our opinion, this
schedule, when considered in relation to the financial statements taken as a
whole, present fairly, in all material respects, the information stated
therein.
  /s/
      Eisner LLPNew
      York, New YorkJune
      27, 2008
  F-3
  ON2
TECHNOLOGIES, INC.
 CONSOLIDATED
BALANCE SHEETS
 December
      31,2008
                                                
                                                
                                                2007(In
      thousands, except par value and
                                                  share
      amounts)ASSETSCurrent
      assets:Cash
      and cash equivalents
                                                
                                                $
                                                4,157
                                                
                                                
                                                $
                                                9,573Investments,
      at market
                                                
                                                
                                                132
                                                
                                                
                                                
                                                5,521Accounts
      receivable, less allowance for doubtful accounts of $623 and $519 as of
      December 31, 2008 and 2007, respectively
                                                
                                                
                                                2,730
                                                
                                                
                                                
                                                7,513Prepaid
      expenses and other current assets
                                                
                                                
                                                439
                                                
                                                
                                                
                                                1,492Total
      current assets
                                                
                                                
                                                7,458
                                                
                                                
                                                
                                                24,099Acquired
      software, net
                                                
                                                
                                                2,212
                                                
                                                
                                                
                                                10,333Other
      acquired intangibles, net
                                                
                                                
                                                5,276
                                                
                                                
                                                
                                                7,144Goodwill
                                                
                                                
                                                9,099
                                                
                                                
                                                
                                                37,023Property
      and equipment, net
                                                
                                                
                                                715
                                                
                                                
                                                
                                                707Capital
      leases, net
                                                
                                                
                                                686
                                                
                                                
                                                
                                                44Other
      assets
                                                
                                                
                                                430
                                                
                                                
                                                
                                                175Total
      assets
                                                
                                                $
                                                25,876
                                                
                                                
                                                $
                                                79,525LIABILITIES
      AND STOCKHOLDERS’ EQUITYCurrent
      liabilities:Accounts
      payable
                                                
                                                $
                                                1,352
                                                
                                                
                                                $
                                                1,433Accrued
      expenses
                                                
                                                
                                                4,368
                                                
                                                
                                                
                                                4,820Deferred
      revenue
                                                
                                                
                                                2,133
                                                
                                                
                                                
                                                1,887Current
      portion of long-term debt
                                                
                                                
                                                1,148
                                                
                                                
                                                
                                                491Short-term
      borrowings
                                                
                                                
                                                63
                                                
                                                
                                                
                                                2,198Capital
      lease obligation
                                                
                                                
                                                260
                                                
                                                
                                                
                                                24Total
      current liabilities
                                                
                                                
                                                9,324
                                                
                                                
                                                
                                                10,853Capital
      lease obligation, excluding current portion
                                                
                                                
                                                432
                                                
                                                
                                                
                                                18Long-term
      debt
                                                
                                                
                                                1,802
                                                
                                                
                                                
                                                3,082Total
      liabilities
                                                
                                                
                                                11,558
                                                
                                                
                                                
                                                13,953Commitments
      and contingencies (Note 11)
                                                
                                                
                                                —
                                                
                                                
                                                
                                                —Stockholders’
      equity:Preferred
      stock, $0.01 par value; 20,000,000 shares authorized and -0- issued and
      outstanding
                                                
                                                
                                                —
                                                
                                                
                                                
                                                —Common
      stock, $0.01 par value; 250,000,000 shares authorized; 171,769,000 and
      170,475,000 shares issued and issuable at December 31, 2008 and 2007,
      respectively, and 171,769,000 and 157,975,000 outstanding at December 31,
      2008 and 2007, respectively
                                                
                                                
                                                1,718
                                                
                                                
                                                
                                                1,705Additional
      paid-in capital
                                                
                                                
                                                196,371
                                                
                                                
                                                
                                                194,453Accumulated
      other comprehensive (loss) income
                                                
                                                
                                                (1,073
                                                )
                                                
                                                
                                                906Accumulated
      deficit
                                                
                                                
                                                (182,698
                                                )
                                                
                                                
                                                (131,492
                                                )Total
      stockholders’ equity
                                                
                                                
                                                14,318
                                                
                                                
                                                
                                                65,572Total
      liabilities and stockholders’ equity
                                                
                                                $
                                                25,876
                                                
                                                
                                                $
                                                79,525
  See
accompanying notes to consolidated financial statements
 F-4
  ON2
TECHNOLOGIES, INC.
 CONSOLIDATED
STATEMENTS OF OPERATIONS
 For
      The Years Ended December 31,2008
                            
                            
                            2007
                            
                            
                            2006(In
      thousands, except per share data)Revenue
                            
                            $
                            16,268
                            
                            
                            $
                            13,237
                            
                            
                            $
                            6,572Operating
      expenses:Costs
      of revenue (1)
                            
                            
                            4,154
                            
                            
                            
                            2,549
                            
                            
                            
                            2,328Research
      and development (2)
                            
                            
                            10,736
                            
                            
                            
                            3,833
                            
                            
                            
                            972Sales
      and marketing (2)
                            
                            
                            7,095
                            
                            
                            
                            4,272
                            
                            
                            
                            1,093General
      and administrative (2)
                            
                            
                            11,228
                            
                            
                            
                            5,200
                            
                            
                            
                            4,384Asset
      impairments
                            
                            
                            33,268
                            
                            
                            
                            —
                            
                            
                            
                            —Equity-based
      compensation:Research
      and development
                            
                            
                            433
                            
                            
                            
                            147
                            
                            
                            
                            98Sales
      and marketing
                            
                            
                            204
                            
                            
                            
                            157
                            
                            
                            
                            103General
      and administrative
                            
                            
                            1,026
                            
                            
                            
                            491
                            
                            
                            
                            1,184Total
      operating expenses
                            
                            
                            68,144
                            
                            
                            
                            16,649
                            
                            
                            
                            10,162Loss
      from operations
                            
                            
                            (51,876
                            )
                            
                            
                            (3,412
                            )
                            
                            
                            (3,590
                            )Other
      income (expense), netInterest
      income (expense), net
                            
                            
                            13
                            
                            
                            
                            200
                            
                            
                            
                            78Other
      income (expense), net
                            
                            
                            657
                            
                            
                            
                            (3,667
                            )
                            
                            
                            (1,304
                            )Total
      other income (expense), net
                            
                            
                            670
                            
                            
                            
                            (3,467
                            )
                            
                            
                            (1,226
                            )Loss
      before income taxes
                            
                            
                            (51,206
                            )
                            
                            
                            (6,879
                            )
                            
                            
                            (4,816
                            )Income
      tax expense
                            
                            
                            —
                            
                            
                            
                            25
                            
                            
                            
                            30Net
      loss
                            
                            
                            (51,206
                            )
                            
                            
                            (6,904
                            )
                            
                            
                            (4,846
                            )Convertible
      preferred stock deemed dividend
                            
                            
                            —
                            
                            
                            
                            —
                            
                            
                            
                            68Convertible
      preferred stock 8% dividend
                            
                            
                            —
                            
                            
                            
                            82
                            
                            
                            
                            285Net
      loss attributable to common stockholders
                            
                            $
                            (51,206
                            )
                            
                            $
                            (6,986
                            )
                            
                            $
                            (5,199
                            )Basic
      and diluted net loss attributable to common stockholders per common
      share
                            
                            $
                            (0.30
                            )
                            
                            $
                            (0.06
                            )
                            
                            $
                            (0.05
                            )Weighted
      average basic and diluted common shares outstanding
                            
                            
                            171,231
                            
                            
                            
                            121,561
                            
                            
                            
                            96,642
  (1)
                  Includes
      equity-based compensation of $288,000, $151,000 and $169,000 for the years
      ended December 31, 2008 2007 and 2006, respectively.(2)
                  Excludes
      equity-based compensation, which is presented
  separately.
  See
accompanying notes to consolidated financial statements
 F-5
  ON2
TECHNOLOGIES, INC.
 CONSOLIDATED
STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
 FOR
THE YEARS ENDED DECEMBER 31, 2008, 2007 AND 2006
 (In
thousands)
 Convertible
                                Preferred
      Stock
                              
                              
                              Common
      Stock
                              
                              
                              Additional
                                Paid-in
                                Capital
                              
                              
                              Treasury
      Stock
                              
                              
                              Accumulated
                                Other
                                Comprehensive
                                Income
      (Loss)
                              
                              
                              Accumulated
                                Deficit
                              
                              
                              Total
                                Stockholders’
                                EquityShares
                              
                              
                              Amount
                              
                              
                              Shares
                              
                              
                              Amount
                              
                              
                              Shares
                              
                              
                              AmountBalance
      at January 1, 2006
                              
                              
                              1,849
                              
                              
                              $
                              19
                              
                              
                              
                              92,295
                              
                              
                              $
                              923
                              
                              
                              $
                              119,772
                              
                              
                              
                              —
                              
                              
                              $
                              —
                              
                              
                              $
                              (43
                              )
                              
                              $
                              (119,307
                              )
                              
                              $
                              1,364Net
      loss
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              (4,846
                              )
                              
                              
                              (4,846
                              )Foreign
      currency translation adjustment
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              (3
                              )
                              
                              
                              
                              
                              
                              
                              (3
                              )Comprehensive
      loss
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              (4,849
                              )Issuance
      of common stock in connection with the exercise of stock
      options
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              1,745
                              
                              
                              
                              17
                              
                              
                              
                              924
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              941Issuance
      of common stock in connection with the exercise of
warrants
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              202
                              
                              
                              
                              2
                              
                              
                              
                              125
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              127Issuance
      of common stock to employees and consultants as
    compensation
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              25
                              
                              
                              
                              —
                              
                              
                              
                              16
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              16Issuance
      of common stock in connection with the Wildform Support and Services
      Agreement
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              280
                              
                              
                              
                              3
                              
                              
                              
                              255
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              258Issuance
      of common stock in connection with the conversion of Series A secured
      convertible debentures
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              2,232
                              
                              
                              
                              22
                              
                              
                              
                              228
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              250Issuance
      of common stock in connection with the conversion and redemption of Series
      D convertible preferred stock
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              1,017
                              
                              
                              
                              10
                              
                              
                              
                              697
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              707Issuance
      of common stock in connection with the payment of interest on the Series A
      secured convertible debentures
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              5
                              
                              
                              
                              —
                              
                              
                              
                              5
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              —
                              
                              
                              
                              5
  F-6
  ON2
TECHNOLOGIES, INC.
 CONSOLIDATED
STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (CONTINUED)
 FOR
THE YEARS ENDED DECEMBER 31, 2008, 2007 AND 2006
 (in
thousands)
 Additional
                                                          Paid-in
                                                          Capital
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        Accumulated
                                                          Other
                                                          Comprehensive
                                                          Income
      (Loss)
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        Total
                                                          Stockholders’
                                                          EquityConvertible
                                                          Preferred
      Stock
                                                        
                                                        
                                                        Common
      Stock
                                                        
                                                        
                                                        Treasury
      StockAccumulated
                                                          DeficitShares
                                                        
                                                        
                                                        Amount
                                                        
                                                        
                                                        Shares
                                                        
                                                        
                                                        Amount
                                                        
                                                        
                                                        Shares
                                                        
                                                        
                                                        AmountIssuance
      of common stock in connection with the payment of dividends and dividends
      accrued on the Series D convertible preferred stock
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        387
                                                        
                                                        
                                                        
                                                        4
                                                        
                                                        
                                                        
                                                        287
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        (285
                                                        )
                                                        
                                                        
                                                        6Issuance
      of common stock in connection with sale of common stock and
      warrants
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        3,070
                                                        
                                                        
                                                        
                                                        31
                                                        
                                                        
                                                        
                                                        398
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        429Deemed
      dividend on Series D convertible preferred stock
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        68
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        (68
                                                        )
                                                        
                                                        
                                                        —Expiration
      of January 2006 warrant extension
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        135
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        135December
      2006 warrant extension
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        106
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        106Compensation
      expense associated with the issuance and extension of stock options and
      restricted stock grants
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        1,538
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        1,538Balance
      at December 31, 2006
                                                        
                                                        
                                                        1,849
                                                        
                                                        
                                                        $
                                                        19
                                                        
                                                        
                                                        
                                                        101,258
                                                        
                                                        
                                                        $
                                                        1,012
                                                        
                                                        
                                                        $
                                                        124,554
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        $
                                                        (46
                                                        )
                                                        
                                                        $
                                                        (124,506
                                                        )
                                                        
                                                        $
                                                        1,033Net
      loss
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        (6,904
                                                        )
                                                        
                                                        
                                                        (6,904
                                                        )Foreign
      currency translation adjustment
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        952
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        952Comprehensive
      loss
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        (5,952
                                                        )Proceeds
      from sale of common stock, net of offering costs of
    $1,048,000
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        14,950
                                                        
                                                        
                                                        
                                                        150
                                                        
                                                        
                                                        
                                                        13,753
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        13,903Exercise
      of stock options
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        2,139
                                                        
                                                        
                                                        
                                                        21
                                                        
                                                        
                                                        
                                                        1,407
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        1,428Cashless
      exercise of stock options
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        1,840
                                                        
                                                        
                                                        
                                                        18
                                                        
                                                        
                                                        
                                                        1,223
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        1,241Cashless
      exercise of warrants
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        27
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —Exercise
      of warrants
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        5,460
                                                        
                                                        
                                                        
                                                        55
                                                        
                                                        
                                                        
                                                        5,418
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        5,473Warrant
      amendments
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        90
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        90Deferred
      financing costs charged on exercise of extended warrant
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        (106
                                                        )
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        (106
                                                        )Issuance
      of restricted stock to employees and directors as
    compensation
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        657
                                                        
                                                        
                                                        
                                                        7
                                                        
                                                        
                                                        
                                                        (7
                                                        )
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —Issuance
      of common stock in connection with the conversion of Series C-IV
      convertible preferred stock
                                                        
                                                        
                                                        (1,849
                                                        )
                                                        
                                                        
                                                        (19
                                                        )
                                                        
                                                        
                                                        3,072
                                                        
                                                        
                                                        
                                                        31
                                                        
                                                        
                                                        
                                                        (12
                                                        )
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
                                                        
                                                        
                                                        
                                                        —
  F-7
  ON2
TECHNOLOGIES, INC.
 CONSOLIDATED
STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (CONTINUED)
 FOR
THE YEARS ENDED DECEMBER 31, 2008, 2007 AND 2006
 (in
thousands)
 Accumulated
                                                                                      Other
                                                                                      Comprehensive
                                                                                      Income
      (Loss)
                                                                                    
                                                                                    
                                                                                    Accumulated
                                                                                      Deficit
                                                                                    
                                                                                    
                                                                                    Total
                                                                                      Stockholders’
                                                                                      EquityConvertible
                                                                                      Preferred
      Stock
                                                                                    
                                                                                    
                                                                                    Common
      Stock
                                                                                    
                                                                                    
                                                                                    Additional
                                                                                      Paid-in
                                                                                      Capital
                                                                                    
                                                                                    
                                                                                    Treasury
      StockShares
                                                                                    
                                                                                    
                                                                                    Amount
                                                                                    
                                                                                    
                                                                                    Shares
                                                                                    
                                                                                    
                                                                                    Amount
                                                                                    
                                                                                    
                                                                                    Shares
                                                                                    
                                                                                    
                                                                                    AmountIssuance
      of common stock in connection with the conversion of Series D convertible
      preferred stock
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    3,891
                                                                                    
                                                                                    
                                                                                    
                                                                                    39
                                                                                    
                                                                                    
                                                                                    
                                                                                    3,044
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    3,083Issuance
      of common stock in connection with the payment of dividends and dividends
      accrued on the Series D convertible preferred stock
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    78
                                                                                    
                                                                                    
                                                                                    
                                                                                    1
                                                                                    
                                                                                    
                                                                                    
                                                                                    101
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    (82
                                                                                    )
                                                                                    
                                                                                    
                                                                                    20Write
      off of the warrant derivative liability
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    5,911
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    5,911Issuance
      and shares issuable of common stock for the acquisition of the outstanding
      stock of On2 Finland Products Oy
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    37,939
                                                                                    
                                                                                    
                                                                                    
                                                                                    379
                                                                                    
                                                                                    
                                                                                    
                                                                                    39,836
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    40,215Compensation
      expense associated with the issuance of stock options and restricted stock
      grants
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    946
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    946Purchase
      of treasury stock
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    (836
                                                                                    )
                                                                                    
                                                                                    
                                                                                    (1,713
                                                                                    )
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    (1,713
                                                                                    )Retirement
      of treasury stock
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    (836
                                                                                    )
                                                                                    
                                                                                    
                                                                                    (8
                                                                                    )
                                                                                    
                                                                                    
                                                                                    (1,705
                                                                                    )
                                                                                    
                                                                                    
                                                                                    836
                                                                                    
                                                                                    
                                                                                    
                                                                                    1,713
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —Balance
      as of December 31, 2007
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    $
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    170,475
                                                                                    
                                                                                    
                                                                                    $
                                                                                    1,705
                                                                                    
                                                                                    
                                                                                    $
                                                                                    194,453
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    $
                                                                                    —
                                                                                    
                                                                                    
                                                                                    $
                                                                                    906
                                                                                    
                                                                                    
                                                                                    $
                                                                                    (131,492
                                                                                    )
                                                                                    
                                                                                    $
                                                                                    65,572Net
      loss
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    (51,206
                                                                                    )
                                                                                    
                                                                                    
                                                                                    (51,206
                                                                                    )Foreign
      currency translation adjustment
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    (1,979
                                                                                    )
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    (1,979
                                                                                    )Comprehensive
      loss
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    (53,185
                                                                                    )Exercise
      of stock options and warrants, net
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    71
                                                                                    
                                                                                    
                                                                                    
                                                                                    1
                                                                                    
                                                                                    
                                                                                    
                                                                                    48
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    49Compensation
      expense associated with the issuance of stock options and restricted stock
      grants
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    1,951
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    1,951Issuance
      of restricted stock to employees and directors as compensation, net of
      terminations
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    1,333
                                                                                    
                                                                                    
                                                                                    
                                                                                    13
                                                                                    
                                                                                    
                                                                                    
                                                                                    (13
                                                                                    )
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    —Purchase
      of treasury stock
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    (110
                                                                                    )
                                                                                    
                                                                                    
                                                                                    (69
                                                                                    )
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    (69
                                                                                    )Retirement
      of treasury stock
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    (110
                                                                                    )
                                                                                    
                                                                                    
                                                                                    (1
                                                                                    )
                                                                                    
                                                                                    
                                                                                    (68
                                                                                    )
                                                                                    
                                                                                    
                                                                                    110
                                                                                    
                                                                                    
                                                                                    
                                                                                    69
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    
                                                                                    —Balance
      as of December 31, 2008
                                                                                    
                                                                                    
                                                                                    —
                                                                                    
                                                                                    
                                                                                    $
                                                                                    —
                                                                                    
                                                                                    
                                                                                    
                                                                                    171,769
                                                                                    
                                                                                    
                                                                                    $
                                                                                    1,718
                                                                                    
                                                                                    
                                                                                    $
                                                                                    196,371
                                                                                    
                                                                                    
                                                                                    $
                                                                                    —
                                                                                    
                                                                                    
                                                                                    $
                                                                                    —
                                                                                    
                                                                                    
                                                                                    $
                                                                                    (1,073
                                                                                    )
                                                                                    
                                                                                    $
                                                                                    (182,698
                                                                                    )
                                                                                    
                                                                                    $
                                                                                    14,318
   F-8
  ON2
TECHNOLOGIES, INC.
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 For
      The Years Ended December 31,2008
                                          
                                          
                                          2007
                                          
                                          
                                          2006(In
      thousands)Cash
      flows from operating activities:Net
      loss
                                          
                                          $
                                          (51,206
                                          )
                                          
                                          $
                                          (6,904
                                          )
                                          
                                          $
                                          (4,846
                                          )Adjustments
      to reconcile net loss to net cash (used in) provided by operating
      activities:Equity-based
      compensation
                                          
                                          
                                          1,951
                                          
                                          
                                          
                                          946
                                          
                                          
                                          
                                          1,554Other
      expense recognized for amendments and extension of
warrants
                                          
                                          
                                          —
                                          
                                          
                                          
                                          90
                                          
                                          
                                          
                                          135Common
      stock issued for debenture interest
                                          
                                          
                                          —
                                          
                                          
                                          
                                          —
                                          
                                          
                                          
                                          5Common
      stock issued to Wildform for Support and Services
Agreement
                                          
                                          
                                          —
                                          
                                          
                                          
                                          —
                                          
                                          
                                          
                                          126Insurance
      expense financed with term loan
                                          
                                          
                                          73
                                          
                                          
                                          
                                          82
                                          
                                          
                                          
                                          52Depreciation
                                          
                                          
                                          554
                                          
                                          
                                          
                                          158
                                          
                                          
                                          
                                          89Amortization
                                          
                                          
                                          2,679
                                          
                                          
                                          
                                          709
                                          
                                          
                                          
                                          247Asset
      impairments
                                          
                                          
                                          33,268
                                          
                                          
                                          
                                          —
                                          
                                          
                                          
                                          —Bad
      debt expense
                                          
                                          
                                          145
                                          
                                          
                                          
                                          518
                                          
                                          
                                          
                                          117Change
      in fair value of warrant liability
                                          
                                          
                                          —
                                          
                                          
                                          
                                          3,582
                                          
                                          
                                          
                                          1,078Loss
      on disposal of equipment
                                          
                                          
                                          1
                                          
                                          
                                          
                                          —
                                          
                                          
                                          
                                          —Unrealized
      loss on marketable securities
                                          
                                          
                                          —
                                          
                                          
                                          
                                          —
                                          
                                          
                                          
                                          46Realized
      loss on marketable securities
                                          
                                          
                                          —
                                          
                                          
                                          
                                          27
                                          
                                          
                                          
                                          —Amortization
      of debt discount
                                          
                                          
                                          —
                                          
                                          
                                          
                                          —
                                          
                                          
                                          
                                          6Changes
      in operating assets and liabilities, net of acquisitions:Accounts
      receivable
                                          
                                          
                                          4,537
                                          
                                          
                                          
                                          (430
                                          )
                                          
                                          
                                          (706
                                          )Prepaid
      expenses and other current assets
                                          
                                          
                                          1,108
                                          
                                          
                                          
                                          (34
                                          )
                                          
                                          
                                          (1
                                          )Other
      assets
                                          
                                          
                                          (258
                                          )
                                          
                                          
                                          9
                                          
                                          
                                          
                                          (95
                                          )Accounts
      payable and accrued expenses
                                          
                                          
                                          (314
                                          )
                                          
                                          
                                          1,949
                                          
                                          
                                          
                                          136Deferred
      revenue
                                          
                                          
                                          309
                                          
                                          
                                          
                                          (345
                                          )
                                          
                                          
                                          467Net
      cash (used in) provided by operating activities
                                          
                                          
                                          (7,153
                                          )
                                          
                                          
                                          357
                                          
                                          
                                          
                                          (1,590
                                          )Cash
      flows from investing activities:Purchases
      of marketable securities
                                          
                                          
                                          (17,685
                                          )
                                          
                                          
                                          (5,617
                                          )
                                          
                                          
                                          (94
                                          )Sale
      of marketable securities
                                          
                                          
                                          23,074
                                          
                                          
                                          
                                          223
                                          
                                          
                                          
                                          75Acquisition
      of On2 Finland Products Oy, net of cash received of $126
                                          
                                          
                                          —
                                          
                                          
                                          
                                          (9,160
                                          )
                                          
                                          
                                          —Proceeds
      from the disposal of equipment
                                          
                                          
                                          1
                                          
                                          
                                          
                                          —
                                          
                                          
                                          
                                          —Purchases
      of property and equipment
                                          
                                          
                                          (364
                                          )
                                          
                                          
                                          (460
                                          )
                                          
                                          
                                          (57
                                          )Net
      cash provided by (used in) investing activities
                                          
                                          
                                          5,026
                                          
                                          
                                          
                                          (15,014
                                          )
                                          
                                          
                                          (76
                                          )Cash
      flows from financing activities:Payments
      on short-term borrowings
                                          
                                          
                                          (2,299
                                          )
                                          
                                          
                                          —
                                          
                                          
                                          
                                          —Principal
      payments on capital lease obligations
                                          
                                          
                                          (204
                                          )
                                          
                                          
                                          (25
                                          )
                                          
                                          
                                          (31
                                          )Proceeds
      attributed to warrant derivative liability
                                          
                                          
                                          —
                                          
                                          
                                          
                                          —
                                          
                                          
                                          
                                          1,251Principal
      payments on debt
                                          
                                          
                                          (491
                                          )
                                          
                                          
                                          (1,035
                                          )
                                          
                                          
                                          (63
                                          )Net
      proceeds from the issuance of common stock
                                          
                                          
                                          —
                                          
                                          
                                          
                                          13,903
                                          
                                          
                                          
                                          429Purchase
      of treasury stock
                                          
                                          
                                          (69
                                          )
                                          
                                          
                                          (472
                                          )
                                          
                                          
                                          —Proceeds
      from exercise of common stock options and warrants, net
                                          
                                          
                                          49
                                          
                                          
                                          
                                          6,901
                                          
                                          
                                          
                                          1,068Net
      cash (used in) provided by financing activities
                                          
                                          
                                          (3,014
                                          )
                                          
                                          
                                          19,272
                                          
                                          
                                          
                                          2,654Net
      change in cash and cash equivalents
                                          
                                          
                                          (5,141
                                          )
                                          
                                          
                                          4,615
                                          
                                          
                                          
                                          988Effect
      of exchange rate changes on cash and cash equivalents
                                          
                                          
                                          (275
                                          )
                                          
                                          
                                          (3
                                          )
                                          
                                          
                                          (3
                                          )Cash
      and cash equivalents, beginning of year
                                          
                                          
                                          9,573
                                          
                                          
                                          
                                          4,961
                                          
                                          
                                          
                                          3,976Cash
      and cash equivalents, end of year
                                          
                                          $
                                          4,157
                                          
                                          
                                          $
                                          9,573
                                          
                                          
                                          $
                                          4,961
  F-9
  ON2
TECHNOLOGIES, INC.
 CONSOLIDATED
STATEMENTS OF CASH FLOWS (CONTINUED)
  Supplemental
disclosure of cash flow information and non-cash transactions:
 For
      The Years Ended December 31,2008
                          
                          
                          2007
                          
                          
                          2006(In
      thousands)Cash
      paid during the year for:Interest
                          
                          $
                          193
                          
                          
                          $
                          107
                          
                          
                          $
                          8Taxes
                          
                          
                          —
                          
                          
                          $
                          26
                          
                          
                          $
                          19Non-cash
      transactions:Acquisition
      of fixed assets under capital leases
                          
                          $
                          849
                          
                          
                          $
                          15
                          
                          
                          $
                          58Prepaid
      insurance financed with term loan
                          
                          $
                          102
                          
                          
                          $
                          82
                          
                          
                          $
                          44Short-term
      insurance financed
                          
                          $
                          140
                          
                          
                          $
                          143
                          
                          
                          $
                          96Conversion
      of Series A, C-V and C-IV convertible preferred stock into common
      stock
                          
                          
                          —
                          
                          
                          $
                          19
                          
                          
                          
                          —Conversion
      and redemption of Series D redeemable convertible preferred stock into
      common stock
                          
                          
                          —
                          
                          
                          $
                          3,
      083
                          
                          
                          $
                          707Conversion
      of debentures into common stock
                          
                          
                          —
                          
                          
                          
                          —
                          
                          
                          $
                          250Common
      stock issued for dividends and dividends accrued on Series D convertible
      preferred stock
                          
                          
                          —
                          
                          
                          $
                          102
                          
                          
                          $
                          290Accrued
      dividend on Series D convertible preferred stock
                          
                          
                          —
                          
                          
                          $
                          20
                          
                          
                          $
                          5Deferred
      financing costs recorded for extension of warrants
                          
                          
                          —
                          
                          
                          
                          
                          
                          
                          $
                          106Stock
      issued to Wildform associated with the Support and Services Agreement for
      prior year services
                          
                          
                          —
                          
                          
                          
                          —
                          
                          
                          $
                          132Cashless
      exercise of stock options and restricted stock vesting
                          
                          
                          
                          
                          
                          $
                          959
                          
                          
                          
                          —Issuance
      of restricted stock
                          
                          $
                          13
                          
                          
                          $
                          7
                          
                          
                          
                          —Retirement
      of treasury stock
                          
                          $
                          69
                          
                          
                          $
                          1,431
                          
                          
                          
                          —Write
      off of warrant derivative liability
                          
                          
                          —
                          
                          
                          $
                          5,911
                          
                          
                          
                          —Acquisition
      of Hantro (On2 Finland)
                          
                          
                          —
                          
                          
                          $
                          40,215
                          
                          
                          
                          —Convertible
      preferred stock deemed dividend
                          
                          
                          —
                          
                          
                          
                          —
                          
                          
                          $
                          68
  See
accompanying notes to consolidated financial statements
 F-10
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (1)
ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
  (a)
Description of the Business
  On2
Technologies, Inc. (“On2”, the “Company”, “we”, “our,” and “us”) is a video
compression technology firm. The Company has developed its proprietary
technology platform and video compression/decompression software (“codec”) to
deliver high quality video at the lowest possible data rates to closed area
networks, such as set-top boxes, the Internet and wireless devices. The Company
offers a suite of products and professional services that encompass its
proprietary compression technology. The Company’s professional service offerings
include customized engineering and consulting services. In addition, the Company
licenses its software products for use with video delivery
platforms.
  (b)
Basis of Presentation
  The
consolidated financial statements include the accounts of the Company and its
wholly owned subsidiaries. All intercompany balances and transactions have been
eliminated in consolidation. The operations of On2 Finland have been included
from the date of acquisition.
  The
Company has experienced significant operating losses and negative operating cash
flows to date. At December 31, 2008, the Company had a negative working capital
of $1,866,000. For the year ended December 31, 2008, the Company incurred a net
loss of $51,206,000 which included non-cash charges of $38,597,000. Cash used
from operating activities was $7,153,000 for the year ended December 31,
2008.
  During
2008, the company implemented a restructuring program, including a reduction of
its workforce, a reduction in overhead costs, and the identification of one time
charges for professional fees. Additionally, on January 28, 2009 the company
notified its employees at On2 Finland that it intends to further reduce its
personnel costs there through furloughs, terminations and/or moving some
full-time employees to part-time. In accordance with Finnish law and the
collective bargaining agreement covering most On2 Finland employees, the details
of this plan to further reduce personnel costs in Finland are subject to final
negotiations with the On2 Finland employee representative. Management estimates
that the 2009 savings related to these cost-cutting measures and one time
charges approximate $11.9 million. Although sales levels were weakened in the
4th
quarter of 2008, we are continuing to focus our efforts on marketing our
compression and video technology to strengthen the demand for our product and
services.
  Additionally,
On2 Finland may borrow funds up to a maximum of €450,000 ($634,000) under a line
of credit as of December 31, 2008. To date, On2 Finland has not borrowed under
the line. Given our cash and short-term investments of $4,289,000 at December
31, 2008, and the Company’s forecasted cash requirements, the Company’s
management anticipates that the Company’s existing capital resources will be
sufficient to satisfy our cash flow requirements for the next 12 months. We have
based our forecasts on assumptions we have made relating to, among other things,
the market for our products and services, economic conditions and the
availability of credit to us and our customers. If these assumptions are
incorrect, or if our sales are less than forecasted and/or expenses higher than
expected, we may not have sufficient resources to fund our operations for this
entire period. In that event, the Company may need to seek other sources of
funds by issuing equity or incurring debt, or may need to implement further
reductions of operating expenses, or some combination of these measures, in
order for the Company to generate positive cash flows to sustain the operations
of the Company. However, because of the recent tightening in global credit
markets, we may not be able to obtain financing on favorable terms, or at
all.
  F-11
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (1)
ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
  (c)
Acquisitions
  Hantro
Products Oy:
  On
November 1, 2007, the Company completed the acquisition of all of the share
capital of Hantro Products Oy (now On2 Technologies Finland Oy and hereinafter
“On2 Finland”), a Finnish corporation. Under the exchange agreement On2
Finland’s security holders each exchanged all of the outstanding capital shares,
and all outstanding options to purchase capital shares, that together
constituted all of the equity ownership of On2 Finland.
  Accordingly,
the Company acquired all of the issued and outstanding shares of capital stock
of On2 Finland and in exchange, On2 paid at closing total consideration of
$6,842,000 in cash and 25,439,000 shares of On2’s common stock. Because the
closing share price was less than $1.50, On2 issued the set number of 25,439,000
shares, as specified in the share exchange agreement. The 25,439,000 shares so
issued represented approximately 22% of On2’s outstanding common stock as of
November 1, 2007.
  The
number of shares issued at closing was subject to an adjustment based on the
difference between On2 Finland’s actual closing net worth and a baseline of
(€3,450,000). The actual closing net worth was (€3,608,000) which was €158,000
over the baseline, and the On2 Finland security holders will pay the net worth
deficiency by cash or by returning On2’s common stock to On2 in such number
equal to the net worth deficiency divided by the deemed closing share price of
$1.50. In February 2008, cash of $233,000 was received from the On2 Finland
security holders to settle this deficiency.
  In
addition, under the share exchange agreement, On2 was obligated to issue
additional shares of its common stock to the On2 Finland security holders if On2
Finland’s net revenue for the fiscal year 2007 exceeded €6,000,000. The maximum
additional shares which may be issued will be 12,500,000 shares if On2 Finland’s
net revenue for 2007 exceeded €9,000,000. On2 Finland’s net revenue for the
fiscal year 2007 was calculated based on the net revenue of On2 Finland as if it
had continued post-closing on a stand-alone basis independent of On2. On2
Finland’s actual net revenue for fiscal 2007 was €9,672,000 and therefore On2
issued (these shares have been reflected as issuable as of December 31, 2007)
12,500,000 shares of its common stock to the Hantro security
holders.
  Pro
Forma Financial Information
  The
unaudited information in the table below summarizes the combined results of
operations of On2 Technologies, Inc. and On2 Finland, on a pro forma basis, as
though the companies had been combined as of the beginning of the period
presented. The pro forma financial information is presented for informational
purposes only and is not indicative of the results of operations that would have
been achieved if the acquisition had taken place at the beginning of each of the
periods presented. The pro forma financial information for all periods presented
includes the business combination accounting effect of historical On2 Finland
revenues, amortization charges from acquired intangible assets and related
deferred tax adjustments.
 Year
      Ended December 312007
                                                                  
                                                                  
                                                                  2006(In
      thousands, except per share data)Total
      revenues
                                                                  
                                                                  $
                                                                  23,189
                                                                  
                                                                  
                                                                  $
                                                                  15,546Net
      loss
                                                                  
                                                                  
                                                                  (9,264
                                                                  )
                                                                  
                                                                  
                                                                  (12,898
                                                                  )Net
      loss per share – basic and diluted
                                                                  
                                                                  
                                                                  (.06
                                                                  )
                                                                  
                                                                  
                                                                  (.09
                                                                  )
  F-12
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (1)
ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(continued)
  (c)
Acquisitions (continued)
  The
On2 Finland acquisition costs are as follows (in thousands):
 Number
      of
                    shares
      issued
                    and
      issuable
                  
                  
                  Fair
      valueCash,
      net of a $233,000 receivable
                  
                  
                  —
                  
                  
                  $
                  6,609Shares
      issued directly to Hantro security holders
                  
                  
                  23,439
                  
                  
                  
                  24,845Shares
      issued into escrow
                  
                  
                  2,000
                  
                  
                  
                  2,120Shares
      to be issued for the earn out
                  
                  
                  12,500
                  
                  
                  
                  13,250Acquisition
      costs
                  
                  
                  —
                  
                  
                  
                  2,67737,939
                  
                  
                  $
                  49,501
  All
the shares were valued at $1.06 which was the close price of the Company’s
common stock on November 1, 2007, the closing date. There was $3,853,000 of net
tangible liabilities assumed in the acquisition.
  Based
upon the purchase price of the acquisition, the purchase price allocation is as
follows (in thousands):
 Current
      assets and other tangible assets:Cash
                  
                  $
                  126Accounts
      receivable
                  
                  
                  6,148Other
      current assets
                  
                  
                  1,143Property
      and equipment
                  
                  
                  273Goodwill
                  
                  
                  36,075Amortizable
      intangible assets:Acquired
      software
                  
                  
                  10,214Customer
      relationships
                  
                  
                  4,074Trademarks
                  
                  
                  2,991Other
      assets
                  
                  
                  58Deferred
      tax asset, net of valuation allowance of $3,401,000
                  
                  
                  4,492Total
      assets acquired
                  
                  
                  65,594Liabilities
      assumed:Short-term
      borrowings
                  
                  
                  2,800Deferred
      revenues
                  
                  
                  1,495Current
      liabilities
                  
                  
                  3,802Deferred
      tax liabilities
                  
                  
                  4,492Other
      long-term liabilities
                  
                  
                  3,504Net
      assets acquired
                  
                  $
                  49,501
  The
Company is required to allocate the purchase price of an acquired company to the
tangible and intangible assets acquired, and liabilities assumed. The Company
uses various models to determine the fair values of the assets acquired and
liabilities assumed. These models include the discounted cash flow (DCF), the
royalty savings method and the cost savings approach. The valuation requires
management to make significant estimates and assumptions, especially with
respect to long-lived and intangible assets.
  F-13
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (1)
ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(continued)
  (c)
Acquisitions (continued)
  Critical
estimates in valuing certain of the intangible assets include, but are not
limited to, future expected cash flows from customer contracts, customer lists,
distribution agreements and acquired developed technologies and patents; the
acquired company’s brand awareness and market position as well as assumptions
about the period of time the brand will continue to be used in the combined
company’s product portfolio; and discount rates. The Company derives its
discount rates from an internal rate of return based on the Company’s internal
forecasts and may adjust the discount rate giving consideration to specific risk
factors of each asset. Management’s estimates of fair value are based upon
assumptions believed to be reasonable but which are inherently uncertain and
unpredictable. Assumptions may be incomplete or inaccurate, and unanticipated
events and circumstances may occur.
  (d)
Cash and Cash Equivalents
  Cash
equivalents consist of money market funds or other highly liquid debt
investments with original maturities when purchased of three months or
less.
  (e)
Revenue Recognition
  The
Company primarily generates revenue from the sale of its software licenses and
its professional service offerings.
  The
Company’s revenue recognition policies are in accordance with Statement of
Position (“SOP”) 97-2, “Software Revenue
Recognition” and other authoritative guidance. Under each arrangement,
revenues are recognized when a non-cancelable agreement has been signed and the
customer acknowledges an unconditional obligation to pay, the products or
applications have been delivered, there are no uncertainties surrounding
customer acceptance, the fees are fixed and determinable, and collection is
considered reasonably assured. Revenues recognized from multiple-element
software arrangements are allocated to each element of the arrangement based on
the fair values of the elements, such as product licenses, post-contract
customer support, or training. The determination of the fair value is based on
the vendor specific objective evidence available to the Company. If such
evidence of the fair value of each element of the arrangement does not exist,
all revenue from the arrangement is deferred until such time that evidence of
the fair value does exist or until all elements of the arrangement are
delivered.
  The
Company assesses collectability based on a number of factors, including past
transaction history with the customer and the credit-worthiness of the customer.
If the Company determines the collection of a fee is not reasonably assured, the
Company will recognize revenue at the time collection becomes reasonably
assured, which is generally upon receipt of payment. If the Company determines
that a fee is not fixed or determinable, the Company will recognize revenue as
the fee becomes due.
  Software
Licenses
  The
Company’s software licensing arrangements typically consist of two elements: a
software license and post-contract customer support (“PCS”). The Company
recognizes software license revenue based on the residual method after all
elements other than PCS have been delivered as prescribed by SOP 98-9. The
Company recognizes PCS revenues over the term of the maintenance contract or on
a “per usage” basis, whichever is stated in the contract. In accordance with SOP
97-2, vendor specific objective evidence of the fair value of PCS is determined
by reference to the price the customer will have to pay for PCS when it is sold
separately (i.e., the renewal rate). Each license agreement offers additional
PCS at a stated price. Revenue is recognized on a per copy basis for licensed
software when each copy of the licensed software purchased by the customer or
reseller is delivered. The Company does not allow returns, exchanges or price
protection for sales to its customers or its resellers nor does it allow its
resellers to purchase software licenses under consignment
arrangements.
  F-14
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (1)
ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(continued)
  (e)
Revenue Recognition (continued)
  Professional
Services
  Professional services consist of customized engineering
and consulting services.
  When customized engineering and consulting services are
sold together with a software license, the arrangement typically requires
customization and integration of the software into a third party hardware
platform. In these arrangements, the Company requires the customer to pay a
fixed fee for the engineering and consulting services and a licensing fee in the
form of a per-unit royalty. The Company accounts for its engineering and
consulting arrangements in accordance with SOP 81-1, “Accounting for Performance of
Construction Type and Certain Production Type Contracts”. When reasonably
dependable estimates are available for the costs and efforts necessary to
complete the engineering or consulting services and those services do not
include contractual milestones or other acceptance criteria, the Company
accounts for the arrangements under the percentage of completion contract method
pursuant to SOP 81-1 based upon input measures such as hours. When such
estimates are not available, the completed contract method is
utilized.
  (f)
Accounts Receivable Allowance
  The Company maintains an allowance for doubtful accounts
for estimated losses resulting from the inability of customers to make payments
when due or within a reasonable period of time thereafter. If the financial
condition of customers were to deteriorate, resulting in the inability to make
required payments, additional allowances may be required. The allowance for
doubtful accounts was $623,000 and $519,000 as of December 31, 2008 and 2007,
respectively
  (g)
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.
  (h) 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-15
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (1)
ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(continued)
  (i)
Fair Value of Financial Instruments and Concentration of Credit
Risk
  Financial
instruments that subject the Company to concentrations of credit risk consist
primarily of cash and cash equivalents, investments and accounts receivable. The
Company maintains cash and cash equivalents in financial institutions in the US
and in foreign countries. The Company performs periodic evaluations of the
relative credit standing of the institutions. The cash balances are insured by
the FDIC, up to $250,000 per depositor. The company has cash balances in a money
market fund and a checking account at December 31, 2008 that exceeds the limit
in the amount of $3.9 million. Additionally, the Company has a balance in an
investment account at December 31, 2008. The investment account is insured by
the Securities Investor Protection Corporation up to a value of $500,000 per
depositor. The Company did not have investments in excess of $500,000 at
December 31, 2008. As of December 31, 2008, one customer accounted for 29% of
our gross accounts receivable. As of December 31, 2007, two customers accounted
for 18% and 12% of gross accounts receivable.
  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.
  (j)
Income Taxes
  The
Company accounts for income taxes using the asset and liability method. Under
this method, deferred tax assets and liabilities are recognized for the future
tax consequences attributable to differences between the consolidated financial
statement carrying amounts of existing assets and liabilities and their
respective tax bases and for operating loss and tax credit carry forwards.
Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in the
consolidated results of operations in the period that the tax change occurs.
Valuation allowances are established, when necessary, to reduce deferred tax
assets to the amount expected to be realized.
  On
January 1, 2007, the Company adopted the provisions of Financial Accounting
Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in
Income Taxes” (“FIN 48”), an interpretation of FASB Statement No. 109,
“Accounting for Income
Taxes.” FIN 48 prescribes a recognition threshold and measurement
attribute for the financial statement recognition and measurement of a tax
position taken or expected to be taken in a tax return. The interpretation
requires that the Company recognize the impact of a tax position in its
financialstatements if it is
more likely than not that the position will be sustained on audit, based on the
technical merits of the position. FIN 48 also provides guidance on
derecognition, classification, interest and penalties, accounting in interim
periods and disclosure. In accordance with the provisions of FIN 48, any
cumulative effect resulting from the change in accounting principle is to be
recorded as an adjustment to the opening balance of accumulated deficit. The
adoption of FIN 48 had no material effects on the Company’s financial
statements.
  The
Company performed an analysis of the limitations on the use of its net operating
losses under Section 382 of the Internal Revenue Code and determined that on
June 7, 2000, the Company experienced an ownership change to which Internal
Revenue Code Section 382 applied. Of the current $96,543,000 in the Company’s
United States net operating loss carryforward, $33,800,000 was incurred prior to
the June 7, 2000 change date. The Company believes the entire pre-change net
operating loss is available for use as of December 31, 2008. However, because
the Company’s ability to utilize these net operating losses is in doubt, the
Company maintains a full valuation allowance against their total net operating
loss carryforward.
  F-16
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (1)
ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(continued)
  (j)
Income Taxes (continued)
  We
intend to classify any future expense for income-tax related interest and
penalties as a component of income tax expense. As of December 31, 2008, no
interest or penalties have been accrued or incurred. The Company files U.S.
federal income tax returns, as well as filing various returns in states and
applicable localities where it holds properties. The Company’s filed income tax
returns are no longer subject to examination by taxing authorities for years
before 2004. The Company also has filings in the United Kingdom and Finland for
its foreign locations.
  (k)
Software Development Costs
  The
Company recognizes costs associated with new software or product development
and/or significant enhancements to current software or products in accordance
with Statement of Financial Accounting Standards (“SFAS”) No. 86, “Software Development Costs”.
Under SFAS No. 86, these costs are expensed until technological feasibility has
been established. The Company essentially has completed its software development
concurrently with technological feasibility and, accordingly, for the years
ended December 31, 2008 and 2007 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.
  (l)
Equity-Based Compensation
  The
Company adopted the provision of Statement of Financial Accounting Standards
(SFAS) No. 123R “Share Based
Payment” effective January 1, 2006, using the modified prospective
transition method. Under the modified prospective transition method, non-cash
compensation expense is recognized under the fair value method for the portion
of outstanding equity-based awards granted prior to the adoption of SFAS 123R
for which service has not been rendered, and for any equity-based awards granted
or modified after adoption. Accordingly, periods prior to adoption have not been
restated. Prior to the adoption of SFAS 123R, the Company accounted for
equity-based compensation using the intrinsic value method. The Company
recognizes equity-based compensation cost associated with awards subject to
graded vesting in accordance with the accelerated method specified in FASB
Interpretation No. 28 pursuant to which each vesting tranche is treated as a
separate award. The compensation cost associated with each vesting tranche is
recognized as expense evenly over the vesting period of that
tranche.
  Equity-based
compensation expense recognized in the Statement of Operations was $1,951,000,
$946,000 and $1,554,000 for the years ended December 31, 2008, 2007 and 2006,
respectively. Equity-based compensation for the years ended December 31, 2008,
2007 and 2006 reflects stock options and restricted stock granted to employees,
directors and consultants and in 2008 and 2006, $81,000 and $128,000,
respectively, are included for the extension of stock options for the Company’s
former presidents and chief executive officers.
  F-17
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (1)
ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(continued)
  (l)
Equity-Based Compensation (continued)
  The
following table summarizes the activity of the Company’s stock options for the
year ended December 31, 2008:
 Shares
                          
                          
                          Weighted
                            Average
                            Exercise
                            Price
                          
                          
                          Weighted
                            Average
                            Remaining
                            Contractual
                            Life
                          
                          
                          Aggregate
                            Intrinsic
                            Value(Thousands)
                          
                          
                          
                          
                          
                          (Years)
                          
                          
                          (Thousands)Number
      of shares under option:Outstanding
      at January 1, 2008
                          
                          
                          7,956
                          
                          
                          $
                          1.03Granted
                          
                          
                          5,463
                          
                          
                          
                          0.44Exercised
                          
                          
                          (71
                          )
                          
                          
                          0.70Canceled,
      forfeited and expired
                          
                          
                          (588
                          )
                          
                          
                          1.26Outstanding
      at December 31, 2008
                          
                          
                          12,760
                          
                          
                          $
                          0.78
                          
                          
                          
                          6.31
                          
                          
                          $
                          1Vested
      or expected to vest at December 31, 2008
                          
                          
                          12,639
                          
                          
                          $
                          0.78
                          
                          
                          
                          6.30
                          
                          
                          $
                          1Exercisable
      at December 31, 2008
                          
                          
                          6,331
                          
                          
                          $
                          0.98
                          
                          
                          
                          5.09
                          
                          
                          $
                          1
  The
following table summarizes the activity of the Company’s stock options for the
year ended December 31, 2007:
 Shares
                        
                        
                        Weighted
                          Average
                          Exercise
                          Price
                        
                        
                        Weighted
                          Average
                          Remaining
                          Contractual
                          Life
                        
                        
                        Aggregate
                          Intrinsic
                          Value(Thousands)
                        
                        
                        
                        
                        
                        (Years)
                        
                        
                        (Thousands)Number
      of shares under option:Outstanding
      at January 1, 2007
                        
                        
                        9,497
                        
                        
                        $
                        1.07Granted
                        
                        
                        2,567
                        
                        
                        
                        1.07Exercised
                        
                        
                        (3,979
                        )
                        
                        
                        0.68Canceled,
      forfeited and expired
                        
                        
                        (129
                        )
                        
                        
                        12.94Outstanding
      at December 31, 2007
                        
                        
                        7,956
                        
                        
                        $
                        1.03
                        
                        
                        
                        6.37
                        
                        
                        $
                        1,506Vested
      or expected to vest at December 31, 2007
                        
                        
                        7,918
                        
                        
                        $
                        1.03
                        
                        
                        
                        6.33
                        
                        
                        $
                        1,489Exercisable
      at December 31, 2007
                        
                        
                        4,848
                        
                        
                        $
                        1.03
                        
                        
                        
                        5.58
                        
                        
                        $
                        1,420
  The
aggregate intrinsic value of options exercised during the years ended December
31, 2008, 2007 and 2006 was $18,000, $6,491,000 and $942,000,
respectively.
  F-18
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (1)
ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(continued)
  (l)
Equity-Based Compensation (continued)
  The
following table summarizes the activity of the Company’s non-vested stock
options for the year ended December 31, 2008 (shares in thousands):
 Shares
                    
                    
                    Weighted
                      Average
                      Grant
                      Date
      Fair ValueNon-vested
      at January 1, 2008
                    
                    
                    3,108
                    
                    
                    $
                    0.58Granted
                    
                    
                    5,463
                    
                    
                    
                    0.24Cancelled,
      forfeited and expired
                    
                    
                    (530
                    )
                    
                    
                    0.54Vested
      during the period
                    
                    
                    (1,612
                    )
                    
                    
                    0.57Non-vested
      at December 31, 2008
                    
                    
                    6,429
                    
                    
                    $
                    0.30
  The
following table summarizes the activity of the Company’s non-vested stock
options for the year ended December 31, 2007 (shares in thousands):
 Shares
                    
                    
                    Weighted
                      Average
                      Grant
                      Date
      Fair ValueNon-vested
      at January 1, 2007
                    
                    
                    1,064
                    
                    
                    $
                    0.72Granted
                    
                    
                    2,567
                    
                    
                    
                    0.54Cancelled,
      forfeited and expired
                    
                    
                    (3
                    )
                    
                    
                    0.59Vested
      during the period
                    
                    
                    (520
                    )
                    
                    
                    0.67Non-vested
      at December 31, 2007
                    
                    
                    3,108
                    
                    
                    $
                    0.58
  As
of December 31, 2008, there was $1,721,000 of total unrecognized compensation
cost related to non-vested equity-based compensation arrangements granted under
existing stock option plans. This cost is expected to be recognized over a
weighted-average period of 2.26 years. The total grant date fair value of shares
that vested during the year ended December 31, 2008 was $919,000.
  The
Company uses the Black-Scholes option-pricing model to determine the fair value
of stock options. The weighted average grant date fair value of options granted
during the years ended December 31, 2008, 2007 and 2006 at date of grant and the
assumptions utilized to determine such values are indicated in the following
table:
 Year
      Ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006Weighted
      average fair value at date of grant for options granted during the
      period
                    
                    $
                    0.24
                    
                    
                    $
                    0.54
                    
                    
                    $
                    0.88Expected
      stock price volatility
                    
                    
                    83
                    %
                    
                    
                    75
                    %
                    
                    
                    114
                    %Expected
      life of options
                    
                    3
      years
                    
                    
                    3
      years
                    
                    
                    5
      yearsRisk
      free interest rates
                    
                    
                    2.40
                    %
                    
                    
                    3.49
                    %
                    
                    
                    5.0
                    %Expected
      dividend yield
                    
                    
                    0
                    %
                    
                    
                    0
                    %
                    
                    
                    0
                    %
  F-19
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (1)
ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(continued)
  (l)
Equity-Based Compensation (continued)
  The
following table summarizes the activity of the Company’s non-vested restricted
common stock for the year ended December 31, 2008 (shares in
thousands):
 Shares
                      
                      
                      Weighted-
                        average
      Grant
                        Date
      Fair ValueNon-vested
      at January 1, 2008
                      
                      
                      1,053
                      
                      
                      $
                      2.04Granted
                      
                      
                      1,035
                      
                      
                      
                      0.66Cancelled
      or expired
                      
                      
                      (165
                      )
                      
                      
                      1.74Vested
      during the period
                      
                      
                      (731
                      )
                      
                      
                      1.80Non-vested
      at December 31, 2008
                      
                      
                      1,192
                      
                      
                      $
                      1.07
  The
following table summarizes the activity of the Company’s non-vested restricted
common stock for the year ended December 31, 2007 (shares in
thousands):
 Shares
                      
                      
                      Weighted-
                        average
      Grant
                        Date
      Fair ValueNon-vested
      at January 1, 2007
                      
                      
                      85
                      
                      
                      $
                      0.63Granted
                      
                      
                      1,099
                      
                      
                      
                      2.10Cancelled
      or expired
                      
                      
                      (46
                      )
                      
                      
                      3.54Vested
      during the period
                      
                      
                      (85
                      )
                      
                      
                      0.63Non-vested
      at December 31, 2007
                      
                      
                      1,053
                      
                      
                      $
                      2.04
  During
the year ended December 31, 2008, the Company granted shares of restricted
common stock to its Board of Directors in which 400,000 shares (net of 54,000
shares forfeited due to a resignation) vest in April 2009, 21,000 shares (net of
11,000 shares forfeited due to a resignation) vest on July 1, 2009, and 10,000
vest on November 10, 2009 and 539,000 shares of restricted common stock to its
employees which vest over a two year period through September 2010. For the year
ended December 31, 2008, the Company recognized $286,000 in compensation expense
related to these grants and $254,000 of unrecognized compensation cost will be
recognized through the September 2010.
  During
the year ended December 31, 2008, the Company received proceeds of $49,000 and
issued 71,000 shares of its common stock for stock option exercises. In
addition, during the year ended December 31, 2008 the Company repurchased
110,000 shares for payment of the taxes for restricted stock
vesting.
  During
the year ended December 31, 2008, the Company granted 5,463,000 stock options to
employees that had an aggregate grant date fair value of
$1,311,000.
  (m)
Advertising costs
  The
Company expenses advertising costs when incurred. Advertising expenses were
$119,000, $251,000 and $135,000 for the years ended December 31, 2008, 2007 and
2006, respectively.
  F-20
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (1)
ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(continued)
  (n)
Net Loss Per Common Share
  The
Company computes net loss per common share in accordance with SFAS No. 128,
“Earnings Per Share”.
In accordance with SFAS No. 128, basic earnings per share is computed using the
weighted average number of common shares outstanding during the period.
Potential common shares consist of the incremental common shares issuable upon
the conversion of the preferred stock and convertible debentures (using the
if-converted method) and shares issuable upon the exercise of stock options and
warrants (using the Treasury Stock method). Diluted loss per share has not been
presented separately since 13,000 stock options at December 31, 2008, 9,009,000
stock options and 1,601,000 warrants at December 31, 2007 and 7,502,000
preferred shares, 9,497,000 stock options, and 7,428,000 warrants at December
31, 2006 are anti-dilutive for each of the periods presented.
  (o)
Use of Estimates
  The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and the disclosure of contingent assets and liabilities at the date
of the financial statements and the reported amounts of revenue and expenses
during the reporting period. Actual results could differ from those estimates.
Assumptions underlying the allowance for doubtful accounts, the estimated value
of the warrant derivative liability and the recoverability of intangible assets
represent sensitive estimates subject to change.
  (p)
Geographical Reporting and Customer Concentration
  The
Company adopted the provisions of SFAS No. 131, “Disclosures About Segments of an
Enterprise and Related Information”. The Company operates in one business
segment, the sale of video compression software and related services, from which
it earns revenues from its customers. The Company’s Chief Operating Decision
Maker is the Company’s Chief Executive Officer (“CEO”), who receives
consolidated financial information for purposes of evaluating the Company’s
operational and financial performance.
  The
Company’s customers typically represent digital communication and media
companies, entertainment companies, telecommunication companies and third party
resellers. For the year ended December 31, 2008, and 2007 there were no
customers that accounted for 10% or more of the Company’s total revenue. For the
year ended December 31, 2006, one customer accounted for 10% of the Company’s
total revenue.
  As
of December 31, 2008, one customer accounted for 29% of gross accounts
receivable. As of December 31, 2007, two customers accounted for 18% and 12% of
gross accounts receivable.
  F-21
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (1)
ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(continued)
  (p)
Geographical Reporting and Customer Concentration (continued)
  The
components of the Company’s revenue for the years ended December 31, 2008, 2007
and 2006 are summarized as follows (in thousands):
 Year
      Ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006License
      software revenue
                    
                    $
                    10,494
                    
                    
                    $
                    10,299
                    
                    
                    $
                    5,472Engineering
      services and support
                    
                    
                    2,302
                    
                    
                    
                    928
                    
                    
                    
                    496Royalties
                    
                    
                    3,397
                    
                    
                    
                    1,935
                    
                    
                    
                    604Other
                    
                    
                    75
                    
                    
                    
                    75
                    
                    
                    
                    —Total
                    
                    $
                    16,268
                    
                    
                    $
                    13,237
                    
                    
                    $
                    6,572
  For the
years ended December 31, 2008, 2007 and 2006, foreign customers accounted
for approximately 57%, 44% and 40%, respectively of the Company’s total revenue.
These customers are primarily located in Europe and Middle East, and
Asia.
  Selected
information by geographic location is a follows (in thousands):
 For
      the Year Ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006Revenue
      from unaffiliated customers:United
      States Operations
                    
                    $
                    10,625
                    
                    
                    $
                    9,102
                    
                    
                    $
                    6,572Finland
      Operations
                    
                    
                    5,643
                    
                    
                    
                    4,135
                    
                    
                    
                    —Total
                    
                    $
                    16,268
                    
                    
                    $
                    13,237
                    
                    
                    $
                    6,572Net
      Loss:United
      States Operations
                    
                    $
                    (6,201
                    )
                    
                    $
                    (6,222
                    )
                    
                    $
                    (4,846
                    )Finland
      Operations
                    
                    
                    (45,005
                    )
                    
                    
                    (682
                    )
                    
                    
                    —Total
                    
                    $
                    (51,206
                    )
                    
                    $
                    (6,904
                    )
                    
                    $
                    (4,846
                    )
 
 As
      of December 31,2008
                                  
                                  
                                  2007
                                  
                                  
                                  2006Identifiable
      assets:United
      States Operations
                                  
                                  $
                                  6,287
                                  
                                  
                                  $
                                  17,631
                                  
                                  
                                  $
                                  7,887Finland
      Operations
                                  
                                  $
                                  19,589
                                  
                                  
                                  $
                                  61,894
                                  
                                  
                                  
                                  —Total
                                  
                                  $
                                  25,876
                                  
                                  
                                  $
                                  79,525
                                  
                                  
                                  $
                                  7,887
  The
Company also maintains an office in the United Kingdom which is included in the
Unites Staes Operations above. This office consists of two software engineers
and does not generate any revenue.
  F-22
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (1)
ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(continued)
  (q)
Recently Issued Accounting Pronouncements
  In
September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS
No. 157”). This Statement defines fair value, establishes a framework for
measuring fair value and expands disclosure of fair value measurements. SFAS No.
157 applies under other accounting pronouncements that require or permit fair
value measurements and accordingly, does not require any new fair value
measurements. SFAS No. 157 is effective for financial statements issued for
fiscal years beginning after November 15, 2007. The implementation of SFAS No.
157 did not have a material effect on the Company’s consolidated financial
position and results of operations.
  In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities” (“SFAS No. 159”). SFAS No. 159
provides companies with an option to report selected financial assets and
liabilities at fair value. SFAS No. 159’s objective is to reduce both complexity
in accounting for financial instruments and the volatility in earnings caused by
measuring related assets and liabilities differently. SFAS No. 159 also
establishes presentation and disclosure requirements designed to facilitate
comparisons between companies that choose different measurement attributes for
similar types of assets and liabilities. SFAS No. 159 requires companies to
provide additional information that will help investors and other users of
financial statements to more easily understand the effect of the company’s
choice to use fair value on its earnings. It also requires entities to display
the fair value of those assets and liabilities for which the company has chosen
to use fair value on the face of the balance sheet. SFAS No. 159 is effective as
of the beginning of an entity’s first fiscal year beginning after November 15,
2007. The implementation of SFAS No. 159 did not have a material effect on the
Company’s consolidated financial position and results of
operations.
  In
December 2007, the FASB issued Statement of Financial Accounting Standards
No. 141R, Business Combinations (“SFAS 141R”), which replaces SFAS No. 141,
Business Combinations. SFAS 141R establishes principles and requirements for
determining how an enterprise recognizes and measures the fair value of certain
assets and liabilities acquired in a business combination, including
noncontrolling interests, contingent consideration, and certain acquired
contingencies. SFAS 141R also requires acquisition-related transaction expenses
and restructuring costs be expensed as incurred rather than capitalized as a
component of the business combination. SFAS 141R will be applicable
prospectively to business combinations for which the acquisition date is on or
after the beginning of the first annual reporting period beginning on or after
December 15, 2008. SFAS 141R would have an impact on accounting for any
businesses acquired after the effective date of this pronouncement.
  In
December 2007, the FASB issued Statement of Financial Accounting Standards
No.160, Noncontrolling
Interests in Consolidated Financial Statements – An Amendment of ARB
No. 51 (“SFAS 160”). SFAS 160 establishes accounting and reporting
standards for the noncontrolling interest in a subsidiary (previously referred
to as minority interests). SFAS 160 also requires that a retained noncontrolling
interest upon the deconsolidation of a subsidiary be initially measured at its
fair value. Upon adoption of SFAS 160, the Company would be required to report
any noncontrolling interests as a separate component of consolidated
stockholders’ equity. The Company would also be required to present any net
income allocable to noncontrolling interests and net income attributable to the
stockholders of the Company separately in its consolidated statements of
operations. SFAS 160 is effective for fiscal years, and interim periods within
those fiscal years, beginning on or after December 15, 2008. SFAS 160 requires
retroactive adoption of the presentation and disclosure requirements for
existing minority interests. All other requirements of SFAS 160 shall be applied
prospectively. SFAS 160 would have an impact on the presentation and disclosure
of the noncontrolling interests of any non wholly-owned businesses acquired in
the future.
  F-23
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (1)
ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(continued)
  (q)
Recently Issued Accounting Pronouncements (continued)
  In
March 2008, the FASB issued SFAS 161, Disclosures about Derivative
Instruments and Hedging Activities - an Amendment of FASB Statement 133.
SFAS 161 enhances required disclosures regarding derivatives and hedging
activities, including enhanced disclosures regarding how: (a) an entity uses derivative
instruments; (b)
derivative instruments and related hedged items are accounted for under FASB
Statement No. 133, Accounting
for Derivative Instruments and Hedging Activities; and (c) derivative instruments and
related hedged items affect an entity’s financial position, financial
performance, and cash flows. Specifically, SFAS 161 requires:
 ●
                  Disclosure
      of the objectives for using derivative instruments be disclosed in terms
      of underlying risk and accounting designation;●
                  Disclosure
      of the fair values of derivative instruments and their gains and losses in
      a tabular format;●
                  Disclosure
      of information about credit-risk-related contingent features;
      and●
                  Cross-reference
      from the derivative footnote to other footnotes in which
      derivative-related information is
disclosed.
  SFAS 161
is effective for fiscal years and interim periods beginning after November 15,
2008. Early application is encouraged. The Company is currently evaluating the
impact of adopting SFAS No. 161 on its consolidated financial position and
results of operations.
  In
May 2008, the FASB issued SFAS 162, The Hierarchy of Generally Accepted
Accounting Principles. SFAS 162 is intended to improve financial
reporting by identifying a consistent framework, or hierarchy, for selecting
accounting principles to be used in preparing financial statements that are
presented in conformity with U.S. generally accepted accounting principles for
nongovernmental entities. SFAS 162 is effective November 15, 2008. The Company
is currently evaluating the impact of adopting SFAS 162 on its consolidated
financial position and results of operations.
  In
June 2008, the EITF reached a consensus in Issue No. 07-5,
“Determining Whether an Instrument (or Embedded Feature) Is Indexed to an
Entity’s Own Stock” (“EITF 07-5”). This Issue addresses the determination of
whether an instrument (or an embedded feature) is indexed to an entity’s own
stock, which is the first part of the scope exception in paragraph 11(a) of SFAS
133. EITF 07-5 is effective for fiscal years beginning after December 15,
2008, and interim periods within those fiscal years. Early application is not
permitted. The Company is currently in the process of evaluating the impact of
the adoption of EITF 07-5 on its consolidated financial position and results of
operations.
  In
October 2008, The FASB issued FSP 157-3 “Determining Fair Value of a Financial
Asset in a Market That is Not Active” (FSP 157-3). FSP 157-3 classified the
application of SFAS No. 157 in an inactive market. It demonstrated how the fair
value of a financial asset is determined when the market for that financial
asset is inactive. FSP 157-3 was effective upon issuance, including prior
periods for which financial statements had not been issued. The implementation
of FSP 157-3 did not have a material effect on the Company’s consolidated
financial position and results of operations.
  (r)
Foreign Currency
  The
functional currency of our foreign subsidiaries is their local currency. The
balance sheet accounts of these subsidiaries are translated into U.S. dollars at
the exchange rate as of the balance sheet date. Monthly revenues, costs and
expenses are translated using the weighted-average rate for that month.
Resulting exchange gains and losses are reported as a component of cumulative
other comprehensive income within stockholders’ equity.
  F-24
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (1)     ORGANIZATION
AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
  (r)
Foreign Currency (continued)
  The
Company’s Finland operations may conduct business in currencies other than their
own functional currency, resulting in foreign exchange gains and losses. These
foreign exchange gains and losses are included in general and administrative
expense on the Consolidated Statement of Operations. For the year ended December
31, 2008 and 2007, the foreign exchange gains were $93,000 and $16,000,
respectively.
  (s)
Reclassifications
  We
have reclassified certain prior period amounts to conform with the current
period presentation.
  (t)
Research and Development
  Research
and development expense relates to the development of new products and processes
including significant improvements to existing products. These costs are
expensed as incurred.
  (2)    
INVESTMENTS
  As
of December 31, 2008 and 2007 the Company held short-term bonds with current
maturities of less than 90 days with a market value of $132,000 and $5,521,000,
respectively.
  (3)     PROPERTY
AND EQUIPMENT
  Property
and equipment are stated at cost, and consist of the following:
 December
      31,2008
                      
                      
                      2007(in
      thousands)Furniture
      and fixtures
                      
                      $
                      176
                      
                      
                      $
                      130Machinery
      and equipment
                      
                      
                      741
                      
                      
                      
                      691Computer
      equipment
                      
                      
                      3,220
                      
                      
                      
                      3,115Leasehold
      improvements
                      
                      
                      71
                      
                      
                      
                      28Licensed
      software
                      
                      
                      732
                      
                      
                      
                      6874,940
                      
                      
                      
                      4,651Less:
      accumulated depreciation and amortization
                      
                      
                      4,225
                      
                      
                      
                      3,944Total
                      
                      $
                      715
                      
                      
                      $
                      707
  Depreciation
expense was $338,000, $132,000 and $65,000 for the years ended December 31,
2008, 2007 and 2006, respectively.
  F-25
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (4)     CAPITAL
LEASES
  The
following is an analysis of the leased property under capital leases by major
classes:
 December
      31,2008
                    
                    
                    2007(in
      thousands)Computer
      equipment
                    
                    $
                    904
                    
                    
                    $
                    230Leasehold
      improvements
                    
                    
                    175
                    
                    
                    
                    —1,079
                    
                    
                    
                    230Less:
      accumulated amortization
                    
                    
                    393
                    
                    
                    
                    186Total
                    
                    $
                    686
                    
                    
                    $
                    44
  Depreciation
expense was $216,000, $26,000 and $24,000 for the years ended December 31,
2008, 2007 and 2006, respectively.
  The
following is a schedule by years of future minimum lease payments under capital
leases together with the present value of the net minimum lease payments as of
December 31, 2008 (in thousands):
 Year
      ending December 31:2009
                    
                    $
                    2932010
                    
                    
                    2602011
                    
                    
                    1142012
                    
                    
                    722013
                    
                    
                    38Total
      minimum lease payments
                    
                    
                    777Less:
      Amount representing interest
                    
                    
                    (85
                    )Present
      value of net minimum lease payments
                    
                    $
                    692
  (5)     INTANGIBLE
ASSETS AND GOODWILL
  (a)Acquisition
of On2 Finland
  In
connection with the Company’s acquisition of On2 Finland on November 1, 2007 (as
described in Note 1), the Company acquired intangible assets of $53,354,000
which included goodwill in the amount of $36,075,000.
  Goodwill
represents the excess of the purchase price over the fair value of net assets
acquired in a business combination. Goodwill is required to be tested for
impairment at the reporting unit level on an annual basis and between annual
tests when circumstances indicate that the recoverability of the carrying amount
of such goodwill may be impaired. Application of the goodwill impairment test
requires exercise of judgment, including the estimation of future cash flows,
determination of appropriate discount rates and other important assumptions.
Changes in these estimates and assumptions could materially affect the
determination of fair value and/or goodwill impairment for each reporting
unit.
  F-26
  ON2
      TECHNOLOGIES, INC.NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTSDECEMBER
      31, 2008, 2007 AND 2006
 
 (5)
                INTANGIBLE
      ASSETS AND GOODWILL (continued)
  (a)
Acquisition of On2 Finland (continued)
  The
allocation to intangible assets recorded for the On2 Finland acquisition are as
follows (in thousands):
 Acquired
      software
                    
                    $
                    10,214Trademarks
                    
                    
                    2,991Customer
      relationships
                    
                    
                    4,074Goodwill
                    
                    
                    36,075Total
      intangible assets acquired
                    
                    $
                    53,354
  The
asset recognized with respect to acquired software is being amortized over its
estimated life of five years. The assets recognized with respect to trademarks
and customer relationships are being amortized over their estimated lives of ten
years. The weighted average amortization period is 8.76 years.
  A summary
of changes in the Company’s On2 Finland intangible assets related to continuing
operations (in thousands):
 December
      31,
                                        2007
                                      
                                      
                                      Acquisitions
      &
                                        Dispositions
                                      
                                      
                                      Amortization
                                      
                                      
                                      Impairment
                                      
                                      
                                      Translation
                                        Adjustments
                                      
                                      
                                      December
      31,
                                        2008Acquired
      software
                                      
                                      $
                                      10,066
                                      
                                      
                                      $
                                      —
                                      
                                      
                                      $
                                      (1,726
                                      )
                                      
                                      $
                                      (5,979
                                      )
                                      
                                      $
                                      (216
                                      )
                                      
                                      $
                                      2,145Trademarks
                                      
                                      
                                      2,999
                                      
                                      
                                      
                                      —
                                      
                                      
                                      
                                      (299
                                      )
                                      
                                      
                                      —
                                      
                                      
                                      
                                      (121
                                      )
                                      
                                      
                                      2,579Customer
      relationships
                                      
                                      
                                      4,084
                                      
                                      
                                      
                                      —
                                      
                                      
                                      
                                      (408
                                      )
                                      
                                      
                                      (807
                                      )
                                      
                                      
                                      (187
                                      )
                                      
                                      
                                      2,682Goodwill
                                      
                                      
                                      36,779
                                      
                                      
                                      
                                      —
                                      
                                      
                                      
                                      —
                                      
                                      
                                      
                                      (26,482
                                      )
                                      
                                      
                                      (1,442
                                      )
                                      
                                      
                                      8,855Total
      intangible assets acquired
                                      
                                      $
                                      53,928
                                      
                                      
                                      $
                                      —
                                      
                                      
                                      $
                                      (2,433
                                      )
                                      
                                      $
                                      (33,268
                                      )
                                      
                                      $
                                      (1,966
                                      )
                                      
                                      $
                                      16,261
 F-27
 
 ON2
      TECHNOLOGIES, INC.NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTSDECEMBER
      31, 2008, 2007 AND 2006
  
 (5)
                INTANGIBLE
      ASSETS AND GOODWILL (continued)
  (a)
Acquisition of On2 Finland (continued)
  Asset
Impairment
  During
2008, the global economy dramatically weakened, which, among other factors, has
contributed to the continued underperformance of our On2 Finland business and a
decline in our overall market value. Based on these circumstances, at September
30, 2008, the Company performed impairment reviews of its goodwill and
intangible assets related to its On2 Finland business. The Company performed an
analysis of the expected future cash flows of the business and based on the
results of this evaluation, the Company has determined that goodwill and other
intangibles are impaired. Accordingly, the Company recorded an impairment charge
during the quarter ended September 30, 2008, totaling $20,265,000 (goodwill) and
$5,980,000 (intangible assets), to reduce their carrying value to an amount that
is expected to be recoverable. During the quarter ended December 31, 2008, the
global economy continued to weaken, which necessitated an additional impairment
analysis. Based on the results of the additional evaluation, the Company has
determined that goodwill and other intangibles are further impaired.
Accordingly, the Company recorded an impairment charge during the quarter ended
December 31, 2008, totaling $6,216,000 (goodwill) and $807,000 (intangible
assets), to reduce their carrying value to an amount that is expected to be
recoverable. Should the global economy continue to weaken, along with other
factors, additional impairment charges may be necessary.
  (b)
Flix Acquisition
  On
April 29, 2005 the Company acquired certain assets related to the Flix software
line of Wildform, pursuant to the terms of the Asset Purchase And Software
License Agreement. Pursuant to the terms of the agreement, the Company acquired
certain assets related to the Flix software and received a perpetual,
irrevocable, royalty-free, sub-licensable license to use certain other
intellectual property (the “Licensed Flix IP”) related to the Flix software. The
Company also received a perpetual, irrevocable, royalty-free license to use
certain web sales software (“E-Commerce Software”). In addition, the Company
granted Wildform a perpetual license to use the purchased Flix assets and new
versions of the Flix software in certain new software products being developed
by Wildform in exchange for a payment of a royalty to the Company by
Wildform.
  The
total acquisition cost of $1,229,000 was allocated as follows (in
thousands):
 Acquired
      software
                  
                  $
                  800Brand
      assets
                  
                  
                  160Non-compete
      agreement
                  
                  
                  25Goodwill
                  
                  
                  244Total
                  
                  $
                  1,229
  The
assets recognized with respect to acquired software, brand assets and the
non-compete agreement are being amortized over their estimated lives of four
years. Amortization expense related to these intangible assets was $246,000 for
each of the years ended December 31, 2008, 2007 and 2006. Accumulated
amortization was $903,000, $657,000 and 410,000 at December 31, 2008, 2007 and
2006, respectively.
  F-28
 
 ON2
      TECHNOLOGIES, INC.NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTSDECEMBER
      31, 2008, 2007 AND 2006
 
 (5)
                INTANGIBLE
      ASSETS AND GOODWILL (continued)
  (b)
Flix Acquisition (continued)
  Based
on the current amount of intangibles subject to amortization, the estimated
future amortization expense related to our intangible assets at December 31,
2008 is as follows (in thousands):
 Future
                      Amortization2009
                    
                    $
                    1,2372010
                    
                    
                    1,1552011
                    
                    
                    1,1552012
                    
                    
                    1,0622013
                    
                    
                    596Thereafter
                    
                    
                    2,283Total
                    
                    $
                    7,488
 
 (6)
                ACCRUED
      EXPENSES
  Accrued
expenses consist of the following:
 December
      31,2008
                                    
                                    
                                    2007Accrued
      compensation
                                    
                                    $
                                    2,084
                                    
                                    
                                    $
                                    3,369Accrued
      professional fees
                                    
                                    
                                    1,483
                                    
                                    
                                    
                                    915Other
      accrued expenses
                                    
                                    
                                    801
                                    
                                    
                                    
                                    536Total
                                    
                                    $
                                    4,368
                                    
                                    
                                    $
                                    4,820
 
 (7)
                  SHORT-TERM
      BORROWINGS
 
 December
      31,2008
                              
                              
                              2007Short-term
      borrowings, carrying a weighted average interest rate at December 31, 2008
      and 2007 of 4.75% and 5.16%, respectively
                              
                              $
                              63
                              
                              
                              $
                              2,198
 
 (a)
      Line of creditOn2
      Finland had available a line of credit with a Finnish bank for $736,000
      (500,000€) at December 31, 2007. The line of credit expired in February
      2008 and was paid in full and not renewed. Borrowings under that line of
      credit carried interest at the Euro Interbank Offered Rate (EURIBOR) plus
      1% (total of 5.288% at December 31, 2007). The bank also required a
      commission payable at 1% of the loan principal. Borrowings were
      collateralized by substantially all assets of On2 Finland and a guarantee
      by On2. The borrowings is also 50% guaranteed by the Finnvera plc
      (Finnvera plc is a specialized financing company which offers financing
      services to promote the domestic operation of Finnish businesses and is
      owned by the Finnish government) , which required a commission payable at
      2.85% on 50% of the loan principal. The outstanding balance on the line of
      credit was $297,000 at December 31,
2007.
  F-29
 
 ON2
      TECHNOLOGIES, INC.NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTSDECEMBER
      31, 2008, 2007 AND 2006
 
 (7)
                SHORT-TERM
      BORROWINGS (continued)(b)
      Line of creditOn2
      Finland has available a line of credit with a Finnish bank for $634,000
      (450,000€) at December 31, 2008. The line of credit has no expiration
      date. Borrowings under the line of credit bear interest at EURIBOR plus
      1.25% (total of 4.243% at December 31, 2008). The bank also requires a
      commission payable at .45% of the loan principal. Borrowings are
      collateralized by substantially all assets of the On2 Finland and a
      guarantee by On2. The outstanding balance on the line of credit was $-0-
      and $352,000 at December 31, 2008 and 2007.(c)
      Factoring line of creditOn2
      Finland had available a line of credit with a Finnish bank for the lesser
      of $2,195,000 (1,490,000€ at December 31, 2007) or 90% of eligible
      accounts receivable. The line of credit expired in February 2008 and was
      paid in full and not renewed. Borrowings under the line of credit carried
      interest at EURIBOR plus .95% (total of 5.238% at December 31, 2007). The
      borrowings were collateralized by 90% of eligible accounts receivable. The
      borrowings also had a 100% guarantee by the Finnvera plc, which required a
      commission payable at 2.15% to 2.95% of the loan principal. The
      outstanding balance on the line of credit was $1,500,000 at December 31,
      2007. The carrying amount of accounts receivable of On2 Finland that
      served as collateral for borrowings totaled $1,820,000 at December 31,
      2007.(d)
      Term loanDuring
      July 2008 the Company obtained unsecured financing in the amount of
      $140,000 to finance its directors’ and officers’ liability insurance. The
      financing arrangement is for nine months and runs through May 2009 and
      provided for interest at an effective interest rate of 4.75%. During June
      2007 the Company obtained unsecured financing in the amount of $143,000 to
      finance its directors’ and officers’ liability insurance. The financing
      arrangement was for nine months and ran through March of 2008 and provided
      for interest at an effective annual rate of 8.032%. The outstanding
      balance on the term loan was $63,000 and $49,000 at December 31, 2008 and
      December 31, 2007, respectively(8)
                INCOME
      TAXES
  Loss
before income taxes consisted of the following (in thousands):
  Year
      Ended December 31,2008
                                      
                                      
                                      2007
                                      
                                      
                                      2006U.S.
                                      
                                      $
                                      (5,688
                                      )
                                      
                                      $
                                      (5,657
                                      )
                                      
                                      $
                                      (4,400
                                      )Foreign
                                      
                                      
                                      (45,518
                                      )
                                      
                                      
                                      (1,222
                                      )
                                      
                                      
                                      (416
                                      )$
                                      (51,206
                                      )
                                      
                                      $
                                      (6,879
                                      )
                                      
                                      $
                                      (4,816
                                      )
  We have
included $29,000 of state franchise fees in general & administrative
expenses for the year ended December 31, 2008. These fees were included in
income tax expense for the years ended December 31, 2007 and
2006.
  F-30
  ON2
      TECHNOLOGIES, INC.NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTSDECEMBER
      31, 2008, 2007 AND 2006
 
 (8)
                INCOME
      TAXES (continued)
  The
provision for income taxes consisted of the following:
 Year
      Ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006Current:Federal
                  
                  $
                  —
                  
                  
                  $
                  —
                  
                  
                  $
                  —State
                  
                  
                  —
                  
                  
                  
                  15,000
                  
                  
                  
                  30,000Foreign
                  
                  
                  —
                  
                  
                  
                  10,000
                  
                  
                  
                  —$
                  —
                  
                  
                  $
                  25,000
                  
                  
                  $
                  30,000Deferred:Federal
                  
                  $
                  —
                  
                  
                  $
                  —
                  
                  
                  $
                  —State
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —Foreign
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  ——
                  
                  
                  
                  —
                  
                  
                  
                  —$
                  —
                  
                  
                  $
                  25,000
                  
                  
                  $
                  30,000
  The
following is a reconciliation of the difference between the actual provision for
income taxes and the provision computed by applying the federal statutory rate
on income before income taxes (in thousands):
 Year
      Ended December 31,2008
                  
                  
                  2007
                  
                  
                  2006Tax
      provision computed at U.S. statutory rate
                  
                  $
                  (17,410
                  )
                  
                  $
                  (2,175
                  )
                  
                  $
                  (1,523
                  )State
      taxes
                  
                  
                  (57
                  )
                  
                  
                  (482
                  )
                  
                  
                  (337
                  )Limitation
      on utilization of U.S. losses and future deductions
                  
                  
                  —
                  
                  
                  
                  2,764
                  
                  
                  
                  1,837Subsidiaries
      results subject to tax rates at rates other than U.S. statutory
      rates
                  
                  
                  3,600
                  
                  
                  
                  (241
                  )
                  
                  
                  (93
                  )Tax
      effect of acquisition related non-deductible goodwill and
      intangibles
                  
                  
                  9,282
                  
                  
                  
                  (33
                  )
                  
                  
                  —Tax
      effect of equity-based compensation
                  
                  
                  244
                  
                  
                  
                  —
                  
                  
                  
                  —Change
      in valuation allowance
                  
                  
                  (1,028
                  )
                  
                  
                  —
                  
                  
                  
                  —Other
      permanent differences
                  
                  
                  (576
                  )
                  
                  
                  —
                  
                  
                  
                  —Change
      in effective tax rate
                  
                  
                  5,771
                  
                  
                  
                  —
                  
                  
                  
                  —Limitation
      on utilization of non-U.S. losses and future deductions
                  
                  
                  174
                  
                  
                  
                  192
                  
                  
                  
                  146Income
      tax provision
                  
                  $
                  —
                  
                  
                  $
                  25
                  
                  
                  $
                  30
  F-31
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (8)
INCOME TAXES (continued)
  The asset
and liability method is used in accounting for income taxes. Under this method,
deferred tax assets and liabilities are determined based on differences between
the financial reporting and tax bases of assets and liabilities and are measured
using the enacted tax rates and laws that will be in effect when the differences
are expected to reverse. The deferred tax assets are comprised of the following
(in thousands):
 Year
      Ended December 31,2008
                                  
                                  
                                  2007U.S.
      federal and foreign net operating loss carryovers
                                  
                                  $
                                  44,357
                                  
                                  
                                  $
                                  43,702Depreciation,
      amortization, and other
                                  
                                  
                                  661
                                  
                                  
                                  
                                  759Stock-based
      compensation
                                  
                                  
                                  718
                                  
                                  
                                  
                                  499Accounts
      receivable reserves
                                  
                                  
                                  199
                                  
                                  
                                  
                                  208Accrued
      expenses
                                  
                                  
                                  —
                                  
                                  
                                  
                                  9Gross
      deferred tax assets
                                  
                                  
                                  45,935
                                  
                                  
                                  
                                  45,177Valuation
      allowance
                                  
                                  
                                  (44,010
                                  )
                                  
                                  
                                  (40,718
                                  )Deferred
      tax assets, net of valuation allowance
                                  
                                  $
                                  1,925
                                  
                                  
                                  $
                                  4,459Deferred
      tax liability
                                  
                                  $
                                  —
                                  
                                  
                                  $
                                  —Acquired
      intangibles
                                  
                                  $
                                  (1,925
                                  )
                                  
                                  $
                                  (4,459
                                  )Deferred
      tax liability, net
                                  
                                  $
                                  (1,925
                                  )
                                  
                                  $
                                  (4,459
                                  )Total
      deferred tax assets (liabilities), net
                                  
                                  $
                                  —
                                  
                                  
                                  $
                                  —
  The
statutory tax rate used for deferred tax assets and liabilities was 35% and 40%
for the year ended December 31, 2008 and 2007, respectively. The Company has
recorded a valuation allowance against all of our deferred tax assets at
December 31, 2008 and December 31, 2007. In accordance with SFAS 109 and based
on all available evidence, including our historical results and the uncertainty
of predicting our future income, the valuation allowance reduces the deferred
tax assets to an amount that is more likely than not to be realized. The amount
of valuation allowance can be attributable to U.S. federal, state and certain
foreign deferred tax assets primarily consisting of reserves, net operating loss
carryovers, accrued expenses and other temporary differences. The valuation
allowance (decreased)/increased by $(1,028,000) and $2,923,000for the years
ended December 31, 2008 and 2007.
  In
accordance with SFAS 109, the Company recorded deferred tax liabilities of
approximately $4,492,000 for the tax effect of the non-deductible amortizable
intangible assets as part of the initial purchase price allocation for the On2
Finland acquisition on November 2007, as discussed in Note 1. The Company has
also recorded deferred tax assets of $7,893,000 relating to acquired net
operating losses in connection with the On2 Finland acquisition. These assets
were subject to a valuation allowance of 3,401,000.
  For U.S.
federal income tax purposes, the Company has net operating loss, (“NOL”),
carryforwards of approximately $96,543,000. These loss carry forwards will
expire in various years through 2028, if not utilized. The Company also has
approximately $40,641,000 of NOL carryforwards in various foreign jurisdictions.
In event that the Company utilizes these NOL carryforwards against its U.S.
federal taxable income, it will release a portion of the valuation
allowance.
  Excess
tax benefits from employee stock option exercises of approximately $1,517,000
and 1,554,000 are included in the deferred tax asset balance at December 31,
2008 and 2007, respectively, as a component of the Company’s net operating loss
carryforwards. The deferred income tax assets for excess tax benefits has a full
valuation allowance against them at December 31, 2008 and 2007.
 
 F-32
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (9)
LONG-TERM DEBT
  Long-term
debt consists of the following at December 31 (in thousands):
 2008
                                                                
                                                                
                                                                2007Note
      payable to a Finnish funding agency in yearly installments of $33,833
      beginning in January 2007, including interest at the Finnish Bank Base
      rate less 3% (1.75% at December 31, 2008) with a 1% minimum, due January
      2009, secured by a guarantee by On2.
                                                                
                                                                $
                                                                34
                                                                
                                                                
                                                                $
                                                                71Note
      payable to a Finnish funding agency in yearly installments of $123,480
      beginning in July 2007, including interest at the Finnish Bank Base rate
      less 3% (1.75% at December 31, 2008) with a 1% minimum, due July 2009,
      secured by a guarantee by On2.
                                                                
                                                                
                                                                124
                                                                
                                                                
                                                                
                                                                258Note
      payable to a Finnish funding agency in yearly installments of $140,970
      beginning in September 2008, including interest at the Finnish Bank Base
      rate less 3% (1.75% at December 31, 2008) with a 1% minimum, due September
      2010, secured by a guarantee by On2.
                                                                
                                                                
                                                                282
                                                                
                                                                
                                                                
                                                                442Note
      payable to a Finnish funding agency in three yearly installments of
      $678,282 beginning in December 2009, including interest at the Finnish
      Bank Base rate less 3% (1.75% at December 31, 2008) with a 1% minimum, due
      December 2011, secured by a guarantee by On2.
                                                                
                                                                
                                                                2,035
                                                                
                                                                
                                                                
                                                                2,126Note
      payable to a Finnish funding agency payable out of distributable earnings
      as determined by the agreement. As of December 31, 2008 there were no
      distributions to pay down this debt, secured by a guarantee by
      On2.
                                                                
                                                                
                                                                47
                                                                
                                                                
                                                                
                                                                50Note
      payable to a Finnish bank in bi-annual installments of $50,346 beginning
      in September 2004, including interest at the 3-month EURIBOR (4.39% at
      December 31, 2008) plus 1.1%, due March 2011, secured by a guarantee by
      the Finnish Government Organization, which also requires additional
      interest at 2.65% of the loan principal.
                                                                
                                                                
                                                                252
                                                                
                                                                
                                                                
                                                                368Unsecured
      Note payable to a Finnish financing company in bi-annual installments of
      $35,242 beginning in September 2005, including interest at the 6 month
      EURIBOR (3.87% at December 31, 2008) plus .5%, due March
    2011.
                                                                
                                                                
                                                                176
                                                                
                                                                
                                                                
                                                                258Total
      Debt
                                                                
                                                                
                                                                2,950
                                                                
                                                                
                                                                
                                                                3,573Less:
      Current Portion
                                                                
                                                                
                                                                (1,148
                                                                )
                                                                
                                                                
                                                                (491
                                                                )Long-term
      debt, less current portion
                                                                
                                                                $
                                                                1,802
                                                                
                                                                
                                                                $
                                                                3,082Future
      maturities of long-term debt are as follows as of December 31, 2008 (in
      thousands):2009
                                                                
                                                                $
                                                                1,1482010
                                                                
                                                                
                                                                1,0382011
                                                                
                                                                
                                                                764$
                                                                2,950
  F-33
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (10)
STOCKHOLDERS’ EQUITY
  (a) Preferred
Stock
  The
Company has 20,000,000 shares of preferred stock authorized for issuance and,
through December 31, 2006, ten series of convertible preferred stock
(collectively “Preferred Stock”) were issued. Pursuant to its Certificate of
Incorporation, the Company may serially designate separate classes of preferred
stock up to the aggregate of its authorized limit. Each class of the Preferred
Stock is convertible into shares of the Company’s Common Stock based on a
conversion rate and has rights and preferences which are generally more senior
to the Company’s Common Stock and are more fully described in the Company’s
Certificate of Incorporation. There was no preferred stock outstanding at
December 31, 2008 and 2007.
  (b) August 2006 - Sale of Common
Stock and Warrants
  In
August 2006, the Company completed the sale of 3,070,000 shares of its common
stock with detachable, five-year warrants to purchase 2,303,000 shares of the
Company’s common stock at an exercise price of $0.77, to two institutional
investors, led by Midsummer Investments Ltd., and received net proceeds of
$1,628,000.
  In
connection with the offering, the parties entered into a registration rights
agreement. The registration rights agreement requires that the Company file a
registration statement registering the securities sold in the offering and use
its best efforts to have the registration statement declared effective on or
before the date that is ninety days after the date on which the parties entered
into the agreement. The registration rights agreement also provides for
liquidated damages of 2% of the aggregate purchase price for the first month and
1% for each subsequent month if the Company failed to register the related
common shares and maintain effectiveness of such registration. The Company filed
a registration statement with the Securities and Exchange Commission (“SEC”) on
September 25, 2006 and an amendment thereto on October 30, 2006. The Company
accounts for the registration rights agreement as a separate freestanding
instrument and accounts for the liquidated damages provision as a derivative
liability subject to SFAS No. 133. The estimated fair value of the derivative
liability is based on estimates of the probability and costs of cash penalties
expected to be incurred and such estimates are revalued at each balance sheet
date with changes in value recorded in other income.
  The
warrants contained certain anti-dilution provisions and accordingly the Company
accounted for the fair value of the warrants as a derivative liability (Warrant
derivative liability) subject to SFAS No. 133. The fair value of the warrants
issued, as calculated using the Black Scholes pricing model, was $1,251,000 on
August 24, 2006 and represents the portion of the proceeds from the financing
that was attributed to the warrant derivative liability. The warrant fair value
was revalued at each reporting date, using the Black Scholes pricing model, with
changes in value recorded in the statement of operations as other income or
expense. The warrant derivative fair value was $2,329,000 as of December 31,
2006. On June 11, 2007, the Company entered into a Letter Agreement with
Midsummer Investments Ltd. and Rockmore Investment Master Fund where the parties
agreed to place a $0.41 per share floor on the base share price for subsequent
dilutive share issuances and received consideration in the form of a decrease in
the warrant exercise price, from $0.77 to $0.69. The number of additional shares
to be issued upon subsequent dilutive issuances is finite and the Company will
reserve for the issuance from its authorized common shares; the warrants were no
longer considered a liability and the Company reclassified the warrant
derivative liability of $5,911,000 on June 11, 2007 to additional paid in
capital. The Company also recorded $86,000 in other expense related for the
modification of the warrant. During the year ended December 31, 2007, the
Company recorded charges of $3,582,000 to reflect the change in the fair value
of the warrant derivative liability. The increase in value of the warrant from
the date of issuance to December 31, 2006 of $1,078,000 is included as an
expense in interest and other income (expense), net. The Company paid financing
costs in the amount of $122,000 of which $52,000 is associated with the
warrants, and is included in interest and other income (expense), net in the
Company’s consolidated statement of operations for the year ended December 31,
2006.
 
 F-34
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (10)
STOCKHOLDERS’ EQUITY (continued)
  (b) August 2006 - Sale of Common
Stock and Warrants (continued)
  During
the year ended December 31, 2007, Midsummer Investment Ltd. exercised all their
warrants issued in conjunction with the Sale of Common Stock and Warrants and
the Company received proceeds from the exercise in the amount of $1,342,000 and
issued 1,974,000 shares of Common Stock.
  (c) October/November 2007 - Sale of Common
Stock
  On
October 17, 2007, the Company entered into an Underwriting Agreement with
ThinkEquity Partners LLC and Merriman Curhan Ford & Co. (collectively, the
“Underwriters”), pursuant to which the Company agreed to sell to the
Underwriters, and the Underwriters agreed to purchase from the Company, in a
firm commitment underwritten offering, 13,000,000 shares of the Company’s common
stock at a purchase price of $1.00 per share. The Company also agreed to sell to
the Underwriters up to an additional 1,950,000 shares of common stock at a
purchase price of $1.00 per share at the option of the Underwriters to cover
over-allotments, which option was required to be exercised within 30 days of the
filing date of the Company’s prospectus covering the shares to be issued in the
offering. The Company issued the 13,000,000 committed shares on October 23,
2007, and the Company issued these option shares on November 9, 2007 after the
Underwriters exercised their option to purchase the additional 1,950,000 shares.
The 14,950,000 shares resulted in net proceeds of $13,903,000, net of
underwriter commissions and offering costs.
  (d) Warrants
  The
Company issued common stock purchase warrants to various consultants, strategic
partners and investors. The following table summarizes information about all
common stock purchase warrants outstanding as of December 31, 2008,
including those issued in connection with Common Stock, Preferred Stock and
Convertible Debentures. All warrants were exercisable as of December 31,
2008.
  The
following table summarizes the common stock issuable upon conversion of all
outstanding warrants at December 31, 2008 and 2007:
 Range
      of
                      Exercise
      Prices
                    
                    Number
      of
                      Warrants
                      Outstanding
                    
                    
                    Weighted
                      Average
                      Exercise
      Price
                    
                    
                    Expiration
      Dates$0.57
      - $0.70
                    
                    
                    470,000
                    
                    
                    $
                    0.659
                    
                    
                    
                    2009
      - 2011$0.75
                    
                    
                    1,132,000
                    
                    
                    $
                    0.754
                    
                    
                    20091,602,000
                    
                    
                    $
                    0.726
                    
                    
                    
                    2009
      -2011
 
 F-35
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (10)
STOCKHOLDERS’ EQUITY (continued)
  (d) Warrants
(continued)
  In
January 2006, the Company extended the expiration date of 1,600,000 warrants
exercisable at $1.68 per share that were due to expire on January 29, 2006. As
part of the agreement the expiration date was changed to December 31, 2006, and
a provision was added to require the holder to exercise of the warrants if the
volume weighted average price of the Company’s common stock for ten consecutive
trading days equals or exceeds $1.93 or forfeit the warrants. In December 2006,
the Company extended the expiration date of these warrants to December 31, 2007
and reduced the volume weighted average price requiring exercise to $1.83. There
is no compensatory relationship with the warrant holder, who is also a common
stockholder. The Company has accounted for the fair value of these modifications
as financing costs. Accordingly, the Company had recognized an expense of
$135,000 in December 2006 for the incremental fair value of the January 2006
modification and has recorded a deferred financing cost of $106,000 as of
December 31, 2006 for the incremental fair value of the December 2006
modification. During 2007, all the warrants were exercised and the Company
received $2,688,000 and issued 1,600,000 shares of its common stock and
additional paid in capital was reduced by the $106,000 of deferred financing
costs.
  (e) Stock
Options
  Pursuant
to the Company’s 1999 Amended and Restated Incentive and Nonqualified Stock
Option Plan (the “1999 Plan”), 5,500,000 shares of Common Stock are reserved for
issuance. The 1999 Plan provides for the issuance of incentive stock options,
which are intended to qualify under Section 422 of the Internal Revenue Code,
non-qualified stock options and restricted stock grants. The granting of
incentive stock options is subject to the limitations as set forth in the 1999
Plan. Directors, officers, employees and consultants are eligible to receive
grants under the 1999 Plan. A committee selected by the Company’s Board of
Directors has the authority to approve option grants and the terms, which
include the option price and the vesting terms. Options granted under the 1999
Plan expire after a ten-year period and are subject to acceleration upon the
occurrence of certain events. )
  Pursuant
to the Company’s 2000 Nonqualified Stock Option Plan (the “2000 Plan”),
5,000,000 shares of the Company’s Common Stock are reserved for issuance. The
2000 Plan authorizes the Board of Directors to issue nonqualified stock options
as provided in Section 422 of the Internal Revenue Code, restricted stock and
stock appreciation rights. Only employees, including officers, of the Company
and its subsidiaries are eligible to receive grants under the 2000 Plan. A
committee selected by the Company’s Board of Directors has the authority to
approve option grants and the terms, which include the option price and the
vesting terms. Options granted under the 2000 Plan expire after a ten-year
period and are subject to acceleration upon the occurrence of certain
events.
  In
May 2005, the Company’s stockholders approved the On2 Technologies, Inc. 2005
Incentive Compensation Plan (the “2005 Plan”). Pursuant to the Company’s 2005
Plan, 7,000,000 shares of the Company’s Common Stock are reserved for issuance,
as Performance Grants, Restricted Stock, Goal-Based Stock options, or Stock
Appreciation rights. Options granted under the 2005 Plan may be incentive Stock
Options or Nonstatutory Stock Options. Employees, including officers, of the
Company and its subsidiaries are eligible to receive grants under the 2005 Plan.
The 2005 Plan also permits the award of only Nonstatutory Stock Options and
Restricted Stock to directors on the On2 Board, if such directors are not
employees of On2 and individuals who are consultants or advisors to On2. The
2005 Plan is administered by the Compensation Committee, of the Board for all
present and future employees of the Company and its subsidiaries. The Board will
administer the 2005 Plan for outside directors and consultants, based upon
recommendations by the Compensation Committee. The Compensation Committee has
the authority to approve option grants and the terms, which include the option
price and the vesting terms. Options granted under the 2005 Plan expire after an
eight-year period.
 
 F-36
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (10)
STOCKHOLDERS’ EQUITY (continued)
  (e) Stock Options
(continued
  In
October 2007, the Company’s stockholders approved an additional 13,000,000
options (for a total of 20,000,000 options) for grant under the Company’s 2005
Plan.
  The
following table summarizes the stock option activity under all plans (shares in
thousands):
 Options
                            Granted
                          
                          
                          Weighted
                            Average
                            Exercise
      PriceOutstanding
      January 1, 2006
                          
                          
                          10,299
                          
                          
                          $
                          0.98Granted
                          
                          
                          1,820
                          
                          
                          
                          0.87Exercised
                          
                          
                          (1,745
                          )
                          
                          
                          0.54Canceled,
      forfeited and expired
                          
                          
                          (877
                          )
                          
                          
                          0.68Outstanding
      December 31, 2006
                          
                          
                          9,497
                          
                          
                          $
                          1.07Granted
                          
                          
                          2,567
                          
                          
                          
                          1.07Exercised
                          
                          
                          (3,979
                          )
                          
                          
                          0.68Canceled,
      forfeited and expired
                          
                          
                          (129
                          )
                          
                          
                          12.94Outstanding
      at December 31, 2007
                          
                          
                          7,956
                          
                          
                          $
                          1.03Granted
                          
                          
                          5,463
                          
                          
                          
                          0.44Exercised
                          
                          
                          (71
                          )
                          
                          
                          0.70Canceled,
      forfeited and expired
                          
                          
                          (588
                          )
                          
                          
                          1.26Outstanding
      at December 31, 2008
                          
                          
                          12,760
                          
                          
                          $
                          0.78Exercisable
      at December 31, 2008
                          
                          
                          6,331
                          
                          
                          $
                          0.98Exercisable
      at December 31, 2007
                          
                          
                          4,848
                          
                          
                          $
                          1.03Options
      available for grant at December 31, 2008
                          
                          
                          4,732
 
 F-37
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (10)
STOCKHOLDERS’ EQUITY (continued)
  (e) Stock Options
(continued)
  The
following table summarizes information about stock options outstanding as of
December 31, 2008 (shares in thousands):
 Options
      Outstanding
                      
                      
                      Options
      ExercisableRange
      of Exercise
                        Prices
                      
                      Number
                        of
      Shares
                      
                      
                      Weighted
                        Average
                        Exercise
                        Price
                      
                      
                      Weighted
      Average
                        Remaining
                        Contractual
      Life
                        (in
      years)
                      
                      
                      Number
                        of
      Shares
                      
                      
                      Weighted
                        Average
                        Exercise
                        Price$0.14
      - $0.70
                      
                      
                      6,731
                      
                      
                      $
                      0.44
                      
                      
                      
                      6.8
                      
                      
                      
                      2,002
                      
                      
                      $
                      0.52$0.73
      - $1.07
                      
                      
                      5,362
                      
                      
                      
                      0.93
                      
                      
                      
                      5.9
                      
                      
                      
                      3,670
                      
                      
                      
                      0.89$1.08
      - $1.61
                      
                      
                      417
                      
                      
                      
                      1.36
                      
                      
                      
                      4.9
                      
                      
                      
                      416
                      
                      
                      
                      1.36$2.25
      - $3.59
                      
                      
                      177
                      
                      
                      
                      3.37
                      
                      
                      
                      2.0
                      
                      
                      
                      170
                      
                      
                      
                      3.38$3.60
      - $25.00
                      
                      
                      73
                      
                      
                      
                      10.70
                      
                      
                      
                      0.9
                      
                      
                      
                      73
                      
                      
                      
                      10.7012,760
                      
                      
                      $
                      0.78
                      
                      
                      
                      6.3
                      
                      
                      
                      6,331
                      
                      
                      $
                      0.98
  During
the year ended December 31, 2008 options for 71,000 shares were exercised and
the Company received $49,000 in proceeds. In addition, during the year ended
December 31, 2008 certain employees and directors had restricted stock vest in
which the Company retained 110,000 shares of common stock, and paid $69,000 in
cash, for payroll withholding taxes. During the year ended December 31, 2007
options for 2,139,000 shares were exercised and the Company received $1,428,000
in proceeds. In addition, during the year ended December 31, 2007 certain
employees exercised 1,840,000 stock options in cashless exercises and the
Company retained 836,000 shares of common stock, and paid $472,000 in cash, for
payroll withholding taxes.
  During
the year ended December 31, 2008 the Company granted 1,035,000 shares (of which
65,000 shares were subsequently forfeited due to resignations), of its
restricted common stock, to its directors, officers and certain employees that
had a fair value on the dates of grant of $683,000, of which no shares vested
during 2008. The unrecognized compensation costs and intrinsic value of these
shares at December 31, 2008 was $254,000 and $648,000, respectively. During the
year ended December 31, 2007 the Company granted 1,053,000 shares, of its
restricted common stock, to its directors, officers and certain employees that
had a fair value on the dates of grant of $2,067,000, of which no shares vested
during 2007. The unrecognized compensation costs and intrinsic value of these
shares at December 31, 2007 was $1,601,000 and $1,096,000,
respectively.
  (f) Treasury
Stock
  During
the year ended December 31, 2008, certain employees and directors had restricted
stock vest in which the Company retained shares for the payment of taxes.
According to certain Stock Option Plans the Company is required to record all
shares received in payment of the options (including restricted stock) and
related withholding taxes as treasury stock. Accordingly, the Company received
110,000 shares of its common stock at a value of $69,000. The Company’s Board of
Directors approved the retirement of all the shares received. The Company paid
$69,000 in cash for employee’s withholding taxes on certain restricted stock
vesting. During the year ended December 31, 2007, certain employees of the
Company exercised their stock options in cashless exercises. According to
certain Stock Option Plans the Company is required to record all shares received
in payment of the options and related withholding taxes as treasury stock.
Accordingly, the Company received 836,000 shares of its common stock at a value
of $1,431,000. The Company’s Board of Directors approved the retirement of all
the shares received. The Company paid $472,000 in cash for employee’s
withholding taxes on certain cashless exercises.
 
 F-38
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (11)
COMMITMENTS AND CONTINGENCIES
  (a) Operating
Leases
  The
Company has entered into several non-cancelable leases, primarily related to the
rental of certain equipment, automobiles and facilities. Future minimum lease
payments, by year and in the aggregate, under material operating leases
consisted of the following at December 31, 2008 (in
thousands):
 Year
      ended December 31,
                        
                        Amount2009
                        
                        $
                        1,1692010
                        
                        
                        1,0382011
                        
                        
                        3622012
                        
                        
                        1952013
                        
                        
                        130Total
      minimum lease payments
                        
                        $
                        2,894
  Rent
expense under operating leases was approximately $1,871,000, $396,000 and
$221,000 for the years ended December 31, 2008, 2007 and 2006,
respectively.
  (b) Employment
Agreements
  The
Company maintains employment agreements with certain executives of the Company
expiring at various dates through October 2011. The employment agreements
provide for minimum salaries at ranges of $157,000 to $250,000, incentive
compensation and certain benefits, among other items. The employment agreements
also provide for the payment by the Company of up to one year’s salary in the
event of the termination of the employee other than for cause or the resignation
by the employee for good reason.
  (c) Litigation
  Islandia
  On
August 14, 2008, Islandia, L.P. filed a complaint against On2 in the Supreme
Court of the State of New York, New York County. Islandia was an investor in the
Company’s October 2004 issuance of Series D Convertible Preferred Stock pursuant
to which On2 sold to Islandia 1,500 shares of Series D Convertible Preferred
Stock, raising gross proceeds for the Company from Islandia of $1,500,000.
Islandia’s Series D Convertible Preferred Stock was convertible into On2 common
stock at an effective conversion price of $0.70 per share of common stock.
Pursuant to this transaction, Islandia also received two warrants to purchase an
aggregate of 1,122,754 shares of On2 common stock.
  The
complaint asserts that, at various times in 2007, On2 failed to make monthly
redemptions of the Series D Preferred Stock in a timely manner and that On2
failed to deliver timely notice of its intention to make such redemptions using
shares of On2’s common stock. The complaint also asserts that Islandia timely
exercised its right to convert the Series D Preferred Stock into shares of On2
common stock and that On2 failed to credit to Islandia such allegedly converted
shares. The complaint further asserts that On2 failed to pay to Islandia certain
Series D dividends to which it was entitled. The complaint seeks a total of
$4,645,193 in damages plus interest and reasonable attorneys’ fees.
 
 F-39
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (11)
COMMITMENTS AND CONTINGENCIES (continued)
  (c) Litigation
(continued)
  On
October 8, 2008, On2 filed an answer in which it denied the material assertions
of the complaint and asserted various affirmative defenses, including that (i)
On2 made the required Series D redemptions in full and on the dates agreed upon
by the parties, (ii) On2 provided timely notice that it would pay redemptions in
On2 common stock and that Islandia accepted all of the redemption payments on
the dates made without protest, (iii) Islandia failed to timely assert its
conversion rights under the terms of the Series D agreements and (iv) On2 duly
paid the dividends owed to Islandia under the terms of the Agreement and
Islandia accepted all dividend payments without protest. As of the date of these
Consolidated Financial Statements, the case was in the discovery phase of
litigation.
  On2
believes this lawsuit is without merit and intends to vigorously defend itself
against Islandia’s complaint. As of December 31, 2008, the Company has not
recorded any provision associated with this complaint.
  Beijing
E-world
  On
March 31, 2006, we commenced arbitration against our customer, Beijing E-World,
relating to a dispute arising from two license agreements that On2 and Beijing
E-World entered into in June 2003.
  Under
those agreements, we licensed the source code to our video compression (codec)
technology to Beijing E-World for use in Beijing E-World’s video disk (EVD) and
high definition television (HDTV) products as well as for other non-EVD/HDTV
products. We believe that the license agreements impose a number of obligations
on Beijing E-World, including the requirements that:
  ●
                    Beijing
      E-World pay to On2 certain minimum quarterly payments;
  and●
                    Beijing
      E-World use best reasonable efforts to have our video codec “ported” to
      (i.e., integrated with) a chip to be used in EVD
  players.
  On2
has previously commenced arbitration regarding the license agreements with
Beijing E-World. In March 2005, the London Court of International Arbitration
tribunal released the decision of the arbitrator, in which he dismissed our
claims in the prior arbitration, as well as Beijing E-World’s counterclaims, and
ruled that the license agreements remained in effect, and that the parties had a
continuing obligation to work towards porting On2’s software to two
commercially-available DSPs.
 
 F-40
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (11)
COMMITMENTS AND CONTINGENCIES (continued)
  (c) Litigation
(continued)
  Although
a substantial amount of time has passed since the conclusion of the previous
arbitration, the parties have nevertheless not completed the required porting of
On2 software to two commercially available DSPs. Our current arbitration claim
alleges that, despite its obligations under the license agreements, Beijing
E-World has:
  ●
                    failed
      to pay On2 the quarterly payments of $1,232,000, which the Company
      believes are currently due and owing; and●
                    failed
      to use best reasonable efforts to have On2 video codec ported to a
      chip.
  On2
has requested that the arbitrator award us approximately $5,690,000 in damages
under the contract and grant us further relief as may be just and
equitable.
  Beijing
E-World has appeared in the arbitration, although it has not yet filed any
responses to our filings in the proceeding. Following Beijing E-World’s
appearance, it entered into an agreement with us pursuant to which Beijing
E-World agreed by November 30, 2006 to pay us an amount in settlement equal to
approximately 25% of the remaining unpaid portion of the license fees set forth
in the license agreements. Upon payment of the settlement payment, the parties
will terminate the arbitration, the license agreements will terminate, and we
will release Beijing E-World from all liability arising from the matters
underlying the arbitration. As of the date of these Consolidated Financial
Statements, Beijing E-World has not paid the amount agreed for
settlement.
  (12)
RELATED PARTY TRANSACTIONS
  During
the years ended December 31, 2008, 2007 and 2006, the Company retained
McGuireWoods LLP to perform certain legal services on behalf of the Company and
incurred costs of approximately $231,000, $1,022,000 and $150,000, respectively.
William A. Newman, a director of the Company, was a partner of McGuireWoods LLP
until May 2008. In May 2008, Mr. Newman became a partner at Sullivan &
Worcester LLP and the company incurred $118,000 in legal service fees to
Sullivan & Worcester LLP for the year ended December 31, 2008. In November
of 2008 Mr. Newman resigned as a director of the Company.
  In
January 2008, we retained VPR Associates to perform certain lobbying services on
our behalf and incurred approximately $75,000 in expenses during the year ended
December 31, 2008 for such services. Vincent Reusing, a principal in VPR
Associates, is the father of Tim Reusing, who has served as the company’s
General Counsel and Executive Vice President, Corporate Development since
September 2008.
  We
believe that the terms of this transaction are comparable to, or more favorable
to us than the terms that would have been obtained in an arms’ length
transaction with an unaffiliated party.
 
 F-41
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  (13)
SUBSEQUENT EVENTS
  In
January 2009 there was a 1,157,000 restricted stock grant issued to the
directors of the Company which will vest in January 2010. Additionally, in
January 2009, there were 100,000 options granted to an employee which will vest
in January 2012. In March 2009 there was a 2,499,000 restricted stock grant
issued to various employees of the Company which will fully vest in March
2012.
  (14)
SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
  Quarterly
financial data for fiscal 2008, 2007 and 2006 is as follows (in thousands,
except per share data):
 Quarter
      Ended 2008March
      31,
                                              
                                              
                                              June
      30,
                                              
                                              
                                              September
      30,
                                              
                                              
                                              December
      31,Revenue
                                              
                                              $
                                              4,452
                                              
                                              
                                              $
                                              3,265
                                              
                                              
                                              $
                                              4,971
                                              
                                              
                                              $
                                              3,580Gross
      profit
                                              
                                              
                                              3,022
                                              
                                              
                                              
                                              2,071
                                              
                                              
                                              
                                              4,031
                                              
                                              
                                              
                                              2,990Net
      loss
                                              
                                              
                                              (4,739
                                              )
                                              
                                              
                                              (7,175
                                              )
                                              
                                              
                                              (29,115
                                              )
                                              
                                              
                                              (10,177
                                              )Net
      loss attributable to common stockholders
                                              
                                              
                                              (4,739
                                              )
                                              
                                              
                                              (7,175
                                              )
                                              
                                              
                                              (29,115
                                              )
                                              
                                              
                                              (10,177
                                              )Basic
      and diluted net loss attributable to common stockholders per
      share
                                              
                                              $
                                              (0.03
                                              )
                                              
                                              $
                                              (0.04
                                              )
                                              
                                              $
                                              (0.17
                                              )
                                              
                                              $
                                              (0.06
                                              )
  Quarter
      Ended 2007March
      31,
                              
                              
                              June
      30,
                              
                              
                              September
      30,
                              
                              
                              December
      31,Revenue
                              
                              $
                              2,815
                              
                              
                              $
                              2,369
                              
                              
                              $
                              1,935
                              
                              
                              $
                              6,118Gross
      profit
                              
                              
                              2,392
                              
                              
                              
                              1,980
                              
                              
                              
                              1,332
                              
                              
                              
                              4,984Net
      loss
                              
                              
                              (721
                              )
                              
                              
                              (3,005
                              )
                              
                              
                              (1,382
                              )
                              
                              
                              (1,796
                              )Net
      loss attributable to common stockholders
                              
                              
                              (775
                              )
                              
                              
                              (3,023
                              )
                              
                              
                              (1,389
                              )
                              
                              
                              (1,799
                              )Basic
      and diluted net loss attributable to common stockholders per
      share
                              
                              $
                              (0.01
                              )
                              
                              $
                              (0.03
                              )
                              
                              $
                              (0.01
                              )
                              
                              $
                              (0.01
                              )
  Quarter
      Ended 2006March
      31,
                              
                              
                              June
      30,
                              
                              
                              September
      30,
                              
                              
                              December
      31,Revenue
                              
                              $
                              1,217
                              
                              
                              $
                              1,535
                              
                              
                              $
                              1,703
                              
                              
                              $
                              2,117Gross
      profit (loss)
                              
                              
                              634
                              
                              
                              
                              830
                              
                              
                              
                              1,174
                              
                              
                              
                              1,606Net
      loss
                              
                              
                              (1,179
                              )
                              
                              
                              (1,549
                              )
                              
                              
                              (608
                              )
                              
                              
                              (1,510
                              )Net
      loss attributable to common stockholders
                              
                              
                              (1,252
                              )
                              
                              
                              (1,622
                              )
                              
                              
                              (750
                              )
                              
                              
                              (1,575
                              )Basic
      and diluted net loss attributable to common stockholders per
      share
                              
                              $
                              (0.01
                              )
                              
                              $
                              (0.02
                              )
                              
                              $
                              (0.01
                              )
                              
                              $
                              (0.02
                              )
  F-42
  ON2
TECHNOLOGIES, INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008, 2007 AND 2006
  ON2
TECHNOLOGIES, INC.
 SCHEDULE
II – VALUATION AND QUALIFYING ACCOUNTS
  Description
                    
                    Balance
      at
                      Beginning
                      Of
      Period
                    
                    
                    Charged
      to
                      Costs
      and
                      Expenses
                    
                    
                    Charged
      to
                      Other
                      Accounts
                    
                    
                    Deductions
                    
                    
                    Balance
      at
                      End
      of
                      Period(in
      thousands)Year
      ended December 31, 2008 allowance for doubtful accounts
                    
                    
                    $ 
      519
                    
                    
                    
                    $ 
      145
                    
                    
                    
                    $ 
      —
                    
                    
                    
                    $ 
      (41)
                    
                    
                    
                    $ 
      623Year
      ended December 31, 2007 allowance for doubtful accounts
                    
                    
                    $ 
        56
                    
                    
                    
                    $ 
      518
                    
                    
                    
                    $ 
      —
                    
                    
                    
                    $ 
      (55)
                    
                    
                    
                    $ 
      519Year
      ended December 31, 2006 allowance for doubtful accounts
                    
                    
                    $  
       13
                    
                    
                    
                    $ 
      117
                    
                    
                    
                    $ 
      —
                    
                    
                    
                    $ 
      (74)
                    
                    
                    
                    $   
      56
  F-43