UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549




FORM
10-K




x
            Annual
      report under Section 13 or 15(d) of the Securities Exchange Act of 1934
      for the fiscal year ended December 31, 2007;
  or




o
            Transition
      report under 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
      of Incorporation)
            (IRS
      Employer Identification Number)




3006
Longhorn Boulevard, Suite 107, Austin, Texas 78758


(Address
of principal executive office, including Zip Code)




Registrant’s
telephone number, including area code: (512) 339-5020




Securities
registered pursuant to Section 12(b) of the Exchange Act:


Title
      of each class
            Name
      of Each Exchange on Which RegisteredCommon
      Stock, $0.001 par value
            OTC
      Bulletin Board




Securities
registered pursuant to Section 12(g) of the Exchange Act: None




Indicate
by check mark if the registrant is a well-known seasoned issuer as defined in
Rule 405 of the Securities Act. Yes  o   
No  þ




Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act. Yes  o   No 
þ




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




Yes  þ   
No  o




Indicate
by check mark if disclosure of delinquent filers in response to Item 405 of
Regulation S-K is not contained in this form and will not be contained, to the
best of registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.   þ




Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.




Large
Accelerated Filer  o   
Accelerated Filer  þ




Non-accelerated
Filer  o     Smaller
Reporting Company  o




Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).




Yes  o   
No  þ




The
aggregate market value of the Common Stock held by non-affiliates of the
Registrant, based upon the average of the closing bid and asked price of the
Common Stock on the OTC Bulletin Board system on June 29, 2007 of $1.22, was
approximately $130 million. As of February 18, 2008, the registrant had
107,173,549 shares of Common Stock issued and outstanding.




Documents
Incorporated by Reference




No
documents are incorporated by reference into this annual report on Form
10-K














TABLE
OF CONTENTS




PagePart
      I.Item
      1.
            
            Business
            1Item
      1A.
            
            Risk
      Factors
            11Item
      1B.
            
            Unresolved
      Staff Comments
            16Item
      2.
            
            Properties
            17Item
      3.
            
            Legal
      Proceedings
            17Item
      4.
            
            Submission
      of Matters to a Vote of Security Holders
            18PART
      IIItem
      5.
            
            Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities
            19Item
      6.
            
            Selected
      Financial Data
            21Item
      7.
            
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
            22Item
      7A.
            
            Quantitative
      and Qualitative Disclosures About Market Risk
            28Item
      8.
            
            Financial
      Statements and Supplementary Data
            29Item
      9.
            
            Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
            52Item
      9A.
            
            Controls
      and Procedures
            52Item
      9B.
            
            Other
      Information
            54PART
      IIIItem
      10.
            
            Directors,
      Executive Officers and Corporate Governance
            55Item
      11.
            
            Executive
      Compensation
            57Item
      12.
            
            Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
            66Item
      13.
            
            Certain
      Relationships and Related Transactions, and Director
      Independence
            68Item
      14.
            
            Principal
      Accountant Fees and Services
            69PART
      IVItem
      15.
            
            Exhibits
      and Financial Statement Schedules
            70







Important
Information Concerning Forward-Looking Statements




Our
disclosure and analysis in this report contains some forward-looking statements.
Forward-looking statements give our current expectations or forecasts of future
events. They use words such as “anticipate”, “believe”, “expect”, “estimate”,
“project”, “intend”, “plan”, and other words and terms of similar meaning in
connection with any discussion of future operating or financial performance. In
particular, these include statements relating to future actions, prospective
products or product approvals, future performance or results of current and
anticipated products, sales efforts, expenses, the outcome of contingencies such
as legal proceedings, and financial results. From time to time, we also may
provide oral or written forward-looking statements in other materials we release
to the public.




Any or
all of our forward-looking statements in this report and in any other public
statements we make may turn out to be wrong. They can be affected by inaccurate
assumptions we might make, or by known or unknown risks or uncertainties. Many
factors mentioned in the risk factors are important in determining future
results. Consequently, no forward-looking statement can be guaranteed. Actual
future results may vary materially.




We
undertake no obligation to publicly update any forward-looking statements,
whether as the result of new information, future events, or otherwise. You are
advised, however, to consult any further disclosures we make on related subjects
in our 10-Q, 8-K, and 10-K reports to the SEC. Also note that we include a
cautionary discussion of risks, uncertainties, and possibly inaccurate
assumptions relevant to our business. These are factors that we think could
cause our actual results to differ materially from expected and historical
results. Other factors besides those listed here could also adversely affect
us.





PART
I.




When used
in this document, the words “anticipate”, “believe”, “expect”, “estimate”,
“project”, “intend”, “plan”, and similar expressions are intended to identify
forward-looking statements. Such statements are subject to certain risks,
uncertainties, and assumptions. Should one or more of these risks or
uncertainties materialize, or should underlying assumptions prove incorrect,
actual results may vary materially from those anticipated, believed, expected,
estimated, projected, intended, or planned. For additional discussion of such
risks, uncertainties, and assumptions, see “Important Information Concerning
Forward-Looking Statements” included at the beginning of this report and “Risk
Factors” beginning on page 11 of this report.




Item
1.  Business.




DESCRIPTION
OF BUSINESS




General




We are a
nanotechnology company engaged in research based primarily on unique
applications of carbon nanotube technology. Our research is based on
intellectual property and expertise that we have developed over the past 20
years. As part of our research we perform services for others and develop
products and materials based on this intellectual property. Our ultimate goal is
to generate sustainable recurring revenues by licensing our technology to
others.




We were
incorporated in Texas in 1987 and completed our initial public offering in 1993.
Our initial focus was on a next generation display technology called field
emission display (“FED”). The majority of our research over the years has been
related to FED technology, and we have accumulated significant intellectual
property in this area. FED technology has evolved significantly over the life of
the company, and we have been at the forefront of that evolution, accumulating
intellectual property at each step of the way. We believe our intellectual
property will be required by any entity that develops a display using FED
technology. As discussed in greater detail under the heading “Electron emission
activities”, our FED technology includes both carbon nanotube based field
emission displays and thin-film based field emission technology, such as the
technology recently introduced by Canon and Toshiba referred to as
SED.




While
focusing primarily on FED technology, in the past several years we have
performed research in many other areas. Much of this research was an outgrowth
of our work in the FED area. This research was either related to other display
technologies, used processes learned while we were working with FED technology,
used raw materials used in our FED research, or capitalized on other unique
capabilities within our organization. As a result we have developed significant
intellectual property in other areas beyond that solely related to the FED
technology. At present, we have over 300 total U.S. and foreign patents,
including 131 issued, 190 pending, and 3 allowed.




Business
Model




We are
first and foremost a research and development company. We have an extensive
portfolio of intellectual property that we have developed throughout the last 20
years, and we intend to develop a portfolio of recurring revenue streams by
licensing our intellectual property to others.




Much of
our intellectual property relates to next-generation technologies that are not
in wide current use and as such, additional development work is required before
products can be manufactured using these technologies. Our research and
development efforts occur across a continuum moving from concept to
commercialization as follows:




Concept →
Laboratory → Development → Pilot /Introduction → Commercialization




To aid in
the process of moving our technologies from concept to commercialization, we
frequently perform funded research for both government entities and large
corporations. This enables us to focus our resources in areas that have the
highest level of interest to others, and thus the highest probability for
commercialization.


Page
1




Research
and Development




As a
result of our focus on developing and protecting our intellectual property, we
spend significant amounts on research and development. We spent $4,526,166,
$3,590,148, and $2,635,412 on research and development in the years ended
December 31, 2007, 2006, and 2005, respectively. This represents approximately
54%, 41%, and 41% of our total operating costs and expenses in each of those
years. We expect to continue to invest heavily in research and development, and
we expect our research and development costs for 2008 to be approximately 56% of
our operating costs.




Business
Segments




Our
operations currently consist of three reportable business segments.




Applied Nanotech,
Inc. ANI is the
main focus of our efforts. It was incorporated in January 1997 and is developing
our proprietary carbon nanotube and related technologies. Accordingly, our
research is focused in the broad area of carbon nanotube technology and its
application to the display, electronics, sensor, medical, and other industries.
Our development plans for our technologies are discussed later in this
report.




Electronic
Billboard Technology, Inc. EBT was incorporated in
January 1997 and initially focused on developing sun-readable display products
for outdoor use. Its primary product initially was an electronic billboard that
would enable the outdoor advertising industry to exploit the Internet and
information revolution by placing ads at different locations at different times.
The focus of EBT was rapidly shifted to displays for indoor use that could be
used as part of an overall point of purchase advertising program. We developed a
patented product called the E-WindowTM, as well as patents surrounding the
process of communicating with electronic displays for the purpose of placing
advertisements. In 2002, we restructured EBT and stopped selling products
directly and instead limited ourselves to licensing our intellectual property.
We did this to focus on our business at ANI, which had higher short run
potential and was less capital intensive. In 2006, we sold EBT’s intellectual
property in two simultaneous transactions. This is discussed in greater detail
below. To the extent that EBT is basically inactive, information relative to
this segment may not be that meaningful.




Other.We also incur general
overhead to operate that is not associated with any specific subsidiary or other
segment. This overhead is the approximate cost of being a public company, which
is the amount in excess of that which might be incurred by a private company
performing these same activities.




Following
is a summary of revenues, net loss from continuing operations, and total assets
for each segment for each of the last three years.





2007
            
            
            2006
            
            
            2005RevenuesANI
            
            $
            3,989,803
            
            
            $
            1,116,670
            
            
            $
            565,660EBT
            
            $
            —
            
            
            $
            —
            
            
            $
            —Other
            
            $
            —
            
            
            $
            —
            
            
            $
            —Total
      Revenues
            
            $
            3,989,803
            
            
            $
            1,116,670
            
            
            $
            565,660Net
      income (loss) from continuing operationsANI
            
            $
            (3,212,051
            )
            
            $
            (6,108,745
            )
            
            $
            (4,326,467
            )EBT
            
            $
            (1,298
            )
            
            $
            933,720
            
            
            $
            (3,734
            )Other
            
            $
            (1,043,542
            )
            
            $
            (1,418,867
            )
            
            $
            (1,488,615
            )Total
            
            $
            (4,256,891
            )
            
            $
            (6,593,892
            )
            
            $
            (5,818,816
            )AssetsANI
            
            $
            778,863
            
            
            $
            1,101,205
            
            
            $
            301,870EBT
            
            $
            —
            
            
            $
            —
            
            
            $
            —Other
            
            $
            2,965,995
            
            
            $
            1,592,237
            
            
            $
            886,111Total
            
            $
            3,744,858
            
            
            $
            2,693,442
            
            
            $
            1,187,981


Page
2






Applied
Nanotech, Inc.




Overall




We are a
nanotechnology company focusing our efforts on research, development of proof of
concepts for proposed products, and licensing our technology to others. We are
developing world-class technologies that generally fall under one of four
technology platforms. These platforms are:




·
            Electron
      emission activities, primarily in the display
  area


·
              Sensor
      technology


·
              Nanoelectronic
      applications


·
              Functional
      nanomaterials


·
              Nanoecology






We intend
to license our technology to others to allow them to manufacture products using
our technology. We have no plans to establish any manufacturing facilities in
the foreseeable future, and manufacturing is not a part of our core
strategy. To the extent that manufacturing capabilities are needed for products
using our technology, we intend to use manufacturing partnerships, joint
ventures, or arrange to have products manufactured through contract
manufacturers.




Electron Emission
Activities




Our main
focus for virtually the entire life of Nano-Proprietary has been on electron
emission activities. We have performed extensive research and accumulated
significant intellectual property in this area.  From inception until
recent years, the bulk of that activity has centered on Field Emission Display
(“FED”) technology. Field emission display is a next generation display
technology that is ideally suited for use in large flat screen televisions, with
“large” being defined as 50-inch diagonal or greater and discussed in greater
detail below. While  we have always worked, at least peripherally with
non-display related emission activities, recently we have observed an increase
in activities in this field and as a result we are focusing more of our research
on non-display activities. We have developed a broad patent portfolio covering
numerous aspects of emission activities, with the majority involving carbon. Our
most significant patent in this area is U.S. Patent 5869922, a patent we refer
to as the Raman Spectrum Patent. This basic patent covers field emission devices
using various forms of carbon; including carbon nanotubes (CNT)s, carbon films,
and other forms of carbon that fall within a particular range on the Ultraviolet
Raman band. Basic patents are fundamental and have broad applicability. This
patent has wide geographic coverage, having been issued in the U.S., China,
South Korea and has been validated in several European countries. The patent
application is also pending in Japan.




These
electron emission activities can be divided into display activities and
non-display activities. The display applications represent potentially huge
markets for the use of our technology. The display industry is, in general,
dominated by large multinational corporations primarily based in Asia and
participation in manufacturing products for the display market involves
significant capital investments. Our intellectual property in this area is well
developed, and we believe that any manufacturer that develops a product based on
electron emission activities involving carbon will require a license to our
technology; however, any products using this technology are still at present,
next generation products. We believe that the successful introduction of any
display products using this technology will likely involve the participation of
an existing display manufacturer or component suppliers. These manufacturers and
suppliers in general have a variety of interests, and the introduction of new
display products may impact other areas of their business, which may impact the
timing and introduction of new products.




There is
also a wide array of non-display related electron emission applications. These
potential applications are spread among a much larger group of potential
licensees, and the markets generally  are not as large as the display
markets, although the markets are still very significant and would generate
substantial royalties if products are introduced. As discussed further below, we
have performed research related to lighting applications, ion sources, traveling
wave tubes, and are exploring other applications. We believe these applications
may have the capability of generating license revenues sooner than many display
applications, may be easier to integrate into existing products, and may be in
wide use sooner than many display applications. While the breadth (number of
patents) of our display related emission activity patents is currently greater
than for non-display patents, our basic Raman patent is expected to cover all
emission activities. In addition we are continually generating new intellectual
property as we work in these areas.


Page
3




Display
Applications




Large area
CNT  flat screen color field emission displays. TVs using FED
technology are intended to compete with and improve on the plasma, projection,
LCD, and CRT displays currently available in the large screen TV market. Because
of cost advantages, carbon nanotubes are currently the preferred method in the
display industry for construction of large area flat screen color TVs using FED
technology. Although, as discussed below some companies are still working with
other forms of carbon emission. Companies including Samsung, DuPont, Noritake,
Motorola, and others have made public announcements related to the development
of large area carbon nanotube based field emission displays, or manufacturing
processes for such displays. To the extent that these companies, or any other
companies, bring a TV to market using carbon nanotube based field emission
display technology, we believe that they would be required to license one or
more of our patents.




We have
also developed our own proofs of concepts of carbon nanotube based field
emission display TVs, including a 14-inch monochrome, 14-inch color, and 25-inch
color displays. The 25-inch color proof of concept was built in conjunction with
a consortium of Japanese component manufactures with the goal of attracting a
manufacturer. In 2006 we signed a letter of intent with Da Ling Co. Ltd, a
corporation based in Taiwan, to enter into an agreement to form a joint venture
funded by Da Ling to construct and operate a pilot line for a carbon nanotube
television using our technology and processes. No final agreement was ever
reached and Da Ling ultimately made the decision to not commit the resources
necessary for a pilot line.




Large
area surface conduction color field emission displays. Canon, Inc. and
Toshiba also have jointly developed a large area flat screen color TV based on
our FED technology, using a technology that they call SED, which they have
indicated does not use the emission from carbon nanotubes. Canon and Toshiba
formed a joint venture in 2004 to manufacture components for this TV, have
constructed a manufacturing line, and demonstrated their product on many
occasions, but as yet neither has introduced a product. Toshiba has never had a
license to any of our technology. Canon originally had a non-exclusive license
with us, signed in 1999, which covered substantially all of our field emission
patents, but excluded specific applications for those field emission display
patents. Canon lost that license in 2006 as a result of a material breach of the
license agreement and now does not have a license to any of our technology.
After termination of the license, Canon bought out Toshiba’s interest in the
joint venture. We are currently in litigation with Canon, as described in
greater detail in Item 3 of this report; however, Canon has appealed the
termination of its license.




Backlights for
displays.Our carbon nanotube technology is ideally suited to be used as
a backlight for other types of displays, such as LCDs. Use of CNTs in backlights
would improve the luminous efficiency at lower power levels and eliminate the
use of mercury and its related negative environmental impacts. We have developed
a proof of concept using our proprietary functionalized CNTs as a backlight for
an LCD, and we expect to continue performing significant research in this area
in 2008. Many other companies have also performed research in this area. We
believe that successful development of a backlight device using carbon nanotubes
by anyone will require a license to our intellectual property and that such a
product would be applicable to the entire LCD market - not just large screen
displays.  We are currently working with Mitsui & Co., Ltd., a
large corporate conglomerate headquartered in Japan, to extend licenses in this
area.




PETS for medium
resolution large area electronic billboards- The PET, or Picture Element
Tube, is a basic display device that could be used in many applications in
addition to electronic billboards. The carbon nanotube field emission technology
provides several advantages over the existing technologies used in these areas.
It generally has a higher image quality, better sunlight readability, lower
cost, lower energy usage, improved viewing angle and excellent video
capabilities. We licensed a previous version of field emission display
technology that is not based on carbon nanotubes to a large Japanese display
manufacturer. This license calls for royalties of 2% of the licensee’s sales of
products using our technology, once its sales exceed $100 million. The licensee
has not yet introduced a product using this technology.


Page
4




Non-Display
Applications




Traveling wave
tubes –Traveling wave tubes (“TWT”) are key components for generating
high frequency and high power for communications, radar, and other electronic
equipment. Almost all current TWTs use thermal cathodes that require heating to
generate the high current density beam required for effective and efficient TWT
operation. A cold cathode using carbon nanotubes as the electron source has the
potential to improve the operating life of the cathode and the efficiency of the
TWT. We currently have a Phase II grant from the Air Force, in conjunction with
our development partner, Northrop Grumman, to further develop this
application.




Non-radioactive
sources. We are also working with the electron emission from carbon
nanotubes to replace radioactive sources in commercial applications. We are
currently working with Sionex Corporation, under a U.S. Department of Homeland
Security grant, to replace the ion source in a specific ion detection device
manufactured by Sionex. We consider the use of carbon nanotubes in replacing
radiological sources to be an extremely promising area of research.




Neutron
and gamma-ray sources. Near the end of 2007 we were informed by the
Department of Homeland Security that it would support a research program in the
form of an SBIR Phase I related to the utilization of CNTs for neutron and
gamma-ray radiation sources. This type of radiation is needed today for the
detection of “special nuclear materials” that are of high interest to Homeland
Security authorities. We consider this another extremely promising area of
research.




Lighting Devices.We have done work in the area of specialty lighting devices using carbon
nanotubes. In particular we have worked with and have a license agreement with
Shimane Masuda Electronics, Co., Ltd. (“SME”). In 2005, SME established a pilot
line for the development and production of carbon nanotube electron emission
based lighting devices and in 2006 signed a license agreement for a portion of
our technology. This license agreement limits SME to manufacturing in Japan and
sales in Asia. We received a payment of approximately $84,000 at the time the
license was signed, and we will receive an additional approximately $125,000, if
and when SME goes into production and begins shipping products. We will also
receive a royalty of 5% based on SME’s sales of products using the licensed
technology. We are also working with Mitsui & Co., Ltd., to extend
additional licenses for this technology in Asia.




Key
Intellectual Property




In
addition to the previously mentioned Raman Spectrum Patent (U.S. Patent 5869922)
which is a basic patent covering emissions from a wide range of carbon forms, we
have an extensive portfolio of other patents in the area. We also licensed 6
patents from Till Keesmann in 2000, and we have an exclusive agreement to
license these patents to others. This agreement is described in greater detail
in the Technology Agreements section below. These patents are also basic patents
covering the use of emissions from carbon nanotubes. The U.S. Patent (No.
RE38,223 E) was reissued in August 2003. This reissuance significantly
strengthened and reinforced the basic nature of this patent. It is our belief
that any company using carbon nanotubes in the U.S. or in certain western
European countries in an emission mode, regardless of application, will be
required to license this, as well as our patents.. No companies have yet
licensed the Keesmann patents from us, nor have they obtained the right to use
these patents. While this patent is more limited in scope and geography that our
basic Raman Spectrum Patent, we believe this to be a valuable patent and a nice
compliment to our core patent portfolio. As discussed in Item 3 to this Annual
Report on Form 10-K, the Keesmann agreement is currently the subject of
litigation.




Competition.Because of the strength of our intellectual property in the electron
emission area, our competition comes from other technologies, rather than from
other companies. We believe that any company developing a carbon nanotube-based
FED large area flat screen color TV will be required to license our patents.
There are other companies attempting to develop non-carbon nanotube based field
emission display technologies. It is our opinion that these technologies will
not be as cost efficient or demonstrate as high a level of brightness as the
field emission technology using forms of carbon, whether carbon nanotube based
or other carbon based methods such as the SED. However, even companies
developing these non-carbon based field emission displays may be required to
license other portions of our patent portfolio in order to bring a product to
market.




In the
large area flat screen color TV industry, the primary competition comes from
plasma panel displays, LCD displays, organic LED displays, and color picture
tubes. We believe FED technology, when fully developed, will primarily compete
with plasma displays and LCD displays, and generally compares favorably visually
and technically with both types of displays. In addition, carbon nanotube based
field emission displays are expected to be less costly than plasma displays. LCD
displays have quality issues related to the viewing angle and are generally not
economical once the size exceeds 45 inches, and therefore are not considered
strong competition because our technology is targeted at displays greater than
50 inches. Several companies are currently developing backlights for LCDs using
carbon nanotubes. Successful development of a carbon nanotube backlight would
require a license to our intellectual property.


Page
5




Sensors




Overview.We have greatly expanded our work and intellectual property in the area
of sensor technology. This is becoming an increasingly important part of our
business, and we expect it to become even more important in the future. Our
approach to sensor technology offers the unique advantage of manipulating
materials at the molecular level at which sensing events occur. We are pursuing
a multiplatform approach to address specific market needs. Some of the potential
applications are as follows:




Hydrogen
sensors. These sensors are initially targeted for use in fuel cells for
automobiles and for remote monitoring of large power transformers. We developed
a hydrogen sensor for use in the measurement of hydrogen in power transformer
products. We are currently working with a large manufacturer of instruments,
controls, and monitoring systems used in the power transmission industry, and we
have an all encompassing agreement covering development, technology transfer,
and licensing with this partner. We expect this partner will introduce a product
using our sensor in 2008 and that it will begin generating royalties for
us.




Carbon Monoxide
Sensors.We have developed a low-power carbon monoxide sensor that can
last for 10,000 hours on a single battery. The sensor will be specific to carbon
monoxide with no cross sensitivity to other gases and elements and is also
easily portable and highly sensitive. We are working on a Phase II project for
the U.S. Air Force for this carbon monoxide sensor. When completed, we plan to
commercialize the sensor to be able to license the technology for both
commercial and government purposes.




Biosensors.
Our carbon nanotube technology is ideally suited for use in biosensors. Sensors
based on carbon nanotubes or other nanomaterials can be used to detect chemical,
organic, or biological warfare agents, as well as explosives, hydrogen, ammonia
and numerous other chemicals. We have developed several proof of concepts
demonstrating the viability of our sensor technology, and are currently seeking
development partners to license the technology and integrate it into specific
products.




Other sensors.We have demonstrated that carbon nanotubes can be used to develop sensors
for chemical, organic, and biological warfare agents. We have also demonstrated
that carbon nanotubes and other nanodetectors can be used for the remote
detection of explosives, sensors used in environmental monitoring, health care,
the food industry, biotech-biopharma applications, genetic biosensors, and
immunosensors. We are currently seeking funding to take our research in this
area to the next level of development, which would include proofs of concept,
and product development. Ideally, we would do this with a development partner
that would fund the development and license the technology for manufacturing
upon completion, or in conjunction with a development partner under a government
funding program. We most likely would have different development partners for
different sensors that may be used in different industries.




Competition.Our competition in the sensor area will come from a variety of
technologies and companies depending on the purpose and use of the sensor. There
are other technologies used in sensors; however, we believe carbon nanotube
based sensors and other nanodetectors are more versatile, can sense a broader
range of materials, and are more selective (sensitive) in their sensor results.
We believe that selecting the right strategic partners for development of proof
of concepts for our sensor technology is an important step in the market
acceptance of sensors using our technology.




Nanoelectronics
Applications




We are
working in several other areas that have grown out of our basic work in the
electron emission area. These technologies are related to previously discussed
applications in that they use common materials, such as carbon nanotubes, use
similar processes, capitalize on knowledge that we have gained in our research
in other areas, or take advantage of unique capabilities of our technical staff.
One such important area is conductive inks.




Conductive
Inks.




As a
result of the move towards flexible electronics, soldering processes are slowly
disappearing and new processes that are digital in nature, allowing a move
directly from design to the production line, are needed. One of those areas that
we have chosen to focus on is conductive inks. Nanotechnology will play an
important role in this process because only nanoparticles are capable of
producing inks that are compatible with the nozzles used in digital
printing.


Page
6




To
facilitate our development of conductive inks, we entered into a research and
development agreement in 2006 with a leading industrial chemical products
company headquartered in Japan to develop conductive inks that can be deposited
using an additive process such as ink-jet printing or screen printing. The
target market for these technical inks includes printed circuit boards, flexible
electronics and displays, communications instrumentation, and RFIDs. This first
phase of the project started in late 2006, lasted one year and generated
$500,000 in revenue for us. Upon successful completion of the first phase, we
began a second phase with the same company that will also last approximately one
year and generate a minimum of $635,000 in revenue.




We chose
to start this project by focusing on nanocopper inks using copper nanoparticles
because of copper’s superior electrical conductivity properties and because it
is the material of choice in the printed circuit board industry. We have been
able to achieve electrical conductivity properties similar to that of bulk
copper with these inks. We are optimistic that completion of this second phase
of this project will lead to a license agreement.




Competition.Numerous other companies are working with other technologies with the
goal of achieving results similar to the goals of our technology. The ultimate
success of products using our technology will be dependent upon the results of
our research compared with results achieved by others.




Functional
Nanomaterials




We are in
the advanced stages of research into nanomaterials using carbon nanotube and
other composites. We believe that some of the first widespread use of
nanotechnology by established companies will be in this area as they work to
improve existing products, materials, and processes. A significant opportunity
exists in this area for us to develop and license our technology. We are
currently exploring opportunities with several companies in this
area.




Large Sporting
Goods Manufacturer.In September 2005, we signed a development contract
with a large sporting goods manufacturer to develop nanocomposites to be used in
the manufacturer’s sporting equipment. The goal of the project, which involved
three separate areas, was to improve the existing base materials currently used
by the manufacturer to make the equipment stronger, lighter, and more powerful.
Upon completion of the initial phase of the project in 2006, we began a second
phase of the project and are still working with this manufacturer. Based on the
results obtained to date, we expect to sign a license agreement with this
manufacturer in 2008.




Competition.Since this is a developing area of nanotechnology, there are not
established competitors. Our competition would come from companies working with
other materials. Since each project is unique, there are not necessarily any
established competitors in the market.




Nano-ecology




Photoscrub®
Technology.We developed a concept called Photoscrub® which is based on
an air purification technology originally developed by one of our strategic
partners, Andes Electric Co., Ltd. The Photoscrub® is a thin film coating on a
flexible fiberglass cloth that decomposes pollutants at the molecular level in
liquids and gases. We began a one year project in the amount of roughly $950,000
to further develop this technology for the U.S. Army in November 2006. Based on
the results of this first phase, we have been included in an appropriation for a
second phase. We expect to be awarded a contract of roughly $1.52 million in
2008 to integrate this technology into commercial air handling
systems.




EBT




Electronic
Display Products.EBT was formed to develop sun-readable display products
for outdoor use. We quickly expanded our focus to large area displays for indoor
use that would compete with Plasma and could be used as part of an overall point
of purchase advertising program and developed a patented product called the
E-WindowTM. We restructured EBT, stopped selling products directly, and instead
limited ourselves to licensing our intellectual property. As discussed below, we
sold EBT’s intellectual property in 2006.


Page
7




Communication
patents.We
have applied for patents covering a system of selling advertising for electronic
displays over the internet and other digital networks. The first of the patents,
which was filed in April 2000 with a priority date of April 1999, was issued in
2006. The allowed claims on this patent relate to methods, systems and computer
programs that facilitate displaying advertising information on multiple indoor
or outdoor electronic displays. There are also applied for similar patents and
have applications pending in Europe, Canada, Korea, and Japan. As discussed
below, we sold these patents in 2006.




Sale of
Intellectual Property.In 2006 we began discussions related to licensing
our communication patents referred to above. Those discussions culminated in the
sale of EBTs intellectual property in two simultaneous transactions to Novus
Communications Technologies, Inc. in June 2006. In the first transaction, we
sold our communications patents to Novus Partners, LLC, a majority owned
subsidiary of Novus Communications. We received an upfront payment of $1,000,000
and the right to future royalties based on the revenue received by Novus
Partners. The agreement also contains certain provisions related to future
minimum royalty payments, which if not met, cause the patents to revert back to
EBT. There are no minimum royalty payments due in 2008.




In the
second transaction, we sold EBT’s remaining intellectual property and other
assets, which consisted solely of items related to the intellectual property,
such as drawings, etc. to Novus Displays, LLC, a newly formed organization owned
by Novus Communications. In exchange for the remaining intellectual property, we
received $500,000 and a 25% ownership interest in Novus Displays. One of the
patents that we sold in this transaction was a patent that had been assigned to
us by Advanced Technology Incubator, Inc. (“ATI”), a company owned by
Dr. Zvi Yaniv, our Chief Operating Officer. In order to acquire the
remaining interest in the patent and settle all potential future obligations to
ATI, we issued 200,000 shares of our common stock, valued at $400,000 to ATI.
Dr. Yaniv also received a 5% ownership interest in Novus Displays as part
of the transaction.




Future
Activities.EBT’s future activities
are limited to participation in the digital signage industry through Novus
Communications. Our communication patents are part of a larger package of
related patents held by Novus Partners and any future income that we may receive
is dependent on the ability of Novus Partners to license that patent package. We
have not received any royalties from Novus Partners since the time of the
initial payment in 2006, and we will not receive any royalties from Novus
Partners until such time as they have revenue producing agreements. While we
anticipate receiving income in 2008, we have no control over, or input into, the
licensing activities of Novus Partners.




Our
ownership interest in Novus Displays is a passive ownership interest, and we
have no active role in the day to day management. Our sale of our remaining
intellectual property to Novus Displays was done to facilitate the sale of our
communications patents to Novus Partners. We had no interest in devoting further
resources to development of that technology. The sale to Novus Displays provided
us the opportunity to receive additional future value from that technology, if
it is successfully deployed by Novus Displays. We will receive no income from
Novus Displays and only profit from an eventual sale of Novus Displays, if it
occurs. To the best of our knowledge, Novus Displays has not yet been
capitalized beyond its initial minimal capitalization and is not yet actively
developing any of the technology acquired from us, or carrying on any
significant business activities.




Technology
Agreements




Till Keesmann.We have licensed certain patents related to carbon nanotube technology
from Till Keesmann (“the Keesmann patents”). We licensed 6 patents, including
foreign filings, in 2000 in exchange for a payment of $250,000. The U.S. patent
was reissued in August 2003. This reissuance significantly strengthened and
reinforced this patent. Under the terms of the agreement, we are obligated to
pay license fees equal to 50% of any royalties received by the Company
specifically related to these patents. We are allowed to offset certain
expenses, up to a maximum of $50,000 per year, against payments due under this
agreement. The agreement also contains provisions related to minimum license fee
payments, certain of which were deferred by Mr. Keesmann until after the
reissuance of the patent was completed. A total of $1,000,000 of minimum
payments has been made, with the last payment made in May 2004. No future
minimum payments are due, and the minimum payments made to date can be offset
against future royalties due under the license agreement. As described in more
detail in Item 3 of this Annual Report on Form 10-K, this agreement is the
subject of current litigation.




MCC. We acquired 62 patents and
patent applications related to the carbon film based field emission technology
from MCC in 1998. We are obligated to pay MCC a royalty of 2% of future
commercial revenues related to these patents. We can, however, offset certain
pre-defined expenses against these royalty payments. Based on the expenses
incurred and cost of maintaining the patents, the possibility is remote that we
will be required to pay MCC any royalties at any time in the future. MCC has
since gone out of business.


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8




Intellectual
Property Rights




An
important part of our product development strategy is to seek, when appropriate,
protection for our products and proprietary technology through the use of
various United States and foreign patents. Our patent portfolio consists of over
300 patents, including 131 issued patents, 3 allowed patents, and 190 patent
applications pending before foreign and United States Patent and Trademark
Offices. We also have several unsubmitted patent applications in process. The
patents, allowances and applications relate to carbon nanotube field emission
technology and other technologies. In addition, there are foreign counterparts
to certain United States patents and applications. We consider our patent
portfolio to be our most valuable asset.




The
patenting of technology-related products and processes involves uncertain and
complex legal and factual questions. To date, no consistent policy has emerged
regarding the breadth of claims of such technology patents. Therefore, there is
no assurance that our pending United States and foreign applications will issue,
or what scope of protection any issued patents will provide, or whether any such
patents ultimately will be upheld as valid by a court of competent jurisdiction
in the event of a legal challenge. Interference proceedings, to determine
priority of invention, also could arise in any of our pending patent
applications. The costs of such proceedings would be significant and an
unfavorable outcome could result in the loss of rights to the invention at issue
in the proceedings. If we fail to obtain patents for our technology, and are
required to rely on unpatented proprietary technology, there is no assurance
that we can protect our rights in such unpatented proprietary technology, or
that others will not independently develop substantially equivalent proprietary
products and techniques, or otherwise gain access to our proprietary
technology.




Competitors
have filed applications for, or have been issued patents, and may obtain
additional patents and proprietary rights relating to products or processes used
in, necessary to, competitive with, or otherwise related to, our patents. The
scope and validity of these patents, the extent to which we may be required to
obtain licenses under these patents, or under other proprietary rights and the
cost and availability of licenses are unknown. This may limit our ability to
license our technology. Litigation concerning these or other patents could be
protracted and expensive. If suit were brought against us for patent
infringement, a challenge in the suit by us as to the validity of the other
patent would have to overcome a legal presumption of validity. There can be no
assurance that the validity of the patent would not be upheld by the court or
that, in such event, a license of the patent to us would be available. Moreover,
even if a license were available, the payments that would be required are
unknown and could materially reduce the value of our  interest in the
affected products. We do, however, consider our patents to be very strong and
defendable in any action that may be brought against us. A major law firm has
reviewed our patent portfolio and agreed to handle litigation related to certain
of our patents on a contingency basis.




We also
rely upon unpatented trade secrets. No assurances can be given that others will
not independently develop substantially equivalent proprietary information and
techniques or otherwise gain access to our trade secrets or disclose such
technology or that we can meaningfully protect our rights to our unpatented
trade secrets.




We
require our employees, directors, consultants, outside scientific collaborators,
sponsored researchers, and other advisors to execute confidentiality agreements
upon the commencement of employment or consulting relationships with us. These
agreements provide that all confidential information developed or made known to
the individual during the course of the relationship is to be kept confidential
and not disclosed to third parties except in specific circumstances. In the case
of employees, the agreements provide that all inventions conceived by the
individual shall be our exclusive property. There is no assurance, however, that
these agreements will provide meaningful protection for our trade secrets in the
event of unauthorized use or disclosure of such information.


Page
9




Government
Regulation




Products
using our technology will be subject to extensive government regulation in the
United States and in other countries. In order to produce and market existing
and proposed products using our technology, our licensees must satisfy mandatory
safety standards established by the U.S. Occupational Safety and Health
Administration (“OSHA”), pollution control standards established by the U.S.
Environmental Protection Agency (“EPA”) and comparable state and foreign
regulatory agencies. We may also be subject to regulation under the Radiation
Control for Health and Safety Act administered by the Center for Devices and
Radiological Health (“CDRH”) of the U.S. Food and Drug Administration. We do not
believe that carbon nanotube field emission products will present any
significant occupational risks to the operators of such equipment. In addition,
the carbon nanotube field emission products are not expected to produce
significant hazardous or toxic waste that would require extraordinary disposal
procedures.  Nevertheless, OSHA, the EPA, the CDRH and other
governmental agencies, both in the United States and in foreign countries, may
adopt additional rules and regulations that may affect us and products using our
technology. Additionally, our arrangements with our licensees and their
affiliates may subject products using our technology to export and import
control regulations of the U.S. and other countries. The cost of compliance with
these regulations has not been significant in the past and is not expected to be
material in the future.




A portion
of our revenue has consisted of reimbursement of expenditures under U.S.
government contracts. We recognized $2,328,010 of revenue in 2007, $583,236 in
2006, and $208,211 in 2005, related to government contracts. These
reimbursements represent all or a portion of the costs associated with such
contracts. As of December 31, 2008, we have several grants in process that have
approximately $3.4 million of revenue yet to be recognized. Government contracts
are subject to delays and risk of cancellation. Also, government contractors
generally are subject to various kinds of audits and investigations by
government agencies. These audits and investigations involve review of a
contractor’s performance on its contracts, as well as its pricing practices, the
costs it incurs and its compliance with all applicable laws, regulations and
standards. We are, and in the future expect to be, audited by the
government.




Employees




As of
February 18, 2008 we had 38 full-time employees, including 4 executive officers.
Within the next twelve months, based on new government contracts that we have
received and expect to receive, we likely will hire two to four additional
employees to support our plans for increasing research levels. We are not
subject to any collective bargaining agreements and we consider our relations
with our employees to be good.




Available
Information




Our
website is http://www.nano-proprietary.com.
Our periodic reports and all amendments to those reports required to be filed or
furnished pursuant to Section 13(a) or Section 15(d) of the Securities Exchange
Act of 1934 are available free of charge through its website. During the period
covered by this report, the Company made its periodic reports on Form 10-K, and
Form 10-Q and its current reports on Form 8-K and amendments to those documents
available on its website as soon as reasonably practicable after those reports
were filed with or furnished electronically to the Securities and Exchange
Commission. The Company will continue to make such reports and amendments to
those reports available on its website as soon as reasonably practicable after
those reports are filed with or furnished to the Securities and Exchange
Commission. Material contained on our website is not incorporated by reference
in this Annual Report on Form 10-K.


Page
10




Item
      1A.
            Risk
      Factors




Our
success is dependent on our principal technologies




Our
technology platforms, which include sensor technology, electron emission
activities, nano-electronics, functional nano-materials, and nano-ecology, are
emerging technologies. Our financial condition and prospects are dependent upon
licensing our intellectual property to others. Additional R&D needs to be
conducted on many of our technologies before others can produce products using
this technology. Market acceptance of products using our technology will be
dependent upon the acceptance within the industries of those products of the
quality, reliability, performance, efficiency, and breadth of application and
cost-effectiveness of the products. There can be no assurances that these
products will be able to gain commercial market acceptance.




Products
using our technology may not be accepted by the market




Since our
inception, we have focused our product development and R&D efforts on
technologies that we believe will be a significant advancement over currently
available technologies. With any new technology, there is a risk that the market
may not appreciate the benefits or recognize the potential applications of the
technology. Market acceptance of products using our technology will depend, in
part, on the ability of our licensees to convince potential customers of the
advantages of such products as compared to competitive products. It will also
depend upon our ability to train manufacturers and others to use our
products.




Our
technology development is in its early stages and the outcome is
uncertain




Our many
applications of nanotechnologies, and certain products that use these
technologies, will require significant additional development, engineering,
testing and investment prior to commercialization. We are exploring the use of
our technology in several different types of products. We have developed proof
of concepts of potential products based on carbon nanotube technologies. In some
cases, we are developing products jointly with others based on our technology.
Upon successful completion of the development process, our development partners
will be required to license our technology to produce and sell the products. Our
development partners retain all rights to any intellectual property that they
develop in the process.




If any of
the potential products that are being developed using our technologies are
successfully developed, it may not be possible for potential licensees to
produce these products in significant quantities at a price that is competitive
with other similar products. At the present time, the only significant revenue
that we receive related to our technology is related to reimbursed research
expenditures, and development fees. These revenues are identified in our
quarterly filings on Form 10-Q and our annual filings on Form 10-K as revenues
of our Applied Nanotech, Inc. subsidiary in the related “Management’s Discussion
and Analysis of Financial Condition and Results of Operations” sections. We also
anticipate receiving up-front license fees in 2008.




Our
development partners have certain rights to jointly developed property and to
license our technology




We have
committed to license our technology to our development partners upon completion
of certain development projects that are in process. The terms of any such
license have not yet been finalized. One of our past development partners, a
large Japanese display company, has paid us $2.0 million for research services
and has the right to offset this payment against any future license fee payments
due as a result of an existing license agreement that we have with this company.
Our development partners in the HYFEDTM project also have rights to any jointly
developed property; however, any such jointly developed property would be based,
at least in part, on our underlying technology and would require our partners to
enter into an agreement with us. See also “Our technology development is in
its early stages and the outcome is uncertain” above for further
discussion.




We
have limited resources and our focus on particular products may result in our
failure to capitalize on other opportunities




We have
limited resources available to successfully develop and commercialize our
technology. As of February 18, 2008, we had 38 full-time employees. There is a
wide array of potential applications for our technology and our limited
resources require us to focus on specific product areas, while ignoring others.
We focus our efforts on those projects for which we can obtain external funding
since the availability of funding provides an external verification of the
probability of commercial success of resulting products.


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11




We
may not be able to provide system integration




In order
to prove that our technologies work and will produce a complete product, we must
ordinarily integrate a number of highly technical and complicated subsystems
into a fully integrated prototype. There is no assurance that we will be able to
successfully complete the development work on some of our proposed products or
that there will ultimately be any market for those products.




Many
products that may be developed using our technology will need to be integrated
into end-user products by manufacturers of those products. Although we intend to
develop products to be integrated into existing manufacturing capabilities,
manufacturers may be required to make modifications to, or expand their
manufacturing capabilities. Manufacturers may not elect to integrate products
using our technology into their end-user products, or they may not devote
adequate resources to modifying their manufacturing capabilities so that our
technologies can be successfully incorporated into their end-user products. The
complexity of integration may delay the introduction of products using our
technology.




Rapid
technological changes could render our technology obsolete; and we may not
remain competitive




The
industries in which we compete are highly competitive and are characterized by
rapid technological change. Our existing and proposed products will compete with
other existing products and may compete against other developing technologies.
Development by others of new or improved products, processes or technologies may
reduce the size of potential markets for our products. There is no assurance
that other products, processes or technologies will not render our proposed
products obsolete or less competitive. Many of our competitors have greater
financial, managerial, distribution, and technical resources than we do. We will
be required to devote substantial financial resources and effort to further
R&D. There is no assurance that we will successfully differentiate our
technology from our competitors’ technology, or that we will adapt to evolving
markets and technologies, develop new technologies, or achieve and maintain
technological advantages.




We
have limited manufacturing capacity and experience




We have
no established commercial manufacturing facilities; and we have no intention of
establishing a manufacturing facility related to our field emission technology,
sensors, nanomaterials which include using composites, or any other aspects of
our technology. We are focusing our efforts on licensing our intellectual
property to others for use in their manufacturing processes. To the extent that
any of the products that we develop require manufacturing facilities, we intend
to contract with a qualified manufacturer.




The
health effects of nanotechnology are unknown




There is
no scientific agreement on the health effects of nanomaterials, but some
scientists believe that in some cases, nanomaterials may be hazardous to an
individual’s health or the environment. The science of nanotechnology is based
on arranging atoms in such a way as to modify or build materials not made in
nature; therefore, the effects are unknown. The Company takes appropriate
precautions for its employees working with carbon nanotubes and believes that
any health risks related to carbon nanotubes used in potential products can be
minimized. Future research into the effects of nanomaterials in general, and
carbon nanotubes in particular, on health and environmental issues may have an
adverse effect on products using our technology.




Public
perception(s) of ethical and social issues may discourage the use of
nanotechnology




Nanotechnology
has received both positive and negative publicity and is increasingly the
subject of public discussion and debate. Governments may, for social or health
purposes, prohibit or regulate the use of nanotechnology. This may restrict our
ability to license our technology, or the ability of our licensees to sell their
products.




The
loss of key personnel could adversely affect our business




Our
future success will depend on our ability to attract and retain highly qualified
scientific, technical and managerial personnel. Competition for such personnel
may be intense. We may not be able to attract and retain all personnel necessary
for the development of our business. In addition, much of the know-how and
processes developed by us reside in our key scientific and technical personnel.
The loss of the services of key scientific, technical and managerial personnel
could have a material adverse effect on us until we are able to replace those
personnel.


Page
12




We
have a history of net losses




We have a
history of net losses. From our inception through December 31, 2007, we incurred
net losses of approximately $106 million. Our only profitable year was 1999,
based on the strength of a license agreement of approximately $5.6 million
signed in March 1999. We have incurred net income and losses as shown
below:





Year
      Ended December 31
            
            Net
      Income
              (Loss)1995
            
            ($14,557,426)1996
            
            ($14,583,506)1997
            
            ($7,306,232)1998
            
            ($4,361,742)1999
            
            $474,5992000
            
            ($9,471,279)2001
            
            ($6,047,698)2002
            
            ($5,452,890)2003
            
            ($4,017,374)2004
            
            ($7,139,109)2005
            
            ($5,818,816)2006
            
            ($6,593,892)2007
            
            ($4,256,891)







Although
we expect to be profitable in the future, we may not be. Our profitability in
2008 is dependent on the signing of additional license agreements, obtaining
additional research funding, or a combination of the two. We may, however,
continue to incur additional operating losses for an extended period of time as
we continue to develop our technologies. We do, however, expect the magnitude of
those losses, if they continue, to decrease. We have funded our operations to
date primarily through the proceeds from the sale of our equity securities and
debt offerings. We are primarily a contract research and development
organization and are dependent on license agreements and research funding to
achieve profitability. In order to continue development of our technology, we
anticipate that substantial research and development expenditures will continue
to be incurred.




We
have no current royalty agreements producing significant revenue




Our
strategy is dependent on licensing our technology to other companies and
obtaining royalties based on products that these licensees develop and sell. We
have no plans to manufacture and sell any products ourselves, and as such, we
have no product revenues. While we do have existing licenses, none of the
licensees are producing products at the present time and therefore none of the
licenses are producing current revenue.




We expect
to license our technology to be used in many applications. See additional
discussion in the risk factor “Our technology development is in its early stages
and the outcome is uncertain” above. It is our intention that all future license
agreements will include a provision that requires the payment of ongoing
royalties, although there is no assurance that will occur.




We
are dependent on the availability of materials and suppliers




The
materials used in producing current and future products using our technology are
purchased from other vendors. We anticipate that the majority of raw materials
used in products to be developed by us will be readily available to
manufacturers. However, there is no assurance that the current availability of
these materials will continue in the future, or if available, will be procurable
at favorable prices.





Page
13




Our
revenues have been dependent on government contracts in the past




In many
years, a significant portion of our revenues are derived from contracts with
agencies of the United States government. Following is a summary of those
revenues for the past twelve years:





Year
      Ended December 31
            
            Revenues
      from
              Government
              Contracts
            
            Percentage
      of
              Total
      Revenue1995
            
            $1,009,000
            
            33%1996
            
            $2,869,000
            
            50%1997
            
            $854,000
            
            24%1998
            
            $0
            
            0%1999
            
            $0
            
            0%2000
            
            $352,341
            
            13%2001
            
            $466,680
            
            15%2002
            
            $254,152
            
            18%2003
            
            $339,790
            
            44%2004
            
            $305,721
            
            80%2005
            
            $208,211
            
            37%2006
            
            $583,236
            
            52%2007
            
            $2,328,010
            
            58%







We
currently have commitments for future government funding of approximately $3.4
million. We do not intend to seek any government funding unless it directly
relates to achievement of our strategic objectives.




Contracts
involving the United States government are, or may be, subject to various risks
including, but not limited to, the following:




·
              Unilateral
      termination for the convenience of the
  government


·
              Reduction
      or modification in the event of changes in the government’s requirements
      or budgetary constraints


·
              Increased
      or unexpected costs causing losses or reduced profits under fixed-price
      contracts or unallowable costs under cost reimbursement
      contracts


·
              Potential
      disclosure of our confidential information to third
  parties


·
              The
      failure or inability of the prime contractor to perform its prime contract
      in circumstances where we are a
subcontractor


·
              The
      failure of the government to exercise options provided for in the
      contract.


·
              The
      right of the government to obtain a non-exclusive, royalty free,
      irrevocable world-wide license to technology developed under contracts
      funded by the government if we fail to continue to develop the
      technology




We
are exposed to litigation liability




As
described in more detail in Item 3 of this Annual Report on Form 10-K, we are
the plaintiff in two separate pieces of litigation. The first is against, Canon,
Inc., and the second is against Till Keesmann. While there is risk associated
with any litigation, we expect to prevail in both of these cases. If we were to
not prevail in the Canon litigation, we would expect that would have no impact
on our current financial condition beyond the additional costs incurred through
the completion of the litigation. If we were not to prevail in the Keesmann
litigation and Keesmann were allowed to terminate the existing agreement, we
could lose any potential future revenue specifically associated with licensing
the patents covered by the agreement. It would not, however, eliminate the need
for any licensee of the Keesmann patents for use in the display industry to also
license our patents as well. In addition, if Keesmann were allowed to terminate
the patent, we would seek damages equal to the value that we bestowed upon the
patent during the term of the license agreement. It is our opinion that the
majority of the value of the Keesmann patent today is as a result of our work on
the reissuance of the patent.


Page
14




We have
lawsuits that arise in the normal course of business. We have been subject to
litigation in the past and have settled litigation in the past that has in rare
instances resulted in material payments. We expect all current lawsuits to be
resolved with no material negative impact on our financial statements, and we
are unaware of any other potential significant litigation. If we were to become
subject to a judgment that exceeds our ability to pay, that judgment would have
a material impact on our financial condition and could affect our ability to
continue in existence.




We
may have future capital needs and the source of that funding is
uncertain




We expect
to continue to incur substantial expenses for R&D, product testing, and
administrative overhead. The majority of R&D expenditures are for the
development of our technologies. Some of the proposed products using our
technology may not be available for commercial sale or routine use in the
immediate future. Commercialization of existing and proposed products that would
use our technology may require additional capital in excess of that currently
available to us. A shortage of capital could prevent us from achieving
profitability for an extended period of time. Because the timing and receipt of
revenues from the sale of products using our technology will be tied to the
achievement of certain product development, testing, manufacturing and marketing
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 activities and/or
seek additional financing from other sources. We may seek additional financing
through the offer of debt, equity, or any combination of the two at any time,
although we do not expect to seek any significant additional financing for the
remainder of the year.




We have
developed a plan to allow us to maintain operations until we are able to sustain
ourselves, and we believe our current cash levels are sufficient to fund
operations until we reach that point. We have the resources, including expected
revenue, to continue operations for a period through at least the end of 2008
and into 2009. Our plan is primarily dependent on raising funds through the
licensing of our technology and revenue generated from performing contract
research services. We intend to raise additional capital through debt or equity
offerings, only if necessary. We expect to sign significant license and
development contracts within the next year, although there is no assurance that
this will occur.




Our plan
is based on current development plans, current operating plans, the current
regulatory environment, historical experience in the development of electronic
products and general economic conditions. Changes could occur which would cause
certain assumptions on which this plan is based to be no longer valid. Our plan
is primarily dependent on increasing revenues, licensing our technology, and
raising additional funds through additional debt and equity offerings, only if
necessary. If adequate funds were not available from operations or additional
sources of financing, we may have to eliminate, or reduce substantially,
expenditures for research and development, and testing of our products. We may
have to obtain funds through arrangements with other entities that may require
us to relinquish rights to certain of our technologies or products. These
actions could materially and adversely affect us.




We
may be unable to enforce or defend our ownership and use of proprietary
technology




Our
ability to compete effectively with other companies will depend on our ability
to maintain the proprietary nature of our technology. Although we have been
awarded patents, have filed applications for patents, or have licensed
technology under patents that we do not own, the degree of protection offered by
these patents or the likelihood that pending patents will be issued is
uncertain. Competitors in both the United States and foreign countries, many of
which have substantially greater resources and have made substantial investment
in competing technologies, may already have, or may apply for and obtain patents
that will prevent, limit or interfere with our licensee’s ability to make and
sell our products using our technology. Competitors or potential licensees may
also intentionally infringe on our patents. The defense and prosecution of
patent suits is both costly and time-consuming, even if the outcome is favorable
to us.




In
foreign countries, the expenses associated with such proceedings can be
prohibitive. In addition, there is an inherent unpredictability in obtaining and
enforcing patents in foreign countries. An adverse outcome in the defense of a
patent suit could subject us to significant liabilities to third parties.
Although third parties have not asserted infringement claims against us, there
is no assurance that third parties will not assert such claims in the future. A
major law firm has reviewed our patent portfolio and agreed to handle litigation
related to certain of our patents on a contingency basis.


Page
15




Changes
in patent laws could have a negative impact on us




New
legislation, regulations, or rules related to obtaining or enforcing patents
could significantly increase our operating costs and make it more difficult to
enforce or license our patents. If new legislation, regulations, or rules are
implemented by either Congress, the United States Patent and Trademark Office,
or the courts that impact the patent application process, the patent enforcement
process, or the rights of patent holders, these changes could negatively affect
our expenses and potential revenue.




We
rely on unpatented proprietary technology




We also
rely on unpatented proprietary technology, and there is no assurance that others
will not independently develop the same or similar technology, or otherwise
obtain access to our proprietary technology. To protect our rights in these
areas, we require employees, consultants, advisors and collaborators to enter
into confidentiality agreements. These agreements may not provide meaningful
protection for our trade secrets, know-how, or other proprietary information in
the event of any unauthorized use, misappropriation or disclosure of such trade
secrets, know-how, or other proprietary information. While we have attempted to
protect proprietary technology that we develop or acquire and will continue to
attempt to protect future proprietary technology through patents, copyrights and
trade secrets, we believe that our success will depend upon further innovation
and technological expertise.




We
have technologies subject to licenses




As a
licensee of certain research technologies through license and assignment
agreements with Microelectronics and Computer Technology Corporation (“MCC”), we
have acquired rights to develop and commercialize certain research technologies.
In certain cases, we are required to pay royalties on the sale of products
developed from the licensed technologies and fees on revenues from sublicenses.
We also have to pay for the costs of filing and prosecuting patent applications.
The agreement is subject to termination by either party, upon notice, in the
event of certain defaults by the other party. We consider it unlikely that any
royalty payments would be required to be made to MCC based on the substantial
amounts of revenues that would have to be generated to offset the costs of
maintaining the patents over the years. MCC is also no longer in
business.




We have
also licensed certain patents related to carbon nanotube technology from Till
Keesmann (“the Keesmann patents”). We licensed 6 patents, including foreign
filings, in 2000 in exchange for a payment of $250,000. The U.S. patent was
reissued in August 2003. This reissuance significantly strengthened and
reinforced this patent. Under the terms of the agreement, we are obligated to
pay license fees equal to 50% of any royalties received by the Company
specifically related to these patents. Sublicenses are subject to the approval
of Mr. Keesmann. We are allowed to offset certain expenses, up to a maximum of
$50,000 per year, against payments due under this agreement. The agreement also
contains provisions related to minimum license fee payments, certain of which
were deferred by Mr. Keesmann until after the reissuance of the patent was
completed. A total of $1,000,000 of minimum payments has been made, with the
last payment made in May 2004. No future minimum payments are due and the
minimum payments made to date can be offset against future royalties due under
the license agreement. No license agreements have yet been signed that involve
the Keesmann patents. This license agreement is currently the subject of
litigation as described in greater detail in Item 3 of this Annual Report on
Form 10-K.




Our
business is subject to changing regulation of corporate governance and public
disclosure




Because
our common stock is publicly traded, we are subject to certain rules and
regulations of federal and state entities charged with the protection of
investors and the oversight of companies whose securities are publicly traded.
These entities have continued to develop additional regulations and requirements
in response to laws enacted by Congress, most notably the Sarbanes-Oxley Act of
2002. Complying with these new regulations have resulted in, and are likely to
continue to result in, increased general & administrative costs and a
diversion of management time and attention from revenue generating and other
business activities to compliance activities.


Item
1B. Unresolved Staff
Comments
  None.


Page
16


Item
2. Properties




We lease
a facility in Austin that is used for our corporate headquarters and research
and development activities under a lease expiring in February 2008. In February
2008, we signed a new six year lease on the facility effective March 1, 2008.
The lease calls for payments of $12,505 for the first 24 months, $13,432 for
months 25 through 48, and $14,461 for the last 24 months.




We
believe that these facilities are suitable for our current needs and will be
adequate for our anticipated research, development, and administrative
activities, at least through the end of the lease period. We are currently
studying our facility needs and likely will move to a different facility at the
end of the lease period. We would expect a new facility to be similar in size to
our existing facility. If we embark on significant new research that requires
significant additional employees, we may have to establish additional
facilities.




We do not
currently invest in real estate or interests in real estate, real estate
mortgages, or securities of or interests in persons primarily engaged in real
estate activities. However, the Company has no policy, either for or against,
making such investments.




Item
3. Legal
Proceedings




Canon
litigation




In April
2005, we filed suit against the Japanese camera and copier manufacturer Canon,
Inc., and its wholly-owned U.S. subsidiary Canon USA, Inc., in the U.S. District
Court for the Western District of Texas, Austin Division, seeking a declaratory
judgment that new SED color television products being developed
and manufactured by a Canon/Toshiba joint venture are not covered under a
non-exclusive 1999 patent license agreement that we granted to Canon. 
We asserted that the Canon/Toshiba joint-venture – SED, Inc. – was not a
licensed party under that agreement.  The original complaint asserted
additional claims related to whether the Canon/Toshiba joint venture’s
television panels constituted excluded products under the 1999 license, as well
as breach of covenant of good faith and fair dealing, tortious interference and
a Lanham Act violation by Canon. In the fall of 2005, Canon moved to dismiss
Canon U.S.A. from the litigation, and moved to dismiss several of the counts
asserted.  The court denied the motion, in part, by ruling that Canon
U.S.A. was an appropriate defendant and refusing to dismiss our claims for
breach of the covenant of good faith and fair dealing.  Our tortious
interference and Lanham Act claims were dismissed, without
prejudice.




After
initial discovery, in April 2006, we amended the complaint to drop one count
related to the definition of excluded products in the 1999 license, and add two
counts for fraudulent inducement and fraudulent non-disclosure related to events
and representations made during our negotiations on the license,  and
leading up to and following the formation by Canon and Toshiba of their joint
venture effort, including Canon’s failure to disclose an ongoing relationship
with Toshiba and misrepresentations made to us about the joint venture’s
structure and operation.  Canon moved to dismiss the fraud claims, and
the Court denied Canon’s motion in May 2006.  Discovery was completed
in August 2006. Upon completion of discovery, Canon filed a motion for partial
summary judgment seeking to dismiss the claim that SED is not a licensed party
under the agreement. Canon did not file a motion for summary judgment seeking to
dismiss the other claims. In November 2006, the Court denied Canon’s partial
motion for summary judgment, describing SED, Inc. as a “corporate fiction
designed for the sole purpose of evading Canon’s contractual
obligations”.




In
January 2007, Canon filed another motion for partial summary judgment seeking a
declaration that a reconstituted SED, Inc. which is purportedly owned 100% by
Canon but which still involved numerous reciprocal agreements with Toshiba,
would be considered a Canon subsidiary. At the same time, we filed a motion for
partial summary judgment, seeking the Court’s affirmation of our termination of
the license agreement due to Canon’s breach of contract in 2004. On February 22,
2007, the Court issued a ruling denying Canon’s motion and granting our motion
for partial summary judgment, ruling our termination of the contract effective
December 1, 2006, to be valid.




A trial
on the case began on April 30, 2007 and a final judgment was entered in the case
in May 2007. The final judgment reaffirmed Canon’s material breach of the patent
license, while awarding no additional damages. Both parties have filed appeals
related to the litigation. All appeal briefs and responses have been filed with
the Fifth Circuit Court of Appeals and we are currently waiting for the Court to
set a date for oral arguments in the case.


Page
17




Keesmann
litigation




In May
2006, we filed suit in the U.S. District Court for the Northern District of
Illinois against Till Keesmann, a German citizen who in 2000 granted us an
exclusive and perpetual license to certain of his U.S. and European patents in
carbon nanotube cathode technology.   In 2005, Keesmann conveyed
part of his interests in the Exclusive License to investors associated with a
German patent evaluation firm, IP Bewertungs AG (“IPB”).  Thereafter,
IPB approached us with proposals to buy or auction our rights to Keesmann’s
patents.  On March 22, 2006, after we declined to participate in the
auction process, Keesmann purported to terminate the exclusive license that he
granted to us six years earlier.  Our May 2006 complaint seeks a
declaratory judgment that Keesmann had no right to terminate the exclusive
license and a Temporary Restraining Order and Preliminary Injunction to prevent
Keesmann from taking any actions inconsistent with his obligations under the
exclusive license.  The Court granted a consent order that prevents
Keesmann from licensing the patents pending an injunction hearing and
decision.  In June 2006, Keesmann filed an Answer and Counterclaim,
denying that the purported termination was null and void, and asserting a
counterclaim that asked the court to find that we breached the exclusive license
by not actively marketing the Keesmann patents, among other
things.




We
amended our complaint in December 2006 to include additional defendants, JK
Patentportfolio GmbH & Co., Jochen Kamlah, NPV Nano Patent GmbH & Co.,
and Arnold Amsinck. The amended complaint also contains additional claims
including breach of contract, conversion, aiding and abetting conversion,
conspiracy to commit conversion, misappropriation, aiding and abetting
misappropriation, conspiracy to commit conversion, Lanham Act violations,
tortious interference with a prospective economic relationship, aiding and
abetting tortious interference with a prospective economic relationship, and
conspiracy to tortiously interfere with a prospective economic
relationship.




In
January 2007, the Court granted our motion for preliminary injunction, ruling
that there is a reasonable likelihood that we will prevail on the merits of the
case. The preliminary injunction enjoins Keesmann, his agents, employees, and
all those acting in concert with him from terminating the license agreement for
the reasons asserted in the March 2006 default notice, or otherwise acting in
violation of the license agreement. In connection with this injunction, the
Court set a surety bond, which is required by law, at $100,000. We posted the
bond in February 2007.  Days after the Court issued the injunction,
Keesmann again asserted a number of alleged defaults under the license. In April
2007, we filed a second motion for a temporary restraining order and preliminary
injunction. We have established a discovery schedule leading up to trial, but no
trial date has yet been set. We have had settlement discussions at various times
during the course of the litigation, but have not, as yet reached a settlement
agreement to resolve the litigation.




From time
to time the Company and its subsidiaries are also defendants in various lawsuits
that may arise related to minor matters. It is expected that any such lawsuits
would be settled for an amount no greater than the liability recorded in the
financial statements for such matters. If resolution of any of these suits
results in a liability greater than that recorded, it could have a material
impact on us.







Item
4. Submission of Matters to a Vote of
Security Holders




There
were no matters submitted to a vote of security holders during the fourth
quarter of 2007.





Page
18


PART
II




Item
5. Market for Registrant’s Common
Stock, Related Stockholder Matters and Issuer Purchases of Equity
Securities




Our
common stock, $0.001 par value, trades on the OTC Bulletin Board system under
the symbol “NNPP”. The following table sets forth, on a per share basis for the
periods indicated, the high and low sale prices for the common stock as reported
by the OTC Bulletin Board system. These quotations reflect inter-dealer prices,
without retail mark-up, mark-down or commission and may not represent actual
transactions.




High
            
            Low2006
            
            First
      Quarter
            
            $2.68
            
            $2.05Second
      Quarter
            
            $2.62
            
            $1.47Third
      Quarter
            
            $1.75
            
            $1.08Fourth
      Quarter
            
            $1.72
            
            $0.922007
            
            First
      Quarter
            
            $2.96
            
            $1.20Second
      Quarter
            
            $2.86
            
            $1.10Third
      Quarter
            
            $1.33
            
            $0.88Fourth
      Quarter
            
            $1.40
            
            $1.032008
            
            First
      Quarter (through February 18, 2008)
            
            $1.10
            
            $0.87




As of
February 18, 2008, the closing sale price for our common stock as reported on
the OTC Bulletin Board system was $0.89. As of February 18, 2008, there were
approximately 360 shareholders of record for our common stock. This does not
include shareholders holding stock in street name in brokerage
accounts.






Cash
Dividends




We have
never paid cash dividends on our common stock, and it is unlikely that we will
pay any dividends in the foreseeable future. We currently intend to invest
future earnings, if any, to finance expansion of our business. Any payment of
cash dividends in the future will be dependent upon our earnings, financial
condition, capital requirements, and other factors deemed relevant by our board
of directors.





Page
19




Performance
Graph




The
following graph shows a comparison, since December 31, 2002, of cumulative total
return for Nano-Proprietary, the NASDAQ Market Index, and an index for
Commercial Physical Research (SIC code 8731).











12/31/02
            
            12/31/03
            
            12/31/04
            
            12/31/05
            
            12/31/06
            
            12/31/07Nano-Proprietary,
      Inc.
            100.00
            
            1,645.55
            
            1,315.15
            
            1,303.03
            
            848.48
            
            654.55NASDAQ
      Market Index
            100.00
            
            140.18
            
            179.95
            
            192.46
            
            209.30
            
            242.71Commercial
      Physical Research
              (SIC
      Code 8731)
            100.00
            
            150.36
            
            163.00
            
            166.58
            
            183.68
            
            201.91




The
performance graph assumes $100 invested on December 31, 2002 in our common
stock, the NASDAQ Market Index, and an index based on a basket of stocks
composing SIC Code 8731. The total return assumes reinvestment of dividends for
the NASDAQ Market Index and the SIC Code Index. The total return is based on
historical results and is not intended to indicate future performance. These
dates represent arbitrary points in time and if different dates were presented,
different results would be obtained. However, for the dates presented,
Nano-Proprietary, Inc. common stock substantially outperformed the
indexes.





Recent
Sales of Unregistered Securities




We issued
no unregistered shares of our securities in the fiscal quarter ended December
31, 2007.






Page
20




Item
6.            Selected Financial
Data





2007
            
            2006
            
            2005
            
            2004
            
            2003Revenues
            $
            3,989,803
            $
            1,116,670
            $
            565,660
            $
            382,522
            $
            773,959Net
      income (loss)
            $
            (4,256,891)
            $
            (6,593,892)
            $
            (5,818,816)
            $
            (7,139,109)
            $
            (4,017,374)Income
      (loss) per share
            $
            (0.04)
            $
            (0.07)
            $
            (0.06)
            $
            (0.07)
            $
            (0.05)Total
      assets
            $
            3,744,858
            $
            2,693,442
            $
            1,187,981
            $
            1,144,368
            $
            3,784,017Long-term
      obligations
            $
            30,044
            $
            —
            $
            —
            $
            5,944
            $
            27,353Net
      shareholders’ equity (deficit)
            $
            2,828,902
            $
            642,262
            $
            859,339
            $
            846,456
            $
            3,552,829Cash
      dividends per common share
            $
            —
            $
            —
            $
            —
            $
            —
            $
            —










We
restructured our Electronic Billboard Technology, Inc. subsidiary. EBT no longer
sells products or services, but seeks to license its intellectual property to
others. Revenue from continuing operations includes $130,386 in 2003. There was
no revenue from EBT in all other years presented.


Page
21




Item
7.            Management’s Discussion and Analysis
of Financial Condition and Results of Operations




The
following discussion should assist in understanding our financial condition,
liquidity, and capital resources as of December 31, 2007, and the results of
operations for the years ended December 31, 2007, 2006 and 2005. The Notes to
our Consolidated Financial Statements included later in this report contain
detailed information that should also be read in conjunction with this
discussion.




OVERVIEW




We are
engaged in research and development related to nanotechnology products,
primarily those involving carbon nanotubes, to be used in the display,
electronics, sensor, and other industries. Our technology, as well as many of
its potential applications, is still new and in the early stages of development.
Our revenue has primarily consisted of development projects involving either the
U.S. government or large multinational corporations.




OUTLOOK




We expect
our cash needs for 2008 to be approximately $7.5 million, excluding costs
related to litigation. We intend to fund those needs through a combination of
sales, reimbursements for research, and license agreements. We anticipate
receiving significantly more revenue in 2008 than was received in 2007. We have
developed a plan to enable us to achieve positive cash flow from operations with
approximately $7.8 million of revenue. As of February 18, 2008, we have
approximately $2.4 million in cash to cover any potential revenue shortfall that
may occur for the year. We do not expect to need to raise any additional equity
in 2008, but that could change if conditions change.




Our plan
is to generate sufficient revenues in 2008 to achieve breakeven or better;
however, losses may continue as we continue to fund the development of field
emission technology, sensors, nano-electronics, and nanomaterials. There can be
no assurances that we will be profitable in the future. Full commercial
development of our technology may require additional funds in the future. We
expect to continue our concentrated research and development of ANI’s technology
in 2008.




We have
developed a plan to allow ourselves to maintain operations until we are able to
sustain ourselves on our own revenue. Our plan is primarily dependent on raising
funds through the licensing of our technology and through reimbursed research
arrangements. Our current cash balances are adequate to insure that we can
maintain our operations at the present level. We believe that we have the
ability to continue to secure short term funding, if needed, to enable us to
continue operations until our plan can be completed if this plan takes longer
than anticipated.




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




Critical
Accounting Policies




Our
significant accounting policies are summarized in the footnotes to our financial
statements. Some of the most critical policies are also discussed
below.




Stock based
compensation-We routinely grant stock
options to employees and others. We have granted options in the past and each
year all employees have the opportunity to earn additional goal-based option
awards. We account for these options under the provisions
of  Statement of Financial Accounting Standards No. 123R (Revised
2004), Share-Based Payment (“SFAS No. 123R”), which requires that the
compensation cost relating to share-based payment transactions be recognized in
financial statements based on the provisions of SFAS 123 issued in
1995.


Page
22




Other-As a matter of policy,
we review our major assets for impairment. Our major operating assets are
accounts receivable, and property and equipment. We depreciate our property and
equipment over their estimated useful lives. We did not identify any impaired
items in 2005, 2006 or 2007. We have not experienced significant bad debts
expense, and we do not believe that we need an allowance for doubtful accounts
for any exposure to loss in our December 31, 2007 accounts
receivable.




LIQUIDITY
AND CAPITAL RESOURCES




Our cash
balance was $3,020,096 at December 31, 2007, which was significantly higher than
the cash balance of $2,085,338 at December 31, 2006. Our working capital was
approximately $2.5 million at December 31, 2007, a substantial increase from the
working capital of roughly $500,000 at December 31, 2006. During the same
period, our current ratio increased from approximately 1.2 to 1 to approximately
3.8 to 1. The reason for the significant change in our working capital ratio is
that current assets increased substantially as a result of our increased cash
balances and current liabilities decreased substantially as a result of our
decreased accounts payable balances. Our cash balance increased significantly as
a result of the increase in cash provided by financing activities, offset by the
amount of cash used as a result of our net loss, both of which are discussed
below. Our current liabilities decreased substantially from December 31, 2006 to
December 31, 2007, as a result of the deferred payment arrangement that we had
with our attorneys in connection with the Keesmann litigation. The amount due
under this arrangement was $1.1 million as of December 31, 2006. This
arrangement is described in more detail below in the selling, general, and
administrative expense section. This entire amount was paid in
2007.




The
principal source of our liquidity has been funds received from exempt offerings
of common stock. Cash provided by financing activities was $6,302,116,
$5,026,489, and $4,519,913 in 2007, 2006, and 2005, respectively. Of this, the
majority came from private placements of our common stock in the amounts of
$6,000,000, $5,004,193, and $4,000,000 in 2007, 2006, and 2005, respectively.
The majority of the balance of the cash provided by financing activities in all
years came from proceeds from the exercise of stock options by current and
former employees. We would anticipate a substantially decreased level of private
placement activity in 2008 and have no current plans to raise any additional
funds from the sale of equity.




As of
February 18, 2008, our cash balance is approximately $2.4 million. This combined
with expected revenue is enough for us to operate well into 2009, even if there
were no significant new positive developments. We may receive additional funds
from the exercise of employee stock options, although a significant portion of
the funds received from stock option exercises in 2007, 2006 and 2005 was from
former employees that had options expiring. There are minimal remaining options
held by former employees and only minimal options expiring in 2008. The level of
option exercise activity is also highly correlated with the market price of our
common stock.




In the
event that we need additional funds in 2008 beyond the amount that we have as of
the date of this filing and those that we expect to receive as revenues or from
other sources, we may seek to sell additional debt or equity securities. We have
no plans to do this, however. While we expect to be able to obtain any funds
needed for operations, there is no assurance that any financing alternatives can
be arranged on commercially acceptable terms. We believe that our success in
reaching profitability will be dependent upon the viability of products using
our technology and their acceptance in the marketplace.




Net cash
used in operating activities was $5,254,676 in 2007, $3,736,466 in 2006, and
$4,507,579 in 2005. The cash used in operations was primarily the result of the
net losses incurred in each year. The amount decreased from 2005 to 2006,
despite the larger loss in 2006 primarily as a result of the previously
discussed $1.1 million in payables at December 31, 2006 related to the Keesmann
litigation. The cash used in operations increased from 2006 to 2007, despite the
reduced loss in 2007, as a result of the payment of the same $1.1 million of
litigation expenses in 2007. We have a plan to generate positive cash from
operations in 2008; however, since that will require significantly increased
revenues, there is no assurance that will be achieved. Such significantly
increased revenues would most likely result from license agreements with
significant up-front payments, substantial research contracts, or litigation
results.


Page
23




Cash used
in investing activities was the result of the purchase of capital assets in all
years. We would expect minimal cash to be used in investing activities in 2008.
No material commitments exist as of December 31, 2007, for future purchases of
capital assets.




The only
contractual cash obligations that we have as of December 31, 2007 are operating
and capital leases. We have no long-term debt or notes payable. A summary of our
lease obligations at December 31, 2007 is as follows:





Total
            2007
            2008
            2009Capital
      leases
            $59,420
            $29,416
            $30,004
            —Operating
      leases
            $90,405
            $47,579
            $22,344
            $20,482







We
believe that we currently have the cash available to meet our cash requirements
for fiscal 2008.




RESULTS
OF OPERATIONS




Business Segments. We
have three reportable business segments, our Applied Nanotech, Inc. subsidiary,
our Electronic Billboard Technology, Inc. subsidiary and our remaining
activities, primarily corporate overhead. Because our Electronic Billboard
Technology, Inc. subsidiary has only minimal activity, our management discussion
and analysis related to results of operations is much more meaningful if done on
a consolidated basis. To the extent that EBT activity had a significant impact
on consolidated activity, it will be discussed in the context of the
consolidated results. The only significant financial activity at EBT was the
sale of its intellectual property in 2006.




Revenues. Following
is a summary of key revenue categories for the three years covered by this
report.





2007
            
            2006
            
            2005Government
      Revenues
            $
            2,328,010
            $
            583,236
            $
            208,211Other
      Contract Research
            $
            990,598
            $
            360,054
            $
            59,995License
      Fees and Royalties
            $
            —
            $
            83,928
            $
            —Total
      ANI Revenues
            $
            3,989,803
            $
            1,116,670
            $
            565,660Total
      EBT Revenues
            $
            —
            $
            —
            $
            —Total
      Revenues
            $
            3,989,803
            $
            1,116,670
            $
            565,660Revenue
      backlog at December 31
            $
            3,891,000
            $
            3,026,000
            $
            2,764,000











All of
the revenues during the 3-year period came from ANI. The government revenues in
2005 were primarily all the result of one Phase II SBIR grant. The government
revenues increased substantially in 2006 as a result of two new SBIR Phase II
grants, another significant contract from the United States Army, and several
SBIR Phase I grants. The government revenues increased substantially again in
2007 as a result of work on those and other new contracts. We also experienced a
substantial increase in other contract research over the three year period as a
result of our increased focus on that area. The revenue in 2005 came from our
contract with a large sporting goods manufacturer. The revenue in 2006 and 2007
resulted primarily from the same contract with the sporting goods manufacturer
and a contract with a large Japanese chemical manufacturer. We also received
some license revenue in 2006 as a result of the license agreement that we signed
with Shimane Masuda Electronics.




The
revenue backlog as of December 31, 2007 results from several government programs
and private contracts and represents an increase from prior years. The majority
of these programs are currently in progress and generating revenue, with the
remainder related to contracts awarded, but not yet started. The majority of
this backlog will be converted into revenue in 2008. The backlog as of December
31, 2005 included several contracts for which notification had been received,
but work had not yet commenced. As a result, work did not start on several of
these contracts until mid to late 2006 and several of those contracts remained
in the backlog as of December 31, 2006.


Page
24




We expect
revenue to be significantly higher in 2008 than in 2007, and we plan to generate
minimum revenues in 2008 of $5.8 million at ANI. Of that, $2.8 million is
already committed and in process, and the remaining $3.0 million has been
specifically identified. There is no guarantee that these revenues will be
obtained; however, we think it is more likely that revenues will exceed these
numbers, than it is that they fall short of them. Revenues could increase above
these levels as a result of royalty agreements or additional research revenues,
but there is no assurance that this will occur, or that even the projected
minimum of $5.8 million in revenue will be achieved. We are currently pursuing
many opportunities in several areas that could result in additional revenue in
2008.




Of the
$5.8 million of specifically identified revenues, we expect a minimum of $3.6
million to come from government contracts. Approximately $2.4 million of this is
expected to result from contracts currently in process and $1.2 million from new
contracts expected to be obtained.




The
remaining specifically identified revenue of $2.2 million is expected to come
from non-governmental sources. This amount is entirely from projects in process,
as well as expected extensions of those projects beyond current formal
commitments. Any projects started with new customers would be additive to these
numbers.




Cost of sales.
Because we do not ship products or provide homogenous services, we do not incur
costs of sales in the traditional sense. We do keep track of our costs on
individual projects, but because there is a wide variation in cost percentages,
presenting cost of sales information is not meaningful. Government sponsored
research has nominal or no gross margins and is primarily just a reimbursement
of costs. In some cases we charge nominal amounts for projects that have much
higher costs because we are proving a concept that will be helpful to us in
other areas, or are seeking a significantly larger follow up contract with the
customer. In other instances we may perform research contracts that have
significant positive margins because we are able to capitalize on work that we
have done and knowledge that we have gained in the past. At the present stage of
our development, it is more meaningful to look at total research and development
costs in conjunction with revenues than to look at solely internally funded
research projects and the cost of research associated with revenue producing
contracts.




Research and
development. Following is a summary of research and development
expenditures for the past three years.





2007
            
            2006
            
            2005ANI
      Research and development
            $
            4,526,166
            $
            3,590,148
            $
            2,635,412EBT
      Research and development
            $
            —
            $
            —
            $
            —Total
      Research and development
            $
            4,526,166
            $
            3,590,148
            $
            2,635,412







Company
sponsored research and development expenses at Applied Nanotech, Inc. increased
substantially from 2005 to 2006, and again from 2006 to 2007. These increases
were the result of much higher levels of activity. As of the end of 2006, we had
roughly 12 more employees than we had at the beginning of 2005, and at the end
of 2007, we had approximately 5 more employees than at the end of 2006. These
employees are associated with new revenue producing projects. In 2006, we
started 3 significant new government contracts and a significant new contract
with a large chemical manufacturer. We also started additional projects in 2007.
Because of the higher level of activity, we also spent more on research
materials.




We expect
to continue to incur substantial expenses in support of additional research and
development activities related to the commercial development of our field
emission technology, sensors, nano-electronics, and functional nanomaterials. We
expect to incur at least $4.6 million in research related expenditures in 2008.
We expect our research expenditures to increase in 2008 because of the new
research contracts that we have obtained and because of additional contracts
that we expect to obtain. We may, however, incur more research and development
expense in 2008 than presently expected. We are pursuing numerous opportunities
for research contracts and depending upon the nature of the contracts signed, we
may require more research materials than expected, or we may require additional
personnel.


Page
25




Selling, general, and
administrative. Following are key components of selling, general, and
administrative expense:





2007
            
            2006
            
            2005Stock
      based compensation
            $
            22,705
            $
            410,448
            $
            1,072,362Litigation
      related expenses
            $
            1,110,946
            $
            1,933,603
            $
            172,816EBT
      related S, G, & A
            $
            1,298
            $
            166,280
            $
            3,734Other
      S, G, & A
            $
            2,723,771
            $
            2,718,683
            $
            2,530,908Total
      selling, general, and administrative
            $
            3,858,720
            $
            5,229,014
            $
            3,779,820







Total
selling, general and administrative expense increased significantly from 2005 to
2006 and then decreased significantly in 2007; however, the total is
significantly impacted by several factors that are discussed below.




The first
significant component of selling, general, and administrative expense is stock
based compensation. The expense associated with stock based compensation
declined from 2005 to 2006 and again from 2006 to 2007. This was based on two
factors. First, the number of options vested, or expected to vest, declined each
year. Second, the fair value of the options vested also decreased. One of the
factors impacting the fair value is the price of the stock. As a general rule,
options granted when the stock price is lower will have a lower fair value than
options granted when the stock price is higher. The price of our stock generally
declined from 2005 to 2006 and again in 2007. We will incur stock based
compensation expense in 2008, but it is difficult to predict the amount. The
majority of options that we grant are performance based options that vest upon
the achievement of specified goals. The amount of expense that we incur in 2008
will depend on the goals achieved. As of December 31, 2007, there were
outstanding unvested options with a total fair value of approximately $1.0
million. This amount, in addition to the fair value of any new options granted
that vest, may be recognized as an expense in 2008 or after. The better our
financial results are, the more of these options will vest, and thus the larger
our stock based compensation expense will be.




The
second major component of selling, general, and administrative expense during
the periods presented is litigation related expense. In 2005, we initiated
litigation against Canon, Inc. and incurred legal expenses of $172,816 related
to that litigation. That litigation continued in 2006, and we incurred an
additional $494,120 in expense related to the Canon litigation in 2006. We also
initiated litigation against Till Keesmann in 2006 and incurred expense of
$1,439,483 related to that litigation. We incurred $759,803 of litigation
expense related to the Canon litigation and $351,143 of expense related to the
Keesmann litigation in 2007. Our attorneys are handling the Canon litigation on
a contingency basis; however, we are responsible for any out of pocket costs.
The major costs incurred in the Canon litigation relate to translation, expert
witness fees, and local counsel costs. Our attorneys are handling the Keesmann
litigation on a modified contingency basis, whereby we deferred payment on the
professional fees and paid only the out of pocket expenses on a current basis.
Those deferred professional fees became due and were paid in November
2007.




We will
incur additional litigation expense in 2008; however, the amount cannot be
predicted with a high degree of accuracy. See Item 3 of this Annual Report on
Form 10-K for the current status of both cases. The Canon case is currently
under appeal and expenses associated with that case should be minimal. If the
case were sent back to the District Court for a new trial, the expenses could be
significant. The amount of expense that we incur in 2008 related to the Keesmann
case is subject to a wide range of variability depending on the progress and
status of the case. If the case proceeds through trial, we could incur expense
in an amount as large as $1.0 million, or more.




The
increase in other selling, general, and administrative expenses from year to
year generally related to payroll related items. The increase from 2005 to 2006
largely related to turnover in the CEO position. We had three CEO’s during the
year and there were periods of overlapping compensation, including a consulting
arrangement with one of the departing CEOs. In addition, we paid an executive
search fee in connection with hiring a new CEO. Other selling, general and
administrative expense was largely unchanged from 2006 to 2007.




We expect
selling, general and administrative expense in 2008 to be approximately $2.8
million, excluding any stock based compensation expenses or litigation related
expenses, up only slightly from 2007, primarily as a result of higher payroll
and related items.


Page
26




Gain on sale of intellectual
property and other assets. In 2002 EBT restructured its operations and
stopped selling products and began focusing its efforts on licensing its
intellectual property. In 2005, we began negotiating a license agreement related
to part of our intellectual property. This ultimately resulted in an agreement
in 2006 that was structured as a sale of the intellectual property to Novus
Communications. The sale agreement called for an up-front payment and ongoing
royalties based on a percentage of the revenue received by Novus Partners, a
majority owned subsidiary of Novus Communications. As part of the agreement, we
also sold the remainder of EBT’s intellectual property to Novus Displays, a
newly formed subsidiary of Novus Communications. We received a total of $1.5
million in cash, the right to future royalties from Novus Partners, and an
ownership interest in Novus Displays. One of the patents that we sold was a
patent that had been assigned to us by Advanced Technology Incubator, Inc.
(“ATI”), a company owned by Dr. Zvi Yaniv, our Chief Operating Officer. In
order to acquire the remaining interest in the patent and settle all potential
future obligations to ATI, we issued 200,000 shares of our common stock, valued
at $400,000 to ATI. The gain of $1.1 million recorded in the financial
statements resulted from the cash payment received of $1.5 million, less the
$400,000 cost associated with the acquisition of the patent rights.




Any
future royalties received from Novus Partners will be reflected in our financial
statements as a gain on the sale of intellectual property. We have received no
additional payments from Novus Partners, beyond the initial payment that we
received at the time that the license agreement was signed. We expect to receive
royalty payments from Novus Partners in 2008; however, we cannot predict the
amount of any such royalties, nor is there any guarantee that we will receive
any royalties from Novus Partners. The patents that Novus Partners acquired from
us are now part of a package of related patents. Licensing of that package is
completely under the control of Novus Partners, and we are not part of that
process. Our ability to receive royalties is dependent on Novus Partners signing
revenue producing agreements. As of the present time, we have not received any
royalties since the time of the initial payment in June 2006.




Other income.
Following is a summary of other income for the last three fiscal
years.




2007
            
            2006
            
            2005Interest
      expense
            $
            (926)
            $
            (604)
            $
            (2,590)Interest
      Income
            $
            139,118
            $
            9,204
            $
            33,346







Our
interest expense in all years was associated with capital leases. We expect
interest expense to remain at insignificant levels in 2008. Our interest income
is earned as a result of the investment of excess cash balances. The amount of
interest earned was lower in 2006 than 2005 because our average cash balance was
lower during that year. Our interest income increased in 2007 increased as a
result of the private placement of our common stock that was completed in April
2007 and resulted in higher average levels of invested funds. We expect our
interest income to decline in 2008, but still remain at relatively high levels.
The amount of interest income is dependent on interest rates, however if rates
remain at current levels, interest income should approach $100,000 in
2008.




Overview




The
largest single component of cost that we incur is payroll related expense.
Excluding the cost related to stock based compensation, we incurred payroll
related expense of approximately, $2.3 million in 2005, $2.9 million in 2006,
and $3.3 million in 2007. We expect payroll related expense in 2007 to be
approximately $3.7 million as a result of anticipated new personnel and cost
increases. We expect our burn rate for 2008 to average about $650,000 per month,
excluding litigation expenses and prior to any revenue. Based on this, we
believe we can reach breakeven at a revenue level of $7.8 million, but there is
no assurance that this will occur, or that we can achieve that level of
revenue.




SEASONALITY
AND INFLATION




Nano-Proprietary’s
business is not seasonal in nature. Management believes that Nano-Proprietary’s
operations have not been affected by inflation.


Page
27




ACCOUNTING
PRONOUNCEMENTS




In June
2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in
Income Taxes. This Interpretation clarifies that the recognition for uncertain
tax positions should be based on a more-likely-than-not threshold that the tax
position will be sustained upon audit. The tax position is measured as the
largest amount of benefit that has a greater than 50 percent probability of
being realized upon settlement. The standard was adopted in 2007 and had no
effect on the financial statements.




In
September 2006, the FASB issued Statement No. 157, Fair Value Measurements. This
Statement defines fair value and expands disclosures about fair value
measurements. These methods will apply to other accounting standards that use
fair value measurements and may change the application of certain measurements
used in current practice. The effective date is the beginning of 2008. The
adoption is not expected to have a material effect on the company’s consolidated
financial statements.




In
February 2007, the FASB issued Statement No. 159, The Fair Value Option for
Financial Assets and Financial Liabilities. This Statement permits entities to
measure most financial instruments at fair value if desired. It may be applied
on a contract by contract basis and is irrevocable once applied to those
contracts. The standard may be applied at the time of adoption for existing
eligible items, or at initial recognition of eligible items. After election of
this option, changes in fair value are reported in earnings. The items measured
at fair value must be shown separately on the balance sheet. The effective date
is the beginning of 2008. The Company has not elected to measure eligible items
at fair value and does not believe adoption of the statement will have a
material effect on the consolidated financial statements.




In
December 2007, the FASB issued Statement No. 141 (revised 2007), Business
Combinations, and Statement No. 160, Noncontrolling Interests in Consolidated
Financial Statements. Statement No. 141 (revised 2007) which requires an
acquirer to measure the identifiable assets acquired, the liabilities assumed
and any noncontrolling interest in the acquiree at their fair values on the
acquisition date, with goodwill being the excess value over the net identifiable
assets acquired. This standard also requires the fair value measurement of
certain other assets and liabilities related to the acquisition such as
contingencies and research and development. Statement No. 160 clarifies that a
noncontrolling interest in a subsidiary should be reported as equity in the
consolidated financial statements. Consolidated net income should include the
net income for both the parent and the noncontrolling interest with disclosure
of both amounts on the consolidated statement of income. The calculation of
earnings per share will continue to be based on income amounts attributable to
the parent. The effective date for both Statements is the 2009 calendar year.
The company does not believe that adoption of the statements will have a
material effect on the consolidated financial statements.




Item
7A.         Quantitative and Qualitative
Disclosures About Market Risk




We do not
use any derivative financial instruments for hedging, speculative, or trading
purposes. Our exposure to market risk is currently immaterial.





Page
28


Item
8. Financial Statements and
Supplementary Data




INDEX
TO CONSOLIDATED FINANCIAL STATEMENTS


OF
NANO-PROPRIETARY, INC.




CONSOLIDATED
FINANCIAL STATEMENTS





Independent
      Auditor’s Report
            30Consolidated
      Balance Sheets - December 31, 2007 and 2006
            31Consolidated
      Statement of Operations - Years Ended December 31, 2007, 2006, and
      2005
            32Consolidated
      Statements of Shareholders’ Equity - Years Ended December 31, 2007, 2006,
      and 2005
            33Consolidated
      Statements of Cash Flows - Years Ended December 31, 2007, 2006, and
      2005
            34Notes
      to Consolidated Financial Statements
            35
























Page
29


INDEPENDENT
AUDITOR’S REPORT




To the
Board of Directors and Shareholders


Nano-Proprietary,
Inc.


Austin,
Texas




We have
audited the accompanying consolidated balance sheets of Nano-Proprietary, Inc.
and Subsidiaries (collectively, the “Company”) as of December 31, 2007 and 2006
and the related consolidated statements of operations, shareholders’ equity and
cash flows for each of the years in the three year period ended December 31,
2007. These consolidated financial statements are the responsibility of the
Company’s management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.




We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.




In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Nano-Proprietary, Inc. and
Subsidiaries as of December 31, 2007 and 2006, and the results of its operations
and its cash flows for each of the years in the three year period ended December
31, 2007 in conformity with accounting principles generally accepted in the
United States of America.




We also
have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the effectiveness of the Company’s internal
control over financial reporting as of December 31, 2007, based on criteria
established in Internal Control-Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO), and our report dated
February 21, 2008 expressed an unqualified opinion on the effectiveness of
internal control over financial reporting.




Padgett,
Stratemann & Co, L.L.P.


Austin,
Texas


February
21, 2008





Page
30


NANO-PROPRIETARY,
INC. AND SUBSIDIARIES


CONSOLIDATED
BALANCE SHEETS




ASSETSDecember
      31,2007
            
            
            2006Current
      assets:Cash
      and cash equivalents
            
            $
            3,020,096
            
            
            $
            2,085,338Accounts
      receivable, trade – net of allowance for doubtful accounts
            
            
            253,963
            
            
            
            364,718Prepaid
      expenses and other current assets
            
            
            77,038
            
            
            
            79,301Total
      current assets
            
            
            3,351,097
            
            
            
            2,529,357Property
      and equipment, net
            
            
            278,456
            
            
            
            154,545Other
      assets
            
            
            115,305
            
            
            
            9,540Total
      assets
            
            $
            3,744,858
            
            
            $
            2,693,442LIABILITIES
      AND SHAREHOLDERS’ EQUITYCurrent
      liabilities:Accounts
      payable
            
            $
            447,106
            
            
            $
            1,562,488Obligations
      under capital lease
            
            
            29,416
            
            
            
            —Accrued
      liabilities
            
            
            103,003
            
            
            
            87,237Deferred
      revenue
            
            
            306,427
            
            
            
            401,455Total
      current liabilities
            
            
            885,952
            
            
            
            2,051,180Obligations
      under capital lease, long-term
            
            
            30,004
            
            
            
            —Total
      liabilities
            
            
            915,956
            
            
            
            2,051,180Commitments
      and contingencies
            
            
            —
            
            
            
            —Shareholders’
      equity :Preferred
      stock, $1.00 par value, 2,000,000 shares authorized;
              no
      shares issued and outstanding
            
            
            —
            
            
            
            —Common
      stock, 120,000,000 shares authorized, $.001 par value,
      107,173,549
              and
      104,257,607 shares issued and outstanding, respectively
            
            
            107,174
            
            
            
            104,258Additional
      paid-in capital
            
            
            108,580,565
            
            
            
            102,139,950Accumulated
      deficit
            
            
            (105,858,837
            )
            
            
            (101,601,946
            )Total
      shareholders’ equity
            
            
            2,828,902
            
            
            
            642,262Total
      liabilities and shareholders’ equity
            
            $
            3,744,858
            
            
            $
            2,693,442































See notes
to consolidated financial statements.


Page
31





NANO-PROPRIETARY,
INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF OPERATIONS




Year
      ended December 31,2007
            
            
            2006
            
            
            2005RevenuesContract
      research
            
            $
            990,598
            
            
            $
            360,054
            
            
            $
            59,995Government
      contracts
            
            
            2,328,010
            
            
            
            583,236
            
            
            
            208,211License
      fees and royalties
            
            
            —
            
            
            
            83,928
            
            
            
            —Other
            
            
            671,195
            
            
            
            89,452
            
            
            
            297,454Total
      revenues
            
            
            3,989,803
            
            
            
            1,116,670
            
            
            
            565,660Operating
      costsResearch
      and development
            
            
            4,526,166
            
            
            
            3,590,148
            
            
            
            2,635,412Selling,
      general and administrative expenses
            
            
            3,858,720
            
            
            
            5,229,014
            
            
            
            3,779,820Total
      operating costs
            
            
            8,384,886
            
            
            
            8,819,162
            
            
            
            6,415,232Gain
      on sale of assets and other intellectual property
            
            
            —
            
            
            
            1,100,000
            
            
            
            —Loss
      from operations
            
            
            (4,395,083
            )
            
            
            (6,602,492
            )
            
            
            (5,849,572
            )Other
      income (expense):Interest
      income
            
            
            139,118
            
            
            
            9,204
            
            
            
            33,346Interest
      expense
            
            
            (926
            )
            
            
            (604
            )
            
            
            (2,590
            )Total
      other Income
            
            
            138,192
            
            
            
            8,600
            
            
            
            30,756Loss
      before taxes
            
            
            (4,256,891
            )
            
            
            (6,593,892
            )
            
            
            (5,818,816
            )Provision
      for taxes
            
            
            —
            
            
            
            —
            
            
            
            —Net
      loss applicable to common shareholders
            
            $
            (4,256,891
            )
            
            $
            (6,593,892
            )
            
            $
            (5,818,816
            )Earnings
      (loss) per shareBasic
      and diluted
            
            $
            (0.04
            )
            
            $
            (0.07
            )
            
            $
            (0.06
            )Weighted
      average common shares outstandingBasic
      and diluted
            
            
            106,321,400
            
            
            
            100,895,795
            
            
            
            98,957,812

















See notes
to consolidated financial statements.


Page
32







NANO-PROPRIETARY,
INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF SHAREHOLDERS’ EQUITY





AdditionalPreferred
            
            
            Common
            
            
            Paid-In
            
            
            AccumulatedShares
            
            
            Amount
            
            
            Shares
            
            
            Amount
            
            
            Capital
            
            
            Deficit
            
            
            TotalBalance
      December 31, 2004
            
            
            -
            
            
            
            -
            
            
            
            97,246,422
            
            
            
            97,246
            
            
            
            89,938,448
            
            
            
            (89,189,238
            )
            
            
            846,456Issuance
      of common stock
              options
      as compensation
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            1,288,760
            
            
            
            -
            
            
            
            1,288,760Issuance
      of common stock
              as
      a result of the exercise of
              employee
      stock options
            
            
            -
            
            
            
            -
            
            
            
            817,625
            
            
            
            818
            
            
            
            542,121
            
            
            
            -
            
            
            
            542,939Issuance
      of common stock for cash
            
            
            -
            
            
            
            -
            
            
            
            1,682,393
            
            
            
            1,682
            
            
            
            3,998,318
            
            
            
            -
            
            
            
            4,000,000Net
      (loss)
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (5,818,816
            )
            
            
            (5,818,816
            )Balance
      December 31, 2005
            
            
            -
            
            
            
            -
            
            
            
            99,746,440
            
            
            
            99,746
            
            
            
            95,767,647
            
            
            
            (95,008,054
            )
            
            
            859,339Issuance
      of common stock
              options
      as compensation
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            695,978
            
            
            
            -
            
            
            
            695,978Issuance
      of common stock
              as
      a result of the exercise of
              employee
      stock options
            
            
            -
            
            
            
            -
            
            
            
            54,383
            
            
            
            55
            
            
            
            26,589
            
            
            
            -
            
            
            
            26,644Issuance
      of common stock for cash
            
            
            -
            
            
            
            -
            
            
            
            4,039,393
            
            
            
            4,040
            
            
            
            5,000,153
            
            
            
            -
            
            
            
            5,004,193Issuance
      of common stock for
              accounts
      payable
            
            
            -
            
            
            
            -
            
            
            
            217,391
            
            
            
            217
            
            
            
            249,783
            
            
            
            -
            
            
            
            250,000Issuance
      of Common Stock for
              Patents
            
            
            -
            
            
            
            -
            
            
            
            200,000
            
            
            
            200
            
            
            
            399,800
            
            
            
            -
            
            
            
            400,000Net
      (loss)
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (6,593,892
            )
            
            
            (6,593,892
            )Balance
      December 31, 2006
            
            
            -
            
            
            
            -
            
            
            
            104,257,607
            
            
            $
            104,258
            
            
            $
            102,139,950
            
            
            $
            (101,601,946
            )
            
            
            642,262Issuance
      of common stock
              as
      a result of the exercise of
              employee
      stock options
            
            
            -
            
            
            
            -
            
            
            
            307,244
            
            
            
            307
            
            
            
            304,116
            
            
            
            -
            
            
            
            304,423Issuance
      of common stock for cash
            
            
            -
            
            
            
            -
            
            
            
            2,608,698
            
            
            
            2,609
            
            
            
            5,997,391
            
            
            
            -
            
            
            
            6,000,000Issuance
      of common stock
              options
      as compensation
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            128,957
            
            
            
            -
            
            
            
            128,957Issuance
      of restricted common
              stock
      as compensation
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            10,151
            
            
            
            -
            
            
            
            10,151Net
      (loss)
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (4,256,891
            )
            
            
            (4,256,891
            )Balance
      December 31, 2007
            
            
            -
            
            
            $
            -
            
            
            
            107,173,549
            
            
            $
            107,174
            
            
            $
            108,580,565
            
            
            $
            (105,858,837
            )
            
            $
            2,828,902

















See notes
to consolidated financial statements.


Page
33







NANO-PROPRIETARY,
INC. AND SUBSIDIARIES


CONSOLIDATED
STATEMENTS OF CASH FLOWS




Year
      Ended
              December
      31,2007
            
            
            2006
            
            
            2005Cash
      flows from operating activities:Net
      loss
            
            $
            (4,256,891
            )
            
            $
            (6,593,892
            )
            
            $
            (5,818,816
            )Adjustments
      to reconcile loss to net
              cash
      used in operating activities:Depreciation
      and amortization expense
            
            
            50,498
            
            
            
            49,172
            
            
            
            56,260Stock
      and options issued for services
            
            
            139,108
            
            
            
            695,978
            
            
            
            1,288,760Stock
      issued for patent
            
            
            —
            
            
            
            400,000
            
            
            
            —Changes
      in assets and liabilities:Accounts
      receivable, trade
            
            
            110,755
            
            
            
            (270,615
            )
            
            
            (87,368
            )Prepaid
      expenses and other assets
            
            
            (103,502
            )
            
            
            6,005
            
            
            
            (171
            )Accounts
      payable
            
            
            (1,115,382
            )
            
            
            1,581,357
            
            
            
            90,534Accrued
      expenses
            
            
            15,766
            
            
            
            (5,926
            )
            
            
            18,207Customer
      deposits and other current liabilities
            
            
            (95,028
            )
            
            
            401,455
            
            
            
            (54,985
            )Total
      adjustments
            
            
            (997,785
            )
            
            
            2,857,426
            
            
            
            1,311,237Net
      cash used in operating activities
            
            
            (5,254,676
            )
            
            
            (3,736,466
            )
            
            
            (4,507,579
            )Cash
      flows from investing activities:Capital
      expenditures
            
            
            (112,682
            )
            
            
            (101,932
            )
            
            
            (16,672
            )Net
      cash used in investing activities
            
            
            (112,682
            )
            
            
            (101,932
            )
            
            
            (16,672
            )Cash
      flows from financing activities:Proceeds
      from issuance of common stock
            
            
            6,304,423
            
            
            
            5,030,837
            
            
            
            4,542,939Repayment
      of capital lease obligations
            
            
            (2,307
            )
            
            
            (4,348
            )
            
            
            (23,026
            )Net
      cash provided by financing activities
            
            
            6,302,116
            
            
            
            5,026,489
            
            
            
            4,519,913Net
      increase (decrease) in cash and cash equivalents
            
            
            934,758
            
            
            
            1,188,091
            
            
            
            (4,338
            )Cash
      and cash equivalents, beginning of year
            
            
            2,085,338
            
            
            
            897,247
            
            
            
            901,585Cash
      and cash equivalents, end of year
            
            $
            3,020,096
            
            
            $
            2,085,338
            
            
            $
            897,247






















See notes
to consolidated financial statements.





Page
34


NANO-PROPRIETARY,
INC. AND SUBSIDIARIES


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS




1. Organization, Operations,
and Liquidity:




Nano-Proprietary,
Inc. and its subsidiaries (“the Company”) are engaged in the development of
products for applications using proprietary field emission technology, sensors,
nanoelectronics, and nanomaterials, as well as the performance of significant
research in that area. We intend to obtain development revenues for applying our
technology to specific applications for customers and royalty revenues from
licensing this technology to others. We have also developed patented electronic
sign technology and sold products using that technology, but have now sold that
technology. We may receive additional income from the sale of that technology
based on license revenues received by the purchaser of the
technology.




Until we
are able to operate profitably as a result of revenues from either reimbursed
research or license agreements, we may be required to seek additional funds
through the equity markets, or raise funds through debt instruments to allow us
to maintain operations. There is no assurance that license agreements will be
signed, that commercialization of our technology and products will result in
income from operations, or that funds will be available in the equity or debt
markets. Management believes it will continue to be able to secure additional
short term funding, if necessary, to allow the Company to continue operations
until we achieve profitability.




The
principal source of our liquidity since the time of our initial public offering
in 1993 has been from the funds received from exempt offerings of common stock,
preferred stock, and convertible debt securities, as well as license and
development revenues. We will likely receive additional funds from the exercise
of options. We may also seek to increase our liquidity through bank borrowings
or other financings, although this is not likely. There can be no assurance that
any of these financing alternatives can be arranged on commercially acceptable
terms. We believe that our success in reaching profitability will depend on the
viability of our technology and products using that technology, their acceptance
in the marketplace, and our ability to obtain additional debt or equity
financings in the future.




A portion
of our research and development has been funded by others. To the extent that
other funding is not available, the research and development performed is
internally funded by us.




2. Summary of Significant
Accounting Policies:




Principles
of consolidation




The
accompanying consolidated financial statements include the accounts of the
Company and its subsidiaries, Applied Nanotech, Inc. (“ANI”), and Electronic
Billboard Technology, Inc. (“EBT”), after the elimination of all significant
intercompany accounts and transactions. ANI is primarily involved in developing
products for applications using the Company’s proprietary field emission
technology, sensors, nanoelectronics, and nanomaterials which include
composites. EBT was primarily involved in the commercialization of electronic
digitized sign technology, but has now sold its technology.




Management’s
estimates




The
preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets, liabilities, revenues, and expenses, as
well as the disclosure of contingent assets and liabilities. Actual results
could differ from those estimates. Significant estimates include NOL reserves,
bad debt reserves, assumptions used in calculating share based compensation
under FAS 123R, depreciation, and litigation reserves.





Page
35






NANO-PROPRIETARY,
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


2. Summary of Significant
Accounting Policies (continued):




Revenue
recognition




Our
revenues include reimbursements under agreements to perform research and
development for government agencies and others. We do not perform research
contracts that are contingent upon successful results. Larger projects are
broken down in phases to allow the customer to determine at the end of each
phase if they wish to move to the next phase. The agreements with federal
government agencies generally provide that, upon completion of a technology
development program, the funding agency is granted a royalty-free license to use
any technology developed during the course of the program for its own purposes,
but not any preexisting technology used by us. We retain all other rights to
use, develop, and commercialize the technology and recognize revenue when it is
earned pursuant to the terms of the contract. Agreements with other entities
generally allow the other entity to license the technology from us upon
completion of the project.




The
Company revenues also include royalties from licensing its technology, revenue
from the sale of products, and other miscellaneous revenues. Many of the
company’s projects may involve a combination of these types of revenues.
Revenues are recognized as follows.




Government
Contracts - Revenue from government contracts is recognized when it is earned
pursuant to the terms of the contract. Long-term projects, such as SBIR Phase II
grants that usually range from $500,000 to $1,000,000 in total and usually
extend for a period of approximately two years, are generally based on
reimbursement of costs. These projects are usually billed monthly based on
costs, hours, or some other measure of activity during the month. Short-term
projects, such as SBIR Phase I grants that usually are less than $100,000 and
usually extend for a period of approximately 6 months, are billed at periodic
intervals as specified in the contract. As a general rule, we recognize revenue
on these contracts based on the activity level of the contract during the period
as compared with total estimated activity. This generally would be a measure of
cost incurred as compared with total expected cost. The recognition of revenue
may not correspond with the billings allowable under the contract. To the extent
that billings exceed revenue earned, a portion of the revenue is deferred until
such time as it is earned.




Other
Research Contracts - Revenue from nongovernmental contracts is recognized when
it is earned pursuant to the terms of the contract. Each contract is unique and
tailored to the needs of the customer and goals of the project. Some contracts
may call for a monthly payment for a fixed period of time. Other contracts may
be for a fixed dollar amount with an unspecified time period, although there is
frequently a targeted completion date. These contracts generally involve some
sort of up front payment. Some contracts may call for the delivery of samples,
or may call for the transfer of equipment or other items developed during the
project to the customer. As a general rule, we recognize revenue on long term
contracts based on the activity level of the contract during the period as
compared with total estimated activity. This generally would be a measure of
cost incurred as compared with total expected cost. However, to the extent there
are other significant contract provisions such as the delivery of more than a
nominal amount of samples or delivery of equipment, we would modify this as
appropriate. For other short term contracts, generally less than $50,000, we
recognize revenue when it is billed under the terms of the
contract.




Royalty
Revenue - The Company recognizes royalty revenues based on the shipment of
products by a licensee at the time the underlying product upon which the royalty
is based is shipped by the entity paying the royalty. For minimum royalty
payments paid by a licensee that are required for the licensee to maintain
exclusivity, royalty revenue is recognized at the time the minimum royalty
payment, is due, which normally corresponds with the time that the payment is
received. The Company recognizes license fees due at the time of the signing of
a royalty agreement when the licensee has an enforceable commitment to pay,
unless the terms of the agreement make it clear that the license fee is a
prepayment of future royalties. This normally corresponds with  or is
reasonably close to the time of receipt of the payment.




Product
Sales - Revenue from product sales is recognized at the time the product
shipped. The Company’s primary business is research and development and the
licensing of its technology, not the sale of products. Product sales are
generally insignificant in number, and are usually limited to the sale of
samples, proofs of concepts, prototypes, or other items resulting from its
research.




Page
36


NANO-PROPRIETARY,
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
 2. Summary of Significant
Accounting Policies (continued):


Other
Revenue - Other miscellaneous revenue is recognized as deemed appropriate given
the facts of the situation and is generally not material.




Cash and
cash equivalents




The
Company considers all highly liquid investments purchased with an original
maturity of three months or less to be cash equivalents.




Accounts
receivable




The
Company occasionally sells products to others on credit; however most sales are
to large financially stable companies, or the Federal government. It is the
Company’s policy to record reserves for potential credit losses. Since
inception, the Company has experienced minimal credit losses. The Company
considered no reserves to be necessary for any of the years
presented.




Property
and equipment




Property
and equipment are recorded at cost, net of accumulated depreciation and
amortization. Depreciation is provided on the straight-line method over the
estimated useful lives of the assets, which range from three to seven years, or
the lease term for leasehold improvements, if less. Expenses for major renewals
and betterments that extend the original estimated economic useful lives of the
applicable assets are capitalized. Expenses for normal repairs and maintenance
are charged to operations as incurred. The cost and related accumulated
depreciation of assets sold or otherwise disposed of are removed from the
accounts, and any gain or loss is included in income.




Impairment




At each
balance sheet date, the Company evaluates the carrying amount and the
amortization period for its long-lived assets. If an indicator of impairment
exists, it is recorded at that time. There were no impairment charges recorded
in any of the years presented in these financial statements.




Income
taxes




The
Company accounts for income taxes using the liability method pursuant to
Statement of Financial Accounting Standards (“SFAS”) No. 109. Under this method,
deferred income taxes are recorded to reflect the tax consequences on future
years of temporary differences between the tax basis of the assets and
liabilities and their financial amounts at year-end. The Company provides a
valuation allowance to reduce deferred tax assets to their net realizable
value.




Research
and development expenses




Costs of
research and development for Company-sponsored projects are expensed as
incurred.




Disclosures
about fair value of financial instruments




The
following methods and assumptions were used to estimate the fair value of each
class of certain financial instruments for which it is practicable to estimate
that fair value. For cash equivalents and accounts receivable,  the
carrying amount approximates fair value because of the short-term nature of
these instruments. The fair value of the Company’s capital lease obligations is
estimated based on the quoted market prices for the same, or similar issues, or
on the current rates offered to the Company for obligations of the same
remaining maturities with similar collateral requirements. For all years
presented, the fair value of the Company’s capital lease obligations approximate
their carrying values.


Page
37


NANO-PROPRIETARY,
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
  2. Summary of Significant
Accounting Policies (continued):


Income
(loss) per common share




Basic per
share amounts are computed, generally, by dividing net income or loss by the
weighted average number of common shares outstanding. Diluted per-share amounts
assume the conversion, exercise, or issuance of all potential common stock
instruments unless the effect is anti-dilutive, thereby reducing the loss or
increasing the income per common share. As described in Notes 7, 8 and 9, the
Company had options and warrants outstanding as indicated in the table below.
However, because the Company incurred losses in all years presented, the
inclusion of those potential common shares in the calculation of diluted loss
per-share would have an anti-dilutive effect. Therefore, basic and diluted
per-share amounts are the same in all years presented.




2007
            
            2006
            
            2005Options
            
            6,897,180
            
            7,713,912
            
            6,703,151Warrants
            
            1,304,353
            
            60,000
            
            95,000Weighted
      average exercise price
            
            $1.70
            
            $1.58
            
            $1.57









Share-based
payments




The
Company has four stock based compensation plans described in greater detail in
Note 8 to these financial statements. The Company uses the fair value method to
account for stock-based compensation. The fair value of each award is estimated
on the date of each grant. For restricted stock the fair market value is based
on the market value of the stock granted on the date of the grant. For options,
it is estimated using the Black Scholes option pricing model that uses the
assumptions noted in the following table. Estimated volatilities are based on
the historical volatility of the Company’s stock over the same period as the
expected term of the options. The expected term of options granted represents
the period of time that options granted are expected to be outstanding. The
Company uses historical data to estimate option exercise behavior and to
determine this term. The risk free rate used is based on the U.S. Treasury yield
curve in effect at the time of the grant using a time period equal to the
expected option term. The Company has never paid dividends and does not expect
to pay any dividends in the future.





2007
            
            2006
            
            2005Expected
      dividend yield
            
            0%
            
            0%
            
            0%Risk
      Free Interest Rate
            
            3.3%-
      4.8%
            
            4.6%-
      5.2%
            
            3.5%
      - 4.4%Expected
      option term (in years)
            
            3.5
      - 5.0
            
            2.0
      - 3.5
            
            1.5
      - 3.5Turnover/Forfeiture
      Rate
            
            0%
            
            0%
            
            0%Expected
      volatility
            
            75%
      - 82%
            
            70%
      - 87%
            
            72%
      - 100%Weighted-average
      volatility
            
            79%
            
            78%
            
            99%









The
Black-Scholes option valuation model and other existing models were developed
for use in estimating the fair value of traded options that have no vesting
restrictions and are fully transferable. These option valuation models require
the input of, and are highly sensitive to, subjective assumptions including the
expected stock price volatility. Nano-Proprietary’s stock options have
characteristics significantly different from those of traded options, and
changes in the subjective input assumptions could materially affect the fair
value estimate.


Page
38


NANO-PROPRIETARY,
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
   2. Summary of Significant
Accounting Policies (continued):


Recently
issued accounting pronouncements




In June
2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in
Income Taxes. This Interpretation clarifies that the recognition for uncertain
tax positions should be based on a more-likely-than-not threshold that the tax
position will be sustained upon audit. The tax position is measured as the
largest amount of benefit that has a greater than 50 percent probability of
being realized upon settlement. The standard was adopted in 2007 and had no
effect on the financial statements.




In
September 2006, the FASB issued Statement No. 157, Fair Value Measurements. This
Statement defines fair value and expands disclosures about fair value
measurements. These methods will apply to other accounting standards that use
fair value measurements and may change the application of certain measurements
used in current practice. The effective date is the beginning of 2008. The
adoption is not expected to have a material effect on the company’s consolidated
financial statements.




In
February 2007, the FASB issued Statement No. 159, The Fair Value Option for
Financial Assets and Financial Liabilities. This Statement permits entities to
measure most financial instruments at fair value if desired. It may be applied
on a contract by contract basis and is irrevocable once applied to those
contracts. The standard may be applied at the time of adoption for existing
eligible items, or at initial recognition of eligible items. After election of
this option, changes in fair value are reported in earnings. The items measured
at fair value must be shown separately on the balance sheet. The effective date
is the beginning of 2008. The Company has not elected to measure eligible items
at fair value and does not believe adoption of the statement will have a
material effect on the consolidated financial statements.




In
December 2007, the FASB issued Statement No. 141 (revised 2007), Business
Combinations, and Statement No. 160, Noncontrolling Interests in Consolidated
Financial Statements. Statement No. 141 (revised 2007) which requires an
acquirer to measure the identifiable assets acquired, the liabilities assumed
and any noncontrolling interest in the acquiree at their fair values on the
acquisition date, with goodwill being the excess value over the net identifiable
assets acquired. This standard also requires the fair value measurement of
certain other assets and liabilities related to the acquisition such as
contingencies and research and development. Statement No. 160 clarifies that a
noncontrolling interest in a subsidiary should be reported as equity in the
consolidated financial statements. Consolidated net income should include the
net income for both the parent and the noncontrolling interest with disclosure
of both amounts on the consolidated statement of income. The calculation of
earnings per share will continue to be based on income amounts attributable to
the parent. The effective date for both Statements is the 2009 calendar year.
The company does not believe that adoption of the statements will have a
material effect on the consolidated financial statements.









3. Operating Lease
Obligations:




The
Company leases various facilities and equipment under operating lease agreements
having terms expiring at various dates through 2010. Rental expense was
$179,594, $124,805, and $133,487 for the years ended December 31, 2007,
2006 and 2005, respectively.




Future
minimum lease payments under operating leases that have initial or remaining
noncancelable lease terms in excess of one year at December 31, 2007, were as
follows:




2008
            
            
            47,5792009
            
            
            22,3442010
      and thereafter
            
            
            20,482Total
      future minimum lease payments
            
            $
            90,405





Page
39


NANO-PROPRIETARY,
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)







4. Capital Lease
Obligations:




Capital
leases payable at December 31, 2007 and 2006 consisted of the
following:





2007
            
            
            2006Capital
      lease equipment due in 24 monthly
              installments
      of $2,883 through November 2009.
              The
      equipment value and lease obligation was determined
              using
      a discount rate of 11.20%.  The equipment is included in
              office
      equipment at December 31, 2007 at a cost of $92,586
              and
      with accumulated amortization of $772.
            
            $
            66,301
            
            
            $
            —Less
      interest
            
            
            6,881
            
            
            
            —Less
      current portion
            
            
            29,416
            
            
            
            —Capital
      Lease Obligations, long-term
            
            $
            30,004
            
            
            $
            —










5. Details of Certain Balance
Sheet Accounts:




Additional
information regarding certain balance sheet accounts at December 31, 2007 and
2006 is as follows:





December
      31,2007
            
            
            2006Property
      and equipment:Plant
      and equipment
            
            $
            974,324
            
            
            $
            837,436Furniture
      and office equipment
            
            
            134,911
            
            
            
            106,146Leasehold
      Improvements
            
            
            19,019
            
            
            
            14,382Total
      carrying cost
            
            
            1,128,254
            
            
            
            957,964Less
      accumulated depreciation
            
            
            (849,798
            )
            
            
            (803,419
            )$
            278,456
            
            
            $
            154,545Accrued
      liabilities:Payroll
      and related accruals
            
            $
            79,003
            
            
            $
            63,237Other
            
            
            24,000
            
            
            
            24,000Total
            
            $
            103,003
            
            
            $
            87,237









Depreciation
and amortization for the years ended December 31, 2007, 2006, and 2005 was
$50,498, $49,172, and $56,260, respectively. Equipment held under capital leases
and accumulated amortization on that equipment is included in these
totals.





Page
40


NANO-PROPRIETARY,
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)







6. Income
Taxes:




The
components of deferred tax assets (liabilities) at December 31, 2007 and 2006,
were as follows:





December
      31,2007
            
            
            2006Deferred
      tax assets:Net
      operating loss carry forwards
            
            $
            33,920,000
            
            
            $
            32,904,000Stock
      Based Compensation
            
            
            1,718,000
            
            
            
            1,804,000Research
      and experimentation credits
            
            
            460,000
            
            
            
            468,000Partnership
      Asset
            
            
            57,000
            
            
            
            —Capitalized
      intangible assets
            
            
            112,000
            
            
            
            149,000Depreciation
      assets
            
            
            3,000
            
            
            
            5,000Accrued
      expenses not deductible until paid
            
            
            27,000
            
            
            
            24,000Total
      deferred tax assets
            
            
            36,297,000
            
            
            
            35,354,000Deferred
      tax liabilities:
            
            
            —
            
            
            
            —Net
      deferred tax assets before valuation allowance
            
            
            36,297,000
            
            
            
            35,354,000Valuation
      allowance
            
            
            (36,297,000
            )
            
            
            (35,354,000
            )Net
      deferred tax asset$
            —
            
            
            $
            —







The
following is a reconciliation of the amount of the income tax expense (benefit)
that would result from applying the statutory federal income tax rates to pretax
income (loss) and the reported amount of income tax expense (benefit) for the
periods ended December 31, 2007, 2006, and 2005.




December
      31,2007
            
            
            2006
            
            
            2005Expected
      income tax expense (benefit)
            
            $
            (1,447,000
            )
            
            $
            (2,242,000
            )
            
            $
            (1,978,000
            )Non-deductible
      expenses
            
            
            10,000
            
            
            
            10,000
            
            
            
            11,000Expiration
      of Tax Credit Carryforwards
            
            
            8,000
            
            
            
            —
            
            
            
            1,000Expiration
      of NOL Carryforwards
            
            
            486,000
            
            
            
            —
            
            
            
            —Other
            
            
            —
            
            
            
            (4,000
            )
            
            
            2,000Increase
      in Valuation Allowance
            
            
            943,000
            
            
            
            2,236,000
            
            
            
            1,964,000Total
      Tax
            
            $
            —
            
            
            $
            —
            
            
            $
            —









As of
December 31, 2006, the Company had net operating loss carry forwards of
approximately $100 million that expire from 2008 through 2027, and are available
to offset future taxable income. The majority of these carry forwards expire
after 2009. Additionally, the Company has tax credit carry forwards related to
research and development expenditures of approximately $460,000 that expire
through 2011.




The
Company’s IPO, completed in 1993, and subsequent issuances of stock have
effected ownership changes under Internal Revenue Code Section 382. The
ownership changes resulting from these stock issuances will likely limit the
Company’s ability to utilize any net operating loss carry forwards or credits
generated before the changes in ownership.


Page
41


NANO-PROPRIETARY,
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)






7. Capital
Stock:




Preferred
stock




The
Company has authorization for the issuance of 2,000,000 shares of $1.00 par
value preferred stock. There were no shares of preferred stock outstanding for
any of the years presented.




Common
stock




During
2005, 2006, and 2007, the Company issued shares of its common stock in a series
of private placements in exempt offerings under Regulation D of the Securities
Act of 1933. These shares were issued at prices that represented a slight
discount to the market price of the stock at the time of the offerings. All of
these shares were registered to enable the shareholder to be able to sell the
shares, with the latest registration statement declared effective June 19, 2007.
The shares issued in 2006 include both shares issued for cash and shares issued
in payment of accounts payable.





Shares
            
            Proceeds2007
            
            2,608,698
            $
            6,000,0002006
            
            4,256,784
            $
            5,254,1932005
            
            1,682,393
            $
            4,000,000







In 2006
in an exempt offering under Regulation D of the Securities Act of 1933 , the
Company also issued 200,000 shares in connection with the acquisition and resale
of a patent. See Notes 18 and 19 for additional information.




At
December 31, 2007, common stock was reserved for the following
reasons:





Exercise
      of stock warrants
            
            
            1,304,353Exercise
      and future grants of stock options
            
            
            10,331,633Total
      shares reserved
            
            
            11,635,986




8. Stock
Options:




The
Company sponsors four stock-based incentive compensation plans (the “Plans”),
which are described below. The compensation cost that has been charged against
income for these plans for the years ended December 31, 2007, 2006, and 2005 was
$139,108, $695,978, and $1,288,760, respectively. No income tax benefit was
recognized in the income statement and no compensation was capitalized in any of
the years presented.




The plans
allow the Company to grant incentive stock options, non-qualified stock options,
or restricted stock. The incentive stock options are exercisable for up to ten
years, at an option price per share not less than the fair market value on the
date the option is granted. The incentive stock options are limited to persons
who have been regular full-time employees of the Company or its present and
future subsidiaries for more than one (1) year and at the date of the grant of
any option are in the employ of the Company or its present and future
subsidiaries. Historically, the Company has not granted incentive stock options.
Non-qualified options may be granted to any person, including, but not limited
to, employees, independent agents, consultants and attorneys, who the Company’s
Compensation Committee believes have contributed, or will contribute, to the
success of the Company. Non-qualified options may be issued at option prices of
less than fair market value on the date of grant and are exercisable for up to
ten years from date of grant. The option vesting schedule for options granted is
determined by the Compensation Committee of the Board of Directors at the time
of the grant. The plans provide for accelerated vesting of unvested options if
there is a change in control, as defined in the plan.


Page
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NANO-PROPRIETARY,
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)




8.           
         Stock Options
(continued):




In March
1992, the shareholders of the Company approved the 1992 Employees Stock Option
Plan (the “1992 Employees Plan”) for purposes of granting incentive or
non-qualified stock options. The plan was amended several times by the Company’s
Board of Directors to increase the number of shares authorized under the plan.
The latest amendment, in December 1999, increased the authorized shares under
the plan to 6,500,000. This plan expired in March 2002; however, options granted
under this plan prior to expiration remain outstanding until they are exercised,
forfeited, or the exercise period expires. At December 31, 2007, no shares
remained available for grant under the 1992 Employees Plan.




In March
1992, the Board of Directors adopted the 1992 Outside Directors’ Stock Option
Plan (the “1992 Directors Plan”), for purposes of granting non-qualified options
to non-employee directors of the Company. The plan was amended several times,
the latest being in December 1999. A total of 1,000,000 shares were reserved for
issuance under the plan and were issued each year based on a formula defined by
the plan. The stock options granted under the 1992 Directors Plan are
exercisable for up to 10 years at an option price equal to the fair market value
on the date the option is granted. This plan expired in March 2002; however,
options granted under the plan prior to expiration remain outstanding until they
are exercised, forfeited, or the exercise period expires. At December 31, 2007,
no shares remained available for grant under the 1992 Directors
Plan.




In May
1998, the Board of Directors of the Company established the 1998 Officers and
Directors Stock Option Plan (the “1998 Officers and Directors Plan”) and
reserved a total of 1,200,000 shares for issuance under the Plan. The plan was
amended in January 1999 by the Board of Directors of the Company to increase the
shares reserved for issuance under the plan to 2,500,000. Options under this
plan were granted at the discretion of the Board of Directors. No additional
shares are currently available under this plan and no shares will become
available under this plan in the future.




In
September 2002, the Board of Directors of the Company established the 2002
Equity Compensation Plan  to replace the 1992 Employees Plan and the
1992 Directors Plan, both of which expired in 2002, and reserved a total of
5,000,000 shares for issuance under the Plan. The plan was amended effective
December 31, 2004 to increase the authorized shares to 8,000,000, and again
effective December 12, 2007 to increase the authorized shares to 10,000,000. A
total of 3,402,786 shares remain available for grant under this at December 31,
2007.




The
company issues new shares for all options exercised, It does not expect to
repurchase any shares to facilitate future option exercises. The following table
summarizes information about stock options outstanding, all of which are
expected to ultimately vest, and options currently exercisable under all four
stock option plans at December 31, 2007:






Options
      Outstanding
            Options
      ExercisableRange
      of
              Exercise
      Prices
            Number
              Outstanding
              at
      12/31/07
            Wgtd.  Avg.
              Remaining
              Contractual
              Life
            Wgtd.
      Avg.
              Exercise
      Price
            Number
              Exercisable
              at
      12/31/07
            Wgtd.  Avg.
              Remaining
              Contractual
              Life
            Wgtd.
      Avg.
              Exercise
      Price$0.00
      - $0.50
            679,998
            1.8
      Years
            $0.44
            679,998
            1.8
      Years
            $0.44$0.51
      - $1.00
            981,250
            3.8
      Years
            $0.83
            981,250
            3.8
      Years
            $0.83$1.01
      - $2.00
            2,788,696
            8.3
      Years
            $1.28
            1,204,946
            6.3
      Years
            $1.41$2.01
      - $3.00
            2,447,236
            5.2
      Years
            $2.38
            2,447,236
            5.2
      Years
            $2.38Total
            6,897,180
            5.9
      Years
            $1.52
            5,313,430
            Years
            $1.62Aggregate
      intrinsic value
            
            $676,929
            
            
            $676,929





Page
43




NANO-PROPRIETARY,
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)





8.                  
   Stock Options
(continued):




The
following is a summary of stock option activity under all four
plans:




Number
      of
              Shares
            
            
            Wgtd.
      Ave.
              Exercise
              PriceOptions
      outstanding at December 31, 2004
            
            
            5,398,703
            
            
            $
            1.52Granted
            
            
            2,872,073
            
            
            $
            2.25Exercised
            
            
            (817,625
            )
            
            $
            0.66Cancelled
            
            
            (750,000
            )
            
            $
            2.42Options
      outstanding at December 31, 2005
            
            
            6,703,151
            
            
            $
            1.84Granted
            
            
            2,972,970
            
            
            $
            1.54Exercised
            
            
            (54,383
            )
            
            $
            0.49Cancelled
            
            
            (1,907,826
            )
            
            $
            2.43Options
      outstanding at December 31, 2006
            
            
            7,713,912
            
            
            $
            1.58Granted
            
            
            1,831,196
            
            
            $
            1.20Exercised
            
            
            (307,244
            )
            
            $
            0.99Cancelled
            
            
            (2,340,684
            )
            
            $
            1.52Options
      outstanding at December 31, 2007
            
            
            6,897,180
            
            
            $
            1.52




The
weighted-average grant-date fair value of options granted during the years ended
December 31, 2007, 2006, and 2005 was $0.63, $0.90, and $1.43, respectively. The
total intrinsic value of options exercised during the years ended December 31,
2007, 2006, and 2005 was $387,905, $57,050, and $1,552,038 respectively. As of
December 31, 2007, there was $966,015 of total unrecognized compensation cost
related to 1,583,750 non-vested options granted under the plan. Of these
unvested options, 697,500 vest based on the passage of time and the remaining
options vest upon the attainment of goals. This cost is expected to be
recognized over a period of weighted average period of approximately 1.9 years.
The fair value of shares vested during the years ended December 31, 2007, 2006,
and 2005 was $299,519, $1,363,348, and $764,166, respectively.




During
the years ended December 31, 2007 and 2006, we extended the contractual life of
20,000 options granted to a consultant by two years and one year, respectively,
and as a result, we recognized additional compensation expense of $5,990 and
$1,750, respectively. During 2006, we also recognized $9,000 of compensation
expense when we repriced 100,000 options granted to a consultant. These options
were originally priced above market when issued in 2005. We account for options
issued to consultants using the same assumptions as for employees.




The 2002
Equity Compensation Plan also allows the issuance of restricted shares of common
stock. During the year, we granted 31,667 shares of restricted stock, resulting
in compensation expense of $10,151, in connection with our compensation of
outside Directors. A total of 20,001 of these shares were granted when our stock
price was $0.94, resulting in a total fair value of $18,801. The remaining
11,666 shares were granted when our stock price was $1.19, resulting in a total
fair value of $13,882. These shares vest quarterly over a one year time period
starting with the date of the grant and no share certificates are actually
issued until the grants are fully vested, so none of these shares are reflected
as issued and outstanding. As of December 31, only 4,700 of these shares were
vested. No shares of restricted stock were granted prior to 2007. The weighted
average fair value of shares granted during the year, vested during the year,
and unvested at December 31, 2007 was $1.03, $0.94, and $1.05,
respectively.


Page
44




NANO-PROPRIETARY,
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)





9. Stock
Warrants:




Common
stock warrants




In 1996
and 1997, the Company issued a total of 110,000 warrants to an advisor in
connection with the Company’s fundraising activities. These warrants enabled the
holder to purchase shares of the Company’s common stock at prices of $1.00 to
$2.00 per share through 2007. A total of 15,000 of these warrants were exercised
in 1999. These remaining warrants expired unexercised.




In 2007,
the Company issued 1,304,353 warrants to shareholders in connection with a
private placement of the Company’s stock. These warrants enable the holder to
purchase shares of the Company’s common stock at a price of $2.50 per share
through April 2008.




The
following is a summary of outstanding warrants:







Number
      of
              Shares
            
            Exercise
              PriceWarrants
      outstanding at January 1, 2005
            95,000
            
            $1.00-2.00Exercised
            —
            
            —Expired
      or canceled
            —
            
            —Warrants
      outstanding at December 31, 2005
            95,000
            
            $1.00-2.00Exercised
            —
            
            —Expired
            (35,000)
            
            $2.00Warrants
      outstanding at December 31, 2006
            60,000
            
            $1.00-2.00Issued
            1,304,353
            
            $2.50Exercised
            —
            
            —Expired
            (60,000)
            
            $1.00Warrants
      outstanding at December 31, 2007
            1,304,353
            
            $2.50









10.         
         Supplemental Cash Flow
Information:




Cash paid
for interest was $926, $604, and $2,590 for 2007, 2006, and 2005, respectively.
The following non-cash transactions have been excluded from the accompanying
consolidated statement of cash flows:





2007
            
            2006
            
            2005Non-cash
      financing activities:Issuance
      of common shares in payment of accounts payable
            
            $
            —
            
            
            $
            250,000
            
            
            $
            —Capital
      lease transaction
            
            $
            61,727
            
            
            $
            —
            
            
            $
            —











Page
45




NANO-PROPRIETARY,
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)





11.              
    Commitments and
Contingencies:




Till
Keesmann Agreement




In May
2000, we licensed the rights to 6 carbon nanotube patents from Till Keesmann in
exchange for a payment of $250,000 payable in shares of our common stock. Under
the terms of the agreement, we are obligated to pay license fees equal to 50% of
any royalties received by us specifically related to these patents. We are
allowed to offset certain expenses, up to a maximum of $50,000 per year, against
payments due under this agreement. The agreement also contained provisions
related to minimum license fee payments. These minimum payments, totaling
$1,000,000, have been made and no further minimum payments are due. We are
allowed to offset these minimum payments against future royalty payments;
however, once these minimum payments and the expenses have been offset, we may
be liable for additional royalty payments. As discussed in more detail below,
this agreement is currently under litigation.




Research
and development commitments




As of
December 31, 2007, the Company had several research contracts pending and in
process. The total amount of those contracts is $6,614,281. Of that total,
$2,723,439 has been recognized as revenue and $3,890,842 will be recognized in
the future. The revenue to be recognized from these research contracts in
2007 is expected to exceed the cost of this research.




Agreements
with MCC




We
entered into an agreement in 1994 with Microelectronics and Computer Technology
Corporation (“MCC”) that was amended on several subsequent occasions to cross
license and pool technologies. As part of this relationship with MCC, 62 Diamond
Field Emission patents and patent applications were assigned directly to us and
we agreed to pay a royalty fee of 2% of future commercial revenues related to
the patents received. We have the right to offset one half of the costs of
maintaining these patents against any royalties due under the agreement. No
payments have been made to, or are due to MCC under this agreement, and the
possibility is remote that any payments will ever be due under this
agreement.




Government
contracts




Governmental
contractors are subject to many levels of audit and investigation. Among United
States agencies that oversee contract performance are: the Defense Contract
Audit Agency, the Inspector General, the Defense Criminal Investigative Service,
the General Accounting Office, the Department of Commerce, the Department of
Justice and Congressional Committees. The Company’s management believes that an
audit or investigation, if any, as a result of such oversight would not have any
material adverse effect upon the Company’s financial condition or results of
operations.




Legal
proceedings




Canon
litigation





In April 2005, we filed suit against
the Japanese camera and copier manufacturer Canon, Inc., and its wholly-owned
U.S. subsidiary Canon USA, Inc., in the U.S. District Court for the Western
District of Texas, Austin Division, seeking a declaratory
judgment that new SED color television products being developed
and manufactured by a Canon/Toshiba joint venture are not covered under a
non-exclusive 1999 patent license agreement that we granted to Canon. 
We asserted that the Canon/Toshiba joint-venture – SED, Inc. – was not a
licensed party under that agreement.  The original complaint asserted
additional claims related to whether the Canon/Toshiba joint venture’s
television panels constituted excluded products under the 1999 license, as well
as breach of covenant of good faith and fair dealing, tortious interference and
a Lanham Act violation by Canon. In the Fall of 2005, Canon moved to dismiss
Canon U.S.A. from the litigation, and moved to dismiss several of the counts
asserted.  The court denied the motion, in part, by ruling that Canon
U.S.A. was an appropriate defendant and refusing to dismiss our claims for
breach of the covenant of good faith and fair dealing.  Our tortious
interference and Lanham Act claims were dismissed, without
prejudice.





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46




NANO-PROPRIETARY,
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)





11. Commitments and
Contingencies (continued):





After
initial discovery, in April 2006, we amended the complaint to drop one count
related to the definition of excluded products in the 1999 license, and add two
counts for fraudulent inducement and fraudulent non-disclosure related to events
and representations made during our negotiations on the license,  and
leading up to and following the formation by Canon and Toshiba of their joint
venture effort, including Canon’s failure to disclose an ongoing relationship
with Toshiba and misrepresentations made to us about the joint venture’s
structure and operation.  Canon moved to dismiss the fraud claims, and
the Court denied Canon’s motion in May 2006.  Discovery was completed
in August 2006. Upon completion of discovery, Canon filed a motion for partial
summary judgment seeking to dismiss the claim that SED is not a licensed party
under the agreement. Canon did not file a motion for summary judgment seeking to
dismiss the other claims. In November 2006, the Court denied Canon’s partial
motion for summary judgment, describing SED, Inc. as a “corporate fiction
designed for the sole purpose of evading Canon’s contractual
obligations”.





In
January 2007, Canon filed another motion for partial summary judgment seeking a
declaration that a reconstituted SED, Inc. which is purportedly owned 100% by
Canon but which still involved numerous reciprocal agreements with Toshiba,
would be considered a Canon subsidiary. At the same time, we filed a motion for
partial summary judgment, seeking the Court’s affirmation of our termination of
the license agreement due to Canon’s breach of contract in 2004. On February 22,
2007, the Court issued a ruling denying Canon’s motion and granting our motion
for partial summary judgment, ruling our termination of the contract effective
December 1, 2006, to be valid.





A trial
on the case began on April 30, 2007 and a final judgment was entered in the case
in May 2007. The final judgment reaffirmed Canon’s material breach of the patent
license, while awarding no additional damages. Both parties have filed appeals
related to the litigation. All appeal briefs and responses have been filed with
the Fifth Circuit Court of Appeals and we are currently waiting for the Court to
set a date for oral arguments in the case.




Keesmann
litigation





In May
2006, we filed suit in the U.S. District Court for the Northern District of
Illinois against Till Keesmann, a German citizen who in 2000 granted us an
exclusive and perpetual license to certain of his U.S. and European patents in
carbon nanotube cathode technology.   In 2005, Keesmann conveyed
part of his interests in the Exclusive License to investors associated with a
German patent evaluation firm, IP Bewertungs AG (“IPB”).  Thereafter,
IPB approached us with proposals to buy or auction our rights to Keesmann’s
patents.  On March 22, 2006, after we declined to participate in the
auction process, Keesmann purported to terminate the exclusive license that he
granted to us six years earlier.  Our May 2006 complaint seeks a
declaratory judgment that Keesmann had no right to terminate the exclusive
license and a Temporary Restraining Order and Preliminary Injunction to prevent
Keesmann from taking any actions inconsistent with his obligations under the
exclusive license.  The Court granted a consent order that prevents
Keesmann from licensing the patents pending an injunction hearing and
decision.  In June 2006, Keesmann filed an Answer and Counterclaim,
denying that the purported termination was null and void, and asserting a
counterclaim that asked the court to find that we breached the exclusive license
by not actively marketing the Keesmann patents, among other things.





We
amended our complaint in December 2006 to include additional defendants, JK
Patentportfolio GmbH & Co., Jochen Kamlah, NPV Nano Patent GmbH & Co.,
and Arnold Amsinck. The amended complaint also contains additional claims
including breach of contract, conversion, aiding and abetting conversion,
conspiracy to commit conversion, misappropriation, aiding and abetting
misappropriation, conspiracy to commit conversion, Lanham Act violations,
tortious interference with a prospective economic relationship, aiding and
abetting tortious interference with a prospective economic relationship, and
conspiracy to tortiously interfere with a prospective economic
relationship.














Page
47


NANO-PROPRIETARY,
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
  11. Commitments and
Contingencies (continued):





In
January 2007, the Court granted our motion for preliminary injunction, ruling
that there is a reasonable likelihood that we will prevail on the merits of the
case. The preliminary injunction enjoins Keesmann, his agents, employees, and
all those acting in concert with him from terminating the license agreement for
the reasons asserted in the March 2006 default notice, or otherwise acting in
violation of the license agreement. In connection with this injunction, the
Court set a surety bond, which is required by law, at $100,000. We posted the
bond in February 2007.  Days after the Court issued the injunction,
Keesmann again asserted a number of alleged defaults under the license. In April
2007, we filed a second motion for a temporary restraining order and preliminary
injunction. We have established a discovery schedule leading up to trial, but no
trial date has yet been set. We have had settlement discussions at various times
during the course of the litigation, but have not, as yet reached a settlement
agreement to resolve the litigation.





Other
litigation




On July
20, 1998, TFI Telemark, Inc. filed a complaint in the County Court at Law No. 2
of Travis County, Texas against the Company for debts of its now defunct
subsidiary, Plasmatron. The Company was served with notice of this suit on
August 5, 1998. The Company believes that no amounts are due to TFI; however,
all amounts claimed as owing by TFI are recorded as liabilities in the
consolidated financial statements of the Company. There has been no activity on
this case in the last year. The Company believes the ultimate resolution of this
matter will not have a material impact on the consolidated financial statements
of the Company.




From time
to time the Company and its subsidiaries are also defendants in various lawsuits
that may arise related to minor matters. It is expected that all such lawsuits
will be settled for an amount no greater than the liability recorded in the
financial statements for such matters. If resolution of any of these suits
results in a liability greater than that recorded, it could have a material
impact on us.




12. Research and Development
Contracts:




The
Company makes significant expenditures for research and development. On
occasion, the Company may seek funding for a portion of its research and
development costs to reduce the cost of such expenditures to the Company. The
Company only seeks funding for projects that it already intended to do, or for
projects that would apply its technology for other uses in instances where that
application would allow the Company to achieve technical milestones that are
part of its strategic plan. A substantial portion of the Company’s funded
research has been from government contracts. Under government contracts, the
government has the right to utilize the results for its purposes and the Company
has the right to utilize the technology for commercial purposes. Generally, when
the Company contracts with other entities, the entity is also conducting its own
internal research related to application of the Company’s technology to its
products and such expenditures by the entity may exceed the amount of funding
provided to the Company. Usually the entity has the right to license the
technology at the conclusion of the project, if they desire. The costs of a
particular research program may significantly exceed the funding received,
however since the research was part of planned research, these contracts
generally involve only nominal additional costs to the Company.




The
following schedule summarizes certain information with respect to research and
development contracts:


2007
            
            
            2006
            
            
            2005Contract
      research revenues
            
            $
            3,318,608
            
            
            $
            943,290
            
            
            $
            268,206Costs
      incurred charged to operations included in research and
      development
            
            $
            2,222,473
            
            
            $
            879,592
            
            
            $
            254,656Amount
      of additional funding commitments at December 31
            
            $
            3,890,842
            
            
            $
            3,026,133
            
            
            $
            2,763,565











Page
48


NANO-PROPRIETARY,
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
  13. Retirement
Plan:




The
Company sponsors a defined contribution 401(k) profit sharing plan. No company
contributions were made in any of the years presented.







14. Concentrations of Credit
Risk:




The
Company’s financial instruments that are exposed to concentrations of credit
risk consist of cash and cash equivalents and receivables. The Company places
its cash and cash equivalents with high credit quality financial institutions;
however for periods of time during the year, bank balances on deposit were in
excess of the Federal Deposit Insurance Corporation insurance limit. No amounts
in excess of the FDIC limit were held in bank accounts as of either December 31,
2005 or 2007, however $1,345,520 in excess of the FDIC limit was held at JP
Morgan Chase at December 31, 2006 At December 31, 2007 and 2006, the Company
held $2,414,958 and $439,808, respectively, in excess of the Securities Investor
Protection Corporation limits in an account at Charles Schwab & Co.
Inc.




The
Company’s receivables are uncollateralized and result primarily from its
research and development projects performed primarily for U.S. Federal
Government Agencies and services performed for large U.S. and multinational
corporations. The Company has not incurred any material losses on these
receivables.





15. Quarterly Financial
Information (Unaudited):





First
            
            
            Second
            
            
            Third
            
            
            Fourth
            
            
            TotalQuarter
            
            
            Quarter
            
            
            Quarter
            
            
            Quarter
            
            
            Year2007Revenues
            
            $
            956,867
            
            
            $
            916,038
            
            
            $
            1,049,749
            
            
            $
            1,067,149
            
            
            $
            3,989,803Operating
      income (loss)
            
            
            (1,357,317
            )
            
            
            (1,281,562
            )
            
            
            (790,693
            )
            
            
            (965,511
            )
            
            
            (4,395,083
            )Net
      (loss)
            
            
            (1,345,887
            )
            
            
            (1,229,787
            )
            
            
            (759,910
            )
            
            
            (921,307
            )
            
            
            (4,256,891
            )Earnings
      (loss) per shareBasic
      and Diluted
            
            
            (0.01
            )
            
            
            (0.01
            )
            
            
            (0.01
            )
            
            
            (0.01
            )
            
            
            (0.04
            )2006Revenues
            
            $
            162,184
            
            
            $
            115,009
            
            
            $
            213,841
            
            
            $
            625,636
            
            
            $
            1,116,670Operating
      income (loss)
            
            
            (1,797,193
            )
            
            
            (1,387,807
            )
            
            
            (1,933,196
            )
            
            
            (1,484,296
            )
            
            
            (6,602,492
            )Net
      (loss)
            
            
            (1,794,166
            )
            
            
            (1,385,583
            )
            
            
            (1,931,038
            )
            
            
            (1,483,105
            )
            
            
            (6,593,892
            )Earnings
      (loss) per shareBasic
      and Diluted
            
            
            (0.02
            )
            
            
            (0.01
            )
            
            
            (0.02
            )
            
            
            (0.01
            )
            
            
            (0.07
            )2005Revenues
            
            $
            68,815
            
            
            $
            88,544
            
            
            $
            245,917
            
            
            $
            162,384
            
            
            $
            565,660Operating
      income (loss)
            
            
            (1,368,793
            )
            
            
            (1,386,251
            )
            
            
            (1,526,478
            )
            
            
            (1,568,050
            )
            
            
            (5,849,572
            )Net
      (loss)
            
            
            (1,365,194
            )
            
            
            (1,376,209
            )
            
            
            (1,516,913
            )
            
            
            (1,560,500
            )
            
            
            (5,818,816
            )Earnings
      (loss) per shareBasic
      and Diluted
            
            
            (0.01
            )
            
            
            (0.01
            )
            
            
            (0.02
            )
            
            
            (0.02
            )
            
            
            (0.06
            )




Annual
Earnings (loss) per share may not equal the sum of the four quarterly amounts
due to rounding.


Page
49


NANO-PROPRIETARY,
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
  16. Segment
Information:




The
Company’s operations are classified into three principal reportable segments
that provide slightly different services.




ANI
            
            
            EBT
            
            
            All
      Other
            
            
            Total2007Revenue
            
            $
            3,989,803
            
            
            $
            —
            
            
            $
            —
            
            
            $
            3,989,803Interest
      Expense
            
            
            926
            
            
            
            —
            
            
            
            —
            
            
            
            926Depreciation
      and Amortization
            
            
            49,575
            
            
            
            —
            
            
            
            923
            
            
            
            50,498Research
      and Development
            
            
            4,526,166
            
            
            
            —
            
            
            
            —
            
            
            
            4,526,166Net
      Loss
            
            
            (3,212,051
            )
            
            
            (1,298
            )
            
            
            (1,043,542
            )
            
            
            (4,256,891
            )Assets
            
            
            778,863
            
            
            
            —
            
            
            
            2,965,995
            
            
            
            3,744,858Capital
      Expenditures
            
            
            174,409
            
            
            
            —
            
            
            
            —
            
            
            
            174,4092006Revenue
            
            $
            1,116,670
            
            
            $
            —
            
            
            $
            —
            
            
            $
            1,116,670Interest
      Expense
            
            
            573
            
            
            
            —
            
            
            
            31
            
            
            
            604Depreciation
      and Amortization
            
            
            46,191
            
            
            
            —
            
            
            
            2,982
            
            
            
            49,173Research
      and Development
            
            
            3,590,148
            
            
            
            —
            
            
            
            —
            
            
            
            3,590,148Net
      Loss
            
            
            (6,108,745
            )
            
            
            933,720
            
            
            
            (1,418,867
            )
            
            
            (6,593,892
            )Assets
            
            
            1,101,205
            
            
            
            —
            
            
            
            1,592,237
            
            
            
            2,693,442Capital
      Expenditures
            
            
            101,932
            
            
            
            —
            
            
            
            —
            
            
            
            101,9322005Revenue
            
            $
            565,660
            
            
            $
            —
            
            
            $
            —
            
            
            $
            565,660Interest
      Expense
            
            
            2,193
            
            
            
            —
            
            
            
            397
            
            
            
            2,590Depreciation
      and Amortization
            
            
            52,242
            
            
            
            —
            
            
            
            4,018
            
            
            
            56,260Research
      and Development
            
            
            2,635,412
            
            
            
            —
            
            
            
            —
            
            
            
            2,525,292Net
      Loss
            
            
            (4,326,457
            )
            
            
            (3,734
            )
            
            
            (1,488,615
            )
            
            
            (5,818,806
            )Assets
            
            
            301,870
            
            
            
            —
            
            
            
            886,111
            
            
            
            1,187,981Capital
      Expenditures
            
            
            13,017
            
            
            
            —
            
            
            
            3,655
            
            
            
            16,672




Financial
information is furnished to the chief operating officer for review regarding
each subsidiary of the Company.




The ANI
segment consists of the activities of ANI and includes license revenues and
contract research revenues related to ANI’s technology. In both years,
virtually all ANI revenues were contract research revenues. The Company’s EBT
subsidiary previously sold electronic display products, but sold its technology
in 2006. All other segments include the Company’s general overhead.




The
accounting policies applied by each of the segments are the same as those used
by the Company.





Page
50


NANO-PROPRIETARY,
INC. AND SUBSIDIARIES
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)






17. Significant
Customers:




Applied
Nanotech, Inc. received research and development revenues from the U.S.
Government in the three years as disclosed on the income statement. ANI’s
revenues tend to be project oriented and are not necessarily recurring with a
particular customer at the present time.  In addition to the U.S.
Government, the Company had two customers in 2007 from which it received in
excess of 10% of its consolidated revenues. In the year ended December 31, 2007,
we had revenues of $416,787 from Mitsui & Co., Ltd. compared with revenues
of $31,060 in the year ended December 31, 2006. We also had revenues from
Ishihara Chemical Company, Ltd. of $685,963 and $111,600 in the years ended
December 31, 2007 and 2006, respectively. We also had revenues of $348,448 and
$248,454 in the years ended December 31, 2007 and 2006 respectively from Yonex
Co. Ltd.







18. Related Party
Transactions:




During
2006, as part of a transaction to sell intellectual property owned by our EBT
subsidiary, we entered into an agreement with a related party. One of the
patents that we sold was a patent that had been assigned to us by Advanced
Technology Incubator, Inc. (“ATI”), a company owned by Dr. Zvi Yaniv, our
Chief Operating Officer. In order to acquire the remaining interest in the
patent and settle all potential future obligations to ATI, we issued 200,000
shares of our common stock, valued at $400,000 to ATI. We also paid $25,000 to
ATI for additional services related to this transaction during the
year.




19. Gain on Sale of Intellectual
Property and Other Assets:




In June
2006, our Electronic Billboard Technology, Inc. subsidiary sold all of its
intellectual property in two simultaneous transactions. We received a total of
$1.5 million in cash, the right to future royalties, and an ownership interest
in a newly formed entity. One of the patents that we sold was a patent that had
been assigned to us by Advanced Technology, Incubator, Inc. (“ATI”), a company
owned by Dr. Zvi Yaniv, our Chief Operating Officer. In order to acquire
the remaining interest in the patent and settle all potential future obligations
to ATI, we issued 200,000 shares of our common stock, valued at $400,000 to ATI.
The gain of $1.1 million recorded in the financial statements resulted from the
cash payment received of $1.5 million, less the $400,000 cost associated with
the acquisition of the patent rights.







20. Subsequent
Events:




In February 2008, we signed a new six
year lease on our facility, effective March 1, 2008. The lease calls for
payments of $12,505 for each of the first 24 months, payments of $13,432 for
months 25 through 48, and $14,461 for the final 24 months of the
lease.


Page
51




Item
9.Changes in and Disagreements with
Accountants on Accounting and Financial Disclosure.




None




Item
9A. Controls and
Procedures.




Management
is responsible for establishing and maintaining effective disclosure controls
and procedures, as defined under Rule 13a-15 of the Securities Exchange Act
of 1934, that are designed to cause the material information required to be
disclosed by Nano-Proprietary in the reports it files or submits under the
Securities Exchange Act of 1934 to be recorded, processed, summarized, and
reported to the extent applicable within the time periods required by the
Securities and Exchange Commission’s rules and forms. In designing and
evaluating the disclosure controls and procedures, management recognized that a
control system, no matter how well designed and operated, can provide only
reasonable, not absolute, assurance that the objectives of the control system
are met. Because of the inherent limitations in all control systems, no
evaluation of controls can provide absolute assurance that all control issues
and instances of fraud, if any, with a company have been detected.




As of the
end of the period covered by this report, Nano-Proprietary performed an
evaluation under the supervision and with the participation of management,
including the Chief Executive Officer and Chief Financial Officer, of the
effectiveness of the design and operation of its disclosure controls and
procedures pursuant to Rule 13a-15 of the Securities Exchange Act of 1934.
Based upon that evaluation, the Chief Executive Officer and Chief Financial
Officer concluded that the disclosure controls and procedures were effective at
the reasonable assurance level.




Report
on Management’s Assessment of Internal Control over Financial
Reporting




The
management of Nano-Proprietary, Inc. is responsible for establishing and
maintaining adequate internal control over financial reporting. Internal control
over financial reporting is defined under applicable Securities and Exchange
Commission rules as a process designed under the supervision of the Company’s
Chief Executive Officer and Chief Financial Officer and effected by the
Company’s Board of Directors, management and other personnel to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of the Company’s financial statements for external purposes in
accordance with U.S. generally accepted accounting principles. The Company’s
internal control over financial reporting includes those policies and procedures
that:




·
              Pertain
      to the maintenance of records that, in reasonable detail, accurately and
      fairly reflect the transactions and dispositions of the assets of the
      Company;




·
              Provide
      reasonable assurance that transactions are recorded as necessary to permit
      preparation of financial statements in accordance with U.S. generally
      accepted accounting principles, and that receipts and expenditures of the
      Company are being made only in accordance with authorizations of
      management and the directors of the Company;
and




·
              Provide
      reasonable assurance regarding prevention or timely detection of
      unauthorized acquisition, use or disposition of the Company’s assets that
      could have a material effect on the financial
  statements.




Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.




As of
December 31, 2007, management, with the participation of the Company’s
Chief Executive Officer and Chief Financial Officer, assessed the effectiveness
of the Company’s internal control over financial reporting based on the criteria
for effective internal control over financial reporting established in “Internal
Control — Integrated Framework,” issued by the Committee of Sponsoring
Organizations (COSO) of the Treadway Commission. Based on the assessment,
management determined that the Company’s internal control over financial
reporting was effective as of December 31, 2007.


Page
52




Changes
in Internal Control over Financial Reporting




No
changes were made to the Company’s internal control over financial reporting (as
defined in Rule 13a-15 under the Securities Exchange Act of 1934) during
the last fiscal quarter that materially affected, or are reasonably likely to
materially affect, the Company’s internal control over financial
reporting.




Attestation
Report of Independent Registered Public Accounting Firm




To the
Board of Directors and Stockholders of Nano-Proprietary, Inc.:




We have
audited the internal control over financial reporting of Nano-Proprietary, Inc.
(the Company) as of December 31, 2007, based on criteria established in Internal
Control—Integrated Framework issued by the Committee of Sponsoring Organizations
of the Treadway Commission (COSO).  The Company’s management is
responsible for maintaining effective internal control over financial reporting
and for its assessment of the effectiveness of internal control over financial
reporting included in the accompanying Report on Management’s Assessment of
Internal Control over Financial Reporting.  Our responsibility is to
express an opinion on the Company's internal control over financial reporting
based on our audit.





We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was maintained in all
material respects. Our audit included obtaining an understanding of internal
control over financial reporting, assessing the risk that a material weakness
exists, and testing and evaluating the design and operating effectiveness of
internal control based on the assessed risk.  Our audit also included
performing such other procedures as we considered necessary in the
circumstances.  We believe that our audit provides a reasonable basis
for our opinion.





A
company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles.  A company's internal
control over financial reporting includes those policies and procedures that (1)
pertain to the maintenance of records that, in reasonable detail, accurately and
fairly reflect the transactions and dispositions of the assets of the company;
(2) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial
statements.





Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements.  Also, projections of any evaluation
of effectiveness to future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.





In our
opinion, Nano-Proprietary, Inc. maintained, in all material respects, effective
internal control over financial reporting as of December 31, 2007, based on
criteria established in Internal Control—Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission
(COSO).





We have
also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated balance sheets and the related
consolidated statements of operations, shareholders equity and cash flows of
Nano-Proprietary, Inc and our report dated February 21, 2008 expressed an
unqualified opinion.





Padgett,
Stratemann & Co., L.L.P.


Austin,
TX


February
21, 2008


Page
53




Item 9B. Other
Information.




None




























Page
54


PART
III




Item
10. Directors, Executive
Officers and Corporate Governance




The
following sets forth the names, ages and certain information concerning the
Directors and Executive Officers of Nano-Proprietary.







Name
            Age
            Position
            Director/Officer
      Since
            Term
      ExpiresThomas
      F. Bijou
            56
            Director,
              Chief
      Executive Officer
            December
      2006
            2008Dr. Zvi
      Yaniv
            61
            Director,
      President,
              Chief
      Operating Officer
            July
      1996
            2008Douglas
      P. Baker
            51
            Director,
              Chief
      Financial Officer
            June
      1996
            2008Ronald
      J.  Berman
            51
            Director
            May
      1996
            2008Dr.
      Robert Ronstadt
            66
            Director
            January
      2003
            2008Bradford
      S. Lamb
            47
            Director
            December
      2006
            2008Howard
      Westerman
            55
            Director
            May
      2007
            2008Tracy
      K. Bramlett
            52
            Director
            September
      2007
            2008Patrick
      V. Stark
            53
            Director
            September
      2007
            2008Dr.
      Richard Fink
            48
            Vice
      President
            January
      2008
            N/A





______________




Thomas F.
Bijou has been Chief Executive Officer and a member of the Board of Directors
since December 1, 2006. From 1997 through the present, Mr. Bijou has been
Chief Executive Officer of BHM Associates, a company involved in funding and
mentoring technology companies. In connection with these BHM activities,
Mr. Bijou also served as Chairman of Knowledge Communications, Inc., an
early pioneer in the distance learning marketplace. Mr. Bijou began his
career at General Electric Company, but left GE in 1982 with several associates
to form Tigon Corporation, a voicemail outsourcing company that was sold to
Ameritech in 1988.




Dr. Zvi
Yaniv has served as the Company’s President and Chief Operating Officer and a
Director since July 29, 1996. Dr. Yaniv has degrees in physics,
mathematics, and electro-optics as well as a Ph.D. in Physics. Prior to joining
the Company, in May 1996, Dr. Yaniv operated a consulting practice and
previously was President and CEO of Optical Imaging Systems Inc., a supplier of
flat panel color liquid crystal displays to the avionics and defense
industries.




Douglas
P. Baker has been with the Company since June 17, 1996, and has been a Director
since May 2006. Mr. Baker is a Certified Public Accountant and has both a
Bachelors in Business Administration and a Masters in Business Administration.
Immediately prior to joining Nano-Proprietary, Inc., Mr. Baker was a
divisional controller for MascoTech, Inc. from 1991 to 1996. Mr. Baker also
has prior experience in public accounting and as CFO of a privately held
company. Mr. Baker is also Chairman of the Board of Directors of Total Health
Care, Inc., a non-profit Health Maintenance Organization and has been a member
of the Board of Directors of that organization since 1987.




Ronald J.
Berman has been a Director since May 1996. Mr. Berman co-founded BEG
Enterprises, Inc. with Marc W. Eller and was its President from 1989 until 1998.
Mr. Berman currently is President of R.J. Berman Enterprises, Ltd., a real
estate development company, Inergi Fitness, and Walkers Warehouse.
Mr. Berman earned a Juris Doctor degree in 1980 from the University of
Detroit.




Dr. Robert
Ronstadt has been a Director since January 2003. Dr. Ronstadt was Vice
President of Technology Commercialization for Boston University from June
2003 through 2005. At the same time, he became the Director of Boston
University’s Technology Commercialization Institute. He was special advisor to
the Chancellor of Boston University from January to May 2003. Prior to
that, from 1998 to 2002, he was Director of the IC2 Institute at the
University of Texas in Austin and the J. Marion West Chair of Constructive
Capitalism. Dr. Ronstadt was a professor of entrepreneurship at the
Pepperdine University School of Business Management from 1992 to 1998 and
Babson College in Wellesley Massachusetts from 1975 to 1985. From 1986
to 1992, he was the CEO of a software enterprise.


Page
55




Bradford
S. Lamb has been a Director of the Company since December 2006, and is currently
President of Columbia Power Technologies, a position that he has held since
November 2006. Prior to that, from 1993 to 2006, he was President of InteLex
Corporation. Prior to InteLex, he spent 10 years with GE Medical systems in
various capacities.




Howard
Westerman is the Chief Executive Officer of JW Operating Company, a privately
held energy development and energy services company headquartered in Dallas,
Texas. Mr. Westerman joined JW Operating Company in 1978 and became CEO in 1999.
Under his leadership as CEO, the Company’s revenues increased from approximately
$70 million to $1 Billion. Mr. Westerman is also a member of the Board of
Directors of Peerless Manufacturing Company, a global provider of environmental
and separation filtration products, listed on the NASDAQ Global Market Exchange.
Mr. Westerman also serves on numerous charitable and community
boards.




Tracy K.
Bramlett is President of Industrial Hygiene and Safety Technology, Inc. (IHST),
a full service industrial hygiene consulting company that he formed in 1987.
IHST specializes in Indoor Environmental Quality issues. Prior to forming IHST,
Mr. Bramlett was a corporate industrial hygienist for Burlington Northern
Railroad.




Patrick
V. Stark is an attorney with the firm of Kane Russell Colman and Logan in
Dallas. Mr. Stark is a Director at the firm and specializes in corporate finance
and securities law, representing clients in a variety of
industries.




Dr.
Richard Fink is Vice President of Engineering for Applied Nanotech, Inc.; a
subsidiary of Nano-Proprietary, Inc. Dr. Fink has a Bachelor in Science degree
from South Dakota State University and a Masters in Science and Ph.D.
in Physics from the University of Illinois and has worked for the Company since
1995. Dr. Fink is also the co-founder of the
Nanomaterials Applications Center at Texas State University
– San Marcos, and has been chairman of the Texas Chapter of the Society for
Information Display since 2004.




Shareholder
Director Nominating Procedures




The
Company does have a procedure in place for holders of the Company’s common stock
to recommend nominees to the Company’s Board of Directors. These procedures are
set forth in Article 9(b) of the Company’s Restated Articles of Incorporation
(the “Restated Articles”). A copy of the Company’s Restated Articles is filed as
Exhibit 3(I) to this Annual Report on Form 10-K. As set forth in Article 9(b) of
the Restated Articles, only persons who are nominated in accordance with the
procedures set forth in that Article are eligible for election as Directors of
the Company. Nominations of persons for election to the Board of Directors of
the Company may be made at a meeting of shareholders by or at the direction of
the Board of Directors or by any shareholder of the Company entitled to vote for
the election of Directors at the meeting who complies with the notice procedures
set forth in Article 9(b). Such nominations, other than those made by or at the
direction of the Board of Directors, shall be made pursuant to timely notice in
writing to the Secretary of the Corporation. To be timely, a shareholder’s
notice shall be delivered to or mailed and received at the principal executive
offices of the Company not less than 60 days nor more than 90 days prior to the
meeting; provided, however, that in the event that less than 70 days’ notice or
prior public disclosure of the date of the meeting is given or made to
shareholders, notice by the shareholder to be timely must be so received not
later than the close of business on the 10th day following the date on which
such notice of the date of the meeting was mailed or such public disclosure was
made. Such shareholder’s notice shall set forth (i) as to each person whom the
shareholder proposes to nominate for election or re-election as a Director, (A)
the name, age, business address and residence address of such person, (B) the
principal occupation or employment of such person, (C) the class and number of
shares of the Company which are beneficially owned by such person, and (D) any
other information relating to such person that is required to be disclosed in
solicitations of proxies for election of Directors, or is otherwise required, in
each case pursuant to Regulation 14A under the Securities Exchange Act of 1934,
as amended (including without limitation such person’s written consent to being
named in the proxy statement as a nominee and to serve as a Director if
elected); and (ii) as to the shareholder giving the notice, (1) the name and
address, as they appear on the Company’s books, of such shareholder and (2) the
class and number of shares of the Company which are beneficially owned by such
shareholder. No person shall be eligible for election as a Director of the
Company unless nominated in accordance with the procedures set forth in Article
9(b) of the Restated Articles. The Chairman of the meeting shall, if the facts
warrant, determine and declare to the meeting that a nomination was not made in
accordance with the procedures prescribed herein, and if he should so determine,
he shall so declare to the meeting and the defective nomination shall be
disregarded.


Page
56




Committees




The Board
of Directors has three committees. The audit committee consists of
Mr. Lamb, Mr. Westerman and Mr. Stark. Mr. Lamb is chairman of the audit
committee. The compensation committee consists of Mr. Berman, Mr. Bramlett,
and Mr. Lamb. Mr. Berman is chairman of the compensation committee. The
nominating committee consists of Dr. Ronstadt, Mr. Westerman, and Mr.
Bramlett. Dr. Ronstadt is chairman of the nominating committee.




Audit
Committee Financial Expert





The Board
of Directors has determined that Mr. Westerman is an “audit committee financial
expert” under applicable SEC rules and that all members of our audit committee
qualify as “independent” as defined under applicable SEC rules.




Code
of Ethics




We have
adopted a Code of Ethics within the meaning of Item 406(b) of Regulation S-K of
the Securities Exchange Act of 1934. This Code of Ethics applies to all
directors, officers, and employees of the Company. A copy of this Code of Ethics
is publicly available on our website at www.nano-proprietary.com.




Section
16(a) Beneficial Ownership Reporting Compliance




Section
16(a) of the Securities of Exchange Act of 1934 requires Nano-Proprietary’s
officers, Directors, and persons who beneficially own more than 10 % of a
registered class of Nano-Proprietary’s common stock, to file reports of
ownership and changes in ownership with the Securities and Exchange Commission.
Officers, Directors, and beneficial owners of more than 10% of
Nano-Proprietary’s common stock are required by the Securities and Exchange
Commission regulations to furnish Nano-Proprietary with copies of all Section
16(a) forms that they file.




Based
solely on review of the copies of such reports furnished to us, or written
representations that no reports were required, we believe that for the period
from January 1, 2007 through December 31, 2007, all Officers, Directors, and
greater than 10% beneficial owners complied with all Section 16(a) filing
requirements applicable to them.




Item
11. Executive Compensation




Compensation
Discussion and Analysis




Objectives
of Compensation Program




The
primary objective of our compensation program for employees, including our
compensation program for executive officers, is to attract, retain, and motivate
qualified individuals and reward them in a manner that is fair to all
stakeholders. We strive to provide incentives for every employee that rewards
them for their contribution to the Company, while at the same time promoting an
ownership mentality.




Elements
of Compensation




There are
three main components to our compensation package - base salaries, bonuses, and
stock based compensation. A fourth, less significant component is other benefits
and perquisites. Our compensation program is designed to be competitive with
other employment opportunities and to align the interests of all employees,
including executive officers, with the long-term interests of our shareholders.
For our executive officers, we link a much higher percentage of total
compensation to incentive compensation such as bonus and stock based
compensation than we do for other employees.


Page
57




Base
Salaries




We
provide our executive officers with a level of cash compensation that
facilitates an appropriate lifestyle and provides a reasonable minimum
compensation. We make this determination based on a variety of factors including
professional accomplishments, level of education, past experience and scope of
responsibilities. The actual amount of base salary paid to each named executive
officer is set forth in the summary compensation table included later in this
section. The salary level for both our chief executive officer and our chief
operating officer was set at a rate of $250,000 per year at the beginning of
2005 and remained at that level in 2006. When Mr. Bijou joined us in
December 2006, we entered into a slightly modified arrangement with Mr. Bijou.
He was paid at an annualized rate of $288,000 per year; however that amount
represents a combination of salary and management fee paid to an entity owned by
Mr. Bijou. As part of the management fee, Mr. Bijou assumes
responsibility for certain costs, including basic employee benefits that would
normally be paid by us. We believe the amount that we pay Mr. Bijou is
similar to the amounts paid to or on behalf our previous CEOs. The salary level
for our chief financial officer was set at a rate of $180,000 per year at the
beginning of 2005 and remained at that level for 2006 and 2007. As discussed in
more detail below, the  following base salary amounts for these
executive officers became effective January 1, 2008: Mr. Bijou - $300,000, Dr.
Yaniv - $275,000, and Mr. Baker $225,000. In addition, effective December 31,
2007, Dr. Richard Fink, Vice President became a named executive officer. Dr.
Fink’s salary became $125,000 effective January 1, 2008.




Bonuses




We have a
formula bonus plan covering all employees, including executive officers. This
plan was originally established in 2004 and is based solely on the profitability
of the company. This plan is designed to reward all employees when we are
successful in reaching profitability. No bonuses have ever been paid under this
plan, since we have incurred losses in each of the years since adoption of the
plan. The maximum bonuses payable under this plan are $250,000 for the chief
executive officer, $200,000 for the chief operating officer, and $150,000 for
the chief financial officer. The maximum amounts would be payable if our net
income is equal to, or exceeds $10 million. For purposes of this plan, net
income is calculated using the accounting principles in effect at the time the
plan was adopted, meaning stock based compensation using fair value as required
by FAS 123R is excluded from the calculation. There are no minimum amounts
payable under the plan and the target amounts are equal to the maximum amounts
payable. The compensation committee of the board of the directors also has the
power to award discretionary bonuses; however, no such bonuses have been granted
since 2002 in the case of the CEO and the CFO. The COO received a discretionary
bonus of $115,000 in 2007.




Stock
Based Compensation




All of
our employees participate in our stock based compensation plans and receive
awards of non-qualified stock options annually. We use non-qualified options
because of the favorable tax treatment to us and the near universal expectation
by employees in our industry that they will receive stock options. The
overwhelming majority of these awards are performance based awards that only
vest upon achievement of specific goals. For non-executive officer employees,
these goals tend to be operational oriented goals relating to specific projects
or potential projects. For executive officers, these goals are broad in nature
and involve more substantial accomplishments. Following is a discussion of the
option grants to executive officers.




In 2004,
the compensation committee adopted a multiyear program of performance based
option covering the years from 2004 to 2007. The goals associated with this
program related to breakeven in various years and certain revenue targets. When
Mr. Bijou commenced employment in December 2006, he also received an option
package which included a small portion of time based options which vested over a
period of one year and the remainder of which were performance based options
vesting based on achievement of certain modified cashflow from operations and
EPS goals.




By the
end of 2007, the majority of the options included in the 2004 grant had not
vested and certain of the goals associated with the options granted in December
2006 were no longer considered reasonable based on events that had occurred in
2007. As such, a new multiyear program was adopted at the end of 2007 designed
to replace expiring performance based options, provide reasonable goals, and
align the goals of all executive officers. This program included a mixture of
time based option and performance based options. The majority of these grants
were performance based options with goals related to modified cashflow from
operations and various earnings per share targets. This new program did not
result in an increase in the number of options held by any of the existing
executive officers. Dr. Fink received options as part of this program, however
as previously indicated, Dr. Fink became an executive officer effective December
31, 2007 and was not an executive officer at the time of the
grant.


Page
58




For
purposes of this discussion of performance based option goals, we consider the
goals related to modified cash-flow from operations, or earnings per share
targets, to be part of our confidential strategic plans, and as such we do not
disclose the specifics of the goals at this time. Attainment of many of these
goals will require the company to achieve financial results never before
achieved in the history of the Company. We consider these goals achievable, but
they represent a stretch and are considered essential to proving the business
model. They align the interests of the executive officers with those of the
shareholders.




At the
present time, we have no formal policy related to stock ownership for executive
officers, other than for those officers that are also members of the Board of
Directors and are covered under the Board policy, which is described later in
this section. In establishing grant levels, we do not consider the equity
ownership levels of the executive officer. In general, we do not consider the
existence of fully vested prior awards when establishing new grants. However,
with newer executive officers, we may consider the lack of prior awards in
establishing a higher level of new grants.




Timing of
Option Grants




We do not
have a formal written policy related to the timing of option grants; however we
do have certain time periods when options are normally granted. At the present
time, we do not have any analysts that follow our stock and the release of our
quarterly financial reports normally has no impact on the price of our stock. As
such, we do not have trading windows, nor do we limit option grants to any sort
of windows. There are two normal situations where options are granted. The first
would be at the time a new employee, including executive officers, is hired. If
a new employee receives options as part of starting employment, those options
are granted either at, or shortly after, the employment start date.




The
majority of options are performance based awards granted on an annual basis as
part of a budgeting/goal setting process. For executive officers, the
compensation committee meets annually to establish compensation levels,
including salary, bonus, and options, for the year. This meeting normally occurs
in late November or early December prior to the start of the new year - for
example in December 2007 for 2008 compensation. It could, however, occur as
early as November as late as January. For all other employees, the goal setting
process starts in December, but since it involves many more distinct goals and
many more individuals; it is a longer process and as a result usually is not
ready for submission to the Compensation Committee until January or later. All
performance based awards for employees other than executive officers are annual
awards that must either vest by the end of the calendar year, or they will
expire unvested. At the time of the proposed award, we consider whether there
are any known upcoming significant events, and have in the past delayed awards
as a result of expected positive events.




All
option grants for employees are approved by the compensation committee of the
Board of Directors. The compensation committee has authorized the executive
officers to grant limited amounts of options to new hires without seeking
additional compensation committee approval. The compensation committee does not
delegate any of its powers for granting options to others.




Other
Benefits and Perquisites




Since we
have not yet reached profitability on a consistent basis, we take a relatively
bare-bones approach to benefits for all employees, including executive officers.
There are no benefit plans available to executive officers that are not
available to all employees. Executive officers participate in the same benefit
plans covering other employees. These benefits include limited health and dental
insurance, group term life insurance, and limited long-term disability
insurance. The only retirement plan that we maintain is a 401K plan funded
entirely by employee elective deferrals. We have no company funded retirement
plans or deferred compensation plans. We also do not provide any of the perks
common at larger companies. The only perk that we provide is an auto allowance.
We have provided an auto allowance of $1,000 per month to our COO and $500 per
month to our CFO and effective January 1, 2008; we began providing an auto
allowance of $1,000 per month to our CEO. The amounts paid as auto allowances
are considered in setting the overall level of compensation for the executive
officer.


Page
59




Compensation
Approval Process




The
Compensation Committee of the Board of Directors approves all compensation and
awards to executive officers. The CEO provides recommendations to the
compensation committee for the other executive officers, all of which directly
or indirectly report to him, and regarding most compensation matters, including
executive compensation, the CFO in consultation with the CEO, provides
information to the Compensation Committee. However, the Compensation Committee
does not delegate any of its functions to others in setting compensation. We did
not make formal use of any compensation consultants in determining executive
compensation levels for any of the executive officers.




In 2006
we used an executive search firm in connection with our search for a new CEO.
That firm, Christian & Timbers, indicated that at the time our CEO salary
was at the low end of the range, although when considering options, it fell
within the normal range of CEO compensation for similar companies. In November
2007, we performed a compensation analysis to benchmark our compensation package
against other similar companies. We did not use an outside compensation
consultant for this study, but rather performed the analysis internally. We
selected the following companies: Nanogen (NGEN), Nanosphere (NSPH), Harris
& Harris (TINY), Nanosys (NNSY), Acacia Research/Acacia Technologies (ACTG),
Arrowhead Research (ARWR), and Symyx Technologies (SMMX). In selecting these
companies, we considered such factors as nanotechnology involvement, market
capitalization, revenue levels, profitability, and line of business. While no
particular company is a perfect match, we believe that overall this is a
representative mix of companies to use as a comparison. We gathered data on
these companies from publicly available data, including SEC filings. In general,
there was a lag of one or more years related to these filings, so the most
recent data available for these companies was from 2006 or prior.




The
results of our benchmarking study showed that the compensation paid to executive
officers at Nano-Proprietary, Inc. was well below average for the peer group
selected.  Salaries were at or near the bottom of the range. In the
case of the CEO and COO, all but one of the comparison companies paid higher
salaries and in the case of the CFO, all of the comparison companies paid higher
salaries. The majority of the comparison companies paid bonuses despite the
existence of net operating losses. While the Nano-Proprietary officers had the
potential for larger option grants, based on options actually vested, on average
the comparison companies also had higher levels of options granted.




When
setting compensation levels for 2008, we considered the result of this study.
Salaries were set at the previously disclosed levels based on this study and in
consideration of the fact that salary levels had been unchanged for three years.
These new salary levels are, in general, still below average for the comparison
companies, but much closer than previous levels. Until such time as the company
attains profitability, we believe it reasonable for salaries to be slightly
below average. When the company reaches profitability, it is anticipated that
salaries will be adjusted to market levels. We continued our bonus plan based on
profitability and it is anticipated that future bonuses will not be paid until
such time as we have reached profitability. Finally, as previously described, we
granted options to the executive officers in December 2006. These options
included both time based and performance based options, although the majority of
the options were performance based. This split was determined, in part based on
the option vesting history over the past several years.




Compensation
Committee Report




We have
reviewed and discussed with management certain Compensation Discussion and
Analysis provisions to be included in the Company’s 2006 Annual Report on Form
10-K for the fiscal year ended December 31, 2007, filed pursuant to Section 13
or 15(d) of the Securities Exchange Act of 1934 (“Form 10-K”). Based on the
reviews and discussions referred to above, we recommend to the Board of
Directors that the Compensation Discussion and Analysis referred to above be
included in the Company’s Form 10-K.







Compensation
Committee


Ronald J.
Berman, Chairman;


Bradford
Lamb;


Tracy
Bramlett










Page
60




The
following table sets forth the total cash compensation paid or to be paid, as
well as certain other compensation paid or accrued, for services rendered during
the fiscal years ended December 31, 2007, 2006 and 2005 by all individuals that
served as Chief Executive Officer during 2007, the Chief Financial Officer, all
individuals that were Named Executive Officers as of the end of the previous
year, and all executive officers whose total annual salary and bonus exceeded
$100,000 for the fiscal year ended December 31, 2007 (the “Named Executive
Officers”):




SUMMARY
COMPENSATION TABLE





Name & Principal
      Position
            Year
            Salary
            Option Awards
      (1)
            All
      Other
              Compensation
      (4)
            TotalThomas
      F. Bijou (2)
            2007
            $  288,000
            $    505,357
            $           0
            $    793,357Chief
      Executive Officer
            2006
            $    24,000
            $    663,422
            $           0
            $    687,422Dr.
      Zvi Yaniv
            2007
            $  250,000
            $    247,588
            $  12,000
            $    509,588Chief
      Operating Officer
            2006
            $  250,000
            $    265,369
            $  12,000
            $    527,3692005
            $  250,000
            $
      1,005,430
            $  12,000
            $
      1,267,430Douglas
      P. Baker
            2007
            $  180,000
            $    154,743
            $    6,000
            $    340,743Chief
      Financial Officer
            2006
            $  180,000
            $    132,684
            $    6,000
            $    318,6842005
            $  180,000
            $    502,715
            $    6,000
            $    688,715Dr.
      Richard Fink (3)
            2007
            $  100,000
            $      73,842
            $           0
            $    173,8422006
            $    97,667
            $      18,244
            $           0
            $    115,9112005
            $    86,000
            $      23,221
            $           0
            $    109,221










(1)
Amounts included in the option awards column are calculated utilizing the
provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123R,
“Share-Based Payments.” See Note 8 of the consolidated financial statements
included in this annual report for the assumptions underlying valuation of
equity awards. The amounts are calculated based on all options granted during
the year without regard to whether the options vest or expire. As discussed in
the Compensation Discussion and Analysis, the majority of options granted are
performance based options associated with specific goals. To the extent that the
goals are not achieved, the options do not vest and expire. The amount included
for 2005 is based on the number of options awarded to Dr. Yaniv and
Mr. Baker, of 700,000 and 350,000, respectively. For Dr. Yaniv,
200,000 of those options ultimately vested and 500,000 of those options expired.
For Mr. Baker, 100,000 of those options ultimately vested and 250,000 of
those options expired. All of the options granted to executive officers in 2005
are priced significantly above the current market price of the stock and none of
the vested options have been exercised.




None of
the options granted in 2006 to Dr. Yaniv, or Mr. Baker vested and all
have expired as of December 31, 2007. A total of 1,000,000 options were granted
to Mr. Bijou in 2006, of which 200,000 of those options have vested and the
remaining 800,000 options have expired as of December 31, 2007. None of the
options granted to Mr. Bijou, Dr. Yaniv, or Mr. Baker have vested as of February
18, 2008. All of the options granted to Dr. Fink in 2005 and 2006 are fully
vested. Of the options granted to Dr. Fink in 2007, 16,713 are fully vested and
100,000 are unvested as of February 18, 2008.




(2)
Mr. Bijou began employment as CEO on December 1, 2006.




(3) Dr.
Fink has been employed by the Company since 1995; however he only became a named
executive officer as of December 31, 2007. Amounts for 2005 and 2006 are
included for comparative purposes.




(4) The
amounts included in the “All Other Compensation” column for Dr. Yaniv and Mr.
Baker represents an automobile allowance in all years.





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61


GRANTS
OF PLAN-BASED AWARDS TABLE


Name
            Grant
      Date
            Approval
              Date
            Estimated
      Future Payouts Under
              Equity
      Incentive Plan
              Awards (Shares)
      (1)
            All
      Other
              Option
              Awards
              Number
      of
              Shares
              Underlying
              Options
            Exercise
              Price
      of
              Option
              Awards
            Market
              Price
      on
              Date
      of
              GrantThreshold
            Target
            MaximumThomas
      F. Bijou
            12/03/2007
            11/30/2007
            
            
            
            360,000
            $1.19
            $1.0612/03/2007
            11/30/2007
            0
            200,000
            200,000
            
            $1.19
            $1.0612/12/2007
            12/12/2007
            0
            240,000
            240,000
            
            $1.19
            $1.11Dr.
      Zvi Yaniv
            12/03/2007
            11/30/2007
            
            
            
            180,000
            $1.19
            $1.0612/03/2007
            11/30/2007
            0
            100,000
            100,000
            
            $1.19
            $1.0612/03/2007
            11/30/2007
            0
            120,000
            120,000
            
            $1.19
            $1.06Douglas
      P. Baker
            12/03/2007
            11/30/2007
            
            
            
            112,500
            $1.19
            $1.0612/03/2007
            11/30/2007
            0
            62,500
            62,500
            
            $1.19
            $1.0612/03/2007
            11/30/2007
            0
            75,000
            75,000
            
            $1.19
            $1.06Dr.
      Richard Fink
            01/29/2007
            01/29/2007
            
            
            
            16,713
            $1.28
            $1.2812/03/2007
            11/30/2007
            
            
            
            45,000
            $1.19
            $1.0612/03/2007
            11/30/2007
            0
            25,000
            25,000
            
            $1.19
            $1.0612/03/2007
            11/30/2007
            0
            30,000
            30,000
            
            $1.19
            $1.06






_____________________




(1)
Performance-based option awards that vest upon the achievement of established
goals.


Page
62


OUTSTANDING
EQUITY AWARDS AT FISCAL YEAR-END TABLE







The
following table sets forth information concerning the outstanding equity awards
held by the Named Executive Officers at December 31, 2007.





Option
      AwardsNumber
      of Securities Underlying
              Unexercised
      Options
            Equity
      Incentive Plan
              Awards:
      Number of
              Securities
      Underlying
              Unexercised
      Unearned
              OptionsName
            Number
              Exercisable
            Number
              Unexercisable
            Option
              Exercise
      Price
            Option
              Expiration
              DateThomas
      F. Bijou
            200,000
            -
            
            $1.19
            11/30/2016-
            360,000
            
            $1.19
            12/03/2017-
            -
            200,000
            $1.19
            12/03/2017-
            -
            240,000
            $1.19
            12/12/2017Dr.
      Zvi Yaniv (1)
            100,000
            -
            
            $0.50
            01/11/200930,000
            -
            
            $1.50
            02/02/2010200,000
            -
            
            $1.50
            06/27/201030,000
            -
            
            $0.96
            07/28/2013250,000
            -
            
            $2.73
            12/31/201350,000
            -
            
            $2.17
            12/31/2014200,000
            -
            
            $2.17
            01/01/2015-
            180,000
            
            $1.19
            12/03/2017-
            -
            100,000
            $1.19
            12/03/2017-
            -
            120,000
            $1.19
            12/03/2017Douglas
      P. Baker (1)
            30,000
            -
            
            $1.50
            02/02/201050,000
            -
            
            $1.50
            06/27/201060,000
            -
            
            $0.63
            03/02/2011100,000
            -
            
            $0.92
            07/16/2011150.000
            -
            
            $0.73
            12/05/201113,000
            -
            
            $0.96
            07/28/2013200,000
            -
            
            $2.73
            12/31/201350,000
            -
            
            $2.17
            12/31/2014100,000
            -
            
            $2.17
            01/01/2015-
            112,500
            
            $1.19
            12/03/2017-
            -
            62,500
            $1.19
            12/03/2017-
            -
            75,000
            $1.19
            12/03/2017Dr.
      Richard Fink
            2.500
            -
            
            $1.50
            01/03/20102,500
            -
            
            $1.50
            02/15/20102,000
            -
            
            $0.58
            02/16/201132,750
            -
            
            $1.00
            12/31/20126,875
            -
            
            $0.50
            03/20/201321,000
            -
            
            $0.56
            04/16/201319,881
            -
            
            $2.50
            03/10/201415,906
            -
            
            $2.17
            01/01/20153,487
            -
            
            $2.17
            02/14/201610,112
            -
            
            $2.25
            04/11/201616,713
            -
            
            $1.28
            01/29/2017-
            45,000
            
            $1.19
            12/03/2017-
            -
            25,000
            $1.19
            12/03/2017-
            -
            30,000
            $1.19
            12/03/2017




______________________




(1)
Includes options still outstanding that were previously transferred by gift and
reported on Form 4 by the Named Executive Officer. For Dr. Yaniv these options
are the 100,000 options expiring 01/11/2009. For Mr. Baker, these options are
the 60,000 options expiring 03/02/2011.


Page
63




OPTION
EXERCISE AND STOCK VESTED TABLE







Name
            Number
      of Shares
              Acquired on Exercise
      (#)
            Value
      Realized on
              Exercise
      ($)Douglas P. Baker
      (1)
            32,000
            $
      27,84040,000
            $
      71,800




(1)           All
transactions are option exercises that were exercised in buy and hold
transactions. Value realized represents the intrinsic value of the options on
the date of exercise and not actual value realized by the named executive
officer. The 40,000 options represent options previously transferred by gift,
but reported in this table.




PENSION
BENEFITS TABLE




We
maintain no retirement plans covering Named Executive Officers or other
employees, except for a 401K plan funded solely by elective employee
contributions. As such no pension benefits table is included.




NON-QUALIFIED
DEFERRED COMPENSATION TABLE




We do not
maintain any non-qualified deferred compensation plans covering Named Executive
Officers or other employees. As such, no deferred compensation table is
included.




POTENTIAL
PAYMENTS UPON TERMINATION OR CHANGE IN CONTROL




None of
the named executive officers have employment contracts, and therefore, there are
no formal payments due on change in control or other employment termination. Our
2002 Equity Compensation Plan, which includes all employees, including executive
officers, includes a provision which accelerates the vesting of all unvested
options upon certain change in control events. Unvested options held by Named
Executive Officers as of December 31, 2007 are reflected in the Outstanding
Equity Awards at Fiscal Year-End Table included in this item.




It is our
policy to pay severance upon termination when termination is initiated by us and
is for other than cause. We have no formal guidelines, but rather each case is
handled on an individual basis. Factors considered include position, length of
service, reason for termination, possible future relationships, as well as other
potential factors. Payments may be made in a lump sum or in periodic
installments and are usually accompanied by a severance agreement that includes
a release, a non-disparagement clause, and possibly a non-compete agreement.
There are no minimum amounts payable to any of the executive officers; however,
it is likely that if any of the Named Executive Officers were terminated by the
Company for other than cause, payments would be made in connection with that
termination.




DIRECTOR
COMPENSATION




Name
            
            Fees
      Earned or
              Paid
      in Cash
            
            Restricted
      Stock Awards
              (1)
            
            Option
      Awards
              (2)
            
            TotalHoward
      Westerman (3)
            
            $   5,000
            
            $   4,542
            
            -
            
            $   9,542Ronald
      J. Berman
            
            $
      18,800
            
            $
      11,592
            
            -
            
            $
      30,392Bradford
      S. Lamb
            
            $   4,800
            
            $   2,975
            
            $15,510
            
            $
      23,285Tracy
      K. Bramlett (3)
            
            $   1,000
            
            $      991
            
            -
            
            $   1,991Dr. Robert
      Ronstadt
            
            $
      18,700
            
            $
      11,592
            
            -
            
            $
      30,292Patrick
      V. Stark (3)
            
            $   1,000
            
            $      991
            
            -
            
            $   1,991Marc
      W. Eller (4)
            
            $
      19,000
            
            -
            
            -
            
            $
      19,000Charles
      Bailey (4)
            
            $      150
            
            -
            
            -
            
            $      150Eddie
      Lee (4)
            
            $
      14,300
            
            -
            
            -
            
            $
      14,300







Page
64




(1)
Amounts included in the restricted stock awards column are calculated based on
the total fair market value of the shares granted on the date of the
grant.




(2)
Amounts included in the option awards column are calculated utilizing the
provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123R,
“Share-Based Payments.” See Note 8 of the consolidated financial statements
included in this annual report for the assumptions underlying valuation of
equity awards. See the table titled “Security Ownership of Management” included
in Item 12 of this report for stock option grants outstanding at year held by
each Director.




(3)
Directors Westerman, Bramlett, & Stark became Directors during 2007.
Director Westerman was appointed in May 2007 and subsequently elected at the
annual shareholders meeting in September 2007. Directors Stark and Bramlett were
elected at the annual shareholders meeting in September 2007.




(4)
Director Bailey resigned in June 2007. Directors Eller and Lee chose not to run
for reelection to the Board of Directors and their terms expired at the time of
the annual shareholders meeting in September 2007.







We also
revised our director compensation plan in June 2007.  Up until that
time, all Directors who were not employees of the Company received $150 per
board meeting or committee meeting attended in person, and $50 per telephonic
meeting. Reasonable expenses incurred by each Director in connection with his
duties as a Director are also reimbursed by Nano-Proprietary. The outside
Directors also participated in the 2002 Equity Compensation Plan, under which
Nano-Proprietary may grant stock options to any Director. Previously each
Director was granted 50,000 options priced at market on the last Monday of July.
The level of 50,000 options per year was set by the Board of Directors in April
2001, and ratified each successive year since then by the compensation committee
of the Board of Directors.




Under
this plan, the compensation that we paid to our outside Directors was heavily
weighted toward stock based compensation to minimize the amount of cash that we
used, and it was designed to compensate the Directors for the risk that they
assume as directors of a public company. One drawback to this plan, given the
nominal amounts of cash paid, was that for an outside Director to actually
realize any compensation for services performed, they had to exercise the
options and sell the underlying shares. Although sales of securities can occur
for a variety of reasons, sales by insiders are often perceived as negative by
shareholders. In order to avoid that inherent conflict, we revised our
compensation plan for outside Directors as described in the following
paragraph.




We now
pay our outside Directors with a combination of cash and restricted stock. The
Directors each receive an annual retainer of $12,000, paid quarterly. Each
committee chairman receives an additional annual retainer of $6,000, paid
quarterly, and the Board Chairman, if not an employee, receives an additional
annual retainer of $8,000. In addition to the cash payments, each outside
Director receives a quarterly grant of 2,500 shares of restricted stock on the
last day of January, April, July, and October. These grants are prorated if a
Director only serves a portion of the quarter, the grants vest quarterly over a
one year period starting on the date of the grant.




This plan
replaced the option grants that would have been made on the last day of July
2007 and as such the amounts paid in July 2007 were prorated annual amounts. One
Director, Brad Lamb received the option grant in July 2007, rather than the new
plan. Mr. Lamb first became a Board Member in December 2006 and was made aware
of the existing compensation plan at the time. Since Mr. Lamb had received no
previous option grants, he requested that he be compensated under the old method
for 2007 and this was approved by the Board. Effective with the third quarter
2007 payments, Mr. Lamb’s compensation was switched to the new system to match
the other Outside Directors.




All of
the Directors have retained the right to pursue additional business activities
that are not competitive with the business of Nano-Proprietary, and do not
adversely affect their performance as Directors. If, as, and when conflicts of
interest arise, the nature of the conflict must be fully disclosed to the Board
of Directors, and the person who is subject to the conflict must abstain from
participating in any decision that may impact on his conflict of interest.
Except for this disclosure and abstention policy, the Directors will not be in
breach of any fiduciary duties owed to Nano-Proprietary or the shareholders by
virtue of their participation in such additional business
activities.


Page
65




Director
Ownership Requirements




At the
same time that we adopted the new compensation plan for Outside Directors, we
also adopted stock ownership requirements covering all Directors - both outside
Directors and employee Directors. All Directors are required to own a minimum of
20,000 shares of Nano-Proprietary common stock. There is no time limit in which
a new director must meet those requirements; however, until a Director owns a
minimum of 20,000 shares, the Director is not allowed to sell any shares.
Furthermore, if a Director owns in excess of 20,000 shares, that Director is not
allowed to sell shares, whether owned or received as a result of the exercise of
options, if at the completion of the transaction, it will result in an ownership
position of less than 20,000 shares. All current Directors currently meet this
ownership requirement with the exception of Director Bramlett, who became a
Director in September 2007 and owns 13,333 shares as of the date of this
filing.  He has purchased 10,000 shares since becoming a Director and
received an additional 3,333 shares of restricted stock under the Director
compensation plan.




Compensation
Committee Interlocks and Insider Participation




The
Compensation Committee currently consists of Mr. Berman, Mr. Bramlett, and
Mr. Lamb. None of them is or has been an officer or employee of
Nano-Proprietary, nor do any of them have any relationships requiring disclosure
under Item 404 of Regulation S-K. No interlocking relationship existed during
the fiscal year ended December 31, 2007, between Nano-Proprietary’s Board of
Directors or Compensation Committee and the board of directors or compensation
committee of any other company.




Item
12. Security Ownership of
Certain Beneficial Owners and Management and Related Stockholder
Matters.




CERTAIN
BENEFICIAL OWNERS




The only
persons or entities known to be the beneficial owner of 5% or more of the
outstanding voting stock of the common stock of Nano-Proprietary, Inc. stock as
of February 18, 2008, are listed below. For the purposes of this Annual Report
on Form 10-K, beneficial ownership of securities is defined in accordance with
the rules of the SEC to mean generally the power to vote or dispose of
securities, regardless of any economic interest therein.




Beneficial
              Ownership
            
            Percent
      of
              Outstanding
              Common StockPinnacle
      Fund, L.P.
            
            7,301,776
            
            6.81%Barry
      Kitt, General Partner
              4965
      Preston Park Blvd., Suite 240
              Plano,
      TX 75093







Page
66


SECURITY
OWNERSHIP OF MANAGEMENT




Set forth
below is certain information with respect to beneficial ownership of
Nano-Proprietary’s common stock as of February 18, 2008, by each Director, each
Named Executive Officer and by the directors and executive officers as a group.
Unless otherwise indicated, each person or member of the group listed has sole
voting and investment power with respect to the shares of common stock
listed.





Name
            Options
      and Restricted Stock Included
              in
      Beneficial
              Ownership
      (1)
            Common
      Stock
              Beneficial
              Ownership
            Percentage
              of
      ClassThomas
      F. Bijou
            245,000
            463,429
            *Dr. Zvi
      Yaniv
            782,500
            942,500
            *Douglas
      P. Baker
            707,062
            766,562
            *Dr.
      Richard Fink
            139,349
            139,349
            *Ronald
      J. Berman
            720,209
            1,140,134
            1.05%Howard
      Westerman
            1,459
            188,499
            *Dr. Robert
      Ronstadt
            180,209
            191,659
            *Bradford
      S. Lamb
            29,792
            124,213
            *Tracy
      Bramlett
            208
            10,208
            *Patrick
      V. Stark
            208
            39,503
            *All
      Executive Officers and
              Directors
      as a group (10 persons)
            2,805,996
            4,006,056
            3.64%




*
            Less
      than 1%




(1)
            This
      column lists shares that are subject to options exercisable within sixty
      (60) days of February 18, 2008 and restricted stock that vests within
      sixty (60) days of February 18, 2008, and are included in common stock
      beneficial ownership pursuant to Rule 13d-3(d)(1) of the Exchange
      Act.




SECURITIES
AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS





Equity
      Compensation
              Plans
      Not Approved by
              the
      Shareholders of
              Nano-Proprietary
            Number
      of Securities to
              be
      issued upon exercise
              of
      outstanding options
            Weighted-average
              exercise
      price of
              outstanding
      options
            Number
      of Securities
              remaining
      available
              for future
      issuance under
              equity
      compensation
              plans
      (4)(a)
            (b)
            (c)1992
      Employee Plan (1)
            905,000
            $1.05
            -1992
      Outside DirectorsPlan
      (2)
            210,000
            $1.11
            -1998
      Directors andOfficers
      Plan
            500,000
            $0.46
            -2002
      EquityCompensation
      Plan (3)
            5,282,180
            $1.72
            3,434,453Total
            6,897,180
            $1.52
            3,434,453




(1)
            The
      1992 Employee Plan was originally approved by shareholders and authorized
      3.0 million shares. The plan was subsequently amended twice by the Board
      to increase the authorized number of shares and is therefore classified as
      a plan not approved by our
shareholders.


Page
67









(2)
            The
      1992 Outside Directors Plan was originally approved by shareholders and
      authorized 500,000 shares. The plan was subsequently amended by the Board
      to increase the authorized number of shares and is therefore classified as
      a plan not approved by our
shareholders




(3)
            The
      2002 Equity Compensation Plan was overwhelmingly approved by a majority of
      the shareholders actually casting votes at the 2007 annual meeting of
      shareholders. However, since less than 50% of the shares eligible to vote
      actually cast votes, the plan does not fall into the category of plans
      approved by shareholders under SEC
rules.




(4)
            This
      column excludes securities reflected in column
  (a)




There are
no equity compensation plans approved by shareholders at the present
time.




The 1992
Employee Plan was created in 1992 for the purpose of granting incentive or
non-qualified stock options to employees of, or contractors for, the Company. A
total of 6.5 million shares were authorized under the plan. All options granted
under this plan were priced at the fair market value of our common stock on the
date of grant, or greater, and have a life of ten (10) years from their date of
grant, subject to earlier termination as set forth in such plan. The plan
expired in 2002; however, options granted prior to such plan’s expiration remain
exercisable, subject to the terms of the respective option grants.




The 1992
Outside Directors’ Plan was established in 1992 for the purpose of granting
non-qualified options to non-employee Directors of the Company. A total of 1.0
million options were authorized under the plan. All options granted under this
plan were priced at the fair market value of our common stock or greater on the
date of grant and have a life of ten (10) years from their date of grant,
subject to earlier termination as set forth in such plan. The plan expired in
2002; however, options granted prior to such plan’s expiration remain
exercisable, subject to the terms of the respective option grants.




In 1998,
the Company’s Board of Directors established the 1998 Directors’ and Officers
Plan to award non-qualified options to Officers and Directors. All options
granted under this plan were priced at the fair market value of our common
stock, or greater, on the date of grant and have a life of ten (10) years from
their date of grant, subject to earlier termination as set forth in such plan. A
total of 2.5 million options were granted under this plan; however no options
remain available for granting under this plan.




In 2002,
the Company’s Board of Directors established the 2002 Equity Compensation Plan
for the purpose of granting incentive or non-qualified stock options to
employees or directors of the Company. All options granted under this plan were
priced at the fair market value of our common stock, or greater, on the date of
grant and have a life of up to ten (10) years from their date of grant, subject
to earlier termination as set forth in such plan. A total of 5,000,000 options
were initially authorized under this plan. This plan was amended December 31,
2004 to increase the authorized shares by 3,000,000 to a total of 8,000,000
shares and again on December 12, 2007 to increase the authorized shares by
another 2,000,000 to a total of 10,000,000 shares.




For a
further description of each of the stock option plans described above, please
see Note 8 to the Consolidated Financial Statements herein.




Item
13. Certain Relationships and
Related Transactions, and Director Independence




It is our
written policy that all material related party transactions be approved by the
Board of Directors, with any member of the Board affected by the related party
transaction abstaining from the vote.




In
October 1998, EBT entered into a Patent Assignment and Royalty Agreement with
Advanced Technology Incubator, Inc., (“ATI”) a corporation based in Austin,
Texas and owned by Dr. Zvi Yaniv, the Company’s President and Chief
Operating Officer. Under the terms of the agreement, ATI agreed to assign U.S.
Patent No. 5,469,187 related to certain LCD technology to EBT in exchange for an
initial payment of $200,000. In addition, ATI was entitled to receive a royalty
of 5% of gross revenue related to products using this patent. EBT could
terminate this assignment at any time upon 30 days written notice to ATI. The
assignment could have been terminated by ATI if, within two years of the first
sale or lease of a display unit using this technology, cumulative royalty
payments under the agreement did not total $500,000, or if payments did not
equal $500,000 in any one-year period following the initial two-year period. If
the assignment was terminated by ATI, EBT would have been granted a
non-exclusive worldwide license to use the technology under terms similar to
those contained in this agreement. There have been no sales or leases of display
units using this technology; therefore, the two year period that could have
resulted in minimum payments being due never started.


Page
68









In 2006,
we sold the intellectual property of EBT. The purchaser was interested in
acquiring all intellectual property, including this patent, as part of the
package, but not in assuming the agreement that we had with ATI. In order to
complete the transaction, we were required to acquire the remaining interest in
the patent and settle all potential future obligations to ATI. To do this, we
issued 200,000 shares of our common stock, valued at $400,000 to ATI. We also
paid $25,000 to ATI for additional services related to this transaction during
the year.




Item
14. Principal Accountant Fees
and Services




Audit
Fees




No fees
were billed to the Company in 2007 or 2006 by, the Company’s current auditor.
Our prior auditor, Sprouse & Anderson, L.L.P. merged with Padgett,
Stratemann & Co., L.L.P. in 2007 and no longer exists. The aggregate fees
billed to the Company by Sprouse & Anderson, L.L.P. for the audit of
Nano-Proprietary’s annual financial statements and for the review of the
financial statements included in its quarterly reports on Form 10-Q for the
Fiscal Years ended December 31, 2007 and 2006 totaled $56,609 and $57,200,
respectively.




Audit-Related
Fees




Nano-Proprietary
did not incur or pay any fees to either Padgett, Stratemann & Co. L.L.P. or
Sprouse & Anderson, L.L.P., and neither Padgett, Stratemann & Co. L.L.P.
or Sprouse & Anderson; L.L.P. provided any services related to audit-related
fees in the last two fiscal years.




Tax
Fees




There
were no fees billed to Nano-Proprietary by either Padgett, Stratemann & Co.
L.L.P. or Sprouse & Anderson, L.L.P. for services rendered to
Nano-Proprietary during the last two fiscal years for tax compliance, tax
advice, or tax planning.




All
Other Fees




There
were no fees billed to Nano-Proprietary by either Padgett, Stratemann & Co.
L.L.P. or Sprouse & Anderson, L.L.P. for services rendered to
Nano-Proprietary during the last two fiscal years, other than the services
described above under “Audit Fees.”




It is the
audit committee’s policy to pre-approve all services provided by the Company’s
auditors. All services provided by Sprouse & Anderson, L.L.P. during the
years ended December 31, 2007 and 2006 were pre-approved by the audit
committee.




As of the
date of this filing, Nano-Proprietary current policy is to not engage Padgett,
Stratemann & Co., L.L.P. to provide, among other things, bookkeeping
services, appraisal or valuation services, or internal audit services. The
policy provides that Nano-Proprietary engage Padgett, Stratemann & Co.,
L.L.P. to provide audit, tax, and other assurance services, such as review of
SEC reports or filings.




The Audit
Committee considered and determined that the provision of the services other
than the services described under “Audit Fees” is compatible with maintaining
the independence of the independent auditors.





Page
69


PART
IV




Item
15. Exhibits and Financial
Statement Schedules




(a)
            The
      following documents are filed as part of this Annual Report on Form
      10-K:




(1)
            All Financial
      Statements




The
response to this portion of Item 15 is set forth in Item 8 of Part II
hereof.




(2)
            Financial Statement
      Schedules




Schedules
for which provision is made in the applicable accounting regulations of the
Securities and Exchange Commission are not required under the related
instructions or are inapplicable, and therefore have been omitted.




(3)
            Exhibits




See
accompanying Index to Exhibits on page 72 for a descriptive response to this
item. The Company will furnish to any shareholder, upon written request, any
exhibit listed in the accompanying Index to Exhibits upon payment by such
shareholder of the Company’s reasonable expenses in furnishing any such
exhibit.




(b)
            Reference
      is made to Item 15(a)(3)
above.




(c)
            Reference
      is made to Item 15 (a)(2)
above.


Page
70


SIGNATURES




Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the registrant has caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.




NANO-PROPRIETARY,
      INC.By:
            /s/
      Thomas F. BijouThomas
      F. Bijou, Chief Executive Officer
              February
      25, 2008




Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed by the following persons on behalf of the registrant and in the
capacities and on the dates indicated.




Signature
            Title
            Date/s/
      Thomas F. Bijou
              Thomas F. Bijou
            Chairman,
      Chief Executive
              Officer
      (Principal Executive Officer and Director)
            February
      25, 2008/s/
      Douglas P. Baker
              Douglas
      P. Baker
            Vice
      President and Chief Financial Officer
              (Principal
      Financial Officer and Principal Accounting Officer and
      Director)
            February
      25, 2008Dr. Robert
      Ronstadt*
              Bradford
      S. Lamb*
              Ronald
      J. Berman*
              Dr. Zvi
      Yaniv*
              Howard
      Westerman*
              Tracy
      Bramlett*
              Patrick
      V. Stark*
            Directors
            February
      25, 2008




*By:
            /s/
      Douglas P. Baker(Douglas
      P. Baker,
              Attorney-in-Fact)





Page
71


INDEX TO
EXHIBITS




The
exhibits indicated by an asterisk (*) have been previously filed with the
Securities




and
Exchange Commission and are incorporated herein by reference.




EXHIBIT
              NUMBER
            DESCRIPTION
      OF EXHIBIT3(i).1*
            Restated
      Articles of Incorporation of Company, as filed with the Secretary of State
      for the State of Texas. (Exhibit 3(i).1 to the Company’s Current Report on
      Form 8-K dated as of December 12, 2007).3(ii).1*
            Amended
      and Restated Bylaws of the Company. (Exhibit 3(ii).1 to the Company’s
      Current Report on Form 8-K dated as of December 12,
  2007).4.1
      *
            Form
      of Certificate for shares of the Company’s common stock (Exhibit 4.1 to
      the Company’s Registration Statement on Form SB-2[No.33-51446-FW] dated
      January 7, 1993).4.2*
            Amended
      and Restated Rights Agreement dated as of November 16, 2000, between the
      Company and American Securities Transfer, Incorporated, as Rights Agent,
      which includes as Exhibit A the form of Statement of Resolution
      establishing and designating series of preferred stock as “Series H Junior
      Participating Preferred Stock” and fixing and determining the relative
      rights and preferences thereof, as Exhibit B the form of Rights
      Certificate, and as Exhibit C the Summary of Rights to Purchase Preferred
      Shares. (Exhibit 4.1 to the Company’s Current Report on Form 8-K dated as
      of November 16, 2000).4.3*
            Form
      of Regulation D Subscription agreement by and between the Company and the
      participants of private placements. (Exhibit 4.3 to the Company’s Annual
      Report on Form 10-K for the fiscal year ended December 31,
      2004)4.4*
            Form
      of Registration Rights Agreement by and between the Company and the
      participants of private placements. (Exhibit 4.4 to the Company’s Annual
      Report on Form 10-K for the fiscal year ended December 31,
      2004)10.1*
            Amended
      and Restated 1992 Outside Directors’ Stock Option Plan (Exhibit 4.2 to the
      Company’s Registration Statement on Form S-8 [No. 333-56547] dated June 9,
      1998).10.2*
            1998
      Directors and Officers Stock Option Plan (Exhibit 4.3 to the Company’s
      Registration Statement on Form S-8 [No. 333-56547] dated June 9,
      1998).10.3*
            Amended
      and Restated 1992 Stock Option Plan (Exhibit 4.1 to the Company’s
      Registration Statement on Form S-8 [No. 333-56457] dated June 9,
      1998)10.4*
            Amended
      and Restated 2002 Equity Compensation Plan. (Exhibit 99.1 to the Company’s
      Current Report on Form 8-K dated as of December 12,
  2007).10.6*
            Amendment
      No. 1 to the lease agreement between the Company and Industrial Properties
      Corporation dated as of December 15, 2006.10.7*
            Nano-Proprietary,
      Inc. Audit Committee Charter (Exhibit 10.23 to the Company’s Annual Report
      on Form 10-KSB for the fiscal year ended December 31,
  2002)10.8*
            Nano-Proprietary,
      Inc. Compensation Committee Charter (Exhibit 10.18 to the Company’s
      Current Report on Form 10-K for the fiscal year ended December 31,
      2005).10.9*
            Nano-Proprietary,
      Inc. Nominating Committee Charter (Exhibit 10.19 to the Company’s Current
      Report on Form 10-K for the fiscal year ended December 31,
      2005).10.10*
            Patent
      License Agreement between SI Diamond Technology, Inc. and Till Keesmann
      (Exhibit 10 to the Company’s Quarterly Report on Form 10-QSB for the
      quarter ended June 30, 2000)10.11*
            Second
      Addendum to Patent License Agreement by and among Nano-Proprietary, Inc.
      and Till Keesmann (Exhibit 10.1 to the Company’s Current Report on Form
      8-K dated as of November 18, 2002).10.12*
            Asset
      Purchase Agreement between Novus Communication Technologies, Inc., Novus
      Displays, LLC, Electronic Billboard Technology, Inc. and Nano-Proprietary,
      Inc. (Exhibit 10.1 to the Company’s Current Report on Form 8-K dated as of
      June 22, 2006)10.13*
            Asset
      Purchase Agreement between Novus Communication Technologies, Inc.,
      Electronic Billboard Technology, Inc. and Nano-Proprietary, Inc. (Exhibit
      10.1 to the Company’s Current Report on Form 8-K dated as of June 22,
      2006)


Page
72





11
            Computation
      of (Loss) per Common Share14
      *
            Nano-Proprietary,
      Inc. Code of Ethics (Exhibit 14 to the Company’s Annual Report on Form
      10-KSB for the fiscal year ended December 31, 2004)21
            Subsidiaries
      of the Company24
            Powers
      of Attorney31.1
            Rule
      13a-14(a)/15d-14(a) Certificate of Thomas F. Bijou, Chief Executive
      Officer31.2
            Rule
      13a-14(a)/15d-14(a) Certificate of Douglas P. Baker, Chief Financial
      Officer32.1
            Section
      1350 Certificate of Thomas F. Bijou, Chief Executive
    Officer32.2
            Section
      1350 Certificate of Douglas P. Baker, Chief Financial
    Officer