Table of Contents

**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 period endedSeptember 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 theregistrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.

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

As of October 27, 2004, the registrant had 96,977,591 shares of common stock, par value$.001 per 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 Balance Sheets--September 30, 2004 and December 31,2003 | 3 |
|                               |                                                                                                                                                                                                                     |   |   |
|                               |                                                                                                                                                                                                                     |  Consolidated Statements of Operations--Three Months and Nine Months Ended           September 30, 2004 and 2003 | 4 |
|                               |                                                                                                                                                                                                                     |   |   |
|                               |                                                                                                                                                                                                                     |  Consolidated Statements of Cash Flows --Nine Months Ended           September 30, 2004 and 2003 | 5 |
|                               |                                                                                                                                                                                                                     |   |   |
|                               |                                                                                                                                                                                                                     | Notes to Consolidated Financial Statements | 6 |
|                               |                                                                                                                                                                                                                     |   |   |
|                               | Item 2.Management’s Discussion and Analysisof FinancialCondition                      andResults of Operations | 8 |
|                               |                                                                                                                                                                                                                     |   |   |
|                               | Item 3. Controls and Procedures                                                                                                                                                                                     | 12 |
|                               |                                                                                                                                                                                                                     |   |   |
| Part II. Other Information    |                                                                                                                                                                                                                     |
|                               |                                                                                                                                                                                                                     |   |   |
|                               | Item 1.  Legal Proceedings                                                                                                                                                                                          | 13 |
|                               |                                                                                                                                                                                                                     |   |   |
|                               | Item 6.  Exhibits                                                                                                                                                                                              | 14 |
|                               |                                                                                                                                                                                                                     |   |   |
| Signatures                         | 15                                                                                                                                                                                                                       |

2

----

**PART I. FINANCIAL INFORMATION**

### **ITEM 1. FINANCIAL STATEMENTS**

**NANO-PROPRIETARY, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS**

| **ASSETS**                                                                                                                                                                                                                                                                                                                                                 |                                                                                                                | **(Unaudited) September 30, 2004** |         | **December 31, 2003** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------|------------------------------------|--------------------------------------------|-----------------------|
| Current assets:                                                                                                                                                                                                                                                                                                                                            |                                                                                                                |                               |                                       |                  |
|                                                                                                                                                                                                                                                                                                                                                       | Cash and cash equivalents                                                                                           |  $                            | 1,501,892                             | $                     | 3,564,570  |
|                                                                                                                                                                                                                                                                                                                                                       | Accounts receivable, trade – net of allowance for doubtful accounts                                           |                               | 61,263                                |                  | 41,132  |
|                                                                                                                                                                                                                                                                                                                                                       | Prepaid expenses and other current assets                                                                           |                               | 171,434                               |                  | 100,201  |
|                                                                                                                                                                                                                                                                                                                                                       |                                                                                                                |                               |                                       |                  |   |
|                                                                                                                                                                                                                                                                                                                                                       |                Total current assets      |                               | 1,734,589                             |                  | 3,705,903  |
|                                                                                                                                                                                                                                                                                                                                                       |                                                                                                                |                               |                                       |                  |   |
|                                                                                                                                                                                                                                                                                                                                                       | Property and equipment, net                                                                                         |                               | 133,781                               |                  | 77,314  |
|                                                                                                                                                                                                                                                                                                                                                       | Other assets                                                                                                        |                               | 800                                   |                  | 800  |
|                                                                                                                                                                                                                                                                                                                                                       |                Total assets              | $                                  | 1,869,170                             | $                     | 3,784,017  |
|                                                                                                                                                                                                                                                                                                                                                       |                                                                                                                |                               |                                       |                  |   |
|                                                                                                                                                                                                                                                                                                                                                       | **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                      |                               |                                       |                  |   |
|                                                                                                                                                                                                                                                                                                                                                       |                                                                                                                |                               |                                       |                  |   |
| Current liabilities:                                                                                                                                                                                                                                                                                                                                       |                                                                                                                |                               |                                       |                  |
|                                                                                                                                                                                                                                                                                                                                                       | Accounts payable                                                                                                    | $                                  | 239,756                               | $                     | 126,809  |
|                                                                                                                                                                                                                                                                                                                                                       | Obligations under capital lease                                                                                     |                               | 20,883                                |                  | 19,380  |
|                                                                                                                                                                                                                                                                                                                                                       | Accrued liabilities                                                                                                 |                               | 59,884                                |                  | 57,646  |
|                                                                                                                                                                                                                                                                                                                                                       |                                                                                                                |                               |                                       |                  |   |
|                                                                                                                                                                                                                                                                                                                                                       |                Total current liabilities |                               | 320,523                               |                  | 203,835  |
|                                                                                                                                                                                                                                                                                                                                                       |                                                                                                                |                               |                                       |                  |   |
| Obligations under capital lease                                                                                                                                                                                                                                                                                                                            |                                                                                                                | 11,513                        |                                       | 27,353           |
|                                                                                                                                                                                                                                                                                                                                                       |                                                                                                                |                               |                                       |                  |   |
|  Total Liabilities                                                                                                                                                                                                                                                                                                                                    |                                                                                                                |  332,036                 |                                       | 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,             96,834,341 and 95,612,990 shares issued and outstandingat             September 30, 2004 and December 31, 2003,respectively |                                                                                                                | 96,834                        |                                       | 95,613           |
| Additional paid-in capital                                                                                                                                                                                                                                                                                                                                 |                                                                                                                | 80,377,393                    |                                       | 78,918,605       |
| Accumulated deficit                                                                                                                                                                                                                                                                                                                                        |                                                                                                                | (78,937,093)                       |                                       | (75,461,389)          |
|                                                                                                                                                                                                                                                                                                                                                       |                                                                                                                |                               |                                       |                  |
|                Total stockholders equity                                                                                                                                                                                                                                        |                                                                                                                | 1,537,134                     |                                       | 3,552,829             |
|                                                                                                                                                                                                                                                                                                                                                       |                                                                                                                |                               |                                       |                  |
|                Total liabilities and stockholders equity                                                                                                                                                                                                                        | $                                                                                                                   | 1,869,170                     | $                                          | 3,784,017        |

 See notes to consolidated financial statements.

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

 

 

**For the Three MonthsEnded September 30,**

 

 

**For  the Nine MonthsEnded September 30,**

 

 

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

Revenues

 

 

 

 

 

 

 

 

 

 

 

 

Government contracts

$

90,501 

 

$

86,483 

 

$

222,179 

 

$

253,195 

 

Privately funded research

 

– 

 

 

– 

 

 

– 

 

 

400,000 

 

Royalties

 

1,122 

 

 

1,328 

 

 

1,122 

 

 

2,248 

 

Other

 

8,850 

 

 

384 

 

 

55,548 

 

 

37,584 

 

          Total Revenues

 

100,473 

 

 

88,195 

 

 

278,849 

 

 

693,027 

 

 

 

 

 

 

 

 

 

 

 

 

 

Research and development

 

635,105 

 

 

483,492 

 

 

1,916,512 

 

 

1,264,429 

Selling, general and administrative expenses

 

573,706 

 

 

805,330 

 

 

1,357,738 

 

 

1,660,082 

Royalty expense

 

–  

 

 

–  

 

 

500,000 

 

 

400,000 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating costs and expenses

 

1,208,811 

 

 

1,288,822 

 

 

3,774,250 

 

 

3,324,511 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loss from operations

 

(1,108,338)

 

 

(1,200,627)

 

 

(3,495,401)

 

 

(2,631,484)

 

 

 

 

 

 

 

 

 

 

 

 

 

Other income (expense), net

 

 

 

 

 

 

 

 

 

 

 

 

Interest Expense

 

(1,224)

 

 

(13,308)

 

 

(3,493)

 

 

(54,835)
 
Interest Income
 
9,028 
  
1,655
  
23,065  
  
7,014 

 

Other

 

– 

 

 

– 

 

 

125 

 

 

– 

 

 

 

 

 

 

 

 

 

 

 

 

 

 Loss from continuing operations before taxes

 

(1,100,534)

 

 

(1,212,280)

 

 

(3,475,704)

 

 

(2,679,305)

 

 

 

 

 

 

 

 

 

 

 

 

 

 Provision for taxes

 

 – 

 

 

 – 
 
 

 – 

 

 

 – 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

$

(1,100,534)

 

$

(1,212,280)

 

$

(3,475,704)

 

$

(2,679,305)
 
 

 

 

 

 

 

 

 

 

 

 

Loss per share
           
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic and Diluted

 

 

$

(0.01)

 

$

(0.01)

 

$

(0.04)

 

$

(0.03)
 
 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding
           
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic and Diluted

 

 

 

96,800,352 

 

 

88,590,429 

 

 

96,450,666 

 

 

84,656,310

See notes to consolidated financial statements.

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

 

**For  the Nine Months Ended September 30,**

 

**2004**

      
 
**2003**

Cash flows from operating activities:

 

 

 
 
 

 

 Net loss

 

 

$

(3,475,704)

$

(2,679,305)

 

 

Adjustments to reconcile net loss to net

 

 

 

 

 

 

 

cash used in operating activities:

 

 

 

 

 

 

 

Depreciation and amortization expense

 

38,864 

 

33,940 
   
Gain on sale of fixed assets
 
(125)
 
(4,695)

 

 

 

Options issued for services

 

116,600 

 

– 

 

 

 

Non-cash variable option pricing expense

 

(297,300)

 

389,385 

 

 

 

Common shares issued for patent option

 

– 

 

13,636 

 

 

 

Changes in assets and liabilities:

 

 

 

 

 

 

 

 

Accounts receivable, trade

 

(20,131)

 

(9,443)

 

 

 

 

Prepaid expenses and other current assets

 

 (71,233)

 

 (53,862)

 

 

 

 

Accounts payable and accrued liabilities

 

115,185 

 

(269,482)

 

 

 

 

 

 

 

 

 

 

 

 

 

Total adjustments

 

(118,140)

 

99,479 

 

 

 

 

 

 

 

 

 

 

 

 

Net cash used in operating activities

 

(3,593,844)

 

(2,579,826)

 

 

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

 

Capital expenditures

 

 

(95,331)

 

(5,195)

 

 

Proceeds from sale of fixed assets

 

125 

 

4,695 

 

 

       Net cash used in investing activities

 

(95,206)

 

  (500)

 

 

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

 

Repayment of notes payable

 

(14,337)

 

(52,811)

 

 

Proceeds of stock issuance, net of costs

 

1,640,709 

 

5,443,182 

 

 

 

 

 

 

 

 

 

 

 

       Net cash provided by financingactivities

 

1,626,372 

 

5,390,371 

 

 

 

 

 

 

 

 

 

Net increase (decrease) in cash and cash equivalents

 

(2,062,678)

 

2,810,045 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents, beginning of period

 

3,564,570 

 

15,868 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents, end of period

$

1,501,892 

 

$

2,825,913 

See notes to consolidated financial statements.

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

1.       Basis of Presentation

               The consolidated financial statements for the three and nine month periods ended September 30, 2004 and 2003 have been prepared byus without audit pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, alladjustments necessary to present fairly our financial position, results of operations, and cash flows as of September 30, 2004 and2003, and for the periods then ended, have been made. Those adjustments consist of normal and recurring adjustments. Theconsolidated balance sheet as of December 31, 2003, has been derived from the audited consolidated balance sheet as of thatdate.

               Certain information and note disclosures normally included in our annual financial statements prepared in accordance with generallyaccepted accounting principles have been condensed or omitted. These consolidated financial statements should be read inconjunction with a reading of the financial statements and notes thereto included in our Annual Report on Form 10-KSB for thefiscal year ended December 31, 2003, as filed with the U.S. Securities and Exchange Commission.

               The results of operations for the three and nine month periods ended September 30, 2004, are not necessarily indicative of theresults to be expected for the full year.

2.       Supplemental Cash Flow Information

               Cash paid for interest for the nine months ended September 30, 2004 and 2003, was $3,439 and $3,335, respectively. During the ninemonths ended September 30, 2004, we had non-cash transactions related to variable option pricing and options issued to aconsultant. During the nine months ended September 30, 2003, we had non-cash transactions related to the conversion of notespayable, including related accrued interest, into shares of the our common stock, as well as the payment of certain accountspayable and accrued expenses with common stock, and variable option pricing. These transactions are described in greater detail inNote 3.

3.       Stockholders’ Equity

               In the nine months ended September 30, 2004, we issued 401,887 restricted shares of our common stock and received net proceeds of$1,065,000 in an exempt offering under Regulation D of the Securities Act of 1933.  We issued 799,464 shares of our commonstock and received $557,309 in connection with the exercise of employee stock options, primarily by former employees, and issued20,000 shares and 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 nine months ended September 30, 2004, the price of our common stock declined and closed at$2.13 on September 30, 2004. We reversed $297,300 of the previously recorded expense in the nine months ended September 30, 2004,as a result of this price decline.

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

               In the nine months ended September 30, 2003, we issued 6,860,039 restricted shares of our common stock and received net proceeds of$3,604,250 in exempt offerings under Regulation D of the Securities Act of 1933.  We issued 2,280,789 shares of our commonstock and received $1,838,932 in connection with the exercise of employee stock options. We also issued 7,707,020 shares of commonstock in connection with the payment of convertible notes payable and related accrued interest. The face amount of the notes was$1,600,000 and the related accrued interest totaled $161,213. We also issued 125,000 shares valued at $276,782 in connection withthe 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 a defendant in minor lawsuits described in greater detail in our  2003 annual report on Form 10-KSB. We expect anypotential eventual payment to have no material affect on the financial statements.

5.       Business Segments

Following is information related to our business segments for the nine months endedSeptember 30, 2004 and 2003:

 

 

ANI
     
EBT
         
All Other
 
Total

2004

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$ 

278,849 

 

$ 

 - 

 

$

 - 

 

$ 

278,849 

 

 

 

 

 

 

 

 

 

Profit (Loss)

 

(3,122,054)

 

107,297

 

(460,947)

 

(3,475,704)

 

 

 

 

 

 

 

 

 

Expenditures for

 

 

 

 

 

 

 

 

     long-lived assets

 

92,958  

 

- 

 

2,373 

 

95,331 

 

 

 

 

 

 

 

 

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$ 

693,027 

 

$ 

 - 

 

$

 - 

 

$ 

693,027 

 

 

 

 

 

 

 

 

 

Profit (Loss)

 

(1,812,679)

 

(181,559) 

 

(685,067)

 

(2,679,305)

 

 

 

 

 

 

 

 

 

Expenditures for

 

 

 

 

 

 

 

 

     long-lived assets

 

5,195  

 

- 

 

- 

 

- 

6.       Subsequent Events

          For the period from October 1,2004 through October 22, 2004, we issued a total of 143,250 shares of common stock, and received proceeds of $144,969, inconnection with the exercise of options under our stock option plans.

           In October 2004, ANI entered an agreement with Shimane Masuda Electronics Co., Ltd. to develop new products utilizingcarbon nanotube sources. In the development phase, which will last up to twelve months, SME will pay ANI $110,000 for specificequipment and development work to be done by ANI. At the conclusion of the development phase, the parties can either enter a jointventure or sign a license agreement. In the case of a joint venture, SME will pay ANI an additional $90,000 and the joint venturewill pay a 3% royalty to ANI for  products sold by the joint venture using ANI patents. In the case of a license agreement,SME will pay ANI an upfront payment ranging from $100,000 to $250,000 plus a 5% royalty on products sold using ANI’sintellectual property.

7.       Recently Issued AccountingStandards

               There are no recent accounting pronouncements that we have not implemented that are expected to have a material impact on ourfinancial statements.

7
**ITEM 2: MANAGEMENT'S DISCUSSION 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 Form 10-QSB containscertain forward-looking statements that we believe are within the meaning of Section 27A of the Securities Act of 1933 and Section21E of the Securities Exchange Act of 1934, which are intended to be covered by the safe harbors created by such acts. For thispurpose, any statements that are not statements of historical fact may be deemed to be forward-looking statements, including thestatements under "Management's Discussion and Analysis of Financial Condition and Results of Operations" regarding our strategy,future operations, future expectations or future estimates, financial position and objectives of management. Those statements inthis Form 10-QSB containing the words "believes," "anticipates," "plans," "expects" and similar expressions constituteforward-looking statements, although not all forward-looking statements contain such identifying words. These forward-lookingstatements are based on our current expectations and are subject to a number of risks, uncertainties and assumptions relating toour operations, results of operations, competitive factors, shifts in market demand and other risks and uncertainties.

          Although we believe that theassumptions underlying our forward-looking statements are reasonable, any of the assumptions could be inaccurate and actual resultsmay differ from those indicated by the forward-looking statements included in this Form 10-QSB.  In light of the significantuncertainties inherent in the forward-looking statements included in this Form 10-QSB, you should not consider the inclusion ofsuch information as a representation by us or anyone else that we will achieve such results. Moreover, we assume no obligation toupdate these forward-looking statements to reflect actual results, changes in assumptions or changes in other factors affectingsuch forward-looking statements.

**Nine months ended September 30, 2004 and 2003**

**OVERVIEW**

During the nine months ended September 30, 2004, our primary revenues were earned as aresult of reimbursed research expenditures at our Applied Nanotech, Inc. (“ANI”) subsidiary. We continued to incursubstantial expenses in support of the development of our proprietary Carbon Nanotube Based Field Emission (“CFE”)Technology and other Carbon Nanotube Based Technologies. As more fully discussed in our Annual Report on Form 10-KSB for the yearended December 31, 2003, we expect to incur additional research and development expenses throughout 2004 in developing our CFEtechnology. We are focused on licensing our technology and obtaining sufficient revenue to cover our ongoing researchexpenditures.

**OUTLOOK**

          We expect our present cashbalances of approximately $1.3 million as of the date of this filing, when combined with known revenue sources, to enable us tooperate at least through 2004 and well into the 1st quarter of 2005.  We expect to achieve at least break-even forthe fourth quarter of 2004. In order to achieve break-even for the entire calendar year 2004, we would have to sign a significantlicense agreement that results in an upfront payment large enough to offset the loss through September. There can be no assurancethat we will achieve profitability, or even break-even, in the future.  To the extent our revenues do not allow us tobreak-even, or if the timing of revenues does not match with expenses, we could be required to raise additional funds through theissuance of debt or equity securities to enable us to maintain operations at the present level. The mix of revenues received couldalso cause the revenues required to reach break-even to increase. If revenue producing projects require unanticipated expenses, orheavier than anticipated use of outside services or materials, we may be unable to achieve profitability at the expected level ofrevenues.

          We have developed a plan toallow ourselves to maintain operations until we are able to sustain ourselves on our own revenue. Our plan is primarily dependenton raising funds through the licensing of our technology and reimbursed research contracts. Our current cash of approximately $1.3million as of the date of this filing is sufficient to allow us to maintain operations through at least the end of 2004 and wellinto the first quarter of 2005. We expect additional revenue producing projects or license agreements to be finalized during thattime period. We believe that we have the ability to continue to raise funding, if necessary, to enable us to continue operationsuntil our plan can be completed.

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

         This plan is based on currentdevelopment plans, current operating plans, the current regulatory environment, historical experience in the development ofelectronic display and other products and general economic conditions. Changes could occur which would cause certain assumptions onwhich this plan is based to be no longer valid. Although we do not expect funding our operations to be a problem, if adequate fundsare not available from operations, or additional sources of financing, we may have to eliminate, or reduce substantially,expenditures for research and development, testing and production of its products, or obtain funds through arrangements with otherentities that may require us to relinquish rights to certain of its technologies or products. Such results would materially andadversely affect us.

**RECENT DEVELOPMENTS**

          InFebruary 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 an unqualified opinion that expressed doubt about the Company’s abilityto continue 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 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 gives the licensee the exclusive right for the use of the technology for the measurement of hydrogen in powertransformers, tap changers, and breakers. ANI will provide pre-production design, development, and engineering work, as well assell the hydrogen sensors to be used in the final product. The licensee will pay a royalty of 10% of the sales of the productscontaining the hydrogen sensors. Under the original agreement, to maintain exclusivity, the licensee was required to pay minimumroyalties of $55,100 annually beginning October 1, 2004 and increasing each year to a level of $1,000,000 in the fourth year. Thelicensee can elect to avoid the minimum royalty payment by terminating the exclusivity portion of the contract prior to each year,beginning with the first year starting October 1, 2004. The deadline for the start of the first minimum royalty payment period wasextended to November 1, 2004.

            InOctober 2004, ANI entered an agreement with Shimane Masuda Electronics Co., Ltd. to develop new products utilizing Carbon Nanotubesources. In the development phase, which will last up to twelve months, SME will pay ANI $110,000 for specific equipment anddevelopment work to be done by ANI. At the conclusion of the development phase, the parties can either enter a joint venture orsign a license agreement. In the case of a joint venture, SME will pay ANI an additional $90,000 and the joint venture will pay a3% royalty to ANI for  products sold by the joint venture using ANI patents. In the case of a license agreement, SME will payANI an upfront payment ranging from $100,000 to $250,000 plus a 5% royalty on products sold using ANI’s intellectualproperty.

            Duringthe 3rd quarter 2004, ANI completed its prototype 14-inch carbon nanotube display. ANI is also working on a prototype ofa 25-inch display in conjunction with a consortium of primarily Japanese companies that are component suppliers to televisionmanufacturers. That prototype is currently expected to be completed by the end of 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 quarterly loss for thethird quarter ended September 30, 2004 was $1,100,534 as compared with the loss of $1,212,280 for the same period last year. Thebiggest single factor in this decreased loss was the effect of the variable option repricing. In the quarter ended September 30,2004, there was a reduction to expense of $43,950 as compared with an increase in expense of $389,385 during the quarter endedSeptember 30, 2003. Without the effect of variable option repricing, our quarterly loss would have been higher during the quarterended September 30, 2004, as a result of increased research and development expenditures, than it was in the quarter endedSeptember 30, 2003. Our loss of $3,475,704 for the nine months ended September 30, 2004 was approximately 30% higher than the lossfor the nine months ended September 30, 2003. This increased loss was primarily the result of decreased revenue and increasedspending on research and development. We expect to be profitable in the fourth quarter of 2004 as the result of revenue fromexpected license agreements and other sources.

          Our revenues for the quarterended September 30, 2004 totaled $100,473 compared to $88,195 for the same quarter of 2003. For the nine-month period endedSeptember 30, 2004 (the “2004 Period”), our revenues were $278,849 as compared with $693,027 for the nine-month periodended September 30, 2003 (the “2003 Period”). The revenues in both periods were all from ANI and substantially all werethe result of reimbursed research expenditures. The major difference between the two periods is that the 2003 Period included$400,000 of revenue related to the completion of a major research contract with a large Japanese display manufacturer. During the2004 Period, $222,179 of the revenue came from government contracts and $56,670 came from other miscellaneous sources. During the2003 Period, $400,000 came from the previously mentioned research contract, $253,195 of the revenue came from government contracts,and $39,832 came from other miscellaneous sources. At the present stage of our development, significant conclusions can’t bedrawn from comparing revenues from period to period. Our business strategy is built on developing a royalty stream from licensingour intellectual property. To supplement this, we also seek funding from both governmental and private sources to help fund ourresearch. Until we are able to develop a steady revenue stream from royalties, our revenues will tend to fluctuate greatly fromquarter to quarter. Our private research funding tends to come in large amounts at sporadic times.

          We have one government programin progress at September 30, 2004, and we have a revenue backlog of $212,722 related to that contract. We had a total revenuebacklog of approximately $521,496 as of September 30, 2003, all of which related to the same government contract. Our ability toperform continued research, or fulfill our backlog, should not require significant additional personnel.

          We incurred research anddevelopment expenses of $1,916,512 for the 2004 Period, which was a substantial increase from the $1,264,429 incurred in the 2003Period. One reason for this significant increase is the spending on our 14-inch and 25-inch prototypes of our color high-definitionCNT based flat screen TVs. We spent in excess of $650,000 on these prototypes in the nine months ended September 30, 2004. Inaddition, we have had significant spending related to our biosensor development.. We expect total research and development expenseto decline somewhat in the final quarter of the year. The 14-inch prototype was completed in the 3rd  quarter of2004, and the 25-inch prototype is expected to be completed in the 4th quarter of 2004.

        Our selling, general, and administrativeexpenses were $1,357,738 for the 2004 Period, compared with $1,660,082 for the 2003 Period. While the selling, general, andadministrative expenses were decreased in total, a non-cash item in the amount of $297,300 related to variable option pricingimpacted the 2004 Period. 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 nine months ended September 30,2004, the price of our common stock declined and closed at $2.13 on September 30, 2004. We reversed $297,300 of the previouslyrecorded expense in the nine months ended September 30, 2004, as a result of this price decline. In the 2003 Period, there was acharge of 389,385 that increased expenses in that period. The combined effect of the decreased expense in the 2004 Period and theincreased expense in the 2003 Period resulted in a difference of approximately $687,000 in S,G,&A expense between thesePeriods. Without the effect of the variable option pricing, S,G&A expenses would have been $384,341 higher in the 2004 Periodthan in the 2003 Period. Major contributors to this increase include increased professional fees, primarily related to patents, ofapproximately $90,000; a charge of $116,600 related to options issued to a consultant; increases in salaries and benefits ofapproximately $75,000; and increased travel related to conferences and international trips of approximately $70,000.

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**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 further future minimum royalty payments are due under thisagreement, and we expect royalty 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 cash position decreased by$2,062,678 during the 2004 Period. At September 30, 2004, we had cash and cash equivalents in the amount of $1,501,892 as comparedwith cash and cash equivalents of $3,564,570 at December 31, 2003.  This decrease in cash is primarily the result of cash usedin operating activities, offset by cash provided by financing activities. The cash used in operations was primarily the result ofour net operating loss for the period. The cash used in operating activities during the 2004 Period of $3,593,844 was higher thanthe $2,579,826 used in the 2003 Period for the same reasons previously discussed that the loss in the 2004 Periodincreased.

          As described in greater detailin the notes to the financial statements, we received net proceeds of $1,640,709 from the issuance of common stock related toprivate placements and option exercises during the 2004 Period, as compared with $5,443,182 from the issuance of common stockduring the 2003 Period.  We have raised less money during the 2004 Period than we did in the 2003 Period because we expect tosign license agreements later this year that may preclude the need for further fund-raising.

          We used net cash of $95,206for investing activities in the 2004 Period related to the purchase of leasehold improvements and equipment as, compared with $500used for investing activities in the 2003 Period.

          The principal source of ourliquidity has been funds received from exempt offerings of common and preferred stock. In the event that we need additional funds,we may seek to sell additional debt or equity securities. While we expect to be able to obtain any funds needed for operations,there can be no assurance that any of these financing alternatives can be arranged on commercially acceptable terms. We believethat our success in reaching profitability will be dependent on our patent portfolio and upon the viability of products using ourtechnology and their acceptance in the marketplace, as well as our ability to obtain additional debt or equity financings in thefuture, if needed.

          We expect to continue to incursubstantial expenses for research and development  ("R&D"). Further, we believe that certain products that may bedeveloped by potential licensees of our technology may not be available for commercial sale or routine use for a period of one totwo years. Others are expected to be available in 2004. While we would likely receive initial license payments, ongoing royaltystreams related to those licenses will not be available until potential licensees have introduced products using our technology.Therefore, it is possible that the commercialization of our existing and proposed products may require additional capital in excessof our current funding. We do, however, expect to at least break-even in the fourth quarter of 2004 based on the receipt ofresearch funding and other revenues. Achievement of at least break-even would enable us to continue our research without seekingadditional debt or equity financing.

          Because the timing and receiptof revenues from the license or royalty agreements will be tied to the achievement of certain product development, testing andmarketing objectives, which cannot be predicted with certainty, there may be substantial fluctuations in our results of operations.If revenues do not increase as rapidly as anticipated, or if product development and testing require more funding than anticipated,we may be required to curtail our operations or seek additional financing from other sources. The combined effect of the foregoingmay prevent us from achieving sustained profitability for an extended period of time.

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**ITEM 3.       Controls and Procedures**

          Under the supervision of andwith the participation of our management, including our principal executive officer and principal financial officer, we conductedan evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, within 90 days of the filing date of this report (the"Evaluation Date"). Based upon this evaluation, our principal executive officer and principal financial officer concluded as of theEvaluation Date that our disclosure controls and procedures were effective such that the material information required to theincluded in our Securities and Exchange Commission ("SEC") reports is recorded, processed, summarized, and reported within the timeperiods specified in SEC rules and forms relating to the Company, including, our consolidated subsidiaries, and was made known tothem by others within those entities, particularly during the period when this report was being prepared.

          In addition, there were nosignificant changes in our internal controls or in other factors that could significantly affect these controls subsequent to theEvaluation Date. We have not identified any significant deficiencies or material weaknesses in our internal controls, andtherefore, there were no corrective actions taken.

 

 

 

 

 

 

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**PART II. OTHER INFORMATION**

ITEM 1.  LEGAL PROCEEDINGS

          None

 

 

 

 

 

 

 

 

 

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ITEM 6.     EXHIBITS

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

 

 

 

 

 

 

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**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:     October 29, 2004

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

 

 

Date:     October 29, 2004

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

 
**  **
 

 

 

 

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**INDEX TO EXHIBITS**

The following documents are filed as part of this Report:

Exhibit
 
10.1

Letter of Intent between AppliedNanotech, Inc.  and Shimane Masuda Electronics, Co., Ltd.
  
11

Computation of (Loss) Per Common Share

 

 

31.1

Rule 13a-14(a)/15d-14(a) Certificate of Marc W. Eller

 

 

31.2

Rule 13a-14(a)/15d-14(a) Certificate of Douglas P. Baker

 

 

32.1

Section 1350 Certificate of Marc W. Eller

 

 

32.2

Section 1350 Certificate of Douglas P. Baker

 

 

 

 

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