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

                                   FORM 10-KSB

        (Mark One)

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

                 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003

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

                         COMMISSION FILE NUMBER 1-15117.

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


                 DELAWARE                                84-1280679
      (State or other jurisdiction of                  (I.R.S. Employer
      incorporation or organization)                  Identification No.)


               21 CORPORATE DR.                             12065
                  SUITE 103                               (Zip Code)
               CLIFTON PARK, NY
   (Address of principal executive offices)


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


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

    TITLE OF EACH CLASS           NAME(S) OF EACH EXCHANGE ON WHICH LISTED

        Common Stock                        American Stock Exchange


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

                                      NONE

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

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

      Issuer's revenues for the year ended December 31, 2003 were approximately
$3,302,000.

      The aggregate market value of the voting and non-voting common equity held
by non-affiliates of the registrant as of March 26, 2004, was approximately
$72,734,053

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


                      APPLICABLE ONLY TO CORPORATE ISSUERS:

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

      75,693,560 shares as of March 26, 2004.

<PAGE>

                       DOCUMENTS INCORPORATED BY REFERENCE

      Items 9, 10, 11, and 12 of Part III are incorporated by reference from the
Company's definitive Proxy Statement for the Annual Meeting of Stockholders, to
be held on May 21, 2004. Registrant's definitive Proxy Statement will be filed
with the Securities and Exchange Commission on or before 120 days after December
31, 2003.


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


<PAGE>


<TABLE>
<CAPTION>
                                TABLE OF CONTENTS

PART I
                                                                                      Page
                                                                                      ----
<S>                  <C>                                                              <C>
 ITEM 1.             DESCRIPTION OF BUSINESS                                             4
 ITEM 2.             DESCRIPTION OF PROPERTY                                            11
 ITEM 3.             LEGAL PROCEEDINGS                                                  11
 ITEM 4.             SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                11

PART II

 ITEM 5.             MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS           11
 ITEM 6.             MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
                     AND RESULTS OF OPERATIONS                                          12
 ITEM 7.             FINANCIAL STATEMENTS                                               26
 ITEM 8.             CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
                     AND FINANCIAL DISCLOSURE                                           26

PART III

 ITEM 9.             DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL
                     PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT         27
 ITEM 10.            EXECUTIVE COMPENSATION                                             27
 ITEM 11.            SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
                     AND MANAGEMENT                                                     27
 ITEM 12             CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                     27
 ITEM 13             CONTROLS AND PROCEDURES                                            27
 ITEM 14             EXHIBITS AND REPORTS ON FORM 8-K                                   28

Signatures
</TABLE>

                                       3


<PAGE>

                                     PART I

ITEM 1.            DESCRIPTION OF BUSINESS

FORWARD-LOOKING STATEMENTS

      This document contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. These statements relate to future events or our future
financial performance and are not statements of historical fact. In some cases,
you can identify forward-looking statements by terminology such as "may,"
"will," "should," "could," "might," "expect," "plan," "anticipate," "believe,"
"estimate," "predict," "potential," "future," "objective," "forecast," "goal" or
"continue," the negative of such terms, or other comparable terminology. These
statements are only predictions, and actual events or results may differ
materially. Although we believe that the expectations reflected in the
forward-looking statements are reasonable, we cannot guarantee future results,
levels of activity, performance or achievements, and in all cases, such
statements are subject to our ability to secure sufficient financing or to
increase revenues to support our operations. In this regard, our business and
operations are subject to substantial risks that increase the uncertainty
inherent in the forward-looking statements contained in this Form 10-KSB. In
evaluating our business, you should give careful consideration to the
information set forth below under the caption "Management's Discussion and
Analysis -- Risk Factors That May Affect Future Operating Results," in addition
to the other information set forth herein.

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

OVERVIEW

      We are a leading video compression technology firm. We have developed a
proprietary technology platform and video compression/decompression software
("codec") to deliver high-quality video at the lowest possible data rates over
proprietary networks and the Internet to devices such as set-top boxes, personal
computers, and wireless and other devices. We offer a suite of products and
services, centered around our VPx family of products (e.g., VP5, VP6), that
incorporate our proprietary compression technology. Our service offerings
include customized engineering, consulting, and encoding services and technical
support. In addition, we license our software products, which include video and
audio codecs and encoding, player and server software, for use with video
delivery platforms.

DEVELOPMENT OF OUR BUSINESS

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

BUSINESS STRATEGY

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

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

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

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

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


                                       4
<PAGE>

OUR TECHNOLOGY, PRODUCTS AND SERVICES

      We have designed our technology to deliver the highest-quality video at
the lowest possible data rates. We currently license and develop a number of
products related to our TrueMotion line of codecs and TrueCast line of server
and player products for proprietary networks, the Internet and consumer
electronic industries.

TRUEMOTION(R) 2X (TM2X)

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

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

TRUEMOTION VP3 SERIES

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

OPEN SOURCE VP3.2

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

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

VP4 CODEC

      Released in the second quarter of 2001, VP4 was initially optimized for
set-top boxes and closed area environments, VP4 is widely recognized as being
among the most efficient video compression technologies available. VP4 achieves
near-DVD quality at 450 kbps and near-VHS quality at 150 kbps at full-screen and
full-motion. VP4 offers a 20% bandwidth reduction over some of our competitor's
technologies, allowing for greatly reduced costs for comparable quality video.
In August 2003, we announced that we would offer VP4 free of charge for personal
use and would provide individuals and developers with VP4 source code and
implementation for PCs and certain chips such as Equator and Texas Instruments.


                                       5
<PAGE>


VP5 CODEC

      We made VP5 available for license in the second quarter of 2002. VP5
allows a 50% reduction over the bandwidth required to show comparable quality
video using VP4. Additional features offered by VP5 include real-time encoding
and the ability to handle interlaced content, making it the first codec on the
market to offer true broadcast-quality, real-time compression of difficult live
material such as sports and action footage at sub-megabit data rates. In tests
across a broad spectrum of content, competitive codecs typically require data
rates 50% higher than VP5 to achieve comparable quality. VP5 also outperforms
the proposed H.26L standard (even with all of its advanced options enabled) in
quality, data rate and performance while maintaining lower decode and encode
complexity. The ability to handle interlaced content sets VP5 apart from the
litany of Internet codecs that are available.

VP6 CODEC

      We launched the Beta version of our TrueMotion VP6 series of codecs in May
2003 and the official version in October 2003, and we have since released
updated versions VP6.1 and VP6.2. At the time of VP6's launch, we announced that
we would make the VP6 encoder free for personal use for individuals, developers,
and companies that register at the On2 website., although organizations or
developers who want to license the codec for commercial use must enter into a
commercial use license agreement with us. As with prior versions of our codec,
VP6 represented a significant improvement over its predecessors, offering a 40%
image quality improvement over and 50% faster playback than VP5. VP6 improves
upon all the features contained in VP5 and supports real-time encoding at full
D1 resolution. It also consistently outperforms Windows Media 9 and H.264 based
on tests of Peak Signal-to-Noise Ratios measured at data rates ranging from
dial-up (28.8 Kbps) to DVD and HD (6 to 8 Mbps). Since our introduction of VP6,
we have ported it to the Equator BSP-15, on which it runs on high definition
(1280 x 720p) and the Texas Instruments' DSP-based TMS320DM642.

AUDIO FOR VIDEO CODEC TECHNOLOGY (AVC)

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

ON2'S ENCODER PRODUCT

      Our Encoder enables content owners to efficiently re-master and compress
their assets into the VP4, VP5, or VP6 format at their own convenience.
Beginning with capturing uncompressed video through high quality SDI inputs,
users can create an optimized digital file using our proprietary re-mastering
tools. These tools are geared toward the video professional that wants exact
control over the optimization process. Once the raw file has been optimized, our
compression software has the capability of creating multiple data rate
compressed files.

TRUECAST(R) SERVER SOFTWARE

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

      TrueCast comes optimized in two manners: one for transport using our own
proprietary protocol, TrueCast Transport Protocol (TTP), and one for RTSP/RTP to
various set-top box platforms. TrueCast and VP3/VP4/VP5/VP6 are an ideal
combination for low-bit-rate Video-On-Demand systems. Our TrueCast Servers and
our encoder provide the necessary tools for high-quality video over low speed IP
connections.


                                       6
<PAGE>

      In the first quarter of 2003, we released TrueCast version 7.5. This
version of TrueCast provides support for multicast presentations, and can
simultaneously stream a single audio and video stream from a server, including
HTTP-based Web servers, to thousands of users. It also permits local playback of
AVI files from a user's hard disk, and set-top box/DSP platforms from Texas
Instruments, Equator Technologies, and others.

      In the third quarter of 2003, we announced that we have added Microsoft
Windows CE to the family of operating systems supported by our TrueCast set-top
box solution.

      In addition, TrueCast 7.5 is able to stream content that is captured and
encoded directly from "live" video sources using the company's revolutionary VP5
and VP6 real-time encoders. This feature is ideal for time-critical applications
such as streaming live events, video conferencing, Digital Television over DSL,
and personal video recorders.

DIGITAL SIGNAL PROCESSOR (DSP) AND SERVER INTEGRATIONS

      VP4, VP5 and VP6 have been integrated (i.e. "ported") with the Equator
MAP-CA and Equator BSP-15 and to Texas Instruments' 6200 and 6400 DSPs. The On2
player has been ported to Equator's Dolphin and Tetra platforms as well as Texas
Instruments' 64x platform. We believe that by porting to these platforms, we
will facilitate the use of On2's codec in set-top-box and other consumer device
deployments.

SERVICES

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

CUSTOM ENGINEERING AND CONSULTING SERVICES

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

ENCODING

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

RESEARCH AND DEVELOPMENT

      The focus of our research and development activities is to improve and
expand upon our core codec technology, which improves the video experience for
end users. Our research and development efforts have enabled us to provide
quality video compression and decompression at lower broadband data rates (e.g.,
DSL) and certain narrowband data rates (e.g., dial-up). We believe that
continued advances in our technology are key to the success of our business.
Consequently, we devote a substantial portion of our resources to our research
and development efforts. Research and development expenses for the year ended
December 31, 2003 were $1,124,000 as compared to $2,149,000 for the year ended
December 31, 2002.

DISTRIBUTION METHODS

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


                                       7
<PAGE>

SALES AND BUSINESS DEVELOPMENT

      The goal of our sales and business development departments is to build
relationships that fall into two basic categories: product licensing and
professional services. Our sales and business development teams focus on
engaging chip-set manufacturers, global cable and telecommunication companies
and manufacturers of hardware platforms for consumer electronic and wireless
devices. We seek to license our compression software to manufacturers of video
or video-enabled equipment and providers of video services, and we seek to
encourage developers of chip-sets and software platforms to integrate their
products with our codecs. Additionally, our teams focus on selling encoding and
streaming software licenses to content providers who are delivering video over
proprietary networks and to IP-based end users. Our professional services are
usually incident to our product licensing and primarily focus on porting or
optimizing our compression technologies to multiple hardware platforms used in
video delivery solutions by manufacturers who have licensed our compression
technology.

INTERNATIONAL

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

      For the year ended December 31, 2003, foreign customers accounted for
approximately 67% of total revenue. These customers are primarily located in
Asia. For the year ended December 31, 2002, foreign customers accounted for
approximately 50% of total revenue.

ASIA

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

Beijing E-World

In June 2003, we announced that we had licensed our VP5 and VP6 codecs to
Beijing E-World Technology Co. Ltd. (E-World), a consortium of several Chinese
consumer electronics manufacturers. Under the terms of the license agreements,
we granted E-World:

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

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

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

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

E-World has already launched the first generation EVD, which uses MPEG-2
compression technology. We are optimistic that our license agreements with
E-World will result in significant revenues for us based upon our historical
level of revenues. There is no guarantee, however, that the EVD standard will be
widely adopted in China or abroad. In addition, E-World and Chinese authorities
may choose to include other companies' video compression technologies in the EVD
standard. Moreover, one of the advantages that our compression technology has
over other companies' technologies is the high compression rates that our
software achieves, permitting a full-length, high-definition movie to be stored
on a single video disk. E-World could adopt certain hardware technologies, such
as "Blu-ray" technology, that could compensate for the lower compression rates
of other compression software.


                                       8
<PAGE>


Even if EVD is not successful or VP5 and VP6 are not the exclusive compression
technology for the EVD, we are nevertheless entitled to certain minimum payments
under the terms of our license agreements with E-World. In 2004, E-World is
contractually-bound to pay us at least $1,642,000, and in 2005, E-World is
contractually-bound to pay us at least $3,350,000.

EUROPE

      In addition to our progress in marketing our products and services in the
Asian markets, we are continuing to make in-roads into the European market,
although we have not yet had the success there that we have had in Asia. In
April, we appointed a reseller in Italy to market our products. We have also had
success with our U.K.-based partners TVZ Ltd. and QuickLink Ltd. in powering
newsgathering and dissemination applications for major news organizations such
as the BBC. Despite these successes, however, we have not yet established the
strong relationships with customers and resellers that we have in Asia, so we
will have to continue to focus on increasing the visibility of our compression
products in Europe.

LOCATION OF ASSETS AND OPERATIONS

      All of the Company's assets and operations have been and are currently
based within the United States, except for two research and development
employees located in the United Kingdom. We did not generate any revenue from
our United Kingdom operations for the years ended December 31, 2003 and 2002.

COMPETITION

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

      o     lowering the amount of bandwidth that customers need,

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

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

      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, customer service,
network quality, service offerings and the flexibility to adapt to changing
market conditions. In the broadband codec market, we compete with companies such
as Microsoft, Intel, RealNetworks, Apple and Sorenson, and in the proprietary
networks market, we compete with H.264, MPEG2 and MPEG-4 and several codecs that
position themselves as "MPEG-4-based".

      The size of our company and the fact that we have developed a proprietary,
non-standards-based video codec both help and hinder our ability to compete.
Companies such as Microsoft and RealNetworks benefit from name recognition that
we do not enjoy. Microsoft is also able to use its market power to support
anti-competitive pricing on its products that compete with ours. With respect to
standards-based codecs (e.g., MPEG-4 and H.264), there are numerous developers
programming to those standards, and there are certain customers that prefer to
license standards-based codecs. Nevertheless, we believe that our small size and
proprietary products frequently are attractive to customers, especially
overseas, that will seek to license our products because they are not Microsoft
products and do not involve burdensome standards-based licenses and fee
structures.

      We also compete with companies that provide encoding services and
companies that encode their content in-house. In establishing our business
strategy, we face a number of strong, firmly entrenched competitors who are
currently providing similar services to low-bandwidth and high-bandwidth users.
These and other companies are already providing broadband video-based services
and technology. In addition to competition from other content and technology
companies, well-established media distribution companies, particularly in the
cable television and satellite markets, have established, and continue to seek
to establish, interactive, on-demand digital services through the development of
sophisticated digital set-top technology and related back-end server systems.
Many of our existing competitors have, and some future competitors may have,
significantly greater financial and technical resources than we have. See the
section "Management's Discussion and Analysis -- Overview" for further
discussion of our competitors.


                                       9
<PAGE>


CUSTOMERS

      Our customers, and the potential customers of our resellers, typically are
large digital communication and media companies, entertainment companies,
telecommunication companies and other global corporations that operate within
the digital media industry. For the year ended December 31, 2003, three
customers accounted for 35%, 19% and 11% of the Company's total revenues. For
the year ended December 31, 2002, three customers accounted for 27%, 11% and 11%
of the Company's total revenues. As of December 31, 2003, two customers
accounted for 59% and 18% of total accounts receivable. As of December 31, 2002,
four customers accounted for 22%, 20%, 19% and 15% 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 regard our copyrights, service marks, trademarks,
trade secrets, proprietary technology and similar intellectual property as
critical to our success. We currently hold several U.S. patents and have some
U.S. and international patent applications pending. We believe that the patents
that are currently issued are not material to our business. While we try to
ensure that the quality of the On2 brand is maintained through such measures,
there can be no assurance that steps we have taken and continue to take to
protect our proprietary rights will be adequate or that third parties will not
infringe on our intellectual property. In addition, there can be no assurance
that third parties will not assert infringement claims against us which, even if
not meritorious, could result in the expenditure of substantial resources and
management effort.

      In connection with our software license agreements with third parties, we
seek to control access to and distribution of our technology, documentation and
other proprietary information. Even with all of these precautions, it could be
possible for someone else to either copy or otherwise obtain and use our
proprietary information without our authorization or to develop similar
technology independently. Effective trademark, copyright and trade secret
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. We cannot be sure that the steps we have
taken will prevent misappropriation of our proprietary information. Any
misappropriation could have a material adverse effect on our business. In the
future, we may need to go to court to either enforce our intellectual property
rights, to protect our trade secrets or to determine the validity and scope of
the proprietary rights of others. That litigation might result in substantial
costs and diversion of resources and management attention.

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

GOVERNMENT REGULATION

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

      Moreover, we may be liable to third parties for any content that we
encode, distribute or make available on our website if that content violates a
third party's intellectual property rights or violates any applicable laws, such
as obscenity laws or defamation laws. Although we try to mitigate this risk by
seeking indemnification from our customers and suppliers, we may still be
subject to liability if indemnification is not obtained, is contested or does
not provide us with enough resources to cover any potential liability.

EMPLOYEES

      As of December 31, 2003, we had approximately 25 full-time employees. Of
the total employees, 18 were engineering and product development personnel, 1
was sales and marketing personnel and 6 were general and administrative
personnel.

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


                                       10
<PAGE>

ITEM 2. DESCRIPTION OF PROPERTY

      We do not own any real property. We lease approximately 5,540 square feet
of space at 21 Corporate Dr., Suite 103, Clifton Park, NY 12065 where our
principal executive, administrative and engineering offices are located at an
annual rental fee of approximately $72,000. This lease expires on January 31,
2006. In addition, we lease approximately 400 square feet of space for certain
of our executives and IT staff at 1560 Broadway, 10th Floor, New York, New York
10036. We pay an annual rental fee of approximately $98,000. This lease expires
February 11, 2005. Management believes these facilities are all in usable
condition and that these facilities are sufficient to meet our needs for the
immediate future. Management also believes that both facilities are adequately
covered by insurance.

      We do not invest in real estate or interests in real estate, real estate
mortgages or securities of or interests in persons primarily engaged in real
estate. It is not our policy to acquire assets primarily for possible capital
gain or primarily for income, although in December 2003, we did license our
software to Powerlinx, Inc., a publicly-traded company, and we accepted as
payment $150,000 in unregistered shares of Powerlinx. As of March 22, 2004, the
fair value of those shares is approximately $89,000. Any gain or loss on those
shares would be a capital gain or loss to us.

ITEM 3. LEGAL PROCEEDINGS

      The Company is not party to any pending legal proceeding. From time to
time we have been named in claims arising in the ordinary course of business. In
the opinion of management, the ultimate disposition of these other matters will
not have a material adverse effect on our consolidated financial position,
results of operations or liquidity.

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

      None.

                                     PART II

ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

      Our common stock is traded on the American Stock Exchange under the symbol
"ONT". The following table sets forth for the fiscal periods indicated the high
and low bid prices of our common stock, as reported on the American Stock
Exchange, since January 1, 2002:


                                                                  HIGH      LOW
                                                                  ----      ---
FISCAL YEAR 2004
                      First Quarter (through March 26, 2004)     $ 1.66    $0.90

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

FISCAL YEAR 2002
                      First Quarter                              $ 0.50    $0.37
                      Second Quarter                             $ 0.46    $0.23
                      Third Quarter                              $ 0.35    $0.08
                      Fourth Quarter                             $ 0.54    $0.22


      There were approximately 258 stockholders of record of our common stock as
of March 26, 2004.

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


                                       11
<PAGE>


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

      In September 2002, we issued $650,000 principal amount, 5.75%, four-year
Series A Secured Convertible Debentures due in 2006 to a group of existing
investors and two of our former board members who were, at the time of issuance,
members of our board. The Company received all of the proceeds from the sale of
the debentures. The debentures are convertible into the our common stock at a
price of $0.112. In addition, we issued to the purchasers of the debentures
warrants to acquire our common stock. We sold sixty-five units with a principal
amount of $10,000 per unit; each unit contained one warrant to purchase 20%
warrant coverage shares of our common stock at $0.112 per share. The debentures
require us to pay interest to the debenture holders each November and May. The
interest is payable in common stock based on the average closing price of the
stock for the ten trading days prior to the payment date. The debentures are
convertible into 5,804,000 shares of our common stock. The warrants are
convertible into 1,161,000 shares of our common stock. We relied on Section
(4)(2) of the Securities Act in issuing the debentures and warrants without
registration. An aggregate of $200,000 of the Series A Secure Convertible
Debentures was converted into 1,786,000 shares of the Company's common stock in
2003.

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

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

OVERVIEW

        We are a leading video compression technology firm. We have developed a
proprietary technology platform and the VPx family (e.g., VP4, VP5, VP6) of
video compression/decompression software ("codec") to deliver high-quality video
at the lowest possible data rates over proprietary networks and the Internet to
set-top boxes, personal computers and wireless devices. Unlike other video
codecs that are based on standard compression specifications set by industry
groups (e.g., MPEG and H.264), our video compression software is based solely on
intellectual property that we developed and own ourselves.

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


        PRODUCTS               o  video codecs;

                               o  audio codecs; and

                               o  encoding and server software, for use with
                                  video delivery platforms


        SERVICES               o  customized engineering and consulting
                                  services;

                               o  technical support; and

                               o  high-level video encoding


      Our customers use our products and services chiefly to provide the
following video-related products and services to end users:


TYPE OF CUSTOMER APPLICATION                    EXAMPLES
----------------------------                    --------

Video and Audio Distribution   o  providing video-on-demand services to
over Proprietary Networks         residents in multi-dwelling units (MDUs)

                               o  video surveillance

Consumer Electronic Devices    o  digital video players

                               o  digital video recorders

Wireless Applications          o  delivery of video via satellite

                               o  providing video to web-enabled cellphones
                                  and PDAs

Video and Audio                o  video-on-demand
Distribution over IP-based
Networks (Internet)            o  teleconferencing services

                               o  video instant messaging


                                       12
<PAGE>


      As discussed in greater detail below, we derive revenue chiefly through
licensing our software and providing specialized software engineering and
consulting services to customers. When we license our software, we often charge
a royalty fee based on the number of units of the customer's product containing
the relevant On2 software product that are sold or distributed. Some of our
agreements with customers also require that the customers pay us a percentage of
the revenues that they earn from any of their products or services that
incorporate our software. In addition, we generally require that customers pay
us if they desire to receive any upgrades to our software (i.e., from VP6 to
VP7). We usually charge a flat fee for engineering and consulting services,
based on an estimate of the time it will take our software engineers to provide
the services, or an hourly fee for ongoing services such as product support.

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

      One of the most significant recent trends in our business is our
increasing reliance on the success of the product deployments of our customers.
As referenced above, an increasing number of our license agreements with
customers provide for the payment of license fees (i.e., royalties) that are
dependent on the number of units of a customer's product incorporating our
software that are sold or the amount of revenue generated by a customer from the
sale of products or services that incorporate our software. We have chosen this
royalty-dependent licensing model because, as a company of only 25 employees, we
do not have the product development or marketing resources to develop and market
end-to-end video solutions. Instead, our software is primarily intended to be
used as a building block for companies that are developing end-to-end video
products and/or services. Although we are confident that we have adopted the
licensing model most appropriate for a business of our size and expertise, a
natural result of this licensing model is that the amount of revenue we generate
is highly dependent on the success of our customers' product deployments. If the
products of customers with whom we have established per-unit royalty or revenue
sharing relationships do not generate significant sales, our revenues will be
negatively affected. Conversely, if one or more of such customers' products are
widely adopted, our revenues will likely be enhanced.

      Another significant recent trend in our business is the emergence of
Microsoft as a principal competitor in the market for digital media creation and
distribution technology. Microsoft currently competes with us in the market for
digital media servers, players, codecs and other technology and services related
to digital distribution of media. Microsoft's commitment to and presence in the
media delivery industry has increased. Microsoft distributes its competing
streaming encoder, media server, player, tools and digital rights management
products by bundling them with its Windows operating systems and servers at no
additional cost or otherwise making them available free of charge or at a low
cost. Microsoft's practices have caused, and may continue to cause, pricing
pressure on our revenue generating products and services and affect usage of our
competing products and formats. Microsoft's anticompetitive practices have led
in some cases, and could continue to lead to, longer sales cycles, decreased
sales, loss of existing and potential customers and reduced market share. In
addition, we believe that Microsoft has used and may continue to use its
monopoly position in the computer industry and its financial resources to secure
preferential or exclusive distribution, use and bundling contracts for its media
delivery technologies and products with third parties, such as ISPs, content
delivery networks, content providers, entertainment and media companies, VARs
and OEMs, including third parties with whom we have relationships.

      A potential trend that we are currently monitoring is the possible
emergence of H.264 as a competitor in the video compression field. H.264 is a
standards-based codec that is the successor to MPEG-4. Although we believe our
technology is superior to H.264, H.264 may become widely adopted by potential
customers because, as a standards-based codec, there are numerous developers
programming to the H.264 standard and developing products based on such
standard. In addition, there are certain customers that prefer to license
standards-based codecs.

      The market for digital media creation and delivery technology is
constantly changing and intensely and increasingly competitive. We have and
continue to take a number of steps to address this competition. First and
foremost, we focus on providing our customers with video
compression/decompression technology that delivers the highest possible video
quality at the lowest possible data rates. In order to do this, we devote a
significant portion of our engineering capacity to research and development.
Although we expect that competition from Microsoft and others will continue to
intensify, and that additional competition from H.264 may emerge, we currently
expect that our video compression technology will remain competitive and that we
will continue to innovate in the video compression field. We also address the
competitive threats that we face by focusing on developing relationships with
customers who do not want to do business with Microsoft and/or do not find the
complex and rigid standards-based licenses and fee structures appealing.


                                       13
<PAGE>

COMPANY HISTORY

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

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

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


      In August 2002, our Board of Directors approved a plan to relocate the
Company's offices from New York City and consolidate operations in Clifton Park,
New York for the purpose of decreasing the Company's operating expenses.
Beginning in June 2002, the Company began staff reductions that continued
through August of that year. In September 2002, the Company terminated the
building lease in New York City. In connection with this relocation plan, the
Company took the following restructuring and cost curtailment charges: (1)
$113,000 related to severance accrued and paid to terminated employees; (2)
$172,000 in penalties to terminate the lease on the Company's office space in
New York City; (3) $7,000 in relocation costs incurred to relocate the Company's
offices to the Albany, New York area; (4) $289,000 in the write-off of the net
carrying value of fixed assets abandoned as a result of closing the New York
City office. The charges were $581,000 for the year ended December 31, 2002.

      In view of the increasingly-evolving nature of our business and our
limited operating history, we have limited experience forecasting our revenues.
Therefore, we believe that period-to-period comparisons of financial results are
not necessarily meaningful and should not be relied upon as an indication of our
future performance. To date, we have incurred substantial costs to create
technology products and services. As of December 31, 2003, we had an accumulated
deficit of $107.7 million. We will continue to incur costs to develop, introduce
and enhance products and services, build brand awareness and grow our business.
We may also incur significant additional costs related to technology, marketing
or acquisitions of businesses and technologies to respond to changes in this
rapidly developing industry. These costs may not correspond with any meaningful
increases in revenues in the near term, if at all. As such, these costs may
result in negative operating cash flows until such time as we generate
sufficient revenues to offset such costs.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

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


                                       14
<PAGE>


            o     Revenue recognition

            o     Valuation of goodwill, intangible assets and other long-lived
                  assets

      Our management generally uses traditional GAAP to measure our performance,
rather than other non-GAAP measures. Certain financial analysts and investors
may track our performance based on measures other than GAAP, including EBITDA
(Earnings Before Interest, Taxes, Depreciation and Amortization). As a result,
we have regularly included a statement of our EBITDA performance in the press
releases by which we announce our quarterly or annual earnings. The Company's
management believes that the presentation of EBITDA provides useful information
regarding the Company's financial performance and earnings potential because
this measure gives investors insight into the profitability of the Company's
operating business. The Company's management uses this measure for the same
purpose.

      Revenue Recognition. We currently recognize revenue from professional
services and the sale of software licenses. As described below, our management
must make significant judgments and estimates in determining the amount of
revenue recognized in any given accounting period. Certain judgments and
estimates that management makes may result in material differences in the amount
and timing of our revenue for any given accounting period.

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


Our software licensing arrangements typically consist of two elements: a
software license and post-contract customer support ("PCS"), which typically
does not include upgrades. We recognize license revenues based on the residual
method after all elements other than PCS have been delivered as prescribed by
SOP 98-9. In arrangements where we share our customers' revenues from the sale
of goods and services containing our software (i.e., royalties), we recognize
those related revenues at the time that our customers notify us of their
revenues, such as when they provide us with quarterly revenue reports. Depending
on the language of the contract with our customers, we recognize PCS revenues
over the term of a maintenance contract or on a "per usage" basis (i.e., at
hourly rates). 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"). Most of the contracts under which we agree to provide services contain
"statements of work" establishing contractual milestones, such as the dates by
which we will deliver certain customized software products and bill customers
for those products and the amounts we may bill for our services. When reliable
estimates are available for the costs and efforts necessary to complete the
engineering or consulting services and those services do not include contractual
milestones or other acceptance criteria, we recognize revenue under the
percentage of completion contract method based upon input measures, such as
hours. When such estimates are not available, we defer all revenue recognition
until we have completed the contract and have no further obligations to the
customer.

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


                                       15
<PAGE>


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

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

RESULTS OF OPERATIONS

                                    REVENUES

    The following table sets forth a comparison of revenues for the years for
the years ended December 31, 2003, and December 31, 2002:

                          2003                         2002
Revenues               $3,302,000                   $3,353,000


Our 2003 annual revenues of $3,302,000 represent a decrease of 1.5% from our
2002 annual revenues of $3,353,000.

      We attribute the lower-than-expected twelve month revenue primarily to two
factors:

            o     later-than-anticipated unit deployments by Asia-based
                  customers who have agreed to pay us a per-unit royalty; and

            o     a delay in completion of software and hardware customization
                  process necessary to permit our video codec to operate on a
                  specialized digital signal chip in connection with our
                  agreement with Beijing E-World.

      We earned revenues for the years ended December 31, 2003 and 2002 from the
sale of software licenses and engineering and consulting services. The following
table sets forth the allocation of revenues, in terms of percentages, for the
years ended December 31, 2003 and 2002:

                                                  2003           2002
        Engineering and Consulting                 19%            46%
        Licensing                                  81%            53%
        Encoding                                    -%             1%
                                   Total          100%           100%


      For the years ended December 31, 2003 and 2002, the sale of software
licenses and fees for engineering and consulting revenues were our most
significant revenue streams. We expect that the sale of software licenses and
engineering and consulting services as well as royalties (including contractual
minimums) will be the significant future revenue steams as we continue to
provide these products and services to clients who deliver high-quality video to
proprietary networks, consumer electronic devices, wireless applications and
IP-based end users. We believe that the shift from video delivery over IP-based
networks to proprietary networks and wireless devices will continue to reduce
the amount of encoding services we provide as we foresee content providers
purchasing our encoding software as opposed to contracting with us to perform
the services in-house. Because we anticipate that content providers will be
acquiring our encoding software instead of hiring us to provide encoding
services, we believe that the increase in revenues from the sale of our encoders
may offset the loss of revenues from encoding services.


                                       16
<PAGE>

                               OPERATING EXPENSES

      The Company's operating expenses consist of cost of revenues, research and
development, sales and marketing and general and administrative expenses
(including cost curtailment and restructuring charges that are presented
separately in our financial statements). Operating expenses for the year ended
December 31, 2003 were $5,665,000 as compared to $8,621,000 for the year ended
December 31, 2002. This represents a decrease of 34% and, as we discuss in
greater detail below, is due largely to a decrease in the number of personnel
performing research and development, sales and marketing, and general and
administrative functions.

      Cost of Revenues. Cost of revenues includes personnel and consultant
compensation costs, related overhead expenses, bandwidth costs, fees paid for
licensed technology, depreciation costs and the amortization of purchased
technology. Cost of revenues was $1,506,000 for the year ended December 31, 2003
as compared to $2,056,000 for the year ended December 31, 2002. Amortization of
purchased technology was $463,000 and $627,000 for each of the years ended
December 31, 2003 and 2002, respectively. The purchased technology became fully
amortized in 2003.

      Research and Development. Research and development expenses primarily
consist of salaries and related expenses and consulting fees for research and
product development personnel associated with the development and production of
our products and services, operating lease costs and depreciation costs.
Research and development expenses were $1,124,000 as compared with $2,149,000
for the years ended December 31, 2003 and 2002, respectively. The decrease is
primarily attributed to a full year's reduction in research and development
personnel attributed to our cost savings initiatives that were completed in
2002. We believe that continued investments in research and development are
necessary to maintain our competitive advantage and we will continue to invest
in such costs as considered necessary.

      Sales and Marketing. Sales and marketing expenses consist primarily of
salaries and related costs, business development and marketing personnel,
tradeshow costs, marketing and promotional costs incurred to create brand
awareness and public relations expenses. Sales and marketing expenses for the
year ended December 31, 2003 were $527,000 as compared with $924,000 for the
year ended December 31, 2002. The decrease is primarily attributable to a
decrease in our personnel, tradeshow costs and marketing efforts. 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
cost curtailment and restructuring charges) consist primarily of salaries and
related personnel costs for general corporate functions including finance, human
resources, legal and facilities, outside legal and professional fees and
insurance. These general and administrative costs for the year ended December
31, 2003 were $2,508,000 as compared with $2,911,000 for the year ended December
31, 2002. The decrease is attributable to decreased personnel, a decrease in
depreciation, a decrease in rent attributable to the closing of our New York
City office in September 2002 and a general decrease in operating overhead
attributable to an entity-wide decrease in personnel.

      Cost Curtailment and Restructuring Charges. The Company did not incur cost
curtailment and restructuring charges for the year ended December 31, 2003. Cost
curtailment and restructuring charges were $581,000 for the year ended December
31, 2002.

      In August 2002, the Board approved a plan to relocate the Company's
offices from New York City and consolidate operations in Clifton Park, New York
for the purpose of reducing the Company's operating expenses and the Company
terminated its building lease in New York City. In addition, the Company reduced
its staff. The restructuring and cost curtailment charges of $581,000 for the
year ended December 31, 2002 reflects $113,000 of severance for terminated
employees, $172,000 of lease termination penalties, $289,000 related to the
abandonment of fixed assets at the vacated premises and $7,000 of relocation
costs.

      Interest and Other Income (Expense), Net. Interest and other income
(expense) was ($2,000) for the year ended December 31, 2003 as compared with
$(5,000) for the year ended December 31, 2002. Interest and other income
(expense) primarily consists of interest earned on our cash and cash equivalent
balances and expense related to capital lease obligations and indebtedness,
debentures and the amortization of debt discounts. The decrease in interest and
other expense for the year ended December 31, 2003 reflects an increase in
interest expense of $63,000 resulting from a full year of the Series A
convertible Secured Debenture interest and related amortization of the discount
and receipt of $75,000 representing the final payment in the E-Coin litigation
settlement.

      Income Taxes. Income taxes are state and local taxes on business and
investment capital. Income taxes for the year ended December 31, 2003 were
$10,000 as compared with $28,000 for the year ended December 31, 2002. The
decrease is attributable to a decrease in certain local taxes.

      At December 31, 2003, we had 25 full-time employees. We expect to hire
employees as necessary in order to attain our strategic objectives.


                                       17
<PAGE>


LIQUIDITY AND CAPITAL RESOURCES

      At December 31, 2003, we had cash and cash equivalents of $2,963,000 as
compared with $553,000 at December 31, 2002. At December 31, 2003 we had working
capital of $3,520,000 as compared with $731,000 at December 31, 2002.

      Net cash used in operating activities was $1,980,000 and $3,484,000 for
the years ended December 31, 2003 and 2002, respectively. The decrease in net
cash used in operating activities is primarily attributable to a decrease in our
net loss, excluding depreciation and amortization, the loss on abandonment of
assets, and the changes in accounts receivable, prepaid expenses and other
assets, and accounts payable and accrued expenses.

      Net cash used in investing activities was $39,000 and $78,000 for the
years ended December 31, 2003 and 2002, respectively. The decrease is
attributable to decreases in the purchases of property and equipment.

      Net cash provided by financing activities was $4,431,000 and $3,906,000
for the years ended December 31, 2003 and 2002, respectively. The increase is
attributable to proceeds received from the exercise of common stock options and
warrants, although in 2003 we received fewer proceeds from the sale of common
stock and convertible debentures than we did in 2002.

      The Company currently has no material commitments for the next 12 months
other than those under operating lease arrangements. These arrangements consist
primarily of lease arrangements for the Company's office space in Albany and New
York City. The aggregate required payments for the next 12 months under these
arrangements are $177,000. Additionally, notwithstanding the above, our most
significant non-contractual operating costs for the next 12 months are
compensation and benefit costs, insurance costs and general overhead costs such
as telephone and utilities. During 2004, we anticipate incurring approximately
$420,000 per month in cash operating costs.

      The Company may require additional financing to fund revenue growth,
develop new technologies or acquire strategic assets. The Company's management
is actively pursuing increases to our net cash flows through increases in
revenues or additional financing. Management believes that a combination of
increases to operating cash flow, primarily through revenue growth, reduced
costs and funds that may be received from the equity lines of credit and
additional financing will generate sufficient cash flow to fund our operations
through 2004. However, there are no assurances that such increases in revenues
will be attained or that draws on the equity line or additional financings will
be successfully consummated. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Risk Factors That May Affect
Future Operating Results."

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

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


                                       18
<PAGE>

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

      In the event we cannot procure appropriate capital resources, through our
net operating cash flows or equity lines of credit or additional financing or
some combination of both, we may be required to reduce the development of our
products and services or scale back current operations until funds become
available on terms acceptable to us.

IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

      In May 2003, Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 150 ("SFAS No. 150"),
"Accounting for Certain Financial Instruments with Characteristics of Both
Liabilities and Equity." SFAS No. 150 establishes standards for how an issuer
classifies and measures in its statement of financial position certain financial
instruments with characteristics of both liabilities and equity. SFAS No. 150
requires that an issuer classify a financial instrument that is within SFAS No.
150's scope as a liability (or an asset in some circumstances) because the
financial instrument embodies an obligation of the issuer. The Company believes
that the adoption of SFAS No. 150 will not have a significant impact on its
results of operations or financial position.

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

      At December 31, 2003, the Company had available net operating loss
carry-forwards of approximately $76,223,000. The net operating loss
carry-forwards expire at various dates through 2023.

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

      The merger of The Duck Corporation with and into a wholly-owned subsidiary
of Applied Capital Funding, Inc., may have involved an "ownership change" and
thus we may be unable to use a material portion of our available net operating
loss carry-forwards. Furthermore, as part of our plan to increase revenues, add
complementary products to our product line, and ensure our long-term success, we
are currently contemplating acquiring other technology companies or business
and/or securing additional filing, and we would likely issue additional shares
of our common or preferred stock in connection with those transactions In
addition, the exercise of outstanding convertible preferred stock, warrants and
certain options to purchase shares of Common Stock may require us to issue
additional shares of Common Stock. The issuance of a significant number of
shares of Common Stock could result in an "ownership change." If we were to
experience such an "ownership change," we might not be able to use a substantial
amount of our available net operating loss carry-forwards to reduce future
taxable income.

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

RISK FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS

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


                                       19
<PAGE>


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

      Since our inception, we have incurred significant losses and negative cash
flow from operations, and as of December 31, 2003, we had an accumulated deficit
of approximately $107.7 million. During fiscal 2004, we expect to meet our
working capital obligations and other cash requirements with cash derived from
operations, from our cash reserves and the Company's equity line of credit and
other financing as required. There can be no assurance, however, that cash from
operations and the other sources described above will be achieved or will be
sufficient for our operating needs or that we will be able to achieve
profitability on a consistent basis, if at all. In the event that cash flow from
operations is less than anticipated and we are unable to secure additional
funding, in order to preserve cash, we would be required to further reduce
expenditures and effect further reductions in our corporate infrastructure,
either of which could have a material adverse effect on our ability to continue
our current level of operations. Even if we obtain additional working capital in
the near future, to the extent that operating expenses increase or we need
additional funds to make acquisitions, develop new technologies or acquire
strategic assets, the need for additional funding may be accelerated and there
can be no assurances that any such additional funding can be obtained on terms
acceptable to us, if at all.

IF WE CANNOT GENERATE SUFFICIENT POSITIVE CASH FLOWS FROM OUR OPERATIONS, OUR
OPERATING RESULTS AND OUR STOCK PRICE MAY BE NEGATIVELY IMPACTED.

      Although we have significantly decreased our operating expenses, we are
still incurring approximately $420,000 of monthly operating costs. We currently
do not generate sufficient revenues to offset our operating costs, and our net
loss for the fiscal year ended December 31, 2003 was $2,375,000. We do not have
and have not sought a current source of financing, and our current commitments
for capital do not guarantee us enough cash to cover our current level of
operating expenses. Moreover, as we continue to expand our product and service
offerings to maintain our competitive advantage, we may be required to incur
additional costs to hire and retain additional personnel, license complementary
third party technology for use in our proprietary software or expand both our
international and domestic presence to enter new markets. These costs may
significantly increase our current level of monthly operating expenses. Failure
to generate sufficient capital through both our revenue streams and financings
may require us to execute additional corporate restructurings, scale back our
product or service offerings or limit the markets into which we enter. Any of
these items, or a combination thereof, could have a harmful effect on our
operating results and our stock price.

WE HAVE A HISTORY OF LOSSES AND NEGATIVE CASH FLOW 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.

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

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


                                       20
<PAGE>

     Our ability to generate profits will depend on our ability:

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

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

      o     to control costs.

      We therefore do not have a significant operating history upon which you
can evaluate us and our prospects, and you should not rely upon our past
performance to predict our future performance.

OUR STOCK PRICE MAY FLUCTUATE FOR REASONS BEYOND OUR CONTROL, WHICH COULD RESULT
IN LOSSES ON YOUR INVESTMENT IN OUR STOCK.

      Fluctuations in the market price of our common stock may adversely affect
our access to capital and financing and our ability to attract and retain
qualified personnel. Historically, our common stock price has fluctuated widely,
with a 52-week range as of March 26, 2004 of $0.37 to $ 4.50. We expect
fluctuations to continue in the future for a number of reasons, including:

o     quarterly variations in our operating results;

o     competitive announcements;

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

o     news relating to trends in our markets; and o changes in financial
      estimates by securities analysts or failure to meet analyst estimates.

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

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

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

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

      We derive, and expect to continue to derive substantially all of our
revenue from the sale of technology and services used over Internet connections
and proprietary networks that require broadband access. If the long-term growth
in demand for broadband access does not grow as we expect, the demand for many
of our products and services may decline or grow more slowly than we expect. As
a result, we may not be able to grow our business, and our revenue and
profitability may decline from current levels.

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

o     inadequate network infrastructure;

o     security concerns;

o     inconsistent quality of service; and

o     availability of cost-effective, high-speed service.


                                       21
<PAGE>

IF WE ARE UNABLE TO CONTINUE TO ATTRACT, RETAIN AND MOTIVATE HIGHLY SKILLED
EMPLOYEES, WE MAY NOT BE ABLE TO EXECUTE OUR BUSINESS PLAN.

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

LOSS OF KEY PERSONNEL COULD ADVERSELY AFFECT OUR BUSINESS.

Our success depends largely on the skills, experience, and performance of some
key members of our management, including our Chairman, President and Chief
Executive Officer, Douglas A. McIntyre. The loss of any key members of our
management may materially and adversely affect our business, financial
condition, and results of operations.

MUCH OF OUR TECHNOLOGY RELIES ON OWNED OR LICENSED INTELLECTUAL PROPERTY, AND IF
SUCH RIGHTS ARE NOT PROTECTED FROM THE USE OF OTHERS, INCLUDING POTENTIAL
COMPETITORS, OUR BUSINESS PROSPECTS MAY BE HARMED.

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

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

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

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


                                       22
<PAGE>


ADVANCES IN HARDWARE-BASED TECHNOLOGY COULD COMPENSATE FOR SOME OF THE
ADVANTAGES OF OUR SOFTWARE-BASED COMPRESSION TECHNOLOGY.

      One of the advantages that our compression technology has over others is
its high compression rates, which can allow users to store archival video images
in smaller files. In the context of optical digital storage media, for instance,
this means that customers using our software can store a full-length,
high-definition movie on a single video disk, where they might need two or more
disks using our competitors' technologies. At least one hardware technology, the
so-called "Blu-ray" technology, may partially or fully compensate for the lower
compression rates of other compression software, and it is possible that
developers may create other hardware technologies that could achieve similar
results. At present, Blu-ray technology is relatively expensive. If it is widely
adopted, however, it could result in our losing revenues from customers who
would otherwise buy our software because of its high compression rates.

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.

OUR INDUSTRY IS EXPERIENCING CONSOLIDATION THAT MAY INTENSIFY COMPETITION.

      The Internet and media distribution industries are undergoing substantial
change which has resulted in increasing consolidation and a proliferation of
strategic transactions. Many companies in these industries have been going out
of business or are being acquired by competitors. As a result, we are
increasingly competing with larger competitors that have substantially greater
resources than we do. We expect this consolidation and strategic partnering to
continue. Acquisitions or strategic relationships could harm us in a number of
ways. For example:

            o     competitors could acquire or enter into relationships with
                  companies with which we have strategic relationships and
                  discontinue their relationship with us, resulting in the loss
                  of distribution opportunities for our products and services or
                  the loss of certain enhancements or value-added features to
                  our products and services;

            o     competitors could obtain exclusive access to desirable
                  multimedia content and prevent that content from being
                  available in our formats, thus decreasing the use of our
                  products and services to distribute and experience the content
                  that audiences most desire, and hurting our ability to attract
                  advertisers to our Web sites and product offerings;

            o     suppliers of important or emerging technologies could be
                  acquired by a competitor or other company which could prevent
                  us from being able to utilize such technologies in our
                  offerings, and disadvantage our offerings relative to those of
                  competitors;

            o     a competitor could be acquired by a party with significant
                  resources and experience that could increase the ability of
                  the competitor to compete with our products and services; and

            o     other companies with related interests could combine to form
                  new, formidable competition, which could preclude us from
                  obtaining access to certain markets or content, or which could
                  dramatically change the market for our products and services.

Any of these results could put us at a competitive disadvantage which could
cause us to lose customers, revenue and market share. They could also force us
to expend greater resources to meet the competitive threat, which could also
harm our operating results.

WE MAY BE UNABLE TO SUCCESSFULLY COMPETE WITH MICROSOFT AND OTHER COMPANIES IN
THE VIDEO COMPRESSION AND MEDIA DELIVERY MARKET

The market for software and services for video compression and IP based video
delivery is relatively new, constantly changing and intensely and increasingly
competitive. As IP based video delivery expands, more companies are entering the
market for, and expending increasing resources to develop, video compression and
IP based video delivery software and services. We expect that competition will
continue to intensify. Increased competition could hurt our business and the
trading price of our stock. Increased competition may also result in price
reductions, reduced margins, loss of customers, and a change in our business and
marketing strategies, any of which could harm our business.

Many of our current and potential competitors have longer operating histories,
greater name recognition, more employees and significantly greater financial,
technical, marketing, public relations and distribution resources than we do. In
addition, new competitors with potentially unique or more desirable products or
services are entering the market all the time. The competitive environment may
require us to make changes in our products, pricing, licensing, services or
marketing to maintain and extend our current brand and technology franchise.
Price concessions or the emergence of other pricing, licensing and distribution
strategies or technology solutions of competitors may reduce our revenue,
margins or market share, any of which will harm our business. Other changes we
have to make in response to competition could cause us to expend significant
financial and other resources, disrupt our operations, strain relationships with
partners, or release products and enhancements before they are thoroughly
tested, any of which could harm our operating results and stock price.


                                       23
<PAGE>


Microsoft is a principal competitor in the development and distribution of
digital media and media distribution technology. Microsoft currently competes
with us in the market for digital media servers, players, encoders, codecs and
other technology and services related to digital distribution of media.
Microsoft's commitment to and presence in the media delivery industry has
increased. Microsoft recently announced the settlement of antitrust litigation
with AOL Time Warner in which Microsoft reportedly paid AOL Time Warner $750
million and the two companies agreed to collaborate on long-term digital media
initiatives, an announcement which may or may not have a substantive business
impact. We expect that Microsoft will continue to increase competitive pressure
in the overall market for digital media and media distribution.

Microsoft distributes its competing streaming media server, player, tools and
digital rights management products by bundling them with its Windows operating
systems and servers at no additional cost or otherwise making them available
free of charge. Microsoft's practices have caused, and may continue to cause,
pricing pressure on our revenue generating products and services and affect
usage of our competing products and formats. Microsoft's practices have led in
some cases, and could continue to lead to, longer sales cycles, decreased sales,
loss of existing and potential customers and reduced market share. In addition,
we believe that Microsoft has used and may continue to use its monopoly position
in the computer industry and its financial resources to secure preferential or
exclusive distribution, use and bundling contracts for its media delivery
technologies and products with third parties, such as ISPs, content delivery
networks, content providers, entertainment and media companies, VARs and OEMs,
including third parties with whom we have relationships. Such arrangements,
together with Microsoft's aggressive marketing of its Windows operating systems,
server products and digital media products, may reduce our share of the
streaming media and digital distribution markets. While courts have ruled that
several of Microsoft's practices violated relevant laws related to illegal
maintenance of monopoly power, court remedies to date have had only a minor
impact. There can be no assurance that there will be future court remedies
against Microsoft's illegal actions, or if there are any such future remedies,
there can be no assurance that these remedies will be effective in curtailing
these activities.

      Microsoft has aggressively marketed and licensed its Windows Media
technology to consumer electronics companies, a number of which have built
support for Windows Media in their products. If Microsoft is successful in
spreading Windows Media technology to non-PC devices -- in part through
leveraging their operating system monopoly -- and we are not, it could harm our
business.

      In addition to Microsoft, we face competition from other companies that
develop and market streaming media products. For example, Apple Computer offers
the QuickTime streaming media technology and other technology based on MPEG-4
standards, including a free media player and a free streaming media server, and
licenses for free source code to the server under the conditions of Apple's end
user license agreement.

WE MAY NOT SUCCESSFULLY DEVELOP NEW PRODUCTS AND SERVICES.

      Our growth depends on our ability to continue to develop leading-edge
media delivery and digital distribution products and services. Our business and
operating results would be harmed if we fail to develop products and services
that achieve widespread market acceptance or that fail to generate significant
revenues or gross profits to offset our development and operating costs. We may
not timely and successfully identify, develop and market new product and service
opportunities. If we introduce new products and services, they may not attain
broad market acceptance or contribute meaningfully to our revenues or
profitability.

Because the markets for our products and services are changing rapidly, we must
develop new offerings quickly. We have experienced development delays and cost
overruns in our development efforts in the past and we may encounter such
problems in the future. Delays and cost overruns could affect our ability to
respond to technological changes, evolving industry standards, competitive
developments or customer requirements. Our products also may contain undetected
errors that could cause increased development costs, loss of revenues, adverse
publicity, reduced market acceptance of our products or services or lawsuits by
customers.


                                       24
<PAGE>

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

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

REGULATORY CHANGES IN THE INTERNET INDUSTRY INVOLVE UNCERTAINTIES, AND THE
RESOLUTION OF THESE UNCERTAINTIES COULD ADVERSELY AFFECT OUR BUSINESS BY RAISING
OUR COSTS OR REDUCING POTENTIAL REVENUES.

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

H.264 AND OTHER STANDARDS-BASED CODECS MAY CONTINUE TO BE WIDELY ADOPTED BY
POTENTIAL CUSTOMERS.

      Our video compression/decompression software competes directly with
standards-based compression software such as MPEG-2, MPEG-4 and H.264. Because
those codecs are based on common standards that encourage development by
different software designers, there are numerous developers programming to these
standards and developing products based on these standards. In addition, there
are certain customers that prefer to license standards-based codecs. If
standards-based codecs continue to be widely adopted by potential customers, we
may encounter difficulty in selling or licensing our products and achieving
expected revenue levels.

WE ARE INCREASINGLY RELIANT ON THE SUCCESS OF THE PRODUCT DEPLOYMENTS OF OUR
CUSTOMERS.

      An increasing number of our license agreements with customers provide for
the payment of license fees (i.e., royalties) 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. Therefore, the amount of revenue we generate is
highly dependent on the success of our customers' product deployments. If the
products of customers with whom we have established per unit royalty or revenue
sharing relationships do not generate significant sales, our revenues will be
negatively affected.

BEIJING E-WORLD COULD CHOOSE TO ADOPT VIDEO COMPRESSION TECHNOLOGY OTHER THAN
VP5/VP6.

      Although the management of Beijing E-World has assured us that our video
compression technology will be included in the next generation of EVD, E-World
may nevertheless adopt video compression technologies for EVD and HDTV other
than VP5/VP6. E-world would nevertheless continue to be contractually obligated
to make minimum royalty payments to us in 2004 and 2005. To the extent E-world
chooses video compression technologies other than VP5/VP6, we may not generate
additional revenue from the E-world relationship over and above the minimum
royalty amounts.

THE EVD STANDARD MAY NOT BE WIDELY ADOPTED IN CHINA OR THE REST OF THE WORLD.

      E-world is building EVD to be the high-definition successor to DVD in
China and potentially the rest of the world. Although the EVD initiative is
backed by the Chinese government, it faces competition from at least two
formidable competitors: the Blu-ray group, consisting of Sony, Matsushita,
Hewlett Packard, Dell and at least seven other companies and the HD DVD group
backed by the NEC Corp. and Toshiba. If the EVD standard is not widely adopted
in China or the rest of the world, we may not generate additional revenue from
the E-world relationship over and above the minimum royalty amounts.


                                       25
<PAGE>


EFFECTS OF ANTI-TAKEOVER PROVISIONS COULD INHIBIT POTENTIAL INVESTORS OR DELAY
OR PREVENT A CHANGE OF CONTROL THAT MAY FAVOR YOU.

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

o     discourage potential acquisition proposals;

o     delay or prevent a change in control; and

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

      In particular, our board of directors is authorized to issue up to
20,000,000 shares of non-voting 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.

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

At December 31, 2003, we had available net operating loss carry-forwards of
approximately $76,223,000. The net operating loss carry-forwards expire at
various dates through 2023. Under Section 382 of the Internal Revenue Code, the
use of the prior net operating losses is limited after a corporation undergoes
an "ownership change". Certain actions previously taken by us, future issuances
of equity interests by us, or on the exercise of outstanding warrants or options
to purchase our common stock, may have resulted or may result in an ownership
change that is large enough to trigger the Section 382 limitations, and we may
therefore be unable to use a material portion of our available net operating
loss carry-forwards. If we were deemed to have experienced such an "ownership
change," we might not be able to use a substantial amount of our available net
operating loss carry-forwards to reduce future taxable income.

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

      We do not anticipate paying dividends on our stock in the foreseeable
future.

ITEM 7. FINANCIAL STATEMENTS

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

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

      Effective March 15, 2002, the Board of Directors, upon the recommendation
of the Audit Committee, approved the engagement of Eisner LLP (formerly Richard
A. Eisner & Company, LLP) as its independent accountants for the fiscal year
ending December 31, 2002 and dismissed the firm of Arthur Andersen LLP.

      Andersen's report on our consolidated financial statements for the fiscal
year ended December 31, 2001 did not contain an adverse opinion or disclaimer of
opinion, nor was it qualified or modified as to uncertainty, audit scope or
accounting principles, except that the report contained an explanatory paragraph
regarding On2's ability to continue as a going concern. We did not have any
disagreements with Anderson on any matter of accounting principles or practices,
financial statement disclosure or auditing scope or practice that, it not
resolved to Anderson's satisfaction, would have caused it to make reference to
the subject matter of the disagreement(s) in connection with its report.

      During our two most recent fiscal years ended December 31, 2002, and the
subsequent interim period through March 26, 2003, we did not consult with Eisner
LLP regarding any of the matters or events set forth in Item 304(a)(2)(i) and
(ii) of Regulation S-B.


                                       26
<PAGE>

                                    PART III


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

      The information required is incorporated by reference from the sections
entitled "Directors and Executive Officers", "The Board of Directors" and
"Compliance with Section 16(a) of the Exchange Act" contained in the Proxy
Statement for the Annual Meeting of Stockholders to be held on May 21, 2004 (the
"Proxy Statement"), which is to be filed with the Securities and Exchange
Commission.


ITEM 10. EXECUTIVE COMPENSATION

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


ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

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


ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

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


ITEM 13. CONTROLS AND PROCEDURES

      (a) Evaluation of Disclosure Controls and Procedures

      Our chief executive officer and chief financial officer have evaluated the
effectiveness of the Company's disclosure controls and procedures (as defined in
Rules 13a-14(c) and 15d-14(c) of the Securities Exchange Act of 1934), as of a
date within 90 days of the filing date of this annual report (Evaluation Date),
that ensure that information relating to the registrant which is required to be
disclosed in this report is recorded, processed, summarized and reported, within
required time periods. They have concluded that as of the Evaluation Date, the
registrant's disclosure controls and procedures were adequate and effective to
ensure that material information relating to the registrant and its consolidated
subsidiaries would be made known to them by others within those entities,
particularly during the period in which this annual report was being prepared.

      (b) Changes in Internal Controls

      There were no significant changes in the Company's internal controls or in
other factors that could significantly affect these controls subsequent to the
Evaluation Date, nor were there any significant deficiencies or material
weaknesses in these controls requiring corrective actions.


                                       27
<PAGE>


ITEM 14. EXHIBITS AND REPORTS ON FORM 8-K.

EXHIBIT
  NO.                          IDENTIFICATION OF EXHIBIT
----------                     -------------------------
3.1****             Certificate of Incorporation of the Company

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

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

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

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

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

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

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

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

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

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

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

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

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

10.1**              Employment Agreement with Douglas McIntyre


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

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

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

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

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

10.7                License Agreement by and between Bevmax Office Centers 1560,
                    LLC and the Company, dated as of January 23, 2004.

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

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

10.10*************  Software Distribution Agreement, dated as of August 25,
                    2003, and incorporated by reference herein.

10.11               Employment Agreement with Tim Reusing

10.12               Employment Agreement with Eric Ameres

21*******           Subsidiaries

23.1                Consent of Eisner LLP

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

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

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

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



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

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

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

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

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

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

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

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

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

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

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

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

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


                                       28
<PAGE>


      (b) Reports filed on Form 8-K for the three months ended December 31,
2003.

      The Company filed Form 8-K on October 1, 2003, containing its press
releases relating to: (i) the mutual termination of the previously announced
investment in On2 by an affiliate of Beijing E-world Technology, Co. Ltd.; and
(ii) to various business and regulatory initiatives.

      The Company filed Form 8-K on October 28, 2003, containing a press release
announcing the Company's results of operations for the third quarter ending
September 30, 2003.



                                       29
<PAGE>


SIGNATURES


      Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended, the Company has duly caused this report to be
signed on its behalf by the undersigned, thereby duly authorized on March 29,
2004.

ON2 TECHNOLOGIES, INC.

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


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


<TABLE>
<CAPTION>
        SIGNATURE                                  TITLE                                             DATE
<S>                            <C>                                                              <C>
/s/ DOUGLAS A. MCINTYRE        Chairman, President and Chief Executive Officer                  March 29, 2004
   (Douglas A. McIntyre)

/s/ ANTHONY PRINCIPE           Executive Vice President and Chief Financial Officer             March 29, 2004
   (Anthony Principe)          (Principal Financial Officer)

/s/ MIKE KOPETSKI              Director                                                         March 29, 2004
   (Mike Kopetski)

/s/ WILLIAM A. NEWMAN          Director                                                         March 29, 2004
   (William A. Newman)

/s/ J. ALLEN KOSOWSKY          Director                                                         March 29, 2004
   (J. Allen Kosowsky)

/s/ THOMAS WEIGMAN             Director                                                         March 29, 2004
   (Thomas Weigman)

/s/ DOUGLAS A. MCINTYRE        Director                                                         March 29, 2004
   (Douglas A. McIntyre)
</TABLE>



                                       30
<PAGE>


                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

                                                                         Page
                                                                         ----
Independent Auditor's Report........................................      F-2

Consolidated Balance Sheets as of December 31, 2003 and 2002........      F-3

Consolidated Statements of Operations for the years ended
    December 31, 2003 and 2002......................................      F-4

Consolidated Statements of Changes in Stockholders' Equity
    for the years ended December 31, 2003 and 2002..................      F-5

Consolidated Statements of Cash Flows for the years ended
    December 31, 2003 and 2002......................................      F-7

Notes to Consolidated Financial Statements..........................      F-9


                                      F-1

<PAGE>


                          INDEPENDENT AUDITOR'S REPORT

Board of Directors and Stockholders
On2 Technologies, Inc.
Clifton Park, New York

        We have audited the accompanying consolidated balance sheets of On2
Technologies, Inc. and subsidiaries (the "Company") as of December 31, 2003 and
2002 and the related consolidated statements of operations, changes in
stockholders' equity and cash flows for the years then ended. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

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

        In our opinion, the financial statements enumerated above present
fairly, in all material respects, the consolidated financial position of On2
Technologies, Inc. and subsidiaries as of December 31, 2003 and 2002, and the
consolidated results of their operations and their consolidated cash flows for
the years then ended in conformity with accounting principles generally accepted
in the United States of America.

/s/ EISNER LLP

Eisner LLP

New York, New York
January 22, 2004


                                      F-2
<PAGE>


                             ON2 TECHNOLOGIES, INC.
                           CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                                  December 31,
                                                                        --------------------------------
                                                                            2003               2002
                                                                        -------------      -------------
                               ASSETS

Current assets:
<S>                                                                     <C>                <C>
  Cash and cash equivalents .......................................     $   2,963,000      $     553,000
  Accounts receivable, less allowance for doubtful
    accounts of $15,000 and $50,000 as of December 31,
    2003 and 2002, respectively ...................................           826,000            601,000
  Prepaid and other current assets ................................           164,000            101,000
                                                                        -------------      -------------
       Total current assets .......................................         3,953,000          1,255,000

Property and equipment, net .......................................           149,000            353,000
Intangible assets, net ............................................                              463,000
Other assets ......................................................            26,000              9,000
                                                                        -------------      -------------
       Total assets ...............................................     $   4,128,000      $   2,080,000
                                                                        =============      =============

                 LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:

  Accounts payable ................................................     $     119,000      $     266,000
  Accrued expenses ................................................           221,000            254,000
  Deferred revenue ................................................            30,000
  Term-loan .......................................................            63,000
  Capital lease obligations .......................................                                4,000
                                                                        -------------      -------------
       Total current liabilities ..................................           433,000            524,000

Capital lease obligation, excluding current portion ...............                                5,000
Convertible debentures ............................................           409,000            569,000
                                                                        -------------      -------------
        Total liabilities .........................................           842,000          1,098,000
                                                                        -------------      -------------

Commitments and contingencies (Note 12)

Stockholders' equity:
    Preferred stock, $0.01 par value; 20,000,000 shares authorized;
       5,565,000 and 9,920,000 convertible shares issued and
       outstanding at December 31, 2003 and 2002, respectively ....            56,000             99,000
    Common stock, $0.01 par value; 100,000,000 shares
      authorized; 74,146,000 and 59,588,000 shares issued and
      outstanding at December 31, 2003 and 2002, respectively .....           741,000            596,000
    Additional paid-in ............................................       110,229,000        105,422,000
    capital
    Accumulated other comprehensive loss ..........................           (18,000)           (16,000)
    Accumulated deficit ...........................................      (107,722,000)      (105,119,000)
                                                                        -------------      -------------

        Total stockholders' equity ................................         3,286,000            982,000
                                                                        -------------      -------------

        Total liabilities and stockholders' equity ................     $   4,128,000      $   2,080,000
                                                                        =============      =============
</TABLE>

           See accompanying notes to consolidated financial statements

                                      F-3
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
                                                                       Year Ended December 31,
                                                                   ------------------------------
                                                                       2003              2002
                                                                   ------------      ------------
<S>                                                                <C>               <C>
Revenue ......................................................     $  3,302,000      $  3,353,000

Operating expenses:
        Cost of revenue ......................................        1,506,000         2,056,000
        Research and development .............................        1,124,000         2,149,000
        Sales and marketing ..................................          527,000           924,000
        General and administrative ...........................        2,508,000         2,911,000(1)
        Cost curtailment and restructuring charges ...........                            581,000
                                                                   ------------      ------------

Total operating expenses .....................................        5,665,000         8,621,000
                                                                   ------------      ------------

Loss from operations .........................................       (2,363,000)       (5,268,000)

Interest and other income (expense), net .....................           (2,000)           (5,000)
                                                                   ------------      ------------

Loss before provision for income taxes .......................       (2,365,000)       (5,273,000)

Provision for income taxes ...................................           10,000            28,000
                                                                   ------------      ------------

Net loss .....................................................       (2,375,000)       (5,301,000)

Convertible preferred stock deemed dividend ..................          228,000           668,000
                                                                   ------------      ------------


Net loss attributable to common stockholders .................     $ (2,603,000)     $ (5,969,000)
                                                                   ============      ============

Basic and diluted net loss attributable to common stockholders
  per common share ...........................................     $      (0.04)     $      (0.11)
                                                                   ============      ============

Weighted average basic and diluted common shares outstanding .       64,654,000        52,252,000
                                                                   ============      ============
</TABLE>


(1)   General and administrative expenses for the year ended December 31, 2002
      excludes $581,000 of cost curtailment and restructuring charges, which are
      presented separately.


           See accompanying notes to consolidated financial statements

                                      F-4
<PAGE>


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

<TABLE>
<CAPTION>
                                                               Convertible                                     Additional
                                                             Preferred Stock            Common Stock            Paid-in
                                                           Shares       Amount        Shares      Amount        Capital
                                                        -----------   ----------  ------------   ----------   ------------
<S>                                                     <C>           <C>         <C>            <C>          <C>
Balance at January 1, 2002 ........................      12,929,000   $  129,000    38,565,000   $  386,000   $ 99,549,000

Net loss...........................................

Foreign currency translation adjustment............


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

Issuance of common stock
  in connection with the
  employee stock purchase plan.....................                                     61,000        1,000         16,000

Issuance of common stock and
  warrants in connection with the
  conversion of Series A
  convertible debentures...........................                                  4,444,000       44,000      1,980,000

Issuance of common stock in
  connection with the equity
  line of credit...................................                                 12,537,000      126,000      3,114,000

Issuance of common stock in
  connection with the conversion
  of Series C II preferred stock...................        (925,000)      (9,000)    1,333,000       13,000         (4,000)

Issuance of common stock in
  connection with the conversion of
  Series C III preferred stock.....................      (2,050,000)     (21,000)    2,614,000       26,000         (5,000)

Issuance of common stock in
  connection with the conversion of
  Series B preferred stock.........................         (34,000)                    34,000

Warrants issued for consulting services............                                                                 16,000

Warrants issued and discount recognized in
  connection with issuance of convertible
  debentures.......................................                                                                 88,000

Convertible preferred stock deemed dividends.......                                                                668,000
                                                        -----------   ----------  ------------   ----------   ------------

Balance at December 31, 2002.......................       9,920,000   $   99,000    59,588,000   $  596,000   $105,422,000
                                                        ===========   ==========  ============   ==========   ============
</TABLE>


<TABLE>
<CAPTION>
                                                              Other                             Total
                                                          Comprehensive     Accumulated      Stockholders'
                                                              Loss            Deficit          Equity
                                                           -----------     -------------     ------------
<S>                                                        <C>             <C>               <C>
Balance at January 1, 2002 ........................        $  (10,000)     $ (99,150,000)    $    904,000

Net loss...........................................                           (5,301,000)      (5,301,000)

Foreign currency translation adjustment............            (6,000)                             (6,000)
                                                                                             ------------

Comprehensive loss.................................                                            (5,307,000)
                                                                                             ------------
Issuance of common stock
  in connection with the
  employee stock purchase plan.....................                                                17,000

Issuance of common stock and
  warrants in connection with the
  conversion of Series A
  convertible debentures...........................                                             2,024,000

Issuance of common stock in
  connection with the equity
  line of credit...................................                                             3,240,000

Issuance of common stock in
  connection with the conversion
  of Series C II preferred stock...................                                                     0

Issuance of common stock in
  connection with the conversion of
  Series C III preferred stock.....................                                                     0

Issuance of common stock in
  connection with the conversion of
  Series B preferred stock.........................                                                     0

Warrants issued for consulting services............                                                16,000

Warrants issued and discount recognized in
  connection with issuance of convertible
  debentures.......................................                                                88,000

Convertible preferred stock deemed dividends.......                             (668,000)               0
                                                           -----------     -------------     ------------

Balance at December 31, 2002.......................        $  (16,000)     $(105,119,000)    $    982,000
                                                           ==========      =============     ============
</TABLE>


                                      F-5
<PAGE>


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

<TABLE>
<CAPTION>
                                                               Convertible                                     Additional
                                                             Preferred Stock            Common Stock            Paid-in
                                                           Shares       Amount        Shares      Amount        Capital
                                                        -----------   ----------  ------------   ----------   ------------
<S>                                                     <C>           <C>         <C>            <C>          <C>

Balance at December 31, 2002.......................       9,920,000   $   99,000    59,588,000   $  596,000   $105,422,000

Net loss...........................................

Foreign currency translation adjustment............

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

Issuance of common stock in connection with the
  exercise of stock options........................                                  2,579,000       25,000      1,355,000

Issuance of common stock in connection with the
  exercise of warrants.............................                                  1,503,000       15,000      1,710,000

Issuance of common stock in connection with the
  conversion of Series A secured convertible
  debentures.......................................                                  1,786,000       18,000        182,000

Issuance of common stock in connection with the
equity line of credit .............................                                  3,387,000       34,000      1,280,000

Issuance of common stock in connection with the
conversion of Series C V preferred stock...........      (1,923,000)     (19,000)    2,644,000       26,000         (7,000)

Issuance of common stock in connection with the
conversion of Series C VI preferred stock..........      (2,432,000)     (24,000)    2,606,000       26,000         (2,000)

Issuance of common stock in connection with the
payment of interest on the Series A secured
convertible debentures.............................                                     53,000        1,000         43,000

Warrants issued for consulting services............                                                                 60,000

Purchase of warrants...............................                                                                (42,000)

Warrants issued and discount recognized in
  connection with issuance of convertible
  debentures.......................................

Convertible preferred stock deemed dividends.......                                                                228,000
                                                        -----------   ----------  ------------   ----------   ------------

Balance at December 31, 2003.......................       5,565,000   $   56,000    74,146,000   $  741,000   $110,229,000
                                                        ===========   ==========  ============   ==========   ============
</TABLE>

<TABLE>
<CAPTION>
                                                              Other                             Total
                                                          Comprehensive     Accumulated      Stockholders'
                                                              Loss            Deficit          Equity
                                                           -----------     -------------     ------------
<S>                                                        <C>             <C>               <C>

Balance at December 31, 2002.......................        $  (16,000)     $(105,119,000)    $    982,000

Net loss...........................................                           (2,375,000)      (2,375,000)

Foreign currency translation adjustment............            (2,000)                             (2,000)
                                                                                             ------------
Comprehensive loss.................................                                            (2,377,000)
                                                                                             ------------
Issuance of common stock in connection with the
  exercise of stock options........................                                             1,380,000

Issuance of common stock in connection with the
  exercise of warrants.............................                                             1,725,000

Issuance of common stock in connection with the
  conversion of Series A secured convertible
  debentures.......................................                                               200,000

Issuance of common stock in connection with the
equity line of credit .............................                                             1,314,000

Issuance of common stock in connection with the
conversion of Series C V preferred stock...........                                                     0

Issuance of common stock in connection with the
conversion of Series C VI preferred stock..........                                                     0

Issuance of common stock in connection with the
payment of interest on the Series A secured
convertible debentures.............................                                                44,000

Warrants issued for consulting services............                                                60,000

Purchase of warrants...............................                                               (42,000)

Warrants issued and discount recognized in
  connection with issuance of convertible
  debentures.......................................

Convertible preferred stock deemed dividends.......                             (228,000)               0
                                                           -----------     -------------     ------------

Balance at December 31, 2003.......................        $  (18,000)     $(107,722,000)    $  3,286,000
                                                           ==========      =============     ============
</TABLE>

           See accompanying notes to consolidated financial statements

                                      F-6
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                                           Year Ended December 31,
                                                                                        ----------------------------
                                                                                           2003             2002
                                                                                        -----------      -----------
Cash flows from operating activities:
<S>                                                                                     <C>              <C>
  Net loss ........................................................................     $(2,375,000)     $(5,301,000)
    Adjustments to reconcile net loss to net cash used in operating activities:
        Equity based compensation .................................................          60,000           16,000
        Common shares issued for debenture interest ...............................          44,000
        Debt conversion costs .....................................................                           24,000
        Restructuring and impairment charges ......................................                           30,000
        Depreciation and amortization .............................................         706,000        1,500,000
        Reserve for bad debts .....................................................         (35,000)          50,000
        Loss on abandonment of assets .............................................                          289,000
        Amortization of debt discount .............................................          40,000            7,000

        Changes in operating assets and liabilities:

           Accounts receivable ....................................................        (190,000)          29,000
           Prepaid and other current assets .......................................         (63,000)         121,000
           Other assets ...........................................................         (17,000)         254,000
           Accounts payable and accrued expenses ..................................        (180,000)        (468,000)
           Deferred revenue .......................................................          30,000          (35,000)
                                                                                        -----------      -----------

               Net cash used in operating activities ..............................      (1,980,000)      (3,484,000)
                                                                                        -----------      -----------

Cash flows from investing activities:

  Purchases of property and equipment .............................................         (39,000)         (78,000)
                                                                                        -----------      -----------

Cash flows from financing activities:

  Principal payments on capital lease obligations .................................          (9,000)          (2,000)
  Purchase of common stock warrants ...............................................         (42,000)
  Proceeds from the issuance of a term-loan, net ..................................          63,000
  Proceeds from the sale of common stock, net .....................................       1,314,000        3,258,000
  Proceeds from the issuance of convertible debentures ............................                          650,000
  Proceeds from exercise of common stock options and warrants .....................       3,105,000
                                                                                        -----------      -----------

               Net cash provided by financing activities ..........................       4,431,000        3,906,000
                                                                                        -----------      -----------
Net change in cash and cash equivalents ...........................................       2,412,000          344,000
Effect of exchange rate changes on cash and cash equivalents ......................          (2,000)          (7,000)
Cash and cash equivalents, beginning of year ......................................         553,000          216,000
                                                                                        -----------      -----------

Cash and cash equivalents, end of year ............................................     $ 2,963,000      $   553,000
                                                                                        ===========      ===========
</TABLE>

                                      F-7
<PAGE>


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

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

<TABLE>
<CAPTION>

                                                                                  Year Ended December 31,
                                                                                --------------------------
                                                                                   2003           2002
                                                                                ----------     -----------
<S>                                                                             <C>            <C>
Cash paid during the year for:

    Interest ..............................................................     $   12,000     $    6,000
                                                                                ==========     ==========

    Taxes .................................................................     $   14,000     $   18,000
                                                                                ==========     ==========

    Non-cash transactions:

    Acquisition of fixed assets under capital leases ......................                    $   33,000
                                                                                               ==========

    Conversion of Preferred Stock into Common Stock .......................     $   43,000     $   30,000
                                                                                ==========     ==========

    Conversion of debentures into common stock and warrants ...............                    $2,024,000
                                                                                               ==========

    Conversion of debentures into common stock ............................     $  200,000
                                                                                ==========

    Debt discount in connection with the issuance of convertible debentures
         and warrants                                                                          $   88,000
                                                                                               ==========

    Convertible preferred stock deemed dividends ..........................     $  228,000     $  668,000
                                                                                ==========     ==========
</TABLE>

           See accompanying notes to consolidated financial statements

                                      F-8
<PAGE>


                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


(1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

      (a) Description of the Business

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

      The Company's consolidated financial statements have been prepared
assuming that it will continue as a going concern. The Company has incurred
recurring operating losses and negative operating cash flows since its
inception. At December 31, 2003 the Company had cash and cash equivalents and
working capital of $2,963,000 and $3,520,000, respectively. The Company is
actively pursuing increases to its net cash flows through increases in revenues
and financing from the sale of additional common shares, subject to stockholder
approval, under its equity lines of credit (see Note 8). During the year ended
December 31, 2002 the Company terminated its building lease in New York City,
reduced its staff and consolidated operations in the Albany, New York area for
purposes of reducing the Company's operating expenses. The Company believes that
a combination of increases to operating cash flow, primarily through revenue
growth, and funds that may be received from its equity lines of credit or
additional financings will generate sufficient cash flow to fund its operations
through 2004. The Company's plan to increase cash flows from operations relies
significantly on increases in revenue generated from its compression technology
services, products and licenses. However, there are no assurances that such
increases in revenues will be attained or that draws on the equity line or
additional financings will be successfully consummated.

      (b) Basis of Presentation

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

      (c) Cash and Cash Equivalents

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

      (d) Property and Equipment

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


                                      F-9
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


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

      (e) Intangible Assets

      As of December 31, 2002, the Company's intangible assets consisted of
purchased technology which was being amortized over its useful life of four
years. Purchased technology was fully amortized at December 31, 2003.

      (f) 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.

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

      The fair values of accounts receivables and accounts payables approximate
their carrying values based on the short-term maturities of these financial
instruments.

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

      (h) 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.

      (i) Revenue Recognition

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



                                      F-10
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


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

      (i) Revenue Recognition (continued)

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

      Software Licenses

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

      Professional Services

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

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

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


                                      F-11
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


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

      (j) Cost of Revenues

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

      (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") SFAS No.
86, "Software Development Costs". Under SFAS No. 86, these costs are expensed
until technological feasibility has been established, at which time any
additional costs are capitalized. The Company essentially has completed its
software development concurrently with technological feasibility and,
accordingly, has not capitalized any software development costs.

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

      (l) Stock-Based Compensation

      SFAS No. 123, "Accounting for Stock-Based Compensation" encourages the use
of the fair value based method of accounting for stock-based employee
compensation. Alternatively, SFAS No. 123 allows entities to continue to apply
the intrinsic value method prescribed by Accounting Principles Board ("APB")
Opinion 25, "Accounting for Stock Issued to Employees," and related
interpretations and provide pro forma disclosures of net income (loss) and
earnings (loss) per share, as if the fair value-based method of accounting had
been applied to employee awards. The Company has elected to continue to apply
the provisions of APB Opinion 25 and provide the disclosures required by SFAS
No. 123 and SFAS No. 148, "Accounting for Stock-Based Compensation -- Transition
and Disclosure," which was released in December 2002 as an amendment of SFAS No.
123. The following table illustrates the effect on net loss and loss per share
if the fair value-based method had been applied to all awards.

<TABLE>
<CAPTION>
                                                                              Year Ended December 31,
                                                                           ----------------------------
                                                                              2003             2002
                                                                           -----------      -----------
<S>                                                                        <C>              <C>
          Reported net loss attributable to common stockholders            $(2,603,000)     $(5,969,000)
          Stock-based employee compensation determined under the
              fair value-based method                                         (688,000)      (3,797,000)
                                                                           -----------      -----------

          Pro forma net loss                                               $(3,291,000)     $(9,766,000)
                                                                           ===========      ===========

          Loss attributable to common stockholders per share
              (basic and diluted):
                As reported                                                $     (0.04)     $     (0.11)
                                                                           ===========      ===========
                Pro forma                                                  $     (0.05)     $     (0.19)
                                                                           ===========      ===========
</TABLE>


                                      F-12
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


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

      (l) Stock-Based Compensation (continued)

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

                                                    Year Ended December 31,
                                                    -----------------------
                                                  2003                  2002
                                                 ------                ------

           Volatility                              138%                   116%
           Expected life of options             5 years                3 years
           Risk free interest rate                 3.5%                   3.5%
           Dividend yield                            0%                     0%

      The weighted average fair value of options granted during the years ended
      December 31, 2003 and 2002 were $0.56 and $0.22, respectively.

      (m) Net Loss Per Common Share

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

      Diluted loss per share has not been presented separately, as the
convertible preferred stock, convertible debentures and the outstanding stock
options and warrants (aggregating 24,540,000 potential common shares at December
31, 2003 and 36,883,000 at December 31, 2002) are anti-dilutive for each of the
periods presented.

      (n) Use of Estimates

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

      (o) Segment Reporting

      The Company adopted the provisions of SFAS No. 131, "Disclosures About
Segments of an Enterprise and Related Information". The Company operates in one
business segment, the sale of video compression software and related services,
for which it receives revenues from its customers. The Company's Chief Operating
Decision Maker is the Company's Chief Executive Officer ("CEO"), who receives
consolidated financial information for purposes of evaluating the Company's
operational and financial performance. The CEO does not receive discrete
financial information regarding the operating results of the Company's
individual products and services.


                                      F-13
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


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

      (p) Segment Reporting (continued)

      Our customers typically represent large digital communication and media
companies, entertainment companies, telecommunication companies and other global
corporations that operate within the digital media industry. For the year ended
December 31, 2003, three customers accounted for 35%, 19% and 11% of the
Company's total revenues. For the year ended December 31, 2002, three customers
accounted for 27%, 11% and 11% of the Company's total revenues. As of December
31, 2003, two customers accounted for 59% and 18% of total accounts receivable.
As of December 31, 2002, four customers accounted for 22%, 20%, 19% and 15% of
total accounts receivable.

      For the year ended December 31, 2003, foreign customers accounted for
approximately 67% of total revenue. These customers are primarily located in
Asia. For the year ended December 31, 2002, foreign customers accounted for
approximately 50% of total revenue.

      The Company's assets and operations have been and are currently based
within in the United States, except for two research and development employees
located in the United Kingdom. There was no significant revenue generated from
the United Kingdom operations for the years ended December 31, 2003 and 2002.

      (q) Recently Issued Accounting Pronouncements

      In May 2003, Financial Accounting Standards Board ("FASB") issued SFAS No.
150, "Accounting for Certain Financial Instruments with Characteristics of Both
Liabilities and Equity." SFAS No. 150 establishes standards for how an issuer
classifies and measures in its statement of financial position certain financial
instruments with characteristics of both liabilities and equity. SFAS No. 150
requires that an issuer classify a financial instrument that is within SFAS No.
150's scope as a liability (or an asset in some circumstances) because the
financial instrument embodies an obligation of the issuer. The Company believes
that the adoption of SFAS No. 150 will not have a significant impact on its
results of operations or financial position.

(2) PROPERTY AND EQUIPMENT

<TABLE>
<CAPTION>
                                                                   December 31,
                                                             -------------------------
                                                               2003            2002
                                                             ----------     ----------
<S>                                                          <C>            <C>
          Furniture and fixtures .......................     $   65,000     $   65,000
          Computer equipment ...........................      2,314,000      2,286,000
          Leasehold improvements .......................         23,000         73,000
          Licensed software ............................        588,000        588,000
                                                             ----------     ----------
                                                              2,990,000      3,012,000

          Less accumulated depreciation and amortization      2,841,000      2,659,000
                                                             ----------     ----------

              Total ....................................     $  149,000     $  353,000
                                                             ==========     ==========
</TABLE>


                                      F-14
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


(2) PROPERTY AND EQUIPMENT (continued)

      As of December 31, 2003, property and equipment included assets under
capital leases of $103,000 with related accumulated depreciation of $98,000. As
of December 31, 2002, property and equipment included assets under capital
leases of $103,000 with related accumulated depreciation of $92,000.
Depreciation expense was $243,000 and $854,000 for the years ended December 31,
2003 and 2002, respectively.

      In August 2002, the Board approved a plan to relocate the Company's
offices from New York City and consolidate operations in the Albany, New York
area for the purpose of decreasing the Company's operating expenses. The Company
wrote off $289,000 of the net carrying value of fixed assets abandoned as a
result of closing the New York City office.

(3) INTANGIBLE ASSETS


                                                    December 31,
                                             -------------------------
                                                2003            2002
                                             ----------     ----------
          Purchased technology .........     $2,509,000     $2,509,000
          Less accumulated amortization       2,509,000      2,046,000
                                             ----------     ----------

              Total ....................     $        0     $  463,000
                                             ==========     ==========

      Amortization of purchased technology was $463,000 and $627,000 for the
years ended December 31, 2003 and 2002, respectively.

(4) ACCRUED EXPENSES

                                                     December 31,
                                               -----------------------
                                                 2003            2002
                                               --------       --------
          Accrued compensation .........       $ 28,000       $ 78,000
          Accrued professional fees ....         65,000         54,000
          Other accrued expenses .......        128,000        122,000
                                               --------       --------

                  Total ................       $221,000       $254,000
                                               ========       ========

(5) TERM LOAN

      During July 2003 the Company obtained unsecured financing in the amount of
$160,000 to finance their directors' and officers' liability insurance. The
financing arrangement is for nine months; runs through March of 2004 and bears
interest at an annual rate of 7.75%.

(6) INCOME TAXES

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


                                      F-15
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


(6) INCOME TAXES (continued)

      As of December 31, 2003, the Company has net operating loss carry forwards
of approximately $76,223,000 which expire at various dates through 2023,
resulting in a deferred tax asset of approximately $30,489,000. Past and future
stock issuances may subject the Company to an annual limitation on the
utilization of its net operating loss under Section 382 of the Internal Revenue
Code. At December 31, 2003 the principal timing difference between tax and
financial reporting was due to depreciation expense. A full valuation allowance,
which increased by $751,000 (the deferred tax asset as of December 31, 2002, was
$29,738,000) during the year ended December 31, 2003, has been recorded related
to the deferred tax asset as a result of management's uncertainty as to the
realization of such asset. Accordingly, no provision for federal income tax
benefit has been recognized. The tax provisions of $10,000 and $28,000 for the
years ended December 31, 2003 and 2002, respectively, relate primarily to
various state and local taxes.

(7) CONVERTIBLE DEBENTURES

      (a) Series A Convertible Debentures

      In January 2001, the Company entered into a financing agreement with an
existing shareholder of the Company whereby the Company would receive up to
$2,000,000 in exchange for Series A Convertible Debentures ("Debentures") and
warrants to purchase shares of Common Stock. The timing of and the dollar value
of amounts received under this financing arrangement were required to equal
amounts received and coincide with investments by others in the Company, up to a
maximum of $2,000,000.

      Under the terms of the agreement, the Debentures consist of 200 units,
which are comprised of (1) $10,000 principal amount of Debentures and (2) one
warrant to purchase 6,667 shares of Common Stock at an exercise price of $1.68
per share. The principal amount of the Debentures were convertible into shares
of Common Stock at a conversion price of $0.45 six months after the date of
issuance at the discretion of the holder. The principal amount of the Debentures
was due 4 years from the date of issuance and was non-interest bearing.

      In March 2002, the holder of the $2,000,000 aggregate principal amount of
the Company's Series A Convertible Debentures (the "Debentures") elected to
convert its principal into the underlying 4,444,000 shares of the Company's
common stock. The conversion ratio and the number of underlying shares of common
stock were determined upon execution of the original agreement in January 2001.
In connection with the conversion, the Company issued to the holder of the
Debentures a warrant to purchase 200,000 shares of common stock at an exercise
price of $0.43 per share. The warrant was immediately exercisable and expires in
March 2007. The estimated fair value of the warrant was $68,000 based upon the
Black-Scholes pricing model. The fair value of the underlying shares of common
stock was $1,956,000 on the date of conversion. The Company recorded a non-cash
charge of $24,000 for the excess of the fair value of the underlying shares of
common stock and the warrant issued over the original net proceeds of
$2,000,000.


                                      F-16
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


(7) CONVERTIBLE DEBENTURES (continued)

      (b) Series A Secured Convertible Debentures

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

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

      An aggregate principal amount of $200,000, of the Series A Secured
Convertible Debentures, was converted into 1,786,000 shares the Company's common
stock as of December 31, 2003.

      The amortization of the discount was $40,000 and $7,000 for the years
ended December 31, 2003 and 2002, respectively.

(8) STOCKHOLDERS' EQUITY

      (a) Preferred Stock

      The Company has 20,000,000 shares of preferred stock authorized for
issuance and, through December 31, 2003, eight 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. The holders of the
various series of Preferred Stock generally have similar rights and privileges.
Each class of the Preferred Stock is convertible into shares of the Company's
Common Stock based on a conversion rate and has rights and preferences which are
generally more senior to the Company's Common Stock and are more fully described
in the Company's Certificate of Incorporation.

      Series A Convertible Preferred Stock

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

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


                                      F-17
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


(8) STOCKHOLDERS' EQUITY (continued)

      (a) Preferred Stock (continued)

      Series A Convertible Preferred Stock (continued)

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

      In May and June 2000, 1,067,000 and 533,000 shares of Series A Preferred
Stock, respectively, were converted into equivalent shares of the Company's
Common Stock.

      Series B Convertible Preferred Stock

      In April 2000, the Company designated and issued 34,000 shares of its
authorized preferred stock as Series B Preferred Stock, $0.01 par value ("Series
B Preferred"), in connection with an acquisition. Each share of Series B
Preferred was convertible into one share of the Company's Common Stock. During
2002 all of the outstanding shares of Series B Convertible Preferred Stock were
converted into 34,000 shares of Common Stock.

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

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

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

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


                                      F-18
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


(8) STOCKHOLDERS' EQUITY (continued)

      (a) Preferred Stock (continued)

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

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

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

      As of December 31, 2001, the conversion price of the Series C-IV Preferred
Stock was adjusted to $1.90 per share, the Company issued 182,000 additional
warrants and the exercise price of the warrants was reduced to $1.90 per share.
As a result of the issuance of the Series A Secured convertible debentures in
September 2002, the conversion price of the Series C-IV Preferred Stock was
further adjusted to $1.7549 per share, the Company issued 52,000 additional
warrants and the exercise price of the warrants was further reduced to $1.7549
per share.

      Additionally, as of December 31, 2001, the conversion price of the Series
C-V Preferred Stock was adjusted to $0.9756 per share, the Company issued
272,000 additional warrants and the exercise price of the warrants was reduced
to $0.9012 per share. As a result of the issuance of the Series A Secured
convertible debentures in September 2002, the conversion price of the Series C-V
Preferred Stock was further adjusted to $0.9047 per share, the Company issued
101,000 additional warrants and the exercise price of the warrants was further
reduced to $0.8363 per share. The Company recorded a deemed non-cash convertible
preferred stock dividend of $226,000 for the year ended December 31, 2002, to
recognize the additional benefit received by Travelers for their anti-dilution
provisions.

      During the year ended December 31, 2003, 1,923,000 shares of Series C-V
Preferred Stock were converted into 2,644,000 shares of the Company's common
stock.

      Series C-II Convertible Preferred Stock

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



                                      F-19
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


(8) STOCKHOLDERS' EQUITY (continued)

      (a) Preferred Stock (continued)

      Series C-II Convertible Preferred Stock (continued)

      In addition to the Series C-II Preferred, the Series C-II Investors
received detachable warrants which provided them the right to purchase an
aggregate of 396,000 shares of the Company's Common Stock at an exercise price
of $2.65 per share. The warrants were immediately exercisable and were due to
expire September 28, 2003.

      The holders of the Series C-II Preferred Stock were entitled to certain
anti-dilution protections, triggered by certain subsequent issuances of debt or
equity by the Company. The anti-dilution provision primarily adjusts the
conversion price of the Series C-II Preferred Stock and the number and exercise
price of the original warrants issued. The anti-dilution provision for the
Series C-II Preferred Stock was triggered by certain subsequent debt and equity
financings consummated by the Company. As of December 31, 2001, the conversion
price of the Series C-II Preferred Stock was adjusted to $1.90 per share, the
Company issued an additional 156,000 warrants and the exercise price of the
warrants was reduced to $1.90 per share. As a result of the issuance of the
Series A Secured convertible debentures in September 2002, the conversion price
of the Series C-II Preferred Stock was further adjusted to $1.7549 per share,
the Company issued 46,000 additional warrants and the exercise price of the
warrants was further reduced to $1.7549 per share. The Company recorded a deemed
non-cash convertible preferred stock dividend of $427,000 for the year ended
December 31, 2002, to record the additional benefit received by the Series C-II
Investors. During the year ended December 31, 2002, all of the shares of Series
C-II Preferred Stock were converted into 1,333,000 shares of the Company's
Common Stock. During the year ended December 31, 2003 the Company granted a
cashless exercise right to a C-II Preferred Stock warrant holder and recorded a
deemed dividend of $85,000. During the year ended December 31, 2003, all of the
C-II Preferred Warrants were exercised into 550,000 shares of the Company's
Common Stock and the Company received proceeds of $910,000 in connection with
their exercise.

      Series C-III Convertible Preferred Stock

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

      In addition to the Series C-III Preferred, the Series C-III Investors
received detachable warrants which provided them the right to purchase an
aggregate of 635,000 shares of the Company's Common Stock at an exercise price
of $1.14 per share. The warrants were immediately exercisable and were due to
expire December 7, 2003.


                                      F-20
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


(8) STOCKHOLDERS' EQUITY (continued)

      (a) Preferred Stock (continued)

      Series C-III Convertible Preferred Stock

      The holders of the Series C-III Preferred Stock are entitled to certain
anti-dilution protections, triggered by certain subsequent issuances of debt or
equity by the Company. The anti-dilution provision primarily adjusts the
conversion price of the Series C-III Preferred Stock and the number and exercise
price of the original warrants issued. The anti-dilution provision for the
Series C-III Preferred Stock was triggered by certain subsequent debt and equity
financings consummated by the Company. As of December 31, 2001, the conversion
price of the Series C-III Preferred Stock was adjusted to $0.9756 per share, the
Company issued an additional 175,000 warrants and the exercise price of the
warrants was reduced to $0.9012 per share. As a result of the issuance of
convertible debentures in September 2002, the Company issued 63,000 additional
warrants and the exercise price of the warrants was further reduced to $0.8363
per share. The Company recorded a deemed non-cash convertible preferred stock
dividend of $15,000 for the year ended December 31, 2002, to record the
additional benefit received by the Series C-III Investors. During the year ended
December 31, 2002 all the shares of Series C-III Preferred Stock were converted
into 2,614,000 shares of the Company's Common Stock. During the year ended
December 31, 2003, the Company received proceeds of $730,000 in connection with
the exercise of all of the C-III Preferred Warrants into 873,000 shares of the
Company's Common Stock.

      Series C-VI Convertible Preferred Stock

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

      The Series C-VI Convertible Preferred Stock includes a liquidation
preference. In the event of any liquidation, dissolution or winding up of the
Company, either voluntary or involuntary, the holders of shares of Series C-VI
Convertible Preferred Stock are entitled to receive an amount equal to $0.56 per
share. The liquidation price per share would be paid out of the assets of the
Company available for distribution prior to any payments made on any shares of
the Company's Common Stock or any other capital stock other than the Preferred
Stock.

      The aggregate fair market value of the Series C-VI Preferred was
$2,000,000, based upon the fair market value of the Company's Common Stock on
that date. Additionally, the fair market value of the warrants issued, as
calculated using the Black Scholes pricing model, was $1,729,000. In accordance
with EITF 98-5, the Company allocated the net proceeds between the Series C-VI
Preferred Stock and the warrants based on the relative fair value method as
described in APB No. 14. The Company allocated $1,073,000 to the Series C-VI
Preferred and recorded $927,000 of additional paid-in-capital to account for the
issuance of the warrants. The difference between the net proceeds allocated to,
and the fair market value of, the Series C-VI Preferred on the closing date,
which amounted to $927,000, was recorded as a non-cash convertible preferred
stock dividend for the year ended December 31, 2001.



                                      F-21
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


(8) STOCKHOLDERS' EQUITY (continued)

      (a) Preferred Stock (continued)

      Series C-VI Convertible Preferred Stock (continued)

      During the year ended December 31, 2003 the Company agreed to extend
certain anti-dilution rights to the holders of its Series C-VI Preferred Stock,
retroactive to the issuance of such shares. The conversion price of the Series
C-VI Preferred Stock has been adjusted to $0.5226 from $0.5601 per share as a
result of the retroactive treatment. The Company recorded deemed dividends of
$143,000 during the year ended December 31, 2003 relating to this adjustment.

      During the year ended December 31, 2003 2,432,000 shares of Series C-VI
Preferred were converted into 2,606,000 shares of the Company's Common Stock.

      The following table summarizes the common stock issuable upon conversion
of all outstanding Preferred Stock and the exercise of related warrants at
December 31, 2003:

                                                                     Shares of
                                                                    Common Stock
                                       Conversion or               Issuable upon
                                       Exercise Price               Conversion/
Convertible Security                     per Share                   Exercise
--------------------                     ---------                   --------
Series A Preferred Stock                  $7.50                        400,000
Series C-IV Preferred Stock               $1.7549                    2,792,000
Series C-V Preferred Stock                $0.9047                    2,993,000
Series C-VI Preferred Stock               $0.5226                    1,221,000
Series C-VI Warrants                      $0.5600                    5,357,000


      (b) Common Stock

      Equity-Line of Credit

      In December 2000, the Company entered into a common stock purchase
agreement ("Initial Stock Purchase Agreement") with an accredited investor
("Investor"), for the sale, from time to time, of the Company's Common Stock.
Pursuant to the Initial Stock Purchase Agreement, the Investor has committed to
purchase up to $23,000,000 of Common Stock over a 36-month period. The Investor
may be required to invest an additional $17,000,000 upon the attainment of
certain trading volumes and weighted average market prices in the Company's
Common Stock. However, the Company's ability to procure funds through the
Initial Stock Purchase Agreement may be limited or prohibited based on certain
trading volumes and weighted average market prices in the Company's Common
Stock.

      Under the Initial Stock Purchase Agreement, shares of Common Stock are
periodically sold to the Investor at a discount from market value ranging from
6%-10%, depending on the closing price of the Company's Common Stock. The amount
of Common Stock sold is at the sole discretion of the Company and at no time
throughout the term of the Stock Purchase Agreement is the Company obligated to
sell its Common Stock, unless the Company issues a drawdown notice. The Company
issued warrants to purchase 50,000 shares of the Company's Common


                                      F-22
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


(8) STOCKHOLDERS' EQUITY (continued)

      (b) Common Stock (continued)

      Equity-Line of Credit (continued)

Stock and incurred $25,000 of transaction costs in connection with the Stock
Purchase Agreement. During the year ended December 31, 2003, the Company
received proceeds of $76,000 in connection with the exercise of the
above-mentioned warrants were exercised into 50,000 shares of the Company's
Common Stock.

      In May 2001, the Company's shareholders approved the sale, at the sole
discretion of the Company, of up to 15,500,000 shares of Common Stock in
connection with the Initial Stock Purchase Agreement. The Company sold 7,024,000
shares of Common Stock for net proceeds of approximately $2,513,000 and
8,476,000 shares of Common Stock for net proceeds of approximately $4,191,000
under the Initial Stock Purchase Agreement, during the years ended December 31,
2002 and 2001, respectively.

      In November 2001, the Company entered into a second common stock purchase
agreement ("Second Stock Purchase Agreement") with the Investor, for sale, from
time to time, of the Company's Common Stock. Under the Second Stock Purchase
Agreement, the Investor has committed to purchase an additional $23,000,000
million over a 36-month period, with an additional commitment for $17,000,000
million upon the attainment of certain price and volume thresholds. Under the
Second Stock Purchase Agreement, providing that the volume weighted average
stock price for the 30-day period preceding a draw-down notice is at least
$0.30, the Company may request (a) a minimum amount of $300,000 or (b) a maximum
amount equal to the greater of $500,000 or $300,000 plus 4.5% of the volume
weighted average stock price for the preceding 30-day period multiplied by the
total trading volume for the preceding 3-month period. If the volume weighted
average stock price is below $0.30 and greater than $0.10, the minimum draw down
amount is pro-ratably reduced from $300,000 to $100,000.

      Under the Second Stock Purchase Agreement, shares of Common Stock are
periodically sold to the Investor at a discount from market value ranging from
6%-10%, depending on the closing price of the Company's Common Stock. The amount
of Common Stock sold is at the sole discretion of the Company and at no time
throughout the term of the Stock Purchase Agreement is the Company obligated to
sell its Common Stock, unless the Company issues a draw down notice. The Company
issued 100,000 shares of unrestricted Common Stock and incurred approximately
$10,000 of transaction costs in connection with the Second Stock Purchase
Agreement.

      Since April 2002, when the Company's stockholders approved the sale, at
the sole discretion of the Company, of up to 9,000,000 shares of Common Stock in
connection with the Second Stock Purchase Agreement, the Company has sold
9,000,000 shares of Common Stock for net proceeds of approximately $2,073,000
through December 31, 2003 at which time the Company had issued all the stock
registered for the Second Stock Purchase Agreement. For the twelve months ended
December 31, 2003 the Company issued 3,387,000 shares of its common stock and
received proceeds of $1,314,000 in connection with the Second Stock Purchase
Agreement.

      Investment by RealNetworks, Inc.

      In July 2001, the Company entered into a Common Stock Purchase Agreement
with RealNetworks, Inc. ("Real") whereby Real purchased 1,786,000 shares of the
Company's Common Stock for net proceeds of $1,000,000. The shares were issued to
Real at the fair market value at the time of the transaction (see Note 12).



                                      F-23
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


(8) STOCKHOLDERS' EQUITY (continued)

      (c) Warrants

      The Company issued common stock purchase warrants to various consultants,
strategic partners and investors. The following table summarizes information
about all common stock purchase warrants outstanding as of December 31, 2003.
All warrants were exerciseable as of December 31, 2003.


<TABLE>
<CAPTION>
           Range of                Number of Warrants         Weighted Average
         Exercise Prices               Outstanding             Exercise Price        Expiration Dates
         ---------------               -----------             --------------        ----------------
<S>                               <C>                         <C>                    <C>
        $ 0.11 - $ 0.56                 6,760,000                  $ 0.48               2005 - 2007
        $ 1.34 - $ 1.68                 1,785,000                  $ 1.67               2004 - 2007
        $11.25 - $28.38                   224,000                  $24.40               2004 - 2005
                                  -----------------------

                                        8,769,000                  $ 1.33
                                  =======================
</TABLE>


(9) STOCK OPTION PLANS

      In 1999, the Company adopted the 1999 Stock Option Plan that replaced all
then outstanding option plans. Under the 1999 Stock Option Plan, all options
issued under prior plans were recognized as issued and outstanding under the
original terms granted. The Company had originally reserved 4,000,000 shares of
Common Stock for issuance under the 1999 Stock Option Plan.

      In February 2000, the Company amended the 1999 Stock Option Plan to create
the 1999 Amended and Restated Incentive and Nonqualified Stock Option Plan (the
"1999 Plan"). The 1999 Plan increased the shares of Common Stock reserved for
issuance from 4,000,000 to 5,500,000. The Company's stockholders approved the
1999 Plan in May 2000. The 1999 Plan provides for the issuance of incentive
stock options, which are intended to qualify under section 422 of the Internal
Revenue Service 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.

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


                                      F-24
<PAGE>

      (9) STOCK OPTION PLANS (continued)

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

<TABLE>
<CAPTION>
                                                                               Weighted
                                                                               Average
                                                                Options        Exercise
                                                                Granted         Price
                                                               -----------     --------
<S>                                                           <C>              <C>
          Outstanding January 1, 2002 ....................      7,253,000      $   4.97

                Granted ..................................      2,906,000          0.31
                Canceled .................................     (3,876,000)         6.76
                                                               -----------

          Outstanding December 31, 2002 ..................      6,283,000          1.71

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

          Outstanding at December 31, 2003 ...............      4,347,000      $   1.52
                                                               ===========

          Exercisable at December 31, 2002 ...............      4,279,000      $   2.16
                                                               ===========

          Exercisable at December 31, 2003 ...............      3,477,000      $   1.73
                                                               ===========

          Options available for grant at December 31, 2003      2,280,000
                                                               ===========
</TABLE>

      The following table summarizes information about stock options outstanding
as of December 31, 2003:

<TABLE>
<CAPTION>

                                                       Options Outstanding                               Options Exercisable
                                 ---------------------------------------------------------------  ----------------------------------
                                                                              Weighted Average
                                                           Weighted              Remaining                               Weighted
         Range of                     Number                Average           Contractual Life         Number             Average
     Exercise Prices                of Shares            Exercise Price          (in years)           of Shares          Exercise
   ---------------------------------------------------------------------------------------------  ----------------------------------
<S>                                <C>                  <C>                   <C>                    <C>                 <C>
     $ 0.10 - $ 0.46                 2,236,000              $  0.35                 8.6                1,554,000         $  0.35
     $ 0.60 - $ 0.88                   925,000                 0.80                 7.1                  875,000            0.80
     $ 1.25 - $ 2.25                   372,000                 1.50                 8.7                  236,000            1.60
     $ 2.27 - $ 3.88                   596,000                 2.81                 6.8                  594,000            2.81
     $10.63 - $11.81                   157,000                11.59                 6.1                  157,000           11.59
     $12.25 - $25.00                    61,000                16.71                 5.6                   61,000           16.71
                                  -----------------                                                 ----------------

                                     4,347,000              $  1.52                 7.93               3,477,000         $  1.73
                                  =================                                                 ================
</TABLE>


      Non-cash stock based compensation of $60,000 and $16,000 were charged to
operations for the years ended December 31, 2003 and 2002, respectively, and
represents warrants to purchase shares of Common Stock granted to certain
consultants in both 2003 and 2002.


                                      F-25
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


(10) EMPLOYEE STOCK PURCHASE PLAN

      In February 2001, the Board of Directors adopted the 2001 Employee Stock
Purchase Plan ("ESPP"). The ESPP provided eligible employees of the Company the
opportunity to apply a portion of their after tax compensation to the purchase
of shares of the Company's Common Stock at a 15% discount from market value. The
Company reserved 4,000,000 authorized but unissued shares of Common Stock for
issuance under the ESPP. The ESPP was approved at the Company's Annual Meeting
of Shareholders in May 2001. The Company issued 61,000 shares of Common Stock
under the ESPP during the year ended December 31, 2002. The Company cancelled
the ESPP during 2002.

(11) RESTRUCTURING CHARGES

      Cost Curtailment and Restructuring Charges

      In August 2002, the Board approved a plan to relocate the Company's
offices from New York City and consolidate operations in the Albany, New York
area for the purpose of reducing the Company's operating expenses and the
Company terminated its building lease in New York City. In addition, the Company
reduced its staff. The accompanying financial statements include restructuring
and cost curtailment charges of $581,000 for the year ended December 31, 2002
which reflects $113,000 of severance for terminated employees, $172,000 of lease
termination penalties, $289,000 related to the abandonment of fixed assets at
the vacated premises and $7,000 of relocation costs.

(12) COMMITMENTS AND CONTINGENCIES

      (a) Operating Leases

      In August 2002, the Company terminated the building lease in New York City
where its principal offices had been located and incurred termination penalties
of $172,000. The Company moved its principal offices to the Albany, New York
area in order to reduce operating costs.

      The Company has entered into several non-cancelable leases, primarily
related to the rental of certain facilities and equipment. Future minimum lease
payments, by year and in the aggregate, under material operating leases with
initial or remaining terms in excess of one year consisted of the following at
December 31, 2003:

          Year ended December 31,                              Amount
                                                              --------

          2004 ........................................       $177,000
          2005 ........................................        73,000
                                                              --------

               Total minimum lease payments ...........       $250,000
                                                              ========

      Rent expense under operating leases was approximately $127,000 and
$408,000 for the years ended December 31, 2003 and 2002, respectively.

      (b) Employment Agreements

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



                                      F-26
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


(12) COMMITMENTS AND CONTINGENCIES (continued)

      (c) Litigation

      The Company sued Ecoin Co. Ltd. ("Ecoin") on April 30, 2001 in the United
States Court for the Southern District of New York. Our complaint alleged breach
of contract arising from the failure of Ecoin to pay approximately $400,000 owed
to On2 under a Technology License and Reseller Agreement that On2 and Ecoin
entered into in February 2001. Ecoin counterclaimed in December 2001 for an
amount to be determined at trial, but in no event less than $100,000, alleging
fraudulent inducement and demanding rescission. In April 2002 the Company
entered into a settlement agreement with Ecoin Co. Ltd. in connection with the
litigation, pursuant to which Ecoin agreed to pay a total of $225,000 to the
Company in exchange for a mutual release of all past claims between the parties.
The Company received the final payment of $75,000 in May 2003.

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

      (d) Other Matters

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

      During 2003, the Company licensed its software to a customer and received
468,750 unregistered common shares of the customer's common stock and recognized
revenue for the then fair value of $150.000. The common shares were received in
January, 2004. The Company has "piggy back" registration rights, and after
nine-months from the sale, demand registration rights.



                                      F-27
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                           DECEMBER 31, 2003 AND 2002


(13) RELATED PARTY TRANSACTIONS

      During the years ended December 31, 2003 and 2002, the Company retained a
law firm to perform certain legal services on its behalf and incurred
approximately $56,000 and $178,000, respectively, for such legal services. A
member of the board of directors is a partner at the law firm.

      During the years ended December 31, 2003 and 2002, the Company retained a
consulting firm to facilitate entering into a contract with a customer and
incurred approximately $108,000 and $4,000, respectively, for such services. A
consultant at the consulting firm became a director in August, 2003.



                                      F-28