<PAGE>

================================================================================

                UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549
                                    Form 10-K

   (Mark One)

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

            For the fiscal year ended December 31, 2005

      [ ]   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 Identification No.)
 incorporation or organization)

21 Corporate Drive, Suite 103, Clifton Park, NY                          12065
   (Address of principal executive offices)                           (Zip Code)

               Registrant's telephone number, including area code:
                                 (518) 348-0099

        Securities to be Registered Pursuant to Section 12(b) of the Act:

         Title of Each Class     Name(s) of Each Exchange on Which Listed
            Common Stock                  American Stock Exchange

           Securities Registered Pursuant to Section 12(g) of the Act:
                                      NONE

      Indicate by check mark if the registrant is a well-seasoned issuer, as
defined in Rule 405 of the Securities Act. Yes [ ] No [X]

      Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or Section 15(d) of the Act. Yes [ ] No [X]

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

      Indicate by check mark if disclosure of delinquent filers in response to
Item 405 of Regulation S-K is not contained herein, and will not will be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. [X]

      Indicate by check mark whether the registrant is a large accelerated
filer, and accelerated filer, or a non-accelerated filer. (Check one):

  Large Accelerated Filer [ ] Accelerated Filer [ ] Non-Accelerated Filer [X]

      Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act.

                                 Yes [ ]No [X]

<PAGE>

      The aggregate market value of the voting and non-voting common equity held
by non-affiliates of the registrant as of March 13, 2006, was approximately
$78,945,000.

                   (APPLICABLE ONLY TO CORPORATE REGISTRANTS)

      State the number of shares outstanding of each of the issuer's classes of
common stock, $0.01 par value ("Common Stock"), as of the latest practicable
date: 92,877,379 shares as of March 13, 2006.

DOCUMENTS INCORPORATED BY REFERENCE

      Items 9, 10, 11, and 12 of Part III are incorporated by reference from the
Company's definitive Proxy Statement, to be filed with the Securities and
Exchange Commission on or before 120 days after December 31, 2005.


                                       2
<PAGE>

<TABLE>
<CAPTION>
                                          Table of Contents

PART I
<S>          <C>                                                                                 <C>
 ITEM 1.     DESCRIPTION OF BUSINESS                                                              4
 ITEM 2.     DESCRIPTION OF PROPERTY                                                             16
 ITEM 3.     LEGAL PROCEEDINGS
                                                                                                 16
 ITEM 4.     SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                 16
PART II
 ITEM 5.     MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS                            16
 ITEM 6.     SELECTED FINANCIAL DATA                                                             19
 ITEM 7.     MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
             OPERATIONS                                                                          19
 ITEM 8.     FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                         29
 ITEM 9A.    CONTROLS AND PROCEDURES                                                             30
PART III
 ITEM 10.    DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH
             SECTION 16(a) OF THE EXCHANGE ACT                                                   30
 ITEM 11.    EXECUTIVE COMPENSATION                                                              30
 ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT                      30
 ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                                      30
 ITEM 14.    PRINCIPAL ACCOUTING FEES AND SERVICES                                               31
 ITEM 15.    EXHIBITS                                                                            31

</TABLE>


                                                 3
<PAGE>

                                     PART I


Item 1.     Description of Business


Forward-Looking Statement

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

      These statements are only predictions, and actual events or results may
differ materially. The forward-looking statements are based on management's
beliefs and assumption using information available at the time. We cannot
guarantee future results, levels of activity, performance or achievements.
Factors that may cause actual results to differ are often presented with the
forward-looking statements themselves. Additionally, other risks that may cause
actual results to differ from predicted results are set forth, and in "Risk
Factors That May Affect Future Operating Results" on page 26 of this Form 10-K.

      Many of the forward-looking statements are subject to additional risks
related to our need to either secure additional financing or to increase
revenues to support our operations. We believe that between the funds we have on
hand and the funds we expect to generate, we have sufficient funds to finance
our operations for the next 12 months. However, there is no assurance that
additional funds will not be required to support our operations. In this regard,
the business and operations of the Company are subject to substantial risks that
increase the uncertainty inherent in the forward-looking statements contained in
this Form 10-K. In evaluating our business, you should give careful
consideration to the information set forth below under the caption "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 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

      On2 Technologies is a leading video compression technology firm. We have
developed a proprietary technology platform and the TrueMotion VPx family (e.g.,
VP5, VP6, VP7) of video compression/decompression ("codec") software to deliver
high-quality video at the lowest possible data rates over proprietary networks
and the Internet to set-top boxes, personal computers and wireless devices.
Unlike many other video codecs that are based on standard compression
specifications set by industry groups (e.g., MPEG-2 and H.264), our video
compression software is based solely on intellectual property that we developed
and own ourselves.


                                       4
<PAGE>

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


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

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

  Video and Audio Distribution over      o  Providing video-on-demand services
  Proprietary Networks                      to 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 cell
                                            phones and PDAs

  Video and Audio Distribution over      o  Video-on-demand
  IP-based Networks (Internet)           o  Teleconferencing services
                                         o  Video instant messaging
                                         o  Video for Voice-over-IP (VOIP)
                                            services

      In addition, as discussed at greater length below, we have recently begun
marketing encoding software for use either by end users or by developers who
want to add video-encoding functionality to the software they have developed.

      As covered in greater detail below, we earn revenue chiefly through
licensing our software and providing specialized software engineering and
consulting services to customers. In addition to license fees, we often charge a
royalty fee based on the number of units of some or all of the customer's
products that contain the relevant On2 software products 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 use our software. Royalties may be subject to
guaranteed minimum amounts and/or maximum amounts (e.g., annual caps).

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

      As part of our strategy to develop complementary products that could allow
us to capitalize on our customers' success, in April 2005 we completed the
acquisition from Wildform, Inc. of its Flix line of encoding software. The Flix
software allows users to encode video and other multimedia content for playback
on Adobe(R) Flash(R) player, which is a widely distributed multimedia player.
The Flix brand has existed since the advent of Flash video and has a loyal
following among its users. Because Adobe has integrated our VP6 codec software
into its Flash 8 player, we believed that there was an opportunity for us to
sell Flash 8 encoding software to end users, such as video professionals and web
designers, and to software development companies that wish to add Flash 8
encoding functionality to their software. We concluded that by taking the
well-regarded Flix software and updating it with Flash 8 encoding capability, we
could best take advantage of the anticipated wide distribution of the Flash 8
player.

                                       5
<PAGE>

      In addition to licensing our software to software developers and end users
for their own use, we sell licenses to certain third-party resellers. We also
generally require that customers pay us if they desire to receive any upgrades
to our software (e.g., from VP6 to VP7). We charge a 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.

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

      Another factor that may affect our success is the relative complexity of
our video compression software, as compared with other compression software
producing comparable compression rates and image quality. Software with lower
complexity can run on a computer chip that is less powerful, and therefore
generally less expensive, than would be required to run software with greater
complexity. Increased compression rates frequently result in increased
complexity. While customers want software that produces the highest possible
compression rates and the best possible decompressed image, they also want to
keep production costs low by using the lowest-powered and accordingly least
expensive chips that - still -perform the processing they require. In addition,
in some embedded applications, such as mobile devices, size and power
constraints, in addition to price issues, can limit the capability of the chips.
Of course, in devices in which a great deal of processing power can be devoted
to video compression and decompression, the issue of software complexity is less
important. In addition, in certain applications, savings in chip costs related
to the use of low complexity software may be offset by increased costs (or
reduced revenue) stemming from less efficient compression (e.g., increased
bandwidth costs).

      One of the most significant recent trends in our business is our
increasing reliance on the success of the product deployments of our customers.
As mentioned above, an increasing number of our license agreements with
customers provide for the payment of fees that are dependent either on the
number of units of a customer's product incorporating our software that are sold
or on the amount of revenue generated by a customer from the sale of products or
services that incorporate our software. We have chosen this licensing model
because, as a company of only approximately 35 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.

      As addressed above, under our agreements with certain customers, we have
retained the right to market products that complement those customer
applications. These arrangements allow us to take advantage of our customers'
often superior ability to produce and market end-to-end video products and
services, while offering those customers the benefit of including
technologically-advanced software in their applications. As with arrangements in
which we receive royalties or revenue shares, the ability to market
complementary products can yield total revenues over time in excess of an
initial, one-time license fee. In instances where we have licensed our products
to well-known customers, our right to sell complementary products may be of
significant value. But unlike royalties and revenue shares, which we generally
expect to receive without any significant additional effort on our part, the
successful sale of complementary products requires that we effectively execute
an end-user product development and marketing program. Developing and marketing
products aimed at end users is a relatively new business for us. Until recently,
we had generally produced software targeted at developers, who integrate our
software into their products.

      Although we believe 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 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, or
for which we expect to market complementary products, do not generate
significant sales, the revenues we earn from that relationship are likely not to
attain significant levels. Conversely, if one or more of such customers'
products is widely adopted, our revenues will likely be enhanced.


                                       6
<PAGE>

      Another significant 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 ("DRM")
products by bundling them with its Windows operating systems and servers at no
additional cost or otherwise making them available free of charge or at a low
cost. Microsoft's practices have caused, and may continue to cause, pricing
pressure on our revenue generating products and services and may affect usage of
our competing products and formats. Microsoft's anticompetitive practices have,
in some cases, led , and could continue to lead, to longer sales cycles,
decreased sales, loss of existing and potential customers and reduced market
share. In addition, we believe that Microsoft has used and may continue to use
its competitive position in the computer industry and its financial resources to
secure preferential or exclusive distribution, use and bundling contracts for
its media delivery technologies and products with third parties, such as ISPs,
content delivery networks, content providers, entertainment and media companies,
VARs and OEMs, including third parties with whom we have relationships. Finally,
Microsoft's DRM product, which prevents unauthorized copying and re-distribution
of proprietary content, is widely accepted among movie studios and others in the
content industry. Unfortunately, Microsoft DRM does not integrate well with
non-Microsoft video and audio software. Many companies that want to distribute
copy-protected content are therefore forced to choose Microsoft video technology
to be able to use Microsoft's DRM technology.

      Another trend is the 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. We believe our technology is superior to H.264, and that we can offer
significantly more flexibility in licensing terms than customers get when
licensing H.264. H.264 has nevertheless started to gain adoption by potential
customers because, as a standards-based codec, it has the advantage of having
numerous developers who are programming to the H.264 standard and developing
products based on such standard. In addition, at least several manufacturers of
multimedia processors have done the work necessary to have H.264 operate on
their chips. These advantages may allow potential customers to implement a
solution based on H.264 with less initial development time and expense than a
solution using On2 Video might require, even though the H.264 solution could be
less efficient and more expensive than On2 Video solution in the final analysis.
In addition, there are certain customers that prefer to license standards-based
codecs.

      We are also watching with interest and participating in the trend towards
the proliferation of consumer-created video content on the web. As Internet use
has grown worldwide and Internet connection speeds have increased, there has
been a marked increase in consumer-created content on the web. While that
content initially consisted primarily of text content and still photographs, the
availability of relatively inexpensive digital video cameras, the growth in the
number of users with access to broadband Internet connections, and improvements
in video compression technology have contributed to a groundswell in
consumer-created video content. Weblogs (blogs) and podcasts (broadcasts of
audio content to iPod(R) and MP3 devices) are evolving to include video content.
A number of services has sprung up to host consumer-created video, and many
commercial sites now also feature amateur videos. The continued proliferation of
consumer-created video on the Internet may have a positive effect on our
business. The Adobe(R) Flash(R) video is a popular format for Web video. Because
Flash 8 uses On2's VP6 codec, On2 may have the opportunity to license Flash
encoding tools for use in video blogs, video podcasts, and to consumer-created
video services or to individual users of those services.

      The market for digital media creation and delivery technology is
constantly changing and has become 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, H.264 developers, and others
will - intensify, we also expect that our video compression technology will
remain competitive and that our relatively small size will allow us to innovate
in the video compression field and respond to emerging trends more quickly than
monolithic organizations such as Microsoft and the MPEG consortium. We also
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.

                           Development of Our Business

We detail the history and evolution of our business under the section
"Management's Discussion and Analysis of Financial Condition and of Operation --
Company - History".


                                       7
<PAGE>

Business Strategy

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

o     Continuing our research and development efforts to increase the quality of
      video technology in order to improve the experience of end users;
o     Using the success of current customer implementations of our technology
      (e.g., Adobe Flash 8, Skype) to increase our brand recognition and promote
      new business;
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;
o     Employing flexible licensing strategies to offer customers more attractive
      business terms than those available for competing technologies; and
o     Entering into licensing arrangements with customers that provide for
      receipt of recurring revenue or that offer us the opportunity to market
      products that complement our customers implementations of our software;
o     Expanding into international markets by contracting with resellers of our
      products and services and by developing relationships with large,
      innovative customers.

Our Technology, Products and Services

      We have designed our technology to deliver the highest-quality video at
the lowest possible data rates and to encode (compress) and decode (decompress)
video on comparatively low-powered chips suitable for consumer electronics
products. We currently 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. The
licensing of our proprietary TrueMotion codec and TrueCast server technology has
accounted for 29%, 16%, and 6% percent of our revenue for the three fiscals
years ended December 31, 2005, 2004 and 2003, respectively.

TrueMotion(R) 2X (TM2X)

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

      At the time it was introduced, TM2X offered comparatively high resolutions
(320x240, 640x480) and high bit-rates that could play back smoothly on a wide
range of CPUs available at the time. The product was part of QuickTime and Video
for Windows and can be used in programs such as Adobe Premiere and Terran's
Media Cleaner Pro. It is also a cross-platform codec: QuickTime works 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 2000 and was the original codec used on our website, at
data rates between 300 and 400 kbps. VP3.1 was launched in June 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 2000, VP3.2 was 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.


                                       8
<PAGE>

Open Source VP3.2

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

      In June 2002, the Company entered into an agreement with the Xiph.Org
Foundation, developers of Vorbis, the popular open-source audio codec, for Xiph
to be the prime source of support, distribution, and further development of VP3.
In addition, with On2's support, Xiph integrated 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. At the time it was introduced, VP4
was widely recognized as 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 offered a 20% bandwidth reduction over
then-current competitive technologies, allowing for greatly reduced costs for
comparable quality video.

VP5 Codec

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

VP6 Codec

      We launched the Beta version of our TrueMotion VP6 series of codecs in May
2003 and the official version in October 2003, and we have since released
updated versions VP6.1 and VP6.2. 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 based on tests
of Peak Signal-to-Noise Ratios (PSNR) measured at data rates ranging from
dial-up (28.8 Kbps) to DVD and HD (6 to 8 Mbps). Since our introduction of VP6,
we have ported it to the following digital signal processors (DSPs) across a
range of resolutions: Texas Instruments' TMS320C64x, Analog Devices' Blackfin,
ARC International's ARCTangent, Equator Technologies' MAP-CA and the ARM 7 and
ARM 9. Despite the introduction of VP7, we have continued to license VP6
extensively for use with a wide variety of applications on numerous platforms.

VP7 Codec

      We introduced our TrueMotion VP7 codec in early March 2005. Like prior
versions of the TrueMotion codecs, VP7 shows a marked improvement over its
predecessors, producing up to a 30% image quality improvement over VP6. Like its
predecessor, in objective PSNR tests, VP7 shows better performance than its main
competitors, including Windows Media 9, Real 10, and MPEG-4-compatible codecs at
data rates ranging from dial-up (28.8 Kbps) to DVD and HD. In addition, VP7
regularly outperforms all but the best implementations of H.264 across
data-rates and is highly competitive with the most advanced H.264
implementations. As with VP6, VP7 also supports real-time encoding at full D1
resolution. VP7 has been developed to run on low-cost DSPs, and On2's engineers
and certain third parties are currently working to port VP7 to a number of DSPs.


                                       9
<PAGE>

Audio for Video Codec Technology (AVC)

      AVC is an advanced compression algorithm that is ideal for a variety of
audio sources, including music, human speech, film and broadcast television. AVC
can achieve very high quality audio at bit rates lower than current standards
such as MP3 or AC-3. This algorithm is designed for easy portability to embedded
devices and can be licensed for a lower per-unit cost than other audio codecs on
the market. AVC runs with On2's video codecs, and this combination can provide a
seamless low-bit-rate multimedia experience. VP6 or VP7 combined with AVC is
comparable to MPEG-4 combined with AC-3, but with a substantial data rate
savings. It is particularly useful for implementations such as VOD deployment
over DSL or cable networks. AVC also allows for less transfer time and storage
space for downloaded files.

TrueMotion Encoder Products

      Our Encoder enables content owners to re-master and compress their assets
efficiently into the VP4, VP5, VP6, or VP7 format at their own convenience.
Beginning with capturing uncompressed video through high quality SDI inputs,
users can create an optimized digital file using our proprietary re-mastering
tools. These tools are geared toward the video professional who wants exact
control over the optimization process. Once the raw file has been optimized, our
compression software has the capability to create multiple data rate compressed
files.

TrueMobile Mobile Video Products

      In October 2005, On2 announced its arrangement with China Transport
Telecommunications Broadband Network Service Co., Ltd. (CTTnet) under which On2
and CTTnet would jointly develop mobile video products based on On2's TrueMotion
video compression technology. Prior to entering into its agreement with CTTnet,
On2's research and development team had developed proof-of-concept video players
operating in the Symbian and Smartphone Mobile environments. Those players
formed the foundation of the first commercial TrueMobile products, and in
January 2006, On2 and CTTnet announced that they had TrueMobile players
operating on four Symbian handset models, 10 Smartphone handset models, and
several Windows CE PDA models.

TrueCast(R) Server Software

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

      TrueCast comes optimized in two manners: one for transport using our own
proprietary protocol, TrueCast Transport Protocol (TTP), and one for RTSP/RTP to
various set-top box platforms. TrueCast and VP5/VP6/VP7 are an ideal combination
for low-bit-rate Video-On-Demand systems. Our TrueCast Servers and our encoder
provide the necessary tools for high-quality video over low speed IP
connections.

      In the first quarter of 2005, we released TrueCast version 8.0. This
version of TrueCast provides support for multicast presentations, and can
simultaneously stream a single audio and video stream from a server, including
HTTP-based Web servers, to thousands of users. It also permits local playback of
AVI files from a user's hard disk, and set-top box/DSP platforms from Texas
Instruments, Equator Technologies, and others.

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

      In addition, TrueCast 8.0 is able to stream content that is captured and
encoded directly from "live" video sources using the company's revolutionary
VP6, VP7 and earlier-generation On2 real-time encoders. This feature is ideal
for time-critical applications such as streaming live events, video
conferencing, Digital Television over DSL, and personal video recorders.


                                       10
<PAGE>

Digital Signal Processor (DSP) and Server Integrations

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

Encoding Tools for Customer Formats

      In 2005, we entered the business of selling video encoding software that
allows users to encode video in formats used by two of our customers, Macromedia
(now Adobe) and AOL. Both Adobe's Flash 8 multimedia player and AOL's Nullsoft
video (NSV) player use On2's TrueMotion VP6 technology. Although we continue to
offer Nullsoft encoding tools, that business constitutes a small fraction of our
third-party encoding tool business. In 2005, the licensing of Flash and Nullsoft
encoding tools together accounted for 59 percent of our revenue.

      We launched our encoding software business as part of strategy of
capitalizing on our customers' successful deployments of products that
incorporate our technology. In particular, we believed that the inclusion of our
technology in the widely-distributed Adobe Flash player represented a
significant opportunity for us. We acquired the Flix line of Flash encoding
software from Wildform, Inc., discussed in greater detail in "Description of
Business - Overview", to further our plan for rapidly establishing a significant
business of marketing Flash encoding tools.

      We sell two types of Flash encoding tools. We distribute end-user software
such as our desktop Flix encoding tools (Flix Pro and Flix Standard) and our
Flix Engine software, which can operate in desktop or server environments. These
products allow users to convert and/or encode video in Flash 6, 7, and 8
formats. We also sell Flash encoder software development kits that allow
customers to enable their products to encode in the Flash format. These products
range from low-level tools such as our Flash 8 SDK to relatively high-level,
more fully-featured tools such our Flix Engine. The Flix Engine can be
integrated with our customers' applications, as well as being used as an
off-the-shelf end user software product.

      Our marketing efforts for our Flash encoding tools are generally directed
at three groups of customers. First, we offer our desktop Flix encoding tools
(Flix Pro and Flix Standard) for purchase online by end users, both professional
and non-professional. Second, we market our desktop and server products directly
to enterprise customers, such as content providers and Internet advertising
firms. Finally, we promote our Flash SDKs to software developers. Some such
developers will use our SDKs to integrate our Flash encoder with their software
products for sale to end users. Other developers will incorporate our Flash
encoder products that they will use in their own services (e.g., an online video
search service might develop a Flash encoding tool for use internally or by
their customers).

      We believe that the prospects of our Flash encoding business are closely
related to the success of Adobe's Flash player and Flash authoring business.
While the increasing worldwide adoption of Flash players will not ensure the
success of our Flash encoder business, the failure of Adobe's Flash 8 initiative
would almost certainly have a serious, negative impact on our sales of Flash
encoding software.

Services

      In addition to licensing our software, we offer a variety of custom
engineering and consulting services to our customers. Fees derived from
engineering and consulting services accounted for 7%, 14%, and 19% percent of
our revenue for the years ended December 31, 2005, 2004 and 2003, respectively.
In particular, we offer the following services:


                                       11
<PAGE>

Custom Engineering and Consulting Services

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

      o     customizing our software to add a feature, user interface or other
            function requested by a customer;
      o     porting and optimizing our technology platform and algorithm
            libraries onto DSPs and embedded devices, such as set-top boxes,
            mobile phones and other portable devices;
      o     evaluating potential customer implementations of our software; and
      o     providing technical support for existing customers.

Encoding

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

Research and Development

      The primary focus of our research and development activities is to advance
and expand upon our core codec technology, which improves the video experience
for end users. In addition, we devote significant research and development time
to exploring new uses of our codecs, such as implementing our software on mobile
platforms or in new operating environments. Our research and development efforts
have enabled us to provide quality video compression and decompression at lower
broadband data rates (e.g., DSL) and certain narrowband data rates (e.g.,
dial-up and cell phone). Our speculative research in new platforms or operating
environments also regularly results in commercial products that may become a
significant source of revenue. We believe that continued advances in our
technology are key to the success of our business. Consequently, we devote a
substantial portion of our resources to our research and development efforts.
Research and development expenses for the years ended December 31, 2005, 2004,
and 2003 were $1,035,000, $884,000 and $1,124,000 respectively.

Distribution Methods

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

Sales and Business Development

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

International

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


                                       12
<PAGE>

      For the years ended December 31, 2005, 2004 and 2003, foreign customers
accounted for approximately 27%, 20% and 67% respectively, of total revenue.
These customers are primarily located in Asia. The decrease the percentage of
foreign customers from 2003 to 2004 and 2005 is a result of decrease in sales
from our Japan reseller and the completion of a large engineering project with a
leading Japanese electronics manufacturer in 2003.

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
(TrueMotion 2X) software was widely-distributed because of its inclusion in
several popular video games, such as Final Fantasy 7 for PC. We are currently
involved with several Asian entities that are considering using our video
compression and server software in set-top box deployments. We also aim to
expand internationally by appointing resellers of our products and services who
purchase software licenses from us and sell them in a designated international
market. To date, we have signed reseller agreements for a number of Asian
markets, including China, Japan, Korea, Hong Kong, Taiwan, and Singapore.

Beijing E-World

      In June 2003, we announced that we had licensed our VP5 and VP6 codecs to
Beijing E-World Technology Co. Ltd. (E-World), a consortium of several Chinese
consumer electronics manufacturers. Under the terms of two license agreements
with E-world, we granted E-World a license to use our codecs in E-World's
Enhanced Versatile Disk (EVD) technology as well as other video products.
E-world is developing EVD as a next-generation videodisk technology that is
hoped will become the industrial standard for China for the recording and
playback of video, audio and data. E-World did not pay certain minimum quarterly
payments that we believed were due under its license agreements with us, and we
commenced an arbitration proceeding seeking damages for E-World's failure to
perform. In a ruling issued March 10, 2005, the arbitrator rejected our claims
that E-World had breached the agreements and also denied a request by E-World to
declare that it had complied with its obligations under the agreements. The
arbitrator further noted that agreements remained in effect and that the parties
had a continuing obligation to work to jointly select and port On2's software to
two commercial DSPs for use in the EVD players. Despite the arbitrator's
expectations regarding completion of the porting work, On2 and E-world have not
made significant progress on the porting.

CTTNet

      In January 2006, On2 and China Transport Telecommunications Broadband
Network Service Co., Ltd. (CTTnet) entered into an agreement to jointly develop
and distribute On2 TrueMobile mobile video software in China and the Asian
markets. Under the terms of the Agreement, On2 granted CTTNet a license to On2's
VP6 and VP7 software as well as certain reseller rights for China and other
Asian markets. On2 and CTTNet have jointly announced that they have made
significant progress in the development and deployment throughout China of
mobile video software for the Symbian and SmartPhone mobile platforms.

Europe

      We continue to pursue sales and business development opportunities in the
European market, although we have not yet had the success there that we have had
in Asia. We have had success with our U.K.-based partners TVZ Ltd. and QuickLink
Ltd. in powering news gathering and dissemination applications for major news
organizations such as the BBC, but we have not yet established the breadth or
depth of relationships with European customers and resellers that we have with
Asian customers. We need 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, 2005, 2004 and
2003.


                                       13
<PAGE>

Competition

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

      o     lowering the amount of bandwidth that customers need to deliver
            video,
      o     allowing customers to deliver video to more users without increasing
            bandwidth, or
      o     permitting customers to deliver good-quality video at lower data
            rates than those at which other video codecs can operate
            effectively.

Increased compression offers similar advantages in storage of video files,
enabling customers to:

      o     store video at a set resolution using less storage capacity than
            required by competitive compression software;
      o     store more video at a set resolution in a given storage space than
            competitive compression software;
      o     store more video of a higher quality in a given storage space than
            competitive compression software.

      Our business is highly competitive and affected by rapid change. We
believe that the principal competitive factors in our business include
technological innovation, versatility of products, pricing, availability of
content, ease of integration with and availability of use on low-cost
processors, customer service, service offerings and the flexibility to adapt to
changing market conditions. Our video compression technology competes with that
of companies such as Microsoft, RealNetworks, and Apple, and with
standards-based codecs such as MPEG-2, H.264, MPEG-4 and several codecs that
position themselves as "MPEG-4-based". In the market for mobile video players,
our newly-developed On2 TrueMobile products compete with products from companies
such as MobiTV, Inc., GoTV, PacketVideo and SmartVideo. Our server technology
faces competition from products marketed by RealNetworks, Microsoft and other
companies and various open source server technology.

      The size of our company and the fact that we have developed a proprietary,
non-standards-based video codec both help and hinder our ability to compete.
Companies such as Microsoft and RealNetworks benefit from name recognition that
we do not enjoy. Microsoft is also able to use its market power to support
aggressive pricing on its products that compete with ours. There are three major
standards-based codecs, MPEG-2, H.264, and the less widely-adopted MPEG-4; in
addition, Microsoft is proceeding towards establishing a standard, dubbed VC1,
based on its Window Media 9 technology. With respect to standards-based codecs,
there are numerous developers programming to those standards, and there are
certain customers that prefer to license standards-based codecs. In addition,
because of significant adoption of standards-based codecs and Windows Media 9,
there is a number of chip manufacturers that have designed low-cost chips
designed to operate with those codecs. The availability of a range of chips
means that potential customers of standards-based codecs or Windows Media 9 may
not have to incur added cost or experience delays if they choose to use those
codecs in their products.

      Nevertheless, we believe that our small size and proprietary products
frequently are attractive to customers, especially overseas, that will seek to
license our products not only because of their superior performance, but also
because:

      o     our products do not come from Microsoft or a consortium of
            conglomerates (such as those that own the core intellectual property
            used in the proprietary codecs), and we offer highly responsive,
            customized service befitting a company of our size and culture;
      o     we offer flexible licensing terms that do not involve burdensome
            standards-based licenses and fee structures; and
      o     we are able to upgrade our technology regularly, because we do not
            have to submit proposed revisions to slow-acting standards
            committees.

      See the section "Management's Discussion and Analysis -- Overview" for
further discussion of our competitors.

Customers

                                       14
<PAGE>

      Our customers, and the potential customers of our resellers, fall into
several categories. The customers for our TrueMotion video compression
technology and Flash encoding software development kits typically are either
software or hardware developers who want to enable their products to store or
transmit digital video, or providers of online services that want to add video
capabilities to their services. The customers for our engineering services are
generally customers of our video compression technology who need assistance
customizing our software to work on a certain platform or need us to modify our
software to work with their software. In addition, we have begun to provide a
growing range of engineering services to customers who have requested
customization of our Flash encoding software. Finally, the customers who
purchase our Flix Flash encoding tools are individual or small-business users
who buy single or multiple units of software or large content providers and
Internet advertising firms who may buy enterprise licenses. For the year ended
December 31, 2005, two customers accounted for 20%and 11% of the Company's total
revenues. For the year ended December 31, 2004, one customer accounted for 47%
of the Company's total revenue. For the year ended December 31, 2003, three
customers accounted for 35%, 19% and 11% of the Company's total revenue. For the
year ended December 31, 2005, four customers accounted for 20%, 18%, 11% and 11%
of total accounts receivable. For the year ended December 31, 2004, two
customers accounted for 21% and 13% of total accounts receivable.

Intellectual Property

      We regard much of our technology as proprietary and try to protect it by
relying on trademarks, copyrights, patents, trade secret laws and
confidentiality agreements. We view our copyrights, service marks, trademarks,
trade secrets, proprietary technology and similar intellectual property as
critical to our success. We currently hold several U.S. patents and have several
U.S. and international patent applications pending. We believe that the patents
that are currently issued are 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, someone else
could conceivably copy or otherwise obtain and use our proprietary information
without our authorization, or could develop similar technology independently.
Effective trademark, copyright and trade secret protection may not be available
in every country in which our services are made available through the Internet,
and policing unauthorized use of our proprietary information is difficult and
expensive. In addition, some of our technology is protected as trade secrets for
which government registration is not available. Our only means of protecting our
trade secrets is to restrict scrupulously the disclosure of that information.

      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 enforce our intellectual property rights, 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. Historically, we have not required any
material third party technology licenses. As we have entered into the Flash
encoding business, however, we have found it necessary to license third-party
software to allow us to decode and encode video and audio files in a variety of
formats. We cannot be 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 and
publicly-traded companies generally, except that certain U.S. export controls
and import controls of other countries, including controls on the use of
encryption technologies, 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 intellectual property, user privacy,
e-commerce, information security and taxation. In addition, the applicability of
existing laws to the Internet is uncertain and evolving. As a result of this
uncertainty, it is difficult to predict the impact, if any, that future
regulation or changes in regulation may have on our operations.

Employees

      As of December 31, 2005, we had 35 full-time employees. Of the total
employees, 26 were engineering and product development personnel, 2 were sales
and marketing personnel and 7 were general and administrative personnel.


                                       15
<PAGE>

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

Item 2.     Description of Property

      We do not own any real property. We lease approximately 7,000 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 $106,000. This lease expires on February 1,
2009. In addition, we lease approximately 750 square feet of space for certain
of our executives and certain IT staff at 1560 Broadway, 10th Floor, New York,
New York 10036. We pay an annual rent of approximately $108,000. This lease
expires August 31, 2006. Management believes these facilities are all in usable
condition and that these facilities are sufficient to meet our needs for the
immediate future. Management also believes that both facilities are adequately
covered by insurance.

      We do not invest in real estate or interests in real estate, real estate
mortgages or securities of or interests in persons primarily engaged in real
estate. It is not our policy to acquire assets primarily for possible capital
gain or primarily for income, although during the year ended December 31, 2004
we received 2,224,000 shares of Powerlinx, Inc. common stock as payment of
license fees pursuant to the terms of an August 2004 license agreement, and we
recognized $289,000 of revenue based on the market value of the stock. We also
received 469,000 shares of this customer's common stock pursuant to the terms of
a license agreement for a license fee of $150,000, which we recognized in 2003.
During the year ended December 31, 2004 the Company sold 574,000 shares of
Powerlinx for proceeds of $89,000 and held 2,119,000 shares with a market value
of $445,000 ($0.21 per share) as of December 31, 2004. There were no sales for
the year ended December 31, 2005, and the 2,119,000 shares held by the Company
as of December 31, 2005, had a market value of $106,000 ($0.05 per share) as of
that date. The market value of these securities was $0.04 per share as of March
6, 2006. Douglas A. McIntyre, the Company's former Chief Executive Officer (who
was also a director and shareholder of the Company) is a director of Powerlinx.

Item 3.     Legal Proceedings

      On March 2, 2006, the Company filed a Form 8-K, which disclosed that it
had voluntarily reported to the Securities and Exchange Commission ("SEC") that
the Company had undertaken an internal investigation into facts and
circumstances concerning investor and other communications made by the Company's
former Chairman, Chief Executive Officer and President. The Company is
voluntarily working with the SEC to complete the investigation, which is
ongoing.

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, 2004:

                                                               High        Low
             Fiscal Year 2006
                   First Quarter (through March 13, 2006)   $   1.48    $   0.76
                                   Fiscal Year 2005
                   First Quarter                            $   1.28    $   0.62
                   Second Quarter                           $   0.70    $   0.52
                   Third Quarter                            $   0.94    $   0.52
                   Fourth Quarter                           $   1.20    $   0.55
                                   Fiscal Year 2004
                   First Quarter                            $   1.66    $   0.86
                   Second Quarter                           $   1.24    $   0.59
                   Third Quarter                            $   1.04    $   0.63
                   Fourth Quarter                           $   0.76    $   0.50


                                       16
<PAGE>

      There were approximately 268 stockholders of record of our common stock as
of March 13, 2006.

      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.

<TABLE>
<CAPTION>
                                                            Equity Compensation Plan Information
                                                                                              Number of securities
                                       Number of securities                                  remaining available for
                                           to be issued             Weighted-average          future issuance under
                                         upon exercise of          exercise price of        equity compensation plans
                                       outstanding options,       outstanding options,        (excluding securities
            Plan category               warrants and rights       warrants and rights       reflected in column (a))
                                        -------------------       -------------------       ------------------------
                                                (a)                       (b)                          (c)
<S>                                         <C>                            <C>                        <C>
       Equity compensation
         plans approved by
         security holders.....              10,299,000                     $0.98                      2,066,000

       Equity compensation
         plans not approved
         by security holders                         0                         0                              0

                   Total......              10,299,000                     $0.98                      2,066,000


                                                        17
</TABLE>
<PAGE>

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

Series D Convertible Preferred Stock

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

      On October 28, 2004, the Company issued to Wainwright 285,714 warrants
(the "Wainwright Warrants"); these warrants were further payment, in addition to
the $240,000 cash fee described above, for Wainwright's services as placement
agent in connection with the MidSummer Transaction. Warrants in this series are
convertible into Common Stock at an exercise price of $0.70 per share, expire on
October 27, 2009, and are subject to weighted-average anti-dilution protection
for issuances of securities below the conversion price.

      The Company has filed a registration statement with the SEC for resale of
the Common Stock issuable upon conversion of the Series D Preferred Stock,
Series A Warrants, Series B Warrants, and Wainwright Warrants. The Series D
Investors have since exercised all of the Series A Warrants and have paid the
exercise price of $1,946,000 to the Company. In addition, the Series D Investors
have also converted 385 shares of the Series D Preferred Stock into 550,000
shares of Common Stock. Upon receipt of the Series A Warrant exercise fee, the
Company paid Wainwright a cash fee of $60,000 as further compensation for acting
as placement agent on the MidSummer Transaction. In January 2006 Wainwright
exercised 202,000 warrants and the Company received $127,000 in cash for the
exercise.

Issuance of Common Stock in Connection with the Acquisition of the Flix Business

      On April 29, 2005 (the "Closing Date"), we completed the acquisition of
certain assets related to the "Flix" software line of business of Wildform, Inc.
("Wildform"). In connection with the acquisition, On2 and Wildform entered a
Support and Maintenance Agreement, dated as of April 29, 2005, under which
Wildform agreed to perform certain software integration, technical support and
marketing services. In consideration for the services, we agreed to pay Wildform
$160,000 and 280,000 shares of Common Stock, issuable upon the 12-month
anniversary of the Closing Date. We relied on Section (4)(2) of the Securities
Act in agreeing to issue the Stock without registration. We have agreed to file
a registration statement to register the shares of Common Stock issuable to
Wildform.


                                       18
<PAGE>

Item 6. Selected Financial Data.

<TABLE>
<CAPTION>
                                                                       For the years ended December 31,
                                                ----------------------------------------------------------------------------------
Statements of Operations Data                        2005             2004             2003              2002             2001
                                                -------------    -------------    -------------     -------------    -------------
<S>                                             <C>              <C>              <C>               <C>              <C>
Revenue                                         $   2,208,000    $   3,028,000    $   3,302,000     $   3,353,000    $   2,220,000

Total operating expenses                            6,497,000        6,518,000        5,665,000         8,621,000       17,599,000
                                                -------------    -------------    -------------     -------------    -------------

 Loss from operations                              (4,289,000)      (3,490,000)      (2,363,000)       (5,268,000)     (15,379,000)

Interest and other income (expense), net             (284,000)          47,000           (2,000)           (5,000)      (1,589,000)

Provision for income taxes                             32,000            2,000           10,000            28,000           64,000
                                                -------------    -------------    -------------     -------------    -------------

Net loss                                           (4,605,000)      (3,445,000)      (2,375,000)       (5,301,000)     (17,032,000)

Convertible preferred stock deemed dividend         2,844,000          120,000          228,000           668,000        4,130,000
Convertible preferred stock 8% dividend               325,000           57,000
Accretion of costs associated with the
  Series D Preferred Stock                            175,000           14,000
                                                -------------    -------------    -------------     -------------    -------------

Net loss attributable to common stockholders    $  (7,949,000)   $  (3,636,000)   $  (2,603,000)    $  (5,969,000)   $ (21,162,000)
                                                =============    =============    =============     =============    =============

Basic and diluted net loss attributable to
 common stockholders' per common share          $       (0.09)   $       (0.05)   $       (0.04)    $       (0.11)   $       (0.64)
                                                =============    =============    =============     =============    =============

Balance Sheet Data
     Cash and cash equivalents                  $   3,976,000    $   5,418,000    $   2,963,000     $     553,000    $     216,000
     Working capital                                4,179,000        5,466,000        3,520,000           731,000           95,000
     Total assets                                   6,314,000        6,610,000        4,128,000         2,080,000        3,927,000
     Convertible debentures                           244,000          330,000          409,000           569,000        2,000,000
     Capital lease obligations                         26,000           43,000                              9,000
     Series D redeemable convertible
       preferred stock                              3,790,000        1,156,000
     Convertible preferred stock                       19,000           33,000           56,000            99,000          129,000
     Common stock and APIC                        120,695,000      115,663,000      110,970,000       106,018,000       99,935,000
     Accumulated deficit and other
       comprehensive loss                        (119,330,000)    (111,400,000)    (107,740,000)     (105,135,000)     (99,160,000)
     Total stockholders' equity                     1,364,000        4,296,000        3,286,000           982,000          904,000

</TABLE>

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

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

Overview

      We are a leading video compression technology firm. We have developed a
proprietary technology platform and video compression/decompression software
("codec") to allow the efficient storage of high-quality video and delivery of
that video at the lowest possible data rates over proprietary networks and the
Internet to personal computers, wireless devices and set-top boxes. We offer a
suite of products and services based on our proprietary compression technology


                                       19
<PAGE>

and multimedia server software. Our service offerings include customized
engineering, consulting services, technical support and high-level video
encoding. In addition, we license our software products, which include video and
audio codecs, encoding and server software, for use with video delivery
platforms. We have also recently begun to license software that encodes video in
the Adobe/Macromedia Flash 8 format; the Flash 8 format uses our VP6 video
codec.

Company History

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

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

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

      In view of the rapidly evolving nature of our business and our limited
operating history, we have limited experience forecasting our revenues and
operating costs. Therefore, we believe that period-to-period comparisons of
financial results are not necessarily meaningful and should not be relied upon
as an indication of our future performance. To date, we have incurred
substantial costs to create technology products and services. As of December 31,
2005, we had an accumulated deficit of $119.3 million. We will continue to incur
costs to develop, introduce and enhance products and services, build brand
awareness, and expand our business. We may also incur significant additional
costs related to technology, marketing or acquisitions of businesses and
technologies to respond to changes in this rapidly developing industry. These
costs may not correspond with any meaningful increases in revenues in the near
term, if at all. As such, these costs may result in negative operating cash
flows until such time as we generate sufficient revenues to offset such costs.

Critical Accounting Policies and Estimates

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

o     Revenue recognition
o     Equity-based compensation
o     Valuation of goodwill, intangible assets and other long-lived assets


                                       20
<PAGE>

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

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


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

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

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

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

      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


                                       21
<PAGE>

      Long-lived assets and identifiable intangibles with finite lives are
reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable. Recoverability of
assets to be held and used is measured by a comparison of the carrying amount of
an asset to future undiscounted net cash flows expected to be generated by the
asset. If such assets are considered to be impaired, the impairment recognized
is measured by the amount by which the carrying amount of the assets exceeds the
fair value of the assets. Assets to be disposed of are reported at the lower of
the carrying amount or fair value less costs to sell. As of December 31, 2005,
the Company believes that no such impairment has occurred.

Results of Operations

      Revenue. Revenue for the years ended December 31, 2005, 2004 and 2003 was
$2,208,000, $3,028,000 and $3,302,000, respectively and was derived from the
sale of software licenses, engineering and consulting services and license
royalties. Revenue decreased $820,000 for the year ended December 31, 2005 as
compared with 2004. The decrease is attributable to the sale of a single license
to Macromedia for approximately $1,500,000 in 2004 partially offset by increases
in revenue generated from license royalties and the sale of licenses from our
Flix line of Flash encoding software. As a percent of total sales, license
revenue increased to 88% in 2005 from 85% in 2004 while engineering services and
support decreased to 7% in 2005 from 14% in 2004 and royalties increased to 5%
of sales in 2005 from 1% in 2004. Revenue decreased $38,000 for the year ended
December 31, 2004 as compared with 2003. The decrease is attributable to a small
decrease in engineering fees.

      For the year ended December 31, 2005, license revenue was $1,947,000 of
which the Company's VPx licenses were $1,381,000 and Flix licenses were
$566,000. For the year ended December 31, 2004 and 2003, license revenue was
$2,571,000 and $2,637,000 respectively, consisting of all VPx licenses.

      The following table sets forth the allocation of revenues, in terms of
percentages, for the years ended December 31, 2005, 2004 and 2003:

                                                  2005        2004        2003
                                                 ------      ------      ------
Licenses                                             88%         85%         80%

Engineering services and support                      7          14          19

Royalties                                             5           1           1
                                                 ------      ------      ------

                                Total               100%        100%        100%
                                                 ======      ======      ======


      For the years ended December 31, 2005, 2004 and 2003, software licenses
were the significant revenue stream and are expected to be the significant
future revenue stream as we continue to provide these services and products to
clients who deliver high quality video to proprietary networks, consumer
electronic devices, wireless applications and IP based end users.

OPERATING EXPENSES

      The Company's operating expenses consist of cost of revenues, research and
development, sales and marketing and general and administrative expenses.
Operating expenses for the year ended December 31, 2005, 2004 and 2003 were
$6,497,000, $6,518,000 and $5,665,000, respectively.

      Cost of Revenue. Cost of revenue includes personnel and related overhead
expenses, rent and related energy costs, fees paid for licensed technology,
depreciation, amortization of purchased intangible assets and certain other
operating expenses. Cost of revenue was $1,919,000 for the year ended December
31, 2005 as compared with $1,437,000 for the year ended December 31, 2004. Cost
of revenue increased $482,000 for the year ended December 31, 2005 as compared
with 2004. The increase is primarily attributable to an increase of
approximately $124,000 in personnel and related overhead, $203,000 associated
with the support of the Flix product line by Wildform in 2005, and $164,000 in
amortization of the Flix software assets. Cost of revenues was $1,437,000 for
the year ended December 31, 2004 as compared to $1,506,000 for the year ended
December 31, 2003. Cost of revenue decreased $69,000 for the year ended December
31, 2004, however when excluding amortization of $463,000 in 2003 related to
purchased technology, cost of revenue increased by $400,000. The $400,000
increase is due to $165,000 in equity-based compensation and $235,000 in
additional personnel costs.


                                       22
<PAGE>

      Research and Development. Research and development expenses includes
personnel and related overhead expenses, rent and related energy costs and
depreciation, associated with the development and pre-production of our products
and services. Research and development expenses were $1,035,000 and $884,000 for
the years ended December 31, 2005 and 2004, respectively. The increase of
$151,000 is primarily from an increase of approximately $156,000 in personnel
and related overhead attributed to research and development. Research and
development expenses were $1,124,000 for the year ended December 31, 2003. The
decrease of $240,000, in the year ended December 31, 2004 as compared with 2003,
is primarily from a decrease in personnel and depreciation allocated to research
and development. We believe that continued investments in research and
development are necessary to improve our competitive advantage and we will
continue to invest in such costs as considered necessary.

      Sales and Marketing. Sales and marketing expenses consist primarily of
salaries and related overhead costs, tradeshow costs, marketing and promotional
costs incurred to create brand awareness and public relations expenses. Sales
and marketing expenses for the year ended December 31, 2005 were $794,000 as
compared with $459,000 for the year ended December 31, 2004. The increase of
$335,000 is primarily attributable to an increase in personnel and related
overhead expenses and an increase in tradeshow and promotional costs. Sales and
marketing expenses for the year ended December 31, 2003 were $527,000. The
decrease of $68,000, for the year ended December 31, 2003 as compared with 2004,
is attributable to a decrease in personnel and tradeshow costs. We intend to
continue to recruit and hire experienced personnel, as necessary, to sell and
market our products and services.

      General and Administrative. General and administrative expenses consist
primarily of salaries and related overhead costs for general corporate functions
including legal, finance, human resources and management information systems.
Also included are outside legal and professional fees, stock-listing fees,
reserves for uncollectible accounts receivable and costs of liability and
directors and offices' insurance. General and administrative costs for the year
ended December 31, 2005 were $2,749,000 as compared with $3,068,000 for the year
ended December 31, 2004. The decrease of $319,000 is attributable to a decrease
in outside legal fees, stock listing fees and a decrease in the reserve for
uncollectible accounts receivable partially offset by an increase in personnel
and related overhead expenses as a result of increases in labor and related
overhead rates. General and administrative costs for the year ended December 31,
2003 were $2,448,000. The increase of $620,000 for the year ended December 31,
2004 as compared with 2003, is attributable to an increase in legal fees, stock
listing fees and an increase in the reserve for uncollectible accounts
receivable partially offset by decreases in depreciation and insurance costs.

      Equity-based Compensation. During 2004 the Company granted restricted
stock to its employees and directors as compensation. The company issued 870,000
shares of its common stock, with a fair value of $835,000. The related
compensation expense of $835,000 was recognized in 2004, including $165,000
included in cost of revenue.

      Interest and Other Income (Expense), Net. Interest and other income
(expense) was $(284,000) for the year ended December 31, 2005 as compared with
$47,000 for the year ended December 31, 2004. The $284,000 in interest and other
expense, net for the year ended December 31, 2005 is primarily a result of a
$339,000 unrealized loss on marketable equity securities, interest paid on debt
of $39,000 partially offset by interest earned on the Company's cash balances of
$89,000 and $5,000 in other income. Interest and other income (expense) was
$(2,000) for the year ended December 31, 2003. The increase in interest and
other income of $49,000 for the year ended December 31, 2004 as compared with
2003, is primarily a result of net gain on marketable equity securities in 2004
partially offset by the E-Coin settlement received in 2003. Interest and other
income (expense) primarily consists of net gains (losses) on marketable equity
securities and interest earned on our cash and cash equivalent balances,
interest on capital lease obligations and indebtedness, and the amortization of
debt discounts.

      Income Taxes. Income taxes reflect state and local franchise taxes. Income
taxes were $32,000, $2,000 and 10,000 for the years ended December 31, 2005,
2004 and 2003, respectively.

      At December 31, 2005, we had approximately 35 full-time employees. We
expect to hire employees as necessary in order to attain our strategic
objectives.


                                       23
<PAGE>

Liquidity and Capital Resources

      At December 31, 2005, the Company had cash and cash equivalents of
$3,976,000 as compared with $5,418,000 at December 31, 2004. At December 31,
2005 we had working capital of $4,179,000 as compared with $5,466,000 at
December 31, 2004.

      Net cash used in operating activities was $4,307,000, $2,108,000 and
$1,980,000 for the years ended December 31, 2005, 2004 and 2003, respectively.
The net cash used in 2005 was principally from the net loss of $4,605,000,
adjusted for $236,000 of depreciation and amortization and $339,000 of
unrealized loss on marketable securities, and an increase in accounts receivable
of $497,000. The net cash used in 2004 was principally from the net loss of
$3,445,000 adjusted for $835,000 of equity-based compensation, $115,000 of
depreciation and amortization and $289,000 of marketable securities received as
payment of a license fee, partially offset by a decrease in accounts receivable
of $427,000, an increase in accounts payable and accrued expenses of $203,000
and an increase in deferred revenue of $123,000. The net cash used in 2003 was
principally from the net loss of $2,375,000, adjusted for $706,000 of
depreciation and amortization, an increase in accounts receivable of $225,000
and a decrease in accounts payable and accrued expenses of $180,000.

      Net cash (used in) provided by investing activities was $(1,420,000),
$70,000 and $(39,000) for the years ended December 31, 2005, 2004 and 2003,
respectively. The net cash used in 2005 was principally for the purchase of the
Flix software line from Wildform for $1,229,000 and purchases of property and
equipment of $116,000. The net cash provided in 2004 reflects $89,000 of
proceeds from the sale of marketable equity securities. The net cash used in
2003 was for purchases of property and equipment.

      Net cash provided by financing activities was $4,286,000, $4,517,000 and
$4,431,000 for the years ended December 31, 2005, 2004 and 2003, respectively.
The net cash provided in 2005 was principally from $4,365,000 of proceeds from
the exercise of stock options and warrants. The net cash provided in 2004 is
principally from net proceeds of $3,699,000 from the issuance of Series D
redeemable, convertible preferred stock and $830,000 from the exercise of stock
options and warrants. The net cash provided in 2003 is principally from proceeds
of $3,105,000 from the exercise of stock options and warrants and $1,314,000
from the sale of common stock.

      The Company currently has no material commitments for the next 12 months
other than those under operating lease arrangements. These arrangements consist
primarily of lease arrangements for the Company's office space in Clifton Park
and New York City. The aggregate required payments for the next 12 months under
these arrangements are $183,000. 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 2006, we anticipate incurring approximately
$600,000 per month in cash operating costs.

      The Company believes that existing funds are sufficient to fund its
operations through 2006. The Company plans to increase cash flows from
operations principally from increases in revenue generated from its compression
technology services and products. The Company may also pursue additional
financings. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Risk Factors That May Affect Future Operating Results."

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

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

      The Investors also received one-year warrants (the "Series A Warrants") to
purchase an aggregate of 2,994,000 shares of common stock at an exercise price
of $0.65 per share and five-year warrants (the "Series B Warrants") to purchase
an aggregate of 2,994,000 shares of Common Stock at an exercise price of $0.76
per share. The Series D Preferred and warrants are subject to certain
anti-dilution protection for issuances of securities below the conversion price.
Holders of Series D Preferred are entitled to receive an 8% annual cumulative
dividend, payable quarterly in cash or shares of Common Stock at the Company's
option, subject to the satisfaction of certain conditions. In 2005, the Series D
Investors have exercised all of the Series A Warrants and paid the exercise
price of $1,946,000 to the Company.


                                       24
<PAGE>

      The Series D Preferred includes a liquidation preference. In the event of
any liquidation, dissolution or winding up of the Company, either voluntary or
involuntary, the holders of shares of Series D Preferred are entitled to receive
an amount equal to $1,000 per share. The liquidation price per share would be
paid out of the assets of the Company available for distribution prior to any
payments made on any shares of the Company's junior securities.

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

Off-Balance Sheet Arrangements

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

Tabular Disclosure of Contractual Obligations

<TABLE>
<CAPTION>
                                                             Payments due by period
                                       ---------------------------------------------------------------
                                                   Less than 1    1 - 3         3 - 5      More than 5
      Contractual Obligations           Total         year        years         years         years
----------------------------------     --------     --------     --------     --------     -----------
<S>                                     <C>         <C>           <C>         <C>
Series A Secured Convertible 5.75%
Debentures                             $250,000     $250,000

Capital lease obligation                 30,000                  $ 30,000

Operating lease for office space        402,000      182,000      211,000     $  9,000
                                       --------     --------     --------     --------     -----------

Total                                  $682,000     $432,000     $241,000     $  9,000
                                       ========     ========     ========     ========     ===========

</TABLE>

Impact of Recently Issued Accounting Pronouncements

      In December 2004, the FASB issued SFAS No. 123 (revised 2004) "Share-Based
Payment" ("SFAS 123(R)"). SFAS 123(R) addresses the accounting for transactions
in which an enterprise exchanges its equity instruments for employee services.
It also addresses transactions in which an enterprise incurs liabilities that
are based on the fair value of the enterprise's equity instruments or that may
be settled by the issuance of those equity instruments in exchange for employee
services. The cost of employee services received in exchange for equity
instruments, including employee stock options, is to be measured on the
grant-date fair value of those instruments. That cost will be recognized as
compensation expense over the service period, which would normally be the
vesting period. SFAS 123(R) became effective for the Company as of January 1,
2006. The impact of adopting SFAS 123(R) cannot currently be estimated since it
will depend on future share-based awards.

      In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error
Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3"
("SFAS 154"). This Statement replaces APB Opinion No. 20, Accounting Changes,
and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial
Statements, and changes the requirements for the accounting for and reporting of
a change in accounting principle. This statement is effective for fiscal periods
beginning after December 15, 2005 and is not expected to have a significant
impact on the Company's financial statements.

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

      At December 31, 2005, the Company had available net operating loss
carry-forwards of approximately $84,986,000. The net operating loss
carry-forwards expire at various dates through 2025.


                                       25
<PAGE>

      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. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Company History". Furthermore, in the
ordinary course of the Company's business operations we have and may continue to
issue shares in conjunction with acquisitions or additional financing, in order
to meet the Company's growth objectives and liquidity constraints. In addition,
the exercise of outstanding warrants and certain options to purchase shares of
Common Stock may require us to issue additional shares of Common Stock. Past and
future issuances of shares of Common Stock may limit our ability to use a
substantial amount of our available net operating loss carry-forwards to reduce
future taxable income.

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

Risk Factors That May Affect Future Operating Results

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

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, 2005, we had an accumulated deficit
of approximately $119.3 million. On February 28, 2006, we had cash reserves of
approximately $3,626,000. During fiscal 2006, we expect to meet our working
capital obligations and other cash requirements with cash derived from the sale
of our products and services and from our cash reserves. There can be no
assurance, however, that cash derived from the sale of our products and services
will be sufficient for our operating needs or that we will be able to achieve
profitability on a consistent basis, if at all. In the event that cash used in
operations is higher than anticipated and we are unable to secure additional
funding, in order to preserve cash, we would be required to further reduce
expenditures and effect further reductions in our corporate infrastructure,
either of which could have a material adverse effect on our ability to continue
our current level of operations. Even if we obtain additional working capital in
the near future, to the extent that operating expenses increase or we need
additional funds to make acquisitions, develop new technologies or acquire
strategic assets, the need for additional funding may be accelerated and there
can be no assurances that any such additional funding can be obtained on terms
acceptable to us, if at all.

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

      We currently do not generate sufficient revenues to offset our operating
costs. Moreover, as we continue to expand our product and service offerings to
maintain our competitive advantage, we may be required to incur additional costs
to hire and retain additional personnel, license complementary third party
technology for use in our proprietary software or expand both our international
and domestic presence to enter new markets. These costs may significantly
increase our current level of monthly operating expenses. Failure to generate


                                       26
<PAGE>

sufficient capital through both our revenue streams and financings may require
us to execute additional corporate restructurings, scale back our product or
service offerings or limit the markets into which we enter. Any of these items,
or a combination thereof, could have a harmful effect on our operating results
and our stock price.

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

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

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 13, 2006 of $0.52 to $1.48. 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 our
securities demand registration rights and anti-dilution protections, which may
require us to issue additional shares to those holders certain triggering events
occur, such as our failure to register such holders' shares or the issuance of
additional shares of our common stock below a certain price.. 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.

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


                                       27
<PAGE>

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

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

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

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

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

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

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


                                       28
<PAGE>

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.

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

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

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

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

o     discourage potential acquisition proposals;
o     delay or prevent a change in control; and
o     limit the price that investors might be willing to pay in the future for
      shares of our common stock.

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

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

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

Item 7A     Quantitative and Qualitative Disclosures About Market Risk

      The Company does not currently have any material exposure to interest rate
risk, foreign currency risk, exchange rate risk, commodity price risk or other
relevant market rate or price risks. However, the Company does have some
exposure to foreign currency rate fluctuations arising from maintaining an
office for the Company's U.K. based, wholly-owned subsidiary which transacts
business in the local functional currency. The U.K. based subsidiary does not
conduct any sales and all their costs are funded in United States dollars. To
date, the Company has not entered into any derivative financial instrument to
manage foreign currency risk and is not currently evaluating the future use of
any such financial instruments.

Item 8.     Financial Statements and Supplementary Data

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


                                       29
<PAGE>

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

   None.

Item 9A.     Controls and Procedures


      (a)   Evaluation of Disclosure Controls and Procedures

      Our chief executive officer and chief financial officer have evaluated the
effectiveness of our disclosure controls and procedures (as defined in Rules
13a-14(c) and 15d-14(c) of the Securities Exchange Act of 1934), as of the end
of the period covered by this Form 10-K for the fiscal year ended December 31,
2005. Based upon this evaluation process, our chief executive officer and chief
financial officer have concluded that our disclosure controls and procedures are
effective.

      (b)   Changes in Internal Controls

      There have been no changes in our internal control over financial
reporting, as defined in Rule 13a-15(f) of the Securities Exchange Act, that
occurred during the fiscal quarter ended December 31, 2005, that have materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting.

Item 9B.     Other Information

         None.
                                    PART III

Item 10.     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 2006 Proxy
Statement, which is to be filed with the Securities and Exchange Commission on
or about April 10, 2006 (the "2006 Proxy Statement").

Item 11.     Executive Compensation

      The information required is incorporated by reference from the section
entitled "Executive Compensation" contained in the 2006 Proxy Statement, which
is to be filed with the Securities and Exchange Commission.

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

      The information required is incorporated by reference from the sections
entitled "Security Ownership of Principal Stockholders" and "Security Ownership
of Executive Officers and Directors" contained in the 2006 Proxy Statement.

Item 13.     Certain Relationships and Related Transactions

      The information required is incorporated by reference from the section
entitled "Certain Relationships and Related Transactions" contained in the 2006
Proxy Statement.


                                       30
<PAGE>

Item 14.     Principal Accounting Fees and Services.

      The information required is incorporated by reference from the section
entitled "Proposal To Ratify the Appointment of Eisner LLP" contained in the
2006 Proxy Statement.

PART IV

Item 15.     Exhibits.

Exhibits

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

<TABLE>
<CAPTION>
                                                                  Incorporated by Reference
   Exhibit Number          Exhibit Description                    Form        Date Filed                  Filed Herewith
   --------------          -------------------                    ----        ----------                  --------------
<S>                                                               <C>        <C>
   3.1             Certificate of Incorporation of the Company    10-K       April 2, 2001
   3.2             Bylaws of the Company                          Sch. 14A   March 25, 2002
   4.1             Securityholders Agreement, dated as of         10-K       March 30, 2000
                   Dec. 1, 1999, between the Company and
                   thirteen securityholders party thereto
   4.2             Form of Investor Rights Agreement,             10-K       March 30, 2000
                   dated as of Dec. 1, 1999,between the
                   Company and each of nine investors
   4.3             Form of Warrant issued to the investors        10-K       March 30, 2000
                   party to the Investor Rights Agreement
   4.4             Form of Investors' Rights Agreement between    S-3        Dec. 8, 2000
                   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            10-K       April 2, 2001
                   Company's Series C Preferred Stock
   4.6             Certificate of Designations for the            10-K       April 2, 2001
                   Company's Series C-II Preferred Stock
   4.7             Certificate of Designations for the            10-K       April 2, 2001
                   Company's Series C-III Preferred Stock
   4.8             Form of Warrant issued to the holders of       10-K       April 2, 2001
                   Series C, Series C-II and Series C-III
                   Preferred Stock
   4.9             Common Stock Purchase Agreement, dated as      SB-2/A     Sept. 13, 2001
                   of July 18, 2001 by and between the Company
                   and Real.
   4.10            Investor Rights Agreement, dated as of         SB-2/A     Sept. 13, 2001
                   July 18, 2001, between Real and the Company
   4.11            Indemnity Agreement, dated as of January       S-3        July 11, 2003
                   28, 2002, by and among The Travelers
                   Insurance Company, Travelers Indemnity
                   Company, and the Company
   4.12            Investor's Rights Agreement, dated as of       S-3        Oct. 1, 2003
                   January 29, 2001, between the Company and
                   Abanat Limited
   10.1            Employment Agreement with Douglas McIntyre     10-Q       June 30, 2000
   10.2            Common Stock Purchase Agreement, dated as      S-3        Dec. 8, 2000
                   of Dec. 1, 2000,between the Company and
                   Crossover Ventures, Inc.
   10.3            Deferred Pricing Agreement, dated as of        10-K       April 2, 2001
                   January 19, 2001, between the Company and
                   The Travelers Indemnity Company
   10.4            Development Services and License Agreement     SB-2/A     Sept. 13, 2001
                   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      SB-2       Nov. 29, 2001
                   of November 21, 2001 between the Company
                   and Crossover Ventures, Inc.


                                                           31
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
                                                                  Incorporated by Reference
   Exhibit Number          Exhibit Description                    Form        Date Filed                  Filed Herewith
   --------------          -------------------                    ----        ----------                  --------------
<S>                                                               <C>        <C>
   10.6            Lease Agreement, dated as of Sept. 26, 2002    10-K       March 31, 2003
                   between the Company and Sitterly Associates
                   II, LLC
   10.7            Source Code License and Software               8-K        June 21, 2003
                   Distribution Agreement (EVD Products) dated
                   as of June 21, 2003 between On2
                   Technologies, Inc., Beijing E-World and
                   Nature Talent Limited.
   10.8            Source Code License and Software               8-K        June 21, 2003
                   Distribution Agreement (Non-EVD Products)
                   dated as of June 21, 2003 between On2
                   Technologies, Inc., Beijing E-World and
                   Nature Talent Limited.
   10.9            Software Distribution Agreement, dated as      8-K        August 25, 2003
                   of August 25, 2003, by and between the
                   Company and Allied Telesis K. K.
   10.10           Employment Agreement with Tim Reusing          10-K       March 30, 2004
   10.11           Employment Agreement with Eric Ameres          10-K       March 30, 2004
   10.12           Registration Rights Agreement, dated           S-3        Nov. 26, 2004
                   October 27, 2004
   10.13           Letter Agreement by and between the Company    10-Q
                   and Eric L. Ameres, dated as of May 11, 2005

   10.14           Letter Agreement by and between the Company
                   and Timothy C. Reusing, dated as of May 11,
                   2005

   10.15           License Agreement by and between the                                                        X
                   Company and Bevmax Office Centers 1560, LLC

   10.16           Restated Lease Agreement by and between the                                                 X
                   Company and Sitterly Associates II

   10.17           Separation and Consultancy Agreement by and                                                 X
                   between the Company and Douglas A.
                   McIntyre, dated as of February 2, 2006
   21              Subsidiaries                                   10-K       March 31, 2003
   23.1            Consent of Eisner LLP                                                                       X
   31.1            Certification of Chief Executive Officer                                                    X
                   Pursuant to Section 302 of the
                   Sarbanes-Oxley Action of 2002
   31.2            Certification of Chief Financial Officer                                                    X
                   Pursuant to Section 302 of the
                   Sarbanes-Oxley Action of 2002
   32.1            Certification of Chief Executive Officer                                                    X
                   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                                                    X
                   Pursuant to 18 U.S.C. Section 1350, as
                   Adopted Pursuant to Section 906 of the
                   Sarbanes-Oxley Act of 2002

</TABLE>

      (b)   Reports filed on Form 8-K for the three months ended December 31,
            2005.

The Company filed a Current Report on Form 8-K on January 12, 2005, providing a
transcript of a conference call hosted by the Company's Chairman, President, and
CEO, Douglas A. McIntyre.

The Company filed a Current Report on Form 8-K on March 14, 2005, announcing the
London Court of International Arbitration tribunal's decision in the Company's
proceedings against its licensee, Beijing E-World.

The Company filed a Current Report on Form 8-K on March 15, 2005 containing a
press release announcing the Company's results of operations for the fourth
quarter ending December 31, 2004.

The Company filed a Current Report on Form 8-K on April 5, 2005 containing a
press release announcing that it had entered into a purchase and license
agreement with Wildform, Inc., regarding Wildform's Flix(TM) Flash video encoder
technology.


                                       32
<PAGE>

The Company filed a Current Report on Form 8-K on April 21, 2005 containing a
press release announcing the Company's results of operations for the first
quarter ending March 31, 2005.

The Company filed a Current Report on Form 8-K on May 5, 2005 announcing that it
had completed the acquisition of certain Flix(TM) Flash(R) video encoder
technology from Wildform, Inc.

The Company filed a Current Report on Form 8-K on May 11, 2005 announcing the
adoption of the Company's 2005 Incentive Compensation Plan.

The Company filed a Current Report on Form 8-K on May 13, 2005 announcing:

      o     the adoption of the annual meeting fees and option grants for
            members of the Company's Board for the upcoming year;
      o     the extension of the employment terms of the Company's three
            executive officers for one year each: Mr. McIntyre the Company's
            Chairman, President, and CEO until April 16, 2007; Eric Ameres the
            Company's Executive Vice-President and Chief Technology Officer
            until September 15, 2006; and Timothy Reusing the Company's
            Executive Vice-President, Legal and Business Affairs, until October
            15, 2006; and
      o     the appointment of Afsaneh Naimollah and James Meyer to the
            Company's Board of Directors.

The Company filed a Current Report on Form 8-K on May 31, 2005 announcing the
Company's adoption of a new Code of Ethics for Employees and Directors.

The Company filed a Current Report on Form 8-K on July 28, 2005 containing a
press release announcing the Company's results of operations for the second
quarter ending June 30, 2005.

The Company filed a Current Report on Form 8-K on October 27, 2005 containing a
press release announcing the Company's results of operations for the third
quarter ending September 30, 2005.

The Company filed a Current Report on Form 8-K on November 28, 2005 announcing
the adoption of the annual meeting fees and option grants for members of the
Company's Board for the coming year.


                                       33
<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 15,
2006.


                                          ON2 TECHNOLOGIES, INC.


                                          By: /s/ James Meyer
                                              -----------------------
                                              James Meyer
                                              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/ James Meyer         Interim Chief Executive Officer (Principal Executive Officer) and Director       March 15, 2006
---------------------
(James Meyer)

                          Senior Vice President and Chief Financial Officer (Principal Financial
/s/ Anthony Principe                                     Officer)                                        March 15, 2006
---------------------
(Anthony Principe)


/s/ J. Allen Kosowsky                       Chairman of the Board and Director                           March 15, 2006
---------------------
(J. Allen Kosowsky)


/s/ William A. Newman                                    Director                                        March 15, 2006
---------------------
(William A. Newman)


/s/ Mike Kopetski                                        Director                                        March 15, 2006
---------------------
(Mike Kopetski )


/s/ Thomas Weigman                                       Director                                        March 15, 2006
---------------------
(Thomas Weigman)


/s/ Michael J. Alfant                                    Director                                        March 15, 2006
---------------------
(Michael J. Alfant)


/s/ Afsaneh Naimollah                                    Director                                        March 15, 2006
---------------------
(Afsaneh Naimollah)


                                                           34
</TABLE>
<PAGE>

                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS


                                                                            Page
                                                                            ----

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

Consolidated Balance Sheets as of December 31, 2005 and 2004...............  F-3

Consolidated Statements of Operations for the years ended
    December 31, 2005, 2004 and 2003.......................................  F-4

Consolidated Statements of Changes in Stockholders' Equity
    for the years ended December 31, 2005, 2004 and 2003...................  F-5

Consolidated Statements of Cash Flows for the years ended
    December 31, 2005, 2004 and 2003.......................................  F-8

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


                                      F-1
<PAGE>

             Report of Independent Registered Public Accounting Firm


Board of Directors and Stockholders
On2 Technologies, Inc.


     We have audited the accompanying consolidated balance sheets of On2
Technologies, Inc. and subsidiaries (the "Company") as of December 31, 2005 and
2004 and the related consolidated statements of operations, changes in
stockholders' equity and cash flows for each of the years in the three-year
period ended December 31, 2005. Our audits also included the financial statement
Schedule II - Valuation and Qualifying Accounts. These consolidated financial
statements and schedule are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements and
schedule based on our audits.

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

     In our opinion, the financial statements enumerated above present fairly,
in all material respects, the consolidated financial position of On2
Technologies, Inc. and subsidiaries as of December 31, 2005 and 2004, and the
consolidated results of their operations and their consolidated cash flows for
each of the years in the three-year period ended December 31, 2005 in conformity
with U.S. generally accepted accounting principles. Also in our opinion, the
related financial statement schedule, when considered in relation to the basic
financial statements taken as a whole, presents fairly, in all material
respects, the information stated therein.


/s/ EISNER LLP

Eisner LLP

New York, New York
January 20, 2006


                                       F-2
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                           CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                                              December 31,
                                                                                     --------------------------------
                                                                                         2005               2004
                                                                                     -------------      -------------
                                                                                                      (Restated-Note 14)
                                 ASSETS (Note 8)

<S>                                                                                  <C>                <C>
Current assets:
  Cash and cash equivalents ....................................................     $   3,976,000      $   5,418,000
  Marketable securities, at market .............................................           181,000            445,000
  Accounts receivable, less allowance for doubtful accounts
      of $13,000 and $140,000 as of December 31, 2005 and 2004, respectively ...           746,000            249,000
  Prepaid expenses and other current assets ....................................           186,000            156,000
                                                                                     -------------      -------------

       Total current assets ....................................................         5,089,000          6,268,000

Acquired software, net .........................................................           667,000
Other acquired intangibles, net ................................................           154,000
Goodwill .......................................................................           244,000
Property and equipment, net ....................................................           131,000             87,000
Deferred financing costs .......................................................                              175,000
Other assets ...................................................................            29,000             80,000
                                                                                     -------------      -------------
       Total assets ............................................................     $   6,314,000      $   6,610,000
                                                                                     =============      =============

                      LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
  Accounts payable .............................................................     $      41,000      $     177,000
  Accrued expenses .............................................................           608,000            393,000
  Deferred revenue .............................................................           241,000            153,000
  Term-loan ....................................................................                               62,000
  Capital lease obligation .....................................................            20,000             17,000
                                                                                     -------------      -------------

       Total current liabilities ...............................................           910,000            802,000

Capital lease obligation, excluding current portion ............................             6,000             26,000
Convertible  debentures,  net of debt  discount of $6,000 and
  $20,000 as of December 31, 2005 and 2004, respectively .......................           244,000            330,000
                                                                                     -------------      -------------
      Total liabilities ........................................................         1,160,000          1,158,000

Series D redeemable convertible preferred stock $0.01 par value; 3,790 and
  4,000 shares issued and outstanding, net of discount of $0 and $2,844,000
  at December 31, 2005 and 2004, respectively (liquidation value of
  $3,790,000 and $4,000,000 at December 31, 2005
  and 2004, respectively) ......................................................         3,790,000          1,156,000

Commitments and contingencies (Note 10)

Stockholders' equity:
  Preferred stock, $0.01 par value; 20,000,000 shares authorized;
      1,849,000 and 3,299,000 convertible shares issued and
      outstanding at December 31, 2005 and 2004, respectively
      (aggregate of liquidation value of $5,110,000
      and $6,704,000 as of December 31, 2005 and
      2004, respectively) ......................................................            19,000             33,000
  Common stock, $0.01 par value;  150,000,000 shares authorized;
      92,295,000 and 80,328,000 shares issued and
      outstanding at December 31, 2005 and 2004, respectively) .................           923,000            803,000
  Additional paid-in capital ...................................................       119,772,000        114,860,000
  Accumulated other comprehensive loss .........................................           (43,000)           (42,000)
  Accumulated deficit ..........................................................      (119,307,000)      (111,358,000)
                                                                                     -------------      -------------
      Total stockholders' equity ...............................................         1,364,000          4,296,000
                                                                                     -------------      -------------
      Total liabilities and stockholders' equity ...............................     $   6,314,000      $   6,610,000
                                                                                     =============      =============
</TABLE>
           See accompanying notes to consolidated financial statements


                                       F-3
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
                                                                                     Year Ended December 31,
                                                                         ------------------------------------------------
                                                                            2005               2004               2003
                                                                         ------------      ------------      ------------

<S>                                                                      <C>               <C>               <C>
Revenue (1) ........................................................     $  2,208,000      $  3,028,000      $  3,302,000

Operating expenses:
     Cost of revenue (2) ...........................................        1,919,000         1,437,000         1,506,000
     Research and development (3) ..................................        1,035,000           884,000         1,124,000
     Sales and marketing (3) .......................................          794,000           459,000           527,000
     General and administrative (3) ................................        2,749,000         3,068,000         2,448,000
     Equity-based compensation:
           Research and development ................................                             68,000
           Sales and marketing .....................................                             19,000
           General and administrative ..............................                            583,000            60,000
                                                                         ------------      ------------      ------------

Total operating expenses ...........................................        6,497,000         6,518,000         5,665,000
                                                                         ------------      ------------      ------------

Loss from operations ...............................................       (4,289,000)       (3,490,000)       (2,363,000)

Interest and other income (expense), net ...........................         (284,000)           47,000            (2,000)
                                                                         ------------      ------------      ------------

Loss before provision for income taxes .............................       (4,573,000)       (3,443,000)       (2,365,000)

Provision for income taxes .........................................           32,000             2,000            10,000
                                                                         ------------      ------------      ------------

Net loss ...........................................................       (4,605,000)       (3,445,000)       (2,375,000)

Convertible preferred stock deemed dividend ........................        2,844,000           120,000           228,000
Convertible preferred stock 8% dividend ............................          325,000            57,000
Accretion of costs associated with the Series D Preferred Stock.....          175,000            14,000
                                                                         ------------      ------------      ------------

Net loss attributable to common stockholders .......................     $ (7,949,000)     $ (3,636,000)     $ (2,603,000)
                                                                         ============      ============      ============

Basic and diluted net loss attributable to common stockholders
  per common share .................................................     $      (0.09)     $      (0.05)     $      (0.04)
                                                                         ============      ============      ============

Weighted average basic and diluted common shares outstanding .......       89,183,000        77,187,000        64,654,000
                                                                         ============      ============      ============
</TABLE>

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

           See accompanying notes to consolidated financial statements


                                       F-4
<PAGE>

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

<TABLE>
<CAPTION>

                                                                                             Accumulated
                                Convertible                                                    Other                       Total
                              Preferred Stock            Common Stock          Additional      Compre-                     Stock-
                         ------------------------   ----------------------       Paid-in       hensive    Accumulated     holders'
                           Shares        Amount       Shares      Amount         Capital        Loss        Deficit        Equity
                         ----------   -----------   ----------  -----------   -------------   --------   -------------   ----------
<S>                       <C>         <C>           <C>         <C>           <C>             <C>        <C>             <C>
Balance at
  January 1, 2003 ......  9,920,000   $    99,000   59,588,000  $   596,000   $ 105,422,000   $(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 .....                             2,579,000       25,000       1,355,000                               1,380,000
Issuance of common
  stock in
  connection with
  the exercise
  of warrants ..........                             1,503,000       15,000       1,710,000                               1,725,000
Issuance of common
  stock in
  connection with
  the conversion
  of Series A
  secured
  convertible
  debentures ...........                             1,786,000       18,000         182,000                                 200,000
Issuance of
  common stock in
  connection with
  the equity
  line of credit .......                             3,387,000       34,000       1,280,000                               1,314,000
Issuance of common
  stock in
  connection with
  the conversion
  of Series C-V
  convertible
  preferred stock ...... (1,923,000)      (19,000)   2,644,000       26,000          (7,000)                                      0
Issuance of common
  stock in
  connection with
  the conversion
  of Series C-VI
  convertible
  preferred stock ...... (2,432,000)      (24,000)   2,606,000       26,000          (2,000)                                      0
Issuance of common
  stock in
  connection with
  the payment of
  interest on the
  Series A secured
  convertible
  debentures ...........                                53,000        1,000          43,000                                  44,000
Warrants issued
  for consulting
  services .............                                                             60,000                                  60,000
Purchase of
  warrants .............                                                            (42,000)                                (42,000)
Convertible
  preferred stock
  deemed dividends .....                                                            228,000                   (228,000)           0
                         ----------   -----------   ----------  -----------   -------------   --------   -------------   ----------
Balance at
  December 31, 2003 ....  5,565,000   $    56,000   74,146,000  $   741,000   $ 110,229,000   $(18,000)  $(107,722,000)  $3,286,000
                         ----------   -----------   ----------  -----------   -------------   --------   -------------   ----------
</TABLE>

                                       F-5
<PAGE>

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

<TABLE>
<CAPTION>
                                                                                             Accumulated
                                Convertible                                                    Other                       Total
                              Preferred Stock            Common Stock          Additional      Compre-                     Stock-
                         ------------------------   ----------------------       Paid-in       hensive    Accumulated     holders'
                           Shares        Amount       Shares      Amount         Capital        Loss        Deficit        Equity
                         ----------   -----------   ----------  -----------   -------------   --------   -------------   ----------
<S>                       <C>         <C>           <C>         <C>           <C>             <C>        <C>             <C>
Net loss ...............                                                                                    (3,445,000)  (3,445,000)
Foreign currency
  translation
  adjustment ...........                                                                       (24,000)                     (24,000)
                                                                                                                         ----------
Comprehensive loss .....                                                                                                 (3,469,000)
                                                                                                                         ----------
Issuance of common
  stock in
  connection with
  the exercise
  of stock options .....                               277,000        3,000          64,000                                  67,000
Issuance of common
  stock in
  connection with
  the exercise
  of warrants ..........                             1,435,000       14,000         749,000                                 763,000
Issuance of common
  stock in
  connection with
  the conversion
  of Series A
  secured
  convertible
  debentures ...........                               893,000        9,000          91,000                                 100,000
Issuance of
  common stock to
  employees and
  directors as
  compensation .........                               870,000        9,000         826,000                                 835,000
Issuance of common
  stock in
  connection with
  the conversion
  of Series A
  convertible
  preferred stock ......   (400,000)       (4,000)     400,000        4,000                                                       0
Issuance of common
  stock in
  connection with
  the conversion
  of Series C-V
  convertible
  preferred stock ......   (727,000)       (7,000)   1,000,000       10,000          (3,000)                                      0
Issuance of common
  stock in
  connection with
  the conversion
  of Series C-VI
  convertible
  preferred stock ...... (1,139,000)      (12,000)   1,210,000       12,000                                                       0
Issuance of common
  stock in
  connection with
  the payment
  of interest on
  the Series A
  secured
  convertible
  debentures ...........                                37,000            0          23,000                                  23,000
Issuance of common
  stock in
  connection with
  the payment of
  dividends on the
  Series D
  convertible
  preferred stock ......                                60,000        1,000          29,000                    (30,000)           0
Discount on Series
  D convertible
  preferred stock
  for warrants
  and beneficial
  conversion
  feature ..............                                                          2,964,000                               2,964,000
Series D
  convertible
  preferred
  stock financing
  costs allocated
  to warrants ..........                                                           (112,000)                               (112,000)
Deemed dividend
  on Series D
  convertible
  preferred stock ......                                                                                      (120,000)    (120,000)
Accrued dividend
  on Series D
  convertible
  preferred stock ......                                                                                       (27,000)     (27,000)
</TABLE>

                                       F-6
<PAGE>
                             ON2 TECHNOLOGIES, INC.
     CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (CONTINUED)

<TABLE>
<CAPTION>

                                                                                             Accumulated
                                Convertible                                                    Other                       Total
                              Preferred Stock            Common Stock          Additional      Compre-                     Stock-
                         ------------------------   ----------------------       Paid-in       hensive    Accumulated     holders'
                           Shares        Amount       Shares      Amount         Capital        Loss        Deficit        Equity
                         ----------   -----------   ----------  -----------   -------------   --------   -------------   ----------
<S>                       <C>         <C>           <C>         <C>           <C>             <C>        <C>             <C>
Accretion of
  costs associated
  with the
  issuance of the
  Series D
  convertible
  preferred stock ......                                                                                       (14,000)     (14,000)
                         ----------   -----------   ----------  -----------   -------------   --------   -------------   ----------
Balance at
  December 31,
  2004-restated ........  3,299,000   $    33,000   80,328,000  $   803,000   $ 114,860,000   $(42,000)  $(111,358,000)  $4,296,000
                         ----------   -----------   ----------  -----------   -------------   --------   -------------   ----------
Net loss ...............                                                                                    (4,605,000)  (4,605,000)
Foreign currency
  translation
  adjustment ...........                                                                        (1,000)                      (1,000)
                                                                                                                         ----------
Comprehensive loss .....                                                                                                 (4,606,000)
                                                                                                                         ----------
Issuance of common
  stock in
  connection with
  the exercise
  of stock options .....                               116,000        1,000          41,000                                  42,000
Issuance of common
  stock in
  connection with
  the exercise
  of warrants ..........                             8,052,000       81,000       4,242,000                               4,323,000
Issuance of common
  stock in
  connection with
  the conversion
  of Series A
  secured
  convertible
  debentures ...........                               893,000        9,000          91,000                                 100,000
Issuance of
  common stock in
  connection with
  the conversion
  of Series C-V
  convertible
  preferred stock ...... (1,450,000)      (14,000)   2,040,000       21,000          (7,000)                                      0
Issuance of common
  stock in
  connection with
  the conversion
  of Series D
  convertible
  preferred stock ......                               300,000        3,000         207,000                                 210,000
Issuance of
  common stock in
  connection with
  the payment
  of interest on
  the Series A
  secured
  convertible
  debentures ...........                                28,000       18,000                                                  18,000
Issuance of common
  stock in
  connection with
  the payment of
  dividends and
  dividends
  accrued on the
  Series D
  convertible
  preferred stock ......                               538,000        5,000         320,000                   (325,000)           0
Deemed dividend on
   Series D
  convertible
  preferred stock ......                                                                                    (2,844,000)  (2,844,000)
Accretion of costs
  associated
  with the
  issuance of the
  Series D
  convertible
  preferred stock ......                                                                                      (175,000)    (175,000)
                         ----------   -----------   ----------  -----------   -------------   --------   -------------   ----------
Balance at
  December 31,
  2005 .................  1,849,000   $    19,000   92,295,000  $   923,000   $ 119,772,000   $(43,000)  $(119,307,000)  $1,364,000
                         ==========   ===========   ==========  ===========   =============   ========   =============   ==========
</TABLE>

           See accompanying notes to consolidated financial statements


                                       F-7
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                             Year Ended December 31,
                                                                     ---------------------------------------
                                                                        2005           2004          2003
                                                                     -----------   -----------   -----------
<S>                                                                  <C>           <C>           <C>
Cash flows from operating activities:

  Net loss ........................................................  $(4,605,000)  $(3,445,000)  $(2,375,000)
    Adjustments to reconcile net loss to net cash used
     in operating activities:
     Equity-based compensation ....................................                    835,000        60,000
     Common stock issued for debenture interest ...................       18,000        23,000        44,000
     Write-off of fixed assets ....................................                     20,000
     Depreciation and amortization ................................      236,000       115,000       706,000
     Marketable equity securities received as payment of
       license fee ................................................                   (289,000)
     Unrealized loss (gain) on marketable equity securities .......      339,000      (121,000)
     Realized loss on marketable equity securities ................                     26,000
     Amortization of debt discount ................................       14,000        21,000        40,000
     Changes in operating assets and liabilities:
       Accounts receivable, net ...................................     (497,000)      427,000      (225,000)
       Prepaid expenses and other current assets ..................      (30,000)        8,000       (63,000)
       Other assets ...............................................       51,000       (54,000)      (17,000)
       Accounts payable and accrued expenses ......................       79,000       203,000      (180,000)
       Deferred revenue ...........................................       88,000       123,000        30,000
                                                                     -----------   -----------   -----------
         Net cash used in operating activities ....................   (4,307,000)   (2,108,000)   (1,980,000)
                                                                     -----------   -----------   -----------
Cash flows from investing activities:

  Proceeds from the sale of marketable equity securities ..........                     89,000
  Purchases of marketable securities ..............................      (75,000)
  Purchases of the Flix software line .............................   (1,229,000)
  Purchases of property and equipment .............................     (116,000)      (19,000)      (39,000)
                                                                     -----------   -----------   -----------

         Net cash (used in) provided by investing activities ......   (1,420,000)       70,000       (39,000)
                                                                     -----------   -----------   -----------

Cash flows from financing activities:

  Principal payments on capital lease obligations .................      (17,000)      (11,000)       (9,000)
  Purchase of common stock warrants ...............................                                  (42,000)
  Proceeds from (principal payments on) term-loan, net ............      (62,000)       (1,000)       63,000
  Net proceeds from the sale of common stock ......................                                1,314,000
  Net proceeds from the issuance of Series D redeemable
   convertible preferred stock ....................................                  3,699,000
  Proceeds from exercise of common stock options
   and warrants, net ..............................................    4,365,000       830,000     3,105,000
                                                                     -----------   -----------   -----------
         Net cash provided by financing activities ................    4,286,000     4,517,000     4,431,000
                                                                     -----------   -----------   -----------
Net change in cash and cash equivalents ...........................   (1,441,000)    2,479,000     2,412,000
Effect of exchange rate changes on cash and cash equivalents              (1,000)      (24,000)       (2,000)
Cash and cash equivalents, beginning of year ......................    5,418,000     2,963,000       553,000
                                                                     -----------   -----------   -----------
Cash and cash equivalents, end of year ............................  $ 3,976,000   $ 5,418,000   $ 2,963,000
                                                                     ===========   ===========   ===========
</TABLE>


                                       F-8
<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,
                                                                                      ----------------------------------------
                                                                                       2005            2004            2003
                                                                                      ----------------------------------------
<S>                                                                                   <C>            <C>            <C>
Cash paid during the year for:
   Interest .....................................................................     $    7,000     $   11,000     $   12,000
                                                                                      ==========     ==========     ==========
   Taxes ........................................................................     $   25,000     $    7,000     $   14,000
                                                                                      ==========     ==========     ==========
   Non-cash transactions:
   Acquisition of fixed assets under capital leases .............................                    $   54,000
                                                                                                     ==========
   Conversion of Series A, C-V and C-IV convertible preferred stock into
     common stock ...............................................................     $   14,000     $   23,000     $   43,000
                                                                                      ==========     ==========     ==========
   Conversion of Series D redeemable convertible preferred stock into common
     stock ......................................................................     $  210,000
                                                                                      ==========     ==========     ==========
   Conversion of debentures into common stock ...................................     $  100,000     $  100,000     $  200,000
                                                                                      ==========     ==========     ==========
   Common stock issued for dividends and dividends accrued on Series D
     convertible preferred stock ................................................     $  325,000     $   30,000
                                                                                      ==========     ==========
   Accrued dividend on Series D convertible preferred stock .....................                    $   27,000
                                                                                                     ==========
   Accretion of costs associated with the issuance of Series D convertible
     preferred stock ............................................................     $  175,000     $   14,000
                                                                                      ==========     ==========
   Series D convertible preferred stock deemed dividends ........................     $2,844,000     $  120,000     $  228,000
                                                                                      ==========     ==========     ==========
   Marketable equity securities received as consideration for account
     receivable .................................................................                    $  150,000
                                                                                                     ==========
</TABLE>

           See accompanying notes to consolidated financial statements


                                       F-9
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 2005, 2004 AND 2003


(1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

      (a) Description of the Business

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

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

      (b) Basis of Presentation

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

      The 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, 2005 the Company had cash and cash equivalents of
$3,976,000 and working capital of $4,179,000. The Company believes that existing
funds are sufficient to fund its operations through 2006. The Company plans to
increase cash flows from operations principally from increases in revenue
generated from its compression technology services, products and licenses. The
Company may also pursue additional financings. However, there are no assurances
that such increases in revenues will be attained or that additional financings
will be successfully consummated.

      (c) Cash and Cash Equivalents

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

      (d) 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-10
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 2005, 2004 AND 2003


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

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

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

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

      The fair values of accounts receivable and accounts payable approximate
their carrying values based on the short-term nature of these financial
instruments. The fair value of the Series A secured convertible debentures is
approximately $2,366,000 and $1,969,000 at December 31, 2005 and 2004,
respectively. The fair value of the Series D redeemable convertible preferred
stock is approximately $4,017,000 and $4,000,000 at December 31, 2005 and 2004,
respectively. The fair values were based on the quoted value of the underlying
common stock of the Company.

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

      (g) Income Taxes

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

      (h) Revenue Recognition

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

      The Company's revenue recognition policies are in accordance with
Statement of Position ("SOP") 97-2, "Software Revenue Recognition" 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


                                      F-11
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 2005, 2004 AND 2003


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

      (h) Revenue Recognition (continued)

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

      Professional Services

      Professional services consist of customized engineering and consulting
services.

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

      (i) Cost of Revenue

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


                                      F-12
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 2005, 2004 AND 2003


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

      (j) Software Development Costs

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

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

      (k) Stock-Based Compensation

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

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

<TABLE>
<CAPTION>

                                                                                    Year Ended December 31,
                                                                         ------------------------------------------------
                                                                             2005              2004              2003
                                                                         ------------      ------------      ------------
<S>                                                                      <C>               <C>               <C>
         Reported net loss attributable to common stockholders           $ (7,949,000)     $ (3,636,000)     $ (2,603,000)
         Stock-based employee compensation determined under the fair
         value-based method                                                (2,766,000)       (1,121,000)         (688,000)
                                                                         ------------      ------------      ------------


         Pro forma net loss attributable to common shareholders          $(10,715,000)     $ (4,757,000)     $ (3,291,000)
                                                                         ============      ============      ============

         Loss attributable to common stockholders per share
         (basic and diluted):
               As reported                                               $      (0.09)     $      (0.05)     $      (0.04)
                                                                         ============      ============      ============

               Pro forma                                                 $      (0.12)     $      (0.06)     $      (0.05)
                                                                         ============      ============      ============
</TABLE>

     In December 2004, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 123R "Share-Based Payment" ("SFAS 123R"), which requires all
share-based payments to employees, including grants of


                                      F-13
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 2005, 2004 AND 2003


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

      (k) Stock-Based Compensation (continued)

employee stock options, to be recognized in the statement of operations as an
operating expense, based on their fair values on grant date. Pro forma
disclosure will no longer be an alternative. The Company will recognize
share-based compensation costs on a straight-line basis over the requisite
service periods of awards. That cost will be recognized as compensation expense
over the service period, which would normally be the vesting period of the
options. The Company will adopt the provision of SFAS No. 123R effective January
1, 2006, using the modified prospective transition method which could have a
significant impact on the Company's results of operations. Under the modified
prospective method, non-cash compensation expense will be recognized for the
portion of outstanding stock option awards granted prior to the adoption of SFAS
123R for which service has not been rendered, and for any future stock option
grants. The impact of adopting SFAS 123R cannot be predicted at this time
because it will depend on the share-based payments granted in the future.

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

      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,
                                   --------------------------------
                                     2005        2004         2003
                                   -------      -------     -------
      Volatility                   120%         126%        138%
      Expected life of options     5 years      5 years     5 years
      Risk free interest rate      4.1%         3.6%        3.5%
      Dividend yield                 0%           0%          0%

      The weighted average grant date fair value of options granted during the
years ended December 31, 2005, 2004 and 2003 were $0.59, $0.59 and $0.56,
respectively.

      (l) Advertising costs

      The Company expenses advertising cost when incurred. Advertising expenses
were $115,000, $40,000 and $8,000 for the years ended December 31, 2005, 2004
and 2003, 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). Diluted loss per share has not been presented separately since
26,891,000 potential common shares at December 31, 2005, 33,047,000 potential
common shares at December 31, 2004 and 24,540,000 at December 31, 2003 are
anti-dilutive for each of the periods presented.


                                      F-14
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 2005, 2004 AND 2003


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

      (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. Assumptions underlying revenue recognition represent sensitive
estimates subject to change.

      (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,
from which it earns revenues from its customers. The Company's Chief Operating
Decision Maker is the Company's Chief Executive Officer ("CEO"), who receives
consolidated financial information for purposes of evaluating the Company's
operational and financial performance.

      Our customers typically represent digital communication and media
companies, entertainment companies, telecommunication companies and third party
resellers. For the year ended December 31, 2005, two customers accounted for 20%
and 11% of the Company's total revenues. For the year ended December 31, 2004,
one customer accounted for 47% of the Company's total revenues. For the year
ended December 31, 2003, three customers accounted for 35%, 19% and 11% of the
Company's total revenue. As of December 31, 2005, four customers accounted for
20%, 18%, 11% and 11% of total accounts receivable. As of December 31, 2004, two
customers accounted for 21% and 13% of total accounts receivable. The components
of the Company's revenue for the years ended December 31, 2005, 2004 and 2003
are summarized as follows:

<TABLE>
<CAPTION>
                                                         Year Ended December 31,
                                                ----------------------------------------
                                                  2005            2004           2003
                                                ----------     ----------     ----------
<S>                                             <C>            <C>            <C>
License revenue............................     $1,947,000     $2,571,000     $2,637,000
Engineering services and support ..........        155,000        414,000        633,000
Royalties .................................        106,000         43,000         32,000
                                                ----------     ----------     ----------

   Total ..................................     $2,208,000     $3,028,000     $3,302,000
                                                ==========     ==========     ==========
</TABLE>

      For the years ended December 31, 2005, 2004 and 2003 foreign customers
accounted for approximately 27%, 20% and 67%, respectively. These customers are
primarily located in Asia.

      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 revenue generated from the United
Kingdom operations for the years ended December 31, 2005, 2004 and 2003.


                                      F-15
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 2005, 2004 AND 2003


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

      (p) Recently Issued Accounting Pronouncements

      In December 2004, the FASB issued SFAS No. 123 (revised 2004) "Share-Based
Payment" ("SFAS 123(R)"). SFAS 123(R) addresses the accounting for transactions
in which an enterprise exchanges its equity instruments for employee services.
It also addresses transactions in which an enterprise incurs liabilities that
are based on the fair value of the enterprise's equity instruments or that may
be settled by the issuance of those equity instruments in exchange for employee
services. The cost of employee services received in exchange for equity
instruments, including employee stock options, is to be measured on the
grant-date fair value of those instruments. That cost will be recognized as
compensation expense over the service period, which would normally be the
vesting period. SFAS 123(R) became effective for the Company as of January 1,
2006. The impact of adopting SFAS 123(R) cannot be predicted at this time
because it will depend on the share based payments granted in the future.

      In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error
Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3"
("SFAS 154"). This Statement replaces APB Opinion No. 20, Accounting Changes,
and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial
Statements, and changes the requirements for the accounting for and reporting of
a change in accounting principle. SFAS 154 requires retrospective application to
prior periods' financial statements of a voluntary change in accounting
principle unless it is impractical to determine period specific changes. This
statement is effective for fiscal periods beginning after December 15, 2005 and
is not expected to have a significant impact on the Company's financial
statements.

(2) MARKETABLE SECURITIES

      During the year ended December 31, 2004 the Company received 2,224,000
shares of a customer's common stock as payment of license fees pursuant to the
terms of an August 2004 license agreement and $289,000 of revenue was recognized
based on the market value of the stock. The Company also received 469,000 shares
of this customer's common stock pursuant to the terms of a license agreement for
a license fee of $150,000 that was recognized in 2003. The Company's former
Chief Executive Officer (who is a former director and shareholder of the
Company) is a director of this customer. During the year ended December 31, 2004
the Company sold 574,000 shares for proceeds of $89,000 and held 2,119,000
shares with a market value of $106,000 ($0.05 per share) as of December 31,
2005. The market value of these securities was $0.04 per share as of March 10,
2006. Additionally, at December 31, 2005 the Company held debt securities with a
fair value of $75,000. The Company classifies these as trading securities and
pursuant to SFAS No. 115, "Accounting for Certain Investments in Debt and Equity
Securities", unrealized gains and losses are included in the determination of
net income (loss). Other income for the year ended December 31, 2005 includes
$339,000 of unrealized net loss on these securities. Other income for the year
ended December 31, 2004 includes $95,000 of net gain on these securities.


                                      F-16
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 2005, 2004 AND 2003


(3) PROPERTY AND EQUIPMENT

     Property and equipment consists of the following:

                                                              December 31,
                                                       -------------------------
                                                          2005           2004
                                                       ----------     ----------
Furniture and fixtures ...........................     $   92,000     $   65,000
Computer equipment ...............................      2,437,000      2,367,000
Leasehold improvements ...........................         24,000         23,000
Licensed software ................................        607,000        588,000
                                                       ----------     ----------

                                                        3,160,000      3,043,000

Less accumulated depreciation and amortization ...      3,029,000      2,956,000
                                                       ----------     ----------

   Total .........................................     $  131,000     $   87,000
                                                       ==========     ==========

      As of December 31, 2005, property and equipment included assets under
capital leases of $156,000 with related accumulated depreciation of $136,000. As
of December 31, 2004, property and equipment included assets under capital
leases of $156,000 with related accumulated depreciation of $118,000.
Depreciation expense was $73,000, $115,000 and $243,000 for the years ended
December 31, 2005, 2004 and 2003, respectively.

(4) INTANGIBLE ASSETS

Flix Acquisition

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

      In consideration for the purchased Flix assets and the license of the
Licensed Flix IP and E-Commerce Software, the Company paid Wildform $1,215,000,
$200,000 of which has been deposited in an escrow account that will be
maintained until the one-year anniversary of the Closing Date as security for
Wildform's obligations under the Purchase Agreement and incurred $14,000 in
associated costs.


                                      F-17
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 2005, 2004 AND 2003


(4) INTANGIBLE ASSETS (continued)

Flix Acquisition (continued)

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

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

   Total.....................................................   $    1,229,000
                                                                ==============

      The assets recognized with respect to acquired software, brand assets and
the non-compete agreement are being amortized over their estimated lives of four
years. Amortization expense related to these intangible assets was $163,000 for
the year ended December 31, 2005.

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

      Had the Company acquired the Flix assets as of January 1, 2005 there would
have been a nominal effect on revenue and expenses, other than additional
amortization of acquired intangible assets of approximately $83,000.

(5) ACCRUED EXPENSES

      Accrued expenses consist of the following:

                                                         December 31,
                                                  --------------------------
                                                     2005           2004
                                                  -----------    -----------
Accrued compensation...........................   $   243,000    $    41,000
Accrued professional fees......................        80,000         80,000
Other accrued expenses.........................       285,000        272,000
                                                  -----------    -----------

       Total...................................   $   608,000    $   393,000
                                                  ===========    ===========


                                      F-18
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 2005, 2004 AND 2003


(6) TERM LOAN

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

(7) INCOME TAXES

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

      As of December 31, 2005, the Company had net operating loss carry forwards
for United States purposes of approximately $84,986,000, and approximately
$1,839,000 for United Kingdom purposes, which expire at various dates through
2025. As of December 31, 2005 and 2004, the Company had a deferred tax asset of
approximately $35,779,000 and $33,917,000, respectively, principally
representing the benefits of its net operating loss carry forwards and certain
expenses not currently deductible for tax purposes. Past and future stock
issuances may subject the Company to an annual limitation on the utilization of
its net operating loss under Section 382 of the Internal Revenue Code. At
December 31, 2005 and 2004 the principal timing difference between tax and
financial reporting was due to depreciation and amortization expense. A full
valuation allowance, which increased by $1,862,000, $1,737,000 (the deferred tax
asset as of December 31, 2003 was $32,180,000) and $739,000 (the deferred tax
asset as of December 31, 2002 was $31,441,000) during the years ended December
31, 2005, 2004 and 2003, respectively, has been recorded related to the deferred
tax asset as a result of management's uncertainty as to the realization of such
asset. Accordingly, no income tax benefit has been recognized. The tax
provisions of $32,000, $2,000 and $10,000 for the years ended December 31, 2005,
2004 and 2003, respectively, relate primarily to various state and local taxes.

(8) CONVERTIBLE DEBENTURES

      Series A Secured Convertible Debentures

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


                                      F-19
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 2005, 2004 AND 2003


(8) CONVERTIBLE DEBENTURES (continued)

      Series A Secured Convertible Debentures (continued)

date. The initial common share equivalents for the debentures and the warrants
were 5,804,000 and 1,161,000, respectively.

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

      An aggregate principal amount of $400,000, of the Series A Secured
Convertible Debentures, was converted into 3,571,000 shares of the Company's
common stock as of December 31, 2005. During 2005, 804,000 warrants were
exercised and the Company received proceeds of $90,000. During 2004, 90,000
warrants were exercised. The amortization of the discount was $14,000 and
$21,000 for the years ended December 31, 2005 and 2004, respectively.

(9) STOCKHOLDERS' EQUITY

      (a) Preferred Stock

      The Company has 20,000,000 shares of preferred stock authorized for
issuance and, through December 31, 2005, ten series of convertible preferred
stock (collectively "Preferred Stock") were issued. Pursuant to its Certificate
of Incorporation, the Company may serially designate separate classes of
preferred stock up to the aggregate of its authorized limit. Each class of the
Preferred Stock is convertible into shares of the Company's Common Stock based
on a conversion rate and has rights and preferences which are generally more
senior to the Company's Common Stock and are more fully described in the
Company's Certificate of Incorporation.

      Series 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
(the "Series A Preferred"), $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 was non-voting and was convertible at the
holder's option, at any time, into one share of Common Stock of the Company.

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

      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


                                      F-20
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 2005, 2004 AND 2003


(9) STOCKHOLDERS' EQUITY (continued)

      (a) Preferred Stock (continued)

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

$9,000 in connection with the transaction. This investment was part of an
aggregate financing of $15,000,000. The original conversion price was $6.082.
The additional $5,000,000 was received and satisfied through the issuance of the
Company's Series C-II and Series C-III Convertible Preferred Stock as described
below. In the event of any liquidation, dissolution or winding up of the
Company, either voluntary or involuntary, the holders of the Series C Preferred
are entitled to receive a liquidation amount of $6.082 per share. The
liquidation price per share would be paid out of the assets of the Company
available for distribution prior to any payments made on any shares of the
Company's Common Stock or any other capital stock that ranks junior to the
Preferred Stock.

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

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

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

      As of December 31, 2002, the conversion price of the Series C-IV Preferred
was adjusted to $1.7549 per share, the Company issued 236,000 additional
warrants and the exercise price of the warrants was reduced to $1.7549 per
share. As a result of the issuance of the Series D Convertible Preferred Stock
in October 2004, the conversion price of the Series C-IV Preferred was further
adjusted to $1.6412 per share.

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


                                      F-21
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 2005, 2004 AND 2003


(9) STOCKHOLDERS' EQUITY (continued)

      (a) Preferred Stock (continued)

      Series C-II Convertible Preferred Stock

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

      During the years ended December 31, 2004 and 2003, 727,000 and 1,923,000
shares of Series C-V Preferred were converted into 1,000,000 and 2,644,000
shares, respectively, of the Company's Common Stock. During the year ended
December 31, 2005 the remaining 1,450,000 shares of Series C-V Preferred were
converted into 2,040,000 shares of the Company's Common Stock.

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

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

      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 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.


                                      F-22
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 2005, 2004 AND 2003


(9) STOCKHOLDERS' EQUITY (continued)

      (a) Preferred Stock (continued)

      Series C-VI Convertible Preferred Stock

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

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

      During the year ended December 31, 2003, the Company agreed to extend
certain anti-dilution rights to the holders of its Series C-VI Preferred,
retroactive to the issuance of such shares. The conversion price of the Series
C-VI Preferred was adjusted to $0.5241 from $0.56 per share as a result of the
retroactive treatment. The Company recorded deemed dividends of $143,000 during
the year ended December 31, 2003 relating to this adjustment.

      During the years ended December 31, 2004 and 2003, 1,139,000 and 2,432,000
shares of Series C-VI Preferred were converted into 1,210,000 and 2,606,000
shares, respectively, of the Company's Common Stock. During the year ended
December 31, 2004, the Company received proceeds of $753,000 from the exercise
of 1,345,000 warrants. During the year ended December 31, 2005, the Company
received proceeds of $2,247,000 from the exercise of the remaining 4,012,000
warrants.

      Series D Redeemable Convertible Preferred Stock

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

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


                                      F-23
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 2005, 2004 AND 2003


(9) STOCKHOLDERS' EQUITY (continued)

      (a) Preferred Stock (continued)

      Series D Redeemable Convertible Preferred Stock (continued)

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

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

      During the year ended December 31, 2005, 210 shares of Series D Preferred
were converted into 300,000 shares of the Company's Common Stock.

      During 2005, the Company recorded dividends of $325,000 on the Series D
Preferred of which all were paid, by issuing 538,000 shares of the Company's
Common Stock and $27,000 was accrued. During 2004, the Company recorded
dividends of $57,000 on the Series D Preferred of which $30,000 were paid, by
issuing 60,000 shares of the Company's Common Stock and $27,000 was accrued.


                                      F-24
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 2005, 2004 AND 2003


(9) STOCKHOLDERS' EQUITY (continued)

      (a) Preferred Stock (continued)

      Series D Redeemable Convertible Preferred Stock (continued)

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

      Since the redemption is payable in common stock at the Company's option,
the Series D Preferred was originally included in shareholders' equity. However,
the number of common shares issuable upon redemption is dependent upon a volume
weighted average trade price of the Company's common stock which is currently
indeterminable and may exceed the number authorized at such time. Since
obtaining stockholder approval to increase the authorized shares is not under
the control of the Company, the Series D Preferred has been retroactively
reclassified as temporary equity (mezzanine) for all periods presented (Note
14).

      The Company accounts for the registration rights agreement as a separate
freestanding instrument and accounts for the liquidated damages provision as a
derivative liability subject to SFAS No. 133. The estimated fair value of the
derivative liability is based on estimates of the probability and costs of cash
penalties expected to be incurred and such estimates are revalued at each
balance sheet date with changes in value recorded in other income. As of
December 31, 2005 and 2004 the Company has estimated the fair values of these
derivative liabilities to be nominal and accordingly no liability has been
recorded. There were no changes to the estimated fair value during the years
ended December 31, 2005, 2004 and 2003.


                                      F-25
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 2005, 2004 AND 2003


(9) STOCKHOLDERS' EQUITY (continued)

      (a) Preferred Stock (continued)

      The following table summarizes the common stock issuable upon conversion
of all outstanding Preferred Stock and the exercise of related warrants at
December 31, 2005:

                                                                Shares of Common
                                           Conversion or         Stock Issuable
                                        Exercise Price per      upon Conversion/
         Convertible Security                  Share                Exercise
      ----------------------------      ------------------      ----------------
      Series C-IV Preferred Stock            $1.6412                  2,986,000
      Series D Preferred Stock               $0.7000                  5,414,000
      Series D Warrant                       $0.7600                  2,994,000

      (b) Warrants

      The Company has 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, 2005, including those issued in connection with Preferred Stock and
Convertible Debentures. All warrants were exercisable as of December 31, 2005.

                              Number of         Weighted
           Range of           Warrants          Average
        Exercise Prices      Outstanding     Exercise Price    Expiration Dates
        ---------------      -----------     --------------    ----------------

       $  0.11                 268,000          $  0.11                 2007
       $  0.43 - $ 0.76      3,280,000          $  0.75                 2009
       $  1.43 - $ 1.68      1,650,000          $  1.67             2006 - 2007
                             -----------

                             5,198,000          $  1.01              2006 -2009
                             ===========

      (c) Stock Options

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


                                      F-26
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 2005, 2004 AND 2003


(9) STOCKHOLDERS' EQUITY (continued)

      (c) Stock Options (continued)

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

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


                                      F-27
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 2005, 2004 AND 2003


(9) STOCKHOLDERS' EQUITY (continued)

     (c)  Stock Options  (continued)

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

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

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

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

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

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

                Granted............................................         4,778,000             0.71
                Exercised..........................................          (116,000)            0.35
                Canceled...........................................          (195,000)            0.76
                                                                      ----------------

             Outstanding at December 31, 2005......................        10,299,000            $0.98
                                                                      ================

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

             Exercisable at December 31, 2005......................         8,264,000            $1.05
                                                                      ----------------

             Options available for grant at December 31, 2005......         2,066,000
                                                                      ================
</TABLE>

                                      F-28
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 2005, 2004 AND 2003


(9) STOCKHOLDERS' EQUITY (continued)

     (c)  Stock Options  (continued)

      The following table summarizes information about stock options outstanding
as of December 31, 2005:

<TABLE>
<CAPTION>
                                                   Options Outstanding                      Options Exercisable
                                ----------------------------------------------------    ----------------------------
                                                                  Weighted Average
                                                  Weighted            Remaining                          Weighted
           Range of Exercise      Number           Average      Contractual Life (in      Number          Average
                 Prices          of Shares     Exercise Price          years)           of Shares     Exercise Price
           -----------------    ------------   --------------   --------------------    -----------   --------------
<S>                               <C>             <C>                   <C>              <C>              <C>
           $  0.14 - $  0.46      1,859,000       $  0.37               6.6              1,759,000        $  0.37
           $  0.55 - $  0.69      4,614,000          0.62               7.9              3,638,000           0.56
           $  0.70 - $  0.88      2,895,000          0.79               7.4              1,937,000           0.79
           $  1.25 - $  2.25        522,000          1.48               7.1                521,000           1.48
           $  2.27 - $  3.88        193,000          3.44               4.6                193,000           3.44
           $ 10.63 - $ 11.81        156,000         11.58               4.1                156,000          11.58
           $ 12.25 - $ 25.00         60,000         16.60               3.6                 60,000          16.60
                                ------------                                            -----------
                                 10,299,000       $  0.98               7.3              8,264,000        $  1.05
                                ============                                            ===========
</TABLE>

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

      In December 2004, the Company's then Chief Executive Officer cancelled
1,300,000 of his stock options with exercise prices ranging from $0.74 to $2.50
per share and the Company granted 1,440,000 stock options with an exercise price
of $0.57 per share to other employees.

(10) COMMITMENTS AND CONTINGENCIES

      (a) Operating Leases

      The Company has entered into several non-cancelable leases, primarily
related to the rental of certain facilities. Future minimum lease payments, by
year and in the aggregate, under material operating leases consisted of the
following at December 31, 2005:

              Year ended December 31,                                Amount
                                                                ------------
              2006............................................  $    183,000
              2007  ..........................................       106,000
              2008  ..........................................       106,000
                                                                ------------

                   Total minimum lease payments...............  $    395,000
                                                                ============

      Rent expense under operating leases was approximately $202,000, $170,000
and $127,000 for the years ended December 31, 2005, 2004 and 2003, respectively.


                                      F-29
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 2005, 2004 AND 2003


(10) COMMITMENTS AND CONTINGENCIES (continued)

      (b) Employment Agreements

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

      (c) Litigation

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

      (d) Beijing E-world

      In June 2003, we announced that we had licensed our VP5 and VP6 codecs to
Beijing E-World Technology Co. Ltd. (E-World), a consortium of several Chinese
consumer electronics manufacturers. Under the terms of two license agreements
with E-world, we granted E-World a license to use our codecs in E-World's
Enhanced Versatile Disk (EVD) technology as well as other video products.
E-world is developing EVD as a next-generation videodisk technology that is
hoped will become the industrial standard for China for the recording and
playback of video, audio and data. E-World did not pay certain minimum quarterly
payments that we believed were due under its license agreements with us, and we
commenced an arbitration proceeding seeking damages for E-World's failure to
perform. In a ruling issued March 10, 2005, the arbitrator rejected our claims
that E-World had breached the agreements and also denied a request by E-World to
declare that it had complied with its obligations under the agreements. The
arbitrator further noted that agreements remained in effect and that the parties
had a continuing obligation to work to jointly select and port On2's software to
two commercial DSPs for use in the EVD players. Despite the arbitrator's
expectations regarding completion of the porting work, On2 and E-world have not
made significant progress on the porting.

      (e) Other Matters

      In July 2001, the Company entered into a Common Stock Purchase Agreement
with RealNetworks, Inc. ("Real") whereby Real purchased 1,786,000 shares of the
Company's Common Stock for net proceeds of $1,000,000 and entered into a
Software Development and License Agreement with Real as its exclusive delivery
platform for streamed content over the internet. The Company agreed to develop
software plug-ins in order to incorporate the technologies of the Company and
Real and to license its compression technology for use in Real's media delivery
products and services for a four-year term. In order for the Company to develop
the plug-ins described in the agreement, Real was to provide certain development
software and fulfill certain other obligations. The Company believes that Real
failed to deliver such software and perform such other obligations. During 2002,
the Company notified Real that it had terminated the agreement. Real 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


                                      F-30
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 2005, 2004 AND 2003


      (e) Other Matters (continued)

revenue under arrangements with customers. The accompanying financial statements
do not include any provision for the outcome of this matter, which could have a
material adverse effect on the Company's business and financial condition.

(11) RELATED PARTY TRANSACTIONS

      During the years ended December 31, 2005, 2004 and 2003, the Company
retained a law firm to perform certain legal services on its behalf and incurred
approximately $13,000, $38,000 and $56,000, respectively, for such legal
services. A member of the Company's board of directors is a partner at the law
firm.

      During the years ended December 31, 2005, 2004 and 2003, the Company
retained a consulting firm to facilitate customer relationships in Asia and
incurred approximately $34,000, $122,000 and $108,000, respectively, for such
services. A consultant at the consulting firm became a director of the Company
in August 2003.

      During the years ended December 31, 2005, 2004 and 2003, the Company's
then Chief Executive Officer served as a director for one of the Company's
customers. The Company recognized revenue of $289,000 and $150,000 from this
customer in 2004 and 2003, respectively.

(12) SUBSEQUENT EVENTS

      Subsequent to December 31, 2005, 175 shares of Series D Preferred were
converted into 250,000 shares of the Company's Common Stock.

      Subsequent to December 31, 2005, the Company granted extensions of
1,600,000 warrants at an exercise price of $1.68 that were due to expire on
January 29, 2006. As part of the Agreement the expiration date was changed to
December 31, 2006 and a mandatory exercise provision was added as follows: If
during the exercise period, the volume weighted average price for each of 10
consecutive trading days equals or exceeds $1.93, the holders shall within five
trading days, convert all of these warrants.

(13) SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)

      Quarterly financial data for fiscal 2005 and 2004 is as follows:

<TABLE>
<CAPTION>
                                                                       Quarter Ended 2005
                                                -----------------------------------------------------------------
                                                                                   September
                                                   March 31,        June 30,        30, (1)       December 31,
                                                -----------------------------------------------------------------
<S>                                              <C>              <C>              <C>              <C>
Revenue                                          $   353,000      $   346,000      $   507,000      $ 1,002,000

Gross profit (loss)                                  (16,000)         (64,000)          37,000          332,000
Net loss                                          (1,302,000)      (1,141,000)      (1,044,000)      (1,118,000)
Net loss attributable to common stockholders      (1,585,000)      (1,424,000)      (3,742,000)      (1,198,000)
Basic and diluted net loss attributable to
common stockholders per share                    $     (0.02)     $     (0.02)     $     (0.04)     $     (0.01)


                                                      F-31
</TABLE>
<PAGE>

<TABLE>
<CAPTION>
                                             ON2 TECHNOLOGIES, INC.
                                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                        DECEMBER 31, 2005, 2004 AND 2003


                                                                       Quarter Ended 2004
                                                ---------------------------------------------------------------
                                                   March 31,        June 30,     September 30,    December 31,
                                                ---------------------------------------------------------------
<S>                                              <C>              <C>              <C>              <C>
Revenue                                        $   594,000      $ 1,570,000     $   762,000      $   102,000
Gross profit (loss)                                252,000        1,235,000         363,000         (259,000)
Net income (loss)                                 (723,000)          62,000        (917,000)      (1,867,000)
Net income (loss) attributable to common
stockholders                                      (723,000)          62,000        (917,000)      (2,058,000)

Basic and diluted net loss attributable to
common stockholders per share                  $     (0.01)     $      0.00     $     (0.01)     $     (0.03)

</TABLE>

     (1) Restated to write off, as of September 30, 2005, the unamortized
         balance of deferred financing costs of $111,000 related to the Series D
         Preferred. The net loss attributable to common stockholders and the per
         share amount for the nine months ended September 30, 2005, as restated,
         are $6,751,000 and $0.08, respectively.

(14)  RESTATEMENT

      As described in Note 9(a), there would be an indeterminable number of
shares issuable upon redemption of the Series D convertible preferred stock if
the Company were to pay such redemption in common stock. This might require
approval to increase the number of common shares authorized, which is deemed to
be outside of the Company's control. Accordingly, the Company has retroactively
reclassified the Series D Convertible Preferred Stock from permanent equity to
mezzanine for all periods presented in the accompanying consolidated financial
statements. As a result, $189,000 of the financing costs have been allocated to
the Series D Convertible Preferred Stock based on the relative fair value and
have been reclassified to deferred financing costs with a corresponding increase
to additional paid-in capital. The discount of $2,964,000 has been reflected as
an increase to additional paid-in capital and a discount to the Series D
convertible preferred stock, which is presented net of the amortized discount on
the accompanying balance sheets. The amortization of the discount and the
financing costs are charged to net loss attributable to common stockholders,
which increases the accumulated deficit. Additionally, as described in Note
(13), $111,000 of deferred financing costs have been written off as of September
30, 2005.

      The unaudited 2005 interim condensed consolidated balance sheets, as
restated, are as follows:

<TABLE>
<CAPTION>
                                                           March 31,         June 30,      September 30,
                                                        ------------------------------------------------
<S>                                                      <C>              <C>               <C>
Deferred financing costs                                 $    154,000     $    132,000      $         --
Total assets                                                9,099,000        7,951,000         6,802,000
Series D Convertible Preferred Stock (mezzanine)            1,336,000        1,516,000         4,000,000
Total stockholders' equity                                  6,957,000        5,612,000         2,090,000
Total liabilities and stockholders' equity                  9,099,000        7,951,000         6,802,000
</TABLE>


                                      F-32
<PAGE>

                             ON2 TECHNOLOGIES, INC.
                 SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
<TABLE>
<CAPTION>
                                                Balance at         Charged to       Charged to                          Balance at
                                                 Beginning          Costs and          Other                              End of
                Description                      Of Period          Expenses         Accounts          Deductions         Period
                                                -----------        -----------     ------------       -----------       ----------
<S>                                              <C>               <C>             <C>                 <C>              <C>
Year ended December 31, 2005 allowance for
doubtful accounts                                $ 140,000                         $      --           $(127,000)       $  13,000
Year ended December 31, 2004 allowance for
doubtful accounts                                $  15,000         $ 125,000       $      --                            $ 140,000
Year ended December 31, 2003 allowance for
doubtful accounts                                $  50,000         $  15,000       $      --           $ (50,000)       $  15,000
</TABLE>


                                                                S-1