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UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington, D.C. 20549


Form 10-KSB


|           |  |                                                                                                  
|---------- |  | -------------------------------------------------------------------------------------------------
|(Mark One) |  |                                                                                                  
|þ          |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR
    15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934     
|          
|           |  | For the fiscal year ended December 31,
    2002                                                  
|          
|o          |  | TRANSITION REPORT PURSUANT TO SECTION 13
    OR 15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934.

Commission file number 1-15117.

On2 Technologies, Inc.

(Exact name of registrant as specified in its
charter)


|                                                                                                  |  |                                         
|------------------------------------------------------------------------------------------------- |  | ----------------------------------------
|Delaware                                                                                          |  | 84-1280679                              
|(State or other jurisdiction of
    incorporation or organization)                                |  | (I.R.S. Employer
    Identification No.)
|                                                                                                 
|21 Corporate Dr.,
    Suite 103,
    Clifton Park, NY(Address of principal executive
    offices) |  | 12065(Zip Code)                         

Registrants telephone number, including
area code:

(518) 348-0099


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

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

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

None


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

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

Issuers revenues for the year ended
December 31, 2002 were approximately $3,353,000.

The aggregate market value of the voting stock
held by non-affiliates of the registrant as of the last business
day of the registrants most recently completed fiscal
quarter was approximately $16,828,449.

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

APPLICABLE ONLY TO CORPORATE
ISSUERS:

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

59,612,650 shares as of March 13, 2003.

DOCUMENTS INCORPORATED BY REFERENCE

Items 9, 10, 11, and 12 of Part III are
incorporated by reference from the Companys definitive
Proxy Statement for the Annual Meeting of Stockholders, to be
held on May 21, 2003. Registrants definitive Proxy
Statement will be filed with the Securities and Exchange
Commission on or before 120 days after December 31,
2002.

Transitional Small Business Disclosure Format
(Check one):     Yes o          No þ



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Table of Contents

|           |          |    |                                                                                                                         |  |   
|---------- | -------- | -- | ----------------------------------------------------------------------------------------------------------------------- |  | --
|PART I     |          |   
|           | ITEM 1.  |    | DESCRIPTION OF BUSINESS                                                                                                 |  | 2 
|           | ITEM 2.  |    | DESCRIPTION OF PROPERTY                                                                                                 |  | 7 
|           | ITEM 3.  |    | LEGAL PROCEEDINGS                                                                                                       |  | 7 
|           | ITEM 4.  |    | SUBMISSION OF MATTERS TO A VOTE OF SECURITY
    HOLDERS                                                                 |  | 8 
|PART II    |          |   
|           | ITEM 5.  |    | MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER
    MATTERS                                                            |  | 8 
|           | ITEM 6.  |    | MANAGEMENTS DISCUSSION AND ANALYSIS OF
    FINANCIAL CONDITION AND RESULTS OF OPERATIONS                               |  | 19
|           | ITEM 7.  |    | FINANCIAL STATEMENTS                                                                                                    |  | 23
|           | ITEM 8.  |    | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
    ACCOUNTING AND FINANCIAL DISCLOSURE                                |  | 23
|PART III   |          |   
|           | ITEM 9.  |    | DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND
    CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE
    EXCHANGE ACT |  | 23
|           | ITEM 10. |    | EXECUTIVE COMPENSATION                                                                                                  |  | 23
|           | ITEM 11. |    | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
    AND MANAGEMENT                                                      |  | 23
|           | ITEM 12  |    | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                                                                          |  | 23
|           | ITEM 13  |    | CONTROLS AND PROCEDURES                                                                                                 |  | 24
|           | ITEM 14  |    | EXHIBITS AND REPORTS ON FORM 8-K                                                                                        |  | 24
|Signatures |          | 26

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PART I



|        |                        
|------- | -----------------------
|Item 1. | Description of Business

Forward-Looking Statements

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

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

Overview

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

Business Strategy

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



| |   |                                                                                                                                                                                                                              
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | developing and expanding our expertise in video
    compression and streaming software;                                                                                                                                      
|
| |  | continuing our research and development efforts
    to increase the quality of video technology in order to improve
    the experience of end users;                                                                         
|
| |  | leveraging our existing products and services to
    support new products and services and to expand our presence in
    multiple industries, including the Internet, wireless
    applications and consumer electronics; and
|
| |  | expanding into international markets by
    contracting resellers of our products and services.                                                                                                                              

Our Technology, Products and
Services

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

2



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| |                      
| | ---------------------
| | TrueMotion VP3 Series

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



| |                  
| | -----------------
| | Open Source VP3.2

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

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



| |          
| | ---------
| | VP4 Codec

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



| |          
| | ---------
| | VP5 Codec

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



| |                     
| | --------------------
| | TrueMotion 2X (TM2X)

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

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

3



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| |                                           
| | ------------------------------------------
| | Audio for Video Codec Technology
    (AVC)

AVC is an advanced compression algorithm that is
ideal for a variety of audio sources, including music, human
speech, film and broadcast television. AVC can achieve very high
quality audio at bit rates lower than current standards such as
MP3 or AC-3. This algorithm is designed for easy portability to
embedded devices and can be licensed for a lower per-unit cost
than other audio codecs on the market. AVC has been optimized to
run with the VP3, VP4 and VP5 video codecs, and this combination
can provide a seamless low-bit-rate multimedia experience. VP4
combined with AVC is comparable to MPEG2 combined with AC-3, but
with a substantial data rate savings. It is ideal for VOD
deployment over DSL or cable networks. AVC also allows for less
transfer time and storage space for downloaded files.



| |                      
| | ---------------------
| | On2s Encoder Product

The On2s Encoder enables content owners to
efficiently re-master and compress their assets into the VP4 or
VP5 format at their own convenience. Beginning with capturing
uncompressed video through high quality SDI inputs, users can
create an optimized digital file using our proprietary
re-mastering tools. These tools are geared toward the video
professional that wants exact control over the optimization
process. Once the raw file has been optimized, our compression
software has the capability of creating multiple data rate
compressed files.



| |                         
| | ------------------------
| | TrueCast®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 (i.e. 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 VP4/VP5 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 September of 2002 On2 released TrueCast
version 7.4. This version of TrueCast provides support for
multicast presentations, local playback of AVI files from a
users hard disk, and set-top box/DSP platforms from Texas
Instruments, Equator Technologies, and others.

In addition, TrueCast 7.4 is able to stream
content that is captured and encoded directly from
live video sources using the companys
revolutionary VP5 real-time encoder. This feature is ideal for
time-critical applications such as streaming live events, video
conferencing, Digital Television over DSL, and personal video
recorders.



| |                                                           
| | ----------------------------------------------------------
| | Digital Signal Processor (DSP) and Server
    Integrations

VP4 and VP5 have both been integrated (i.e.
ported) with the Equator MAP-CA and
Equator BSP-15. VP4 and VP5 have also both been ported to
Texas Instruments 6200 and 6400 DSPs. The On2 player
has been ported to Equators Dolphin and Tetra platforms as
well as Texas Instruments 64x platform. The purpose of
performing these ports is to facilitate the use of On2s
codec in set-top-box and other consumer device deployments.

Pursuant to an agreement with SeaChange
International, Inc. announced in May 2002, SeaChanges
MediaCluster servers now have the ability to stream VP4 and VP5
encoded files. SeaChange is the leading international supplier
of digital video servers for cable companies worldwide.



| |                  
| | -----------------
| | Videoconferencing

In July 2002 On2 announced that its VP5
compression technology had been selected to power a web based
video conferencing application being developed by EyeNx, Inc.
EyeNxs video conferencing system will be targeted toward
business and friends & family markets around the world. The
video conferencing software

4



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has a number of key attributes including
high-quality, full duplex audio, real-time video, instant text
communication, free worldwide long-distance, and a centralized
user directory. The EyeNx videoconferencing system is expected
to be commercially deployed in the first half of 2003.
On2s agreement with EyeNx provides for the payment to On2
of per-unit licensing fees based upon the number of video
conferencing applications deployed.


Services

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



| |                                               
| | ----------------------------------------------
| | Custom Engineering and Consulting
    Services

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



| |                         
| | ------------------------
| | Research and Development

The focus of our research and development
activities is to improve and expand upon our core codec
technology, which improves the video experience for end users.
Our research and development efforts have enabled us to provide
quality video compression and decompression at lower broadband
data rates and certain narrowband data rates. We believe that
continued advances in our technology are key to the success of
our business. Consequently, we devote a substantial portion of
our resources to our research and development efforts. Research
and development expenses for the year ended December 31,
2002 were $2,149,000 as compared to $3,856,244 for the year
ended December 31, 2001.

Sales and Business Development

The goal of our sales and business development
departments is to build relationships that fall into two basic
categories: professional services and product licensing.
Professional services primarily focus on porting or optimizing
our compression technologies to multiple hardware platforms used
in video delivery solutions. Our sales and business development
teams focus on engaging chip-set manufacturers, global cable and
telecommunication companies and manufacturers of hardware
platforms for consumer electronic and wireless devices.
Additionally, our sales and business development teams focus on
selling encoding and streaming software licenses to content
providers who are delivering video over proprietary networks and
to IP-based end users.

International

We believe that we are well positioned to
selectively expand our business internationally. With its vast
amount of broadband networks, we believe Asia is one of the
strongest markets for video-on-demand initiatives. Our
International sales and business development efforts have been
focused in this region to date. We are currently involved with
several Asian entities in which we have designed and engineered
set-top box deployments. An additional method for international
expansion is the appointment of resellers of our products and
services whereby such resellers purchase software licenses from
us and sell them in a designated international market. To date,
we have signed reseller agreements for both the Japanese and
Korean markets.

For the year ended December 31, 2002,
foreign customers accounted for approximately 50% of total
revenue. These customers are primarily located in Asia. For the
year ended December 31, 2001, foreign customers accounted
for approximately 67% of total revenue.

Additionally, 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. There was no revenue generated
from the United Kingdom operations for the years ended
December 31, 2002 and 2001.

5



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Competition

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

Our business is highly competitive and affected
by rapid change. We believe that the principal competitive
factors in our business include technological innovation,
versatility of products, pricing, customer service, network
quality, service offerings and the flexibility to adapt to
changing market conditions. In the broadband codec market, we
compete with companies such as Microsoft, Intel, RealNetworks,
Apple and Sorenson, and in the proprietary networks market, we
compete with MPEG2 and MPEG4 and several codecs that position
themselves as MPEG4-based. We also compete with
companies that provide encoding services and companies that
encode their content in-house. In establishing our business
strategy, we face a number of strong, firmly entrenched
competitors who are currently providing similar services to
low-bandwidth and high-bandwidth users. These and other
companies are already providing broadband video-based services
and technology. In addition to competition from other content
and technology companies, well-established media distribution
companies, particularly in the cable television and satellite
markets, have established, and continue to seek to establish,
interactive, on-demand digital services through the development
of sophisticated digital set-top technology and related back-end
server systems. Many of our existing competitors have, and some
future competitors may have, significantly greater financial and
technical resources than we have.

Customers

Our customers, and the potential customers of our
resellers, typically are large digital communication and media
companies, entertainment companies, telecommunication companies
and other global corporations that operate within the digital
media industry. Our top ten customers for the year ended
December 31, 2002 on revenue basis were (in descending
order): Media Cruise Solutions, K.K., Picosoft Ltd., Impact
Imaging, Inc., EyeNx, Inc., Equator Technologies, Inc., America
Online, Inc., Texas Instruments Incorporated, Sony Corporation,
NTT Software Corporation and World Theatre, Inc. These ten
customers accounted for 27%, 11%, 11%, 9%, 8%, 8%, 7%, 4%, 4%,
and 3%, respectively, of total revenue for the year ended
December 31, 2002.

Intellectual Property

We regard much of our technology as proprietary
and try to protect it by relying on trademarks, copyrights,
patents, trade secret laws and confidentiality agreements. We
regard our copyrights, service marks, trademarks, trade secrets,
proprietary technology and similar intellectual property as
critical to our success. We currently hold several
U.S. patents and have some U.S. and international
patent applications pending. We believe that the patents that
are currently issued are not material to our business. While we
try to assure that the quality of the On2 brand is maintained
through such measures, there can be no assurance that steps we
have taken and continue to take to protect our proprietary
rights will be adequate or that third parties will not infringe
on our intellectual property. In addition, there can be no
assurance that third parties will not assert infringement claims
against us which, even if not meritorious, could result in the
expenditure of substantial resources and management effort.

In connection with our software license
agreements with third parties, we seek to control access to and
distribution of our technology, documentation and other
proprietary information. Even with all of these precautions, it
could be possible for someone else to either copy or otherwise
obtain and use our proprietary information without our
authorization or to develop similar technology independently.
Effective trademark, copyright and trade secret protection may
not be available in every country in which our services are made
available through the Internet, and policing unauthorized use of
our proprietary information is difficult and expensive. We
cannot be sure that the steps we have taken will prevent
misappropriation of our proprietary information. Any
misappropriation could have a material adverse effect on our
business. In the future, we may need to go to court to either
enforce our intellectual property rights, to protect our trade
secrets or to

6



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determine the validity and scope of the
proprietary rights of others. That litigation might result in
substantial costs and diversion of resources and management
attention.


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

Government Regulation

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

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

Employees

As of December 31, 2002, we had
approximately 24 full-time employees. Of the total employees, 18
were engineering and product development personnel, 1 was sales
and marketing personnel and 5 were general and administrative
personnel.

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



|        |                        
|------- | -----------------------
|Item 2. | Description of Property

We do not own any real property. We lease
approximately 5,540 square feet of space where our principal
executive, administrative and engineering offices are located at
21 Corporate Dr., Suite 103, Clifton Park, NY 12065 at an
annual rental of approximately $72,000. This lease expires on
January 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, although management
believes that during 2003 it may rent office space in New York
City in order to accommodate several executive and
administrative officers who reside in the New York City area.



|        |                  
|------- | -----------------
|Item 3. | Legal Proceedings

The Company sued Impact Imaging, Inc. on
December 10, 2002 in the Supreme Court of the State of New
York, County of New York. Our complaint alleged breach of
contract and fraud arising from Impact Imagings improper
license of certain On2 software. Impact Imaging obtained this
software pursuant to a January 23, 2002 License and
Services Agreement between On2 and Impact Imaging. On2s
complaint sought compensatory damages, punitive damages,
attorneys fees and a declaratory judgment. Impact Imaging
removed the case to United States District Court for the
Southern District of New York on December 16, 2002. Impact
Imaging counterclaimed on February 20, 2003 alleging that
the Company unlawfully disclosed Impact Imagings
proprietary information and requesting damages in amounts to be
determined at trial. On

7



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March 24, 2003, the Company entered into a
settlement agreement with Impact Imaging. Pursuant to this
settlement agreement, the Company and Impact Imaging agreed,
subject to certain exceptions relating to specific Impact
Imaging customers, to terminate the License and Services
Agreement and all licenses and sublicenses granted thereunder.


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



|        |                                                        
|------- | -------------------------------------------------------
|Item 4. | Submission of Matters to a Vote of Security
    Holders

None.

PART II

Item 5.     Market
for Common Equity and Related Stockholder Matters

Our common stock is traded on the American Stock
Exchange under the symbol ONT. The following table
sets forth for the fiscal periods indicated the high and low bid
prices of our common stock, as reported on the American Stock
Exchange, since our inception on June 15, 1999:

|                 |                                        |      |   |      |  |  |   |      | 
|---------------- | -------------------------------------- | ---- | - | ---- |  |  | - | ---- | 
|                 |                                        | High |   | Low 
|                 |                                        |      |   |     
|Fiscal Year 2003 |                                        |      |   |      |  |  |   |     
|                 | First Quarter (through March 26, 2003) |      | $ | 0.50 |  |  | $ | 0.27 | 
|Fiscal Year 2002 |                                        |      |   |      |  |  |   |     
|                 | First Quarter                          |      | $ | 0.50 |  |  | $ | 0.37 | 
|                 | Second Quarter                         |      | $ | 0.46 |  |  | $ | 0.23 | 
|                 | Third Quarter                          |      | $ | 0.35 |  |  | $ | 0.08 | 
|                 | Fourth Quarter                         |      | $ | 0.54 |  |  | $ | 0.22 | 
|Fiscal Year 2001 |                                        |      |   |      |  |  |   |     
|                 | First Quarter                          |      | $ | 2.05 |  |  | $ | 0.46 | 
|                 | Second Quarter                         |      | $ | 0.85 |  |  | $ | 0.43 | 
|                 | Third Quarter                          |      | $ | 0.87 |  |  | $ | 0.46 | 
|                 | Fourth Quarter                         |      | $ | 0.41 |  |  | $ | 0.29 | 

There were approximately 266 stockholders of
record of our common stock as of March 26, 2003.

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.

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

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 Company board members. The debentures are
convertible into the Companys $0.01 par value common stock
(Common Stock) at a price of $0.112. In addition,
the Company issued to the purchasers of the debentures, warrants
to acquire the Companys Common Stock. The Company sold
sixty-five units with a principal amount of $10,000 per unit;
each unit contained one warrant to purchase 20% warrant coverage
shares of Common Stock at $0.112 per share. The debentures
require interest to be paid each November and May. The interest
is payable in common stock based on the average closing price of
the stock for the ten trading days prior to the payment date.
The debentures are convertible into 5,804,000 shares of Common
Stock. The warrants are convertible into 1,161,000 shares of
Common Stock. We relied on Section (4)(2) of the Securities Act
in issuing the debentures and warrants without registration.

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Use of Proceeds from Registered
Securities

The SB-2 Registration Statement filed by the
Company and deemed effective by the U.S. Securities and Exchange
Commission (the SEC) as of April 19, 2002 (SEC
File No. 333-74194), offered a maximum of 13,704,717 shares
of the Companys $0.01 par value common stock. As of
March 25, 2003, the Company had sold 6,488,104 shares of
common stock under the SB-2 Registration Statement for an
aggregate net proceeds to the company of $1,027,000. The direct
and indirect expenses of the offering as of March 25, 2003
totaled $121,111.10. These expenses consisted of $114,111.10 of
underwriting discounts given to Crossover Ventures, the
underwriter of the offering, and approximately $2,000 in
printing costs and $5,000 in legal fees. The Company used the
proceeds from the offering for general working capital. None of
the proceeds of the offering were paid by us, directly or
indirectly, to any of our directors, officers or general
partners or any of their associates, to any persons owning ten
percent or more of our outstanding stock, or to any of our
affiliates, except for payments made to McGuireWoods LLP, the
law firm that represented us in connection with the SB-2
Registration Statement.

Item
6.     Managements Discussion
and Analysis of Financial Condition and Results of
Operations

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

Overview

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

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

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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 are currently operating.


In 2001, the Company completed certain
restructuring initiatives that were related to the plan
established by the Board of Directors in 2000. Although
identified as of December 31, 2000, our obligations could
not be measured at that time. As a result, we recorded a
non-cash restructuring charge of $293,000 for the year ended
December 31, 2001. The non-cash restructuring charge was
comprised of the following: (1) $210,000 related to the
termination of an employment contract which was satisfied
through the issuance of 150,000 shares of Common Stock in
February 2001 and (2) $83,000 related to the termination of
a commercial lease obligation in San Francisco which was
satisfied through the issuance of 80,000 shares of Common Stock
in March 2001.

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

In view of the 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, 2002, we had an
accumulated deficit of $105.1 million. We will continue to
incur costs to develop, introduce and enhance products and
services, build brand awareness and grow our business. We may
also incur significant additional costs related to technology,
marketing or acquisitions of businesses and technologies to
respond to changes in this rapidly developing industry. These
costs may not correspond with any meaningful increases in
revenues in the near term, if at all. As such, these costs may
result in negative operating cash flows until such time as we
generate sufficient revenues to offset such costs.

Critical Accounting Policies and
Estimates

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



| |   |                                                                         
| | - | ------------------------------------------------------------------------
| |  | Revenue recognition                                                     
|
| |  | Valuation of goodwill, intangible assets and
    other long-lived assets

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

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

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

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

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

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.
The Company will continually evaluate its purchased technology
upon significant changes in certain circumstances that may
result in an impairment of the net carrying value.

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

Results of Operations

Revenues.Revenues
for the year ended December 31, 2002 were $3,353,000 as
compared to $2,220,000 for the year ended December 31,
2001. Revenues for the years ended December 31, 2002 and
2001 were derived primarily from engineering and consulting
services, encoding services and the sale of software licenses.
The following table sets forth the allocation of revenues, in
terms of percentages, for the years ended December 31, 2002
and 2001:

|                           |       |      |    |      |   |  |    |     |  
|-------------------------- | ----- | ---- | -- | ---- | - |  | -- | --- | -
|                           |       | 2002 |    | 2001
|                           |       |      |    |     
|Engineering and Consulting |       |      | 46 | %    |   |  | 65 | %  
|Licensing                  |       |      | 53 | %    |   |  | 17 | %  
|Encoding                   |       |      | 1  | %    |   |  | 15 | %  
|Content                    |       |      |   |      |   |  | 3  | %  
|                           |       |      |    |      |   |  |    |    
|                           | Total |      |    | 100  | % |  |    | 100 | %
|                           |       |      |    |      |   |  |    |    

For the year ended December 31, 2002,
engineering and consulting revenues and software licenses were
the significant revenue streams. Engineering and consulting
services and the sale of software licenses will be the
significant future revenue steams 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. We believe that
the shift from video delivery over IP-based networks to
proprietary networks and wireless devices will continue to
reduce the amount of encoding services we provide as we foresee
content providers purchasing our encoding software as opposed to
contracting with us to perform the services in-house.

For the year ended December 31, 2001,
revenues were primarily related to engineering and consulting,
software licenses and encoding services.

OPERATING EXPENSES

The Companys operating expenses consist of
cost of revenues, research and development, sales and marketing,
general and administrative expenses (including amortization of
goodwill and intangible assets, cost curtailment and
restructuring charges, impairment charges and non-cash stock
based compensation). Operating expenses for the year ended
December 31, 2002 were $8,621,000 as compared to
$17,599,000 for the year ended December 31, 2001.

Cost of Revenues.Cost of revenues includes personnel and consulting compensation
costs, related overhead expenses, bandwidth costs, fees paid for
licensed technology, depreciation costs and the amortization of
purchased technology. Cost of revenues was $2,056,000 for the
year ended December 31, 2002 as compared to $2,233,000 for
the year ended December 31, 2001. Included in cost of
revenue for the year ended December 31, 2001 were
approximately $200,000 related to compensation, production costs
and content licensing fees attributable to our broadband content
network which ceased operations in the first quarter of 2001. We
do not intend to incur any future costs associated with the
production or distribution of content. Future costs of revenues
will consist primarily of compensation costs for engineering and
consulting personnel, bandwidth costs, depreciation costs and
any licensing fees or royalties paid for third party software
products. We did not have material third party licensing fees
for the periods presented. Amortization of purchased technology
was $627,000 for each of the years ended December 31, 2002
and 2001.

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Research and
Development.Research and development
expenses primarily consist of salaries and related expenses and
consulting fees for research and product development personnel
associated with the development and production of our products
and services, operating lease costs and depreciation costs.
Research and development expenses for the year ended
December 31, 2002 were $2,149,000 as compared to $3,856,000
for the year ended December 31, 2001. The decrease is
primarily attributed to a reduction in research and development
personnel attributed to our cost savings initiatives that
continued from 2001 through 2002 and the closing of our New York
City office in September 2002. We believe that continued
investments in research and development are necessary to
maintain our competitive advantage and we will continue to
invest in such costs as considered necessary.

Sales and Marketing.Sales and marketing expenses consist primarily of salaries and
related costs of sales, business development and marketing
personnel, tradeshow costs, marketing and promotional costs
incurred to create brand awareness and public relations
expenses. Sales and marketing expenses for the year ended
December 31, 2002 were $924,000 as compared to $2,295,000
for the year ended December 31, 2001. The decrease is
primarily attributable to a decrease in our personnel a decrease
in our tradeshow costs and marketing efforts. We intend to
continue to recruit and hire experienced personnel, as
necessary, to sell and market our products and services.

General and
Administrative.General and
administrative expenses (excluding amortization of goodwill and
other intangibles, cost curtailment and restructuring charges,
impairment charges and non-cash stock-based compensation)
consist primarily of salaries and related personnel costs for
general corporate functions including finance, human resources,
legal and facilities, outside legal and professional fees and
insurance. These general and administrative costs for the year
ended December 31, 2002 were $2,846,000 as compared to
$4,693,000 for the year ended December 31, 2001. The
decrease is attributable to decreased personnel, a decrease in
legal fees resulting from a decrease in M&A activity, a
decrease in depreciation, a decrease in rent attributable to the
closing of our New York City office in September 2002 and a
general decrease in unallocated operating overhead attributable
to an entity-wide decrease in personnel.

Amortization of Goodwill and Other Intangible
Assets.The amortization of goodwill
and other intangible assets primarily relates to our
acquisitions costs of CII, Quickband and Eight Cylinder Studios
Inc. Amortization of goodwill and other intangibles assets
excludes the amortization of purchased technology, which is
recorded in cost of revenues. Amortization of goodwill and
intangible assets was $19,000 for the year ended
December 31, 2002 as compared to $1,154,000 for the year
ended December 31, 2001. The decrease is due to the
writeoff of substantially all of these assets as of
December 31, 2001.

Cost Curtailment and Restructuring
Charges.Cost curtailment and
restructuring charges were $581,000 and $293,000 for the years
ended December 31, 2002 and 2001, respectively.

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

In 2001, the Company completed certain
restructuring initiatives that were related to the plan
established by the Board of Directors in December 2000. Although
identified as of December 31, 2000, our obligations could
not be measured at that time. As a result, we recorded a
non-cash restructuring charge of $293,000 for the twelve months
ended December 31, 2001. The non-cash restructuring charge
was comprised of the following: (1) $210,000 related to the
termination of an employment contract which was satisfied
through the issuance of 150,000 shares of Common Stock in
February 2001 and (2) $83,000 related to the termination of
a commercial lease obligation in San Francisco which was
satisfied through the issuance of 80,000 shares of Common Stock
in March 2001.

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Impairment Charges.Impairment charges were $30,000 and $2,931,000 for the years
ended December 31, 2002 and 2001, respectively.

For the year ended December 31, 2002, we
recorded an impairment charge of $30,000, related to the
remaining balance of the Quickband content library.

For the year ended December 31, 2001, the
Company recorded an impairment charge of $470,000, related to
its Quickband content library. The Company acquired the content
library, consisting primarily of licensed content for
distribution through DVD sales and the Internet, in April 2000.
The library was originally acquired for the Companys
broadband content network, which ceased operations in the second
quarter of 2000. However, the Company continued to sell the
licensed Quickband content, via DVD sales, through a
distribution agreement acquired in connection with the library.
As of December 31, 2000, the Company terminated all
operations related to its content assets. At that time, the
Company determined that further distribution of the Quickband
content would result in recurring losses. The Company made the
decision to sell the library and reduced the carrying value of
the library to $500,000 at December 31, 2000. This amount
represented the estimated fair value based upon interest in the
library at that time from several potential buyers, which never
materialized. The Company periodically reviewed the value of the
library against market demand and recorded a subsequent
impairment charge of $470,000 in 2001 based upon the perceived
value of the library and its content in the market.

For the year ended December 31, 2001, the
Company recorded an impairment charge $2,344,000 related to its
acquisition of 8CS in November 2000. The impairment charge
represented the net carrying value of the goodwill and
intangible assets recorded in connection with the acquisition.
8CS was a developer of three-dimensional graphic interface
software. The intention of the acquisition was to integrate the
Companys video compression technology with a
three-dimensional web browser to provide a PC-based video
delivery solution. As a result of the economic downturn and the
reduction in its financial resources, the Company determined
that additional development of the 8CS technology was not cost
beneficial. Furthermore, the Company was unsuccessful in its
attempts to sell the technology or create a strategic
partnership for further development. As the Company reached the
one-year anniversary of the 8CS acquisition in the fourth
quarter of 2001, the Company concluded that the
8CS acquisition would provide no future benefit or value
and wrote-off the remaining goodwill and intangible assets. As
of December 31, 2001, there were no material tangible
assets related to 8CS nor would the Company incur additional
costs. Additionally, the Company did not recognize any revenue
related to 8CS since it was acquired.

The Company recorded a charge of $117,000 related
to certain intangible assets from which the Company would no
longer derive a benefit. The write-off reflected the net book
value of the assets at the time they were no longer deemed to
have value.

Non-Cash Stock Based
Compensation.Non-cash stock based
compensation was $16,000 for the year ended December 31,
2002 as compared to $144,000 for the year ended
December 31, 2001. Non-cash stock based compensation for
the year ended December 31, 2002 represents warrants issued
to consultants to purchase common stock in exchange for services
provided to the Company. Non-cash stock based compensation for
the year ended December 31, 2001 represents shares of
common stock issued to our Non-Executive Chairman in lieu of
cash compensation and options to purchase shares of Common Stock
granted to certain consultants.

Interest and Other Income (Expense),
Net.Interest and other income
(expense) was ($5,000) for the year ended December 31,
2002 as compared to $(1,589,000) for the year ended
December 31, 2001. Interest and other income
(expense) primarily consists of interest earned on our cash
and cash equivalent balances, interest paid for capital lease
obligations, debentures and the amortization of debt discounts.
The decrease in interest and other expense is a result of a
decrease in interest income due to a decrease in the average
balance of our cash and cash equivalents and approximately
$1,385,000 of debt discount amortization related to our
Series A convertible debenture financing. The debt discount
was fully amortized as of December 31, 2001.

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Income Taxes.Income
taxes are based solely on state and local taxes on business and
investment capital. Income taxes for the year ended
December 31, 2002 were $28,000 as compared to $64,000 for
the year ended December 31, 2001. The decrease is
attributable to a decrease in our investment capital.

At December 31, 2002, we had approximately
24 full-time employees. We expect to hire employees as
necessary in order to attain our strategic objectives.

Liquidity and Capital Resources

At December 31, 2002, we had cash reserves
of $553,000 as compared to $216,000 at December 31, 2001.
At December 31, 2002 we had working capital of $731,000 as
compared to $95,000 at December 31, 2001.

Net cash used in operating activities was
$3,484,000 and $10,101,000 for the years ended December 31,
2002 and 2001, respectively. The decrease in net cash used in
operating activities is primarily attributable to a decrease in
our net operating losses, excluding depreciation and
amortization, non-cash stock based charges, impairment and
restructuring charges, the loss on abandonment of assets and the
amortization of debt discounts, and the changes in accounts
receivable and accounts payable and accrued expenses.

Net cash used in investing activities was $78,000
and $168,000 for the years ended December 31, 2002 and
2001, respectively. The period-to-period decrease is primarily
attributable to decreases in the purchases of property and
equipment.

Net cash provided by financing activities was
$3,906,000 and $8,929,000 for the years ended December 31,
2002 and 2001, respectively. The decrease is primarily
attributable to a difference in the amount of net proceeds
received from the issuance of Preferred Stock, Common Stock and
convertible debentures offset in 2001 by principal payments on
notes payable and financing costs.

We currently have no material commitments for the
next 12 months other than those under our operating lease
arrangements. These arrangements consist primarily of lease
arrangements for our office space in Albany, New York. The
aggregate required payments for the next 12 months under
these arrangements are $72,000. 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 2003, we anticipate incurring approximately
$400,000 per month in cash operating costs.

If our revenues are not sufficient to cover our
current working capital requirements we will require additional
funding during the next 12 months to finance our current
level of operations. Additionally, we may require additional
financing to fund revenue growth, develop new technologies or
acquire strategic assets. Our management is actively pursuing
increases to our net cash flows through increases in revenues
and our equity line of credit (including $300,000 received in
2003 as of March 25, 2003 ) (our equity lines of credit are
described below). Management believes that a combination of
increases to operating cash flow, primarily through revenue
growth, reduced costs and funds received from our equity lines
of credit will generate sufficient cash flow to fund our
operations through 2003. However, there are no assurances that
such matters will be successfully consummated. See
Managements Discussion and Analysis of Financial
Condition and Results of Operations  Risk Factors
That May Affect Future Operating Results.

In July 2001 we entered into a Software
Development and License Agreement with Real Networks, Inc. Under
terms of the agreement, we agreed to develop a software plug-in
to RealPlayer that would allow consumers to play files encoded
in our VP4 and VP5 compression format using the RealPlayer.
In conjunction with the development of the codec software,
we also agreed to develop a software plug-in to the
RealSystem Server that would enable broadcasters to stream
VP4 and VP5 encoded files and a software plug-in to
the RealProducer that would enable users of the RealProducer to
encode content using VP4 and VP5. In order for us to
develop the plug-ins described in the RealNetworks agreement,
RealNetworks was required to provide us with certain
development software as well as fulfill certain other
obligations. RealNetworks failed to deliver such software and
perform such other obligations. After honoring the contract from
its inception and attempting to resolve the situation with
RealNetworks for over 9 months through business
discussions, in May

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2002 we notified RealNetworks that we were
terminating the agreement. RealNetworks responded and disputed
our right to terminate the agreement and further claimed that we
were in breach of the agreement. We responded by reiterating our
positions. We have not had any contacts or discussions with
RealNetworks since delivering this response. As a result, we are
not generating significant revenues from the sale of
RealNetworks related products.


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

We currently have two equity lines of credit. In
December 2000, we entered into a common stock purchase agreement
(the Initial Stock Purchase Agreement) with an
accredited investor (the Investor), for the sale,
from time to time, of our Common Stock. Pursuant to the Initial
Stock Purchase Agreement, the Investor has committed to purchase
up to $23,000,000 of our Common Stock over a 36-month period.
The Investor is also required to invest an additional
$17,000,000 upon the attainment of certain trading volumes and
weighted average market prices in our Common Stock. However, our
ability to procure funds through the Initial Stock Purchase
Agreement is limited depending on the trading volumes and the
weighted average market prices of our Common Stock. The Company
sold 7,024,000 shares of Common Stock for net proceeds of
approximately $2,513,000 and 8,476,000 shares of Common Stock
for net proceeds of approximately $4,191,000 under the Initial
Stock Purchase Agreement, for the years ended December 31,
2002 and 2001, respectively.

As a result of the price and volume limitations
contained in the Initial Stock Purchase Agreement, in November
2001 we entered into a second common stock purchase agreement
(the Second Stock Purchase Agreement) with the
Investor, for sale, from time to time, of our Common Stock.
Under the Second Stock Purchase Agreement, the Investor has
committed to purchase an additional $23,000,000 over a 36-month
period, with an additional commitment for $17,000,000 upon the
attainment of certain price and volume thresholds. Under the
Second Stock Purchase Agreement, as long as the volume weighted
average price of our stock for the 30-day period preceding a
draw-down notice is at least $0.30, we may request, and the
Investor is obligated to fund, an amount between (a) a
minimum of $300,000 or (b) a maximum equal to the greater
of $500,000 or $300,000 plus 4.5% of the volume weighted average
stock price for the preceding 30-day period multiplied by the
total trading volume for the preceding three-month period. If
the volume weighted average price of our stock is below $0.30
and greater than $0.10, the minimum amount that we may request
and, if requested, that the Investor must provide is ratably
reduced from $300,000 to $100,000. The Company sold
5,513,000 shares of Common Stock for net proceeds of
approximately $727,000 under the Second Stock Purchase
Agreement, for the year ended December 31, 2002. In 2003
(as of March 25) the Company sold 975,104 shares of
Common Stock for net proceeds of approximately $300,000 under
the Second Stock Purchase Agreement.

We may sell up to a total of
24,500,000 shares of our common stock under both stock
purchase agreements, including 21,988,194 already sold through
March 25, 2003.

As we cannot predict the price of our common
stock, there can be no assurances that we will be able to
request the maximum amount of funds through our equity lines, if
at all.

We have experienced significant operating losses
and negative operating cash flows to date. Our managements
plan to increase our cash flows from operations relies
significantly on increases in revenue generated from our
broadband technology services, products and licenses and
decreases in operating expenses (from cost cutting initiatives
implemented in 2002). However, there are no assurances that we
will be successful in effecting such increases. The market for
distribution of broadband technology services is highly
competitive. Additionally, our capital requirements depend on
numerous factors, including market acceptance

16



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##### 



of our technology and services, research and
development costs and the resources we spend on marketing and
selling our products and services. Additionally, we continue to
evaluate investments in complementary businesses, products and
services, some of which may be significant.


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

Impact of Recently Issued Accounting
Pronouncements

In June 2002, the FASB issued SFAS No. 146,
Accounting for Costs Associated with Exit or Disposal
Activities, which addresses financial accounting and
reporting for costs associated with exit or disposal activities
and nullifies Emerging Issues Task Force (EITF)
Issue No. 94-3, Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an
Activity (including Certain Costs Incurred in a
Restructuring). SFAS No. 146 requires that a
liability for a cost associated with an exit or disposal
activity be recognized when the liability is incurred. Under
EITF Issue No. 94-3, a liability for exit costs was
recognized at the date of an entitys commitment to an exit
plan. SFAS No. 146 is effective for exit or disposal
activities that are initiated after December 31, 2002. The
Company believes that the adoption of SFAS No. 146 will not
have a significant impact on its results of operations or
financial position.

In December 2002, the FASB issued SFAS
No. 148, Accounting for Stock-Based
Compensation  Transition and Disclosure as
an amendment to SFAS No. 123 to provide alternative methods
of transition for an entity that voluntarily changes to the fair
value based method of accounting for stock-based employee
compensation. It also amends the disclosure provisions of SFAS
No. 123 to require prominent disclosure about the effects
on reported net income (loss) of an entitys
accounting policy decisions with respect to stock-based employee
compensation and amends APB Opinion No. 28 to require
disclosure about those effects in interim financial information.
The disclosure provisions are effective for fiscal years ending
after December 15, 2002 and for interim periods beginning
after December 15, 2002. The Company follows the intrinsic
value method of accounting for stock-based employee
compensation, but will continue to evaluate the benefits of a
voluntary change to the fair value based method.

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

At December 31, 2002, we had available net
operating loss carry-forwards of approximately $74,000,000. The
net operating loss carry-forwards expire at various dates
through 2022.

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

The merger of The Duck Corporation with and into
a wholly owned subsidiary of Applied Capital Funding, Inc. may
have involved an ownership change and thus we may be
unable to use a material portion of our available net operating
loss carry-forwards. Furthermore, in the ordinary course of the
Companys future business operations, it could become
necessary 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. The issuance of a significant number of shares of
Common Stock could result in an ownership change. If
we were to experience such an ownership change, we
might not be able to use a substantial amount of our available
net operating loss carry-forwards to reduce future taxable
income.

17



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##### 



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

Risk Factors That May Affect Future Operating
Results

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



| |                                                                                                                                                        
| | -------------------------------------------------------------------------------------------------------------------------------------------------------
| | If we do not obtain additional cash to
    operate our business, we may not 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, 2002, we had an accumulated deficit of
approximately $105.1 million. On February 28, 2002, we
had cash reserves of approximately $215,000. During fiscal 2003,
we expect to meet our working capital obligations and other cash
requirements with cash derived from operations, from sales of
our common stock under the equity line of credit arrangements
with Crossover Ventures, Inc., and other financing as required.
There can be no assurance, however, that cash from operations
and the other sources described above will be achieved or will
be sufficient for our operating needs or that we will be able to
achieve profitability on a consistent basis, if at all. In the
event that cash flow from operations is less than anticipated
and we are unable to secure additional funding, in order to
preserve cash, we would be required to further reduce
expenditures and effect further reductions in our corporate
infrastructure, either of which could have a material adverse
effect on our ability to continue our current level of
operations. Even if we obtain additional working capital in the
near future, to the extent that operating expenses increase or
we need additional funds to make acquisitions, develop new
technologies or acquire strategic assets, the need for
additional funding may be accelerated and there can be no
assurances that any such additional funding can be obtained on
terms acceptable to us, if at all.



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

Although we have significantly decreased our
operating expenses throughout 2002, we are still incurring
approximately $400,000 of monthly operating costs. We currently
do not generate sufficient revenues to offset our operating
costs. Our current sources of financing are two common stock
purchase agreements entered into in December 2000 and November
2001 as well as any additional financings into which we may
enter. However, it is possible that current commitments for
capital will not guarantee us enough cash to cover our current
level of operating expenses. Moreover, as we continue to expand
our product and service offerings to maintain our competitive
advantage, we may be required to incur additional costs to hire
and retain additional personnel, license complementary third
party technology for use in our proprietary software or expand
both our international and domestic presence to enter new
markets. These costs may significantly increase our current
level of monthly operating expenses. Failure to generate
sufficient capital through both our revenue streams and
financings may require us to execute additional corporate
restructurings, scale back our product or service offerings or
limit the markets into which we enter. Any of these items, or a
combination thereof, could have a harmful effect on our
operating results and our stock price.



| |                                                                                        
| | ---------------------------------------------------------------------------------------
| | We have a history of losses and negative
    cash flow and anticipate continued losses.

We have not achieved profitability, and it is a
possibility that we will continue to incur operating losses for
the foreseeable future as we fund operating and capital
expenditures in implementing our business plan. Our business
model assumes that consumers will be attracted to and use
broadband-specific video compression technology to access
content available on customer Web sites or over proprietary
networks that will, in turn, allow us to provide our technology
solutions to customers. Our business model is not yet proven,
and we cannot

18



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##### 



assure you that we will ever achieve or sustain
profitability or that our operating losses will not increase in
the future. Our business strategy may be unsuccessful and we may
not be able to adequately address all or any of these risks.
Even if we are able to achieve profitability, we may be unable
to sustain or increase our profitability. In either case, our
operating results and liquidity would be harmed.




| |                                                                                                                                                                                                                     
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Because we recently changed our strategic
    operating model, we are a relatively new company and we may be
    unable to make the changes necessary to operate as a new company
    and execute our business plan.

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

Our ability to generate profits will depend on
our ability:



| |   |                                                                                                                                                                                                              
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | to attract customers to use our technology
    infrastructure and support services;                                                                                                                          
|
| |  | to generate revenues from software licensing and
    sales, broadband streaming services and consulting and
    engineering services for customers wishing to deliver broadband
    content to end users; and
|
| |  | to control costs.                                                                                                                                                                                            



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

Fluctuations in the market price of our common
stock may adversely affect our access to capital and financing
and our ability to attract and retain qualified personnel.
Historically, our common stock price has fluctuated widely, with
a 52-week range as of February 1, 2003 of $0.08 to $0.54.
We expect fluctuations to continue in the future for a number of
reasons, including:



| |   |                                                                                                           
| | - | ----------------------------------------------------------------------------------------------------------
| |  | quarterly variations in our operating results;                                                            
|
| |  | competitive announcements;                                                                                
|
| |  | the operating and stock price performance of
    other companies that investors may deem comparable to us;
|
| |  | news relating to trends in our markets; and                                                               
|
| |  | changes in financial estimates by securities
    analysts or failure to meet analyst estimates.           

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



| |                                                                                                                                                                  
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The sale of shares eligible for future sale
    in the open market may cause our stock price to decline and
    could hinder our future ability to raise capital.

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

19



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In addition, we have entered into two common
stock purchase agreements with Crossover Ventures for the sale
of up to 24,500,000 shares of common stock. As of
March 25, 2003 we had sold 21,988,194 of these shares. We
may sell the remaining shares during 2003. Such sales would be
made based upon formulas and limitations contained in the common
stock purchase agreements. In addition, the shares issuable to
Crossover Ventures under the common stock purchase agreements
will be issued at a discount to the daily volume weighted
average prices of our common stock. As we sell shares of common
stock to Crossover Ventures under the common stock purchase
agreements, and then Crossover Ventures sells the common stock
to third parties, our common stock price may decrease due to the
additional shares in the market. If, as we have done in the
past, we decide to draw down under the common stock purchase
agreements as the price of our common stock decreases, we will
be required to issue more shares of our common stock for any
given dollar amount invested by Crossover Ventures, subject to
the minimum selling price we specify. The more shares that are
issued under the common stock purchase agreements, the more our
shares will be diluted and the more our stock price may decline.
This may encourage short sales, which could place further
downward pressure on the price of our common stock. The
following table represents the number of shares of common stock
we would be required to issue to Crossover Ventures at price
levels ranging from $0.08 to $0.54, which approximates the
52-week high and low price of our common stock as of
February 1, 2003. This analysis assumes we request a draw
down of $300,000 for a 20-day period and assumes the shares are
sold at a 10% discount.

|                                |  |                            |           | 
|------------------------------- |  | -------------------------- | --------- | 
|                                |  | Number of Shares of Common
|Volume Weighted                 |  | Stock Issued to Crossover 
|Average Price for 20-Day Period |  | Ventures                  
|                                |  |                           
|$0.08                           |  |                            | 4,166,666 | 
|$0.17                           |  |                            | 1,960,784 | 
|$0.26                           |  |                            | 1,282,051 | 
|$0.35                           |  |                            | 952,380   | 
|$0.43                           |  |                            | 775,193   | 
|$0.54                           |  |                            | 617,283   | 



| |                                                                                                                                                                       
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Because we depend on the growth of
    broadband internet use, if growth for broadband declines, our
    revenue may decline and we may not achieve
    profitability.

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

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



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



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

Our ability to execute our growth plan and be
successful depends on our continuing ability to attract, retain
and motivate highly skilled employees. As we continue to grow,
we will need to hire additional personnel in all operational
areas. We may be unable to retain our key employees or attract,
assimilate or retain other highly qualified employees in the
future. We have from time to time in the past experienced, and
we expect to continue to experience in the future, difficulty in
hiring and retaining highly skilled employees with appropriate
qualifications. If we do not succeed in attracting new personnel
or retaining and motivating

20



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##### 



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
effect 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
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.

21



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| |                                                                                                                                                                                                                                                                                            
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Potential customers may not purchase our
    technology and services at anticipated levels if internet
    capacity constraints continue to impair the ability of consumers
    to access our web site or our customers web sites, which
    could hinder our ability to generate revenue.

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



| |   |                                                                                                                                          
| | - | -----------------------------------------------------------------------------------------------------------------------------------------
| |  | inadequate development of the necessary
    infrastructure such as a reliable network backbone;                                          
|
| |  | failure to timely develop complementary products
    such as high speed modems that will enable broadband access for
    individuals;    
|
| |  | delays in the development or adoption of new
    standards and protocols required to handle increased levels of
    Internet activity; or
|
| |  | increased government regulation.                                                                                                         

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



| |                                                                                                                                                       
| | ------------------------------------------------------------------------------------------------------------------------------------------------------
| | A third-party could seek to prevent us from
    supporting certain software platforms, including certain
    components of our own software platforms.

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



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

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



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

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



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

22



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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 dividends and do not
    anticipate paying 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 stock in the foreseeable future.



|        |                     
|------- | --------------------
|Item 7. | FINANCIAL STATEMENTS

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



|        |                                                                                         
|------- | ----------------------------------------------------------------------------------------
|Item 8. | Changes In and Disagreements with
    Accountants on Accounting and Financial Disclosure

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

None of the reportable events described under
Item 304(a)(1)(v) of Regulation S-K occurred within
the Companys two most recent fiscal years and the
subsequent interim period through March 15, 2002.
Andersens reports on the Companys consolidated
financial statements for the fiscal years ended
December 31, 2000 and 2001 did not contain an adverse
opinion or disclaimer of opinion, nor were they qualified or
modified as to uncertainty, audit scope or accounting
principles, except that each such report contained an
explanatory paragraph regarding On2s ability to continue
as a going concern.

During the Companys two most recent fiscal
years ended December 31, 2001, and the subsequent interim
period through March 15, 2002, the Company did not consult
with Eisner LLP regarding any of the matters or events set forth
in Item 304(a)(2)(i) and (ii) of Regulation S-K.

PART III



|        |                                                                                                                        
|------- | -----------------------------------------------------------------------------------------------------------------------
|Item 9. | Directors, Executive Officers, Promoters
    and Control Persons; Compliance with Section 16(a) of the
    Exchange Act

The information required is incorporated by
reference from the sections entitled Directors and
Executive Officers, The Board of Directors and
Compliance with Section 16(a) of the Exchange
Act contained in the Proxy Statement for the Annual
Meeting of Stockholders to be held on May 21, 2003 (the
Proxy Statement), which is to be filed with the
Securities and Exchange Commission.



|         |                       
|-------- | ----------------------
|Item 10. | Executive Compensation

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



|         |                                                                   
|-------- | ------------------------------------------------------------------
|Item 11. | Security Ownership of Certain Beneficial
    Owners and Management

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



|         |                                                   
|-------- | --------------------------------------------------
|Item 12. | Certain Relationships and Related
    Transactions

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

23



---



##### 





|         |                        
|-------- | -----------------------
|Item 13. | Controls and Procedures

(a) Evaluation of Disclosure Controls and
Procedures

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

(b) Changes in Internal Controls

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



|         |                                      
|-------- | -------------------------------------
|Item 14. | Exhibits and Reports on
    Form 8-K.

|        |       |                           |  |                                                                                                                                                                                                                                  
|------- | ----- | ------------------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |       |                          
|No.     |       | Identification of Exhibit
|        |       |                          
|        | 3.1*  | ***                       |  | Certificate of Incorporation of the Company                                                                                                                                                                                      
|        | 3.2*  | *******                   |  | Bylaws of the Company                                                                                                                                                                                                            
|        | 4.1*  |                           |  | Securityholders Agreement, dated as of
    December 1, 1999, between the Company and thirteen
    securityholders party thereto                                                                                                  
|        | 4.2*  |                           |  | Form of Investor Rights Agreement, dated as of
    December 1, 1999,between the Company and each of nine
    investors                                                                                                           
|        | 4.3*  |                           |  | Form of Warrant issued to the investors party to
    the Investor Rights Agreement                                                                                                                                               
|        | 4.4*  | ***                       |  | Form of Investors Rights Agreement between
    the Company and the holders of Series C Preferred Stock,
    Series C-II Preferred Stock and Series C-III Preferred
    Stock                                                    
|        | 4.5*  | ***                       |  | Certificate of Designations for the
    Companys Series C Preferred Stock                                                                                                                                                       
|        | 4.6*  | ***                       |  | Certificate of Designations for the
    Companys Series C-II Preferred Stock                                                                                                                                                    
|        | 4.7*  | ***                       |  | Certificate of Designations for the
    Companys Series C-III Preferred Stock                                                                                                                                                   
|        | 4.8*  | ***                       |  | Form of Warrant issued to the holders of
    Series C Preferred Stock,Series C-II Preferred Stock
    and Series C-III Preferred Stock                                                                                           
|        | 4.10  | *****                     |  | Common Stock Purchase Agreement, dated as of
    July 18, 2001 by and between the Company and Real.                                                                                                                              
|        | 4.11  | *****                     |  | Investor Rights Agreement, dated as of
    July 18, 2001, between Real and the Company                                                                                                                                           
|        | 10.1* | *                         |  | Employment Agreement with Douglas McIntyre                                                                                                                                                                                       
|        | 10.2* | *                         |  | Employment Agreement with Mark Meagher                                                                                                                                                                                           
|        | 10.3* | **                        |  | Common Stock Purchase Agreement, dated as of
    December 1, 2000,between the Company and Crossover
    Ventures, Inc.                                                                                                           
|        | 10.4* | ***                       |  | Deferred Pricing Agreement, dated as of
    January 19, 2001, between the Company and The Travelers
    Indemnity Company                                                                                                        
|        | 10.5* | ****                      |  | Development Services and License Agreement dated
    July 18, 2001 between the Company and RealNetworks, Inc.,
    subject to an Order Granting Confidential Treatment under The
    Securities Exchange Act of 1933 (CF #11815).
|        | 10.6* | *****                     |  | Common Stock Purchase Agreement, dated as of
    November 21, 2001,between the Company and Crossover
    Ventures, Inc.                                                                                                          

24



---



##### 



|        |           |                           |  |                                                                                                                                                           
|------- | --------- | ------------------------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |           |                          
|No.     |           | Identification of Exhibit
|        |           |                          
|        | 10.7      |                           |  | Lease Agreement, dated as of September 26,
    2002 between the Company and Sitterly Associates II, LLC.                                                  
|        | 15.1      |                           |  | Statement Regarding Predecessor Independent
    Public Accountants Consent                                                                               
|        | 21******* |                           |  | Subsidiaries                                                                                                                                              
|        | 99.1      |                           |  | Certification of Chief Executive Officer Pursuant
    to 18 U.S.C. Section 1350, as Adopted Pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002 
|        | 99.2      |                           |  | Certification of Chief Financial Officer Pursuant
    to 18 U.S.C. Section 1350, as Adopted Pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002.



---



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



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



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



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



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



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



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



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

(b) Reports filed on Form 8-K for the
three months ended December 31, 2002.

None.

25



---



##### 



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 28,
2003.



| |                       
| | ----------------------
| | ON2 TECHNOLOGIES, INC.



| |     |                        
| | --- | -----------------------
| | By: | /s/ DOUGLAS A. MCINTYRE

| |                                                    
| | ---------------------------------------------------
| |                                                    
| | Douglas A. McIntyre                                
| | Chairman, President and Chief Executive
    Officer

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

|                                             |  |                                                                                                  |  |                |  |     
|-------------------------------------------- |  | ------------------------------------------------------------------------------------------------ |  | -------------- |  | ----
|                                             |  | Signature                                                                                        |  | Title          |  | Date
|                                             |  |                                                                                                  |  |                |  |     
|                                            
|/s/ DOUGLAS A. MCINTYRE(Douglas A. McIntyre) |  | Chairman, President, Chief Executive Officer and
    Director                                    |  | March 28, 2003
|                                            
|/s/ MARK J. MEAGHER(Mark J. Meagher)         |  | Executive Vice President, Chief Financial Officer
    (Principal Financial Officer) and Director |  | March 28, 2003
|                                            
|/s/ ANTHONY PRINCIPE(Anthony Principe)       |  | Vice President, Controller and Principal
    Accounting Officer                                  |  | March 28, 2003
|                                            
|/s/ STEPHEN D. KLEIN(Stephen D. Klein)       |  | Director                                                                                         |  | March 28, 2003
|                                            
|/s/ WILLIAM A. NEWMAN(William A. Newman)     |  | Director                                                                                         |  | March 28, 2003
|                                            
|/s/ J. ALLEN KOSOWSKY(J. Allen Kosowsky)     |  | Director                                                                                         |  | March 28, 2003
|                                            
|/s/ THOMAS WEIGMAN(Thomas Weigman)           |  | Director                                                                                         |  | March 28, 2003

26



---



##### 



CERTIFICATIONS

I, Douglas A. McIntyre, certify that:

1) I have reviewed this annual report on
Form 10-KSB of On2 Technologies, Inc.:

2) Based on my knowledge, this annual report
does not contain any untrue statement of a material fact or omit
to state a material fact necessary to make the statements made,
in light of the circumstances under which such statements were
made, not misleading with respect to the period covered by this
annual report;

3) Based on my knowledge, the financial
statements, and other financial information included in this
annual report, fairly present in all material respects the
financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual
report;

4) The registrants other certifying
officers and I are responsible for establishing and maintaining
disclosure controls and procedures (as defined) in Exchange Act
Rules 13a-14 and 15d-14) for the registrant and we have:



| |                                                                                                                                                                                                                                                                                                                
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) designed such disclosure controls and
    procedures to ensure that material information relating to the
    registrant, including its consolidated subsidiaries, is made
    known to us by others within those entities, particularly during
    the period in which this annual report is being prepared;
|
| | b) evaluated the effectiveness of the
    registrants disclosure controls and procedures as of a
    date within 90 days prior to the filing date of this annual
    report (the Evaluation Date); and                                                                                                      
|
| | c) presented in this annual report our
    conclusions about the effectiveness of the disclosure controls
    and procedures based on our evaluation as of the Evaluation Date;                                                                                                                                

5) The registrants other certifying
officers and I have disclosed, based on our most recent
evaluation, to the registrants auditors and the audit
committee of registrants board of directors (or persons
performing the equivalent function):



| |                                                                                                                                                                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) all significant deficiencies in the
    design or operation of internal controls which could adversely
    affect the registrants ability to record, process,
    summarize and report financial data and have identified for the
    registrants auditors any material weaknesses in internal
    controls; and
|
| | b) any fraud, whether or not material, that
    involves management or other employees who have a significant
    role in the registrants internal controls; and                                                                                                                                                    

6) The registrants other certifying
officers and I have indicated in this annual report whether or
not there were significant changes in internal controls or in
other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies
and material weaknesses.



| |     |                        
| | --- | -----------------------
| | By: | /s/ DOUGLAS A. MCINTYRE

| |                                                    
| | ---------------------------------------------------
| |                                                    
| | Douglas A. McIntyre                                
| | Chairman, President and Chief Executive
    Officer

Date: March 28, 2003

27



---



##### 



CERTIFICATIONS

I, Mark Meagher, certify that:

1) I have reviewed this annual report on
Form 10-KSB of On2 Technologies, Inc.:

2) Based on my knowledge, this annual report
does not contain any untrue statement of a material fact or omit
to state a material fact necessary to make the statements made,
in light of the circumstances under which such statements were
made, not misleading with respect to the period covered by this
annual report;

3) Based on my knowledge, the financial
statements, and other financial information included in this
annual report, fairly present in all material respects the
financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual
report;

4) The registrants other certifying
officers and I are responsible for establishing and maintaining
disclosure controls and procedures (as defined) in Exchange Act
Rules 13a-14 and 15d-14) for the registrant and we have:



| |                                                                                                                                                                                                                                                                                                                
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) designed such disclosure controls and
    procedures to ensure that material information relating to the
    registrant, including its consolidated subsidiaries, is made
    known to us by others within those entities, particularly during
    the period in which this annual report is being prepared;
|
| | b) evaluated the effectiveness of the
    registrants disclosure controls and procedures as of a
    date within 90 days prior to the filing date of this annual
    report (the Evaluation Date); and                                                                                                      
|
| | c) presented in this annual report our
    conclusions about the effectiveness of the disclosure controls
    and procedures based on our evaluation as of the Evaluation Date;                                                                                                                                

5) The registrants other certifying
officers and I have disclosed, based on our most recent
evaluation, to the registrants auditors and the audit
committee of registrants board of directors (or persons
performing the equivalent function):



| |                                                                                                                                                                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) all significant deficiencies in the
    design or operation of internal controls which could adversely
    affect the registrants ability to record, process,
    summarize and report financial data and have identified for the
    registrants auditors any material weaknesses in internal
    controls; and
|
| | b) any fraud, whether or not material, that
    involves management or other employees who have a significant
    role in the registrants internal controls; and                                                                                                                                                    

6) The registrants other certifying
officers and I have indicated in this annual report whether or
not there were significant changes in internal controls or in
other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies
and material weaknesses.



| |     |                    
| | --- | -------------------
| | By: | /s/ MARK J. MEAGHER

| |                                                    
| | ---------------------------------------------------
| |                                                    
| | Mark J. Meagher                                    
| | Chairman, President and Chief Executive
    Officer

Date: March 28, 2003

28



---



##### 



INDEX TO CONSOLIDATED FINANCIAL
STATEMENTS

|                                                                                                                  |  |      |      | 
|----------------------------------------------------------------------------------------------------------------- |  | ---- | ---- | 
|                                                                                                                  |  | Page
|                                                                                                                  |  |     
|Report of Independent Auditors                                                                                    |  |      | F-2  | 
|Report of Previous Independent Accountants                                                                        |  |      | F-3  | 
|Consolidated Balance Sheets as of
    December 31, 2002 and 2001                                                  |  |      | F-4  | 
|Consolidated Statements of Operations for the
    years ended December 31, 2002 and 2001                          |  |      | F-5  | 
|Consolidated Statements of Changes in
    Stockholders Equity for the years ended December 31,
    2002 and 2001 |  |      | F-6  | 
|Consolidated Statements of Cash Flows for the
    years ended December 31, 2002 and 2001                          |  |      | F-8  | 
|Notes to Consolidated Financial Statements                                                                        |  |      | F-10 | 

F-1



---



##### 



REPORT OF INDEPENDENT AUDITORS

Board of Directors and Stockholders

On2 Technologies, Inc.


Clifton Park, New York


We have audited the accompanying consolidated
balance sheet of On2 Technologies, Inc. and Subsidiaries as of
December 31, 2002 and the related consolidated statements
of operations, changes in stockholders equity and cash
flows for the year then ended. These financial statements are
the responsibility of the Companys management. Our
responsibility is to express an opinion on these financial
statements based on our audit. The financial statements of On2
Technologies, Inc. and Subsidiaries as of December 31, 2001
and for the year then ended were audited by other auditors who
have ceased operations. Those auditors expressed an unqualified
opinion on those financial statements in their report dated
February 21, 2002, which calls attention to substantial
doubt about the Companys ability to continue as a going
concern.

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

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

/s/ Eisner LLP

New York, New York

January 23, 2003


With respect to Note 12(c)

March 24, 2003


F-2



---



##### 



INFORMATION REGARDING PREDECESSOR
INDEPENDENT

PUBLIC ACCOUNTANTS REPORT


THE FOLLOWING REPORT IS A COPY OF A PREVIOUSLY
ISSUED REPORT BY ARTHUR ANDERSEN LLP. THE REPORT HAS NOT BEEN
REISSUED BY ARTHUR ANDERSEN LLP NOR HAS ARTHUR ANDERSEN LLP
CONSENTED TO ITS INCLUSION IN THIS ANNUAL REPORT ON
FORM 10-KSB.

REPORT OF PREVIOUS INDEPENDENT PUBLIC
ACCOUNTANTS

To On2 Technologies, Inc.:

We have audited the accompanying consolidated
balance sheet of On2 Technologies, Inc. (a Delaware corporation)
and subsidiaries as of December 31, 2001 and 2000 and the
related consolidated statements of operations,
stockholders equity and cash flows for the years then
ended. These financial statements are the responsibility of the
Companys management. Our responsibility is to express an
opinion on these financial statements based on our audits.

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

In our opinion, the financial statements referred
to above present fairly, in all material respects, the financial
position of On2 Technologies, Inc. and Subsidiaries as of
December 31, 2001 and 2000, and the results of their
operations and their cash flows for the years then ended in
conformity with accounting principles generally accepted in the
United States of America.

The accompanying financial statements have been
prepared assuming that the Company will continue as a going
concern. As discussed in Note 1 to the consolidated
financial statements, the Company has suffered recurring losses
from operations that raise substantial doubt about its ability
to continue as a going concern. Managements plans in
regard to this matter are also described in Note 1. The
financial statements do not include any adjustments that might
result from the outcome of this uncertainty.



| |                        
| | -----------------------
| | /s/ Arthur Andersen LLP

New York, New York

February 21, 2002


F-3



---



##### 



ON2 TECHNOLOGIES, INC.

CONSOLIDATED BALANCE SHEETS

|                                                        |                                                                                                                                                                            |                                            |         |              |           |  |           |             |           | 
|------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ------- | ------------ | --------- |  | --------- | ----------- | --------- | 
|                                                        |                                                                                                                                                                            |                                           
|                                                        |                                                                                                                                                                            | December 31,                              
|                                                        |                                                                                                                                                                            |                                           
|                                                        |                                                                                                                                                                            | 2002                                       |         | 2001        
|                                                        |                                                                                                                                                                            |                                            |         |             
|ASSETS                                                 
|Current assets:                                         |                                                                                                                                                                            |                                            |         |              |           |  |           |            
|                                                        | Cash                                                                                                                                                                       |                                            | $       | 553,000      |           |  | $         | 216,000     |          
|                                                        | Accounts receivable, less allowance for doubtful
    accounts of $50,000 and $136,000 as of December 31, 2002
    and 2001, respectively                                   |                                            |         | 601,000      |           |  |           | 679,000     |          
|                                                        | Prepaid and other current assets                                                                                                                                           |                                            |         | 101,000      |           |  |           | 223,000     |          
|                                                        |                                                                                                                                                                            |                                            |         |              |           |  |           |            
|                                                        |                                                                                                                                                                            | Total current assets                       |         |              | 1,255,000 |  |           |             | 1,118,000 | 
|                                                        | Property and equipment, net                                                                                                                                                |                                            |         | 353,000      |           |  |           | 1,406,000   |          
|                                                        | Intangible assets, net                                                                                                                                                     |                                            |         | 463,000      |           |  |           | 1,121,000   |          
|                                                        | Other assets                                                                                                                                                               |                                            |         | 9,000        |           |  |           | 282,000     |          
|                                                        |                                                                                                                                                                            |                                            |         |              |           |  |           |            
|                                                        |                                                                                                                                                                            | Total assets                               |         | $            | 2,080,000 |  |           | $           | 3,927,000 | 
|                                                        |                                                                                                                                                                            |                                            |         |              |           |  |           |            
|LIABILITIES AND STOCKHOLDERS
    EQUITY               
|Current liabilities:                                    |                                                                                                                                                                            |                                            |         |              |           |  |           |            
|                                                        | Accounts payable                                                                                                                                                           |                                            | $       | 266,000      |           |  | $         | 499,000     |          
|                                                        | Accrued expenses                                                                                                                                                           |                                            |         | 254,000      |           |  |           | 489,000     |          
|                                                        | Deferred revenue                                                                                                                                                           |                                            |         |              |           |  |           | 35,000      |          
|                                                        | Capital lease obligations                                                                                                                                                  |                                            |         | 4,000        |           |  |           |            |          
|                                                        |                                                                                                                                                                            |                                            |         |              |           |  |           |            
|                                                        |                                                                                                                                                                            | Total current liabilities                  |         |              | 524,000   |  |           |             | 1,023,000 | 
|Capital lease obligation, excluding current
    portion |                                                                                                                                                                            |                                            | 5,000   |              |           |  |           |            
|Convertible debentures                                  |                                                                                                                                                                            |                                            | 569,000 |              |           |  | 2,000,000 |            
|                                                        |                                                                                                                                                                            |                                            |         |              |           |  |           |            
|                                                        |                                                                                                                                                                            | Total liabilities                          |         |              | 1,098,000 |  |           |             | 3,023,000 | 
|                                                        |                                                                                                                                                                            |                                            |         |              |           |  |           |            
|Commitments and contingencies (Note 12)                 |                                                                                                                                                                            |                                            |         |              |           |  |           |            
|Stockholders equity:                                   |                                                                                                                                                                            |                                            |         |              |           |  |           |            
|                                                        | Preferred stock, $0.01 par value; 20,000,000
    shares authorized; 9,920,000 and 12,929,000 shares issued and
    outstanding at December 31, 2002 and 2001, respectively |                                            |         | 99,000       |           |  |           | 129,000     |          
|                                                        | Common stock, $0.01 par value; 100,000,000 shares
    authorized; 59,588,000 and 38,565,000 shares issued and
    outstanding at December 31, 2002 and 2001, respectively  |                                            |         | 596,000      |           |  |           | 386,000     |          
|                                                        | Additional paid-in capital                                                                                                                                                 |                                            |         | 105,422,000  |           |  |           | 99,549,000  |          
|                                                        | Accumulated other comprehensive loss                                                                                                                                       |                                            |         | (16,000      | )         |  |           | (10,000     | )        
|                                                        | Accumulated deficit                                                                                                                                                        |                                            |         | (105,119,000 | )         |  |           | (99,150,000 | )        
|                                                        |                                                                                                                                                                            |                                            |         |              |           |  |           |            
|                                                        |                                                                                                                                                                            | Total stockholders equity                 |         |              | 982,000   |  |           |             | 904,000   | 
|                                                        |                                                                                                                                                                            |                                            |         |              |           |  |           |            
|                                                        |                                                                                                                                                                            | Total liabilities and stockholders equity |         | $            | 2,080,000 |  |           | $           | 3,927,000 | 
|                                                        |                                                                                                                                                                            |                                            |         |              |           |  |           |            

See accompanying notes to consolidated financial
statements

F-4



---



##### 



ON2 TECHNOLOGIES, INC.

CONSOLIDATED STATEMENTS OF
OPERATIONS

|                                                                 |                                                          |                         |            |           |  |   |             |           |    
|---------------------------------------------------------------- | -------------------------------------------------------- | ----------------------- | ---------- | --------- |  | - | ----------- | --------- | ---
|                                                                 |                                                          |                        
|                                                                 |                                                          | Year Ended December 31,
|                                                                 |                                                          |                        
|                                                                 |                                                          | 2002                    |            | 2001     
|                                                                 |                                                          |                         |            |          
|Revenues                                                         |                                                          | $                       | 3,353,000  |           |  | $ | 2,220,000   |          
|Operating expenses:                                              |                                                          |                         |            |           |  |   |             |          
|                                                                 | Cost of revenues                                         |                         |            | 2,056,000 |  |   |             | 2,233,000 |    
|                                                                 | Research and development                                 |                         |            | 2,149,000 |  |   |             | 3,856,000 |    
|                                                                 | Sales and marketing(1)                                   |                         |            | 924,000   |  |   |             | 2,295,000 |    
|                                                                 | General and administrative(2)                            |                         |            | 2,846,000 |  |   |             | 4,693,000 |    
|                                                                 | Amortization of goodwill and other intangible
    assets |                         |            | 19,000    |  |   |             | 1,154,000 |    
|                                                                 | Cost curtailment and restructuring charges               |                         |            | 581,000   |  |   |             | 293,000   | (3)
|                                                                 | Impairment charges                                       |                         |            | 30,000    |  |   |             | 2,931,000 | (3)
|                                                                 | Non-cash stock based compensation                        |                         |            | 16,000    |  |   |             | 144,000   |    
|                                                                 |                                                          |                         |            |           |  |   |             |          
|Total operating expenses                                         |                                                          |                         | 8,621,000  |           |  |   | 17,599,000  |          
|                                                                 |                                                          |                         |            |           |  |   |             |          
|Loss from operations                                             |                                                          |                         | (5,268,000 | )         |  |   | (15,379,000 | )        
|Interest and other income (expense), net                         |                                                          |                         | (5,000     | )         |  |   | (1,589,000  | )        
|                                                                 |                                                          |                         |            |           |  |   |             |          
|Loss before provision for income taxes                           |                                                          |                         | (5,273,000 | )         |  |   | (16,968,000 | )        
|Provision for income taxes                                       |                                                          |                         | 28,000     |           |  |   | 64,000      |          
|                                                                 |                                                          |                         |            |           |  |   |             |          
|Net loss                                                         |                                                          |                         | (5,301,000 | )         |  |   | (17,032,000 | )        
|Non-cash convertible preferred stock dividend                    |                                                          |                         | 668,000    |           |  |   | 4,130,000   |          
|                                                                 |                                                          |                         |            |           |  |   |             |          
|Net loss attributable to common stockholders                     |                                                          | $                       | (5,969,000 | )         |  | $ | (21,162,000 | )        
|                                                                 |                                                          |                         |            |           |  |   |             |          
|Basic and diluted net loss per common share                      |                                                          | $                       | (0.11      | )         |  | $ | (0.64       | )        
|                                                                 |                                                          |                         |            |           |  |   |             |          
|Weighted average basic and diluted common shares
    outstanding |                                                          |                         | 52,252,000 |           |  |   | 33,120,000  |          
|                                                                 |                                                          |                         |            |           |  |   |             |          



---



|    |                                                                                                 
|--- | ------------------------------------------------------------------------------------------------
|(1) | Excluding $10,000 of non-cash stock based
    compensation for the year ended December 31, 2001.
|   
|(2) | Excluding the following general and
    administrative expenses, which are presented separately:



| |  |                                                                                                                                                                                                                                                                 
| |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  |  $1,154,000 of amortization of
    goodwill and other intangibles, $293,000 of cost curtailment and
    restructuring charges, $2,931,000 of impairment charges and
    $134,000 of non-cash stock-based compensation for the year ended
    December 31, 2001.
|
| |  |  $19,000 of amortization of goodwill
    and other intangibles, $581,000 of cost curtailment and
    restructuring charges, $30,000 of impairment charges and $16,000
    of non-cash stock-based compensation for the year ended
    December 31, 2002.       



|    |                                                         
|--- | --------------------------------------------------------
|(3) | Reclassified to conform to current year
    presentation

See accompanying notes to consolidated financial
statements

F-5



---



##### 



ON2 TECHNOLOGIES, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN
STOCKHOLDERS EQUITY

|                                                                                                                        |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |        |            |   |  |   |         |   |  |   |         |   |  |   |             |   |  |   |             |  
|----------------------------------------------------------------------------------------------------------------------- |  | --------------- | ---------- | ------------ |  | ---------- | ------- | -------- |  | ------------- | ---------- | ------------ |  | ------------- | ------- | ------- |  | ------ | ---------- | - |  | - | ------- | - |  | - | ------- | - |  | - | ----------- | - |  | - | ----------- | -
|                                                                                                                        |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |        
|                                                                                                                        |  | Convertible     |            |              |  |            |         |          |  |               |            |              |  |              
|                                                                                                                        |  | Preferred Stock |            | Common Stock |  | Additional |         |          |  | Other         |            |              |  | Total        
|                                                                                                                        |  |                 |            |              |  | Paid-In    |         | Deferred |  | Comprehensive |            | Accumulated  |  | Stockholders
|                                                                                                                        |  | Shares          |            | Amount       |  | Shares     |         | Amount   |  | Capital       |            | Compensation |  | Loss          |         | Deficit |  | Equity
|                                                                                                                        |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |       
|Balance at January 1, 2001                                                                                              |  |                 | 5,053,000  |              |  | $          | 50,000  |          |  |               | 27,684,000 |              |  | $             | 277,000 |         |  | $      | 86,294,000 |   |  | $ | (47,000 | ) |  | $ | (4,000  | ) |  | $ | (77,988,000 | ) |  | $ | 8,582,000   |  
|Net loss                                                                                                                |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |        |            |   |  |   |         |   |  |   |         |   |  |   | (17,032,000 | ) |  |   | (17,032,000 | )
|Foreign currency translation adjustment                                                                                 |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |        |            |   |  |   |         |   |  |   | (6,000  | ) |  |   |             |   |  |   | (6,000      | )
|                                                                                                                        |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |        |            |   |  |   |         |   |  |   |         |   |  |   |             |   |  |   |             |  
|Comprehensive loss                                                                                                      |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |        |            |   |  |   |         |   |  |   |         |   |  |   |             |   |  |   | (17,038,000 | )
|                                                                                                                        |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |        |            |   |  |   |         |   |  |   |         |   |  |   |             |   |  |   |             |  
|Non-cash stock based compensation                                                                                       |  |                 |            |              |  |            |         |          |  |               | 200,000    |              |  |               | 2,000   |         |  |        | 142,000    |   |  |   |         |   |  |   |         |   |  |   |             |   |  |   | 144,000     |  
|Issuance of common stock in connection with the
    exercise of stock options                                           |  |                 |            |              |  |            |         |          |  |               | 16,000     |              |  |               |         |         |  |        | 13,000     |   |  |   |         |   |  |   |         |   |  |   |             |   |  |   | 13,000      |  
|Amortization of deferred compensation                                                                                   |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |        |            |   |  |   | 44,000  |   |  |   |         |   |  |   |             |   |  |   | 44,000      |  
|Adjustment for cancellation of warrant                                                                                  |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |        | (3,000     | ) |  |   | 3,000   |   |  |   |         |   |  |   |             |   |  |   |            |  
|Cancellation of Series C convertible
    preferred stock                                                                |  |                 | (1,644,000 | )            |  |            | (16,000 | )        |  |               |            |              |  |               |         |         |  |        | 16,000     |   |  |   |         |   |  |   |         |   |  |   |             |   |  |   |            |  
|Issuance Series C-IV and Series C-V
    convertible preferred stock to replace Series C convertible
    preferred stock |  |                 | 5,949,000  |              |  |            | 59,000  |          |  |               |            |              |  |               |         |         |  |        | (59,000    | ) |  |   |         |   |  |   |         |   |  |   |             |   |  |   |            |  
|Issuance of Series C-VI convertible
    preferred stock and warrants, net of expenses                                   |  |                 | 3,571,000  |              |  |            | 36,000  |          |  |               |            |              |  |               |         |         |  |        | 1,964,000  |   |  |   |         |   |  |   |         |   |  |   |             |   |  |   | 2,000,000   |  
|Issuance of common stock in connection with the
    equity line of credit                                               |  |                 |            |              |  |            |         |          |  |               | 8,476,000  |              |  |               | 85,000  |         |  |        | 4,106,000  |   |  |   |         |   |  |   |         |   |  |   |             |   |  |   | 4,191,000   |  
|Issuance of common stock in connection with the
    employee stock purchase plan                                        |  |                 |            |              |  |            |         |          |  |               | 41,000     |              |  |               |         |         |  |        | 12,000     |   |  |   |         |   |  |   |         |   |  |   |             |   |  |   | 12,000      |  
|Issuance of common stock to settle certain
    compensation and lease arrangements                                      |  |                 |            |              |  |            |         |          |  |               | 262,000    |              |  |               | 3,000   |         |  |        | 324,000    |   |  |   |         |   |  |   |         |   |  |   |             |   |  |   | 327,000     |  
|Common stock issued in connection with private
    placement                                                            |  |                 |            |              |  |            |         |          |  |               | 1,786,000  |              |  |               | 18,000  |         |  |        | 982,000    |   |  |   |         |   |  |   |         |   |  |   |             |   |  |   | 1,000,000   |  
|Transaction costs paid in connection with equity
    credit line                                                        |  |                 |            |              |  |            |         |          |  |               | 100,000    |              |  |               | 1,000   |         |  |        | (12,000    | ) |  |   |         |   |  |   |         |   |  |   |             |   |  |   | (11,000     | )
|Warrants issued and discount recognized in
    connection with issuance of convertible debentures                       |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |        | 1,640,000  |   |  |   |         |   |  |   |         |   |  |   |             |   |  |   | 1,640,000   |  
|Non-cash convertible preferred stock dividends                                                                          |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |        | 4,130,000  |   |  |   |         |   |  |   |         |   |  |   | (4,130,000  | ) |  |   |            |  
|                                                                                                                        |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |        |            |   |  |   |         |   |  |   |         |   |  |   |             |   |  |   |             |  
|Balance at December 31, 2001                                                                                            |  |                 | 12,929,000 |              |  | $          | 129,000 |          |  |               | 38,565,000 |              |  | $             | 386,000 |         |  | $      | 99,549,000 |   |  | $ |        |   |  | $ | (10,000 | ) |  | $ | (99,150,000 | ) |  | $ | 904,000     |  
|                                                                                                                        |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |        |            |   |  |   |         |   |  |   |         |   |  |   |             |   |  |   |             |  

F-6



---



##### 



|                                                                                                                   |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |        |             |   |  |   |   |  |  |   |         |   |  |   |              |   |  |   |            |  
|------------------------------------------------------------------------------------------------------------------ |  | --------------- | ---------- | ------------ |  | ---------- | ------- | -------- |  | ------------- | ---------- | ------------ |  | ------------- | ------- | ------- |  | ------ | ----------- | - |  | - | - |  |  | - | ------- | - |  | - | ------------ | - |  | - | ---------- | -
|                                                                                                                   |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |        
|                                                                                                                   |  | Convertible     |            |              |  |            |         |          |  |               |            |              |  |              
|                                                                                                                   |  | Preferred Stock |            | Common Stock |  | Additional |         |          |  | Other         |            |              |  | Total        
|                                                                                                                   |  |                 |            |              |  | Paid-In    |         | Deferred |  | Comprehensive |            | Accumulated  |  | Stockholders
|                                                                                                                   |  | Shares          |            | Amount       |  | Shares     |         | Amount   |  | Capital       |            | Compensation |  | Loss          |         | Deficit |  | Equity
|                                                                                                                   |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |       
|Balance at December 31, 2001                                                                                       |  |                 | 12,929,000 |              |  | $          | 129,000 |          |  |               | 38,565,000 |              |  | $             | 386,000 |         |  | $      | 99,549,000  |   |  | $ |  |  |  | $ | (10,000 | ) |  | $ | (99,150,000  | ) |  | $ | 904,000    |  
|Net loss                                                                                                           |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |        |             |   |  |   |   |  |  |   |         |   |  |   | (5,301,000   | ) |  |   | (5,301,000 | )
|Foreign currency translation adjustment                                                                            |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |        |             |   |  |   |   |  |  |   | (6,000  | ) |  |   |              |   |  |   | (6,000     | )
|                                                                                                                   |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |        |             |   |  |   |   |  |  |   |         |   |  |   |              |   |  |   |            |  
|Comprehensive loss                                                                                                 |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |        |             |   |  |   |   |  |  |   |         |   |  |   |              |   |  |   | (5,307,000 | )
|                                                                                                                   |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |        |             |   |  |   |   |  |  |   |         |   |  |   |              |   |  |   |            |  
|Issuance of common stock in connection with the
    employee stock purchase plan                                   |  |                 |            |              |  |            |         |          |  |               | 61,000     |              |  |               | 1,000   |         |  |        | 16,000      |   |  |   |   |  |  |   |         |   |  |   |              |   |  |   | 17,000     |  
|Issuance of common stock and warrants in
    connection with the conversion of Series A convertible
    debentures |  |                 |            |              |  |            |         |          |  |               | 4,444,000  |              |  |               | 44,000  |         |  |        | 1,980,000   |   |  |   |   |  |  |   |         |   |  |   |              |   |  |   | 2,024,000  |  
|Issuance of common stock in connection with the
    equity line of credit                                          |  |                 |            |              |  |            |         |          |  |               | 12,537,000 |              |  |               | 126,000 |         |  |        | 3,114,000   |   |  |   |   |  |  |   |         |   |  |   |              |   |  |   | 3,240,000  |  
|Issuance of common stock in connection with the
    conversion of Series C II preferred stock                      |  |                 | (925,000   | )            |  |            | (9,000  | )        |  |               | 1,333,000  |              |  |               | 13,000  |         |  |        | (4,000      | ) |  |   |   |  |  |   |         |   |  |   |              |   |  |   |           |  
|Issuance of common stock in connection with the
    conversion of Series C III preferred stock                     |  |                 | (2,050,000 | )            |  |            | (21,000 | )        |  |               | 2,614,000  |              |  |               | 26,000  |         |  |        | (5,000      | ) |  |   |   |  |  |   |         |   |  |   |              |   |  |   |           |  
|Issuance of common stock in connection with the
    conversion of Series B preferred stock                         |  |                 | (34,000    | )            |  |            |        |          |  |               | 34,000     |              |  |               |        |         |  |        |             |   |  |   |   |  |  |   |         |   |  |   |              |   |  |   |           |  
|Warrants issued for consulting services                                                                            |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |        | 16,000      |   |  |   |   |  |  |   |         |   |  |   |              |   |  |   | 16,000     |  
|Warrants issued and discount recognized in
    connection with issuance of convertible debentures                  |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |        | 88,000      |   |  |   |   |  |  |   |         |   |  |   |              |   |  |   | 88,000     |  
|Non-cash convertible preferred stock dividends                                                                     |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |        | 668,000     |   |  |   |   |  |  |   |         |   |  |   | (668,000     | ) |  |   |           |  
|                                                                                                                   |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |        |             |   |  |   |   |  |  |   |         |   |  |   |              |   |  |   |            |  
|Balance at December 31, 2002                                                                                       |  |                 | 9,920,000  |              |  | $          | 99,000  |          |  |               | 59,588,000 |              |  | $             | 596,000 |         |  | $      | 105,422,000 |   |  | $ |  |  |  | $ | (16,000 | ) |  | $ | (105,119,000 | ) |  | $ | 982,000    |  
|                                                                                                                   |  |                 |            |              |  |            |         |          |  |               |            |              |  |               |         |         |  |        |             |   |  |   |   |  |  |   |         |   |  |   |              |   |  |   |            |  

See accompanying notes to consolidated financial
statements

F-7



---



##### 



ON2 TECHNOLOGIES, INC.

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                                                 |                                                                    |                                                                                 |                                                                                 |                                       |                                           |           |            |             |   |           |            |             |  
|---------------------------------------------------------------- | ------------------------------------------------------------------ | ------------------------------------------------------------------------------- | ------------------------------------------------------------------------------- | ------------------------------------- | ----------------------------------------- | --------- | ---------- | ----------- | - | --------- | ---------- | ----------- | -
|                                                                 |                                                                    |                                                                                
|                                                                 |                                                                    | Year Ended December 31,                                                        
|                                                                 |                                                                    |                                                                                
|                                                                 |                                                                    | 2002                                                                            |                                                                                 | 2001                                 
|                                                                 |                                                                    |                                                                                 |                                                                                 |                                      
|Cash flows from operating activities:                            |                                                                    |                                                                                 |                                                                                 |                                       |                                           |           |            |            
|                                                                 | Net loss                                                           |                                                                                 | $                                                                               | (5,301,000                            | )                                         |           | $          | (17,032,000 | )
|                                                                 |                                                                    | Adjustments to reconcile net loss to net cash
    used in operating activities: |                                                                                 |                                       |                                           |           |            |             |   |          
|                                                                 |                                                                    |                                                                                 | Non-cash stock based charges                                                    |                                       |                                           | 16,000    |            |             |   | 144,000   |           
|                                                                 |                                                                    |                                                                                 | Debt conversion costs                                                           |                                       |                                           | 24,000    |            |             |   |           |           
|                                                                 |                                                                    |                                                                                 | Restructuring and impairment charges                                            |                                       |                                           | 30,000    |            |             |   | 3,224,000 |           
|                                                                 |                                                                    |                                                                                 | Depreciation and amortization                                                   |                                       |                                           | 1,500,000 |            |             |   | 2,987,000 |           
|                                                                 |                                                                    |                                                                                 | Deferred compensation                                                           |                                       |                                           |           |            |             |   | 44,000    |           
|                                                                 |                                                                    |                                                                                 | Reserve for bad debts                                                           |                                       |                                           | 50,000    |            |             |   | 125,000   |           
|                                                                 |                                                                    |                                                                                 | Loss on abandonment of assets                                                   |                                       |                                           | 289,000   |            |             |   |           |           
|                                                                 |                                                                    |                                                                                 | Amortization of debt discount                                                   |                                       |                                           | 7,000     |            |             |   | 1,640,000 |           
|                                                                 |                                                                    |                                                                                 | Impairment of equity investments                                                |                                       |                                           |           |            |             |   | 125,000   |           
|                                                                 |                                                                    |                                                                                 | Changes in operating assets and liabilities, net
    of effect of acquisitions: |                                       |                                           |           |            |             |   |           |           
|                                                                 |                                                                    |                                                                                 |                                                                                 | Accounts receivable                   |                                           |           | 29,000     |             |   |           | (446,000   | )          
|                                                                 |                                                                    |                                                                                 |                                                                                 | Prepaid and other current assets      |                                           |           | 121,000    |             |   |           | 229,000    |            
|                                                                 |                                                                    |                                                                                 |                                                                                 | Other assets                          |                                           |           | 254,000    |             |   |           | 138,000    |            
|                                                                 |                                                                    |                                                                                 |                                                                                 | Accounts payable and accrued expenses |                                           |           | (468,000   | )           |   |           | (1,241,000 | )          
|                                                                 |                                                                    |                                                                                 |                                                                                 | Deferred revenue                      |                                           |           | (35,000    | )           |   |           | (38,000    | )          
|                                                                 |                                                                    |                                                                                 |                                                                                 |                                       |                                           |           |            |            
|                                                                 |                                                                    |                                                                                 |                                                                                 |                                       | Net cash used in operating activities     |           |            | (3,484,000  | ) |           |            | (10,101,000 | )
|                                                                 |                                                                    |                                                                                 |                                                                                 |                                       |                                           |           |            |            
|Cash flows from investing activities:                            |                                                                    |                                                                                 |                                                                                 |                                       |                                           |           |            |            
|                                                                 | Purchases of property and equipment                                |                                                                                 |                                                                                 | (78,000                               | )                                         |           |            | (143,000    | )
|                                                                 | Proceeds from the sale of fixed assets                             |                                                                                 |                                                                                 |                                       |                                           |           |            | 25,000      |  
|                                                                 | Purchase of long-term equity investment                            |                                                                                 |                                                                                 |                                       |                                           |           |            | (8,000      | )
|                                                                 | Cash paid for acquisitions, net of cash acquired                   |                                                                                 |                                                                                 |                                       |                                           |           |            | (42,000     | )
|                                                                 |                                                                    |                                                                                 |                                                                                 |                                       |                                           |           |            |            
|                                                                 |                                                                    |                                                                                 |                                                                                 |                                       | Net cash used in investing activities     |           |            | (78,000     | ) |           |            | (168,000    | )
|                                                                 |                                                                    |                                                                                 |                                                                                 |                                       |                                           |           |            |            
|Cash flows from financing activities:                            |                                                                    |                                                                                 |                                                                                 |                                       |                                           |           |            |            
|                                                                 | Principal payments on capital lease obligations                    |                                                                                 |                                                                                 | (2,000                                | )                                         |           |            | (26,000     | )
|                                                                 | Principal payments on notes payable                                |                                                                                 |                                                                                 |                                       |                                           |           |            | (251,000    | )
|                                                                 | Financing costs                                                    |                                                                                 |                                                                                 |                                       |                                           |           |            | (10,000     | )
|                                                                 | Proceeds from the issuance of Series C-VI
    Preferred Stock, net |                                                                                 |                                                                                 |                                       |                                           |           |            | 2,000,000   |  
|                                                                 | Proceeds from the sale of common stock, net                        |                                                                                 |                                                                                 | 3,258,000                             |                                           |           |            | 5,203,000   |  
|                                                                 | Proceeds from the issuance of convertible
    debentures           |                                                                                 |                                                                                 | 650,000                               |                                           |           |            | 2,000,000   |  
|                                                                 | Proceeds from exercise of common stock options
    and warrants    |                                                                                 |                                                                                 |                                       |                                           |           |            | 13,000      |  
|                                                                 |                                                                    |                                                                                 |                                                                                 |                                       |                                           |           |            |            
|                                                                 |                                                                    |                                                                                 |                                                                                 |                                       | Net cash provided by financing activities |           |            | 3,906,000   |   |           |            | 8,929,000   |  
|                                                                 |                                                                    |                                                                                 |                                                                                 |                                       |                                           |           |            |            
|Net change in cash and cash equivalents                          |                                                                    |                                                                                 | 344,000                                                                         |                                       |                                           |           | (1,340,000 | )          
|Effect of exchange rate changes on cash and cash
    equivalents |                                                                    |                                                                                 | (7,000                                                                          | )                                     |                                           |           | (6,000     | )          
|Cash and cash equivalents, beginning of period                   |                                                                    |                                                                                 | 216,000                                                                         |                                       |                                           |           | 1,562,000  |            
|                                                                 |                                                                    |                                                                                 |                                                                                 |                                       |                                           |           |            |            
|Cash and cash equivalents, end of period                         |                                                                    | $                                                                               | 553,000                                                                         |                                       |                                           | $         | 216,000    |            
|                                                                 |                                                                    |                                                                                 |                                                                                 |                                       |                                           |           |            |            

F-8



---



##### 



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

|                                 |                                                                                          |                         |   |           |  |  |   |        | 
|-------------------------------- | ---------------------------------------------------------------------------------------- | ----------------------- | - | --------- |  |  | - | ------ | 
|                                 |                                                                                          |                        
|                                 |                                                                                          | Year Ended December 31,
|                                 |                                                                                          |                        
|                                 |                                                                                          | 2002                    |   | 2001     
|                                 |                                                                                          |                         |   |          
|Cash paid during the period for: |                                                                                          |                         |   |           |  |  |   |       
|                                 | Interest                                                                                 |                         | $ | 6,000     |  |  | $ | 6,000  | 
|                                 |                                                                                          |                         |   |           |  |  |   |       
|                                 | Taxes                                                                                    |                         | $ | 18,000    |  |  | $ | 55,000 | 
|                                 |                                                                                          |                         |   |           |  |  |   |       
|Non-cash transactions:           |                                                                                          |                         |   |           |  |  |   |       
|                                 | Issuance of common stock to settle contractual
    obligations                           |                         |   |           |  |  | $ | 34,000 | 
|                                 |                                                                                          |                         |   |           |  |  |   |       
|                                 | Shares issued in connection with common stock
    purchase agreement                     |                         |   |           |  |  | $ | 33,000 | 
|                                 |                                                                                          |                         |   |           |  |  |   |       
|                                 | Acquisition of fixed assets under capital leases                                         |                         | $ | 33,000    |  |  |   |        | 
|                                 |                                                                                          |                         |   |           |  |  |   |       
|                                 | Conversion of Preferred Stock into Common Stock                                          |                         | $ | 30,000    |  |  |   |        | 
|                                 |                                                                                          |                         |   |           |  |  |   |       
|                                 | Conversion of debentures into common stock and
    warrants                              |                         | $ | 2,024,000 |  |  |   |        | 
|                                 |                                                                                          |                         |   |           |  |  |   |       
|                                 | Debt discount in connection with the issuance of
    convertible debentures and warrants |                         | $ | 88,000    |  |  |   |        | 
|                                 |                                                                                          |                         |   |           |  |  |   |       
|                                 | Non-cash convertible preferred stock dividends                                           |                         | $ | 668,000   |  |  |   |        | 
|                                 |                                                                                          |                         |   |           |  |  |   |       

See accompanying notes to consolidated financial
statements

F-9



---



##### 



ON2 TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS

December 31, 2002 and 2001


(1) Organization and Summary of
Significant Accounting Policies



| |                                    
| | -----------------------------------
| | (a) Description of the
    Business

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

The Companys consolidated financial
statements have been prepared assuming that it will continue as
a going concern. The Company has incurred recurring operating
losses and negative operating cash flows since its inception.
The Company is actively pursuing increases to its net cash flows
through increases in revenues and financing from its equity
lines of credit (see note 8). During the year ended
December 31, 2002 the Company terminated its building lease
in New York City, reduced its staff and consolidated operations
in the Albany, New York area for purposes of reducing the
Companys operating expenses. The Company believes that a
combination of increases to operating cash flow, primarily
through revenue growth and cost cutting initiatives, and funds
that may be received from its equity lines of credit or
additional financings will generate sufficient cash flow to fund
its operations through 2002. The Companys plan to increase
cash flows from operations relies significantly on increases in
revenue generated from its compression technology services,
products and licenses. However, there are no assurances that
such increases in revenues will be attained or that draws on the
equity line or additional financings will be successfully
consummated.



| |                              
| | -----------------------------
| | (b) Basis of
    Presentation

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



| |                               
| | ------------------------------
| | (c) 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.



| |                      
| | ---------------------
| | (d) Intangible Assets

Intangible assets consist of purchased technology
and certain other intangible assets that are stated at cost less
accumulated amortization. Goodwill and other intangible assets
were amortized using the straight-line method over the expected
period of benefit of the respective asset, ranging from 3 to
15 years. 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. As of December 31,
2001 and 2002, the Company had no recorded goodwill or
indefinite lived intangibles. As of December 31, 2001 and
2002, the Companys intangible assets consisted primarily
of purchased technology and the Company anticipates

F-10



---



##### 



ON2 TECHNOLOGIES, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

amortizing the remaining balance of $463,000 over
the remaining useful life through September 30, 2003.
However, the Company will continually evaluate its purchased
technology upon significant changes in certain circumstances
that may result in an impairment of the net carrying value.



| |                                                                           
| | --------------------------------------------------------------------------
| | (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 cash and cash equivalents,
accounts receivables and accounts payables approximate their
carrying values based on the short-term maturities of these
financial instruments.

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



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

F-11



---



##### 



ON2 TECHNOLOGIES, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)



| |                  
| | -----------------
| | Software Licenses

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



| |                      
| | ---------------------
| | Professional Services

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

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

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



| |                     
| | --------------------
| | (i) Cost of Revenues

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



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

Software developed for internal use is recognized
in accordance with SOP 98-1, Accounting for the
Cost of Computer Software Developed or Obtained for Internal
Use (SOP 98-1). SOP 98-1
requires all costs related to the development of internal use
software other than those incurred during the application

F-12



---



##### 



ON2 TECHNOLOGIES, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

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

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

|                                                                                   |             |                         |            |       |   |   |             |       |  
|---------------------------------------------------------------------------------- | ----------- | ----------------------- | ---------- | ----- | - | - | ----------- | ----- | -
|                                                                                   |             |                        
|                                                                                   |             | Year Ended December 31,
|                                                                                   |             |                        
|                                                                                   |             | 2002                    |            | 2001 
|                                                                                   |             |                         |            |      
|Reported net loss attributable to common
    stockholders                          |             | $                       | (5,969,000 | )     |   | $ | (21,162,000 | )    
|Stock-based employee compensation determined
    under the fair value-based method |             |                         | (3,797,000 | )     |   |   | (7,250,000  | )    
|                                                                                   |             |                         |            |       |   |   |             |      
|Pro forma net loss                                                                 |             | $                       | (9,766,000 | )     |   | $ | (28,412,000 | )    
|                                                                                   |             |                         |            |       |   |   |             |      
|Loss per common share (basic and diluted):                                         |             |                         |            |       |   |   |             |      
|                                                                                   | As reported |                         | $          | (0.11 | ) |   | $           | (0.64 | )
|                                                                                   |             |                         |            |       |   |   |             |      
|                                                                                   | Pro forma   |                         | $          | (0.19 | ) |   | $           | (0.86 | )
|                                                                                   |             |                         |            |       |   |   |             |      



| |                                                                                                                                                     
| | ----------------------------------------------------------------------------------------------------------------------------------------------------
| | 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,
|                         |  |             
|                         |  | 2002         |         | 2001
|                         |  |              |         |     
|Volatility               |  |              | 116     | %    |  |  | 106     | %
|Expected life of options |  |              | 3 years |      |  |  | 3 years |  
|Risk free interest rate  |  |              | 3.5     | %    |  |  | 3.5     | %
|Dividend yield           |  |              | 0       | %    |  |  | 0       | %

The weighted average fair value of options
granted during the years ended December 31, 2002 and 2001
were $0.22 and $0.43, respectively.



| |                                  
| | ---------------------------------
| | (l) Net Loss Per Common
    Share

The Company computes net loss per common share in
accordance with Statement of Financial Accounting Standard
No. 128, Computation of Earnings Per
Share, (SFAS 128). In accordance with
SFAS 128, basic earnings per share is computed using the
weighted average number of common shares outstanding during the
period. Common equivalent 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); common equivalent
shares are excluded from the calculation if their effect is
anti-dilutive.

F-13



---



##### 



ON2 TECHNOLOGIES, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Diluted loss per share has not been presented
separately, as the convertible preferred stock, convertible
debentures and the outstanding stock options and warrants are
anti-dilutive for each of the periods presented.



| |                     
| | --------------------
| | (m) Use of Estimates

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



| |                      
| | ---------------------
| | (n) Segment Reporting

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

Our customers typically represent large digital
communication and media companies, entertainment companies,
telecommunication companies and other global corporations that
operate within the digital media industry. For the year ended
December 31, 2002, three customers accounted for 27%, 11%
and 11% of the Companys total revenues. For the year ended
December 31, 2001, four customers accounted for 26%, 23%,
13% and 13% of the Companys total revenues. As of
December 31, 2002, four customers accounted for 22%, 20%,
19% and 15% of total accounts receivable. As of
December 31, 2001, three customers accounted for 42%, 31%
and 21% of total accounts receivable.

For the year ended December 31, 2002,
foreign customers accounted for approximately 50% of total
revenue. These customers are primarily located in Asia. For the
year ended December 31, 2001, foreign customers accounted
for approximately 67% of total revenue. 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 significant revenue generated from the
United Kingdom operations for the years ended December 31,
2002 and 2001.



| |                                                  
| | -------------------------------------------------
| | (o) Recently Issued Accounting
    Pronouncements

In June 2002, the FASB issued
SFAS No. 146, Accounting for Cost Associated
with Exit or Disposal Activities, which addresses
financial accounting and reporting for costs associated with
exit or disposal activities and nullifies Emerging Issues Task
Force (EITF) Issue No. 94-3, Liability
Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring). SFAS No. 146 requires that a
liability for a cost associated with an exit or disposal
activity be recognized when the liability is incurred. Under
EITF Issue No. 94-3, a liability for exit costs was
recognized at the date of an entitys commitment to an exit
plan. SFAS No. 146 is effective for exit or disposal
activities that are initiated after December 31, 2002. The
Company believes that the adoption of SFAS No. 146 will not
have a significant impact on its results of operations or
financial position.

In December 2002, the FASB issued SFAS
No. 148, Accounting for Stock-Based
Compensation  Transition and Disclosure as an
amendment to SFAS No. 123 to provide alternative
methods of transition for an entity that voluntarily changes to
the fair value based method of accounting for stock-based
employee compensation. It also amends the disclosure provisions
of SFAS No. 123 to require prominent disclosure

F-14



---



##### 



ON2 TECHNOLOGIES, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

about the effects on reported net income (loss)
of an entitys accounting policy decisions with respect to
stock-based employee compensation and amends APB Opinion
No. 28 to require disclosure about those effects in interim
financial information. The disclosure provisions are effective
for fiscal years ending after December 15, 2002 and for
interim periods beginning after December 15, 2002. The
Company follows the intrinsic value method of accounting for
stock-based employee compensation, but will continue to evaluate
the benefits of a voluntary change to the fair value based
method.

(2) Property and Equipment

|                                               |       |              |           |         |  |   |           |           | 
|---------------------------------------------- | ----- | ------------ | --------- | ------- |  | - | --------- | --------- | 
|                                               |       |             
|                                               |       | December 31,
|                                               |       |             
|                                               |       | 2002         |           | 2001   
|                                               |       |              |           |        
|Furniture and fixtures                         |       | $            | 65,000    |         |  | $ | 278,000   |          
|Computer equipment                             |       |              | 2,286,000 |         |  |   | 2,896,000 |          
|Leasehold improvements                         |       |              | 73,000    |         |  |   | 487,000   |          
|Licensed software                              |       |              | 588,000   |         |  |   | 857,000   |          
|                                               |       |              |           |         |  |   |           |          
|                                               |       |              | 3,012,000 |         |  |   | 4,518,000 |          
|Less accumulated depreciation and amortization |       |              | 2,659,000 |         |  |   | 3,112,000 |          
|                                               |       |              |           |         |  |   |           |          
|                                               | Total |              | $         | 353,000 |  |   | $         | 1,406,000 | 
|                                               |       |              |           |         |  |   |           |          

As of December 31, 2002, property and
equipment included assets under capital leases of $103,000 with
related accumulated depreciation of $92,000. As of
December 31, 2001, property and equipment included assets
under capital leases of $91,000 with related accumulated
depreciation of $61,000. Depreciation expense was $854,000 and
$1,205,000 for the years ended December 31, 2002 and 2001,
respectively.

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

(3) Intangible Assets

|                              |       |              |           |         |  |   |           |           | 
|----------------------------- | ----- | ------------ | --------- | ------- |  | - | --------- | --------- | 
|                              |       |             
|                              |       | December 31,
|                              |       |             
|                              |       | 2002         |           | 2001   
|                              |       |              |           |        
|Purchased technology          |       | $            | 2,509,000 |         |  | $ | 2,509,000 |          
|Other intangible assets       |       |              |           |         |  |   | 30,000    |          
|                              |       |              |           |         |  |   |           |          
|                              |       |              | 2,509,000 |         |  |   | 2,539,000 |          
|Less accumulated amortization |       |              | 2,046,000 |         |  |   | 1,418,000 |          
|                              |       |              |           |         |  |   |           |          
|                              | Total |              | $         | 463,000 |  |   | $         | 1,121,000 | 
|                              |       |              |           |         |  |   |           |          

As of December 31, 2001, other intangibles
consisted of a content library of $30,000, which was written off
in 2002. Amortization of goodwill and other intangible assets
was $1,154,000 for the year ended December 31, 2001. These
amounts exclude amortization of purchased technology of $627,000
for each of the years ended December 31, 2002 and 2001 that
was included in cost of revenues.

F-15



---



##### 



ON2 TECHNOLOGIES, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

(4) Accrued Expenses

|                                                                                     |       |              |         |         |  |   |         |         | 
|------------------------------------------------------------------------------------ | ----- | ------------ | ------- | ------- |  | - | ------- | ------- | 
|                                                                                     |       |             
|                                                                                     |       | December 31,
|                                                                                     |       |             
|                                                                                     |       | 2002         |         | 2001   
|                                                                                     |       |              |         |        
|Accrued compensation                                                                 |       | $            | 78,000  |         |  | $ | 96,000  |        
|Accrued professional fees                                                            |       |              | 54,000  |         |  |   | 150,000 |        
|Other accrued expenses                                                               |       |              | 122,000 |         |  |   | 93,000  |        
|Funds received prior to issuance of shares under
    common stock purchase agreement |       |              |         |         |  |   | 150,000 |        
|                                                                                     |       |              |         |         |  |   |         |        
|                                                                                     | Total |              | $       | 254,000 |  |   | $       | 489,000 | 
|                                                                                     |       |              |         |         |  |   |         |        

(5) Acquisitions



| |                                         
| | ----------------------------------------
| | (a) Asset Purchase of DVD Mags,
    Inc.

In 2000, Quickband, Inc. (Quickband),
a wholly owned subsidiary of the Company, acquired substantially
all of the assets of DVD Mags, Inc. In connection with this
acquisition, the Company recorded $2,084,000 of goodwill and
library content.

As part of a restructuring plan approved by the
Board of Directors in December 2000 in which the Company would
dispose of its non-strategic, content related assets, the
Company decided to sell the content acquired and created in
connection with the Quickband library. The Company recorded
non-cash restructuring and impairment charges of $30,000 and
$470,000 for the years ended December 31, 2002 and 2001,
respectively, related to the Quickband content library (see
note 11).



| |                                     
| | ------------------------------------
| | (b) Eight Cylinder Studios,
    Inc.

In connection with the acquisition of Eight
Cylinder Studios, Inc. (8CS) in 2000, the Company
recorded $3,655,000 of goodwill and other intangible assets.

For the year ended December 31, 2001, the
Company recorded an impairment charge of $2,344,000 to write-off
the net carrying values of the goodwill and other intangible
assets related to 8CS (see note 11).

(6) Income Taxes

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

As of December 31, 2002, the Company has net
operating loss carryforwards of approximately $74,346,000 which
expire at various dates through 2022, resulting in a deferred
tax asset of approximately $29,738,000. Past and future stock
issuances may subject the Company to an annual limitation on the
utilization of its net operating loss under Section 382 of
the Internal Revenue Code. At December 31, 2002 there were
no significant timing differences between tax and financial
reporting. A full valuation allowance, which increased by
$1,822,000 (the deferred tax asset as of December 31, 2001,
as restated was $27,916,000) during the year ended
December 31, 2002, has been recorded related to the
deferred tax asset as a result of managements uncertainty
as to the realization of such asset. Accordingly, no provision
for federal income tax benefit has been recognized. The tax
provisions of $28,000 and $64,000 for the years ended
December 31, 2002 and 2001, respectively, relate primarily
to various state and local taxes.

F-16



---



##### 



ON2 TECHNOLOGIES, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

(7) Convertible Debentures



| |                                        
| | ---------------------------------------
| | (a) Series A Convertible
    Debentures

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

Under the terms of the agreement, the Debentures
consist of 200 units, which are comprised of (1) $10,000
principal amount of Debentures and (2) one warrant to
purchase 7,000 shares of Common Stock at an exercise price
of $1.68 per share. The principal amount of the Debentures were
convertible into shares of Common Stock at a conversion price of
$0.45 six months after the date of issuance at the discretion of
the holder. The principal amount of the Debentures is due
4 years from the date of issuance and is non-interest
bearing.

As of December 31, 2001, the Company had
received the full $2,000,000 under the Debenture agreement. The
Company allocated the proceeds received to the principal amount
of the Debentures and the warrants based upon the relative fair
value method. The difference between the relative fair value of
the Debentures and the proceeds received was recorded as a debt
discount. The total amount of the debt discount is limited to
the total proceeds received. The total amount of the debt
discount was $1,640,000 and was fully amortized as of
December 31, 2001.

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



| |                                                
| | -----------------------------------------------
| | (b) Series A Secured Convertible
    Debentures

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

The Company allocated the proceeds received to
the principal amount of the debentures and the warrants based
upon the relative fair value method. The fair value of the
warrants was determined using the Black Scholes pricing model.
The difference between the proceeds allocated to, and the
relative fair value of the debentures, which amounted to
$88,000, was recorded as debt discount and additional paid-in
capital. The discount is being amortized over the life of the
debentures, including $7,000 for the year ended
December 31, 2002.

F-17



---



##### 



ON2 TECHNOLOGIES, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

(8) Stockholders Equity



| |                    
| | -------------------
| | (a) Preferred Stock

The Company has 20,000,000 shares of preferred
stock authorized for issuance and, through December 31,
2002, eight series of convertible preferred stock (collectively
Preferred Stock) were issued. Pursuant to its
Certificate of Incorporation, the Company may serially designate
separate classes of preferred stock up to the aggregate of its
authorized limit. The holders of the various series of Preferred
Stock generally have similar rights and privileges. Each class
of the Preferred Stock is convertible into shares of the
Companys Common Stock based on a conversion rate and has
rights and preferences which are generally more senior to the
Companys Common Stock and are more fully described in the
Companys Certificate of Incorporation.



| |                                         
| | ----------------------------------------
| | Series A Convertible Preferred
    Stock

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

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

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

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



| |                                         
| | ----------------------------------------
| | Series B Convertible Preferred
    Stock

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



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

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

F-18



---



##### 



ON2 TECHNOLOGIES, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

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 at 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 that allowed for the following:

Upon the earlier of (i) a change of control
or (ii) December 31, 2001, the Company would
(a) cancel the Series C Preferred and in its place
issue 1,849,000 shares of Series C-IV Preferred Stock,
par value $0.01 per share, with a conversion price of $2.65 per
share, and 4,100,000 shares of Series C-V Preferred
Stock, par value $0.01 per share, with a conversion price of
$1.244 per share, and (b) cancel the Travelers Warrants and
in their place issue 462,000 warrants with an exercise
price of $2.65 per share and 1,025,000 warrants with an
exercise price of $1.14 per share. Travelers was not entitled to
any further pricing protections. On December 31, 2001, the
Company canceled the Series C Preferred and issued the
Series C-IV and C-V Preferred Stock and the new
warrants to Travelers. The warrants are currently exerciseable
and expire in June 2003.

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

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

Additionally, as of December 31, 2001, the
conversion price of the Series C-V Preferred Stock was
adjusted to $0.9756 per share, the Company issued 272,000
additional warrants and the exercise price of the warrants was
reduced to $0.9012 per share. As a result of the issuance of the
Series A Secured convertible debentures in September 2002,
the conversion price of the Series C-V Preferred Stock was
further adjusted to $0.9047 per share, the Company issued
101,000 additional warrants and the exercise price of the
warrants was further reduced to $0.8363 per share.

The Company recorded a deemed non-cash
convertible preferred stock dividend of $226,000 and $1,160,000
for the years ended December 31, 2002 and 2001,
respectively, to recognize the additional benefit received by
Travelers for their anti-dilution provisions.



| |                                            
| | -------------------------------------------
| | Series C-II Convertible Preferred
    Stock

In September 2000, the Company designated
925,000 shares of its authorized preferred stock as
Series C-II Preferred Stock, $0.01 par value
(Series C-II Preferred) and completed a private
placement of 925,000 shares of the Series C-II Preferred
with detachable warrants for an aggregate purchase price of
$2,450,000 with three investors (the Series C-II
Investors). The original conversion price of the
Series C-II Preferred is $2.65 per share. In the event of
any liquidation, dissolution or winding up of the Company,
either voluntary or involuntary, the holders of the
Series C-II Preferred are entitled to receive an amount
equal to

F-19



---



##### 



ON2 TECHNOLOGIES, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

$2.65 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-II Preferred,
the Series C-II Investors received detachable warrants
which provide them the right to purchase an aggregate of
396,000 shares of the Companys Common Stock at an
exercise price of $2.65 per share. The warrants were immediately
exerciseable and expire in September 2003.

The holders of the Series C-II Preferred
Stock are entitled to certain anti-dilution protections,
triggered by certain subsequent issuances of debt or equity by
the Company. The anti-dilution provision primarily adjusts the
conversion price of the Series C-II Preferred Stock and the
number and exercise price of the original warrants issued. The
anti-dilution provision for the Series C-II Preferred Stock
was triggered by certain subsequent debt and equity financings
consummated by the Company. As of December 31, 2001, the
conversion price of the Series C-II Preferred Stock was
adjusted to $1.90 per share, the Company issued an additional
156,000 warrants and the exercise price of the warrants was
reduced to $1.90 per share. As a result of the issuance of the
Series A Secured convertible debentures in September 2002,
the conversion price of the Series C-II Preferred Stock was
further adjusted to $1.7549 per share, the Company issued 46,000
additional warrants and the exercise price of the warrants was
further reduced to $1.7549 per share.

The Company recorded a deemed non-cash
convertible preferred stock dividend of $427,000 and $1,086,000
for the years ended December 31, 2002 and 2001,
respectively, to record the additional benefit received by the
Series C-II Investors.

During the year ended December 31, 2002, all
of the shares of Series C-II Preferred Stock were converted
into 1,333,000 shares of the Companys Common Stock.



| |                                             
| | --------------------------------------------
| | 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 is $1.244 per
share. In the event of any liquidation, dissolution or winding
up of the Company, either voluntary or involuntary, the holders
of the Series C-III Preferred are entitled to receive an
amount equal to $1.244 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-III Preferred,
the Series C-III Investors received detachable warrants
which provide them the right to purchase an aggregate of
635,000 shares of the Companys Common Stock at an
exercise price of $1.14 per share. The warrants were immediately
exerciseable and expire on December 7, 2003.

The holders of the Series C-III Preferred
Stock are entitled to certain anti-dilution protections,
triggered by certain subsequent issuances of debt or equity by
the Company. The anti-dilution provision primarily adjusts the
conversion price of the Series C-III Preferred Stock and
the number and exercise price of the original warrants issued.
The anti-dilution provision for the Series C-III Preferred
Stock was triggered by certain subsequent debt and equity
financings consummated by the Company. As of December 31,
2001, the conversion price of the Series C-III Preferred
Stock was adjusted to $0.9756 per share, the Company issued an
additional 175,000 warrants and the exercise price of the
warrants was reduced to $0.9012 per share. As a result of the
issuance of convertible debentures in September 2002, the
Company issued 63,000 additional warrants and the exercise price
of the warrants was further reduced to $0.8363 per share.

F-20



---



##### 



ON2 TECHNOLOGIES, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

The Company recorded a deemed non-cash
convertible preferred stock dividend of $15,000 and $956,000 for
the years ended December 31, 2002 and 2001, respectively,
to record the additional benefit received by the
Series C-III Investors.

During the year ended December 31, 2002 all
of the shares of Series C-III Preferred Stock were
converted into 2,614,000 shares of the Companys
Common Stock.



| |                                            
| | -------------------------------------------
| | Series C-VI Convertible Preferred
    Stock

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

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

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



| |                                            
| | -------------------------------------------
| | Series C-VI Convertible Preferred
    Stock

The following table summarizes the common stock
issuable upon conversion of all outstanding Preferred Stock and
related warrants at December 31, 2002:

|                            |  |                |        |               |  |  |           | 
|--------------------------- |  | -------------- | ------ | ------------- |  |  | --------- | 
|                            |  |                |        | Shares of    
|                            |  |                |        | Common Stock 
|                            |  | Conversion or  |        | Issuable upon
|                            |  | Exercise Price |        | Conversion/  
|Convertible Security        |  | per Share      |        | Exercise     
|                            |  |                |        |              
|Series A Preferred Stock    |  | $              | 7.50   |               |  |  | 400,000   | 
|Series C-II Warrants        |  | $              | 1.7549 |               |  |  | 598,000   | 
|Series C-III Warrants       |  | $              | 0.8363 |               |  |  | 873,000   | 
|Series C-IV Preferred Stock |  | $              | 1.7549 |               |  |  | 2,792,000 | 
|Series C-IV Warrants        |  | $              | 1.7549 |               |  |  | 698,000   | 

F-21



---



##### 



ON2 TECHNOLOGIES, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

|                            |  |                |        |               |  |  |           | 
|--------------------------- |  | -------------- | ------ | ------------- |  |  | --------- | 
|                            |  |                |        | Shares of    
|                            |  |                |        | Common Stock 
|                            |  | Conversion or  |        | Issuable upon
|                            |  | Exercise Price |        | Conversion/  
|Convertible Security        |  | per Share      |        | Exercise     
|                            |  |                |        |              
|Series C-V Preferred Stock  |  | $              | 0.9047 |               |  |  | 5,637,000 | 
|Series C-V Warrants         |  | $              | 0.8363 |               |  |  | 1,397,000 | 
|Series C-VI Preferred Stock |  | $              | 0.56   |               |  |  | 3,571,000 | 
|Series C-VI Warrants        |  | $              | 0.56   |               |  |  | 5,357,000 | 



| |                 
| | ----------------
| | (b) Common Stock



| |                      
| | ---------------------
| | Equity-Line of Credit

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

Under the Initial Stock Purchase Agreement,
shares of Common Stock are periodically sold to the Investor at
a discount from market value ranging from 6%-10%, depending on
the closing price of the Companys Common Stock. The amount
of Common Stock sold is at the sole discretion of the Company
and at no time throughout the term of the Stock Purchase
Agreement is the Company obligated to sell its Common Stock,
unless the Company issues a drawdown notice. The Company issued
warrants to purchase 50,000 shares of the Companys
Common Stock and incurred $25,000 of transaction costs in
connection with the Stock Purchase Agreement.

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

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

Under the Second Stock Purchase Agreement, shares
of Common Stock are periodically sold to the Investor at a
discount from market value ranging from 6%-10%, depending on the
closing price of the Companys Common Stock. The amount of
Common Stock sold is at the sole discretion of the Company and
at no time throughout the term of the Stock Purchase Agreement
is the Company obligated to sell its

F-22



---



##### 



ON2 TECHNOLOGIES, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

Common Stock, unless the Company issues a draw
down notice. The Company issued 100,000 shares of
unrestricted Common Stock and incurred approximately $10,000 of
transaction costs in connection with the Second Stock Purchase
Agreement.

In April 2002, the Companys shareholders
approved the sale, at the sole discretion of the Company, of up
to 9,000,000 shares of Common Stock in connection with the
Second Stock Purchase Agreement. The Company sold
5,513,000 shares of Common Stock for net proceeds of
approximately $727,000 under the Second Stock Purchase
Agreement, for the year ended December 31, 2002

As of December 31, 2002 the Company can sell
up to approximately 3.5 million additional shares of Common
Stock under these common stock purchase agreements.



| |                                 
| | --------------------------------
| | Investment by RealNetworks, Inc.

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

Additionally, in July 2001 the Company entered
into a Software Development and License Agreement with
RealNetworks, Inc. Under terms of the agreement, the Company
agreed to develop software plug-ins in order to incorporate the
technologies of the Company and RealNetworks and to license its
compression technology for use in RealNetworks media
delivery products and services for a four-year term. In order
for the Company to develop the plug-ins described in the
agreement, RealNetworks was required to provide certain
development software and fulfill certain other obligations.
RealNetworks failed to deliver such software and perform such
other obligations. During 2002, the Company notified
RealNetworks that it had terminated the agreement. RealNetworks
has disputed the Companys right to terminate the agreement
and further claimed that the Company was in breach of the
agreement. The Company responded by reiterating its position and
has not had any subsequent contacts or discussions with
RealNetworks. The Company believes that it had the right to
terminate the agreement based on the nonperformance of
RealNetworks. However, because the arrangement with RealNetworks
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. The
accompanying financial statements do not include any provision
for the outcome of this matter.



| |             
| | ------------
| | (c) Warrants

The Company has issued common stock purchase
warrants to various consultants, strategic partners and
investors. The following table summarizes information about the
common stock purchase warrants outstanding as of
December 31, 2002. All warrants were exerciseable as of
December 31, 2002.

|                |  |             |            |                |  |                  |       |  |  |  |           | 
|--------------- |  | ----------- | ---------- | -------------- |  | ---------------- | ----- |  |  |  | --------- | 
|                |  | Number of   |            | Weighted       |  |                 
|Range of        |  | Warrants    |            | Average        |  |                 
|Exercise Prices |  | Outstanding |            | Exercise Price |  | Expiration Dates
|                |  |             |            |                |  |                 
|$ 0.11  $ 0.84 |  |             | 9,061,000  |                |  | $                | 0.57  |  |  |  | 2003-2007 | 
|$ 1.34  $ 1.75 |  |             | 3,081,000  |                |  | $                | 1.71  |  |  |  | 2003-2006 | 
|$ 6.08  $11.25 |  |             | 32,000     |                |  | $                | 7.77  |  |  |  | 2003-2004 | 
|$19.89  $28.38 |  |             | 222,000    |                |  | $                | 24.55 |  |  |  | 2004-2005 | 
|                |  |             |            |                |  |                  |       |  |  |  |           | 
|                |  |             | 12,396,000 |                |  | $                | 1.30  |  |  |  |           | 
|                |  |             |            |                |  |                  |       |  |  |  |           | 

F-23



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##### 



ON2 TECHNOLOGIES, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

(9) Stock Option Plans

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

In February 2000, the Company amended the 1999
Stock Option Plan to create the 1999 Amended and Restated
Incentive and Nonqualified Stock Option Plan (the 1999
Plan). The 1999 Plan increased the shares of Common Stock
reserved for issuance from 4,000,000 to 5,500,000. The
Companys stockholders approved the 1999 Plan in May 2000.
The 1999 Plan provides for the issuance of incentive stock
options, which are intended to qualify under section 422 of
the Internal Revenue Service Code, non-qualified stock
options and restricted stock grants. The granting of
incentive stock options is subject to the limitations as set
forth in the 1999 Plan. Directors, officers, employees and
consultants are eligible to receive grants under the 1999 Plan.
A committee selected by the Companys Board of Directors
has the authority to approve option grants and the terms, which
include the option price and the vesting terms. Options granted
under the 1999 Plan expire after a ten-year period and are
subject to acceleration upon the occurrence of certain events.

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

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

|                                                     |           |         |           |                |   |   |      |      | 
|---------------------------------------------------- | --------- | ------- | --------- | -------------- | - | - | ---- | ---- | 
|                                                     |           |         |           | Weighted      
|                                                     |           | Options |           | Average       
|                                                     |           | Granted |           | Exercise Price
|                                                     |           |         |           |               
|Outstanding January 1, 2001                          |           |         | 6,825,000 |                |   | $ | 6.79 |     
|                                                     | Granted   |         |           | 3,585,000      |   |   |      | 0.59 | 
|                                                     | Exercised |         |           | (366,000       | ) |   |      | 0.82 | 
|                                                     | Canceled  |         |           | (2,791,000     | ) |   |      | 4.42 | 
|                                                     |           |         |           |                |   |   |      |     
|Outstanding December 31, 2001                        |           |         | 7,253,000 |                |   |   | 4.97 |     
|                                                     | Granted   |         |           | 2,906,000      |   |   |      | 0.31 | 
|                                                     | Canceled  |         |           | (3,876,000     | ) |   |      | 6.76 | 
|                                                     |           |         |           |                |   |   |      |     
|Outstanding at December 31, 2002                     |           |         | 6,283,000 |                |   | $ | 1.71 |     
|                                                     |           |         |           |                |   |   |      |     
|Exercisable at December 31, 2001                     |           |         | 3,088,000 |                |   |   |      |     
|                                                     |           |         |           |                |   |   |      |     
|Exercisable at December 31, 2002                     |           |         | 4,279,000 |                |   |   |      |     
|                                                     |           |         |           |                |   |   |      |     
|Options available for grant at December 31,
    2002 |           |         | 2,924,000 |                |   |   |      |     
|                                                     |           |         |           |                |   |   |      |     

Included in the 366,000 options exercised in
2001 are 150,000 shares of Common Stock issued to a former
employee to terminate his employment contract (see note 11)
and 200,000 shares of Common Stock issued to the
Companys non-executive Chairman of the Board of Directors
as compensation. The related expense amounts of $210,000 and
$133,000, respectively, have been recognized in the appropriate
expense categories in the Companys consolidated financial
statements. These amounts were excluded from the

F-24



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##### 



ON2 TECHNOLOGIES, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

calculations of the weighted average exercise
price, the weighted average remaining contractual life and the
pro forma expense amounts disclosed herein.

The following table summarizes information about
stock options outstanding as of December 31, 2002:

|                  |  |                     |             |                     |  |                  |       |           |  |          |      |  |  |  |           |  |  |   |       | 
|----------------- |  | ------------------- | ----------- | ------------------- |  | ---------------- | ----- | --------- |  | -------- | ---- |  |  |  | --------- |  |  | - | ----- | 
|                  |  |                     |             |                    
|                  |  | Options Outstanding |             | Options Exercisable
|                  |  |                     |             |                    
|                  |  |                     |             | Weighted            |  | Weighted Average |       |           |  | Weighted
|                  |  |                     |             | Average             |  | Remaining        |       |           |  | Average 
|Range of Exercise |  | Number of           |             | Exercise            |  | Contractual Life |       | Number of |  | Exercise
|Prices            |  | Shares              |             | Price               |  | (in years)       |       | Shares    |  | Price   
|                  |  |                     |             |                     |  |                  |       |           |  |         
|$ 0.10  $ 0.4    |  |                     | 5 3,117,000 |                     |  | $                | 0.30  |           |  |          | 9.3  |  |  |  | 1,344,000 |  |  | $ | 0.30  | 
|$ 0.60  $ 0.8    |  |                     | 8 1,558,000 |                     |  |                  | 0.77  |           |  |          | 7.2  |  |  |  | 1,531,000 |  |  |   | 0.77  | 
|$ 1.20  $ 3.8    |  |                     | 8 1,108,000 |                     |  |                  | 2.60  |           |  |          | 7.7  |  |  |  | 953,000   |  |  |   | 2.58  | 
|$ 6.00  $11.81   |  |                     | 439,000     |                     |  |                  | 10.70 |           |  |          | 7.3  |  |  |  | 393,000   |  |  |   | 10.75 | 
|$12.25  $25.00   |  |                     | 61,000      |                     |  |                  | 16.71 |           |  |          | 6.6  |  |  |  | 58,000    |  |  |   | 16.59 | 
|                  |  |                     |             |                     |  |                  |       |           |  |          |      |  |  |  |           |  |  |   |       | 
|                  |  |                     | 6,283,000   |                     |  | $                | 1.71  |           |  |          | 8.34 |  |  |  | 4,279,000 |  |  | $ | 2.16  | 
|                  |  |                     |             |                     |  |                  |       |           |  |          |      |  |  |  |           |  |  |   |       | 

Non-cash stock based compensation of $16,000 and
$144,000 were charged to operations for the years ended
December 31, 2002 and 2001, respectively, and represents
options to purchase shares of Common Stock granted to certain
consultants in both 2002 and 2001 and represents shares of
Common Stock issued to our Non-Executive Chairman in lieu of
cash compensation in 2001.

(10) Employee Stock Purchase
Plan

In February 2001, the Board of Directors adopted
the 2001 Employee Stock Purchase Plan (ESPP). The
ESPP provided eligible employees of the Company the opportunity
to apply a portion of their after tax compensation to the
purchase of shares of the Companys Common Stock at a 15%
discount from market value. The Company reserved 4,000,000
authorized but unissued shares of Common Stock for issuance
under the ESPP. The ESPP was approved at the Companys
Annual Meeting of Shareholders in May 2001. The Company issued
61,000 and 41,000 shares of Common Stock under the ESPP
during the years ended December 31, 2002 and 2001,
respectively. The Company cancelled the ESPP during 2002.

(11) Restructuring and Impairment
Charges

(a) Cost
Curtailment and Restructuring Charges and Impairment
Charges

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

In 2001, the Company completed certain
restructuring initiatives that were related to the plan
established by the Board of Directors in December 2000. Although
identified as of December 31, 2000, our obligations could
not be measured at that time. As a result, we recorded a
non-cash restructuring charge of $293,000 for the year ended
December 31, 2001. The non-cash restructuring charge was
comprised of the following: (1) $210,000 related to the
termination of an employment contract which was satisfied
through the issuance of 150,000 shares of Common Stock in
February 2001 and (2) $83,000 related to the termination of
a

F-25



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##### 



ON2 TECHNOLOGIES, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

commercial lease obligation in San Francisco
which was satisfied through the issuance of 80,000 shares of
Common Stock in March 2001.

(b) Impairment
Charges

For the year ended December 31, 2001, the
Company recorded an impairment charge of $470,000, related to
its Quickband content library. The Company acquired the content
library, consisting primarily of licensed content for
distribution through DVD sales and the Internet, in April 2000.
The library was originally acquired for the Companys
broadband content network, which ceased operations in the second
quarter of 2000. However, the Company continued to sell the
licensed Quickband content, via DVD sales, through a
distribution agreement acquired in connection with the library.
As of December 31, 2000, the Company terminated all
operations related to its content assets. At that time, the
Company determined that further distribution of the Quickband
content would result in recurring losses. The Company made the
decision to sell the library and reduced the carrying value of
the library to $500,000 at December 31, 2000. This amount
represented the estimated fair value based upon interest in the
library at that time from several potential buyers, which never
materialized. The Company periodically reviewed the value of the
library against market demand and recorded a subsequent
impairment charge of $470,000 in 2001 based upon the perceived
value of the library and its content in the market. In 2002, the
Company recorded impairment charge of $30,000 when it wrote-off
the remaining balance of the content library.

For the year ended December 31, 2001, the
Company recorded an impairment charge $2,344,000 related to its
acquisition of 8CS in November 2000. The impairment charge
represented the net carrying value of the goodwill and
intangible assets recorded in connection with the acquisition.
8CS was a developer of three-dimensional graphic interface
software. The intention of the acquisition was to integrate the
Companys video compression technology with a
three-dimensional web browser to provide a PC-based video
delivery solution. As a result of the economic downturn and the
reduction in its financial resources, the Company determined
that additional development of the 8CS technology was not cost
beneficial. Furthermore, the Company was unsuccessful in its
attempts to sell the technology or create a strategic
partnership for further development. As the Company reached the
one-year anniversary of the 8CS acquisition in the fourth
quarter of 2001, the Company concluded that the 8CS acquisition
would provide no future benefit or value and wrote-off the
remaining goodwill and intangible assets. As of
December 31, 2001, there were no material tangible assets
related to 8CS nor would the Company incur additional costs.
Additionally, the Company did not recognize any revenue related
to 8CS since it was acquired.

The Company recorded a charge of $117,000 in 2001
related to certain intangible assets from which the Company
would no longer derive a benefit. The write-off reflected the
net book value of the assets at the time they were no longer
deemed to have value.

(12) Commitments and
Contingencies

(a) Operating
Leases

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

The Company has entered into several
non-cancelable leases, primarily related to the rental of
certain facilities and equipment. Future minimum lease payments,
by year and in the aggregate, under material

F-26



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##### 



ON2 TECHNOLOGIES, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

operating leases with initial or remaining terms
in excess of one year consisted of the following at
December 31, 2002:

|                        |                              |        |        |         | 
|----------------------- | ---------------------------- | ------ | ------ | ------- | 
|Year Ended December 31, |                              | Amount
|                        |                              |       
|2003                    |                              | $      | 72,000 |        
|2004                    |                              |        | 79,000 |        
|                        |                              |        |        |        
|                        | Total minimum lease payments |        | $      | 151,000 | 
|                        |                              |        |        |        

Rent expense under operating leases was
approximately $408,000 and $851,000 for the years ended
December 31, 2002 and 2001, respectively.

(b) Employment
Agreements

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

(c) Litigation

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

The Company sued Impact Imaging, Inc. in December
2002, alleging breach of contract and fraud arising from the
improper license of certain of the Companys software that
Impact Imaging had obtained pursuant to a License and Services
Agreement. Impact Imaging counterclaimed in February 2003
alleging that the Company unlawfully disclosed Impact
Imagings proprietary information and requesting damages.
In March 2003, the Company entered into a settlement agreement
with Impact Imaging, pursuant to which the License and Services
Agreement was terminated, subject to certain exceptions relating
to specific Impact Imaging customers.

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

(13) Related Party Transactions

The Companys management believes that the
terms of each transaction described below are comparable to, or
more favorable to us than the terms that would have been
obtained in an arms length transaction with an
unaffiliated party.

During the years ended December 31, 2002 and
2001, the Company retained McGuireWoods LLC to perform certain
legal services on its behalf and incurred approximately $178,000
and $340,000, respectively, for such legal services. We are
informed that McGuireWoods LLP provided the same hourly fee
structure to us that they provide to their other clients, which
hourly fees are customary for legal services rendered in their
geographic and practice area markets. William A. Newman, a
director, is a partner at McGuireWoods LLC.

F-27



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##### 



ON2 TECHNOLOGIES, INC.


NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS  (Continued)

In July 2001, the Company entered into a Unit
Purchase Agreement with Travelers whereby it sold an aggregate
of 3,571,000 units that consisted of one share of the
Companys Common Stock and a warrant to purchase
1.5 shares of the Companys Common Stock. The Company
received net proceeds of $2,000,000. On August 10, 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 are
not convertible into the Companys Common Stock until
February 9, 2002. Each share of Series C-VI Preferred
Stock converts on a one-for-one basis into shares of the
Companys Common Stock. In addition, the Company issued to
Travelers a warrant to purchase 5,357,000 shares of the
Companys Common Stock that was not exerciseable until
February 2002. The exercise price of the warrant is
$0.56 and the warrant expires in August 2005. The warrants
were issued to compensate the investor for purchasing shares
that are not registered for resale under the Securities Act. The
price per unit paid by Travelers was approximately
$0.56 per share. The average closing price of the
Companys common stock for the 10 days prior to the
transaction was approximately $0.51 per share. Jack L.
Rivkin, a director, was an officer of an affiliate of Travelers
until December 31, 2001 and Travelers is a beneficial owner
of more than 10% of the Companys Common Stock.

Also in July 2001, the Company entered into a
Software Development and License Agreement and a Common Stock
Purchase Agreement with Real whereby it agreed to use Real as
its exclusive delivery platform for streamed content over the
internet in exchange for which Real acquired 1,786,000 shares of
the Companys common stock and became a holder of 5.05% of
the Companys common stock.

Additionally, in July 2001 the Company entered
into a Software Development and License Agreement with
RealNetworks, Inc. Under terms of the agreement, the Company
agreed to develop software plug-ins in order to incorporate the
technologies of the Company and RealNetworks and to license its
compression technology for use in RealNetworks media
delivery products and services for a four-year term. In order
for the Company to develop the plug-ins described in the
agreement, RealNetworks was required to provide certain
development software and fulfill certain other obligations.
RealNetworks failed to deliver such software and perform such
other obligations. During 2002, the Company notified
RealNetworks that it had terminated the agreement. RealNetworks
has disputed the Companys right to terminate the agreement
and further claimed that the Company was in breach of the
agreement. The Company responded by reiterating its position and
has not had any subsequent contacts or discussions with
RealNetworks. The Company believes that it had the right to
terminate the agreement based on the nonperformance of
RealNetworks. However, because the arrangement with RealNetworks
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. The
accompanying financial statements do not include any provision
for the outcome of this matter.

F-28



---



##### 



SUPPLEMENTAL SCHEDULE

INFORMATION REGARDING PREDECESSOR
INDEPENDENT

PUBLIC ACCOUNTANTS REPORT


The following report is a copy of a previously
issued report by Arthur Andersen LLP. The report has not been
reissued by Arthur Andersen LLP nor has Arthur Andersen LLP
consented to its inclusion in this annual report on
form 10-K.

REPORT OF PREVIOUS INDEPENDENT PUBLIC
ACCOUNTANTS ON

SUPPLEMENTAL SCHEDULE


To On2 Technologies, Inc.:

We have audited the accompanying consolidated
balance sheets of On2 Technologies, Inc. (a Delaware
corporation) and subsidiaries as of December 31, 2001 and
2000 and the related consolidated statements of operations,
stockholders equity and cash flows for the years then
ended. These financial statements are the responsibility of the
Companys management. Our responsibility is to express an
opinion on these financial statements based on our audits.

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

In our opinion, the financial statements referred
to above present fairly, in all material respects, the financial
position of On2 Technologies, Inc. and subsidiaries as of
December 31, 2001 and 2000, and the results of their
operations and their cash flows for the years then ended in
conformity with accounting principles generally accepted in the
United States.

The accompanying financial statements have been
prepared assuming that the Company will continue as a going
concern. As discussed in Note 1 to the consolidated financial
statements, the Company has suffered recurring losses from
operations that raise substantial doubt about its ability to
continue as a going concern. Managements plans in regard
to this matter are also described in Note 1. The financial
statements do not include any adjustments that might result from
the outcome of this uncertainty.



| |                        
| | -----------------------
| | /s/ Arthur Andersen LLP

New York, New York

February 21, 2002