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

Overview

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

On2 Finland Acquisition

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

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

Company History

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

In June of 1999, The Duck Corporation was merged with and into a wholly-owned subsidiary of Applied Capital Funding, Inc., a Delaware corporation and a public company whose name was concurrently changed to On2.com Inc. and subsequently changed to On2 Technologies, Inc. At that time, we had developed proprietary technology that enabled the compression, storage and streaming of high quality video signals over high bandwidth networks (i.e. broadband). On November 1, 2007, we acquired all of the issued and outstanding shares of capital stock of On2 Finland, which thereby became a wholly-owned subsidiary of On2. On2 Finland develops technology for enabling multimedia in resource-limited environments such as battery operated mobile handsets.

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

Critical Accounting Policies and Estimates

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

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

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

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

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

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

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

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

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

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

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

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

Results of Operations

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

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

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

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

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

               Total                                100 %     100 %     100 %

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

OPERATING EXPENSES

Year ended December 2008 versus 2007:

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

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

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

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

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

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

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

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

Other income (expense), net

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

Other income (expense), net primarily consists of the change in the fair value of the warrant derivative liability, realized losses on marketable securities, and grant income. Other income (expense), net was $657,000 and $(3,666,000) for the years ended December 31, 2008 and 2007, respectively. The decrease in expense of $4,323,000 for the year ended December 31, 2008 is primarily a result of the elimination of the derivative liability in the second . . .