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 September 30, 2008.
¨
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
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 Sections12, 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 November 7, 2008, were 171,924,000
Table
of Contents
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Page
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PART
I — FINANCIAL INFORMATION
|
|
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Item
1. Consolidated Financial Statements.
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Condensed
Consolidated Balance Sheets at September 30, 2008 (unaudited) and
December
31, 2007
|
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2
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|
Unaudited
Condensed Consolidated Statements of Operations Three and Nine Months
Ended September 30, 2008 and 2007
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|
|
3
|
|
Unaudited
Condensed Consolidated Statements of Comprehensive Income (Loss)
Three and
Nine Months Ended September 30, 2008 and 2007
|
|
|
4
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|
Unaudited
Condensed Consolidated Statements of Cash Flows Nine Months Ended
September 30, 2008 and 2007
|
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5
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|
Notes
to Unaudited Condensed Consolidated Financial Statements
|
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7
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Item
2. Management’s Discussion and Analysis of Financial Condition and Results
of Operations
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17
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Item
3. Quantitative and Qualitative Disclosures About Market
Risk
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33
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Item
4. Controls and Procedures
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34
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PART
II — OTHER INFORMATION
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Item
1. Legal Proceedings
|
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|
37
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Item
1A. Risk Factors
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38
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Item
4. Submission of Matters to a Vote of Security Holders
|
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39
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Item
6. Exhibits
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40
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Signatures
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41
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Certifications
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|
PART
I — FINANCIAL INFORMATION
Item
1.
Consolidated
Financial Statements
ON2
TECHNOLOGIES, INC.
CONDENSED
CONSOLIDATED BALANCE SHEETS
|
|
September 30,
2008
|
|
December 31,
2007
|
|
|
|
(unaudited)
|
|
|
|
ASSETS
|
Current
assets:
|
|
|
|
|
|
|
|
Cash
and cash equivalents
|
|
$
|
4,491,000
|
|
$
|
9,573,000
|
|
Short-term
investments
|
|
|
132,000
|
|
|
5,521,000
|
|
Accounts
receivable, net of allowance for doubtful accounts of $535,000 at
September 30, 2008 and $519,000 at December 31, 2007
|
|
|
3,997,000
|
|
|
7,513,000
|
|
Prepaid
and other current assets
|
|
|
1,757,000
|
|
|
1,492,000
|
|
Total
current assets
|
|
|
10,377,000
|
|
|
24,099,000
|
|
Property
and equipment, net
|
|
|
1,509,000
|
|
|
751,000
|
|
Acquired
software, net
|
|
|
2,459,000
|
|
|
10,333,000
|
|
Other
acquired intangibles, net
|
|
|
6,445,000
|
|
|
7,144,000
|
|
Goodwill
|
|
|
15,987,000
|
|
|
37,023,000
|
|
Other
assets
|
|
|
430,000
|
|
|
175,000
|
|
Total
assets
|
|
$
|
37,207,000
|
|
$
|
79,525,000
|
|
LIABILITIES
AND STOCKHOLDERS’ EQUITY
|
Current
liabilities:
|
|
|
|
|
|
|
|
Accounts
payable
|
|
$
|
309,000
|
|
$
|
1,433,000
|
|
Accrued
expenses
|
|
|
4,813,000
|
|
|
4,820,000
|
|
Deferred
revenue
|
|
|
3,324,000
|
|
|
1,887,000
|
|
Short-term
borrowings
|
|
|
109,000
|
|
|
2,198,000
|
|
Current
portion of long-term debt
|
|
|
481,000
|
|
|
491,000
|
|
Capital
lease obligation
|
|
|
262,000
|
|
|
24,000
|
|
Total
current liabilities
|
|
|
9,298,000
|
|
|
10,853,000
|
|
Long-term
debt
|
|
|
2,542,000
|
|
|
3,082,000
|
|
Capital
lease obligation, excluding current portion
|
|
|
485,000
|
|
|
18,000
|
|
Total
liabilities
|
|
|
12,325,000
|
|
|
13,953,000
|
|
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; 171,924,000
and
170,475,000 shares issued and issuable, and outstanding at September
30,
2008 and December 31, 2007, respectively
|
|
|
1,719,000
|
|
|
1,705,000
|
|
Additional
paid-in capital
|
|
|
195,851,000
|
|
|
194,453,000
|
|
Accumulated
other comprehensive income (loss)
|
|
|
(167,000
|
)
|
|
906,000
|
|
Accumulated
deficit
|
|
|
(172,521,000
|
)
|
|
(131,492,000
|
)
|
Total
stockholders’ equity
|
|
|
24,882,000
|
|
|
65,572,000
|
|
Total
liabilities and stockholders’ equity
|
|
$
|
37,207,000
|
|
$
|
79,525,000
|
|
See
accompanying notes to unaudited condensed consolidated financial statements
ON2
TECHNOLOGIES, INC.
UNAUDITED
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
|
|
Three Months Ended
September 30,
|
|
Nine Months Ended
September 30,
|
|
|
|
2008
|
|
2007
|
|
2008
|
|
2007
|
|
|
|
|
|
|
|
|
|
|
|
Revenue
|
|
$
|
4,971,000
|
|
$
|
1,935,000
|
|
$
|
12,688,000
|
|
$
|
7,119,000
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating
expenses:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Costs
of revenue (1)
|
|
|
940,000
|
|
|
603,000
|
|
|
3,564,000
|
|
|
1,415,000
|
|
Research
and development (2)
|
|
|
2,848,000
|
|
|
445,000
|
|
|
8,665,000
|
|
|
1,500,000
|
|
Sales
and marketing (2)
|
|
|
2,018,000
|
|
|
676,000
|
|
|
5,782,000
|
|
|
1,886,000
|
|
General
and administrative (2)
|
|
|
1,946,000
|
|
|
1,532,000
|
|
|
8,640,000
|
|
|
3,478,000
|
|
Asset
impairments
|
|
|
26,245,000
|
|
|
-
|
|
|
26,245,000
|
|
|
-
|
|
Equity-based
compensation:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Research
and development
|
|
|
101,000
|
|
|
46,000
|
|
|
325,000
|
|
|
66,000
|
|
Sales
and marketing
|
|
|
35,000
|
|
|
34,000
|
|
|
147,000
|
|
|
88,000
|
|
General
and administrative
|
|
|
257,000
|
|
|
102,000
|
|
|
728,000
|
|
|
330,000
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
operating expenses
|
|
|
34,390,000
|
|
|
3,438,000
|
|
|
54,096,000
|
|
|
8,763,000
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss
from operations
|
|
|
(29,419,000
|
)
|
|
(1,503,000
|
)
|
|
(41,408,000
|
)
|
|
(1,644,000
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Other
income (expense), net
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest
income (expense), net
|
|
|
(27,000
|
)
|
|
118,000
|
|
|
34,000
|
|
|
229,000
|
|
Other
income (expense), net
|
|
|
331,000
|
|
|
3,000
|
|
|
345,000
|
|
|
(3,693,000
|
)
|
Total
other income (expense)
|
|
|
304,000
|
|
|
121,000
|
|
|
379,000
|
|
|
(3,464,000
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
loss
|
|
$
|
(29,115,000
|
)
|
$
|
(1,382,000
|
)
|
$
|
(41,029,000
|
)
|
$
|
(5,108,000
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Convertible
preferred stock 8% dividend
|
|
|
-
|
|
|
7,000
|
|
|
-
|
|
|
78,000
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
loss attributable to common stockholders
|
|
$
|
(29,115,000
|
)
|
$
|
(1,389,000
|
)
|
$
|
(41,029,000
|
)
|
$
|
(5,186,000
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
and diluted net loss attributable to common stockholders per common
share
|
|
$
|
(0.17
|
)
|
$
|
(0.01
|
)
|
$
|
(0.24
|
)
|
$
|
(0.05
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted-average
basic and diluted common shares outstanding
|
|
|
171,613,000
|
|
|
116,353,000
|
|
|
171,028,000
|
|
|
110,615,000
|
|
(1)
Includes
equity-based compensation of $53,000 and $215,000 for the three and nine months
ended September 30, 2008, respectively, and $48,000 and $63,000 for the three
and nine months ended September 30, 2007, 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 INCOME
(LOSS)
|
|
Three Months Ended
September 30,
|
|
Nine Months Ended
September 30,
|
|
|
|
2008
|
|
2007
|
|
2008
|
|
2007
|
|
|
|
|
|
|
|
|
|
|
|
Net
loss
|
|
$
|
(29,115,000
|
)
|
$
|
(1,382,000
|
)
|
$
|
(41,029,000
|
)
|
$
|
(5,108,000
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Other
comprehensive income (loss):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Foreign
currency translation
|
|
|
4,497,000
|
|
|
(1,000
|
)
|
|
1,073,000
|
|
|
(6,000
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Comprehensive
income (loss)
|
|
$
|
24,618,000
|
|
$
|
(1,383,000
|
)
|
$
|
(39,956,000
|
)
|
$
|
(5,114,000
|
)
|
See
accompanying notes to unaudited condensed consolidated financial
statements
ON2
TECHNOLOGIES, INC.
UNAUDITED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
|
|
Nine Months Ended September 30,
|
|
|
|
2008
|
|
2007
|
|
Cash
flows from operating activities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
loss
|
|
$
|
(41,029,000
|
)
|
$
|
(5,108,000
|
)
|
Adjustments
to reconcile net loss to net cash (used in) provided by operating
activities:
|
|
|
|
|
|
|
|
Equity-based
compensation
|
|
|
1,415,000
|
|
|
547,000
|
|
Other
expense recognized for warrant amendment
|
|
|
-
|
|
|
86,000
|
|
Depreciation
and amortization
|
|
|
2,630,000
|
|
|
275,000
|
|
Asset
impairments
|
|
|
26,245,000
|
|
|
-
|
|
Insurance
expenses financed with term loan
|
|
|
29,000
|
|
|
-
|
|
Loss
on disposal of equipment
|
|
|
1,000
|
|
|
-
|
|
Write
off of fixed assets
|
|
|
-
|
|
|
(21,000
|
)
|
Loss
on marketable securities
|
|
|
-
|
|
|
27,000
|
|
Change
in fair value of warrant liability
|
|
|
-
|
|
|
3,582,000
|
|
Changes
in operating assets and liabilities:
|
|
|
|
|
|
|
|
Accounts
receivable
|
|
|
3,398,000
|
|
|
(242,000
|
)
|
Prepaid
expenses and other current assets
|
|
|
(173,000
|
)
|
|
138,000
|
|
Other
assets
|
|
|
(257,000
|
)
|
|
20,000
|
|
Accounts
payable and accrued expenses
|
|
|
(1,007,000
|
)
|
|
969,000
|
|
Deferred
revenue
|
|
|
1,460,000
|
|
|
84,000
|
|
Net
cash (used in) provided by operating activities
|
|
|
(7,288,000
|
)
|
|
357,000
|
|
|
|
|
|
|
|
|
|
Cash
flows from investing activities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Proceeds
from the sale of short-term investments
|
|
|
23,074,000
|
|
|
223,000
|
|
Purchase
of short-term investments
|
|
|
(17,685,000
|
)
|
|
(96,000
|
)
|
Deferred
acquisition costs
|
|
|
-
|
|
|
(1,727,000
|
)
|
Deferred
financing costs
|
|
|
-
|
|
|
(62,000
|
)
|
Purchases
of property and equipment
|
|
|
(313,000
|
)
|
|
(257,000
|
)
|
Proceeds
from disposal of equipment
|
|
|
1,000
|
|
|
-
|
|
Net
cash provided by (used in) investing activities
|
|
|
5,077,000
|
|
|
(1,919,000
|
)
|
|
|
|
|
|
|
|
|
Cash
flows from financing activities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Principal
payments on capital lease obligations
|
|
|
(141,000
|
)
|
|
(19,000
|
)
|
Principal
payments on short-term borrowings
|
|
|
(2,134,000
|
)
|
|
(81,000
|
)
|
Principal
payments on long-term debt
|
|
|
(561,000
|
)
|
|
-
|
|
Proceeds
from the exercise of common stock options and warrants
|
|
|
50,000
|
|
|
6,813,000
|
|
Purchase
of treasury stock
|
|
|
(52,000
|
)
|
|
(472,000
|
)
|
Net
cash (used in) provided by financing activities
|
|
|
(2,838,000
|
)
|
|
6,241,000
|
|
Effect
of exchange rate changes on cash and cash equivalents
|
|
|
(33,000
|
)
|
|
(6,000
|
)
|
Net
(decrease) increase in cash and cash equivalents
|
|
|
(5,082,000
|
)
|
|
4,673,000
|
|
Cash
and cash equivalents, beginning of period
|
|
|
9,573,000
|
|
|
4,961,000
|
|
Cash
and cash equivalents, end of period
|
|
$
|
4,491,000
|
|
$
|
9,634,000
|
|
ON2
TECHNOLOGIES, INC.
UNAUDITED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(CONTINUED)
Supplemental
disclosure of cash flow information and non-cash investing and financing
activities:
|
|
Nine Months Ended September 30,
|
|
|
|
2008
|
|
2007
|
|
Cash
paid during the period for:
|
|
|
|
|
|
|
|
Interest
|
|
$
|
138,000
|
|
$
|
6,000
|
|
Acquisition
of fixed assets under capital leases
|
|
$
|
846,000
|
|
$
|
6,000
|
|
Insurance
premium financed with a term-loan
|
|
$
|
140,000
|
|
$
|
143,000
|
|
Conversion
of preferred stock into shares of common stock
|
|
|
-
|
|
$
|
3,102,000
|
|
Common
stock issued for accrued dividend on Series D Preferred
Stock
|
|
|
-
|
|
$
|
21,000
|
|
Common
stock issued for dividends on Series D Preferred Stock
|
|
|
-
|
|
$
|
93,000
|
|
Write
off of warrant derivative liability
|
|
|
-
|
|
$
|
5,911,000
|
|
Deferred
financing costs charged to paid-in-capital on exercise of
warrants
|
|
|
-
|
|
$
|
106,000
|
|
Cashless
exercise of options and warrants
|
|
|
-
|
|
$
|
959,000
|
|
Retirement
of treasury stock
|
|
$
|
52,000
|
|
$
|
1,431,000
|
|
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, Inc. (“On2” or the “Company”) is a video compression technology
firm that has developed its proprietary technology platform and video
compression/decompression software (“codec”) to deliver high-quality video at
the lowest possible data rates to intra- and internets, such as set-top boxes,
the Internet and wireless devices. The Company offers a suite of products and
professional services that encompass its proprietary compression technology.
The
Company’s professional service offerings include customized engineering and
consulting services and high-level video encoding. In addition, the Company
licenses its software products for use with video delivery platforms.
The
Company’s 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 September 30, 2008, the Company had working capital of
$1,079,000. For the nine months ended September 30, 2008, the Company incurred
a
net loss of $41,029,000 which included non-cash charges of $30,290,000. Cash
used from operating activities was $7,288,000 for the nine months ended
September 30, 2008.
The
Company’s plan to increase cash flows from operations relies significantly on
increases in revenue generated from our compression and video codec technology
services and products. Additionally, in order to reduce operating costs,
management has begun the implementation of a Company-wide cost savings plan.
Given our cash and short-term investments of $4,623,000 at September 30, 2008,
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,
however. 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 Form 10-K
Annual Report for the fiscal year ended December 31, 2007, filed with the SEC
on
June 27, 2008.
Reclassifications
We
have
reclassified certain prior period amounts to conform with the current period
presentation.
(3)
Acquisitions
On
November 1, 2007, the Company completed the acquisition of all of the share
capital of Hantro Products Oy (“Hantro”), a Finnish corporation. The Hantro
acquisition was structured as a share exchange transaction. In accordance with
the exchange agreement that governed the exchange transaction, on November
1,
2007, Hantro’s security holders each transferred to On2 all of the outstanding
capital shares, and all outstanding options to purchase capital shares, that
together constituted all of the equity ownership of Hantro, in exchange for
cash, shares of On2’s common stock and a commitment to issue additional shares
of On2’s common stock in an amount to be determined in accordance with a formula
for calculating contingent consideration.
Pro
Forma Financial Information
The
unaudited information in the table below summarizes the combined results of
operations of On2 Technologies, Inc. and Hantro, on a pro forma basis, as though
the companies had been combined as of the beginning of each of the periods
presented. The pro forma financial information is presented for informational
purposes only and is not indicative of the results of operations that would
have
been achieved if the acquisition had taken place at the beginning of each of
the
periods presented. The pro forma financial information for all periods presented
includes the business combination accounting effect of historical Hantro
revenues and amortization charges from acquired intangible assets.
|
|
Three Months
Ended
September 30,
2007
|
|
Nine Months
Ended
September 30,
2007
|
|
Total
revenues
|
|
$
|
5,750,000
|
|
$
|
15,625,000
|
|
Net
loss
|
|
|
(1,430,000
|
)
|
|
(7,008,000
|
)
|
Net
loss per share – basic and diluted
|
|
$
|
(0.01
|
)
|
$
|
(0.05
|
)
|
(4)
Recently Issued Accounting Pronouncements
In
May
2008, the FASB issued SFAS 162,
The
Hierarchy of Generally Accepted Accounting Principles.
SFAS 162
is intended to improve financial reporting by identifying a consistent
framework, or hierarchy, for selecting accounting principles to be used in
preparing financial statements that are presented in conformity with U.S.
generally accepted accounting principles for nongovernmental entities. SFAS
162
is effective 60 days following the SEC's approval of the PCAOB amendments to
AU
Section 411. The Company is currently evaluating the impact of adopting SFAS
162
on its 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. Early application is encouraged. The Company is currently evaluating
the
impact of adopting SFAS No. 161 on its consolidated financial position and
results of operations.
(5)
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
nine months ended September 30, 2008:
|
|
Shares
|
|
Weighted-
average
Exercise Price
|
|
Weighted-
average
Remaining
Contractual
Life
|
|
Aggregate
Intrinsic
Value
|
|
Number
of shares under option:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Outstanding
at January 1, 2008
|
|
|
7,956,000
|
|
$
|
1.03
|
|
|
|
|
|
|
|
Granted
|
|
|
5,463,000
|
|
|
0.44
|
|
|
|
|
|
|
|
Exercised
|
|
|
(71,000
|
)
|
|
0.70
|
|
|
|
|
|
|
|
Canceled
or expired
|
|
|
(279,000
|
)
|
|
1.24
|
|
|
|
|
|
|
|
Outstanding
at September 30, 2008
|
|
|
13,069,000
|
|
$
|
0.78
|
|
|
7.31
|
|
$
|
6,000
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Vested
and expected to vest at September 30, 2008
|
|
|
12,920,000
|
|
$
|
0.78
|
|
|
7.29
|
|
$
|
6,000
|
|
Exercisable
at September 30, 2008
|
|
|
5,588,000
|
|
$
|
1.00
|
|
|
5.07
|
|
$
|
6,000
|
|
Stock-based
compensation expense recognized in the condensed consolidated statement of
operations was $446,000 and $1,415,000 for the three and nine months ended
September 30, 2008, respectively, which included $924,000 of compensation
expense from restricted stock grants. Stock-based compensation expense
recognized in the condensed consolidated statement of operations was $230,000
and $547,000 for the three and nine months ended September 30, 2007,
respectively, which included $176,000 of compensation expense from restricted
stock grants.
The
aggregate intrinsic value of options exercised during the nine months ended
September 30, 2008 was $18,000.
The
following table summarizes the activity of the Company’s non-vested stock
options for the nine months ended September 30, 2008:
|
|
Shares
|
|
Weighted-
average
Grant
Date Fair Value
|
|
Non-vested
at January 1, 2008
|
|
|
3,108,000
|
|
$
|
0.58
|
|
Granted
|
|
|
5,463,000
|
|
|
0.24
|
|
Cancelled
or expired
|
|
|
(331,000
|
)
|
|
0.56
|
|
Vested
during the period
|
|
|
(759,000
|
)
|
|
0.65
|
|
Non-vested
at September 30, 2008
|
|
|
7,481,000
|
|
$
|
0.32
|
|
As
of
September 30, 2008, there was $1,993,000 of total unrecognized compensation
cost
related to non-vested share-based compensation arrangements granted under
existing stock option plans. This cost is expected to be recognized over a
weighted-average period of 1.68 years. The total grant date fair value of shares
vested during the nine-months ended September 30, 2008 was
$493,000.
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
September 30,
2008
|
|
Three Months
Ended
September 30,
2007
|
|
Weighted
average fair value at date of grant for options granted during the
period
|
|
$
|
0.22
|
|
$
|
0.84
|
|
Expected
stock price volatility
|
|
|
83
|
%
|
|
71
|
%
|
Expected
life of options
|
|
|
3
years
|
|
|
5
years
|
|
Risk
free interest rates
|
|
|
2.41
|
%
|
|
4.26
|
%
|
Expected
dividend yield
|
|
|
0
|
%
|
|
0
|
%
|
The
following table compares characteristics of the Company’s stock options granted
during the nine months ended September 30, 2008 and September 30,
2007:
|
|
Nine Months
Ended
September 30,
2008
|
|
Nine Months
Ended
September 30,
2007
|
|
|
|
|
|
|
|
Weighted-average
fair value at date of grant for options granted during the
period
|
|
$
|
0.24
|
|
$
|
1
.31
|
|
Expected
stock price volatility
|
|
|
83
|
%
|
|
94
|
%
|
Expected
life of options
|
|
|
3
years
|
|
|
5
years
|
|
Risk
free interest rates
|
|
|
2.40
|
%
|
|
4.95
|
%
|
Expected
dividend yield
|
|
|
0
|
%
|
|
0
|
%
|
The
following summarizes the activity of the Company’s non-vested restricted common
stock for the nine months
ended
September 30, 2008:
|
|
Shares
|
|
Weighted-
average
Grant Date
Fair Value
|
|
Non-vested
at January 1, 2008
|
|
|
1,053,000
|
|
$
|
2.04
|
|
Granted
|
|
|
1,065,000
|
|
|
0.65
|
|
Cancelled
or expired
|
|
|
(56,000
|
)
|
|
2.46
|
|
Vested
during the period
|
|
|
(292,000
|
)
|
|
2.41
|
|
Non-vested
at September 30, 2008
|
|
|
1,770,000
|
|
$
|
1.14
|
|
During
the nine months ended September 30, 2008, the Company granted 486,000 shares
of
restricted common stock to its Board of Directors which vest in April and July
2009, and 579,000 shares of restricted common stock to its employees which
vest
at various dates through March 2011. As of September 30, 2008, the Company
recognized $208,000 in compensation expense related to these grants and there
was $1,232,000 of unrecognized compensation cost which will be recognized
through the second quarter of 2011.
(6)
Cash
and cash equivalents and short-term investments
As
of
September 30, 2008, the Company held $132,000 in short-term securities, all
of
which are in a certificate of deposit in a United States bank.
(7)
Intangible Assets and Goodwill
In
connection with the Company’s acquisition of Hantro on November 1, 2007 (as
described in Note 3), the Company acquired intangible assets of $53,354,000
and
included goodwill in the amount of $36,075,000.
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.
During
the quarter ended September 30, 2008, the global economy has dramatically
weakened, which, along with other factors, has contributed to a continued
underperformance of our Hantro business (now operated by our wholly-owned
subsidiary, On2 Finland) and a decline in our overall market value. Based
on these circumstances, at September 30, 2008, the Company performed an
impairment review of its goodwill and intangible assets related to its Hantro
business. The Company engaged an outside valuation specialist to perform
the evaluation, utilizing management’s inputs and assumptions, by analyzing the
expected future cash flows of the business. Based on the results of the
evaluation, the Company has determined that goodwill and other intangibles
are
impaired. Accordingly, the Company recorded an impairment charge during the
quarter ended September 30, 2008, totaling $20,265,000 (goodwill) and $5,980,000
(intangible assets) to reduce their carrying value to an amount that is expected
to be recoverable. Should the global economy continue to weaken,
additional impairment charges may be necessary.
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
$778,000 and $2,340,000 for the three and nine months ended September 30, 2008,
respectively, and $62,000 and $185,000 for the three and nine months ended
September 30, 2007, respectively. The intangible assets and goodwill, decreased
by $ 4,877,000 and by $1,024,000 for the three and nine months ended September
30, 2008, respectively, for the effects of the foreign currency translation
adjustment. There were no other additions of intangible assets and goodwill
during the nine months ended September 30, 2008.
Based
on
the current amount of intangibles subject to amortization, the estimated future
amortization expense related to our intangible assets at September 30, 2008
is
as follows:
For
the Year Ending
September
30,
|
|
Future
Amortization
|
|
2009
|
|
$
|
1,424,000
|
|
2010
|
|
|
1,280,000
|
|
2011
|
|
|
1,280,000
|
|
2012
|
|
|
1,280,000
|
|
2013
|
|
|
754,000
|
|
Thereafter
|
|
|
2,886,000
|
|
Total
|
|
$
|
8,904,000
|
|
(8)
Short-Term Borrowings
At
September 30, 2008, short-term borrowings consisted of the following:
A
line of
credit with a Finnish bank for $650,000 (€450,000 at September 30, 2008). 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 5.523% at September 30,
2008). 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 September 30, 2008.
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 September 30, 2008
was
$109,000.
(9)
Long-Term Debt
At
September 30, 2008, long-term debt consisted of the following:
Unsecured
notes payable to a Finnish funding agency of $2,584,000, including interest
at
1.75%, due at dates ranging from January 2009 to December 2011; $258,000 to
a
Finnish bank, including interest at the 3-month EURIBOR plus 1.1% (total of
5.76% at September 30, 2008), due March 2011, secured by a guarantee by On2,
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 $181,000, including interest at the 6 month EURIBOR plus
.5% (total of 5.465% at September 30, 2008), due March 2011.
Future
maturities of long-term debt are as follows as of September 30,
2008:
For
the Year Ending September 30,
|
|
|
|
|
2009
|
|
$
|
481,000
|
|
2010
|
|
|
1,064,000
|
|
2011
|
|
|
783,000
|
|
2012
|
|
|
695,000
|
|
|
|
|
|
|
Total
|
|
$
|
3,023,000
|
|
(10)
Common Stock
During
the nine months ended September 30, 2008, the Company received $49,000 in
proceeds and issued 71,000 shares of its common stock for stock option
exercises. The Company cancelled 102,000 shares of restricted common stock
grants from 2007 as a result of terminated employees and cancelled 53,000 shares
of common stock resulting from the retirement of Treasury Stock, as outlined
in
Note 11 below.
(11)
Treasury Stock
In
April
2007 the Company’s Board of Directors authorized that all the shares recorded as
treasury stock be cancelled and that all subsequent shares received from
cashless exercises be cancelled immediately after receipt. During the nine
months ended September 30, 2008, the Company allowed its employees to relinquish
shares from the vesting of a portion of restricted stock grants for payment
of
taxes. The Company received a total of 53,000 shares at a value of $52,000
for
payment of taxes.
(12)
Geographical Reporting and Customer Concentration
The
components of the Company’s revenue for the three and nine months ended
September 30, 2008 and 2007 are summarized as follows:
|
|
For the three months ended
September 30
|
|
|
|
2008
|
|
2007
|
|
License
software revenue
|
|
$
|
3,415,000
|
|
$
|
1,278,000
|
|
Engineering
services and support
|
|
|
576,000
|
|
|
180,000
|
|
Royalties
|
|
|
961,000
|
|
|
458,000
|
|
Other
|
|
|
19,000
|
|
|
19,000
|
|
Total
|
|
$
|
4,971,000
|
|
$
|
1,935,000
|
|
|
|
For the nine months ended
September 30
|
|
|
|
2008
|
|
2007
|
|
License
software revenue
|
|
$
|
8,417,000
|
|
$
|
5,193,000
|
|
Engineering
services and support
|
|
|
1,638,000
|
|
|
643,000
|
|
Royalties
|
|
|
2,576,000
|
|
|
1,226,000
|
|
Other
|
|
|
57,000
|
|
|
57,000
|
|
Total
|
|
$
|
12,688,000
|
|
$
|
7,119,000
|
|
For
the
three and nine months ended September 30, 2008, foreign customers accounted
for
approximately 60% and 52%, respectively of the Company’s total revenue. For the
three and nine months ended September 30, 2007 foreign customers accounted
for
approximately 31% and 43%, respectively of the Company’s total revenue. These
customers are primarily located in Asia, Europe and the Middle East.
Selected
information by geographic location is as follows:
|
|
For the three months ended
September 30
|
|
|
|
2008
|
|
2007
|
|
Revenue
from unaffiliated customers:
|
|
|
|
|
|
|
|
United
States Operations
|
|
$
|
3,489,000
|
|
$
|
1,935,000
|
|
Finland
Operations
|
|
|
1,482,000
|
|
|
-
|
|
Total
|
|
$
|
4,971,000
|
|
$
|
1,935,000
|
|
Net
income (loss):
|
|
|
|
|
|
|
|
United
States Operations
|
|
$
|
508,000
|
|
$
|
(1,382,000
|
)
|
Finland
Operations
|
|
|
(29,623,000
|
)
|
|
-
|
|
Total
|
|
$
|
(29,115,000
|
)
|
$
|
(1,382,000
|
)
|
|
|
For the nine months ended
September 30
|
|
|
|
2008
|
|
2007
|
|
Revenue
from unaffiliated customers:
|
|
|
|
|
|
|
|
United
States Operations
|
|
$
|
8,346,000
|
|
$
|
7,119,000
|
|
Finland
Operations
|
|
|
4,342,000
|
|
|
-
|
|
Total
|
|
$
|
12,688,000
|
|
$
|
7,119,000
|
|
|
|
|
|
|
|
|
|
Net
loss:
|
|
|
|
|
|
|
|
United
States Operations
|
|
$
|
(4,510,000
|
)
|
$
|
(5,108,000
|
)
|
Finland
Operations
|
|
|
(36,519,000
|
)
|
|
-
|
|
Total
|
|
$
|
(41,029,000
|
)
|
$
|
(5,108,000
|
)
|
|
|
September 30,
|
|
December 31,
|
|
|
|
2008
|
|
2007
|
|
Identifiable
assets:
|
|
|
|
|
|
|
|
United
States Operations
|
|
$
|
15,600,000
|
|
$
|
17,631,000
|
|
Finland
Operations
|
|
|
21,607,000
|
|
|
61,894,000
|
|
Total
|
|
$
|
37,207,000
|
|
$
|
79,525,000
|
|
The
Identifiable assets for the United States Operations include intangible assets,
net of $387,000 at September 30, 2008 and $572,000 at December 30, 2007. The
identifiable assets for the Finland operations include intangible assets, net
of
$24,504,000 at September 30, 2008 and $53,928,000 at December 30,
2007.
For
the
three months ended September 30, 2008, there was one customer that accounted
for
11% of the Company’s revenue. For the nine months ended September 30, 2008,
there were no customers that accounted for 10% or more of the Company's revenue.
For the three and nine months ended September 30, 2007, there were no customers
that accounted for 10% or more of the Company’s revenue.
Financial
instruments that subject the Company to concentrations of credit risk consist
primarily of cash and cash equivalents and accounts receivable. The company
maintains all of its cash and cash equivalents in one financial institution.
The
Company performs periodic evaluations of the relative credit standing of the
institution. The cash balances are insured by the FDIC, up to $250,000 per
depositor. The company has cash balances in a money market fund and a checking
account at September 30, 2008 that exceeds the limit in the amount of $3.9
million.
(13)
Net
Loss Per Share
Basic
net
loss per share is computed by dividing the net loss applicable to common shares
by the weighted average number of common shares outstanding during the
period. Diluted loss attributable to common shares adjusts basic loss per
share for the effects of convertible securities, warrants, stock options and
other potentially dilutive financial instruments, only in the periods in which
such effect is dilutive. The shares issuable upon the conversion of
preferred stock, 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 September 30, 2008 and 2007, were
not
included in the computation of diluted loss per share and consist of the
following as of September 30:
|
|
2008
|
|
2007
|
|
Warrants
to purchase common stock
|
|
|
-
|
|
|
1,601,000
|
|
Options
to purchase common stock
|
|
|
102,500
|
|
|
4,427,000
|
|
|
|
|
|
|
|
|
|
Total
|
|
|
102,500
|
|
|
6,028,000
|
|
(14)
Related Party Transactions
During
the nine months ended September 30, 2008 and 2007, the Company retained
McGuireWoods LLP to perform certain legal services on behalf of the Company
and
incurred costs of approximately $59,000 and $228,000 for the three and nine
months ended September 30, 2008, respectively, and $308,000 and $845,000 for
the
three and nine months ended September 30, 2007, respectively, for such legal
services. William A. Newman, a director of the Company, was a partner of
McGuireWoods LLP until May 2008. In May 2008, Mr. Newman became a partner at
Sullivan & Worcester LLP and the company incurred $27,000 in legal service
fees to Sullivan & Worcester LLP for the nine months ended September 30,
2008.
(15)
Litigation
Islandia
On
August
14, 2008, Islandia, L.P. filed a complaint against On2 in the Supreme Court
of
the State of New York, New York County. Islandia was an investor in the
Company’s October 2004 issuance of Series D Convertible Preferred Stock pursuant
to which On2 sold to Islandia 1,500 shares of Series D Convertible Preferred
Stock, raising gross proceeds for the Company from Islandia of $1,500,000.
Islandia’s Series D Convertible Preferred Stock was convertible into On2 common
stock at an effective conversion price of $0.70 per share of common stock.
Pursuant to this transaction, Islandia also received two warrants to purchase
an
aggregate of 1,122,754 shares of On2 common stock.
The
complaint 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.
On2
believes this lawsuit is without merit and intends to vigorously defend itself
against Islandia’s complaint. As of September 30, 2008, the Company has not
recorded any provision associated with this complaint.
Beijing
E-World
On
March
31, 2006, On2 commenced arbitration against its customer, Beijing E-World,
relating to a dispute arising from two license agreements that On2 and Beijing
E-World entered into in June 2003.
Under
those agreements, On2 licensed the source code to its video compression (codec)
technology to Beijing E-World for use in Beijing E-World’s video disk (EVD) and
high definition television (HDTV) products as well as for other non-EVD/HDTV
products. We believe that the license agreements impose a number of obligations
on Beijing E-World, including the requirements that:
|
·
|
Beijing
E-World pay to On2 certain minimum quarterly payments; and
|
|
·
|
Beijing
E-World use best
reasonable
efforts to have On2’s video codec “ported” to (i.e., integrated with) a
chip to be used in EVD players.
|
On2
has
previously commenced arbitration regarding the license agreements with Beijing
E-World. In March 2005, the London Court of International Arbitration tribunal
released the decision of the arbitrator, in which he dismissed On2’s claims in
the prior arbitration, as well as Beijing E-World’s counterclaims, and ruled
that the license agreements remained in effect; and that the parties had a
continuing obligation to work towards porting On2’s software to two
commercially-available DSPs.
Although
a substantial amount of time has passed since the conclusion of the previous
arbitration, the parties have nevertheless not completed the required porting
of
On2’s software to two commercially available DSPs.
On2’s
current arbitration claim alleges that, despite its obligations under the
license agreements, Beijing E-World has:
|
·
|
failed
to pay On2 the quarterly payments of $1,232,000, which On2 believes
are
currently due and owing; and
|
|
·
|
failed
to use best reasonable efforts to have On2’s video codec ported to a chip.
|
On2
has
requested that the arbitrator award it approximately $5,690,000 in damages
under
the contract and grant it further relief as may be just and equitable.
Beijing
E-World has appeared in the arbitration, although it has not yet filed any
responses to On2’s filings in the proceeding. Following Beijing E-World’s
appearance, it entered into an agreement with On2 pursuant to which Beijing
E-World agreed by November 30, 2006 to pay On2 an amount in settlement equal
to
approximately 25% of the remaining unpaid portion of the license fees set forth
in the license agreements. Upon payment of the settlement payment, the parties
will terminate the arbitration, the license agreements will terminate, and
On2
will release Beijing E-World from all liability arising from the matters
underlying the arbitration. As of the date of filing, Beijing E-World has not
paid the amount agreed for settlement.
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,” “can”, “could,” “should,” “expect,” “foresee,” “plan,”
“anticipate,” “assume,” “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:
•
|
future
revenues, income taxes, net loss per share, acquisition costs and
related
amortization, and other measures of results of operations;
|
|
|
•
|
the
effects of acquiring Hantro;
|
|
|
•
|
difficulties
in controlling expenses, legal compliance matters or internal control
over
financial reporting review, improvement and
remediation;
|
|
|
•
|
risks
associated with the ineffectiveness of the Company’s internal control over
financial reporting and our ability to remediate material
weaknesses;
|
•
|
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;
|
|
|
•
|
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, 2007,
as
well as in Item 1A of Part II of this quarterly report on Form
10-Q.
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, 2007 in
addition to the other information set forth herein, including Item 1A of Part
II
of this quarterly report on Form 10-Q.
We
undertake no duty to update any of the forward-looking statements, whether
as a
result of new information, future events or otherwise. In light of the
foregoing, readers are cautioned not to place undue reliance on the
forward-looking statements contained in this report.
Costs
Associated with Restatement of Financial Statements
Since
December 31, 2007, we have incurred legal and accounting and other costs related
to the Audit Committee review and restatement of our financial statements for
the second and third quarters of 2007. These restatements are set forth in
Amendment No. 1 to our Quarterly Report on Form 10-Q, filed on June 27, 2008
and
Amendment No. 1 to our Quarterly Report on Form 10-Q for the period ended
September 30, 2007, both filed on June 27, 2008, and are also described in
our
Annual Report on Form 10-K for the year ended December 31, 2007, filed on June
28, 2008. In connection with this, we incurred costs of approximately
$2,186,000, as of September 30, 2008, of which we expensed approximately
$373,000 in the first quarter of 2008 and an additional $1,813,000 the second
quarter of 2008. We expensed these costs in the period in which the
legal, accounting and other services were provided and we recorded these costs
as general and administrative expenses. The Company believes it continues to
have sufficient cash and other resources available to meet working capital
and
other needs that might arise over the next twelve months.
Acquisition
of Hantro Products Oy
On
May
21, 2007, we entered into an exchange agreement with Nexit Ventures Oy, as
the
authorized representative of the holders of all outstanding equity securities
(including outstanding share options) of Hantro to acquire all outstanding
equity securities of Hantro in exchange for cash and common stock. We completed
the acquisition on November 1, 2007 for a total purchase price of $49,501,000.
Under the terms of the exchange agreement, On2 paid $6,608,102 in cash and
issued 25,438,817 shares of the Company's common stock, par value $.01 per
share, directly to the Hantro security holders, of which two million On2 shares
are being held in escrow until the anniversary of the Hantro closing to secure
the indemnification obligations of the shareholders of Hantro. At that time,
Hantro and its subsidiary became wholly-owned subsidiaries of the Company.
The
exchange agreement also required On2 to issue additional shares of common stock,
depending on Hantro’s net revenue in 2007. Hantro’s 2007 net revenue exceeded
€9,000,000, and accordingly, the Company became obligated to issue to the former
security holders of Hantro an additional 12,500,000 shares of On2 common stock
(the maximum number of shares issuable as contingent payment). On July 8, 2008,
the Company issued 11,100,440 of the shares due to the former Hantro security
holders, and on August 28, 2008 issued the remaining 1,399,560
shares.
Asset
Impairment
During
the quarter ended September 30, 2008, the global economy has dramatically
weakened, which, among other factors, has contributed to the continued
underperformance of our Hantro business and a decline in our overall market
value. Based on these circumstances, at September 30, 2008, the Company
performed an impairment review of its goodwill and intangible assets related
to
its Hantro business. The Company engaged an outside valuation specialist
to perform the evaluation, utilizing management’s inputs and assumptions, by
analyzing the expected future cash flows of the business. Based on the
results of the evaluation, the Company has determined that goodwill and other
intangibles are impaired. Accordingly, the Company recorded an impairment charge
during the quarter ended September 30, 2008, totaling $20,265,000 (goodwill)
and
$5,980,000 (intangible assets) to reduce their carrying value to an amount
that
is expected to be recoverable. Should the global economy continue to
weaken, additional impairment charges may be necessary.
Overview
On2
Technologies is a developer of video compression technology and technology
that
enables multimedia in resource-limited environments, such as cellular networks
transmitting to battery operated mobile handsets or High Definition (HD) video
over the Internet. We have developed a proprietary technology platform and
the
TrueMotion® VPx family (e.g., 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 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 Finland (formerly Hantro),
a
Finnish corporation which we acquired on November 1, 2007, we license to chip
and mobile handset manufacturers the hardware and software designs that make
the
encoding or decoding of video possible on devices such as mobile handsets,
set
top boxes, portable media players and cameras. On2 Finland has its headquarters
and research and development facility in Oulu, Finland and it has a global
sales
network with satellite offices in Korea, Japan, Taiwan, Germany, Hong Kong
and
Mainland China. Both On2 and On2 Finland also provide integration, customization
and support services to enable high quality video on and faster interoperability
between devices.
Since
2004, we have licensed our video compression technology to Macromedia, Inc.
(now
Adobe Systems Incorporated) for use in the 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. While our primary focus remains the development of video compression
technology, our Flash encoding business is a significant part of our business.
We
offer
the following suite of products and services that incorporate our proprietary
compression technology:
|
·
|
Encoding
and server software, for use with video delivery
platforms.
|
We
also
offer the following suite of hardware and software products that incorporate
our
mobile video technology:
|
·
|
TrueMotion
VP6 and VP7 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 supporting up to
16MP;
|
|
·
|
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;
and
|
Most
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
|
·
Delivery
of video via satellite
·
Providing
video to web-enabled cell phones
and PDAs
|
|
|
User-Generated
Content (UGC) Sites
|
·
Providing
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
|
On2’s
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:
•
|
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;
|
|
|
•
|
Using
the success of current customer implementations of our TrueMotion
technology (e.g., Adobe® Flash 8, Skype) and other high-profile customers
(e.g., Sun Microsystems) to increase our brand recognition, promote
new
business and encourage proliferation across platforms;
|
|
|
•
|
Updating
and enhancing our existing consumer products, such as the Flix line
and
embedded technologies;
|
•
|
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 our subsidiary, On2 Finland, to develop hardware
designs
of our TrueMotion 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 TrueMotion 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
made
the decision to acquire Hantro in part to assist us in achieving our strategic
goal of implementing our TrueMotion codecs in hardware and developing highly
optimized software libraries for operation on the digital signal processors
(DSPs) used in embedded devices. The Hantro acquisition has allowed us to
increase the resources devoted to improving the ease of implementation of our
codecs across platforms. Prior to the acquisition, we did not have a broad
selection of off-the-shelf optimized software that we could license to customers
who were interested in implementing our codecs on devices. Those customers
were
therefore frequently required to pay us to customize our software, or to perform
the customizations themselves, or to hire third-party consultants to perform
the
customizations. The Hantro acquisition has given us access to experienced
internal resources to enable 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 and Flash 9 players. We therefore 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 we could best take advantage of the anticipated success of Flash
8 by taking the most up-to-date Flash 8 encoding software straight from the
company that developed Flash 8 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 TrueMotion 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).
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 TrueMotion
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. 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 company of
111employees 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 customer 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. Until recently, we have generally produced software targeted
at developers, who integrate our software into their products, and developing
and marketing products aimed at end users is therefore a relatively new business
for us.
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 success of
our
customers’ product 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 and YouTube,
which allow visitors to create and view user generated content, have sprung
up
and seen their popularity soar. Although consumer generated content initially
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
have
recently experienced 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 8 VP6 video,
and while Flash 8 video is available on a vast number of PCs, it has only
recently become available on devices using DSPs, 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 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, a number of 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 TrueMotion video might require. In addition,
there are certain customers that prefer to license standards-based codecs.
In
August 2007, our customer Adobe announced that the latest version of the Flash
video player would support H.264. 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. Our
acquisition of Hantro has significantly increased the resources that we can
devote to these efforts. We have also increased the number of our engineers
who
integrate our codecs on chips, and we have cultivated relationships with chip
companies to enable those companies to perform such integration. 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 presence of Microsoft, Inc. 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.
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 marketing and licensing model has in
some cases led to, 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
financial resources and its competitive position in the computer industry 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.
The
Microsoft DRM (digital rights management) 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’s DRM
does not integrate well with non-Microsoft video and audio software, such as
ours. We believe that the latest generation of codec technology, which includes
VP7, is superior to Microsoft’s video compression software. We also believe that
companies could become more comfortable with using DRM technology produced
by
companies other than Microsoft.
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. We believe our ability to provide both our VPx codecs and standards
based codecs has positioned us uniquely as a one stop shop for the
implementation of multiple codecs on a variety of devices.
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:
|
·
|
RTLs
are cheaper to produce in high
volumes;
|
|
·
|
They
use less energy, which prolongs battery life of mobile
devices;
|
|
·
|
They
produce less heat, which has important implications for, among other
things, circuit design; and
|
|
·
|
They
allow for simultaneous encoding and decoding of HD video
content.
|
But
there
are also disadvantages to hardware implementations of multimedia
tools:
|
·
|
Initial
implementation costs are high; and
|
|
·
|
Hardware
implementations are generally not
upgradeable.
|
Similarly,
software-upgradable DSPs offer certain advantages:
|
·
|
Modifying
software to operate on a DSP is easier and less expensive then
implementing the software in hardware, reducing initial project costs
and
speeding deployment;
|
|
·
|
DSPs
do not require costly re-designs and re-tooling to operate new software;
and
|
|
·
|
They
are more easily upgradeable.
|
But
they
also have certain disadvantages:
|
·
|
Per-chip
costs are higher than pure hardware solutions as volumes
increase;
|
|
·
|
The
increased processor power required to operate diverse software increases
heat and power consumption.
|
Manufacturers
that want to maintain the ability to upgrade mobile devices and PMPs to support
new multimedia software may opt for DSPs rather than hardware solutions, which
could impact our business of licensing hardware codecs. Nevertheless, we believe
that even if manufacturers do choose to use DSPs in their devices, it is likely
that many will continue to implement hardware codecs alongside the DSPs to
take
advantage of the efficiency of those hardware implementations. In addition,
support for DSPs on multimedia devices would have the benefit of making those
devices more easily upgraded to new generations of our TrueMotion 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 unaudited condensed consolidated financial statements that have
been prepared under accounting principles generally accepted in the U.S. The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires our management
to
make estimates and assumptions that affect the reported amounts of assets and
liabilities and the disclosure of contingent assets and liabilities at the
date
of the financial statements and the reported amounts of revenue and expenses
during the reporting period. Actual results could materially differ from those
estimates. The unaudited condensed consolidated financial statements and the
related notes thereto should be read in conjunction with the discussion of
our
critical accounting policies and our annual report for the fiscal year ended
December 31, 2007 on Form 10K, filed with the Securities and Exchange Commission
on June 27, 2008. Our critical accounting policies and estimates
are:
|
•
|
Revenue
recognition;
|
|
•
|
Accounts
receivable allowance;
|
|
•
|
Acquisitions;
|
|
•
|
Equity-based
compensation; and
|
|
•
|
Valuation
of goodwill and intangible assets, including impairment, and other
long-lived assets.
|
Revenue
Recognition.
We
currently recognize revenue from professional services and the sale of software
licenses. As described below, significant management judgments and estimates
must be made and used in determining the amount of revenue recognized in any
given accounting period. Material differences may result in the amount and
timing of our revenue for any given accounting period depending upon judgments
made by management or estimates used 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
,”
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
collectibility is probable. Revenues recognized from multiple-element software
arrangements are allocated to each element of the arrangement based on the
fair
values of the elements, such as product licenses, post-contract customer
support, or training. The determination of the fair value is based on the vendor
specific objective evidence available to us. If such evidence of the fair value
of each element of the arrangement does not exist, we defer all revenue from
the
arrangement until such time that evidence of the fair value does exist or until
all elements of the arrangement are delivered.
Our
software licensing arrangements typically consist of two elements: a software
license and post-contract customer support (“PCS”). We recognize license
revenues based on the residual method after all elements other than PCS have
been delivered as prescribed by SOP 98-9. We recognize PCS revenues over the
term of the maintenance contract or on a “per usage” basis, whichever is stated
in the contract. Vendor specific objective evidence of the fair value of PCS
is
determined by reference to the price the customer will have to pay for PCS
when
it is sold separately (i.e. the renewal rate). Most of our license agreements
offer additional PCS at a stated price. Revenue is recognized on a per copy
basis for licensed software when each copy of the licensed software purchased
by
the customer or reseller is delivered. We do not allow returns, exchanges or
price protection for sales of software licenses to our customers or resellers,
and we do not allow our resellers to purchase software licenses under
consignment arrangements.
When
engineering and consulting services are sold together with a software license,
the arrangement typically requires customization and integration of the software
into a third party hardware platform. In these arrangements, we require the
customer to pay a fixed fee for the engineering and consulting services and
a
licensing fee in the form of a per-unit royalty. We account for engineering
and
consulting arrangements in accordance with SOP 81-1,
Accounting
for Performance of Construction Type and Certain Production Type
Contracts
,
(SOP
81-1). When reliable estimates are available for the costs and efforts necessary
to complete the engineering or consulting services and those services do not
include contractual milestones or other acceptance criteria, we recognize
revenue under the percentage of completion contract method based upon input
measures, such as hours. When such estimates are not available, we defer all
revenue recognition until we have completed the contract and have no further
obligations to the customer.
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. Our credit losses have historically been low and within
our expectations.
Acquisitions.
We are
required to allocate the purchase price of acquired companies to the tangible
and intangible assets acquired, liabilities assumed, as well as purchased
in-process research and development (IPR&D) based on the estimated fair
values. We use various models to determine the fair values of the assets
acquired and liabilities assumed. These models include the discounted cash
flow
(DCF), the royalty savings method and the cost savings approach. The valuation
requires management to make significant estimates and assumptions, especially
with respect to long-lived and intangible assets.
Critical
estimates in valuing certain of the intangible assets include, but are not
limited to, future expected cash flows from customer contracts, customer lists,
distribution agreements and acquired developed technologies and patents; the
acquired company’s brand awareness and market position as well as assumptions
about the period of time the brand will continue to be used in the combined
company’s product portfolio; and discount rates. We derive our discount rates
from our internal rate of return based on our internal forecasts and we may
adjust the discount rate giving consideration to specific risk factors of each
asset. Management’s estimates of fair value are based upon assumptions believed
to be reasonable but which are inherently uncertain and unpredictable.
Assumptions may be incomplete or inaccurate, and unanticipated events and
circumstances may occur.
Equity-Based
Compensation.
The
Company 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.
Valuation
of Goodwill, Intangible Assets and Other Long-Lived Assets.
In
June
2001, the FASB issued SFAS No. 142,
“Goodwill
and Other Intangible Assets”
(“SFAS
No. 142”). SFAS 142 requires goodwill and other intangible assets to be
tested for impairment at least annually, and written off when impaired, rather
than being amortized as previously required.
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. See the discussion of “Asset
Impairment” below under “Results of Operations.”
Results
of Operations
Revenue.
Revenue
for the three months ended September 30, 2008 was $4,971,000, as compared to
$1,935,000 for the three months ended September 30, 2007. Revenue for the nine
months ended September 30, 2008 was $12,688,000, as compared to $7,119,000
for
the nine months ended September 30, 2007. Revenue for the three and nine months
ended September 30, 2008 and 2007 was derived primarily from the sale of
software licenses, engineering and consulting services and royalties. The
increase in revenue for the three and nine months ended September 30, 2008
is
primarily attributed to the revenue contribution of $1,482,000 and $4,342,000,
respectively, from our subsidiary, On2 Finland (formerly Hantro), acquired
in
November 2007, and also increases in license software and royalty sales from
On2
US.
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 September
30,
2008 were $34,390,000 as compared to $3,438,000 for the three months ended
September 30, 2007. Operating expenses were $54,096,000 for the nine months
ended September 30, 2008 as compared to $8,763,000 for the nine months ended
September 30, 2007.
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 September 30, 2008 was
$940,000, as compared to $603,000 for the three months ended September 30,
2007.
Costs of revenue for the nine months ended September 30, 2008 was $3,564,000,
as
compared to $1,415,000 for the nine months ended September 30, 2007. The
increase in expenses for the nine months ended September 30, 2008 as compared
with the nine months ended September 30, 2007 is primarily attributable to
an
increase in production and engineering costs associated with On2 Finland of
$2,708,000, of which $1,791,000 is amortization of the Hantro purchased
technology, offset by a decrease in production and engineering costs for the
US
operations of $558,000 due to fewer hours allocated by our engineering
staff.
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 September 30, 2008 were $2,848,000 as compared to $445,000 for the three
months ended September 30, 2007. The increase of $2,403,000 for the three months
ended September 30, 2008 is primarily the result of an increase of $2,218,000
in
research and development costs incurred by our Finnish subsidiary, which uses
a
greater portion of their engineers in research and development activities ,
and
a $185,000 increase in research and development costs incurred by our US
operations, which is a result of increases in personnel and related costs and
an
increase in the number of hours that our engineering staff worked on development
projects. Research and development expenses for the nine months ended September
30, 2008 were $8,665,000 as compared to $1,500,000 for the nine months ended
September 30, 2007. The increase of $7,165,000 for the nine months ended
September 30, 2008 as compared with September 30, 2007 is primarily a result
of
an increase of $6,249,000 in research and development costs incurred by our
Finnish subsidiary, which utilizes a greater portion of their engineers in
research and development activities and a $917,000 increase in research and
development costs incurred by our US operations, which is a result of increases
in personnel and related costs and an increase in the amount of hours that
our
engineering staff worked on development projects.
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 September 30, 2008 were $2,018,000, as compared to $676,000
for the three months ended September 30, 2007. The increase of $1,342,000 for
the three months ended September 30, 2008 is primarily a result of an increase
of $1,509,000 in sales and marketing personnel and related costs attributable
to
our Finnish subsidiary and a $167,000 decrease in sales and marketing costs
incurred by US operations that is a result of cost reductions that took effect
during the third quarter. Sales and marketing expenses for the nine months
ended
September 30, 2008 were $5,782,000, as compared to $1,886,000 for the nine
months ended September 30, 2007. The increase of $3,896,000 for the nine months
ended September 30, 2008 is primarily a result of an increase of $3,693,000
in
sales and marketing personnel and related costs attributable to our Finnish
subsidiary and a $533,000 increase in sales and business development costs,
offset by a decrease in marketing costs of $305,000 incurred by US.
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 September 30, 2008 were $1,946,000, as
compared with $1,532,000 for the three months ended September 30, 2007. The
increase of $414,000 for the three months ended September 30, 2008 is primarily
a result of an increase of $630,000 in general and administrative costs
attributable to our Finnish subsidiary and a $216,000 decrease in general and
administrative costs incurred by US operations that is a result of cost
reductions that took effect during the third quarter. General and administrative
expenses for the nine months ended September 30, 2008 were $8,640,000, as
compared with $3,478,000 for the nine months ended September 30, 2007. The
increase of $5,162,000 for the nine months ended September 30, 2008 is
attributable to $1,904,000 of related general and administrative costs
attributable to our Finnish subsidiary, increases in legal and accounting fees
of $2,349,000 of which $2,186,000 is related to the Audit Committee’s review of
certain 2007 sales contracts in connection with the restatement, increases
in
salaries and related benefit costs, consulting services related to the Company’s
compliance with Sarbanes-Oxley Section 404 and professional fees associated
with
the Company’s proxy statement and annual report.
Asset
Impairment
.
During
the quarter ended September 30, 2008, the global economy has dramatically
weakened, which, among other factors, has contributed to the continued
underperformance of our Hantro business and a decline in our overall market
value. Based on these circumstances, at September 30, 2008, the Company
performed an impairment review of its goodwill and intangible assets related
to
its Hantro business. The Company engaged an outside valuation specialist
to perform the evaluation, utilizing management’s inputs and assumptions, by
analyzing the expected future cash flows of the business. Based on the
results of the evaluation, the Company has determined that goodwill and other
intangibles are impaired. Accordingly, the Company recorded an impairment charge
during the quarter ended September 30, 2008, totaling $20,265,000 (goodwill)
and
$5,980,000 (intangible assets) to reduce their carrying value to an amount
that
is expected to be recoverable. Should the global economy continue to
weaken, additional impairment charges may be necessary.
Equity-Based
Compensation.
Equity
based compensation, which is presented separately, was $393,000 for the three
months ended September 30, 2008, as compared with $182,000 for the three months
ended September 30, 2007. Equity based compensation was $1,200,000 for the
nine
months ended September 30, 2008, as compared with $484,000 for the nine months
ended September 30, 2007. The increase for the three and nine months ended
September 30, 2008 is primarily due to the amortization of options granted
in
association with the acquisition of our Finnish subsidiary on November 1, 2007.
Equity-based
compensation of $53,000 and $48,000 is included in cost of revenue for the
three
months ended September 30, 2008 and 2007, respectively.
Equity-based compensation of $215,000 and $63,000 is included in cost of revenue
for the nine months ended September 30, 2008 and 2007,
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 $(27,000) and $34,000
for the three and nine months ended September 30, 2008, respectively
,
as
compared to
$118,000
and $229,000 for the three and nine months ended September 30, 2007,
respectively.
Other
income (expense), net primarily consists of the change in the fair value of
the
warrant derivative liability and realized losses on marketable securities.
The
decrease in expense of $4,038,000 for the nine months ended September 30, 2008
is primarily a result of the elimination of the derivative liability in the
second quarter of 2007 which accounted for $3,582,000, the elimination of a
one
time fee for a warrant amendment which accounted for $86,000, the sale of
marketable securities at a loss which accounted for $27,000 and income from
a
grant from our Finnish subsidiary for $331,000. The warrant derivative liability
was recorded in connection with the August 2006 sale of common stock and
warrants to a group of investors led by Midsummer Capital.
Liquidity
and Capital Resources
At
September 30, 2008, the Company had cash and cash equivalents and short-term
investments of $4,623,000, as compared to $15,094,000 at December 31, 2007.
At
September 30, 2008 the Company had working capital of $1,079,000, as compared
with $13,246,000 at December 31, 2007.
Net
cash
(used in) provided by operating activities was $(7,288,000) and $357,000 for
the
nine months ended September 30, 2008 and 2007, respectively. The decrease in
net
cash used in operating activities is primarily related to a net loss of
$41,029,000 and a decrease in accounts payable and accrued expenses of
$1,007,000, partially offset by a decrease in accounts receivable of $3,398,000,
an increase in deferred revenue of $1,460,000, an increase in depreciation
and
amortization of $2,630,000, an asset impairment of $26,245,000 and an increase
in equity-based compensation of $1,415,000.
Net
cash
provided by (used in) investing activities was $5,077,000 and $(1,919,000)
for
the nine months ended September 30, 2008 and 2007, respectively. The increase
in
net cash used in investing activities is primarily a result of the sale of
short-term investments during the first nine months of 2008 and a decrease
in
deferred acquisition costs associated with the then-pending Hantro acquisition,
offset by increases in the purchase of short-term investments and property
and
equipment.
Net
cash
(used in) provided by financing activities was $(2,838,000) and $6,241,000
for
the nine months ended September 30, 2008 and 2007, respectively. The decrease
is
primarily attributable to a decrease in proceeds received from the exercise
of
common stock options and warrants and an increase in payments on short-term
and
long-term debt.
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, Tarrytown, and Manhattan,
New
York, Cambridge UK, and Oulu and Espoo, Finland. The aggregate required payments
for the next 12 months under these arrangements are $901,000. 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
September 30, 2008, short-term borrowings consisted of the following:
A
line of
credit with a Finnish bank for $650,000 (€450,000 at September 30, 2008). 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 4.273% at September 30,
2008). 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 September 30, 2008.
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%.
At
September 30, 2008, long-term debt consisted of the following:
Unsecured
notes payable to a Finnish funding agency of $2,584,000, including interest
at
1.75%, due at dates ranging from January 2009 to December 2011; $258,000 to
a
Finnish bank, including interest at the 3-month EURIBOR plus 1.1% (total of
5.76% at September 30, 2008), due March 2011, secured by a guarantee by On2
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 $181,000, including interest at the 6 month EURIBOR plus
.5% (total of 5.465% at September 30, 2008), due March 2011.
The
Company believes that existing funds are sufficient to fund its operations
for
the next 12 months. The Company plans to increase cash flows from operations
principally from increases in revenue generated from its compression technology
services and products. Our forecasts are predicated upon assumptions we have
made as to, among other factors, the market for our products and services,
global economic conditions, and the availability of credit affecting us and
our
customers. If those assumptions are incorrect, or if sales are less than
projected and/or expenses higher than expected, we may not have sufficient
resources to fund our operations for this entire period,
however.
The
Company may also pursue additional financings, although current economic
conditions may make it impossible for us 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 10-K for the year ended December 31, 2007, as well as in Item 1A of
Part II of this quarterly report on Form 10-Q.
We
have
experienced significant operating losses and negative operating cash flows
to
date. Our management's plan to increase our cash flows from operations relies
significantly on increases in revenue generated from our technology services
and
products. However, there are no assurances that we will be successful in
effecting such increases. The market for distribution of broadband technology
services is highly competitive. Additionally, our capital requirements depend
on
numerous factors, including market acceptance of our technology and services,
research and development costs and the resources we spend on marketing and
selling our products and services. Additionally, we continue to evaluate
investments in complementary businesses, products and services, some of which
may be significant.
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
May
2008 the FASB has issued SFAS Statement No. 162,
The
Hierarchy of Generally Accepted Accounting Principles.
Statement 162 is intended to improve financial reporting by identifying a
consistent framework, or hierarchy, for selecting accounting principles to
be
used in preparing financial statements that are presented in conformity with
U.S. generally accepted accounting principles for nongovernmental entities.
SFAS
162 is effective 60 days following the SEC's approval of the PCAOB amendments
to
AU Section 411. The Company is currently evaluating the impact of adopting
SFAS
162 on its financial reporting
.
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:
|
·
|
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. Early application is encouraged. The Company is currently evaluating
the
impact of adopting SFAS 161 on its consolidated financial position and results
of operations.
Item
3.
Quantitative
and Qualitative Disclosures About Risk
The
Company does not currently have any material exposure to interest rate risk,
commodity price risk or other relevant market rate or price risks. However,
the
Company does have exposure to foreign currency rate fluctuations arising from
maintaining offices in the U.K. and Finland for its wholly-owned subsidiaries
which transact business in the local functional currency. The U.K. based
subsidiary does not conduct any sales and all its costs are funded in United
States dollars. The Finnish subsidiary conducts sales in both Euros and US
dollars and pays its employees and other material obligations in Euros, and
therefore can be substantially impacted by currency translation gains and
losses. To date, the Company has not entered into any derivative financial
instrument to manage foreign currency risk and is not currently evaluating
the
future use of any such financial instruments.
Item
4.
Controls
and Procedures
(a)
Overview.
In
connection with the restatement of the Company’s condensed consolidated
financial statements for the second and third quarters of 2007, the Company’s
management identified three material weaknesses in our internal control over
financial reporting and reported those to our Audit Committee. The material
weaknesses, detailed in the Company’s Annual Report on Form 10-K for the year
ended December 31, 2007, are:
|
·
|
Revenue
recognition procedures
–
Our controls were not adequate to ensure that revenue was properly
recognized when it was earned because we did not maintain effective
procedures for the consideration of the probability that revenue
is
collectible.
|
|
·
|
Control
environment
–
We did not maintain an effective control environment, specifically
relating to our tone at the top. This material weakness was evidenced
by
the control tone and control consciousness of our former Chief Executive
Officer and resulted in the override and the possibility of override
of
controls or interference with our policies, procedures and internal
control over financial reporting.
|
|
·
|
Allowance
for Doubtful Account Procedures
–
Effective controls were not designed and in place to ensure that
an
appropriate analysis of receivables from customers was conducted,
reviewed, approved and documented in order to identify and estimate
required allowance for doubtful accounts in accordance with generally
accepted accounting principles.
|
(b)
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 the company 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 company’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.
We
carried out an evaluation, under the supervision and with the participation
of
our Chief Executive Officer and our Chief Financial Officer, of the
effectiveness of the design and operation of our disclosure controls and
procedures pursuant to Rule 13a-15(b) of the Exchange Act. Based on that
evaluation, our Chief Executive Officer and our Chief Financial Officer
concluded that our disclosure controls and procedures were not effective as
of
the end of the period covered by this report.
(c)
Changes
in Internal Controls:
Except
as
noted below as part of our remediation initiatives, 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 September
30,
2008 that have
materially
affected,
or are reasonably likely to materially affect, our
internal
control
over financial reporting. However, as a result of our efforts beginning in
the
second quarter of 2008 to remediate the identified material weaknesses, we
have
taken certain steps set forth below to remediate the identified material
weaknesses and are in the process of finalizing a plan and timetable for the
implementation of additional remediation measures.
We
believe that the actions we have taken will significantly improve our internal
controls over financial reporting.
Remediation
Initiatives
To
improve our internal controls over financial reporting, we have taken the
following measures:
During
the second quarter of 2008, we took the following remedial steps to address
the
material weakness in internal controls relating to the maintenance of an
effective control environment tone at the top: (i) our Board of Directors sought
and on June 11, 2008, obtained the resignation of our former Chief Executive
Officer, Bill Joll, from all positions with us and our subsidiaries, including
as an officer, employee and director, although Mr. Joll served until September
30, 2008 as an advisor to the interim chief executive officer to effect a smooth
transition of customer relationships and business development opportunities;
(ii) on June 10, 2008, our Board of Directors appointed Matthew Frost, our
EVP, Legal and Business Affairs, as Interim Chief Executive Officer and Chief
Operating Officer; and (iii) we segregated the duties of our accounting
personnel from our non-accounting personnel other than those whose involvement
in accounting-related matters is specifically authorized. During the third
quarter of 2008, we took the additional remedial step of establishing an
independent third party ethics hotline so that employees can anonymously report
violations of our Code of Ethics and other employee concerns, and have
communicated the hotline process to our employees. In addition, prior to the
filing of this report, we took the following additional remedial steps with
regard to this material weakness: (i) our third party consultant on
Sarbanes-Oxley compliance conducted training for our Interim CEO, CFO, General
Counsel and other legal and accounting staff on corporate governance matters,
including corporate ethics, and revenue recognition; and (ii) we have revised
our Code of Ethics to emphasize the importance of adherence to our policies
and
procedures relating to accounting and financial reporting and internal control
of financial reporting and the availability of the ethics hotline for the
reporting of violations of our Code of Ethics and other employee
concerns.
With
regard to the identified material weakness in our revenue recognition
procedures, specifically our procedures for assessing whether the collectibility
of revenue is probable prior to recognition, we took the following remedial
steps during the second quarter of 2008: (i) we revised the process that we
and
our operating subsidiary will follow in assessing whether the collectibilty
of
revenue is probable, as well as in determining that the other requirements
for
recognizing revenue have been met, so that this assessment occurs at the outset
of the arrangement and is thereafter reviewed and confirmed in connection with
our period end closing and financial statement preparation process; and (ii)
we
revised, formalized and expanded the documentation of the procedures we and
our
operating subsidiaries will follow with respect to assessing probability of
collectibility, as well as determining that the other requirements for
recognizing revenue have been met; including, specifically, enhancing and
documenting our policy with respect to the types of information that can be
used
in establishing creditworthiness. In addition, prior to the filing of this
report, we took the following additional remedial steps with regard to this
material weakness: (i) our third party consultant on Sarbanes-Oxley compliance
conducted training for our Interim CEO, CFO, General Counsel and other legal
and
accounting staff on revenue recognition; and (ii) we have adopted and
communicated to our relevant staff a company policy setting forth acceptable
customer payment terms and their importance in revenue recognition.
In
addition, in the first quarter of 2008, we added a certified public accountant
to our accounting and financial reporting staff and during the third quarter
of
2008, we filled a newly-added position to our accounting staff. The addition
of
trained staff will both provide further assistance in the accounting department
and allow other members of the accounting staff to devote more time to
responsibilities connected with financial reporting.
With
respect to addressing the material weakness in the design and operation of
our
procedures for estimating our allowance for doubtful accounts, during the second
quarter of 2008, we enhanced, formalized and documented our procedures for
analyzing our accounts receivable from customers so that we can appropriately
estimate the collectibility of receivables at the end of a period based on
aging
categories and information related to collection efforts and formalized and
documented timely review of that information, and sign off on the recommended
allowance for doubtful accounts, by senior management. During the third quarter
of 2008, we implemented an accounting tool for use by our staff in quantifying
the amount of a reserve to be taken with respect to doubtful accounts and prior
to the filing of this report we communicated to our accounting staff the
Company’s policies governing the calculation and recording of bad debt expenses.
To
generally improve upon the quality of our financial reporting, we have
implemented additional remediation measures
that
improve
the
processes and procedures around the completion and review of quarterly
management representation letters
.
The
Audit
Committee has directed management to develop a detailed plan and timetable
for
the implementation of the foregoing remedial measures (to the extent not already
completed). The Audit Committee has approved our initial remediation efforts
and
the current timetable and will monitor the implementation. In addition, under
the direction of the Audit Committee, management will continue to review and
make necessary changes to the overall design of our internal control
environment, as well as policies and procedures to improve the overall
effectiveness of internal control over financial reporting. Our plan to
remediate the material weaknesses in our internal control over financial
reporting will be finalized and implemented as soon as reasonably practicable.
We intend to continue to review our procedures and test the effectiveness in
our
procedures on an on-going basis, whether through the use of third party
consultants or internal staff.
We
believe that the steps we have taken have significantly improved our internal
control over financial reporting. We are committed to remediating our material
weaknesses and, on an ongoing basis, repairing any internal control deficiencies
that we identify, whether or not they rise to the level of a material weakness.
We intend that, when finalized and fully implemented, our remediation measures
will address the identified material weaknesses and will strengthen our overall
internal control over financial reporting as well. We are committed to
continuing to improve our internal control processes and will continue to
diligently and vigorously review our financial reporting controls and
procedures. As we continue to evaluate and work to improve our internal control
over financial reporting, we may determine to take additional measures to
address control deficiencies or determine to modify, or in appropriate
circumstances not to complete, certain of the remediation measures described
above.
Remediation
generally requires making changes to how controls are designed and then adhering
to those changes for a sufficient period of time such that the effectiveness
of
those changes is demonstrated with an appropriate amount of consistency. As
of
the end of the third quarter, we have conducted preliminary testing of our
internal controls related to the material weaknesses. Final testing of our
internal controls to confirm that the identified material weaknesses have been
remediated is expected to be performed by the end of the fourth quarter.
PART
II — OTHER INFORMATION
Item
1.
Legal
Proceedings
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.
On2
believes this lawsuit is without merit and intends to vigorously defend itself
against Islandia’s complaint. As of September 30, 2008, the Company has not
recorded any provision associated with this complaint.
Beijing
E-World
On
March
31, 2006, On2 commenced arbitration against its customer, Beijing E-World,
relating to a dispute arising from two license agreements that On2 and Beijing
E-World entered into in June 2003.
Under
those agreements, On2 licensed the source code to its video compression (codec)
technology to Beijing E-World for use in Beijing E-World’s video disk (EVD) and
high definition television (HDTV) products as well as for other non-EVD/HDTV
products. We believe that the license agreements impose a number of obligations
on Beijing E-World, including the requirements that:
|
·
|
Beijing
E-World pay to On2 certain minimum quarterly payments; and
|
|
·
|
Beijing
E-World use best
reasonable
efforts to have On2’s video codec “ported” to (i.e., integrated with) a
chip to be used in EVD players.
|
On2
has
previously commenced arbitration regarding the license agreements with Beijing
E-World. In March 2005, the London Court of International Arbitration tribunal
released the decision of the arbitrator, in which he dismissed On2’s claims in
the prior arbitration, as well as Beijing E-World’s counterclaims, and ruled
that the license agreements remained in effect; and that the parties had a
continuing obligation to work towards porting On2’s software to two
commercially-available DSPs.
Although
a substantial amount of time has passed since the conclusion of the previous
arbitration, the parties have nevertheless not completed the required porting
of
On2’s software to two commercially available DSPs.
On2’s
current arbitration claim alleges that, despite its obligations under the
license agreements, Beijing E-World has:
|
·
|
failed
to pay On2 the quarterly payments of $1,232,000, which On2 believes
are
currently due and owing; and
|
|
·
|
failed
to use best reasonable efforts to have On2’s video codec ported to a chip.
|
On2
has
requested that the arbitrator award it approximately $5,690,000 in damages
under
the contract and grant it further relief as may be just and equitable.
Beijing
E-World has appeared in the arbitration, although it has not yet filed any
responses to On2’s filings in the proceeding. Following Beijing E-World’s
appearance, it entered into an agreement with On2 pursuant to which Beijing
E-World agreed by November 30, 2006 to pay On2 an amount in settlement equal
to
approximately 25% of the remaining unpaid portion of the license fees set forth
in the license agreements. Upon payment of the settlement payment, the parties
will terminate the arbitration, the license agreements will terminate, and
On2
will release Beijing E-World from all liability arising from the matters
underlying the arbitration. As of the date of filing, Beijing E-World has not
paid the amount agreed for settlement.
Item
1A. Risk Factors.
On2
has updated certain risk factors that it previously disclosed in its Form 10-K
for the year ended December 31, 2007. The updated risk factors are set forth
below.
Economic
conditions may make it more difficult for us to achieve our sales and revenue
projections.
The
economy in the US and internationally has deteriorated significantly during
2008. We may encounter difficulties in achieving sales if demand for our
products and services decreases as a result of the poor economy. For example,
our customers may reduce or defer purchases of our goods and services due to
economic pressures they encounter, and some of our customers’ businesses may
fail. Customers may also elect to develop products and services internally
rather than purchasing them from us. We may also be forced to reduce the amounts
we charge for our goods and services as competition becomes more intense in
a
tight market. Pressure on our customers may also result in their delaying
payments due to us as they attempt to manage their cash flows or cause them
to
default on payments that they owe us. Although we have taken economic factors
into consideration when making our internal sales and revenue projections,
if
economic conditions and the effect on our sales and collections are worse than
we have anticipated, we may be unable to meet our sales and revenue
expectations. In this case, we may suffer a material adverse affect on our
financial condition and results of operation.
A
lack of investment capital will make it more difficult for us to obtain from
third parties funds we may need to support our
operations.
We
are an
emerging company and have experienced significant operating losses and negative
cash flows to date. We have funded our operations with a series of equity
financing transactions, credit facilities and our operating revenue as we have
moved towards achieving profitability. Given the economic downturn, which has
become more acute during the latter part of 2008, investor appetite for equity
investments has been reduced, and investors who are willing to invest in
emerging companies may demand terms offering greater returns than they had
previously found acceptable. At the same time, credit markets have become more
stringent, with fewer lenders making fewer loans, with more restrictive terms.
Therefore, should we need further third party financing, it may not be available
to us on acceptable terms, or at all. Should this occur, our financial condition
and results of operation will likely be materially adversely
affected
.
Item
4. Submission of Matters to a Vote of Security Holders
On
September 23, 2008, we held our annual stockholders meeting at the Company’s
headquarters in Clifton Park, New York . Our stockholders re-elected our board
of directors and approved all proposals presented at the annual meeting. The
items considered and approved at the annual meeting are described in the proxy
statement dated August 27, 2008. The record date for the annual meeting was
August 1, 2008. The meeting was called for the purpose of considering the
following proposals:
|
1.
|
to
elect eight (8) directors to serve on our Board of Directors for
the term
commencing immediately following the Annual Meeting;
|
|
2.
|
to
ratify the Board of Directors’ appointment of Marcum & Kliegman LLP as
the Company’s independent registered public accounting firm for the fiscal
year ending December 31, 2008; and
|
|
3.
|
to
transact any business as may properly come before the meeting and
any
adjournments thereof.
|
J.
Allen
Kosowsky, Mike Alfant, Mike Kopetski, James Meyer, Afsaneh Naimollah, William
A.
Newman, Pekka Salonoja, and Thomas Weigman were nominated by the Board of
Directors for election to the Board of Directors at the annual meeting. All
of
the nominees were current directors and were elected at the last annual meeting
of stockholders.
The
votes
received on the above proposals, including a separate tabulation with respect
to
each director nominee, were as follows:
Proposal
1: Election of Directors
Director
|
|
For
|
|
%
For
|
|
Withheld
|
|
%
Withheld
|
|
J.
Allen Kosowsky
|
|
|
123,358,397
|
|
|
72.14%
|
|
|
16,327,458
|
|
|
9.55%
|
|
Mike
Alfant
|
|
|
124,984,208
|
|
|
73.09%
|
|
|
14,701,647
|
|
|
8.60%
|
|
Mike
Kopetski
|
|
|
123,810,911
|
|
|
72.41%
|
|
|
15,874,944
|
|
|
9.28%
|
|
James
Meyer
|
|
|
124,954,802
|
|
|
73.08%
|
|
|
14,731,053
|
|
|
8.62%
|
|
Afsaneh
Naimollah
|
|
|
124,860,615
|
|
|
73.02%
|
|
|
14,825,240
|
|
|
8.67%
|
|
William
A. Newman
|
|
|
123,864,580
|
|
|
72.44%
|
|
|
15,821,275
|
|
|
9.25%
|
|
Pekka
Solonoja
|
|
|
125,534,467
|
|
|
73.42%
|
|
|
14,151,388
|
|
|
8.28%
|
|
Thomas
Weigman
|
|
|
124,545,905
|
|
|
72.84%
|
|
|
15,139,950
|
|
|
8.85%
|
|
Proposal
2: Ratification of the Selection of Marcum & Kliegman as the Company’s
Independent Registered Public Accounting Firm
For
|
|
%
For
|
|
Against
|
|
%
Against
|
|
Witheld
|
|
%
Witheld
|
|
|
134,203,531
|
|
|
78.49%
|
|
|
2,512,104
|
|
|
1.47%
|
|
|
2,970,222
|
|
|
1.74
|
|
Proposal
3: Transact such other business as may properly come before the meeting and
any
adjournments thereof
For
|
|
%
For
|
|
Against
|
|
%
Against
|
|
Witheld
|
|
%
Witheld
|
|
|
126,331,380
|
|
|
73.88%
|
|
|
9,496,274
|
|
|
5.55%
|
|
|
3,858,204
|
|
|
2.26
|
|
Item
6. Exhibits.
10.1
Employment
Agreement, dated as of September 15, 2008, by and between the Company and Tim
Reusing
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.
SIGNATURES
In
accordance with the requirements of the Exchange Act, the registrant has caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
|
|
On2
Technologies, Inc.
|
November
7, 2008
|
|
(Registrant)
/s/
MATTHEW FROST
|
(Date)
|
|
(Signature)
Matthew
Frost
Interim
Chief Executive Officer
|
|
|
On2
Technologies, Inc.
|
November
7, 2008
|
|
(Registrant)
/s/
ANTHONY PRINCIPE
|
(Date)
|
|
(Signature)
Anthony
Principe
Senior
Vice President and Chief Financial Officer
(Principal
Financial Officer)
|
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