- Quarterly Report (10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

þ	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the quarterly period ended June 30, 2009.

o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 .
For the transition period from ____ to ____.

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.)


3 Corporate Drive, Suite 100, Clifton Park, New York	12065
(Address of principal executive offices)	(Zip Code)

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

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 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.

þ Yes

o No

Indicated by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or such shorter period that the registrant was required to submit and post such files).

o Yes

o No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definition of “accelerated filer”, “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (Check one).


	o Large accelerated filer	þ Accelerated filer
	o Non-accelerated filer 	o Smaller reporting company

APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY

PROCEEDINGS DURING THE PRECEDING FIVE YEARS:

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. o Yes o No

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest applicable date:

The number of shares of the Registrant’s Common Stock, par value $0.01 (“Common Stock”), outstanding as of July 30, 2009 was 175,504,000.

Table of Contents

PART I — FINANCIAL INFORMATION


		Page
Item 1. Consolidated Financial Statements.

Condensed Consolidated Balance Sheets at June 30, 2009 (unaudited) and December 31, 2008		2
Unaudited Condensed Consolidated Statements of Operations Three and Six Months Ended June 30, 2009 and 2008		3
Unaudited Condensed Consolidated Statements of Comprehensive Income (Loss) Three and Six Months Ended June 30, 2009 and 2008		4
Unaudited Condensed Consolidated Statements of Cash Flows Three and Six Months Ended June 30, 2009 and 2008		5
Notes to Unaudited Condensed Consolidated Financial Statements		7

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		23

Item 3. Quantitative and Qualitative Disclosures About Market Risk		41

Item 4. Controls and Procedures		42

PART II — OTHER INFORMATION

Item 1. Legal Proceedings		42

Item 1A. Risk Factors		43

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		43

Item 4. Submission of Matters to a Vote of Security Holders		44

Item 6. Exhibits		45

Signatures		46

Certifications

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PART I — FINANCIAL INFORMATION

Item 1.

Consolidated Financial Statements

ON2 TECHNOLOGIES, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except par value and share amounts)


	June 30, 2009			December 31, 2008
	(unaudited)

ASSETS
Current assets:
Cash and cash equivalents	$	2,666		$	4,157
Short-term investments		131			132
Accounts receivable, net of allowance for doubtful accounts of $385 at June 30, 2009 and $623 at December 31, 2008		2,199			2,730
Prepaid and other current assets		290			439
Total current assets		5,286			7,458
Property and equipment, net		700			715
Capital leases, net		372			686
Acquired software, net		1,859			2,212
Other acquired intangibles, net		4,945			5,276
Goodwill		9,068			9,099
Other assets		402			430
Total assets	$	22,632		$	25,876
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	1,323		$	1,352
Accrued expenses		4,203			4,368
Accrued restructuring expenses		785			—
Deferred revenue		1,484			2,133
Short-term borrowings		190			63
Current portion of long-term debt		171			1,148
Capital lease obligation		254			260
Total current liabilities		8,410			9,324
Long-term debt		1,979			1,802
Capital lease obligation, excluding current portion		311			432
Warrant derivative liability		139			—
Total liabilities		10,839			11,558
Commitments and contingencies		—			—
Stockholders’ equity:
Preferred stock, $0.01 par value; 20,000,000 authorized and -0- outstanding		—			—
Common stock, $0.01 par value; 250,000,000 shares authorized; 175,504,000 and 171,769,000 shares issued, and outstanding at June 30, 2009 and December 31, 2008, respectively		1,755			1,718
Additional paid-in capital		196,392			196,371
Accumulated other comprehensive loss		(1,247	)		(1,073	)
Accumulated deficit		(185,107	)		(182,698	)
Total stockholders’ equity		11,793			14,318
Total liabilities and stockholders’ equity	$	22,632		$	25,876

See accompanying notes to unaudited condensed consolidated financial statements

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ON2 TECHNOLOGIES, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


	Three Months Ended June 30,						Six Months Ended June 30,
	2009			2008			2009			2008
	(In thousands except per share data)

Revenue	$	4,996		$	3,265		$	9,012		$	7,717

Operating expenses:
Costs of revenue (1)		445			1,194			1,018			2,624
Research and development (2)		1,721			3,009			3,885			5,817
Sales and marketing (2)		926			1,875			1,902			3,764
General and administrative (2)		1,548			3,926			3,622			6,694
Restructuring expense		—			—			1,032			—
Costs associated with proposed merger		420			—			420			—
Litigation settlement costs		523						523
Equity-based compensation:
Research and development		173			105			311			224
Sales and marketing		70			74			119			112
General and administrative		194			258			426			471

Total operating expenses		6,020			10,441			13,258			19,706

Loss from operations		(1,024	)		(7,176	)		(4,246	)		(11,989	)

Other income (expense), net:
Interest (expense) income, net		(33	)		(14	)		(70	)		61
Other income, net		164			15			435			14
Gain from forgiveness of debt		669			—			669			—
Total other income		800			1			1,034			75

Net loss		(224	)		(7,175	)		(3,212	)		(11,914	)

Net loss attributable to common stockholders	$	(224	)	$	(7,175	)	$	(3,212	)	$	(11,914	)

Basic and diluted net loss attributable to common stockholders per common share	$	0.00		$	(0.04	)	$	(0.02	)	$	(0.07	)
Weighted average basic and diluted common shares outstanding		175,507			170,971			174,440			170,729

(1)	Includes equity-based compensation of $59,000 and $130,000 for the three and six months ended June 30, 2009. Includes equity-based compensation of $79,000 and $162,000 for the three and six months ended June 30, 2008.

(2)	Excludes equity-based compensation, which is presented separately.

See accompanying notes to unaudited condensed consolidated financial statements

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ON2 TECHNOLOGIES, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)


	Three Months Ended June 30,						Six Months Ended June 30,
	2009			2008			2009			2008
	(In thousands)						(In thousands)

Net loss	$	(224	)	$	(7,175	)	$	(3,212	)	$	(11,914	)

Other comprehensive income (loss):

Foreign currency translation adjustments		520			(57	)		(174	)		3,423

Comprehensive income (loss)	$	296		$	(7,232	)	$	(3,386	)	$	(8,491	)

See accompanying notes to unaudited condensed consolidated financial statements

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ON2 TECHNOLOGIES, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


	Six Months Ended June 30,
	2009			2008
	(In thousands)
Cash flows from operating activities:

Net loss	$	(3,212	)	$	(11,914	)
Adjustments to reconcile net loss to net cash used in operating activities:
Gain from forgiveness of debt		(669	)		—
Equity-based compensation		986			969
Depreciation		296			281
Amortization		630			1,562
Bad debt expense		(226	)		(131	)
Asset impairments from restructuring		175			—
Change in fair value of warrant derivative liability		18			—
Changes in operating assets and liabilities:
Accounts receivable		725			4,016
Prepaid expenses and other current assets		144			62
Other assets		25			12
Accounts payable and accrued expenses		(126	)		(679	)
Accrued restructuring expense		746			—
Deferred revenue		(617	)		1,745

Net cash used in operating activities		(1,105	)		(4,077	)

Cash flows from investing activities:

Proceeds from the sale of short-term investments		132			23,074
Purchase of short-term investments		(131	)		(17,684	)
Purchases of property and equipment		(168	)		(204	)

Net cash (used in) provided by investing activities		(167	)		5,186

Cash flows from financing activities:

Principal payments on capital lease obligations		(122	)		(95	)
Net proceeds from short-term borrowings		127			(2,281	)
Principal payments on long-term debt		(113	)		(183	)
Purchase of treasury stock		(4	)		(52	)
Proceeds from the exercise of common stock options and warrants		—			49

Net cash used in financing activities		(112	)		(2,562	)

Effect of exchange rate changes on cash and cash equivalents		(107	)		(122	)

Net decrease in cash and cash equivalents		(1,491	)		(1,575	)

Cash and cash equivalents, beginning of period		4,157			9,573

Cash and cash equivalents, end of period	$	2,666		$	7,998

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ON2 TECHNOLOGIES, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(CONTINUED)

Supplemental disclosure of cash flow information:

	Six Months Ended June 30,
	2009			2008
	(In thousands)

Cash paid during the period for interest	$	61		$	76
Warrant derivative liability - opening balance adjustment for liability	$	121			—
Warrant derivative liability - opening balance adjustment additional paid-in capital	$	(924	)		—
Warrant derivative liability - opening balance adjustment retained earnings	$	803			—
Acquisition of fixed assets under capital lease		—		$	461
Retirement of treasury stock	$	4		$	52

See accompanying notes to unaudited condensed consolidated financial statements

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ON2 TECHNOLOGIES, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(1) Description of On2 Technologies, Inc.

On2 Technologies, Inc. (“the Company”, “we”, “us” or “our”) is a developer of video compression technology and technology that enables the creation, transmission, and playback of multimedia in resource-limited environments, such as cellular networks transmitting to battery operated mobile handsets or High Definition (HD) video transmitted over the Internet. We have developed a proprietary technology platform and the On2® Video VPx family (e.g., VP6, VP7, and VP8) of video compression/decompression (“codec”) software to deliver high quality video at the lowest possible data rates over proprietary networks and the Internet to personal computers, wireless devices, set-top boxes and other devices. In addition, through our wholly-owned subsidiary, On2 Technologies Finland Oy, we license to chip and mobile handset manufacturers, and other developers of multimedia consumer products the hardware and software designs that make the encoding or decoding of video possible on mobile handsets, set top boxes, portable media players, cameras and other devices. We offer a suite of products and services based on our proprietary compression technology and mobile video technology. Our service offerings include customized engineering, consulting services, and technical support. In addition, we license our software products, which include video and audio codecs and encoding software, for use with video delivery platforms. We also license software that encodes video in the Adobe® Flash® 8 format and other formats; the Flash 8 format uses our VP6 video codec. We also license our hardware video codecs to companies that incorporate our technology into semi conductors and devices.

The Company’s business is characterized by rapid technological change, new product development and evolving industry standards. Inherent in the Company’s business model are various risks and uncertainties, including its limited operating history, unproven business model and the limited history of the industry in which it operates. The Company’s success may depend, in part, upon the wide adoption of video delivery media, prospective product and service development efforts, and the acceptance of the Company’s technology solutions by the marketplace.

The Company has experienced significant operating losses and negative operating cash flows to date. At June 30, 2009, the Company had negative working capital of $3,124,000. For the six months ended June 30, 2009, the Company incurred a net loss of $3,212,000, which included non-cash charges of $1,210,000. Cash used in operating activities was $1,105,000 for the six months ended June 30, 2009.

During 2008, the Company implemented a restructuring program, including a reduction of its workforce, a reduction in overhead costs, and the identification of one time charges for professional fees. Additionally, on January 28, 2009 the Company notified its employees at On2 Finland that it intended to further reduce its personnel costs there through furloughs, terminations and/or moving some full-time employees to part-time. In accordance with Finnish law, the Company negotiated with the representative of the On2 Finland employees and On2 Finland’s management team to obtain consensus on the reduction in workforce plan. On March 18, 2009 the cost reduction plan was finalized and communicated to On2 Finland employees. We are continuing to focus our efforts on marketing our compression and video technology to strengthen the demand for our product and services.

Additionally, On2 Finland may borrow funds up to a maximum of €450,000 ($632,000 based on exchange rates as of June 30, 2009) under a line of credit. As of June 30, 2009, the balance outstanding on this line of credit was $190,000. On July 30, 2009, the limit on the line of credit was reduced to €300,000. Given our cash and short-term investments of $2,797,000 at June 30, 2009, and the Company’s forecasted cash requirements, the Company’s management anticipates that the Company’s existing capital resources will be sufficient to satisfy our cash flow requirements for the next 12 months. We have based our forecasts on assumptions we have made relating to, among other things, the market for our products and services, economic conditions and the availability of credit to us and our customers. If these assumptions are incorrect, or if our sales are less than forecasted and/or expenses higher than expected, we may not have sufficient resources to fund our operations for this entire period. In that event, the Company may need to seek other sources of funds by issuing equity or incurring debt, or may need to implement further reductions of operating expenses, or some combination of these measures, in order for the Company to generate positive cash flows to sustain the operations of the Company. However, because of the recent tightening in global credit markets, we may not be able to obtain financing on favorable terms, or at all.

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(2) Basis of Presentation

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

The interim condensed consolidated financial statements are unaudited. However, in the opinion of management, such financial statements contain all adjustments (consisting of normally recurring accruals) necessary to present fairly the financial position of the Company and its results of operations and cash flows for the interim periods presented. The condensed consolidated financial statements included herein have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. The Company believes that the disclosures included herein are adequate to make the information presented not misleading. These condensed consolidated financial statements should be read in conjunction with the annual financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2008, filed with the SEC on March 12, 2009.

(3) Recently Adopted Accounting Pronouncements

In June 2009, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles. SFAS 168 establishes the FASB Accounting Standards Codification (Codification) as the single source of authoritative U.S. generally accepted accounting principles (U.S. GAAP) recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the SEC under authority of federal securities laws are also sources of authoritative U.S. GAAP for SEC registrants. SFAS 168 and the Codification are effective for financial statements issued for interim and annual periods ending after September 15, 2009. There will be no change to the Company’s condensed consolidated financial position and results of operations due to the implementation of this Statement.

When effective, the Codification will supersede all existing non-SEC accounting and reporting standards. All other non-grandfathered non-SEC accounting literature not included in the Codification will become non-authoritative. Following SFAS 168, the FASB will not issue new standards in the form of Statements, FASB Staff Positions, or Emerging Issues Task Force Abstracts. Instead, the FASB will issue Accounting Standards Updates, which will serve only to: ( a ) update the Codification; ( b ) provide background information about the guidance; and ( c ) provide the bases for conclusions on the change(s) in the Codification.

In June 2009, the FASB issued the following two standards which change the way entities account for securitizations and special-purpose entities:


	●	SFAS 166, Accounting for Transfers of Financial Assets;
	●	SFAS 167, Amendments to FASB Interpretation No. 46(R).

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SFAS 166 is a revision to FASB SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, and will require more information about transfers of financial assets, including securitization transactions, and where entities have continuing exposure to the risks related to transferred financial assets. It eliminates the concept of a “qualifying special-purpose entity,” changes the requirements for derecognizing financial assets and requires additional disclosures. SFAS 167 is a revision to FASB Interpretation No. 46 (Revised December 2003), Consolidation of Variable Interest Entities, and changes how a reporting entity determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a reporting entity is required to consolidate another entity is based on, among other things, the other entity’s purpose and design and the reporting entity’s ability to direct the activities of the other entity that most significantly impact the other entity’s economic performance. The new standards will require a number of new disclosures. Statement 167 will require a reporting entity to provide additional disclosures about its involvement with variable interest entities and any significant changes in risk exposure due to that involvement. A reporting entity will be required to disclose how its involvement with a variable interest entity affects the reporting entity’s financial statements. Statement 166 enhances information reported to users of financial statements by providing greater transparency about transfers of financial assets and an entity’s continuing involvement in transferred financial assets. SFAS 166 and 167 will be effective at the start of a reporting entity’s first fiscal year beginning after November 15, 2009, or January 1, 2010, for a calendar year-end entity. Early application is not permitted. The Company is currently evaluating the impact of adopting SFAS 166 and SFAS 167 on its condensed consolidated financial position and results of operations.

In May 2009, the FASB issued SFAS 165, Subsequent Events. SFAS 165 establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. Specifically, SFAS 165 provides:


	●	The period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements.
	●	The circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements.
	●	The disclosures that an entity should make about events or transactions that occurred after the balance sheet date.

SFAS 165 is effective for interim or annual financial periods ending after June 15, 2009, and shall be applied prospectively. The Company adopted this statement as of June 30, 2009. This Statement did not impact the condensed consolidated financial results. Management has evaluated subsequent events through August 7, 2009, the date the financial statements were issued.

During the second quarter of 2009, the FASB issued FASB Staff Position (FSP) FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly. This FSP:


	●	Affirms that the objective of fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction.
	●	Clarifies and includes additional factors for determining whether there has been a significant decrease in market activity for an asset when the market for that asset is not active.
	●	Eliminates the proposed presumption that all transactions are distressed (not orderly) unless proven otherwise. The FSP instead requires an entity to base its conclusion about whether a transaction was not orderly on the weight of the evidence.
	●	Includes an example that provides additional explanation on estimating fair value when the market activity for an asset has declined significantly.

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	●	Requires an entity to disclose a change in valuation technique (and the related inputs) resulting from the application of the FSP and to quantify its effects, if practicable.
	●	Applies to all fair value measurements when appropriate.

FSP FAS 157-4 must be applied prospectively and retrospective application is not permitted. FSP FAS 157-4 is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. An entity early adopting FSP FAS 157-4 must also early adopt FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments. The Company has complied with the requirements FSP FAS 157-4.

During the second quarter of 2009, the FASB issued FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments. This FSP:


	●	Changes existing guidance for determining whether an impairment is other than temporary to debt securities.
	●	Replaces the existing requirement that the entity’s management assert it has both the intent and ability to hold an impaired security until recovery with a requirement that management assert: ( a ) it does not have the intent to sell the security; and ( b ) it is more likely than not it will not have to sell the security before recovery of its cost basis.
	●	Incorporates examples of factors from existing literature that should be considered in determining whether a debt security is other-than-temporarily impaired.
	●	Requires that an entity recognize noncredit losses on held-to-maturity debt securities in other comprehensive income and amortize that amount over the remaining life of the security in a prospective manner by offsetting the recorded value of the asset unless the security is subsequently sold or there are additional credit losses.
	●	Requires an entity to present the total other-than-temporary impairment in the statement of earnings with an offset for the amount recognized in other comprehensive income.
	●	When adopting FSP FAS 115-2 and FAS 124-2, an entity is required to record a cumulative-effect adjustment as of the beginning of the period of adoption to reclassify the noncredit component of a previously recognized other-temporary impairment from retained earnings to accumulated other comprehensive income if the entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery.

FSP FAS 115-2 and FAS 124-2 is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. An entity may early adopt this FSP only if it also elects to early adopt FSP FAS 157-4. The Company adopted this FSP for the quarter ended June 30, 2009, and there was no material impact on the Company’s condensed consolidated results of operations or financial position.

During the second quarter of 2009, the FASB issued FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments. This FSP amends FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments, to require an entity to provide disclosures about fair value of financial instruments in interim financial information. This FSP also amends APB Opinion No. 28, Interim Financial Reporting, to require those disclosures in summarized financial information at interim reporting periods. Under this FSP, a publicly traded company shall include disclosures about the fair value of its financial instruments whenever it issues summarized financial information for interim reporting periods. In addition, an entity shall disclose in the body or in the accompanying notes of its summarized financial information for interim reporting periods and in its financial statements for annual reporting periods the fair value of all financial instruments for which it is practicable to estimate that value, whether recognized or not recognized in the statement of financial position, as required by Statement 107.

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FSP 107-1 and APB 28-1 is effective for interim periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. However, an entity may early adopt these interim fair value disclosure requirements only if it also elects to early adopt FSP FAS 157-4 and FSP FAS 115-2 and FAS 124-2. The company adopted this FSP in the quarter ended June 30, 2009. There was no impact on the condensed consolidated financial position and results of operations as it relates only to additional disclosures. The Company has complied with the disclosure requirements of FSP FAS 107-1 and APB 28-1.

On April 1, 2009, the FASB issued FSP FAS 141(R)-1, Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies. This FSP amends the guidance in FASB Statement No. 141 (Revised December 2007), Business Combinations, to:


	●	Require that assets acquired and liabilities assumed in a business combination that arise from contingencies be recognized at fair value if fair value can be reasonably estimated. If fair value of such an asset or liability cannot be reasonably estimated, the asset or liability would generally be recognized in accordance with FASB Statement No. 5, Accounting for Contingencies, and FASB Interpretation (FIN) No. 14, Reasonable Estimation of the Amount of a Loss. Further, the FASB decided to remove the subsequent accounting guidance for assets and liabilities arising from contingencies from Statement 141R, and carry forward without significant revision the guidance in FASB Statement No. 141, Business Combinations.
	●	Eliminate the requirement to disclose an estimate of the range of outcomes of recognized contingencies at the acquisition date. For unrecognized contingencies, the FASB decided to require that entities include only the disclosures required by Statement 5 and that those disclosures be included in the business combination footnote.
	●	Require that contingent consideration arrangements of an acquiree assumed by the acquirer in a business combination be treated as contingent consideration of the acquirer and should be initially and subsequently measured at fair value in accordance with Statement 141R.

This FSP is effective for assets or liabilities arising from contingencies in business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008 (i.e., January 1, 2009 for a calendar year-end company). This FSP was adopted effective January 1, 2009. There was no material impact upon adoption, and its effects on future periods will depend on the nature and significance of business combinations subject to this statement.

In June 2008, the Emerging Issues Task Force (“EITF”) reached a consensus in Issue No. 07-5, Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock (“EITF 07-5”). This Issue addresses the determination of whether an instrument (or an embedded feature) is indexed to an entity’s own stock, which is the first part of the scope exception in paragraph 11(a) of SFAS 133, Accounting for Derivative Instruments and Hedging Activities . EITF 07-5 is effective for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Early application is not permitted. The Company has adopted EITF 07-05 and has made a cumulative adjustment as of January 1, 2009. As of March 31, 2009 the Company had 1.6 million warrants to purchase common stock outstanding at exercise prices ranging from $0.57 to $0.75. The existence of a “subsequent equity sales (anti-dilution)” provision in the warrants prevented the warrants from being considered to be indexed to the Company’s own stock, which is the first part of the scope exception in paragraph 11(a) of Statement of Financial Accounting Standards No. 133. Accordingly, pursuant to SFAS 133, the Company was required to record a cumulative adjustment to increase retained earnings as of January 1, 2009 of $803,000, a decrease to additional paid-in capital of $924,000, and an increase to warrant derivative liability of $121,000 to account for the impact of EITF 07-5.

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In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141R, Business Combinations (“SFAS 141R”), which replaces SFAS No. 141, Business Combinations . SFAS 141R establishes principles and requirements for determining how an enterprise recognizes and measures the fair value of certain assets and liabilities acquired in a business combination, including non-controlling interests, contingent consideration, and certain acquired contingencies. SFAS 141R also requires acquisition-related transaction expenses and restructuring costs be expensed as incurred rather than capitalized as a component of the business combination. SFAS 141R will be applicable prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. The implementation of SFAS 141R did not have a material effect on the Company’s condensed consolidated financial position and results of operations and its effects on future periods will depend on the nature and significance of business combinations subject to this statement.

In April 2009, the FASB issued FASB Staff Position (FSP) Financial Accounting Standard (FAS) 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly . Based on the guidance, if an entity determines that the level of activity for an asset or liability has significantly decreased and that a transaction is not orderly, further analysis of transactions or quoted prices is needed, and a significant adjustment to the transaction or quoted prices may be necessary to estimate fair value in accordance with SFAS No. 157, “Fair Value Measurements.” This FSP is to be applied prospectively and is effective for interim and annual periods ending after June 15, 2009 with early adoption permitted for periods ending after March 15, 2009. The company adopted this FSP in the quarter ended June 30, 2009, and there was no material impact on the Company’s condensed consolidated financial position and results of operations.

(4) Stock-Based Compensation

The Company adopted the provision of SFAS No. 123R effective January 1, 2006, using the modified prospective transition method. Under this method, non-cash compensation expense is recognized under the fair value method for the portion of outstanding share based awards granted prior to the adoption of SFAS 123R for which service has not been rendered, and for any share based awards granted or modified after adoption. Accordingly, periods prior to adoption have not been restated. Prior to the adoption of SFAS 123R, the Company accounted for stock based compensation using the intrinsic value method. The Company recognizes share-based compensation cost associated with awards subject to graded vesting in accordance with the accelerated method specified in FASB Interpretation No. 28 pursuant to which each vesting tranche is treated as a separate award. The compensation cost associated with each vesting tranche is recognized as expense evenly over the vesting period of that tranche.

The following table summarizes the activity of the Company’s stock options for the three months ended June 30, 2009:

	Shares			Weighted- average Exercise Price		Weighted- average Remaining Contractual Life		Aggregate Intrinsic Value
	(Thousands)					(Years)		(Thousands)
Number of shares under option:

Outstanding at January 1, 2009		12,760		$	0.78
Granted		105			0.32
Exercised		—			—
Canceled or expired		(499	)		0.53

Outstanding at June 30, 2009		12,366		$	0.78		5.70	$	106

Vested and expected to vest at June 30, 2009		12,288		$	0.78		5.70	$	105

Exercisable at June 30, 2009		6,424		$	0.97		4.52	$	17

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Stock based compensation expense recognized in the Unaudited Condensed Consolidated Statement of Operations was $496,000 and $986,000 for the three and six months ended June 30, 2009, respectively. Stock based compensation from restricted stock grants for the three and six months ended June 30, 2009 was $301,000 and $600,000, respectively. Stock based compensation expense recognized in the unaudited condensed consolidated statement of operations was $516,000 and $969,000 for the three and six months ended June 30, 2008, respectively. Stock based compensation from restricted stock grants for the three and six months ended June 30, 2008 was $341,000 and $604,000.

The following table summarizes the activity of the Company’s non-vested stock options for the three months ended June 30, 2009:


	Shares			Weighted- average Grant Date Fair Value
	(Thousands)
Non-vested at January 1, 2009		6,429		$	0.30
Granted		105			0.19
Cancelled or expired		(474	)		0.27
Vested during the period		(118	)		0.28

Non-vested at June 30, 2009		5,942		$	0.30

As of June 30, 2009, there was $1,255,000 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under existing stock option plans. This cost is expected to be recognized over a weighted-average period of 1.79 years.

The Company uses the Black-Scholes option-pricing model to determine the weighted-average fair value of options. There were no options granted during the three months ended June 30, 2009 and 2008. The fair value of options at date of grant and the assumptions utilized to determine such values for options granted during the six months ended June 30, 2009 and June 30, 2008 are indicated in the following table:


	Six Months Ended June 30, 2009			Six Months Ended June 30, 2008

Weighted average fair value at date of grant for options granted during the period	$	0.19		$	0.48

Expected stock price volatility		98	%		80	%
Expected life of options	3 years			3 years
Risk free interest rates		1.02	%		2.27	%
Expected dividend yield		0	%		0	%

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The following summarizes the activity of the Company’s non-vested restricted common stock for the three months ended June 30, 2009:


	Shares			Weighted- average Grant Date Fair Value
	(Thousands)
Non-vested at January 1, 2009		1,192		$	1.07
Granted		3,831			0.32
Cancelled or expired		(89	)		0.65
Vested during the period		(489	)		1.18

Non-vested at June 30, 2009		4,445		$	0.42

During the six months ended June 30, 2009, the Company granted 1,157,000 shares of restricted common stock to its Board of Directors, which shares vest in January 2010, and 2,674,000 shares of restricted common stock to its employees, which shares vest in March 2012. The compensation expense related to these grants was $159,000 and $242,000 for the three and six months ended June 30, 2009, and there was $942,000 of unrecognized compensation cost which will be recognized through the first quarter of 2012.

(5) Cash and cash equivalents and short-term investments

As of June 30, 2009, the Company held $131,000 in short-term securities, all of which are in a certificate of deposit in a United States bank.

(6) Intangible Assets and Goodwill

In connection with the Company’s acquisition of On2 Finland on November 1, 2007, the Company acquired intangible assets of $53,354,000, which included goodwill in the amount of $36,075,000. During 2008, the value of these intangible assets were reduced by $33,268,000, including a $26,481,000 reduction for goodwill, as a result of an impairment analysis. There were no intangible asset or goodwill impairment losses recorded during the three or six months ended June 30, 2009.

Goodwill represents the excess of the purchase price over the fair value of net assets acquired in a business combination. Goodwill is required to be tested for impairment at the reporting unit level on an annual basis and between annual tests when circumstances indicate that the recoverability of the carrying amount of such goodwill may be impaired. Application of the goodwill impairment test requires exercise of judgment, including the estimation of future cash flows, determination of appropriate discount rates and other important assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value and/or goodwill impairment for each reporting unit.

The assets recognized with respect to acquired software, trademarks, customer relationships and non-compete agreements are being amortized over their estimated lives. Amortization expense related to these intangible assets was $300,000 and $630,000 for the three and six months ended June 30, 2009, respectively, and $757,000 and $1,562,000 for the three and six months ended June 30, 2008, respectively. The intangible assets and goodwill increased by $943,000 and decreased by $85,000 for the three and six months ended June 30, 2009, respectively, and decreased by $59,000 and increased by $3,853,000 for the three and six months ended June 30, 2008, respectively, for the effects of the foreign currency translation adjustment. There were no other additions of intangible assets during the six months ended June 30, 2009.

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Based on the current amount of intangibles subject to amortization, the estimated future amortization expense related to our intangible assets at June 30, 2009 is as follows (in thousands):

For the Year Ending June 30,	Future Amortization
2010	$	1,151
2011		1,151
2012		1,151
2013		779
2014		593
Thereafter		1,979
Total	$	6,804

(7) Short-Term Borrowings

At June 30, 2009, short-term borrowings consisted of the following:

A line of credit with a Finnish bank for $632,000 (€450,000 at June 30, 2009). The line of credit has no expiration date. Borrowings under the line of credit bear interest at one month EURIBOR plus 1.25% (total of 2.163% at June 30, 2009). The bank also requires a commission payable at .45% of the loan principal. Borrowings are collateralized by substantially all assets of On2 Finland and a guarantee by the Company. The outstanding balance on the line of credit was $190,000 at June 30, 2009. On July 30, 2009 the limit on the line of credit was reduced to €300,000.

Term Loan

During July 2008, the Company renewed its Directors and Officers Liability Insurance and financed the premium with a $140,000, nine-month term-loan that carries an effective annual interest rate of 4.75%. The balance at June 30, 2009 was $-0-.

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(8) Long-Term Debt

During May 2009, the Company received approval for the modification of terms on three notes payable to a Finnish funding agency for its Finland subsidiary. The modification of terms included 1) a forgiveness of debt of €477,000 ($669,000) on one note payable, and 2) extending the due dates of the remaining payments for two years on all three notes payable. The following table summarizes the changes in the payment terms and the forgiveness of debt (amounts in US Dollars using a conversion rate of 1.4048 at June 30, 2009):


	Note Payable 1	Note Payable 2	Note Payable 3

Original Balance:	$123,000	$281,000	$2,025,000

Original payment terms:	$123,000 due 7/3/09	$140,500 due 9/6/09	$675,000 due 12/27/09
		$140,500 due 9/6/10	$675,000 due 12/27/10
			$675,000 due 12/27/11

Forgiveness of debt:	—	—	$669,000

New Balance:	$123,000	$281,000	$1,356,000

New Payment terms:	$123,000 due 7/3/11	$140,500 due 9/6/11	$452,000 due 12/27/11
		$140,500 due 9/6/12	$452,000 due 12/27/12
			$452,000 due 12/27/13

At June 30, 2009, long-term debt consisted of the following:

Unsecured notes payable to a Finnish funding agency of $1,808,000, including interest at 2.00%, due at dates ranging from July 2011 to December 2013; $200,000 to a Finnish bank, including interest at the 3-month EURIBOR plus 1.1% (total of 2.33% at June 30, 2009), due March 2011, secured by guarantees by the Company, and by the Finnish Government Organization, which also requires additional interest at 2.65% of the loan principal; and an unsecured note payable to a Finnish financing company of $140,000, including interest at the 6 month EURIBOR plus .5% (total of 1.94% at June 30, 2009), due March 2011.

Future maturities of long-term debt are as follows as of June 30, 2009 (in thousands):


For the Year Ending June 30,
	2010	$	171
	2011		218
	2012		716
	2013		593
	2014		452

	Total	$	2,150

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(9) Warrant Derivative Liability

In June 2008, the Emerging Issues Task Force (“EITF”) reached a consensus in Issue No. 07-5, Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock (“EITF 07-5”). This Issue addresses the determination of whether an instrument (or an embedded feature) is indexed to an entity’s own stock, which is the first part of the scope exception in paragraph 11(a) of SFAS 133. EITF 07-5 is effective for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Early application is not permitted. Th e Company has adopted EITF 07-05 and has made a cumulative adjustment as of January 1, 2009. As of March 31, 2009 the Company had 1.6 million warrants to purchase common stock outstanding at exercise prices ranging from $0.57 to $0.75. The existence of a “subsequent equity sales (anti-dilution)” provision in the warrants prevented the warrants from being considered to be indexed to the Company’s own stock, which is the first part of the scope exception in paragraph 11(a) of SFAS 133. Accordingly, pursuant to SFAS 133, the Company was required to record a cumulative adjustment to increase retained earnings as of January 1, 2009 of $803,000, a decrease to additional paid-in capital of $924,000, and an increase to warrant derivative liability of $121,000 to account for the impact of EITF 07-5. During the three and six months ended June 30, 2009 the Company recorded a charge of $18,000 to reflect the change in the fair value of the warrant derivative liability. The fair value was calculated using the Black-Scholes pricing model.

(10) Common Stock

During the six months ended June 30, 2009, the Company issued 3,831,000 restricted common stock grants. During this period, the Company cancelled 89,000 shares of restricted common stock grants from 2008 formerly held by terminated employees. The Company cancelled 7,000 shares of common stock resulting from the retirement of Treasury Stock, as outlined in Note 11 below.

(11) Treasury Stock

In April 2007, the Company’s Board of Directors authorized that all the shares recorded as treasury stock be cancelled and that all subsequent shares received from cashless exercises be cancelled immediately after receipt. The Company allowed its employees to relinquish shares from the vesting of a portion of restricted stock grants for payment of taxes. During the six months ended June 30, 2009, the Company received a total of 7,000 shares at a value of $4,000 for payment of taxes. During the six months ended June 30, 2008, the Company received a total of 53,000 shares at a value of $52,000 for payment of taxes.

(12) Geographical Reporting and Customer Concentration

The components of the Company’s revenue for the three and six months ended June 30, 2009 and 2008 are summarized as follows (in thousands):


	For the three months ended June 30
	2009		2008
License software revenue	$	3,198	$	2,087
Engineering services and support		598		482
Royalties		1,181		677
Other		19		19

Total	$	4,996	$	3,265

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	For the six months ended June 30
	2009		2008
License software revenue	$	5,402	$	5,002
Engineering services and support		1,264		1,062
Royalties		2,308		1,615
Other		38		38

Total	$	9,012	$	7,717

For the three and six months ended June 30, 2009 foreign customers accounted for approximately 72% and 63%, respectively of the Company’s total revenue. For the three and six months ended June 30, 2008 foreign customers accounted for approximately 62% and 46%, respectively of the Company’s total revenue. These customers are primarily located in Europe and Middle East, and Asia.

Selected information by geographic location is as follows (in thousands):

	For the three months ended June 30
	2009			2008
Revenue from unaffiliated customers:

United States Operations	$	1,703		$	1,952
Finland Operations		3,293			1,313

Total	$	4,996		$	3,265

Net Loss:
United States Operations	$	(2,106	)	$	(4,069	)
Finland Operations		1,882			(3,106	)

Total	$	(224	)	$	(7,175	)

	For the six months ended June 30
	2009			2008
Revenue from unaffiliated customers:

United States Operations	$	4,227		$	4,857
Finland Operations		4,785			2,860

Total	$	9,012		$	7,717

Net Loss:
United States Operations	$	(3,153	)	$	(5,018	)
Finland Operations		(59	)		(6,896	)

Total	$	(3,212	)	$	(11,914	)

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	June 30, 2009		December 31, 2008
Identifiable assets:
United States Operations	$	4,863	$	6,287
Finland Operations		17,769		19,589
Total	$	22,632	$	25,876

For the three months ended June 30, 2009, there was one customer that accounted for 15% and one customer that accounted for 13% of the Company’s revenue. For the six months ended June 30, 2009, there was one customer that accounted for 10% of the Company’s revenue. For the three and six months ended June 30, 2008, there was one customer that accounted for 23% and 10%, respectively of the Company’s revenue.

Financial instruments that subject the Company to concentrations of credit risk consist primarily of cash and cash equivalents. The Company maintains cash and cash equivalents in two financial institutions in the US and in two financial institutions in foreign countries. The Company performs periodic evaluations of the relative credit standing of the institutions. The cash balances are insured by the FDIC. The Company has cash balances in a money market fund and a checking account at June 30, 2009 that exceeds the FDIC insured amount. Additionally, the Company has a balance in an investment account at June 30, 2009. The investment account is insured by the Securities Investor Protection Corporation up to a value of $500,000 per depositor. The Company did not have investments in excess of $500,000 at June 30, 2009.

(13) Net Loss Per Share

Basic net loss per share is computed by dividing the net loss applicable to common shares by the weighted average number of common shares outstanding during the period. Diluted loss attributable to common shares adjusts basic loss per share for the effects of convertible securities, warrants, stock options and other potentially dilutive financial instruments, only in the periods in which such effect is dilutive. The shares issuable upon the exercise of stock options and warrants are excluded from the calculation of net loss per share as their effect would be anti-dilutive.

Securities that could potentially dilute earnings per share in the future, that had exercise prices below the market price at June, 2009 and 2008, were not included in the computation of diluted loss per share and consist of the following as of June 30:


	2009		2008

Warrants to purchase common stock		—		123,000
Options to purchase common stock		302,500		1,649,000

Total		302,500		1,772,000

(14) Related Party Transactions

During the six months ended June 30, 2008, the Company retained McGuireWoods LLP to perform certain legal services on our behalf and incurred approximately $148,000 and $169,000 for the three and six months ended June 30, 2008, respectively, for such legal services. William A. Newman, a director of the Company during that period, was a partner of McGuireWoods LLP until May 2008. In May 2008, Mr. Newman became a partner at Sullivan & Worcester LLP which continues to represent the Company. Mr. Newman resigned as a Director in November 2008.

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(15) Restructuring

During the first quarter of fiscal 2009, the Company recorded a pre-tax restructuring and impairment charge of $1.032 million, or $0.01 per share, in connection with a number of cost reduction initiatives at its Finnish subsidiary, On2 Finland. These initiatives through June 2009 have resulted in a reduction of workforce that has currently reduced headcount, through resignation and furlough, by 31 On2 Finland employees. In accordance with Finnish law, the Company had negotiated in the first quarter of fiscal 2009 with the representative of the On2 Finland employees and On2 Finland’s management team in order to obtain consensus on the reduction in workforce plan. The Company announced implementation of the final plan to On2 Finland employees on March 18, 2009 and will execute it primarily through a furlough process that began in April 2009 and is anticipated to be fully implemented within fiscal 2009.

The charges consisted primarily of four items: (1) severance and benefits costs for the minimum future post-termination cash payments to be made to employees as required by Finnish law and the collective bargaining agreement covering most On2 Finland employees; (2) lease payments related to office and property no longer required for operations; (3) related legal and other administrative costs; and (4) non-cash write-offs for impairment from discontinued use of excess capital leased equipment. The future post-termination cash payments are triggered if the Company terminates some or all of the furloughed employees or if employees who are furloughed for longer than 200 days elect to terminate their own employment. The total charges incurred will depend on a number of factors, including the duration of the furloughs, the number of employees, if any, that are recalled from furlough or terminated and, for employees that are furloughed for longer than 200 days, the number of such employees that have not obtained other employment. We have currently estimated the cash and non-cash restructuring and impairment charges to be $1.032 million, however, based on the factors noted, this may increase by an additional $0.2 million during 2009 once the 200 day furlough period has concluded.

Restructuring and Impairment charges and liability consist of the following (in thousands):


	Severance & Benefits			Office & Property			Legal & Other			Asset Impairment		Total
Balance at March 18, 2009	$	262		$	583		$	12		$	175	$	1,032
Amount Paid		—			—			—			—		—
Adjustment to Expense:
Increase		—			—			—			—		—
Decrease		—			—			—			—		—
Effect of exchange rate		3			8			—			—		11
Balance at March 31, 2009	$	265		$	591		$	12		$	175	$	1,043
Amount Paid		(58	)		(58	)		(23	)		—		(139	)
Adjustment to Expense:
Increase		241			—			17			—		258
Decrease		—			(258	)		—			—		(258	)
Effect of exchange rate		17			38			1			—		56
Balance at June 30, 2009	$	465		$	313		$	7		$	175	$	960

The Company has recorded and classified the liability at June 30, 2009 of $785,000 for the restructuring as Accrued Restructuring Expenses, and the charges for Asset Impairment has resulted in a $175,000 reduction of the Company’s assets, Capital Leases-Net, on the Company’s condensed consolidated balance sheet at June 30, 2009. The restructuring and impairment charges of $-0- and $1,032,000 for the three and six months ended June 30, 2009, respectively, are classified as Restructuring Expense on the Company’s condensed consolidated statements of operations.

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(16) Litigation

Islandia

On August 14, 2008, Islandia, L.P. filed a complaint against On2 in the Supreme Court of the State of New York, New York County. Islandia was an investor in the Company’s October 2004 issuance of Series D Convertible Preferred Stock pursuant to which On2 sold to Islandia 1,500 shares of Series D Convertible Preferred Stock, raising gross proceeds for the Company from Islandia of $1,500,000. Islandia’s Series D Convertible Preferred Stock was convertible into On2 common stock at an effective conversion price of $0.70 per share of common stock. Pursuant to this transaction, Islandia also received two warrants to purchase an aggregate of 1,122,754 shares of On2 common stock.

The complaint asserted that, at various times in 2007, On2 failed to make monthly redemptions of the Series D Preferred Stock in a timely manner and that On2 failed to deliver timely notice of its intention to make such redemptions using shares of On2’s common stock. The complaint also asserted that Islandia timely exercised its right to convert the Series D Preferred Stock into shares of On2 common stock and that On2 failed to credit to Islandia such allegedly converted shares. The complaint further asserted that On2 failed to pay to Islandia certain Series D dividends to which it was entitled. The complaint sought a total of $4,645,193 in damages plus interest and reasonable attorneys’ fees.

On October 8, 2008, On2 filed an answer in which it denied the material assertions of the complaint and asserted various affirmative defenses, including that (i) On2 made the required Series D redemptions in full and on the dates agreed upon by the parties, (ii) On2 provided timely notice that it would pay redemptions in On2 common stock and that Islandia accepted all of the redemption payments on the dates made without protest, (iii) Islandia failed to timely assert its conversion rights under the terms of the Series D agreements and (iv) On2 duly paid the dividends owed to Islandia under the terms of the Agreement and Islandia accepted all dividend payments without protest.

On July 23, 2009, On2 and Islandia entered into a Release and Settlement Agreement (the “Settlement Agreement”) to settle the litigation without admitting any of the allegations in the complaint. The Settlement Agreement provides for the issuance by On2 of a convertible note to Islandia in the principal amount of $500,000 which bears an interest rate equal to eight percent (8%) per annum paid semiannually in arrears (the “Note”). The Note may be redeemed by On2 at any time and will become due and payable on July 23, 2010 or earlier upon a change of control. At the time of payment, the Note shall be payable in cash or shares of On2 at the sole discretion of On2, subject to certain conditions. The Settlement Agreement provides that Islandia will file a stipulation to discontinue the lawsuit without prejudice within two business days of the issuance of the Note. The Settlement Agreement also provides that Islandia may recommence the original lawsuit if On2 defaults on its obligations to pay principal and interest on the Note, and if such original lawsuit is recommenced and On2 ultimately is held liable to Islandia, On2 shall receive full credit for any and all amounts already paid on the Note. On July 28, 2009, On2 and Islandia executed and filed with New York State Supreme Court a stipulation of discontinuance of the litigation without prejudice.

Litigation settlement costs for the three and six months ended June 30, 2009 were $523,000 of which $500,000 is the settlement cost of the lawsuit and $23,000 is for related legal fees.

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(17) Subsequent Event.

On August 4, 2009, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) by and among the Company, Google Inc., a Delaware corporation (“Google”), and Oxide Inc., a Delaware corporation and a wholly owned subsidiary of Google (“Merger Sub”) pursuant to which Merger Sub will be merged with and into the Company, and as a result the Company will continue as the surviving corporation and a wholly owned subsidiary of Google (the “Merger”). The directors and officers of Merger Sub immediately prior to the Merger shall be the directors and officers of the surviving corporation after the Merger. Under the terms of the Merger Agreement, which was approved by both companies’ boards of directors, for each share of the Company’s common stock owned, the Company’s stockholders will be entitled to receive the number of shares of Google’s Class A common stock equal to $0.60 divided by the volume weighted average trading price of a share of Google’s Class A common stock for the 20 trading day period ending on the second trading day prior to the date of the Company’s stockholders meeting to consider and approve the Merger Agreement. The merger is conditioned upon, among other things, the approval of the Company’s stockholders, and the receipt of regulatory approvals and other closing conditions. Assuming the satisfaction of these conditions, the transaction is expected to close during the fourth quarter of 2009. On August 4, 2009, the Compensation Committee of the Company’s board of directors adopted the On2 Technologies, Inc. Retention and Severance Plan in connection with the proposed Merger.

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Item 2.

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

Forward-Looking Statements

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


	●	the impact of the current global recession on our business and operations, including the markets for our products and services and the availability of credit and/or investment financing which we may need to fund our operations;

	●	the impact of volatile securities markets on our access to capital markets and on our share price and the impact of volatile foreign exchange rates on our business;

	●	future revenues, income taxes, net loss per share, acquisition costs and related amortization, and other measures of results of operations;

	●	the effects of acquiring On2 Finland, including possible future impairments of goodwill associated with that acquisition;

	●	difficulties in controlling expenses, legal compliance matters or internal control over financial reporting review, improvement and remediation;

	●	risks associated with the previously reported ineffectiveness of the Company’s internal control over financial reporting and our ability to remediate material weaknesses, if any;

	●	the financial performance and growth of our business, including future international growth;

	●	our financial position and the availability of resources;

	●	the availability of credit and future debt and/or equity investment capital;

	●	the effects of our furlough and other cost-containment measures undertaken at On2 Finland, including the effectiveness of those measures, the anticipated cost savings associated with those measures and any future restructuring and/or impairment charges arising in connection with current and future cost-containment measures;

	●	risks associated with the proposed merger between the Company and a subsidiary of Google Inc.;

	●	future competition; and

	●	the degree of seasonality in our revenue.

These forward-looking statements are only predictions, and actual events or results may differ materially. The statements are based on management’s beliefs and assumption using information available at the time the statements were made. We cannot guarantee future results, levels of activity, performance or achievements. Factors that may cause actual results to differ are often presented with the forward-looking statements themselves. Additionally, other risks that may cause actual results to differ from predicted results are set forth in “ Risk Factors That May Affect Future Operating Results ” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008.

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Many of the forward-looking statements are subject to additional risks related to our need to either secure additional financing or to increase revenues to support our operations or business or technological factors. We believe that between the funds we have on hand and the funds we expect to generate, we have sufficient funds to finance our operations for the next 12 months. We have based our forecasts on assumptions we have made relating to, among other things, the market for our products and services, economic conditions and the availability of credit to us and our customers. If these assumptions are incorrect, we may not have sufficient resources to fund our operations for this entire period, however. Additional funds may also be required in order to pursue strategic opportunities or for capital expenditures. Because of the recent tightening in global credit markets, we may not be able to obtain financing on favorable terms, or at all. In this regard, the business and operations of the Company are subject to substantial risks that increase the uncertainty inherent in the forward-looking statements contained in this Form 10-Q. In evaluating our business, you should give careful consideration to the information set forth under the caption “ Risk Factors That May Affect Future Operating Results ” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008, in addition to the other information set forth herein.

We undertake no duty to update any of the forward-looking statements except as required by applicable law, 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.

Subsequent Event.

Overview

On2 Technologies is a developer of video compression technology and technology that enables the creation, transmission, and playback of multimedia in resource-limited environments, such as cellular networks transmitting to battery operated mobile handsets or High Definition (HD) video transmitted over the Internet. We have developed a proprietary technology platform and the On2® Video VPx family (e.g., VP6, VP7, and VP8) of video compression/decompression (“codec”) software to deliver high-quality video at the lowest possible data rates over proprietary networks and the Internet to personal computers, wireless devices, set-top boxes and other devices. Unlike many other video codecs that are based on standard compression specifications set by industry groups (e.g., MPEG-2 and H.264), our video compression/decompression technology is based solely on intellectual property that we developed and own ourselves. In addition, through our wholly-owned subsidiary, On2 Technologies Finland Oy, we license to chip and mobile handset manufacturers, and other developers of multimedia consumer products the hardware and software designs that make the encoding or decoding of video possible on mobile handsets, set top boxes, portable media players, cameras and other devices. We also provide integration, customization and support services to enable high quality video on, and faster interoperability between devices.

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In 2004, we licensed our video compression technology to Macromedia, Inc. (now Adobe Systems Incorporated) for use in the Adobe® Flash® multimedia player. In anticipation of Adobe using our codec in the Flash platform, we launched our business of developing and marketing video encoding software for the Flash platform. Flash encoding has become an increasingly important part of our business. In May 2008, we entered into a license agreement with Sun Microsystems for the use of our video compression technology in the JavaFX® platform and anticipate further growth for our encoding and transcoding businesses as a result of this transaction.

In addition, we have also dedicated significant resources to marketing customized software to device manufacturers that enable their devices to decode Flash and JavaFx content.

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


	●	Video codecs, including On2 VP6®, VP7™ and VP8™;

	●	Flix® Pro – an application targeted at web developers for encoding and transcoding video for delivery over the Internet to either Flash or JavaFX players;

	●	Flix Publisher – a set of web browser plug-ins that enable live capture, encoding, and transcoding of video along with posting on web sites or live streaming via the Adobe Flash Media Server;

	●	Flix Engine – a backend server side transcoding platform used by a large number of video sites to repurpose their video for playback over the Internet and devices; and

	●	Flix DirectShow SDK – a set of libraries that enable software vendors to create, edit, and deliver video content for Flash or JavaFX;

We also offer the following suite of hardware and software products that incorporate our video technology for mobile and embedded platforms:


	●	On2 VP6, VP7 and VP8 software video codec designs;

	●	MPEG-4, H.263, H.264 / AVC and VC-1 hardware and software video codec designs;

	●	Hardware and software JPEG codecs;

	●	AMR-NB and Enhanced aacPlus™ audio codecs;

	●	Pre- and post-processing technologies (such as cropping, rotation, scaling) implemented in both software and hardware;

	●	File format and streaming components; and

	●	Recorder and player application logic.

In addition, we offer the following services in connection with both our proprietary video compression technology and our mobile video technology:

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	●	Customized engineering and consulting services;

	●	On2 Flix Cloud, our pay-as-you go encoding service; and

	●	Technical support.

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


TYPE OF CUSTOMER APPLICATION	EXAMPLES
Video and Audio Distribution over Proprietary Networks	● Providing video-on-demand services to residents in multi-dwelling units (MDUs) ● Video surveillance

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

Consumer Electronic Devices	● Digital video players ● Digital video recorders ● Mobile TV ● Video camera recorder ● Mobile video player

Wireless Applications	● Delivering video via wireless networks, e.g., satellite, WLAN, WIMAX, and cellular ● Providing video record and playback capability to battery-operated handsets such as mobile phones, MIDs, PDAs, and PMPs

User-Generated Content (“UGC”) Sites	● Providing video encoding software for use on UGC site operators’ servers ● Providing encoding software for users who are creating UGC ● Providing transcoding software to allow UGC site operators to convert video from one format to another

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


	●	Using the success of current customer implementations of our On2 Video technology (e.g., Adobe Flash, Skype, Move Networks) and other high-profile customers (e.g., Sun Microsystems) to increase our brand recognition, promote new business and encourage proliferation across platforms;

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	●	Continuing our research and development efforts to improve our current codecs and developing new technologies that increase the quality of video technology and improve the experience of end users;

	●	Continuing our research and development efforts to design hardware decoders and encoders that minimize the space used on a chip and to continue to improve the quality of those products;

	●	Updating and enhancing our existing consumer products, such as the Flix line and embedded technologies;

	●	Providing pay-as-you-go encoding in our Flix Cloud software-as-a-service offering using the Amazon EC2® cloud computing environment;

	●	Employing flexible licensing strategies to offer customers more attractive business terms than those available for competing technologies;

	●	Attempting to negotiate licensing arrangements with customers that provide for receipt of recurring revenue and/or that offer us the opportunity to market products that complement our customers’ implementations of our software; and

	●	Using the expertise of On2 Finland to develop hardware designs of our proprietary codecs and optimizations for embedded processors that will allow those products to be easily implemented on devices.

We earn revenue chiefly through licensing our software technology and hardware designs and providing specialized software engineering and consulting services to customers. In addition to up-front license fees, we often require that customers pay us royalties in connection with their use of our software and hardware products. The royalties may come in the form of either a fee for each unit of the customer’s products containing our software products or hardware designs that are sold or distributed or payments based on a percentage of the revenues that the customer earns from any of its products or services that use our software. Royalties may be subject to guaranteed minimum amounts (e.g., minimum annual royalties) and/or maximum amounts (e.g., annual caps) that may vary substantially from deal to deal.

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

We recognize the strategic importance of implementing our proprietary VPx video codecs in hardware and developing highly optimized software libraries for operation on processors used in embedded devices. Prior to the acquisition of our On2 Finland subsidiary, we had a limited selection of off-the-shelf optimized software that we could license to customers who were interested in implementing our codecs on devices. We therefore regularly required customers to pay us to customize our software, or to perform the customizations themselves, or to hire third-party consultants to perform the customizations. The On2 Finland acquisition has given us access to additional experienced internal resources to help us to develop hardware and software implementations that will allow customers to implement our codecs quickly and efficiently on embedded devices.

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As part of our strategy to develop complementary products that could allow us to capitalize on our customers’ success, in 2005 we completed the acquisition from Wildform, Inc., of its Flix line of encoding software. The Flix software allows users to prepare video and other multimedia content for playback on the Adobe Flash player, which is one of the most widely distributed multimedia players. Adobe is currently using our VP6 software as the video engine for Flash 8 video, which is used in the Flash 8 player and all of the subsequent Flash players that have been released to date. We believed that there was an opportunity for us to sell Flash encoding software to end users, such as video professionals and web designers, and to software development companies that wish to add Flash encoding functionality to their software. We concluded that we could best take advantage of the anticipated success of Flash by taking the most up-to-date Flash encoding software straight from the company that developed VP6 video and combining it with the already well-known Flix brand, which has existed since the advent of Flash video and has a loyal following among users. Following Adobe’s announcement in late 2007 of support for the H.264 codec in its Flash 9 player, we announced support for H.264 in our Flix products and have been adding support for additional codecs. These additional features have helped to make the Flix product line a more complete encoding solution for users.

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

Another factor that may affect our success is the relative complexity of our proprietary video compression software compared with other compression software producing comparable compression rates and image quality. Software with lower complexity can run on a computer chip that is less powerful, and therefore generally less expensive, than would be required to run software that is comparatively more complex. In addition, the process of getting software to operate on a chip is easier if the software is less complex. Increased compression rates frequently result in increased complexity. While potential customers desire software that produces the highest possible compression rates while producing the best possible decompressed image, they also want to keep production costs low by using the lowest-powered and accordingly least expensive chips that will still allow them to perform the processing they require. We believe that the encoding and decoding functions of our video compression software are less complex than those offered by our competitors. In addition, in some applications, such as mobile devices, constraints such as size and battery life rather than price issues limit the power of the chips embedded in such devices. Of course, in devices where a great deal of processing power can be devoted to video compression and decompression, the issue of software complexity is less important. In addition, in certain applications, savings in chip costs related to the use of low complexity software may be offset by increased costs (or reduced revenue) stemming from less efficient compression (e.g., increased bandwidth costs).

One of the most significant recent trends in our business is our increasing reliance on the success of the product deployments of our customers. As referenced above, our license agreements with customers increasingly provide for the payment of license fees that are dependent on the number of units of a customer’s product incorporating our software that are sold or the amount of revenue generated by a customer from the sale of products or services that incorporate our software. We have chosen this royalty-dependent licensing model because, as a small company competing in a market that offers a vast range of video-enabled devices, we do not have the product development or marketing resources to develop and market end-to-end video solutions. Instead, our codec software is primarily intended to be used as a building block for companies that are developing end-to-end video products and/or services.

Under our agreements with certain customers, we have retained the right to market products that complement those customers’ applications. These arrangements allow us to take advantage of our customers’ superior ability to produce and market end-to-end video products, while offering those customers the benefit of having us produce technologically-advanced products that should contribute to the success of their applications. As with arrangements in which we receive royalties, the ability to market complementary products can yield revenues in excess of any initial, one-time license fee. In instances where we have licensed our products to well-known customers, our right to sell complementary products may be very valuable. But unlike royalties, which we receive automatically without any additional effort on our part, the successful sale of complementary products requires that we effectively execute an end-user product development and marketing program.

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We believe that we have adopted the licensing model most appropriate for a business of our size and expertise. However, a natural result of this licensing model is that the amount of revenue we generate is highly dependent on the speed with which our customers deploy products containing our technology and the success of those deployments. In certain circumstances, we may decide to reduce the amount of up-front license fees and charge a higher per-unit royalty. If the products of customers with whom we have established per unit royalty or revenue sharing relationships or for which we expect to market complementary products do not generate significant sales, these revenues may not attain significant levels. Conversely, if one or more of such customers’ products are widely adopted, our revenues will likely be enhanced.

We are continuing to participate in the trend towards the proliferation of user generated video content on the web. As Internet use has grown worldwide and Internet connection speeds have increased, sites such as MySpace, Facebook, and YouTube, which allow visitors to create and view user generated content (“UGC”), have sprung up and seen their popularity soar. Although initially consumer generated content consisted primarily of text content and still photographs, the availability of relatively inexpensive digital video cameras and video-enabled mobile phones, the growth in the number of users with access to broadband Internet connections, and improvements in video compression technology have contributed to a rapid rise in consumer-created video content. Weblogs (blogs) and podcasts (broadcasts of audio content to iPod® and MP3 devices) have evolved to include video content. The continued proliferation of UGC video on the Internet and the popularity of Adobe Flash video on the web have had a positive effect on our business and have given us the opportunity to license Flash encoding tools for use in video blogs, video podcasts, and to UGC sites or to individual users of those services.

We continue to experience an increased interest by UGC site operators and device manufacturers to allow users to access UGC content by means of mobile handsets, set-top boxes, and other devices. Many of the UGC sites use Flash VP6 video, and while VP6 video is available on a vast number of PCs, it is still only available on a limited number of chip-based devices, such as mobile devices and set top boxes. We are therefore witnessing demand on two fronts: (1) demand to integrate Flash 8 video onto non-PC platforms, and (2) until most devices can play Flash 8 content, demand to provide transcoding software that allows Flash 8 content to be decoded and re-encoded into a format (such as the 3GPP standard) that is supported on devices. We are actively working to provide solutions for both of these demands and plan to continue to respond as necessary to the evolution and migration of Flash video.

H.264 continues to rise as a competitor with the Company’s VPx products in the video compression field. H.264 is a standards-based codec that is the successor to MPEG-4. We believe that our technology is superior to H.264, and that we can offer significantly more flexibility in licensing terms than customers get when licensing H.264. H.264 has nevertheless gained significant adoption by potential customers because, as a standards-based codec, it has the advantage of having numerous developers who are programming to the H.264 standard and developing products based on that standard. In addition, many manufacturers of multimedia processors have done the work necessary to have H.264 operate on their chips, which makes H.264 attractive to potential customers who would like to enable video on devices. For example, Apple Inc. uses H.264 in its QuickTime® player and has thus chosen H.264 for the current generation of video iPods. Finally, there is already a significant amount of professional content that has been encoded in H.264. These advantages may make H.264 attractive to potential customers and allow them to implement a solution based on H.264 with less initial development time and expense than a solution using On2’s proprietary video codecs might require. In addition, there are certain customers that prefer to license standards-based codecs. We continue to believe that VP6 will be an important part of the Flash video ecosystem for three reasons: (1) Adobe has in the past provided backwards compatibility with all generations of Flash video codecs; (2) VP6 has certain performance advantages over H.264 (e.g., HD VP6 content may be played back on a lower-powered processor than HD H.264 content); and (3) there is a vast amount of existing VP6 content that consumers want on portable and mobile devices.

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The market for digital media creation and delivery technology is constantly changing and becoming more competitive. Our strategy includes focusing on providing our customers with video compression/decompression technology that delivers the highest possible video quality at the lowest possible data rates. To do this, we devote a significant portion of our engineering capacity to research and development. We also are devoting significant attention to enabling our codecs to operate on a wide array of chips, both in software and in hardware. We continue to cultivate relationships with chip companies to enable those companies to integrate our codecs on chips. By increasing support for our technology on the chips that power embedded devices, we hope to encourage use by customers who want to develop video-enabled consumer products in a short timeframe.

A continuing trend in our business is the growing presence of Microsoft Corporation as a significant competitor in the market for digital media creation and distribution technology. In 2007, Microsoft released Silverlight™, a rich Internet application that allows users to integrate multimedia features, such as vector graphics, audio and video, into web applications. Silverlight may compete directly with Flash. If Silverlight gains market share at the expense of Flash, it could have a negative impact on our Flix business. In addition, Microsoft VC1 format also competes in the marketplace with H.264 and our VPx technologies. We believe that our VPx technologies have the same advantages over VC1 as they do over H.264.

Although we expect that competition from Microsoft, H.264 developers, and others will continue to intensify, we expect that our video compression technology will remain competitive and that our relatively small size will allow us to innovate in the video compression field and respond to emerging trends more quickly than monolithic organizations like Microsoft and the MPEG consortium. We focus on developing relationships with customers who find it appealing to work with a smaller company that is not bound by complex and rigid standards-based licenses and fee structures and that is able to offer sophisticated custom engineering services. Moreover, as broadcast networks, web portal operators and others distribute ever-increasing amounts of high-resolution video over the Internet, the cost savings arising from the use of our high quality video should offer an increasing advantage over lower quality competitive technology.

Another one of our primary businesses is the development and marketing of digital electronic hardware designs (known as register transfer level designs or RTL) of video and audio codecs to manufacturers of computer chips and multimedia devices. A licensee of our RTL design might use that product to implement a video decoder on the licensee’s chip, and the decoder would be built into the circuitry of the licensee’s chip. One of the factors affecting our hardware business is our ability to develop efficient RTL designs that minimize the physical area of a chip devoted to our designs. Increasing the surface area of a chip increases the manufacturer’s production costs. Our ability to produce RTL designs that require less surface area than our competitors’ designs results in lower production costs for our licensees and gives us a competitive advantage.

Another factor affecting our hardware business is our reputation for producing reliable products that have been thoroughly tested, are accompanied by good documentation, and are supported by a strong technical support team. Chip and device manufacturers that are potential customers for our hardware products develop the products with which they will integrate our RTL designs. Our technology is hard-wired into chip circuitry rather than loaded as software. In connection with high volume chip production, the per-unit price of a specialized chip that has had multimedia support built into the chip can be substantially less than the costs of using a more powerful software-upgradable digital signal processor (DSP). However, any errors in the software operating on a DSP can be relatively easily corrected through a software upgrade or patch, while errors that have been hardwired into a circuit are more difficult, and may be impossible, to correct. Because customers for our RTL designs will invest a great deal of time and money into the designs, our reputation as a well-established provider of reliable, well-supported RTL designs is an important factor in our continuing success.

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As multimedia content has proliferated on the Internet, manufacturers of mobile devices such as cell phones and personal media players (PMPs) have expanded their product lines to support playback and creation of that content. As noted above, in general, manufacturers have two options to add multimedia support to their devices. They can use either a specialized chip that has multimedia support hard-wired into it (RTL) or a more powerful DSP that can run software to provide the necessary multimedia functions. Hardware implementations that require RTL designs such as ours offer a number of advantages over DSPs with software layers:

	●	They are cheaper to produce in high volumes;

	●	They use less energy, which prolongs battery life of mobile devices;

	●	They produce less heat, which has important implications for, among other things, circuit design; and

	●	They allow for simultaneous encoding and decoding of HD video content.

But there are also disadvantages to hardware implementations of multimedia tools:


	●	Initial implementation costs are high; and

	●	Hardware implementations are generally not upgradeable.

Similarly, software-upgradable DSPs offer certain advantages:


	●	Modifying software to operate on a DSP is easier and less expensive then implementing the software in hardware, reducing initial project costs and speeding deployment;

	●	DSPs do not require costly re-designs and re-tooling to operate new software; and

	●	They are more easily upgradeable.

But they also have certain disadvantages:

	●	Per-chip costs are higher than pure hardware solutions as volumes increase; and

	●	The increased processor power required to operate diverse software increases heat and power consumption.

Manufacturers that want to maintain the ability to upgrade mobile devices and PMPs to support new multimedia software may opt for DSPs rather than hardware solutions, which could impact our business of licensing hardware codecs. Nevertheless, we believe that even if manufacturers do choose to use DSPs in their devices, it is likely that many will continue to implement hardware codecs alongside the DSPs to take advantage of the efficiency of those hardware implementations. In addition, support for DSPs on multimedia devices would have the benefit of making those devices more easily upgraded to new generations of our proprietary codecs. We are continuing to monitor this trend and make the adjustments to our business model necessary to address changing markets.

Critical Accounting Policies and Estimates

This discussion and analysis of our financial condition and results of operations are based on our condensed consolidated financial statements that have been prepared under accounting principles generally accepted in the United States. The preparation of financial statements in conformity with accounting principles generally accepted in the United States 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 our Form 10-K for the fiscal year ended December 31, 2008. 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:

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	●	Revenue recognition;

	●	Accounts receivable allowance;

	●	Equity-based compensation; and

	●	Impairment of goodwill and other intangible assets.

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

We recognize revenue in accordance with SOP 97-2, Software Revenue Recognition (“SOP 97-2”), as amended by SOP 98-4, Deferral of the Effective Date of Sop 97-2, Software Revenue Recognition and SOP 98-9, Modification of Sop 97-2 With Respect To Certain Transactions (“SOP 98-9”) and Staff Accounting Bulletin No. 104 (“SAB 104”). Under each arrangement, revenues are recognized when a non-cancelable agreement has been signed and the customer acknowledges an unconditional obligation to pay, the products or applications have been delivered, there are no uncertainties surrounding customer acceptance, the fees are fixed and determinable, and collection is reasonably assured. Revenues recognized from multiple-element software arrangements are allocated to each element of the arrangement based on the fair values of the elements, such as product licenses, post-contract customer support or training. The determination of the fair value is based on the vendor specific objective evidence available to us. If such evidence of the fair value of each element of the arrangement does not exist, we defer all revenue from the arrangement until such time that evidence of the fair value does exist or until all elements of the arrangement are delivered.

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 we sell engineering and consulting services 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.

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

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

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

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

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

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Results of Operations

Revenue. Revenue for the three months ended June 30, 2009 was $4,996,000, as compared to $3,265,000 for the three months ended June 30, 2008. Revenue for the six months ended June 30, 2009 was $9,012,000, as compared to $7,717,000 for the six months ended June 30, 2008. Revenue for the three and six months ended June 30, 2009 and 2008 was derived primarily from the sale of software licenses and RTL licenses, royalties, and engineering and consulting services. The increase in revenue for both the three and six months ended June 30, 2009 is primarily attributable to an increase in license and royalty revenue from our Finland subsidiary, partially offset by decreases in US license and royalty revenue.

Operating Expenses. The Company’s operating expenses consist of costs of revenue, research and development, sales and marketing, general and administrative expenses, litigation settlement costs, costs associated with proposed merger, and equity based compensation. Operating expenses for the three months ended June 30, 2009 were $6,020,000 as compared to $10,441,000 for the three months ended June 30, 2008. Operating expenses were $13,258,000 for the six months ended June 30, 2009 as compared to $19,706,000 for the six months ended June 30, 2008.

Costs of Revenue. Costs of revenue includes personnel and related overhead expenses, royalties paid for software that is incorporated into the Company’s software, consulting compensation costs, operating lease costs and depreciation and amortization costs. Costs of revenue for the three months ended June 30, 2009 was $445,000 as compared to $1,194,000 for the three months ended June 30, 2008. Costs of revenues for the six months ended June 30, 2009 was $1,018,000 as compared to $2,624,000 for the six months ended June 30, 2008. The decrease of $749,000 for the three months ended June 30, 2009 as compared to the three months ended June 30, 2008 is primarily attributable to a $390,000 decrease in the amortization of purchased technology and customer relationships as a result of the asset impairments in 2008 associated with On2 Finland, and a $359,000 decrease in production and engineering costs, technical support and fewer hours allocated by our engineering staff, and a reduction in the foreign currency exchange rate. The decrease of $1,606,000 for the six months ended June 30, 2009 as compared to the six months ended June 30, 2008 is primarily attributable to a $901,000 decrease in the amortization of purchased technology and customer relationships as a result of the asset impairments in 2008 associated with On2 Finland, and a $705,000 decrease in production and engineering costs, technical support and fewer hours allocated by our engineering staff, as well as a reduction in the foreign currency exchange rate.

Research and Development. Research and development expenses, excluding equity-based compensation, consist primarily of salaries and related expenses and consulting fees associated with the development and production of our products and services, operating lease costs and depreciation costs. Research and development expenses for the three months ended June 30, 2009 were $1,721,000 as compared to $3,009,000 for the three months ended June 30, 2008. Research and development expenses for the six months ended June 30, 2009 were $3,885,000 as compared to $5,817,000 for the six months ended June 30, 2008. The decrease of $1,288,000 and $1,932,000 for the three and six months ended June 30, 2009, respectively, is primarily the result a Company-wide cost savings plan implemented during the second half of 2008, a workforce reduction (furlough) process implemented during the first quarter of 2009 and a reduction in the foreign currency exchange rate.

Sales and Marketing. Sales and marketing expenses, excluding equity-based compensation, consist primarily of salaries and related costs, commissions, business development costs, tradeshow costs, marketing and promotional costs incurred to create brand awareness and public relations expenses. Sales and marketing expenses for the three months ended June 30, 2009 were $926,000 as compared to $1,875,000 for the three months ended June 30, 2008. Sales and marketing expenses for the six months ended June 30, 2009 were $1,902,000 as compared to $3,764,000 for the six months ended June 30, 2008. The decrease of $949,000 and $1,862,000 for the three and six months ended June 30, 2009, respectively, is primarily a decrease in sales and marketing personnel and related travel and overhead costs that is a result of a company-wide cost savings plan implemented during the second half of 2008, a workforce reduction (furlough) process implemented during the first quarter of 2009, and a reduction in the foreign currency exchange rate.

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General and Administrative . General and administrative expenses, excluding equity-based compensation, consist primarily of salaries and related costs for general corporate functions including finance, human resources, management information systems, legal, facilities, outside legal and other professional fees and insurance. General and administrative expenses for the three months ended June 30, 2009 were $1,548,000, as compared to $3,926,000 for the three months ended June 30, 2009. General and administrative expenses for the six months ended June 30, 2009 were $3,622,000 as compared to $6,694,000 for the six months ended June 30, 2008. The decrease of $2,378,000 and $3,072,000 for the three and six months ended June 30, 2009, respectively, is primarily due to a decrease in legal and accounting fees incurred during 2008 related to the Audit Committee’s review of certain 2007 sales contracts in connection with the restatement, a decrease in consulting fees related to the implementation of Sarbanes Oxley Section 404 and other consulting and professional services, a company-wide cost savings plan implemented during the second half of 2008, a workforce reduction (furlough) process implemented during the first quarter of 2009 and a reduction in the foreign currency exchange rate.

Restructuring Expense. Restructuring expenses consist primarily of severance and benefits, unused office and property leases, legal and other administrative costs, and asset impairment related to unused capital leases. Restructuring expenses for the three and six months ended June 30, 2009 were $1,032,000, as compared with $-0- for the three and six months ended June 30, 2008. The increase is due to a restructuring plan implemented during the first quarter of fiscal 2009 for the On2 Finland subsidiary.

Costs Associated with Proposed Merger. Costs associated with proposed merger consist primarily of professional fees related to the proposed merger with a subsidiary of Google. Costs associated with proposed merger for the three and six months ended June 30, 2009 were $420,000.

Litigation Settlement Costs. Litigation settlement costs are the costs of the settlement of the Islandia lawsuit and related legal costs. Litigation settlement costs for the three and six months ended June 30, 2009 were $523,000 of which $500,000 is the settlement cost of the lawsuit and $23,000 is for related legal fees.

Equity-Based Compensation. Equity based compensation, which is presented separately, was $496,000 and $986,000 for the three and six months ended June 30, 2009, respectively. Equity-based compensation of $59,000 and $130,000 is included in cost of revenue for the three and six months ended June 30, 2009, respectively. Equity-based compensation was $516,000 and $969,000 for the three and six months ended June 30, 2008, respectively. Equity-based compensation of $79,000 and $162,000 is included in cost of revenue for the three and six months ended June 30, 2008, respectively. The increase for the six months ended June 30, 2009 is primarily due to the issuance of restricted stock grants during the first quarter of 2009.

Other Income (Expense), Net

Interest income (expense), net primarily consists of interest incurred for capital lease obligations and long-term debt, offset by interest earned on the Company’s invested cash balances. Interest income (expense), net was $(33,000) and $(70,000) for the three and six months ended June 30, 2009, respectively, as compared to $(14,000) and $61,000 for the three and six months ended June 30, 2008, respectively. The decrease of $19,000 and 131,000 for the three and six months ended June 30, 2009, respectively, is primarily related to lower cash balances and additional capital leases during the second half of 2008.

Other income (expense), net primarily consists of government grants related to our Finland subsidiary and changes in the fair value of the warrant derivative liability. The increase in income of $149,000 and $421,000 for the three and six months ended June 30, 2009, respectively, is primarily the result of government grants received by the Company’s Finland subsidiary, offset by the change in the warrant derivative liability.

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Gain from forgiveness of debt

Gain from forgiveness of debt is a result of modifications to our notes payable to a Finnish Funding Agency for the Company’s Finland subsidiary during the second quarter of 2009. Gain from forgiveness of debt for the three and six months ended June 30, 2009 was $669,000.

Liquidity and Capital Resources

At June 30, 2009, the Company had cash and cash equivalents and short-term investments of $2,797,000, as compared to $4,289,000 at December 31, 2008. At June 30, 2009 the Company had negative working capital of $3,124,000 (without the restructuring accrual, negative working capital would have been $2,339,000 at June 30, 2009), as compared with negative working capital of $1,866,000 at December 31, 2008.

Net cash used in operating activities was $1,105,000 and $4,407,000 for the six months ended June 30, 2009 and 2008, respectively. The decrease in net cash used in operating activities is primarily related to a net loss of $3,212,000, a decrease in deferred revenue of $617,000, a decrease in accounts payable and accrued expenses of $126,000, a reduction for bad debt expense of $226,000, a gain from forgiveness of debt income of $669,000, partially offset by a decrease in accounts receivable of $725,000, a decrease in prepaid expenses and other current assets of $82,000, an increase in depreciation and amortization of $926,000, an asset impairment from restructuring of $175,000, an increase in accrued restructuring expenses of $746,000, and an increase in equity-based compensation of $986,000.

Net cash (used in) provided by investing activities was $(167,000) and $5,186,000 for the six months ended June 30, 2009 and 2008, respectively. The decrease in net cash provided by investing activities is primarily a result of the maturing of a majority of the short term investments during the second quarter of 2008.

Net cash used in financing activities was $112,000 and $2,562,000 for the six months ended June 30, 2009 and 2008, respectively. The decrease in net cash used in financing activities is primarily attributable to a decrease in payments on short-term debt for our Finland subsidiary, due to the non-renewal of certain lines of credit.

We currently have material commitments for the next 12 months under our operating lease arrangements and borrowings. These arrangements consist primarily of lease arrangements for our office space in Clifton Park, and Manhattan, New York, Cambridge UK, Oulu, Finland, Beijing, China and Tokyo. The aggregate required payments for the next 12 months under these arrangements are $857,000. 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.

At June 30, 2009, short-term borrowings consisted of the following:

A term loan. During July 2008, the Company renewed its Directors and Officers Liability Insurance and financed the premium with a $140,000, nine-month term-loan that carries an effective annual interest rate of 4.75%. The balance at June 30, 2009 was $-0-.

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At June 30, 2009, long-term debt consisted of the following:

We have experienced significant operating losses and negative operating cash flows to date. We plan to increase cash flows from operations principally from increases in revenue and from cost reduction and restructuring initiatives that we implemented during 2008 and the first quarter of 2009.

During 2008 and the first quarter of 2009, the Company implemented a restructuring program, including a reduction of its workforce, a reduction in overhead costs, and the identification of one time charges for professional fees. On March 18, 2009 the Company began implementing a number of cost reduction initiatives at its Finnish subsidiary, On2 Finland, including a reduction in workforce that is expected to reduce headcount by approximately 31 On2 Finland employees. The Company implemented these cost reduction initiatives in order to align spending with demand that has weakened as a result of the current global economic conditions and uncertainties, particularly in the semiconductor industry in which On2 Finland operates. In accordance with Finnish law, the Company negotiated with the representative of the On2 Finland employees and On2 Finland’s management team in order to obtain consensus on the reduction in workforce plan. The Company implemented the plan primarily through a furlough process that took effect in April 2009 and is expected to be fully implemented within fiscal 2009.

As a result of the cost reduction initiatives at On2 Finland, the Company incurred initial restructuring and impairment charges of approximately $1.032 million the first quarter of 2009. These estimated charges consist primarily of one-time employee reduction costs, the majority of which are related to post-termination employee payments required by Finnish law and the collective bargaining agreement covering most On2 Finland employees, and other related restructuring costs. The post-termination payments are triggered if the Company terminates some or all of the furloughed employees or if employees who are furloughed for longer than 200 days elect to terminate their own employment. The total costs incurred will depend on a number of factors, including the duration of the furloughs, the number of employees, if any, that are recalled from furlough or terminated and, for employees that are furloughed for longer than 200 days, the number of such employees that have not obtained other employment.

Additionally, On2 Finland may borrow funds up to a maximum of €450,000 ($632,000 based on exchange rates as of June 30, 2009) under a line of credit. As of June 30, 2009 the balance on this line of credit was $190,000. On July 30, 2009, the limit on the line of credit was reduced to €300,000. Given our cash and short-term investments of $2,797,000 at June 30, 2009, and the Company’s forecasted cash requirements, the Company’s management anticipates that the Company’s existing capital resources will be sufficient to satisfy our cash flow requirements for the next 12 months.

We have based our forecasts on assumptions we have made relating to, among other things, the market for our products and services, economic conditions and the availability of credit to us and our customers. If these assumptions are incorrect, or if our sales are less than forecasted and/or expenses higher than expected, we may not have sufficient resources to fund our operations for this entire period. In that event, the Company may need to seek other sources of funds by issuing equity or incurring debt, or may need to implement further reductions of operating expenses, or some combination of these measures, in order for the Company to generate positive cash flows to sustain the operations of the Company. However, because of the recent tightening in global credit markets, we may not be able to obtain financing on favorable terms, or at all. See “ Management’s Discussion and Analysis of Financial Condition and Results of Operations – Risk Factors That May Affect Future Operating Results ” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008.

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Off-Balance Sheet Arrangements

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

Impact of Recently-Issued Accounting Pronouncements

In June 2009 the Financial Accounting Standards Board (FASB) has issued Statement of Financial Accounting Standards (SFAS) 168, The “FASB Accounting Standards Codification” and the Hierarchy of Generally Accepted Accounting Principles. SFAS 168 establishes the FASB Accounting Standards Codification (Codification) as the single source of authoritative U.S. generally accepted accounting principles (U.S. GAAP) recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the SEC under authority of federal securities laws are also sources of authoritative U.S. GAAP for SEC registrants. SFAS 168 and the Codification are effective for financial statements issued for interim and annual periods ending after September 15, 2009. There will be no change to the Company’s condensed consolidated financial position and results of operations due to the implementation of this Statement.

In June 2009 the FASB has issued the following two standards which change the way entities account for securitizations and special-purpose entities:


	●	SFAS 166, Accounting for Transfers of Financial Assets;
	●	SFAS 167, Amendments to FASB Interpretation No. 46(R).

SFAS 166 is a revision to FASB SFAS. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, and will require more information about transfers of financial assets, including securitization transactions, and where entities have continuing exposure to the risks related to transferred financial assets. It eliminates the concept of a “qualifying special-purpose entity,” changes the requirements for derecognizing financial assets, and requires additional disclosures. SFAS 167 is a revision to FASB Interpretation No. 46 (Revised December 2003), Consolidation of Variable Interest Entities, and changes how a reporting entity determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a reporting entity is required to consolidate another entity is based on, among other things, the other entity’s purpose and design and the reporting entity’s ability to direct the activities of the other entity that most significantly impact the other entity’s economic performance. The new standards will require a number of new disclosures. Statement 167 will require a reporting entity to provide additional disclosures about its involvement with variable interest entities and any significant changes in risk exposure due to that involvement. A reporting entity will be required to disclose how its involvement with a variable interest entity affects the reporting entity’s financial statements. Statement 166 enhances information reported to users of financial statements by providing greater transparency about transfers of financial assets and an entity’s continuing involvement in transferred financial assets. SFAS 166 and 167 will be effective at the start of a reporting entity’s first fiscal year beginning after November 15, 2009, or January 1, 2010, for a calendar year-end entity. Early application is not permitted. The Company is currently evaluating the impact of adopting SFAS 166 and SFAS 167 on its condensed consolidated financial position and results of operations.

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In May 2009 the FASB has issued SFAS 165, Subsequent Events. SFAS 165 establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. Specifically, SFAS 165 provides:


	●	The period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements;
	●	The circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements; and
	●	The disclosures that an entity should make about events or transactions that occurred after the balance sheet date.

During the second quarter of 2009 the FASB has issued FASB Staff Position (FSP) FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly. This FSP:


	●	Affirms that the objective of fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction.
	●	Clarifies and includes additional factors for determining whether there has been a significant decrease in market activity for an asset when the market for that asset is not active.
	●	Eliminates the proposed presumption that all transactions are distressed (not orderly) unless proven otherwise. The FSP instead requires an entity to base its conclusion about whether a transaction was not orderly on the weight of the evidence.
	●	Includes an example that provides additional explanation on estimating fair value when the market activity for an asset has declined significantly.
	●	Requires an entity to disclose a change in valuation technique (and the related inputs) resulting from the application of the FSP and to quantify its effects, if practicable.
	●	Applies to all fair value measurements when appropriate.

During the second quarter of 2009 the FASB has issued FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments. This FSP:


	●	Changes existing guidance for determining whether an impairment is other than temporary to debt securities;
	●	Replaces the existing requirement that the entity’s management assert it has both the intent and ability to hold an impaired security until recovery with a requirement that management assert: ( a ) it does not have the intent to sell the security; and ( b ) it is more likely than not it will not have to sell the security before recovery of its cost basis;

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	●	Incorporates examples of factors from existing literature that should be considered in determining whether a debt security is other-than-temporarily impaired;
	●	Requires that an entity recognize noncredit losses on held-to-maturity debt securities in other comprehensive income and amortize that amount over the remaining life of the security in a prospective manner by offsetting the recorded value of the asset unless the security is subsequently sold or there are additional credit losses;
	●	Requires an entity to present the total other-than-temporary impairment in the statement of earnings with an offset for the amount recognized in other comprehensive income; and
	●	When adopting FSP FAS 115-2 and FAS 124-2, an entity is required to record a cumulative-effect adjustment as of the beginning of the period of adoption to reclassify the noncredit component of a previously recognized other-temporary impairment from retained earnings to accumulated other comprehensive income if the entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery.

FSP FAS 115-2 and FAS 124-2 is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. An entity may early adopt this FSP only if it also elects to early adopt FSP FAS 157-4. The company adopted this FSP for the quarter ended June 30, 2009, and there was no material impact on the Company’s condensed consolidated results of operations or financial position.

During the second quarter of 2009 the FASB has issued FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments. This FSP amends FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments, to require an entity to provide disclosures about fair value of financial instruments in interim financial information. This FSP also amends APB Opinion No. 28, Interim Financial Reporting, to require those disclosures in summarized financial information at interim reporting periods. Under this FSP, a publicly traded company shall include disclosures about the fair value of its financial instruments whenever it issues summarized financial information for interim reporting periods. In addition, an entity shall disclose in the body or in the accompanying notes of its summarized financial information for interim reporting periods and in its financial statements for annual reporting periods the fair value of all financial instruments for which it is practicable to estimate that value, whether recognized or not recognized in the statement of financial position, as required by Statement 107.

On April 1, 2009 the FASB issued FSP FAS 141(R)-1, Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies. This FSP amends the guidance in FASB Statement No. 141 (Revised December 2007), Business Combinations, to:


	●	Require that assets acquired and liabilities assumed in a business combination that arise from contingencies be recognized at fair value if fair value can be reasonably estimated. If fair value of such an asset or liability cannot be reasonably estimated, the asset or liability would generally be recognized in accordance with FASB Statement No. 5, Accounting for Contingencies, and FASB Interpretation (FIN) No. 14, Reasonable Estimation of the Amount of a Loss. Further, the FASB decided to remove the subsequent accounting guidance for assets and liabilities arising from contingencies from Statement 141R, and carry forward without significant revision the guidance in FASB Statement No. 141, Business Combinations.

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	●	Eliminate the requirement to disclose an estimate of the range of outcomes of recognized contingencies at the acquisition date. For unrecognized contingencies, the FASB decided to require that entities include only the disclosures required by Statement 5 and that those disclosures be included in the business combination footnote.
	●	Require that contingent consideration arrangements of an acquiree assumed by the acquirer in a business combination be treated as contingent consideration of the acquirer and should be initially and subsequently measured at fair value in accordance with Statement 141R.

In June 2008, the EITF reached a consensus in Issue No. 07-5, Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock (“EITF 07-5”). This Issue addresses the determination of whether an instrument (or an embedded feature) is indexed to an entity’s own stock, which is the first part of the scope exception in paragraph 11(a) of SFAS 133. EITF 07-5 is effective for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. Early application is not permitted. Th e Company has adopted EITF 07-05 and has made a cumulative adjustment to increase retained earnings by $803,000 as of January 1, 2009. The Company also recorded an increase to the warrant derivative liability of $121,000, and a decrease to additional paid-in capital of $924,000.

In April 2009, the FASB issued FASB Staff Position (FSP) Financial Accounting Standard (FAS) 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly.” Based on the guidance, if an entity determines that the level of activity for an asset or liability has significantly decreased and that a transaction is not orderly, further analysis of transactions or quoted prices is needed, and a significant adjustment to the transaction or quoted prices may be necessary to estimate fair value in accordance with SFAS No. 157, “Fair Value Measurements.” This FSP is to be applied prospectively and is effective for interim and annual periods ending after June 15, 2009 with early adoption permitted for periods ending after March 15, 2009. The company adopted this FSP in the quarter ended June 30, 2009, and there was no material impact on the Company’s condensed consolidated financial position and results of operations.


Item 3.	Quantitative and Qualitative Disclosures About Risk

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

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Item 4.

Controls and Procedures

(a) Evaluation of Disclosure Controls and Procedures:

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

As of June 30, 2009, we carried out an evaluation, under the supervision and with the participation of our principal executive officer and our principal financial officer of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, our principal executive officer and our principal financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report.

(b) Changes in Internal Controls over Financial Reporting:

There were no changes in our internal control over financial reporting identified in connection with the evaluation required by Rules 13a-15 and 15d-15 that occurred during the quarter ended June 30, 2009 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION


Item 1.	Legal Proceedings

Islandia

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Item 1A.	Risk Factors

With the exception of the following risk factor, there have been no other material changes in our risk factors from those disclosed in Part I, Item 1A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2008.

Merger Agreement with Google

There are a number of risks and uncertainties relating to the proposed merger between the Company and a subsidiary of Google. The risks and uncertainties include the possibility that the transaction may be delayed or may not be completed as a result of failure to obtain necessary approval of the Company’s stockholders, the failure to obtain or any delay in obtaining necessary regulatory clearances or satisfying other closing conditions. Any delay in completing, or failure to complete, the merger could have a negative impact on the Company’s business, its stock price, and its relationships with customers or employees. In addition, under certain circumstances, if the transaction is terminated, the Company may be required to pay a significant termination fee to Google.


Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds

On July 23, 2009, On2 issued a convertible note to Islandia, L.P. in the principal amount of $500,000 which bears an interest rate equal to eight percent (8%) per annum (the “Note”). The Note was issued in connection with the execution of a Release and Settlement Agreement (the “Settlement Agreement”) by and between On2 and Islandia to settle ongoing litigation between the parties. The Note may be redeemed by On2 at anytime and will become due and payable on July 23, 2010 or earlier upon a change of control. At the time of payment, the Note shall be payable in cash or shares of On2 at the sole discretion of On2, subject to certain conditions. If On2 opts to pay the Note in shares of On2 common stock, the conversion price will be calculated by dividing (i) the principal amount plus accrued and unpaid interest outstanding under the Note by (ii) a price per share equal to 85% of the average of the 20 trading day daily volume weighted average price of a share of On2 common stock at the time of conversion ending one trading day prior to the date of payment. On2 issued the Note in a private placement transaction made in reliance upon the exemption from securities registration afforded by Section 4(2) under the Securities Act of 1933, as amended and Regulation D thereunder.

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Item 4.

Submission of Matters to a Vote of Security Holders

On May 20, 2009, we held our annual stockholders meeting at the Company’s headquarters in Clifton Park, New York. Our stockholders re-elected our board of directors and approved all proposals presented at the annual meeting. The items considered and approved at the annual meeting are described in the proxy statement dated April 6, 2009. The record date for the annual meeting was March 31, 2009. The meeting was called for the purpose of considering the following proposals:


	1.	to elect six (6) directors to serve on our Board of Directors for the term commencing immediately following the Annual Meeting;

	2.	To ratify the selection of Marcum & Kliegman LLP as the independent registered public accounting firm of the Company for the fiscal year ending December 31, 2009; and

	3.	to transact any business as may properly come before the meeting and any adjournments thereof.

J. Allen Kosowsky, Mike Alfant, Mike Kopetski, James Meyer, Afsaneh Naimollah, and Thomas Weigman were nominated by the Board of Directors for election to the Board of Directors at the annual meeting. All of the nominees were current directors and were elected at the last annual meeting of stockholders.

The votes received on the above proposals, including a separate tabulation with respect to each director nominee, were as follows:


Proposal 1: Election of Directors

Director	For	% For*	Withheld	% Withheld*
J. Allen Kosowsky	114,413,058	80.25%	28,173,798	19.75%
Mike Alfant	114,795,297	80.51%	27,791,559	19.49%
Mike Kopetski	114,132,839	80.05%	28,454,017	19.95%
James Meyer	112,450,227	78.87%	30,136,628	21.13%
Afsaneh Naimollah	112,331,476	78.79%	30,255,380	21.21%
Thomas Weigman	113,623,661	79.69%	28,963,195	20.31%

Proposal 2: Ratification of the Selection of Marcum & Kliegman as the Company’s Independent Registered Public Accounting Firm

For	% For**	Against	% Against**	Witheld	% Witheld**
134,693,820	77.47%	3,042,269	1.73%	3,561,387	2.02

* - % of shares voted
** - % of shares outstanding

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Item 6. Exhibits.

31.1 Certification by the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2 Certification by the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

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

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

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SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


		On2 Technologies, Inc.
		(Registrant)

August 7, 2009		/s/ MATTHEW FROST
(Date)		(Signature)
		Matthew Frost
		Interim Chief Executive Officer

		On2 Technologies, Inc.
		(Registrant)

August 7, 2009		/s/ WAYNE BOOMER
(Date)		(Signature)
		Wayne Boomer
		Senior Vice President and Chief Financial Officer
		(Principal Financial Officer)

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