On2 Technologies, Inc (ONT) - Description of business

Symbol:	ONT
Type:	AMEX
State location:	NY
State of Inc:	DE
Phone:	518-348-0099
Fax:	518-348-2098
Web Site:	www.on2.com
Full Time Employees:	114
Business Address:	21 Corporate Drive Suite 103 Clifton Park, NY 12065 United States
Mailing Address:	21 CORPORATE DRIVE SUITE 103 CLIFTON PARK NY 12065

On2 Technologies, Inc was founded in 1992. The company develops audio and video compression/decompression (codec), encoding, and server software used with video delivery platforms. Its products include TrueMotion line of codec with VP6 and VP7 series that deliver real-time encoding possibility and TrueCast Server software used for the delivery of multi-media presentations. On2's Flix is a product line of VP6 based video encoding and publishing software solutions for Adobe Flash Player. Flix software is used by many of the leading web video portals and user-generated content and social networking sites. The company also offers software engineering and consulting services as well as technical support to the digital communication and media companies as well as third party resellers.As of September 14, 2007 the company has began its expansion to the Asian market as it has signed contracts with firms in Japan and India.On September 21, 2007, the company announced expansion of management staff. It has appointed Erik Leonard as a new Senior Vice President of Business Development. Mr. Leonard has more than 15 years of sales management experience of selling large IP software and hardware solutions to market leading companies. He will focus on expanding On2's strategic global customer base, and developing new technology and OEM partnerships for On2's solutions with carriers and large video services operators.The company has recently released new Flix group software updates for the support of Adobe Flash Player 9 VP6-S video profile. This technology offers greater simplicity in the encoding and playback of high-resolution, full-screen video. It allows the streaming and playback of high definition video for ordinary PC‘s.While all this sounds very good the company is still not generating enough revenue to be profitable. For the last quarter ended June 30, 2007, the sales actually dropped by nearly 10% to $2.5 million. This has caused the net loss to increase by 266% as it was $-2.8 million for the period. Strangely the stockholder equity has increased by 554% to over $12 million and the tangible assets had a 927% increase to nearly $12 million. This is due to increased cash and decreased long term debt.As stated on August 23, 2007, the company has entered into a share exchange agreement with Nexit Ventures Oy. The agreement should have been closed in September however there is no statement concerning the closure.In our opinion if the current trends continue the stock price should mildly increase over time despite the company's losses which should also gradually turn into profits. Also in spite of rather large stockholder equity increase over the last quarter it will most probably go down over the next period and remain dropping until the company can reach profitability.Here's the description from company's SEC filing:OverviewOn2 Technologies is a leading video compression technology firm. We have developed a proprietary technology platform and the TrueMotion VPx family (e.g., VP5, VP6, VP7) of video compression/decompression ("codec") software to deliver high-quality video at the lowest possible data rates over proprietary networks and the Internet to set-top boxes, personal computers and wireless devices. Unlike many other video codecs that are based on standard compression specifications set by industry groups (e.g., MPEG-2 and H.264), our video compression software is based solely on intellectual property that we developed and own ourselves.We offer the following suite of products and services that incorporate our proprietary compression technology:Products o Video codecs; o Audio codecs; and o encoding and server software, for use with video delivery platformsServices o Customized engineering and consulting services; o Technical support; and o High-level video encodingMany of our customers are software developers who use our products and services chiefly to provide the following video-related products and services to end users:TYPE OF CUSTOMER APPLICATION EXAMPLESVideo and Audio Distribution over o Providing video-on-demand services Proprietary Networks to residents in multi-dwelling units (MDUs) o Video surveillanceConsumer Electronic Devices o Digital video players o Digital video recordersWireless Applications o Delivery of video via satellite o Providing video to web-enabled cell phones and PDAsVideo and Audio Distribution over o Video-on-demand IP-based Networks (Internet) o Teleconferencing services o Video instant messaging o Video for Voice-over-IP (VOIP) servicesIn addition, as discussed at greater length below, we have recently begun marketing encoding software for use either by end users or by developers who want to add video-encoding functionality to the software they have developed.As covered in greater detail below, we earn revenue chiefly through licensing our software and providing specialized software engineering and consulting services to customers. In addition to license fees, we often charge a royalty fee based on the number of units of some or all of the customer's products that contain the relevant On2 software products that are sold or distributed. Some of our agreements with customers also require that the customers pay us a percentage of the revenues that they earn from any of their products or services that use our software. Royalties may be subject to guaranteed minimum amounts and/or maximum amounts (e.g., annual caps).We have recently begun selling products and services that extend from our existing relationships with licensees. For instance, if a customer has licensed our software to develop its own proprietary video format and video players, we may sell encoding software to users who want to encode video for playback on our customers' players or we may provide engineering services to companies that want to modify our customer's software for use on a specific platform, such as a cell phone. As with royalties or revenue share arrangements, complementary sales of encoding software or engineering services should allow us to participate in the success of our customers' products. For instance, if a customer's video platform does well commercially, we would expect there to be a market for encoding software and/or engineering services in support of that platform.As part of our strategy to develop complementary products that could allow us to capitalize on our customers' success, in April 2005 we completed the acquisition from Wildform, Inc. of its Flix line of encoding software. The Flix software allows users to encode video and other multimedia content for playback on Adobe(R) Flash(R) player, which is a widely distributed multimedia player. The Flix brand has existed since the advent of Flash video and has a loyal following among its users. Because Adobe has integrated our VP6 codec software into its Flash 8 player, we believed that there was an opportunity for us to sell Flash 8 encoding software to end users, such as video professionals and web designers, and to software development companies that wish to add Flash 8 encoding functionality to their software. We concluded that by taking the well-regarded Flix software and updating it with Flash 8 encoding capability, we could best take advantage of the anticipated wide distribution of the Flash 8 player.In addition to licensing our software to software developers and end users for their own use, we sell licenses to certain third-party resellers. We also generally require that customers pay us if they desire to receive any upgrades to our software (e.g., from VP6 to VP7). We charge a fee for engineering and consulting services, based on an estimate of the time it will take our software engineers to provide the services, or an hourly fee for ongoing services such as product support.A primary factor that will be critical to our success is our ability to improve continually on our current video compression software, so that it streams the highest-quality video at the lowest transmission rates (bit rates). We believe that our video compression software is highly efficient, allowing customers to stream -good-quality video (as compared with that of our competitors) at low bit rates (i.e., over slow connections) and unsurpassed high resolution video at high bit rates (i.e., over broadband connections). As connection speeds increase, however, the advantage that our highly efficient software has over competing technology may decrease.Another factor that may affect our success is the relative complexity of our video compression software, as compared with other compression software producing comparable compression rates and image quality. Software with lower complexity can run on a computer chip that is less powerful, and therefore generally less expensive, than would be required to run software with greater complexity. Increased compression rates frequently result in increased complexity. While customers want software that produces the highest possible compression rates and the best possible decompressed image, they also want to keep production costs low by using the lowest-powered and accordingly least expensive chips that - still -perform the processing they require. In addition, in some embedded applications, such as mobile devices, size and power constraints, in addition to price issues, can limit the capability of the chips. Of course, in devices in which a great deal of processing power can be devoted to video compression and decompression, the issue of software complexity is less important. In addition, in certain applications, savings in chip costs related to the use of low complexity software may be offset by increased costs (or reduced revenue) stemming from less efficient compression (e.g., increased bandwidth costs).One of the most significant recent trends in our business is our increasing reliance on the success of the product deployments of our customers. As mentioned above, an increasing number of our license agreements with customers provide for the payment of fees that are dependent either on the number of units of a customer's product incorporating our software that are sold or on the amount of revenue generated by a customer from the sale of products or services that incorporate our software. We have chosen this licensing model because, as a company of only approximately 35 employees, we do not have the product development or marketing resources to develop and market end-to-end video solutions. Instead, our software is primarily intended to be used as a building block for companies that are developing end-to-end video products and/or services.As addressed above, under our agreements with certain customers, we have retained the right to market products that complement those customer applications. These arrangements allow us to take advantage of our customers' often superior ability to produce and market end-to-end video products and services, while offering those customers the benefit of including technologically-advanced software in their applications. As with arrangements in which we receive royalties or revenue shares, the ability to market complementary products can yield total revenues over time in excess of an initial, one-time license fee. In instances where we have licensed our products to well-known customers, our right to sell complementary products may be of significant value. But unlike royalties and revenue shares, which we generally expect to receive without any significant additional effort on our part, the successful sale of complementary products requires that we effectively execute an end-user product development and marketing program. Developing and marketing products aimed at end users is a relatively new business for us. Until recently, we had generally produced software targeted at developers, who integrate our software into their products.Although we believe that we have adopted the licensing model most appropriate for a business of our size and expertise, a natural result of this licensing model is that the revenue we generate is highly dependent on the success of our customers' product deployments. If the products of customers with whom we have established per unit royalty or revenue sharing relationships, or for which we expect to market complementary products, do not generate significant sales, the revenues we earn from that relationship are likely not to attain significant levels. Conversely, if one or more of such customers' products is widely adopted, our revenues will likely be enhanced.Another significant trend in our business is the emergence of Microsoft as a principal competitor in the market for digital media creation and distribution technology. Microsoft currently competes with us in the market for digital media servers, players, codecs and other technology and services related to digital distribution of media. Microsoft's commitment to and presence in the media delivery industry has increased. Microsoft distributes its competing streaming encoder, media server, player, tools and digital rights management ("DRM") products by bundling them with its Windows operating systems and servers at no additional cost or otherwise making them available free of charge or at a low cost. Microsoft's practices have caused, and may continue to cause, pricing pressure on our revenue generating products and services and may affect usage of our competing products and formats. Microsoft's anticompetitive practices have, in some cases, led , and could continue to lead, to longer sales cycles, decreased sales, loss of existing and potential customers and reduced market share. In addition, we believe that Microsoft has used and may continue to use its competitive position in the computer industry and its financial resources to secure preferential or exclusive distribution, use and bundling contracts for its media delivery technologies and products with third parties, such as ISPs, content delivery networks, content providers, entertainment and media companies, VARs and OEMs, including third parties with whom we have relationships. Finally, Microsoft's DRM product, which prevents unauthorized copying and re-distribution of proprietary content, is widely accepted among movie studios and others in the content industry. Unfortunately, Microsoft DRM does not integrate well with non-Microsoft video and audio software. Many companies that want to distribute copy-protected content are therefore forced to choose Microsoft video technology to be able to use Microsoft's DRM technology.Another trend is the emergence of H.264 as a competitor in the video compression field. H.264 is a standards-based codec that is the successor to MPEG-4. We believe our technology is superior to H.264, and that we can offer significantly more flexibility in licensing terms than customers get when licensing H.264. H.264 has nevertheless started to gain adoption by potential customers because, as a standards-based codec, it has the advantage of having numerous developers who are programming to the H.264 standard and developing products based on such standard. In addition, at least several manufacturers of multimedia processors have done the work necessary to have H.264 operate on their chips. These advantages may allow potential customers to implement a solution based on H.264 with less initial development time and expense than a solution using On2 Video might require, even though the H.264 solution could be less efficient and more expensive than On2 Video solution in the final analysis. In addition, there are certain customers that prefer to license standards-based codecs.We are also watching with interest and participating in the trend towards the proliferation of consumer-created video content on the web. As Internet use has grown worldwide and Internet connection speeds have increased, there has been a marked increase in consumer-created content on the web. While that content initially consisted primarily of text content and still photographs, the availability of relatively inexpensive digital video cameras, the growth in the number of users with access to broadband Internet connections, and improvements in video compression technology have contributed to a groundswell in consumer-created video content. Weblogs (blogs) and podcasts (broadcasts of audio content to iPod(R) and MP3 devices) are evolving to include video content. A number of services has sprung up to host consumer-created video, and many commercial sites now also feature amateur videos. The continued proliferation of consumer-created video on the Internet may have a positive effect on our business. The Adobe(R) Flash(R) video is a popular format for Web video. Because Flash 8 uses On2's VP6 codec, On2 may have the opportunity to license Flash encoding tools for use in video blogs, video podcasts, and to consumer-created video services or to individual users of those services.The market for digital media creation and delivery technology is constantly changing and has become intensely and increasingly competitive. We have and continue to take a number of steps to address this competition. First and foremost, we focus on providing our customers with video compression/decompression technology that delivers the highest possible video quality at the lowest possible data rates. In order to do this, we devote a significant portion of our engineering capacity to research and development. Although we expect that competition from Microsoft, H.264 developers, and others will - intensify, we also expect that our video compression technology will remain competitive and that our relatively small size will allow us to innovate in the video compression field and respond to emerging trends more quickly than monolithic organizations such as Microsoft and the MPEG consortium. We also address the competitive threats that we face by focusing on developing relationships with customers who do not want to do business with Microsoft and/or do not find the complex and rigid standards-based licenses and fee structures appealing.Development of Our BusinessWe detail the history and evolution of our business under the section "Management's Discussion and Analysis of Financial Condition and of Operation -- Company - History".Business StrategyOur goal is to be one of the premier providers of video compression/decompression software technology and compression tools. We are striving to achieve that goal and the goal of building a stable base of quarterly revenues by implementing the following key strategies:o Continuing our research and development efforts to increase the quality of video technology in order to improve the experience of end users; o Using the success of current customer implementations of our technology (e.g., Adobe Flash 8, Skype) to increase our brand recognition and promote new business; o Leveraging our existing products and services to support new products and services and to expand our presence in multiple industries, including the Internet, wireless applications and consumer electronics; o Employing flexible licensing strategies to offer customers more attractive business terms than those available for competing technologies; and o Entering into licensing arrangements with customers that provide for receipt of recurring revenue or that offer us the opportunity to market products that complement our customers implementations of our software; o Expanding into international markets by contracting with resellers of our products and services and by developing relationships with large, innovative customers.Our Technology, Products and ServicesWe have designed our technology to deliver the highest-quality video at the lowest possible data rates and to encode (compress) and decode (decompress) video on comparatively low-powered chips suitable for consumer electronics products. We currently license and develop a number of products related to our TrueMotion line of codecs and TrueCast line of server and player products for proprietary networks, the Internet and consumer electronic industries. The licensing of our proprietary TrueMotion codec and TrueCast server technology has accounted for 29%, 16%, and 6% percent of our revenue for the three fiscals years ended December 31, 2005, 2004 and 2003, respectively.TrueMotion(R) 2X (TM2X)Originally developed as our state-of-the-art video compression codec in 1998, the TM2X codec is optimized for hard-drive, Kiosk, or CD-ROM based video playback. The TM2X video delivery algorithm was licensed for use in Sega's Dreamcast and Saturn and has also been licensed to gaming developers and manufacturers interested in high quality video on machines with limited processing capabilities.At the time it was introduced, TM2X offered comparatively high resolutions (320x240, 640x480) and high bit-rates that could play back smoothly on a wide range of CPUs available at the time. The product was part of QuickTime and Video for Windows and can be used in programs such as Adobe Premiere and Terran's Media Cleaner Pro. It is also a cross-platform codec: QuickTime works on both Macintosh computers and personal computers.TrueMotion VP3 SeriesOur TrueMotion VP3 series of codecs includes VP3, VP3.1 and VP3.2. VP3 was introduced in January 2000 and was the original codec used on our website, at data rates between 300 and 400 kbps. VP3.1 was launched in June 2000 and provided for full-motion, full-screen television quality video over the Internet at data rates as low as 250 kbps, scaling dynamically to 500 kbps and more. Introduced in August 2000, VP3.2 was designed to offer high-quality video transmission over broadband Internet connections and supply television-quality video at data rates as low as 200 kbps. VP3 files are encoded in multiple bit rates and at optimum frame rates (usually 29.97 fps) within a single file.Open Source VP3.2VP3.2 was made available to the open-source community on September 7, 2001, so as to provide software developers an efficient, open source video codec with no platform limitations or restrictive license fees. VP3 became the first true common format that is open, documented and free. We created VP3-based plug-ins for other media formats, such as Apple's QuickTime. With these plug-ins, users can encode content using VP3 plug-in technology engineered to play that content back through these other popular player-formats.In June 2002, the Company entered into an agreement with the Xiph.Org Foundation, developers of Vorbis, the popular open-source audio codec, for Xiph to be the prime source of support, distribution, and further development of VP3. In addition, with On2's support, Xiph integrated VP3 into its Ogg Multimedia Framework, providing a full-featured, open-source, royalty-free alternative to expensive solutions such as MPEG-4.VP4 CodecReleased in the second quarter of 2001, VP4 was initially optimized for set-top boxes and closed area environments. At the time it was introduced, VP4 was widely recognized as among the most efficient video compression technologies available. VP4 achieves near-DVD quality at 450 kbps and near-VHS quality at 150 kbps at full-screen and full-motion. VP4 offered a 20% bandwidth reduction over then-current competitive technologies, allowing for greatly reduced costs for comparable quality video.VP5 CodecWe made VP5 available for license in the second quarter of 2002. VP5 offered a 50% reduction over the bandwidth required to show comparable quality video using VP4. Additional features offered by VP5 include real-time encoding and the ability to handle interlaced content, making it the first codec on the market to offer true broadcast-quality, real-time compression of difficult live material, such as sports and action footage, at sub-megabit data rates. The ability to handle interlaced content set VP5 apart from the crowd of competitive video codecs available at that time.VP6 CodecWe launched the Beta version of our TrueMotion VP6 series of codecs in May 2003 and the official version in October 2003, and we have since released updated versions VP6.1 and VP6.2. As with prior versions of our codec, VP6 represented a significant improvement over its predecessors, offering a 40% image quality improvement over and 50% faster playback than VP5. VP6 improves upon all the features contained in VP5 and supports real-time encoding at full D1 resolution. It also consistently outperforms Windows Media 9 based on tests of Peak Signal-to-Noise Ratios (PSNR) measured at data rates ranging from dial-up (28.8 Kbps) to DVD and HD (6 to 8 Mbps). Since our introduction of VP6, we have ported it to the following digital signal processors (DSPs) across a range of resolutions: Texas Instruments' TMS320C64x, Analog Devices' Blackfin, ARC International's ARCTangent, Equator Technologies' MAP-CA and the ARM 7 and ARM 9. Despite the introduction of VP7, we have continued to license VP6 extensively for use with a wide variety of applications on numerous platforms.VP7 CodecWe introduced our TrueMotion VP7 codec in early March 2005. Like prior versions of the TrueMotion codecs, VP7 shows a marked improvement over its predecessors, producing up to a 30% image quality improvement over VP6. Like its predecessor, in objective PSNR tests, VP7 shows better performance than its main competitors, including Windows Media 9, Real 10, and MPEG-4-compatible codecs at data rates ranging from dial-up (28.8 Kbps) to DVD and HD. In addition, VP7 regularly outperforms all but the best implementations of H.264 across data-rates and is highly competitive with the most advanced H.264 implementations. As with VP6, VP7 also supports real-time encoding at full D1 resolution. VP7 has been developed to run on low-cost DSPs, and On2's engineers and certain third parties are currently working to port VP7 to a number of DSPs.Audio for Video Codec Technology (AVC)AVC is an advanced compression algorithm that is ideal for a variety of audio sources, including music, human speech, film and broadcast television. AVC can achieve very high quality audio at bit rates lower than current standards such as MP3 or AC-3. This algorithm is designed for easy portability to embedded devices and can be licensed for a lower per-unit cost than other audio codecs on the market. AVC runs with On2's video codecs, and this combination can provide a seamless low-bit-rate multimedia experience. VP6 or VP7 combined with AVC is comparable to MPEG-4 combined with AC-3, but with a substantial data rate savings. It is particularly useful for implementations such as VOD deployment over DSL or cable networks. AVC also allows for less transfer time and storage space for downloaded files.TrueMotion Encoder ProductsOur Encoder enables content owners to re-master and compress their assets efficiently into the VP4, VP5, VP6, or VP7 format at their own convenience. Beginning with capturing uncompressed video through high quality SDI inputs, users can create an optimized digital file using our proprietary re-mastering tools. These tools are geared toward the video professional who wants exact control over the optimization process. Once the raw file has been optimized, our compression software has the capability to create multiple data rate compressed files.TrueMobile Mobile Video ProductsIn October 2005, On2 announced its arrangement with China Transport Telecommunications Broadband Network Service Co., Ltd. (CTTnet) under which On2 and CTTnet would jointly develop mobile video products based on On2's TrueMotion video compression technology. Prior to entering into its agreement with CTTnet, On2's research and development team had developed proof-of-concept video players operating in the Symbian and Smartphone Mobile environments. Those players formed the foundation of the first commercial TrueMobile products, and in January 2006, On2 and CTTnet announced that they had TrueMobile players operating on four Symbian handset models, 10 Smartphone handset models, and several Windows CE PDA models.TrueCast(R) Server SoftwareTrueCast Server Software is designed to take full advantage of our industry-leading VP line of codecs and to guarantee the smoothest delivery of compelling multi-media presentations over private networks (e.g., set-top boxes), embedded platforms or the Internet.TrueCast comes optimized in two manners: one for transport using our own proprietary protocol, TrueCast Transport Protocol (TTP), and one for RTSP/RTP to various set-top box platforms. TrueCast and VP5/VP6/VP7 are an ideal combination for low-bit-rate Video-On-Demand systems. Our TrueCast Servers and our encoder provide the necessary tools for high-quality video over low speed IP connections.In the first quarter of 2005, we released TrueCast version 8.0. This version of TrueCast provides support for multicast presentations, and can simultaneously stream a single audio and video stream from a server, including HTTP-based Web servers, to thousands of users. It also permits local playback of AVI files from a user's hard disk, and set-top box/DSP platforms from Texas Instruments, Equator Technologies, and others.In the third quarter of 2003, we announced that we have added Microsoft Windows CE to the family of operating systems supported by our TrueCast set-top box solution.In addition, TrueCast 8.0 is able to stream content that is captured and encoded directly from "live" video sources using the company's revolutionary VP6, VP7 and earlier-generation On2 real-time encoders. This feature is ideal for time-critical applications such as streaming live events, video conferencing, Digital Television over DSL, and personal video recorders.Digital Signal Processor (DSP) and Server IntegrationsVP4, VP5, VP6, and VP7 have been ported onto a variety of digital signal processing chips (DSPs). DSPs are the computer processing chips frequently used in consumer products such as DVDs, cell phones, and personal digital assistants. The VP6 decoder currently runs on a wide range of DSPs at various resolutions, and the VP6 encoder operates on several DSPs as well. We and several third parties are also working to port the VP7 decoder and encoder to a number of DSPs. We believe that by porting to these platforms, we will facilitate the use of On2's codec in set-top-box and other consumer device deployments where the availability of low-cost chips is important.Encoding Tools for Customer FormatsIn 2005, we entered the business of selling video encoding software that allows users to encode video in formats used by two of our customers, Macromedia (now Adobe) and AOL. Both Adobe's Flash 8 multimedia player and AOL's Nullsoft video (NSV) player use On2's TrueMotion VP6 technology. Although we continue to offer Nullsoft encoding tools, that business constitutes a small fraction of our third-party encoding tool business. In 2005, the licensing of Flash and Nullsoft encoding tools together accounted for 59 percent of our revenue.We launched our encoding software business as part of strategy of capitalizing on our customers' successful deployments of products that incorporate our technology. In particular, we believed that the inclusion of our technology in the widely-distributed Adobe Flash player represented a significant opportunity for us. We acquired the Flix line of Flash encoding software from Wildform, Inc., discussed in greater detail in "Description of Business - Overview", to further our plan for rapidly establishing a significant business of marketing Flash encoding tools.We sell two types of Flash encoding tools. We distribute end-user software such as our desktop Flix encoding tools (Flix Pro and Flix Standard) and our Flix Engine software, which can operate in desktop or server environments. These products allow users to convert and/or encode video in Flash 6, 7, and 8 formats. We also sell Flash encoder software development kits that allow customers to enable their products to encode in the Flash format. These products range from low-level tools such as our Flash 8 SDK to relatively high-level, more fully-featured tools such our Flix Engine. The Flix Engine can be integrated with our customers' applications, as well as being used as an off-the-shelf end user software product.Our marketing efforts for our Flash encoding tools are generally directed at three groups of customers. First, we offer our desktop Flix encoding tools (Flix Pro and Flix Standard) for purchase online by end users, both professional and non-professional. Second, we market our desktop and server products directly to enterprise customers, such as content providers and Internet advertising firms. Finally, we promote our Flash SDKs to software developers. Some such developers will use our SDKs to integrate our Flash encoder with their software products for sale to end users. Other developers will incorporate our Flash encoder products that they will use in their own services (e.g., an online video search service might develop a Flash encoding tool for use internally or by their customers).We believe that the prospects of our Flash encoding business are closely related to the success of Adobe's Flash player and Flash authoring business. While the increasing worldwide adoption of Flash players will not ensure the success of our Flash encoder business, the failure of Adobe's Flash 8 initiative would almost certainly have a serious, negative impact on our sales of Flash encoding software.ServicesIn addition to licensing our software, we offer a variety of custom engineering and consulting services to our customers. Fees derived from engineering and consulting services accounted for 7%, 14%, and 19% percent of our revenue for the years ended December 31, 2005, 2004 and 2003, respectively. In particular, we offer the following services:Custom Engineering and Consulting ServicesWe provide custom engineering and consulting services designed to support customers or assist prospective customers in evaluating our software. Our engineering and consulting services generally consist of:o customizing our software to add a feature, user interface or other function requested by a customer; o porting and optimizing our technology platform and algorithm libraries onto DSPs and embedded devices, such as set-top boxes, mobile phones and other portable devices; o evaluating potential customer implementations of our software; and o providing technical support for existing customers.EncodingWe provide encoding services for customers, although this business has significantly contracted as a component of our total revenue. These services consist of the conversion of archival video and audio content into formats for delivery to end-users.Research and DevelopmentThe primary focus of our research and development activities is to advance and expand upon our core codec technology, which improves the video experience for end users. In addition, we devote significant research and development time to exploring new uses of our codecs, such as implementing our software on mobile platforms or in new operating environments. Our research and development efforts have enabled us to provide quality video compression and decompression at lower broadband data rates (e.g., DSL) and certain narrowband data rates (e.g., dial-up and cell phone). Our speculative research in new platforms or operating environments also regularly results in commercial products that may become a significant source of revenue. We believe that continued advances in our technology are key to the success of our business. Consequently, we devote a substantial portion of our resources to our research and development efforts. Research and development expenses for the years ended December 31, 2005, 2004, and 2003 were $1,035,000, $884,000 and $1,124,000 respectively.Distribution MethodsOur business consists of developing and marketing our software-based technology products and related services. Because we generally sell our software to companies that will integrate the software with their products or distribute the software themselves in connection with their services, and until recently have not regularly attempted to sell products directly to end users, we do not distribute a high volume of individual copies of software. Our customers usually download copies of software that they have purchased by online file transfer, although we will send them a CD-ROM containing the software if they request. Other than temporary interruptions to Internet service, we therefore do not generally suffer from delays in our distribution network. We usually provide our engineering and consulting services and product support from our own facilities.Sales and Business DevelopmentOur sales and business development departments aim to build relationships that fall into two basic categories: product licensing and professional services. These departments focus on engaging chip-set manufacturers, global cable and telecommunication companies, manufacturers of hardware platforms for consumer electronic and wireless devices, and manufacturers of video-enabled products targeted at commercial and government users. We seek to license our compression software to manufacturers of video or video-enabled equipment and providers of video services, and we seek to encourage developers of chip-sets and software platforms to integrate our codecs within their products. Additionally, our teams focus on selling licenses for our encoding and streaming software to content providers who are delivering video over proprietary networks and to IP-based end users. Our professional services are usually incident to our product licensing and primarily focus on porting or optimizing our compression technologies to multiple hardware platforms used in video delivery solutions by manufacturers who have licensed our compression technology.InternationalWe believe that we are well positioned to selectively expand our business internationally. We have focused in particular on identifying and capitalizing on opportunities in Asia and Europe.For the years ended December 31, 2005, 2004 and 2003, foreign customers accounted for approximately 27%, 20% and 67% respectively, of total revenue. These customers are primarily located in Asia. The decrease the percentage of foreign customers from 2003 to 2004 and 2005 is a result of decrease in sales from our Japan reseller and the completion of a large engineering project with a leading Japanese electronics manufacturer in 2003.AsiaWe believe that Asia, with its numerous broadband networks, is one of the strongest markets for video-on-demand initiatives. Our international sales and business development efforts have been primarily focused in this region to date. Our predecessor corporation, The Duck Corporation, has significant name recognition in Asia, especially among video game developers. Our TM2X (TrueMotion 2X) software was widely-distributed because of its inclusion in several popular video games, such as Final Fantasy 7 for PC. We are currently involved with several Asian entities that are considering using our video compression and server software in set-top box deployments. We also aim to expand internationally by appointing resellers of our products and services who purchase software licenses from us and sell them in a designated international market. To date, we have signed reseller agreements for a number of Asian markets, including China, Japan, Korea, Hong Kong, Taiwan, and Singapore.Beijing E-WorldIn June 2003, we announced that we had licensed our VP5 and VP6 codecs to Beijing E-World Technology Co. Ltd. (E-World), a consortium of several Chinese consumer electronics manufacturers. Under the terms of two license agreements with E-world, we granted E-World a license to use our codecs in E-World's Enhanced Versatile Disk (EVD) technology as well as other video products. E-world is developing EVD as a next-generation videodisk technology that is hoped will become the industrial standard for China for the recording and playback of video, audio and data. E-World did not pay certain minimum quarterly payments that we believed were due under its license agreements with us, and we commenced an arbitration proceeding seeking damages for E-World's failure to perform. In a ruling issued March 10, 2005, the arbitrator rejected our claims that E-World had breached the agreements and also denied a request by E-World to declare that it had complied with its obligations under the agreements. The arbitrator further noted that agreements remained in effect and that the parties had a continuing obligation to work to jointly select and port On2's software to two commercial DSPs for use in the EVD players. Despite the arbitrator's expectations regarding completion of the porting work, On2 and E-world have not made significant progress on the porting.CTTNetIn January 2006, On2 and China Transport Telecommunications Broadband Network Service Co., Ltd. (CTTnet) entered into an agreement to jointly develop and distribute On2 TrueMobile mobile video software in China and the Asian markets. Under the terms of the Agreement, On2 granted CTTNet a license to On2's VP6 and VP7 software as well as certain reseller rights for China and other Asian markets. On2 and CTTNet have jointly announced that they have made significant progress in the development and deployment throughout China of mobile video software for the Symbian and SmartPhone mobile platforms.EuropeWe continue to pursue sales and business development opportunities in the European market, although we have not yet had the success there that we have had in Asia. We have had success with our U.K.-based partners TVZ Ltd. and QuickLink Ltd. in powering news gathering and dissemination applications for major news organizations such as the BBC, but we have not yet established the breadth or depth of relationships with European customers and resellers that we have with Asian customers. We need to continue to focus on increasing the visibility of our compression products in Europe.Location of Assets and OperationsAll of the Company's assets and operations have been and are currently based within the United States, except for two research and development employees located in the United Kingdom. We did not generate any revenue from our United Kingdom operations for the years ended December 31, 2005, 2004 and 2003.CompetitionWe believe that our principal competitive advantage is our ability to deliver video that is comparable or superior in quality to other compression technologies at significantly lower data rates. In the streaming video market, this attribute significantly reduces the amount of bandwidth necessary to deliver video of similar quality and allows our customers to realize a greater profit on their video delivery initiatives by either:o lowering the amount of bandwidth that customers need to deliver video, o allowing customers to deliver video to more users without increasing bandwidth, or o permitting customers to deliver good-quality video at lower data rates than those at which other video codecs can operate effectively.Increased compression offers similar advantages in storage of video files, enabling customers to:o store video at a set resolution using less storage capacity than required by competitive compression software; o store more video at a set resolution in a given storage space than competitive compression software; o store more video of a higher quality in a given storage space than competitive compression software.Our business is highly competitive and affected by rapid change. We believe that the principal competitive factors in our business include technological innovation, versatility of products, pricing, availability of content, ease of integration with and availability of use on low-cost processors, customer service, service offerings and the flexibility to adapt to changing market conditions. Our video compression technology competes with that of companies such as Microsoft, RealNetworks, and Apple, and with standards-based codecs such as MPEG-2, H.264, MPEG-4 and several codecs that position themselves as "MPEG-4-based". In the market for mobile video players, our newly-developed On2 TrueMobile products compete with products from companies such as MobiTV, Inc., GoTV, PacketVideo and SmartVideo. Our server technology faces competition from products marketed by RealNetworks, Microsoft and other companies and various open source server technology.The size of our company and the fact that we have developed a proprietary, non-standards-based video codec both help and hinder our ability to compete. Companies such as Microsoft and RealNetworks benefit from name recognition that we do not enjoy. Microsoft is also able to use its market power to support aggressive pricing on its products that compete with ours. There are three major standards-based codecs, MPEG-2, H.264, and the less widely-adopted MPEG-4; in addition, Microsoft is proceeding towards establishing a standard, dubbed VC1, based on its Window Media 9 technology. With respect to standards-based codecs, there are numerous developers programming to those standards, and there are certain customers that prefer to license standards-based codecs. In addition, because of significant adoption of standards-based codecs and Windows Media 9, there is a number of chip manufacturers that have designed low-cost chips designed to operate with those codecs. The availability of a range of chips means that potential customers of standards-based codecs or Windows Media 9 may not have to incur added cost or experience delays if they choose to use those codecs in their products.Nevertheless, we believe that our small size and proprietary products frequently are attractive to customers, especially overseas, that will seek to license our products not only because of their superior performance, but also because:o our products do not come from Microsoft or a consortium of conglomerates (such as those that own the core intellectual property used in the proprietary codecs), and we offer highly responsive, customized service befitting a company of our size and culture; o we offer flexible licensing terms that do not involve burdensome standards-based licenses and fee structures; and o we are able to upgrade our technology regularly, because we do not have to submit proposed revisions to slow-acting standards committees.See the section "Management's Discussion and Analysis -- Overview" for further discussion of our competitors.CustomersOur customers, and the potential customers of our resellers, fall into several categories. The customers for our TrueMotion video compression technology and Flash encoding software development kits typically are either software or hardware developers who want to enable their products to store or transmit digital video, or providers of online services that want to add video capabilities to their services. The customers for our engineering services are generally customers of our video compression technology who need assistance customizing our software to work on a certain platform or need us to modify our software to work with their software. In addition, we have begun to provide a growing range of engineering services to customers who have requested customization of our Flash encoding software. Finally, the customers who purchase our Flix Flash encoding tools are individual or small-business users who buy single or multiple units of software or large content providers and Internet advertising firms who may buy enterprise licenses. For the year ended December 31, 2005, two customers accounted for 20%and 11% of the Company's total revenues. For the year ended December 31, 2004, one customer accounted for 47% of the Company's total revenue. For the year ended December 31, 2003, three customers accounted for 35%, 19% and 11% of the Company's total revenue. For the year ended December 31, 2005, four customers accounted for 20%, 18%, 11% and 11% of total accounts receivable. For the year ended December 31, 2004, two customers accounted for 21% and 13% of total accounts receivable.Intellectual PropertyWe regard much of our technology as proprietary and try to protect it by relying on trademarks, copyrights, patents, trade secret laws and confidentiality agreements. We view our copyrights, service marks, trademarks, trade secrets, proprietary technology and similar intellectual property as critical to our success. We currently hold several U.S. patents and have several U.S. and international patent applications pending. We believe that the patents that are currently issued are not material to our business. While we try to ensure that the quality of the On2 brand is maintained through such measures, there can be no assurance that steps we have taken and continue to take to protect our proprietary rights will be adequate or that third parties will not infringe on our intellectual property. In addition, there can be no assurance that third parties will not assert infringement claims against us which, even if not meritorious, could result in the expenditure of substantial resources and management effort.In connection with our software license agreements with third parties, we seek to control access to and distribution of our technology, documentation and other proprietary information. Even with all of these precautions, someone else could conceivably copy or otherwise obtain and use our proprietary information without our authorization, or could develop similar technology independently. Effective trademark, copyright and trade secret protection may not be available in every country in which our services are made available through the Internet, and policing unauthorized use of our proprietary information is difficult and expensive. In addition, some of our technology is protected as trade secrets for which government registration is not available. Our only means of protecting our trade secrets is to restrict scrupulously the disclosure of that information.We cannot be sure that the steps we have taken will prevent misappropriation of our proprietary information. Any misappropriation could have a material adverse effect on our business. In the future, we may need to go to court to enforce our intellectual property rights, protect our trade secrets, or to determine the validity and scope of the proprietary rights of others. That litigation might result in substantial costs and diversion of resources and management attention.From time to time, we license from third parties technologies incorporated into some of our products and services. Historically, we have not required any material third party technology licenses. As we have entered into the Flash encoding business, however, we have found it necessary to license third-party software to allow us to decode and encode video and audio files in a variety of formats. We cannot be sure that these third-party technology licenses will continue to be available on commercially reasonable terms, if at all.Government RegulationWe are not currently subject to direct regulation by any governmental agency other than rules and regulations that apply to businesses and publicly-traded companies generally, except that certain U.S. export controls and import controls of other countries, including controls on the use of encryption technologies, which may apply to our products. Laws and regulations specifically pertaining to the Internet are new and developing. These laws or regulations govern matters such as intellectual property, user privacy, e-commerce, information security and taxation. In addition, the applicability of existing laws to the Internet is uncertain and evolving. As a result of this uncertainty, it is difficult to predict the impact, if any, that future regulation or changes in regulation may have on our operations.EmployeesAs of December 31, 2005, we had 35 full-time employees. Of the total employees, 26 were engineering and product development personnel, 2 were sales and marketing personnel and 7 were general and administrative personnel.None of our employees is represented by a labor union, and we consider our relationship with our employees to be good. We supplement our work force from time to time with contractors, administrative personnel through employment agencies, and part time employees.