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 March 31,
2009.
|
|
|
¨
|
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
¨
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).
¨
Yes
¨
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).
|
|
¨
Large accelerated
filer
|
þ
Accelerated
filer
|
¨
Non-accelerated
filer
|
¨
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.
¨
Yes
¨
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 April 30, 2009, were 175,511,000.
Table
of Contents
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|
Page
|
|
|
|
PART I — FINANCIAL
INFORMATION
|
|
|
|
|
|
Item
1. Consolidated Financial Statements.
|
|
|
|
|
|
Condensed
Consolidated Balance Sheets at March 31, 2009 (unaudited) and December 31,
2008
|
|
2
|
Unaudited
Condensed Consolidated Statements of Operations Three Months Ended March
31, 2009 and 2008
|
|
3
|
Unaudited
Condensed Consolidated Statements of Comprehensive Loss Three Months Ended
March 31, 2009 and 2008
|
|
4
|
Unaudited
Condensed Consolidated Statements of Cash Flows Three Months Ended March
31, 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
|
|
17
|
|
|
|
Item
3. Quantitative and Qualitative Disclosures About Market
Risk
|
|
32
|
|
|
|
Item
4. Controls and Procedures
|
|
32
|
|
|
|
PART
II — OTHER INFORMATION
|
|
|
|
|
|
Item
1. Legal Proceedings
|
|
34
|
|
|
|
Item
6. Exhibits
|
|
34
|
|
|
|
Signatures
|
|
35
|
|
|
|
Certifications
|
|
36
|
PART
I — FINANCIAL INFORMATION
|
|
Item
1.
|
Consolidated
Financial
Statements
|
ON2
TECHNOLOGIES, INC.
CONDENSED
CONSOLIDATED BALANCE SHEETS
|
|
|
|
|
|
|
|
|
March
31,
2009
|
|
|
December
31,
2008
|
|
|
|
(unaudited)
|
|
|
|
|
|
|
(In
thousands, except par value
and share amounts)
|
|
ASSETS
|
|
|
|
|
|
|
Current
assets:
|
|
|
|
|
|
|
Cash
and cash equivalents
|
|
$
|
3,159
|
|
|
$
|
4,157
|
|
Short-term
investments
|
|
|
131
|
|
|
|
132
|
|
Accounts
receivable, net of allowance for doubtful accounts of $612 at March 31,
2009 and $623 at December 31, 2008
|
|
|
2,178
|
|
|
|
2,730
|
|
Prepaid
and other current assets
|
|
|
659
|
|
|
|
439
|
|
Total
current assets
|
|
|
6,127
|
|
|
|
7,458
|
|
Property
and equipment, net
|
|
|
767
|
|
|
|
715
|
|
Capital
leases, net
|
|
|
421
|
|
|
|
686
|
|
Acquired
software, net
|
|
|
1,896
|
|
|
|
2,212
|
|
Other
acquired intangibles, net
|
|
|
4,793
|
|
|
|
5,276
|
|
Goodwill
|
|
|
8,540
|
|
|
|
9,099
|
|
Other
assets
|
|
|
413
|
|
|
|
430
|
|
Total
assets
|
|
$
|
22,957
|
|
|
$
|
25,876
|
|
LIABILITIES
AND STOCKHOLDERS’ EQUITY
|
|
|
|
|
|
|
|
|
Current
liabilities:
|
|
|
|
|
|
|
|
|
Accounts
payable
|
|
$
|
1,979
|
|
|
$
|
1,352
|
|
Accrued
expenses
|
|
|
3,492
|
|
|
|
4,368
|
|
Accrued
restructuring expenses
|
|
|
868
|
|
|
|
—
|
|
Deferred
revenue
|
|
|
2,217
|
|
|
|
2,133
|
|
Short-term
borrowings
|
|
|
16
|
|
|
|
63
|
|
Current
portion of long-term debt
|
|
|
1,044
|
|
|
|
1,148
|
|
Capital
lease obligation
|
|
|
245
|
|
|
|
260
|
|
Total
current liabilities
|
|
|
9,861
|
|
|
|
9,324
|
|
Long-term
debt
|
|
|
1,608
|
|
|
|
1,802
|
|
Capital
lease obligation, excluding current portion
|
|
|
362
|
|
|
|
432
|
|
Warrant
derivative liability
|
|
|
121
|
|
|
|
—
|
|
Total
liabilities
|
|
|
11,952
|
|
|
|
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; 175,511,000 and
171,769,000 shares issued, and outstanding at March 31, 2009 and December
31, 2008, respectively
|
|
|
1,755
|
|
|
|
1,718
|
|
Additional
paid-in capital
|
|
|
195,900
|
|
|
|
196,371
|
|
Accumulated
other comprehensive loss
|
|
|
(1,767
|
)
|
|
|
(1,073
|
)
|
Accumulated
deficit
|
|
|
(184,883
|
)
|
|
|
(182,698
|
)
|
Total
stockholders’ equity
|
|
|
11,005
|
|
|
|
14,318
|
|
Total
liabilities and stockholders’ equity
|
|
$
|
22,957
|
|
|
$
|
25,876
|
|
See
accompanying notes to unaudited condensed consolidated financial
statements
ON2
TECHNOLOGIES, INC.
UNAUDITED
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
|
|
|
|
|
|
|
|
|
Three
Months Ended March 31,
|
|
|
|
2009
|
|
|
2008
|
|
|
|
(In
thousands
except
per share data)
|
|
|
|
|
|
|
|
|
Revenue
|
|
$
|
4,016
|
|
|
$
|
4,452
|
|
|
|
|
|
|
|
|
|
|
Operating
expenses:
|
|
|
|
|
|
|
|
|
Costs
of revenue (1)
|
|
|
573
|
|
|
|
1,430
|
|
Research
and development (2)
|
|
|
2,164
|
|
|
|
2,808
|
|
Sales
and marketing (2)
|
|
|
976
|
|
|
|
1,889
|
|
General
and administrative (2)
|
|
|
2,074
|
|
|
|
2,768
|
|
Restructuring
expense
|
|
|
1,032
|
|
|
|
—
|
|
Equity-based
compensation:
|
|
|
|
|
|
|
|
|
Research
and development
|
|
|
138
|
|
|
|
119
|
|
Sales
and marketing
|
|
|
49
|
|
|
|
38
|
|
General
and administrative
|
|
|
232
|
|
|
|
213
|
|
|
|
|
|
|
|
|
|
|
Total
operating expenses
|
|
|
7,238
|
|
|
|
9,265
|
|
|
|
|
|
|
|
|
|
|
Loss
from operations
|
|
|
(3,222
|
)
|
|
|
(4,813
|
)
|
|
|
|
|
|
|
|
|
|
Other
income (expense), net
|
|
|
|
|
|
|
|
|
Interest
income (expense), net
|
|
|
(37
|
)
|
|
|
75
|
|
Other
income (expense), net
|
|
|
271
|
|
|
|
(1
|
)
|
Total
other income (expense)
|
|
|
234
|
|
|
|
74
|
|
|
|
|
|
|
|
|
|
|
Net
loss attributable to common stockholders
|
|
$
|
(2,988
|
)
|
|
$
|
(4,739
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
and diluted net loss attributable to common stockholders per common
share
|
|
$
|
(.02
|
)
|
|
$
|
(.03
|
)
|
|
|
|
|
|
|
|
|
|
Weighted-average
basic and diluted common shares outstanding
|
|
|
173,361
|
|
|
|
170,487
|
|
|
|
(1)
|
Includes
equity-based compensation of $71,000 and $83,000 for the three months
ended March 31, 2009 and 2008, respectively.
|
|
|
(2)
|
Excludes
equity-based compensation, which is presented
separately.
|
See
accompanying notes to unaudited condensed consolidated financial
statements
ON2
TECHNOLOGIES, INC.
UNAUDITED
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
|
|
|
|
|
|
|
|
|
Three
Months Ended
March
31,
|
|
|
|
2009
|
|
|
2008
|
|
|
|
(In thousands)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
loss
|
|
$
|
(2,988
|
)
|
|
$
|
(4,739
|
)
|
|
|
|
|
|
|
|
|
|
Other
comprehensive loss:
|
|
|
|
|
|
|
|
|
Foreign
currency translation
|
|
|
(694
|
)
|
|
|
3,480
|
|
|
|
|
|
|
|
|
|
|
Comprehensive
loss
|
|
$
|
(3,682
|
)
|
|
$
|
(1,259
|
)
|
See
accompanying notes to unaudited condensed consolidated financial
statements
ON2
TECHNOLOGIES, INC.
UNAUDITED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
|
|
|
|
|
|
|
|
|
Three
Months Ended March 31,
|
|
|
|
2009
|
|
|
2008
|
|
|
|
(In
thousands)
|
|
|
|
|
|
|
|
|
Cash
flows from operating activities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
loss
|
|
$
|
(2,988
|
)
|
|
$
|
(4,739
|
)
|
Adjustments
to reconcile net loss to net cash (used in) provided by operating
activities:
|
|
|
|
|
|
|
|
|
Equity-based
compensation
|
|
|
490
|
|
|
|
453
|
|
Depreciation
|
|
|
151
|
|
|
|
85
|
|
Amortization
|
|
|
330
|
|
|
|
749
|
|
Bad
debt expense
|
|
|
4
|
|
|
|
253
|
|
Asset
impairments from restructuring
|
|
|
175
|
|
|
|
—
|
|
Insurance
expenses financed with term loan
|
|
|
43
|
|
|
|
—
|
|
Changes
in operating assets and liabilities:
|
|
|
|
|
|
|
|
|
Accounts
receivable
|
|
|
419
|
|
|
|
2,539
|
|
Prepaid
expenses and other current assets
|
|
|
(276
|
)
|
|
|
(161
|
)
|
Other
assets
|
|
|
14
|
|
|
|
11
|
|
Accounts
payable and accrued expenses
|
|
|
22
|
|
|
|
(503
|
)
|
Accrued
restructuring expense
|
|
|
859
|
|
|
|
—
|
|
Deferred
revenue
|
|
|
169
|
|
|
|
1,521
|
|
|
|
|
|
|
|
|
|
|
Net
cash (used in) provided by operating activities
|
|
|
(588
|
)
|
|
|
208
|
|
|
|
|
|
|
|
|
|
|
Cash
flows from investing activities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Proceeds
from the sale of short-term investments
|
|
|
132
|
|
|
|
13,075
|
|
Purchase
of short-term investments
|
|
|
(131
|
)
|
|
|
(17,684
|
)
|
Purchases
of property and equipment
|
|
|
(163
|
)
|
|
|
(85
|
)
|
|
|
|
|
|
|
|
|
|
Net
cash used in investing activities
|
|
|
(162
|
)
|
|
|
(4,694
|
)
|
|
|
|
|
|
|
|
|
|
Cash
flows from financing activities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Principal
payments on capital lease obligations
|
|
|
(61
|
)
|
|
|
(6
|
)
|
Principal
payments on short-term borrowings
|
|
|
(47
|
)
|
|
|
(2,122
|
)
|
Principal
payments on long-term debt
|
|
|
(110
|
)
|
|
|
(183
|
)
|
Proceeds
from the exercise of common stock options and warrants
|
|
|
—
|
|
|
|
16
|
|
|
|
|
|
|
|
|
|
|
Net
cash used in financing activities
|
|
|
(218
|
)
|
|
|
(2,295
|
)
|
|
|
|
|
|
|
|
|
|
Effect
of exchange rate changes on cash and cash equivalents
|
|
|
(30
|
)
|
|
|
(108
|
)
|
|
|
|
|
|
|
|
|
|
Net
decrease in cash and cash equivalents
|
|
|
(998
|
)
|
|
|
(6,889
|
)
|
|
|
|
|
|
|
|
|
|
Cash
and cash equivalents, beginning of period
|
|
|
4,157
|
|
|
|
9,573
|
|
|
|
|
|
|
|
|
|
|
Cash
and cash equivalents, end of period
|
|
$
|
3,159
|
|
|
$
|
2,684
|
|
ON2
TECHNOLOGIES, INC.
UNAUDITED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(CONTINUED)
Supplemental
disclosure of cash flow information:
|
|
|
|
|
|
|
|
Three
Months Ended March 31,
|
|
|
|
2009
|
|
|
2008
|
|
|
|
|
|
|
|
|
|
|
Cash
paid during the period for:
|
|
|
|
|
|
|
|
|
Interest
|
|
$
|
39
|
|
|
$
|
41
|
|
See
accompanying notes to unaudited condensed consolidated financial
statements
ON2
TECHNOLOGIES, INC.
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
|
|
(1)
|
Description
of On2 Technologies,
Inc.
|
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. 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 the 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 March 31, 2009, the Company had negative working capital of
$3,734,000. For the three months ended March 31, 2009, the Company incurred a
net loss of $2,988,000, which included non-cash charges of $1,193,000. Cash used
from operating activities was $588,000 for the three months ended March 31,
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. Management estimates that the 2009 savings related to
these cost-cutting measures and one time charges approximate $11.9 million. 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 ($594,000 based on
exchange rates as of March 31, 2009) under a line of credit. As of March 31,
2009 the balance on this line of credit was $-0-. On2 Finland had borrowings on
this line of credit during the quarter that were paid back by March 31, 2009.
Given our cash and short-term investments of $3,290,000 at March 31, 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.
|
|
(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.
Reclassifications
We have
reclassified certain prior period amounts to conform with the current period
presentation.
|
|
(3)
|
Recently
Adopted Accounting
Pronouncements
|
In
October 2008, The Financial Accounting Standards Board issued FSP 157-3
Determining Fair Value of a
Financial Asset in a Market That is Not Active
(FSP 157-3). FSP 157-3
classified the application of SFAS No. 157 in an inactive market. It
demonstrated how the fair value of a financial asset is determined when the
market for that financial asset is inactive. FSP 157-3 was effective upon
issuance, including prior periods for which financial statements had not been
issued. The implementation of FSP 157-3 did not have a material effect on the
Company’s consolidated financial position and results of
operations.
In March
2008, the FASB issued SFAS 161,
Disclosures about Derivative
Instruments and Hedging Activities - an Amendment of FASB Statement 133.
SFAS 161 enhances required disclosures regarding derivatives and hedging
activities, including enhanced disclosures regarding how: (
a
) an entity uses derivative
instruments; (
b
)
derivative instruments and related hedged items are accounted for under FASB
Statement No. 133,
Accounting
for Derivative Instruments and Hedging Activities;
and (
c
) derivative instruments and
related hedged items affect an entity’s financial position, financial
performance, and cash flows. Specifically, SFAS 161 requires:
|
|
|
|
●
|
Disclosure
of the objectives for using derivative instruments be disclosed in terms
of underlying risk and accounting designation;
|
|
●
|
Disclosure
of the fair values of derivative instruments and their gains and losses in
a tabular format;
|
|
●
|
Disclosure
of information about credit-risk-related contingent features;
and
|
|
●
|
Cross-reference
from the derivative footnote to other footnotes in which
derivative-related information is
disclosed.
|
SFAS 161
is effective for fiscal years and interim periods beginning after November 15,
2008. The Company has complied with the disclosure requirements of SFAS
161.
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. 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 has 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 have
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,
Accounting for Derivative
Instruments and Hedging Activities
(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 months ended
March 31, 2009 there was no material impact on the Company’s Condensed
consolidated statements of operations associated with any changes in the fair
value of such derivative liability.
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 consolidated financial position and results of
operations since no businesses were acquired after the effective date of this
pronouncement.
|
|
(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 March 31, 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
|
|
|
(474
|
)
|
|
0.50
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Outstanding
at March 31, 2009
|
|
|
12,391
|
|
$
|
0.78
|
|
|
5.96
|
|
$
|
2
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Vested
and expected to vest at March 31, 2009
|
|
|
12,295
|
|
$
|
0.78
|
|
|
5.95
|
|
$
|
2
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Exercisable
at March 31, 2009
|
|
|
6,331
|
|
$
|
0.98
|
|
|
4.72
|
|
$
|
2
|
|
Stock-based
compensation expense recognized in the condensed consolidated statement of
operations was $490,000 for the three months ended March 31, 2009 and included
$299,000 of compensation expense from restricted stock grants. Stock-based
compensation expense recognized in the condensed consolidated statement of
operations was $453,000 for the three months ended March 31, 2008 and included
$262,000 of compensation expense from restricted stock grants.
The
following table summarizes the activity of the Company’s non-vested stock
options for the three months ended March 31, 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
|
|
|
—
|
|
|
|
—
|
|
|
|
|
|
|
|
|
|
|
Non-vested
at March 31, 2009
|
|
|
6,060
|
|
|
$
|
0.30
|
|
As of
March 31, 2009, there was $1,444,000 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 2.02 years.
The
Company uses the Black-Scholes option-pricing model to determine the
weighted-average fair value of options. The fair value of options at date of
grant and the assumptions utilized to determine such values are indicated in the
following table:
|
|
|
|
|
|
|
|
|
Three
Months
Ended
March
31,
2009
|
|
|
Three
Months
Ended
March
31,
2008
|
|
|
|
|
|
|
|
|
Weighted
average fair value at date of grant for options granted during the
period
|
|
$
|
0.19
|
|
|
$
|
0.90
|
|
|
|
|
|
|
|
|
|
|
Expected
stock price volatility
|
|
|
98
|
%
|
|
|
104
|
%
|
Expected
life of options
|
|
3
years
|
|
|
3
years
|
|
Risk
free interest rates
|
|
|
1.02
|
%
|
|
|
4.04
|
%
|
Expected
dividend yield
|
|
|
0
|
%
|
|
|
0
|
%
|
The
following summarizes the activity of the Company’s non-vested restricted common
stock for the three months ended March 31, 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
|
|
|
(25
|
)
|
|
|
1.01
|
|
|
|
|
|
|
|
|
|
|
Non-vested
at March 31, 2009
|
|
|
4,909
|
|
|
$
|
0.49
|
|
During
the three months ended March 31, 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. As of March 31, 2009, the Company recognized $83,000
in compensation expense related to these grants and there was $1,097,000 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
March 31, 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 (as
described in Note 3), 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.
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 $330,000 and $748,000 for the three months ended March 31, 2009 and
2008, respectively. The intangible assets and goodwill, decreased by $ 1,028,000
for the three months ended March 31, 2009 for the effects of the foreign
currency translation adjustment. There were no other additions of intangible
assets and goodwill during the three months ended March 31, 2009.
Based on
the current amount of intangibles subject to amortization, the estimated future
amortization expense related to our intangible assets at March 31, 2009 is as
follows (in thousands):
|
|
|
|
|
For
the Year Ending March 31,
|
|
Future
Amortization
|
|
|
|
|
|
|
2010
|
|
$
|
1,103
|
|
2011
|
|
|
1,082
|
|
2012
|
|
|
1,082
|
|
2013
|
|
|
864
|
|
2014
|
|
|
558
|
|
Thereafter
|
|
|
2,000
|
|
Total
|
|
$
|
6,689
|
|
|
|
(7)
|
Short-Term
Borrowings
|
At March
31, 2009, short-term borrowings consisted of the following:
A line of
credit with a Finnish bank for $594,000 (€450,000 at March 31, 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 2.519% at March 31, 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 $-0-
at March 31, 2009.
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 March 31, 2009 was
$16,000.
At March
31, 2009, long-term debt consisted of the following:
Unsecured
notes payable to a Finnish funding agency of $2,331,000, including interest at
2.00%, due at dates ranging from July 2009 to December 2011; $189,000 to a
Finnish bank, including interest at the 3-month EURIBOR plus 1.1% (total of
2.74% at March 31, 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 $132,000, including interest at the 6 month EURIBOR
plus .5% (total of 2.28% at March 31, 2009), due March 2011.
Future
maturities of long-term debt are as follows as of March 31, 2009 (in
thousands):
|
|
|
|
|
For
the Year Ending March 31,
|
|
|
|
|
|
|
|
|
|
2010
|
|
$
|
1,044
|
|
2011
|
|
|
972
|
|
2012
|
|
|
636
|
|
|
|
|
|
|
Total
|
|
$
|
2,652
|
|
During
the three months ended March 31, 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.
|
|
(10)
|
Geographical
Reporting and Customer
Concentration
|
The
components of the Company’s revenue for the three months ended March 31, 2009
and 2008 are summarized as follows (in thousands):
|
|
|
|
|
|
|
|
|
2009
|
|
|
2008
|
|
License
software revenue
|
|
|
2,204
|
|
|
|
2,915
|
|
Engineering
services and support
|
|
|
667
|
|
|
|
580
|
|
Royalties
|
|
|
1,126
|
|
|
|
938
|
|
Other
|
|
|
19
|
|
|
|
19
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
|
4,016
|
|
|
|
4,452
|
|
For the
three months ended March 31, 2009 and 2008, foreign customers accounted for
approximately 51% and 46%, respectively, of the Company’s total revenue. These
customers are primarily located in Asia, Europe and the Middle
East.
Selected
information by geographic location for the three months ended March 31, 2009 and
2008 are summarized as follows (in thousands):
|
|
|
|
|
|
|
|
|
2009
|
|
|
2008
|
|
Revenue
from unaffiliated customers:
|
|
|
|
|
|
|
United
States Operations
|
|
$
|
2,524
|
|
|
$
|
2,905
|
|
Finland
Operations
|
|
|
1,492
|
|
|
|
1,547
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
4,016
|
|
|
$
|
4,452
|
|
Net
income (loss):
|
|
|
|
|
|
|
|
|
United
States Operations
|
|
$
|
(1,047
|
)
|
|
$
|
(949
|
)
|
Finland
Operations
|
|
|
(1,941
|
)
|
|
|
(3,790
|
)
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
(2,988
|
)
|
|
$
|
(4,739
|
)
|
|
|
|
|
|
|
|
|
|
March
31,
2009
|
|
|
December
31,
2008
|
|
Identifiable
assets:
|
|
|
|
|
|
|
United
States Operations
|
|
$
|
5,593
|
|
|
$
|
6,287
|
|
Finland
Operations
|
|
|
17,364
|
|
|
|
19,589
|
|
Total
|
|
$
|
22,957
|
|
|
$
|
25,876
|
|
For the
three months ended March 31, 2009, there was one customer that accounted for 10%
of the Company’s revenue. For the three months ended March 31, 2008, there was
one customer that accounted for 13% 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 March 31, 2009 that exceeds the FDIC insured amount in the amount of
$3.0 million. Additionally, the Company has a balance in an investment account
at March 31, 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 March 31, 2009.
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 March 31, 2009 and 2008, were not
included in the computation of diluted loss per share and consist of the
following as of March 31:
|
|
|
|
|
|
|
|
|
2009
|
|
|
2008
|
|
|
|
|
|
|
|
|
Warrants
to purchase common stock
|
|
|
—
|
|
|
|
1,601,000
|
|
Options
to purchase common stock
|
|
|
12,500
|
|
|
|
4,222,000
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
|
12,500
|
|
|
|
5,823,000
|
|
|
|
(12)
|
Related
Party Transactions
|
During
the three months ended March 31, 2008 the Company retained McGuireWoods LLP to
perform certain legal services on behalf of the Company and incurred costs of
approximately $21,000 for the three months ended March 31, 2008 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.
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 include a reduction in workforce that is expected to reduce
headcount by approximately 37 On2 Finland employees. The Company has 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 has 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
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 expected to be fully implemented during the period April
through July 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 $0.5 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
|
|
The
Company has recorded and classified the liability at March 31, 2009 of $ 868,173
for the restructuring as Accrued Restructuring Expense, and the charges for
Asset Impairment has resulted in a $175,153 reduction of the Company’s assets,
Capital Leases-Net, on the Company’s Condensed consolidated balance sheet at
March 31, 2009. The restructuring and impairment charges of $1,032,152 are
classified as Restructuring Expense on the Company’s Condensed consolidated
statements of operations for the three months ended March 31, 2009.
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 asserts 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 asserts 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 asserts that On2 failed to pay to Islandia certain
Series D dividends to which it was entitled. The complaint seeks 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. As of the date of this
filing, the case was in the discovery phase of litigation.
On2
believes this lawsuit is without merit and intends to vigorously defend itself
against Islandia’s complaint. As of March 31, 2009, the Company has not recorded
any provision associated with this complaint.
|
|
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 recently-announced 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;
|
|
|
|
|
●
|
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.
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.
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.
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:
|
|
|
|
|
●
|
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;
|
|
|
|
|
●
|
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.
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.
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.
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.
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:
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They
are cheaper to produce in high volumes;
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They
use less energy, which prolongs battery life of mobile
devices;
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They
produce less heat, which has important implications for, among other
things, circuit design;
and
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They
allow for simultaneous encoding and decoding of HD video
content.
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But
there are also disadvantages to hardware implementations of multimedia
tools:
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Initial
implementation costs are high; and
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Hardware
implementations are generally not upgradeable.
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Similarly,
software-upgradable DSPs offer certain advantages:
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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;
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DSPs
do not require costly re-designs and re-tooling to operate new software;
and
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They
are more easily upgradeable.
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But
they also have certain disadvantages:
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Per-chip
costs are higher than pure hardware solutions as volumes increase;
and
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The
increased processor power required to operate diverse software increases
heat and power consumption.
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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;
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Accounts
receivable allowance;
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Equity-based
compensation; and
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Impairment
of goodwill and other intangible
assets.
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Revenue Recognition.
We
currently recognize revenue from professional services and the sale of software
licenses. As described below, significant management judgments and estimates
must be made and used in determining the amount of revenue recognized in any
given accounting period. Material differences may result in the amount and
timing of our revenue for any given accounting period depending upon judgments
made by or estimates utilized by management.
We
recognize revenue in accordance with SOP 97-2,
Software Revenue Recognition
(“SOP 97-2”), as amended by SOP 98-4,
Deferral of the Effective Date of
Sop 97-2, Software Revenue Recognition
and SOP 98-9,
Modification of Sop 97-2 With
Respect To Certain Transactions
(“SOP 98-9”) 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.
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.
Results
of Operations
Revenue.
Revenue for the
three months ended March 31, 2009 was $4,016,000, as compared to $4,452,000 for
the three months ended March 31, 2008. Revenue for the three months ended March
31, 2009 and 2008 was derived primarily from the sale of software licenses,
engineering and consulting services and royalties. The decrease in revenue for
the three months ended March 31, 2009 as compared with the three months ended
March 31, 2008 is primarily attributed to a decrease of $711,000 in license
revenue, partially offset by increases in royalties of $188,000 and maintenance
and support of $87,000.
Operating Expenses.
The
Company’s operating expenses consist of costs of revenue, research and
development, sales and marketing, general and administrative expenses and equity
based compensation. Operating expenses for the three months ended March 31, 2009
were $7,238,000 as compared to $9,265,000 for the three months ended March 31,
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 March 31, 2009 was $573,000,
as compared to $1,430,000 for the three months ended March 31, 2008. The
decrease in expenses for the three months ended March 31, 2009 as compared with
the three months ended March 31, 2008 is primarily attributable to a decrease of
approximately $511,000 in the amortization of purchased technology and customer
relationships as a result of the asset impairments in 2008 associated with On2
Finland, a decrease in production and engineering costs of $266,000 due to fewer
hours allocated by our engineering staff, and 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 March 31, 2009 were $2,164,000 as compared to $2,808,000 for the
three months ended March 31, 2008. The decrease of $644,000 for the three months
ended March 31, 2009 as compared with the three months ended March 31, 2008 is
primarily a result of a Company-wide cost savings plan implemented during the
second half of 2008, a decrease in overhead and professional fees, 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 overhead costs, commissions, business development costs,
trade show costs, marketing and promotional costs incurred to create brand
awareness and public relations expenses. Sales and marketing expenses for the
three months ended March 31, 2009 were $976,000, as compared to $1,889,000 for
the three months ended March 31, 2008. The decrease of $913,000 for the three
months ended March 31, 2009 is primarily a result of 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, and a
reduction in the foreign currency exchange rate.
General and Administrative
.
General and administrative expenses, excluding equity-based compensation,
consist primarily of salaries and related overhead costs for general corporate
functions including finance, human resources, legal, information technology,
facilities, outside legal and professional fees and insurance. General and
administrative expenses for the three months ended March 31, 2009 were
$2,074,000, as compared with $2,768,000 for the three months ended March 31,
2008. The decrease of $694,000 for the three months ended March 31, 2009 is
primarily a result of a decrease in general and administrative costs as a result
of a company-wide cost savings plan implemented during the second half of 2008,
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 months ended March 31, 2009 were $1,032,000, as compared
with $-0- for the three months ended March 31, 2008. The increase is due to a
restructuring plan implemented during the first quarter of fiscal 2009 for the
On2 Finland subsidiary.
Equity-Based Compensation.
Equity based compensation, which is presented separately, was $490,000
for the three months ended March 31, 2009, as compared with $453,000 for the
three months ended March 31, 2008. The increase for the three months ended March
31, 2009 is primarily due to the amortization of awards issued throughout 2008
and in the first quarter of 2009. Equity-based compensation of $71,000 and
$83,000 is included in cost of revenue for the three months ended March 31, 2009
and March 31, 2008, respectively.
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 $(37,000) for the
three months ended March 31, 2009 as compared to $75,000 for the three months
ended March 31, 2008. The decrease of $112,000 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. The increase in income of $272,000 for the three months
ended March 31, 2009 is primarily the result of government grants received by
our Finland subsidiary.
Liquidity
and Capital Resources
At March
31, 2009, the Company had cash and cash equivalents and short-term investments
of $3,290,000, as compared to $4,289,000 at December 31, 2008. At March 31, 2009
the Company had negative working capital of $3,734,000 (without the initial
restructuring accrual, negative working capital would have been $2,866,000 at
March 31, 2009), as compared with negative working capital of $1,866,000 at
December 31, 2008.
Net cash
(used in) provided by operating activities was ($588,000) and $208,000 for the
three months ended March 31, 2009 and 2008, respectively. The decrease is
primarily related to a net loss of $2,988,000 and an increase in prepaid
expenses and other current assets of $276,000, partially offset by a decrease in
accounts receivable of $419,000, an increase in deferred revenue of $169,000, an
increase in depreciation and amortization of $481,000, an asset impairment from
restructuring of $175,000, an increase in accrued restructuring expenses of
$859,000 and an increase in equity-based compensation of $490,000.
Net cash
used in investing activities was $162,000 and $4,694,000 for the three months
ended March 31, 2009 and 2008, respectively. The decrease in net cash used in
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 $218,000 and $2,295,000 for the three months
ended March 31, 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, and Oulu and Espoo, Finland, and Hong Kong. The aggregate required
payments for the next 12 months under these arrangements are $971,000.
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 March
31, 2009, short-term borrowings consisted of the following:
A line of
credit with a Finnish bank for $594,000 (€450,000 based on exchange rates as of
March 31, 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 2.519% at
March 31, 2009). The bank also requires a commission payable at .45% of the loan
principal. Borrowings are collateralized by substantially all assets of Hantro
and a guarantee by On2. The outstanding balance on the line of credit was $-0-
at March 31, 2009.
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 outstanding balance on
the line of credit was $-0- at March 31, 2009.
At March
31, 2009, long-term debt consisted of the following:
Unsecured
notes payable to a Finnish funding agency of $2,331,000, including interest at
2.00%, due at dates ranging from July 2009 to December 2011; $189,000 to a
Finnish bank, including interest at the 3-month EURIBOR plus 1.1% (total of
2.74% at March 31, 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 $132,000, including interest at the 6 month EURIBOR
plus .5% (total of 2.28% at March 31, 2009), due March 2011.
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 37 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 will implement the plan primarily through a furlough
process that took effect in April 2009 and is expected to be fully implemented
over the course of the next four
months.
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.
Management
estimates that the 2009 savings related to the overall cost-cutting measures and
elimination of one time charges achieved during 2008 and the first quarter of
2009 will be approximately $11.9 million.
Additionally,
On2 Finland may borrow funds up to a maximum of €450,000 ($594,000 based on
exchange rates as of March 31, 2009) under a line of credit. As of March 31,
2009
the balance on
this line of credit was $-0-. On2 Finland had borrowings on this line of credit
during the quarter which were paid back by March 31, 2009. Given our cash and
short-term investments of $3,290,000 at March 31, 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.
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
October 2008, The FASB issued FSP 157-3
Determining Fair Value of a
Financial Asset in a Market That is Not Active
(FSP 157-3). FSP 157-3
classified the application of SFAS No. 157 in an inactive market. It
demonstrated how the fair value of a financial asset is determined when the
market for that financial asset is inactive. FSP 157-3 was effective upon
issuance, including prior periods for which financial statements had not been
issued. The implementation of FSP 157-3 did not have a material effect on the
Company’s consolidated financial position and results of
operations.
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.
On March
19, 2008, the FASB issued SFAS Statement No. 161,
Disclosures about Derivative
Instruments and Hedging Activities - an Amendment of FASB Statement 133.
SFAS 161 enhances required disclosures regarding derivatives and hedging
activities, including enhanced disclosures regarding how: (
a
) an entity uses derivative
instruments; (
b
)
derivative instruments and related hedged items are accounted for under FASB
Statement No. 133,
Accounting
for Derivative Instruments and Hedging Activities;
and (
c
) derivative instruments and
related hedged items affect an entity’s financial position, financial
performance, and cash flows. Specifically, SFAS 161 requires:
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Disclosure
of the objectives for using derivative instruments be disclosed in terms
of underlying risk and accounting designation;
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Disclosure
of the fair values of derivative instruments and their gains and losses in
a tabular format;
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Disclosure
of information about credit-risk-related contingent features;
and
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Cross-reference
from the derivative footnote to other footnotes in which
derivative-related information is
disclosed.
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SFAS 161
is effective for fiscal years and interim periods beginning after November 15,
2008. Early application is encouraged. The Company has complied with the
disclosure requirements of SFAS 161.
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 consolidated financial
position and results of operations since no businesses were acquired after the
effective date of this pronouncement.
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Item
3.
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Quantitative
and Qualitative Disclosures About
Risk
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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.
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Controls
and Procedures
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(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
March 31, 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 March 31, 2009 that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.
PART
II — OTHER INFORMATION
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Item
1.
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Legal
Proceedings
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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 asserts 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 asserts 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 asserts that On2 failed to pay to Islandia certain
Series D dividends to which it was entitled. The complaint seeks 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. As of the date of this
filing, the case was in the discovery phase of litigation.
On2
believes this lawsuit is without merit and intends to vigorously defend itself
against Islandia’s complaint. As of March 31, 2009, the Company has not recorded
any provision associated with this complaint.
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
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.
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On2
Technologies, Inc.
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(Registrant)
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/s/
MATTHEW FROST
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May
7, 2009
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(Date)
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(Signature)
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Matthew
Frost
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Interim
Chief Executive Officer
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On2
Technologies, Inc.
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(Registrant)
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/s/
WAYNE BOOMER
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May
7, 2009
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(Date)
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(Signature)
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Wayne
Boomer
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Senior
Vice President and Chief Financial Officer
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(Principal
Financial Officer)
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