**UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWASHINGTON, DC 20549**

**FORM 10-QSB**

      ý                                   Quarterly report under Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly periodended June 30, 2004

       ̈                               Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

**COMMISSION FILE NO. 1-11602**

**NANO-PROPRIETARY, INC.**(Exact name of registrant as specified in its charter)

 

| **TEXAS**                       | **                           ** | **76-0273345**                       |
|---------------------------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------------------------------|
| (State or other jurisdiction of |                                                                                                                                                                   | (I.R.S. Employer Identification No.) |
| incorporation or organization)  |                                                                                                                                                                   |                                 |
|                            |                                                                                                                                                                   |                                 |

****

| **3006 Longhorn Blvd., Suite 107**       | **                                     ** | ** ** |
|------------------------------------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| **Austin, Texas**                        | ** **                                                                                                                                                                                                                         | **78758**  |
| (Address of principal executive offices) |                                                                                                                                                                                                                               | (Zip Code) |

| **(512) 339-5020**                                         |
|------------------------------------------------------------|
|                                                            |
| *(Registrant's telephone number, including area code)* |

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

|   | [X] |      Yes |             | [  ] |      No |
|--------|-----|-------------------------|--------------------------------------------------------------------|----------------|-----------------------------|

As of July 28, 2004, the registrant had 96,801,341 shares of common stock, par value $.001per share, issued and outstanding.

Transitional Small Business Disclosure Format.

Yes  [   ]  No  [X]

----

**NANO-PROPRIETARY, INC.INDEX**

| Part I.  Financial Information                                                        | **Page**                                                                                                                                                                                                                   |
|--------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                       |                                                                                                                                                                                                                       |   |   |
|                 | Item 1. Financial Statements                                                                                                                                                                                          |   |
|                                                                                       |                                                                                                                                                                                                                       |   |   |
|                                                                                       |                                                                                                                                                                                                                       | Consolidated BalanceSheets--June 30, 2004 and December 31, 2003 | 3 |
|                                                                                       |                                                                                                                                                                                                                       |   |   |
|                                                                                       |                                                                                                                                                                                                                       | Consolidated Statements of Operations--Three Months and Six Months Ended           June 30, 2004 and 2003 | 4 |
|                                                                                       |                                                                                                                                                                                                                       |   |   |
|                                                                                       |                                                                                                                                                                                                                       | Consolidated Statements of Cash Flows --Six Months Ended           June 30, 2004 and 2003 | 5 |
|                                                                                       |                                                                                                                                                                                                                       |   |   |
|                                                                                       |                                                                                                                                                                                                                       |   Notes  toConsolidated Financial Statements | 6 |
|                                                                                       |                                                                                                                                                                                                                       |   |   |
|                                                                                       | Item 2. Management’s Discussion and Analysis of FinancialCondition                      andResults of Operations | 8 |
|                                                                                       |                                                                                                                                                                                                                       |   |   |
|                                                                                       | Item 3. Controls and Procedures                                                                                                                                                                                       | 12 |
|                                                                                       |                                                                                                                                                                                                                       |   |   |
| Part II.  Other Information                                                           |                                                                                                                                                                                                                       |
|                                                                                       |                                                                                                                                                                                                                       |   |   |
|                                                                                       | Item 1.  Legal Proceedings                                                                                                                                                                                            | 13 |
|                                                                                       |                                                                                                                                                                                                                       |   |   |
|                                                                                       | Item 2. Changes in Securities and Small Business Issuer Purchases ofEquity Securities                                                                                                                                 | 13 |
|                                                                                       |                                                                                                                                                                                                                       |   |
|                                                                                       | Item 6.  Exhibits and Reports on Form 8-K                                                                                                                                                                        | 14 |
|                                                                                       |                                                                                                                                                                                                                       |   |   |
| Signatures                                                                                 | 15                                                                                                                                                                                                                         |

 

2
**PART I.  FINANCIAL INFORMATION**
**ITEM 1. FINANCIAL STATEMENTS**
**NANO-PROPRIETARY, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS**

**ASSETS**

 

**(Unaudited) June 30, 2004**
    
**December 31, 2003**

Current assets:

 

 

 

 

 

Cash and cash equivalents

$

2,387,436 

$

3,564,570 

 

Accounts receivable, trade – net of allowance for doubtful accounts

 

53,465 

 

41,132 

 

Prepaid expenses and other current assets

 

224,626 

 

100,201 

 

 

 

 

 

 

 

               Total current assets

 

2,665,527 

 

3,705,903 

 

 

 

 

 

 

 

Property and equipment, net

 

139,222 

 

77,314 

 

Other assets

 

800 

 

800 

 

               Total assets

$

2,805,549 

$

3,784,017 

 

 

 

 

 

 

 

**LIABILITIES AND STOCKHOLDERS’ EQUITY**

 

 

 

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

$

187,901 

$

126,809 

 

Obligations under capital lease

 

20,370 

 

19,380 

 

Accrued liabilities

 

63,136 

 

57,646 

 

 

 

 

 

 

 

               Total current liabilities

 

271,407 

 

203,835 

 

 

 

 

 

 

Obligations under capital lease

 

16,924 

 

27,353 

 

 

 

 

 

 

 Total Liabilities

 

 288,331 

 

231,188 

 

 

 

 

 

 

Commitments and contingencies

 

– 

 

–  

 

 

 

 

 

Stockholders' (deficit):

 

 

 

 

     Preferred stock, $1.00 par value, 2,000,000 sharesauthorized;             No shares issued and outstanding

 

– 

 

–  

     Common stock, $.00l par value, 120,000,000 sharesauthorized,             96,701,341 and 95,612,990 shares issued and outstandingat             June 30, 2004 and December 31, 2003,respectively

 

96,701 

 

95,613 

Additional paid-in capital

 

80,257,076 

 

78,918,605 

Accumulated deficit

 

(77,836,559)

 

(75,461,389)

 

 

 

 

 

               Total stockholders equity

 

2,517,218 

 

3,552,829

 

 

 

 

 

               Total liabilities and stockholders equity

$

2,805,549 

$

3,784,017 

 See notes to consolidated financial statements.

3
**NANO-PROPRIETARY, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONS(UNAUDITED)**

 

 

**For the Three MonthsEnded June 30,**

 

 

**For  the Six MonthsEnded June 30,**

 

 

**2004**
  
**2003**
  
**2004**
  
**2003**

Revenues

 

 

 

 

 

 

 

 

 

 

 

 

Government contracts

$

65,798 

 

$

156,325 

 

$

131,678 

 

$

166,712 

 

Privately funded research

 

– 

 

 

– 

 

 

– 

 

 

400,000 

 

Royalties

 

– 

 

 

– 

 

 

– 

 

 

920 

 

Other

 

34,920 

 

 

4,055 

 

 

46,698 

 

 

37,200 

 

          Total Revenues

 

100,718 

 

 

160,380 

 

 

178,376 

 

 

604,832 

 

 

 

 

 

 

 

 

 

 

 

 

 

Research and development

 

529,812 

 

 

421,546 

 

 

1,281,407 

 

 

780,937 

Selling, general and administrative expenses

 

340,107 

 

 

420,167 

 

 

784,032 

 

 

854,752 

Royalty expense

 

500,000 

 

 

–  

 

 

500,000 

 

 

400,000 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating costs and expenses

 

1,369,919 

 

 

841,713 

 

 

2,565,439 

 

 

2,035,689 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loss from operations

 

(1,269,201)

 

 

(681,333)

 

 

(2,387,063)

 

 

(1,430,857)

 

 

 

 

 

 

 

 

 

 

 

 

 

Other income (expense), net

 

 

 

 

 

 

 

 

 

 

 

 

Interest Expense

 

(1,097)

 

 

(15,387)

 

 

(2,269)

 

 

(41,527)
 
Interest Income
 
6,769 
  
664 
  
14,037 
  
664 

 

Other

 

– 

 

 

– 

 

 

125 

 

 

4,695 

 

 

 

 

 

 

 

 

 

 

 

 

 

 Loss from continuing operations before taxes

 

(1,263,529)

 

 

(696,056)

 

 

(2,375,170)

 

 

(1,467,025)

 

 

 

 

 

 

 

 

 

 

 

 

 

 Provision for taxes

 

 – 

 

 

 – 
 
 

 – 

 

 

 – 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

$

(1,263,529)

 

$

(696,056)

 

$

(2,375,170)

 

$

(1,467,025)
 
 

 

 

 

 

 

 

 

 

 

 

Loss per share
           
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic and Diluted

 

 

$

(0.01)

 

$

(0.01)

 

$

(0.02)

 

$

(0.02)
 
 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding
           
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic and Diluted

 

 

 

96,536,111 

 

 

85,552,973 

 

 

96,273,901 

 

 

82,661,901

See notes to consolidated financial statements.

4
**NANO-PROPRIETARY, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS(UNAUDITED)**

 

**For  the Six Months Ended June 30,**

 

**2004**

 
 
**2003**

Cash flows from operating activities:

 

 

 
 
 

 

Net loss

 

 

$

(2,375,170)

$

(1,467,025)

 

 

Adjustments to reconcile net loss to net

 

 

 

 

 

 

 

cash used in operating activities:

 

 

 

 

 

 

 

Depreciation and amortization expense

 

25,739 

 

22,516 
   
Gain on sale of fixed assets
 
(125)
 
– 

 

 

 

Options issued for services

 

116,600 

 

– 

 

 

 

Non-cash variable option pricing expense

 

(341,250)

 

– 

 

 

 

Common shares issued for patent option

 

– 

 

13,636 

 

 

 

Changes in assets and liabilities:

 

 

 

 

 

 

 

 

     Accounts receivable, trade

 

(12,333)

 

(8,165)

 

 

 

 

     Prepaid expenses and other current assets

 

 (124,425)

 

 (58,269)

 

 

 

 

     Accounts payable and accrued liabilities

 

66,582 

 

(270,516)

 

 

 

 

 

 

 

 

 

 

 

 

 

Total adjustments

 

(269,212)

 

(300,798)

 

 

 

 

 

 

 

 

 

 

 

 

Net cash used in operating activities

 

(2,644,382)

 

(1,767,823)

 

 

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

 

Capital expenditures

 

 

(87,647)

 

– 

 

 

Proceeds from sale of fixed assets

 

125 

 

– 

 

 

       Net cash used in investing activities

 

(87,522)

 

  – 

 

 

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

 

Repayment of notes payable

 

(9,439)

 

(34,769)

 

 

Proceeds of stock issuance, net of costs

 

1,564,209 

 

2,805,666 

 

 

 

 

 

 

 

 

 

 

 

       Net cash provided by financingactivities

 

1,554,770 

 

2,770,897 

 

 

 

 

 

 

 

 

 

Net increase (decrease) in cash and cash equivalents

 

(1,177,134)

 

1,003,074 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents, beginning of period

 

3,564,570 

 

15,868 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents, end of period

$

2,387,436 

 

$

1,018,942 

See notes to consolidated financial statements.

5
**NANO-PROPRIETARY, INC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS(UNAUDITED)**

 

1.       Basis of Presentation

Theconsolidated financial statements for the three and six month periods ended June30, 2004 and 2003 have been prepared by us without audit pursuant to the rulesand regulations of the Securities and Exchange Commission. In the opinion ofmanagement, all adjustments necessary to present fairly our financial position,results of operations, and cash flows as of June 30, 2004 and 2003, and for theperiods then ended, have been made. Those adjustments consist of normal andrecurring adjustments. The consolidated balance sheet as of December 31, 2003,has been derived from the audited consolidated balance sheet as of that date.

Certaininformation and note disclosures normally included in our annual financialstatements prepared in accordance with generally accepted accounting principleshave been condensed or omitted. These consolidated financial statements shouldbe read in conjunction with a reading of the financial statements and notesthereto included in our Annual Report on Form 10-KSB for the fiscal year endedDecember 31, 2003, as filed with the U.S.  Securities and ExchangeCommission.

The results ofoperations for the three and six month periods ended June 30, 2004, are notnecessarily indicative of the results to be expected for the full year.

2.       Supplemental Cash Flow Information

Cash paid forinterest for the six months ended June 30, 2004 and 2003, was $2,269 and $1,554,respectively. During the six months ended June 30, 2004, we had non-cashtransactions related to variable option pricing and options issued to aconsultant. During the six months ended June 30, 2003, we had non-cashtransactions related to the conversion of notes payable, including relatedaccrued interest, into shares of the our common stock, as well as the payment ofcertain accounts payable and accrued expenses with common stock. Thesetransactions are described in greater detail in Note 3.

3.       Stockholders’ Equity

In the sixmonths ended June 30, 2004, we issued 401,887 restricted shares of our commonstock and received net proceeds of $1,065,000 in an exempt offering underRegulation D of the Securities Act of 1933.  We issued 666,464 shares ofour common stock and received $480,819 in connection with the exercise ofemployee stock options, primarily by former employees, and issued 20,000 sharesand received $18,400 in connection with the exercise of warrants.

In April 2001, we repriced a total of 900,500 options to lower the exercise price of these options to $1.50, which wasapproximately 160% of the market price of the stock at the time of the repricing. The repricing of these options resulted in a newmeasurement date for accounting purposes and reclassification of these options as variable plan awards beginning on the date of therepricing. We previously accounted for these option grants as fixed plan awards. In 2003, our common stock price exceeded theexercise price for the first time since the repricing and remained above it, closing at $2.73 per share on December 31, 2003. Werecorded $749,755 in non-cash option expense for the cumulative effects of the repricing and increased additional paid-in capitalby the same amount in 2003. During the six months ended June 30, 2004, the price of our common stock declined and closed at $2.03on June 30, 2004. We reversed $341,250 of the previously recorded expense in the six months ended June 30, 2004, as a result ofthis price decline.

In the sixmonths ended June 30, 2004, we issued 100,000 options to a consultant with anexercise price of $3.08 per share. In connection with the options, we recorded$116,600 as an expense during the period.

In the sixmonths ended June 30, 2003, we issued 6,271,803 restricted shares of our commonstock and received net proceeds of $2,604,250 in exempt offerings underRegulation D of the Securities Act of 1933.  We issued 309,745  sharesof our common stock and received $201,416 in connection with the exercise ofemployee stock options. We also issued 3,483,746 shares of common stock inconnection with the payment of convertible notes payable and related accruedinterest. The face amount of the notes was $600,000 and the related accruedinterest totaled $105,863. We also issued 100,000 shares valued at $237,782 inconnection with the payment of accounts payable and 71,021 shares valued at$13,636 in connection with a patent extension.

6
**NANO-PROPRIETARY, INC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS(UNAUDITED)**

4.       Contingencies

*Litigation*

We are adefendant in minor lawsuits described in greater detail in our  2003 annualreport on Form 10-KSB. We expect any potential eventual payment to have nomaterial affect on the financial statements.

5.       Business Segments

Following is information related to our business segments for the six months ended June30, 2004 and 2003:

 

 

ANI
 
EBT
 
All Other
 
Total

2004

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

178,376 

 

$

 - 

 

$

 - 

 

$

178,376 

 

 

 

 

 

 

 

 

 

Profit (Loss)

 

(2,290,539)

 

121,497

 

(206,128)

 

(2,375,170)

 

 

 

 

 

 

 

 

 

Expenditures for

 

 

 

 

 

 

 

 

     long-lived assets

 

85,274  

 

- 

 

2,373 

 

87,647 

 

 

 

 

 

 

 

 

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$ 

604,832

 

    $

- 

 

$

-  

 

$

604,832 

 

 

 

 

 

 

 

 

 

Profit (Loss)

 

(1,075,085)

 

7,634

 

  (399,574)

 

(1,467,025)

 

 

 

 

 

 

 

 

 

Expenditures for

 

 

 

 

 

 

 

 

     long-lived assets

 

- 

 

- 

 

-

 

- 

6.       Subsequent Events

For the periodfrom July 1, 2004 through July 28, 2004, we issued a total of 100,000 shares ofcommon stock, and received proceeds of $50,000, in connection with the exerciseof options under our stock option plans by a terminated employee. These optionshad an expiration date of August 31, 2004.

7.       Recently Issued AccountingStandards

There are no recent accountingpronouncements that we have not implemented that are expected to have a materialimpact on our financial statements.

7
**ITEM 2:  MANAGEMENT'SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTSOF OPERATIONS**

The following is management’s discussion and analysis of certain significant factorsthat have affected our financial position and operating results during the periods included in the accompanying consolidatedfinancial statements.

**FORWARD-LOOKING STATEMENTS**

This Form10-QSB contains certain forward-looking statements that we believe are withinthe meaning of Section 27A of the Securities Act of 1933 and Section 21E of theSecurities Exchange Act of 1934, which are intended to be covered by the safeharbors created by such acts. For this purpose, any statements that are notstatements of historical fact may be deemed to be forward-looking statements,including the statements under "Management's Discussion and Analysis ofFinancial Condition and Results of Operations" regarding our strategy, futureoperations, future expectations or future estimates, financial position andobjectives of management. Those statements in this Form 10-QSB containing thewords "believes," "anticipates," "plans," "expects" and similar expressionsconstitute forward-looking statements, although not all forward-lookingstatements contain such identifying words. These forward-looking statements arebased on our current expectations and are subject to a number of risks,uncertainties and assumptions relating to our operations, results of operations,competitive factors, shifts in market demand and other risks and uncertainties.

Although webelieve that the assumptions underlying our forward-looking statements arereasonable, any of the assumptions could be inaccurate and actual results maydiffer from those indicated by the forward-looking statements included in thisForm 10-QSB.  In light of the significant uncertainties inherent in theforward-looking statements included in this Form 10-QSB, you should not considerthe inclusion of such information as a representation by us or anyone else thatwe will achieve such results. Moreover, we assume no obligation to update theseforward-looking statements to reflect actual results, changes in assumptions orchanges in other factors affecting such forward-looking statements.

**Six months ended June 30, 2004 and 2003**

**OVERVIEW**

During the six months ended June 30, 2004, our primary revenues were earned as a result ofreimbursed research expenditures at our Applied Nanotech, Inc. (“ANI”) subsidiary. We continued to incur substantialexpenses in support of the development of our proprietary Carbon Nanotube Based Field Emission (“CFE”) Technology andother Carbon Nanotube Based Technologies. As more fully discussed in our Annual Report on Form 10-KSB for the year ended December31, 2003, we expect to incur additional research and development expenses throughout 2004 in developing our CFE technology. We arefocused on licensing our technology and obtaining sufficient revenue to cover our ongoing research expenditures.

**OUTLOOK**

 We expect our present cashbalances of approximately $2.2 million as of the date of this filing, when combined with expected revenue sources, to enable us tooperate at least through 2004 and into the 1st quarter of 2005.  We expect to achieve at least break-even in 2004.In order to achieve break-even, we will have to receive significant license or other revenues in the last half of 2004. There canbe no assurance that we will achieve profitability, or even break-even, in the future.  To the extent our revenues do notallow us to break-even, or if the timing of revenues does not match with expenses, we could be required to raise additional fundsthrough the issuance of debt or equity securities to enable us to maintain operations at the present level. The mix of revenuesreceived could also cause the revenues required to break-even to increase. If revenue producing projects require unanticipatedexpenses, or heavier than anticipated use of outside services or materials, we may be unable to achieve profitability at theexpected level of revenues.

We havedeveloped a plan to allow ourselves to maintain operations until we are able tosustain ourselves on our own revenue. Our plan is primarily dependent on raisingfunds through the licensing of our technology and reimbursed research contracts.Our current cash of approximately $2.2 million as of the date of this filing issufficient to allow us to maintain operations through at least the end of 2004and into the first quarter of 2005. We expect additional revenue producingprojects or license agreements to be finalized during that time period. Webelieve that we have the ability to continue to raise funding, if necessary, toenable us to continue operations until our plan can be completed.

8
**ITEM 2:  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTSOF OPERATIONS (cont.)**

** **

This plan isbased on current development plans, current operating plans, the currentregulatory environment, historical experience in the development of electronicproducts and general economic conditions. Changes could occur which would causecertain assumptions on which this plan is based to be no longer valid. Althoughwe do not expect funding our operations to be a problem, if adequate funds arenot available from operations, or additional sources of financing, we may haveto eliminate, or reduce substantially, expenditures for research anddevelopment, testing and production of its products, or obtain funds througharrangements with other entities that may require us to relinquish rights tocertain of its technologies or products. Such results would materially andadversely affect us.

 

 **RECENT DEVELOPMENTS**

Wecompleted a private placement of shares of our common stock in February 2004. As a result of this private placement weissued 401,887 shares of our common stock in exchange for gross proceeds of $1,065,000.  Expenses associated with this transaction were negligible. We expect that the proceeds of this transaction, whencombined with our existing cash balances and expected revenues, will enable us to operate at least through the end of 2004 and intothe 1st quarter of 2005.

In February 2004, our independent auditors, Sprouse & Anderson, L.L.P., completed their audit and issued an unqualifiedopinion on our financial statements for the fiscal year ended December 31, 2003.The previous year’saudit opinion from Sprouse & Anderson, L.L.P, was a qualified opinion that expressed doubt about the Company’s ability tocontinue as a going concern. As a result of our improved financial condition, Sprouse & Anderson, L.L.P. was able to removetheir going concern qualification.

In June 2004, ourApplied Nanotech, Inc. subsidiary entered into a strategic partnership with SouthWest Nano Technologies, Inc., a technologyspin-off from the University of Oklahoma and ConocoPhillips. Under the terms of the agreement, ANI will acquire high-quality singlewall carbon nanotubes from SWeNT and represent SWeNT on a non-exclusive basis in Asia. The companies will also jointly apply for aPhase II SBIR grant to produce a high quality, high resolution color CNT TV using SWeNT’s proprietary single wall carbonnanotubes and ANI’s patented technology.

In July 2004, ANIentered into an exclusive development, purchase, and license agreement related to its hydrogen sensor products with aninternational company that specializes in the design, measurement, analysis, and development of electrical measuring equipment. Theagreement is exclusive for the measurement of hydrogen in power transformers, tap changers, and breakers. ANI will providepre-production design, development, and engineering work, as well as sell the hydrogen sensors to be used in the final product. Thepurchaser will pay a royalty of 10% of the sales of the products containing the hydrogen sensors. To maintain exclusivity, thepurchaser must pay minimum royalties of $55,100 annually beginning October 1, 2004 and increasing each year to a level of$1,000,000 in the fourth year. The purchaser can elect to avoid the minimum royalty payment by terminating the exclusivity portionof the contract prior to each year, beginning with the first year starting October 1, 2004.

 

**RECENT ACCOUNTING PRONOUNCEMENTS**

There are no recent accounting pronouncements that we have not implemented that areexpected to have a material impact on our financial statements.

 

 

9
**ITEM 2:  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTSOF OPERATIONS (cont.)**

**RESULTS OF OPERATIONS**

Our quarterlyloss for the second quarter ended June 30, 2004 was $1,263,529 as compared withthe loss of $696,056 for the same period last year. The biggest single factor inthis increased loss was the $500,000 minimum royalty payment made in the quarterended June 30, 2004. No similar payment was included in the quarter ended June30, 2003. Our loss of $2,375,170 for the six months ended June 30, 2004 wasapproximately 60% higher than the loss for the six months ended June 30, 2003.This increased loss was primarily the result of decreased revenue and increasedspending on research and development. We expect our quarterly loss to besubstantially reduced in the third quarter and we expect to be profitable in thefourth quarter as the result of revenue from expected license agreements.

Our revenues for the quarterended June 30, 2004 totaled $100,718 compared to $160,380 for the same quarter of 2003. For the six-month period ended June 30,2004 (the “2004 Period”), our revenues were $178,376 as compared with $604,832 for the six-month period ended June 30,2003 (the “2003 Period”). The revenues in both periods were all from ANI and substantially all the result of reimbursedresearch expenditures. The major difference between the two periods is that the 2003 Period included $400,000 of revenue related tothe completion of a major research contract with a large Japanese display manufacturer. During the 2004 Period, $131,678 of therevenue came from government contracts and $46,698 came from other miscellaneous sources. During the 2003 Period, $166,712 of therevenue came from government contracts and $38,120 came from other miscellaneous sources. At the present stage of our development,significant conclusions can’t be drawn from comparing revenues from period to period. Our business strategy is built ondeveloping a royalty stream from licensing our intellectual property. To supplement this, we also seek funding from bothgovernmental and private sources to help fund our research. Until we are able to develop a steady revenue stream from royalties,our revenues will tend to fluctuate greatly from quarter to quarter. Our private research funding tends to come in large amounts atsporadic times.

We have onegovernment program in progress at June 30, 2004, and we have a revenue backlogof $303,223 related to that contract. We had a total revenue backlog ofapproximately $575,459 as of June 30, 2003, all of which related to the samegovernment contract. Our ability to perform continued research, or fulfill ourbacklog, should not require significant additional personnel.

We incurred research anddevelopment expenses of $1,281,407 for  the 2004 Period, which was a substantial increase from the $780,937 incurred in the2003 Period. One reason for this significant increase is the spending on our 14-inch and 25-inch prototypes of our colorhigh-definition CNT based flat screen TVs. We spent in excess of $425,000 on these prototypes in the six months ended June 30,2004. In addition, we have had significant spending related to our biosensor development.. We expect total research and developmentexpense to decline in the final two quarters of the year. The 14-inch prototype was basically completed in the 2ndquarter of 2004, although some packaging remains, and the 25-inch prototype is expected to be completed in the 3rdquarter of 2004.

Our  selling, general, and administrativeexpenses were $784,032 for the 2004 Period, compared with $854,752 for the 2003 Period. While the selling, general, andadministrative expenses were decreased in total, the 2004 period was impacted by a non-cash item in the amount of $341,250 relatedto variable options pricing. In April 2001, we repriced a total of 900,500 options to lower the exercise price of these options to$1.50, which was approximately 160% of the market price of the stock at the time of the repricing. The repricing of these optionsresulted in a new measurement date for accounting purposes and reclassification of these options as variable plan awards beginningon the date of the repricing. The Company previously accounted for these option grants as fixed plan awards. In 2003, our commonstock price exceeded the exercise price for the first time since the repricing and remained above it, closing at $2.73 per share onDecember 31, 2003. The Company recorded $749,755 in non-cash option expense for the cumulative effects of the repricing andincreased additional paid in capital by the same amount in 2003.

During the sixmonths ended June 30, 2004, the price of our common stock declined and closed at$2.03 on June 30, 2004. We reversed $341,250 of the previously recorded expensein the six months ended June 30, 2004, as a result of this price decline. Therewas no similar charge or reduction in 2003. Offsetting a substantial portion ofthe reduction in costs in the 2004 Period related to the variable option pricingwas a charge of $116,600 related to the value of options issued to a consultantin the six months ended June 30, 2004.

10
**ITEM 2:  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTSOF OPERATIONS (cont.)**

Ourroyalty expense was $500,000 in the 2004 Period as compared with $400,000 in the 2003 Period. The royalty expense results fromminimum payments due in connection with our Keesman patent license. No furtherfuture minimum royalty payments are due under this agreement, and we expectroyalty expense in future periods to be highly correlated with royalty income.

Our interest expense decreased substantially in the 2004 Period because virtually all debtwas paid or converted to equity in 2003. Our only remaining interest expense relates to capital leases. We had interest income in2004 as a result of the investment of excess funds in short term interest bearing instruments, primarily certificates of deposit,commercial paper, and money market funds

**FINANCIAL CONDITION AND LIQUIDITY**

Our cashposition decreased by $1,177,134 during the 2004 Period. At June 30, 2004, wehad cash and cash equivalents in the amount of $2,387,436 as compared with cashand cash equivalents of $3,564,570 at December 31, 2003.  This decrease incash is primarily the result of cash used in operating activities, offset bycash provided by financing activities. The cash used in operations was primarilythe result of our net operating loss for the period. The cash used in operatingactivities during the 2004 Period of $2,644,382 was higher than the $1,767,823used in the 2003 Period for the same reasons previously discussed that the lossin the 2004 Period increased.

As described ingreater detail in the notes to the financial statements, we received netproceeds of $1,564,209 from the issuance of common stock related to privateplacements and option exercises during the 2004 Period, as compared with$2,805,666 from the issuance of common stock during the 2003 Period.  Wehave raised less money during the 2004 Period than we did in the 2003 Periodbecause we expect to sign license agreements later this year that may precludethe need for further fund-raising.

We used netcash of $87,522 for investing activities in the 2004 Period related to thepurchase of leasehold improvements and equipment as, compared with no cash usedfor investing activities in the 2003 Period.

The principalsource of our liquidity has been funds received from exempt offerings of commonand preferred stock. In the event that we need additional funds, we may seek tosell additional debt or equity securities. While we expect to be able to obtainany funds needed for operations, there can be no assurance that any of thesefinancing alternatives can be arranged on commercially acceptable terms. Webelieve that our success in reaching profitability will be dependent on ourpatent portfolio and upon the viability of products using our technology andtheir acceptance in the marketplace, as well as our ability to obtain additionaldebt or equity financings in the future, if needed.

We expect tocontinue to incur substantial expenses for research and development ("R&D"). Further, we believe that certain products that may be developed bypotential licensees of our technology may not be available for commercial saleor routine use for a period of one to two years. Others are expected to beavailable in 2004. While we would likely receive initial license payments,ongoing royalty streams related to those licenses will not be available untilpotential licensees have introduced products using our technology. Therefore, itis possible that the commercialization of our existing and proposed products mayrequire additional capital in excess of our current funding. We do, however,expect to at least break-even in 2004 based on the receipt of research fundingand other revenues. Achievement of at least break-even would enable us tocontinue our research without seeking additional debt or equity financing.

Because thetiming and receipt of revenues from the license or royalty agreements will betied to the achievement of certain product development, testing and marketingobjectives, which cannot be predicted with certainty, there may be substantialfluctuations in our results of operations. If revenues do not increase asrapidly as anticipated, or if product development and testing require morefunding than anticipated, we may be required to curtail our operations or seekadditional financing from other sources. The combined effect of the foregoingmay prevent us from achieving sustained profitability for an extended period oftime.

11 
**ITEM 3.       CONTROLSAND PROCEDURES**

Under thesupervision and with the participation of our management, including ourprincipal executive officer and principal financial officer, we conducted anevaluation of the effectiveness of the design and operation of our disclosurecontrols and procedures, as defined in Rules 13a-14(c) and 15d-14(c) under theSecurities Exchange Act of 1934, within 90 days of the filing date of thisreport (the "Evaluation Date"). Based upon this evaluation, our principalexecutive officer and principal financial officer concluded as of the EvaluationDate that our disclosure controls and procedures were effective such that thematerial information required to the included in our Securities and ExchangeCommission ("SEC") reports is recorded, processed, summarized, and reportedwithin the time periods specified in SEC rules and forms relating to theCompany, including, our consolidated subsidiaries, and was made known to them byothers within those entities, particularly during the period when this reportwas being prepared.

In addition,there were no significant changes in our internal controls or in other factorsthat could significantly affect these controls subsequent to the EvaluationDate. We have not identified any significant deficiencies or material weaknessesin our internal controls, and therefore, there were no corrective actions taken.
 
12
**PART II.  OTHER INFORMATION**

ITEM 1.  LEGAL PROCEEDINGS

None

ITEM 2.  CHANGES IN SECURITIES AND SMALL BUSINESS ISSUER PURCHASES OF EQUITYSECURITIES

From January 1, 2004 through June 30, 2004, in a series of privateplacements only to accredited investors under Rule 506 of Regulation D of theSecurities Act of 1933, we issued a total of 401,887 shares of our common stockin exchange for $1,065,000. These shares were issued at a slight discount to themarket price of our common stock at the time of issuance. The Company filed aregistration statement in May 2004 to register these shares. Following is alisting of those shares:

 

                   

Common shares

Shareholder

 

issued

 

 

 

Karrison Nichols

 

301,887

Southwell Partners

 

100,000

 

 
 
13
ITEM 6.     EXHIBITS AND REPORTS ONFORM 8-K

       (a)     Exhibits: SeeIndex to Exhibits on page 16 for a descriptive response to this item.

       (b)     Reports on Form8-K:

None
 
 

 

 

 

14
 

**SIGNATURES**

Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registranthas duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

NANO-PROPRIETARY, INC. (Registrant)

  

 

Date:     July 30, 2004

     /s/ Marc W.Eller                                  Marc W. Eller Chairman and Chief Executive Officer (Principal Executive Officer)

  

 

Date:     July 30, 2004

     /s/ Douglas P.Baker                                  Douglas P. Baker Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer)

 

15
**INDEX TO EXHIBITS**

The following documents are filed as part of this Report:

Exhibit
   
10.1

Strategic Partnership agreement with SouthWest Nanotechnologies, Inc.
 
11

Computation of (Loss) Per Common Share

  

 

31.1

Section 302 Certificate of Marc W. Eller

 

 

31.2

Section 302 Certificate of Douglas P. Baker

 

 

32.1

Section 906 Certificate of Marc W. Eller

 

 

32.2

Section 906 Certificate of Douglas P. Baker