Table of Contents


UNITED
      STATES


SECURITIES
      AND EXCHANGE COMMISSION


Washington,
      D.C. 20549




**FORM
      10-K**




ý
            Annual
                report under Section 13 or 15(d) of the Securities Exchange Act of
                1934
                for the fiscal year ended
              December
                31, 2005; or ̈
            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**
              (State
                of Incorporation)
            **76-0273345**
              (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 Registered**Common
                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  ̈ 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  ̈ 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  ̈




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.  ̈




Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of accelerated
      filer and large accelerated filer in Rule 12b-2 of the Act.


Large
      Accelerated Filer  ̈ Accelerated Filer þ Non-Accelerated Filer  ̈




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 30, 2005 of $2.20, was
      approximately $216 million.




As
      of
      February 24, 2006, the registrant had 100,496,440 shares of Common Stock issued
      and outstanding.




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


Yes  ̈ No þ




**Documents
      Incorporated by Reference**




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













**TABLEOF
      CONTENTS**




**Page****PART
                I.**Item
                1.
            Business
            1Item
                1A.
            Risk
                Factors
            10Item
                1B.
            Unresolved
                Staff Comments
            15Item
                2.
            Properties
            15Item
                3.
            Legal
                Proceedings
            16Item
                4.
            Submission
                of Matters to a Vote of Security
                Holders
            16**PART
                II**Item
                5.
            Market
                for Registrant’s Common Equity, Related Stockholder
                Matters and Issuer Purchases of Equity Securities
            17Item
                6.
            Selected
                Financial Data
            18Item
                7.
            Management's
                Discussion and Analysis of Financial Condition and Results ofOperations
            19Item
                7A.
            Quantitative
                and Qualitative Disclosures About Market
                Risk
            24Item
                8.
            Financial
                Statements and Supplementary Data
            25Item
                9.
            Changes
                in and Disagreements with Accountants on Accounting and FinancialDisclosure
            47Item
                9A.
            Controls
                and Procedures
            47Item
                9B.
            Other
                Information
            49**PART
                III**Item
                10.
            Directors
                and Executive Officers of the
                Registrant
            50Item
                11.
            Executive
                Compensation
            53Item
                12.
            Security
                Ownership of Certain Beneficial Owners and
                Management and Related Stockholder Matters
            56Item
                13.
            Certain
                Relationships and Related
                Transactions
            58Item
                14.
            Principal
                Accountant Fees and
                Services
            58**PART
                IV**Item
                15.
            Exhibits
                and Financial Statement
                Schedules
            59




**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. ****







Table
            of Contents





**PARTI.**




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” and “Risk Factors” included at the beginning of this
      report.




**Item
      1.** ***Business.***




**DESCRIPTION
      OF BUSINESS**




**General**




Nano-Proprietary,
      Inc. is engaged in the development of proof of concepts of products and
      materials, and the performance of services based principally on novel
      applications of carbon nanotube technology, as well as other nanotechnology
      areas based on intellectual property and expertise that we have developed over
      the years. 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 FED intellectual property will be required by any entity that
      develops a display using this technology. As discussed in greater detail under
      the heading “Display 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, over the 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 in 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
      the area of sensor technology and other areas beyond the FED technology. At
      present, we have over 250 total patents, including 116 issued, 99 pending,
      and
      26 provisional.




**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 $2,525,292,
      $2,611,583, and $1,861,660 on research and development in the years ended
      December 31, 2005, 2004, and 2003, respectively. This represents approximately
      48%, 52%, and 38% of our total operating costs and expenses in 2005, 2004,
      and
      2003, respectively. We expect to continue to invest heavily in research and
      development and expect our research and development costs for 2006 to be in
      excess of 50% 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 current efforts. It was incorporated in January 1997
      and
      is developing our proprietary carbon nanotube and related technology.
      Accordingly, our research is focused in the broad area of carbon nanotube
      technology and its application to the display, electronics, sensor, medical,
      x-ray, and other industries. Our development plans for this technology 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 also 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 potential in
      the
      short run and was less capital intensive. At the present time, we are pursuing
      license agreements related to our intellectual property in this area, although
      we are not currently spending money to further develop EBT’s
      technology.





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            1
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***Other.*** We also
      incur general overhead to operate Nano-Proprietary that is not associated with
      any spe cific
      subsid iary
      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. To the extent that EBT is basically
      inactive, information relative to this segment is not that
      meaningful.






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




2005
            
            2004
            
            2003RevenuesANI
            
            $
            565,660
            
            $
            382,522
            
            $
            773,959EBT
            
            $
            —
            
            $
            —
            
            $
            —Other
            
            $
            —
            
            $
            —
            
            $
            —Total
                Revenues
            
            $
            565,660
            
            $
            382,522
            
            
            773,959Net
                loss from continuing operationsANI
            
            $
            (3,730,450
            )
            $
            (4,030,353
            )
            $
            (2,890,175
            )EBT
            
            $
            (3,734
            )
            $
            106,251
            
            $
            (361,784
            )Other
            
            $
            (927,350
            )
            $
            (687,924
            )
            $
            (962,243
            )Total
            
            $
            (4,661,534
            )
            $
            (4,612,026
            )
            $
            (4,214,202
            )AssetsANI
            
            $
            301,870
            
            $
            310,005
            
            $
            1,424,724EBT
            
            $
            —
            
            $
            —
            
            $
            527Other
            
            $
            886,111
            
            $
            834,363
            
            $
            2,358,766Total
            
            $
            1,187,981
            
            $
            1,144,368
            
            $
            3,784,017








**Applied
      Nanotech, Inc.**




**Overall**




We
      are
      primarily a nanotechnology company.  We are focusing our efforts on
      research, proof of concept development for products, and licensing our
      technology to others. ANI is developing world-class technologies that generally
      fall into one of four markets or categories. These categories are display,
      sensors, functional nanomaterials, and other specific electronic applications.
      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 we would need to develop manufacturing
      capabilities, we intend to use manufacturing partnerships, joint ventures,
      or
      arrange to have products manufactured through contract
      manufacturers.




**Display
      activities**




Our
      main
      focus for virtually the entire life of Nano-Proprietary has been on Field
      Emission Display (“FED”) technology. We have performed significant research and
      accumulated significant intellectual property in this area. 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. TVs using FED technology are intended to compete with and improve
      on
      the plasma, projection, and CRT displays currently available in the large screen
      TV market. FED technology can also be used for large outdoor electronic displays
      in products such as roadside billboards, stadium displays, and other outdoor
      electronic signs. We have developed an extensive patent portfolio covering
      numerous aspects of FED technology.














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***Carbon-nanotube
      based large area flat screen color field emission
      displays.*** 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. As
      discussed in more detail in the Technology Agreements section below, we licensed
      6 patents from Till Keesman in 2000. These patents are 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 strengthened and reinforced the basic
      nature of this patent. It is our belief that any company using a carbon
      nanotubes in an emission mode, regardless of application, will be required
      to
      license this, and other patents from us. No companies have yet obtained the
      right to use this patent from us. We have an equally significant patent that
      we
      refer to as the Raman Spectrum patent. This patent covers all carbon based
      FEDs,
      regardless of whether the emission is from carbon nanotubes, carbon films,
      or
      other forms of carbon.




Other
      companies are developing large area color TVs that may be, in part, based on
      our
      carbon nanotube based field emission technology. Companies including Samsung,
      Dupont, Noritake, and Motorola all 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, 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. We currently have both a 14-inch monochrome and a 14-inch
      color proof of concept that we built internally. We have also developed a
      25-inch color prototype in conjunction with a consortium of Japanese component
      manufacturers. Each member of the consortium contributed its own particular
      expertise to the prototype at its own expense. The purpose of the 25-inch color
      prototype was to demonstrate that scalability is not an issue with the carbon
      nanotube-based field emission display. It was built to specifications enabling
      it to be expanded to a 60-inch display; however, it was built at 25 inches
      due
      to cost considerations. We completed the 25-inch color prototype in the fall
      of
      2005, and it is our goal to start a pilot line with a major manufacturer and
      license the technology. This manufacturer could be one that has done extensive
      work on its own related to carbon nanotube based field emission displays, or
      one
      that perceives itself as behind the curve in this area and would use this as
      an
      opportunity to catch up to others in the area. Other members of the consortium
      would have the opportunity to become equipment suppliers, component
      manufacturers, or manufacturers of carbon nanotube based TVs.




***Other
      large area flat screen color field emission displays.*** Canon,
      Inc. and Toshiba have jointly developed a large area flat screen color TV based
      on our FED technology. Canon and Toshiba have announced that they have formed
      a
      joint venture to manufacture components for this TV, have constructed a
      manufacturing line, demonstrated this product at the January 2006 consumer
      electronics show in Las Vegas, and announced that they would have product
      available in the fall of 2006. We
      signed a non-exclusive license with Canon in 1999 that covered substantially
      all
      of our field emission patents, but excluded the basic carbon nanotube patent
      and
      specific applications for the other field emission display patents including,
      but not limited to, large area color displays. Toshiba and the joint venture
      formed by Canon and Toshiba have no licenses from us. It is our belief that
      all
      entities involved will require licenses from us in order to manufacture and
      sell
      large area flat screen color TVs using this FED technology. The license
      agreement with Canon is currently the subject of litigation. See Item 3 of
      this
      Annual Report on Form10-K for further information on this
      litigation.




***HyFEDTM*** - We
      have developed a new display technology that we call the HyFEDTM. We expect the
      HyFEDTM to be phased in as an improvement to the way our FED technology will be
      used in the large area color displays previously described. HyFEDTM combines what
      we believe to be the best properties of CRTs and our field emission technology.
      We expect the HyFEDTM to significantly cut the cost of the drivers used in a
      field emission display. In January 1999, we formed an International Development
      Team to develop the first HyFEDTM based on our FED technology. The International
      Development Team was composed of six organizations - four from Japan, one from
      Europe, and ourselves. The International Development Team completed a working
      four-inch monochrome prototype of the HyFEDTM in January 2000. The team was
      expanded and developed a prototype with an active gray scale. Each member of
      the
      team was focused on the development of a specific portion of the prototype
      and
      members funded their own portion of the work. Work on the HyFEDTM has been frozen
      until our basic FED technology is being used in the production of large area
      color TVs. These team members will be given the first opportunity to license
      the
      HyFEDTM technology. We expect to license our HyFEDTM technology in the future,
      although there is no assurance that this will occur.




***Backlights
      for displays.*** Our
      carbon nanotube technology is ideally suited to be developed as a backlight
      for
      other types of displays, such as LCDs and we have performed some initial
      research in this area. Many other significant companies have also performed
      research in this area. Successful development of a backlight device using carbon
      nanotubes will require a license to our intellectual property.







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***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 display 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 do not intend to manufacture these
      PETs ourselves, but rather license other manufacturers to produce them. We
      have
      currently licensed a previous version of field emission display technology
      that
      is not based on carbon nanotubes to a large Japanese display manufacturer that
      is now working internally to complete development of the product.




***Licensing
      agreements*** *.*  We
      have
      an extensive patent portfolio that we have developed and acquired over the
      years. Licensing of this technology to major companies is a critical part of
      our
      overall strategic plan and critical to achieving profitability in the short
      run.
      We currently have two license agreements related to our FED technology. In
      March
      1999, we signed our first significant license agreement with Canon, Inc. In
      exchange for a one-time, up-front payment of approximately $5.6 million, Canon
      was granted a non-exclusive right to use a portion of our FED
      technology, but
      excluding the basic carbon nanotube patent and specific applications for other
      field emission display patents including, but not limited to, large area color
      displays. In 2002,
      we signed another license agreement with a large Japanese display manufacturer.
      This license calls for royalties of 2% of the licensee’s sales of products using
      our technology. The licensee will receive credit against royalties due under
      the
      agreement for $2 million of research funding that the licensee provided to
      us
      from 2001 to 2003. Accordingly, no royalties will be due under the agreement
      until sales of the licensee’s products exceed $100 million. We expect to sign
      multiple additional license agreements over the next few years, and we expect
      that such license agreements will include both an up-front payment and a
      continuing royalty stream based on the products sold by the
      licensee.




***Competition.*** Because
      of the strength of our intellectual property in the FED area, our competition
      comes from other technologies, rather than other companies. 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, whether carbon nanotube
      based or the SED. However, even companies developing these non-carbon nanotube
      based field emission displays will likely 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 our 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.




**Sensors**




***Overview.*** We
      have
      greatly expanded or work and intellectual property in the area of sensors,
      including biosensors, hydrogen sensors, carbon monoxide sensors, and other
      sensors. This is becoming an increasingly important part of our business and
      we
      expect it to become even more important in the future.




***Biosensors.*** Our
      carbon nanotube technology is ideally suited for use in biosensors. Sensors
      based on carbon nanotubes 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.




***Hydrogen
      sensors*** .
      These
      sensors are targeted for use in fuel cells for automobiles and for remote
      monitoring of large power transformers. We currently have two agreements related
      to our hydrogen sensors.




The
      first
      is a development, purchase, and license agreement with Kelman, Ltd., an
      international company which operates primarily in the area of power products,
      transformer services, and emission monitoring products. The agreement, signed
      in
      July 2005, gave the licensee the exclusive right for the use of the technology
      for the measurement of hydrogen in power transformer products, if certain
      minimum royalty payments are made.  ANI
      provided pre-production design, development, and engineering work. The licensee
      will pay a royalty of 10% of the sales
      of
      the products containing the hydrogen sensors. In order to maintain its
      exclusivity, Kelman must make cumulative minimum royalty payments of $1.0
      million by June 30, 2006, $2.5 million by June 30, 2007, and $4.5 million by
      June 30, 2008. Due to a redesign of the hydrogen sensor, the introduction of
      Kelman’s product has been delayed beyond the date anticipated when the agreement
      was signed. It is likely that the time period for the previously mentioned
      minimum royalty payments will be extended by some amount of time.





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We
      also
      have a research and development agreement with KRI, Inc, the research and
      development subsidiary of Osaka Gas Co. Ltd., the second largest gas utility
      company in Japan, to develop a hydrogen sensor for automotive fuel cell
      applications. This contract is the result of a joint proposal submitted by
      KRI
      and ANI to NEDO, the New Energy Industrial Technology Development Organization
      established by the Japanese Government in 1980. The initial phase of the project
      was completed by the end of 2005, and we are currently seeking additional
      funding in this area.




***Carbon
      Monoxide Sensors.*** We
      have
      developed a carbon monoxide sensor that is based on a “gated” metal oxide
      approach that allows the sensor to operate without heating, as compared with
      most carbon monoxide sensors that require heating to greater than 250 degrees
      Celsius. Our carbon monoxide sensor was originally developed in connection
      with
      a SBIR phase I government contract with the Department of Defense. We expect
      to
      receive a SBIR phase II contract to continue development to of this sensor.
      Our
      approach to the carbon monoxide sensor allows the sensor to operate at low
      power
      with instant-on operation. 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.




***Other
      sensors*** .
      We have
      also 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, and 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 as 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.




**Functional
      Nanomaterials**




We
      are in
      the advanced stages of research into nanomaterials using carbon nanotube
      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.




***Shimane
      Institute of Technology*** .
      We
      recently  completed
      a research and development agreement with Shimane Institute for Industrial
      Technology (SIIT) to develop a new aluminum alloy using carbon nanotubes that
      has thermal conductivity 4-5 times greater than aluminum metal. SIIT is a
      technology organization fully supported by the government of Shimane Prefecture,
      Japan. We recently completed the first phase of the contract and are negotiating
      a second phase of the project to continue development. Applications include
      any
      microelectronic device that generates heat, including circuit boards for
      computers and high powered radar. These alloys can also improve the strength
      of
      the aluminum without adding weight.








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***PhotoscrubTM
      Technology.*** We
      developed a concept called PhotoscrubTM which is based on an air purification
      technology originally developed by one of our strategic partners, Andes Electric
      Co., Ltd. The PhotoscrubTM is a thin film coating on a flexible fiberglass cloth
      that decomposes pollutants at the molecular level in liquids and gases. The
      2006
      Defense Appropriations Bill signed by President Bush in December 2005 included
      $1 million in funding for ANI to improve the efficiency of the concept and
      explore other air purification concepts.





***Large
      Sporting Goods Manufacturer.*** In
      September 2005, we signed a development contract with a large sporting goods
      manufacture to develop nanocomposites to be used in the manufacturer’s sporting
      equipment. ANI will receive $240,000 for the initial phase of the project,
      which
      is expected to last approximately one year. The goal of the project is to
      improve the existing base materials currently used by the contractor to make
      the
      equipment stronger, lighter, and more powerful.





***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 established
      competitors in the market.




**Other
      Electronic Applications**




We
      are
      working in several other areas that have grown out of our basic work in the
      FED
      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. Following is
      a
      summary of some of these technology areas.




***Cathodes.*** We have
      developed a carbon nanotube cold cathode electron source, which can be utilized
      for many non-display related applications such as x-ray tubes, medical devices,
      microelectronics, low-power thrusters, CRT electron guns, wireless
      communications, and polluted air scrubbing. In previous years we sold cathodes
      using this technology to Oxford Instruments for use in their portable Horizon
      600 hand-held XRF Spectrometer, an X-ray device used for alloy sorting,
      materials identification, and inorganic analysis. These cathodes use our
      proprietary carbon nanotube technology, however Oxford Instruments claims that
      they discontinued use of these cathodes in their product and moved to a
      different technology.




***Memory
      Chips.*** We have
      a license option agreement with the University of Texas at Austin to further
      the
      development of a next generation memory chip using the university’s information
      storage technology based on thin photo-conductive films. The ultimate goal
      is to
      make a low cost non-volatile memory device with increased capacity. We have
      demonstrated an initial proof of concept of the technology and in the next
      step
      we will be designing, fabricating, and optimizing a 10,000-bit proof of concept
      using this technology. We have had initial discussions with major chip
      manufacturers regarding this technology, however additional development work
      is
      needed before these manufactures are willing to enter a license agreement.
      We
      retain our exclusive right to license this technology, including the right
      to
      sublicense, within certain pre-defined parameters through the end of
      2006.




***Shimane
      Masuda Electronics.*** We
      completed a development project with Shimane Masuda Electronics (“SME”) in 2005.
      Upon completion of this project we entered into an agreement with SME to
      establish a joint pilot line for the development and production of carbon
      nanotube electron emission based lighting devices. This pilot line will be
      located in an SME facility, and SME will supply all necessary equipment and
      personnel to develop, engineer, and operate the line. ANI will contribute
      technical support, intellectual property, and know-how. The pilot period is
      expected to be completed by June 30, 2006, and should SME decide to go into
      volume production, they will license ANI’s technology for an upfront payment of
      10 to 25 million yen (approximately $85,000 to $213,000 at current exchange
      rates) and an ongoing royalty rate of 5% of all product sales using CNT electron
      sources. SME’s territory will be limited under the license to products sold in
      Asia.




***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 up on the results of our research
      compared with results achieved by others.





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**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. At the present time, we are
      not developing the technology further, but are actively pursuing technology
      licenses at EBT.




We
      expect
      that any license agreements would include both an upfront payment and ongoing
      royalties based on product sales by the licensee. We expect that potential
      licensees for the E-WindowTM would market it, primarily to major retailers and to
      either manufacture the product, or contract with others to manufacture the
      product.




EBT
      also
      has acquired the right to certain patented Liquid Crystal Display (“LCD”)
      technology that is ideal for use in outdoor electronic billboards. All research
      and development related to this technology has been suspended until we procure
      funding specifically to further develop this technology.




***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 recently
      allowed in February 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. We have also applied for
      similar patents and have applications pending in Europe, Canada, Korea, and
      Japan.




With
      the
      exponential growth that digital advertising is currently experiencing, we expect
      these patents to have significant value, and we expect to generate significant
      revenue in 2006 as a result of these patents. These patents apply to situations
      where the placement of digital ads is remotely controlled using the internet
      and
      other digital networks. Examples of locations where these displays may be
      located include high traffic locations such as airport or trains stations,
      indoor and outdoor sports arenas, digital point of purchase and other
      advertising in national, regional, and local retailers, as well as other high
      traffic locations. We expect to generate revenue with these patents by licensing
      them to others, or combining our resources with industry leaders to deploy
      the
      technology resulting from this intellectual property, or through some
      combination of these two methods.




***Competition***  Our
      E- ****** WindowTM
      product is a unique patented product. It does, however, face competition from
      a
      variety of other indoor display products from a variety of sources. Our success
      in this area will be dependent on the ability of licensees to successfully
      market our products. Our communication patents are unique and any organization
      involved in digital advertising using these methods will require a license.
      Competition would come from more manual and less efficient methods of deploying
      the advertising.




We
      are
      unaware of any other organizations that have developed an electronic billboard
      using an LCD technology. However, we are not currently continuing development
      of
      this technology, and LCD technology is an existing technology used in many
      applications. Competition from other manufacturers could develop at any time.
      There are several other companies either producing or developing electronic
      billboards using other technologies.




**Technology
      Agreements**




***Till
      Keesman.***  We
      have
      licensed certain patents related to carbon nanotube technology from Till Keesman
      (“the Keesman patents”). We licensed 6 patents in 2000 in exchange for a payment
      of $250,000. Under the terms of the agreement, we are obligated to pay license
      fees equal to 50% of any royalties received by the Company 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. 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. Certain of
      the
      products that we are developing may, in part, be based on some of the patents
      that we have licensed. These
      patents cover areas using the emission from a carbon nanotube, such as displays.
      There are other areas of carbon nanotube technology, such as biosensors, that
      are not based on an emission from the carbon nanotube, and therefore would
      not
      require payment of a royalty under this license agreement.







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***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, it is
      considered remote that we will be required to pay MCC any royalties at any
      time
      in the future.




**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
      116
      issued patents, 4 allowed patents, 99 patent applications pending before foreign
      and United States Patent and Trademark Offices, 26 provisional patent
      applications, and 4 published patents. We also have several unsubmitted patent
      applications in process. The patents, allowances and applications relate to
      the
      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 extremely
      valuable.




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.







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**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 $208,211 of revenue in 2005, $305,721 in
      2004, and $339,790 in 2003 related to government contracts. These reimbursements
      represent all or a portion of the costs associated with such contracts. As
      of
      December 31, 2005, we have three grants in process that have minor amounts
      of
      revenue yet to be recognized. We also have commitments for three additional
      grants which, in total, will result in approximately $2.5 million of future
      revenue. 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 24, 2006 we had 29 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.







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**Item
      1A.** ***RiskFactors***




**Our
      success is dependent on our principal technologies**




Our
      technologies, which include sensors, field emission displays, nano-electronics,
      and functional nano-materials, are emerging technologies. Our financial
      condition and prospects are dependent upon our licensing these technologies
      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 our ability 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, in addition to the
      cathodes that we have developed that currently use carbon nanotube technology.
      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 2006.




**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 determined. One of our 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 24, 2006, we had 29 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.







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**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 have 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
      display industry and other 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 in the areas in which we
      are
      conducting our principal research. At the present time, 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 technology to
      others for use in their manufacturing processes. To the extent that any of
      our
      other products 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.




**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.







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**We
      have a history of net losses**




We
      have a
      history of net losses. From our inception through December 31, 2005, we incurred
      net losses of approximately $85 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
            
            ($14,389,856)1996
            
            ($13,709,006)1997
            
            ($6,320,901)1998
            
            ($3,557,548)1999
            
            $1,118,1342000
            
            ($7,671,014)2001
            
            ($5,081,559)2002
            
            ($4,908,856)2003
            
            ($4,214,202)2004
            
            ($4,612,026)2005
            
            ($4,661,534)




Although
      we expect to be profitable in the future, we may not be.  Our profitability
      in 2006 is dependent on the signing of additional license agreements or
      obtaining additional research funding. 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
      future 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 carbon nanotube field emission
      products ourselves, and as such, we have no carbon nanotube field emission
      product revenues. We signed a license agreement in 1999, for a one-time, up
      front, payment of approximately $5.6 million. This was a non-exclusive license
      to Canon, Inc. that covered substantially all of our field emission patents,
      but
      excluding the basic carbon nanotube patent and specific applications for other
      field emission display patents including, but not limited to, large area color
      displays. This license will produce no future revenue unless Canon decides
      to
      license the additional patents or the excluded field emission display
      applications. In 2002, we signed another license agreement with a large Japanese
      display manufacturer. This license agreement calls for us to be paid royalties
      equal to 2% of the licensee’s sales of products using our technology. The
      licensee also will receive credit against royalties due under the agreement
      for
      $2 million of research funding and up-front payments that the licensee has
      provided to us from 2001 to 2003. Accordingly, no royalties will be due under
      the agreement until sales of the licensee’s products exceed $100
      million.




We
      expect
      to license our technology to be used in other applications. See additional
      discussion in the risk factor “Our technology development is in its early stages
      and the outcome is uncertain”. 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.







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**Our
      revenues have been dependent on government contracts in the
      past**




In
      many
      years, a significant part of our revenues is derived from contracts with
      agencies of the United States government. Following is a summary of those
      revenues for the past eleven 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%




We
      currently have commitments for future government funding of approximately $2.6
      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
                contracts




·
            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
      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 sublicensees.
      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.




We
      have
      also licensed certain patents related to carbon nanotube technology from Till
      Keesman (“the Keesman patents”). We licensed 6 patents in 2000 in exchange for a
      payment of $250,000. Under the terms of the agreement, we are obligated to
      pay
      license fees equal to 50% of any royalties received by the Company 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. 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 Keesman patents.
      Certain of the products that we are developing may, in part, be based on some
      of
      the patents that we have licensed.







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**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 existing resources, including
      expected revenue, to continue operations for a period through at least the
      end
      of 2006. 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 licensees ability to make and
      sell our products using our technology. Competitors 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.




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.














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**We
      are exposed to litigation liability**




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.




As
      described in more detail in Item 3, we are the plaintiff in litigation against,
      Canon, Inc. While there is risk associated with any litigation, we expect no
      negative impact on our financial condition as a result of this
      litigation.




**Item
      1B.** ***UnresolvedStaff
      Comments***




None.




**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 2007. We also
      lease office space in Dallas on a month to month basis.




We
      believe that these facilities are suitable and will be adequate for our
      anticipated research, development, and administrative activities for the
      foreseeable future.  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 .














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**** **Item
      3.** **** ***LegalProceedings***





In
      April
      2005, we filed suit against Canon, Inc. and Canon USA, Inc.  in
      the
      U.S. District Court for the Western District of Texas, Austin Division. We
      are
      seeking a declaratory judgment that new SED color
      television products, scheduled to be manufactured by SED, Inc. and sold by
      Canon and/or Toshiba beginning in 2006, are not covered under a 1999 patent
      license agreement that we have with Canon.  We assert that Canon’s license
      does not cover its surface conductor electron emitter display screens (SED)
      for
      a new generation of flat screen color televisions. We also assert that SED,Inc.,
      the joint venture formed by Canon and Toshiba Corporation to produce the
      SED display screens, is not a licensed subsidiary under the 1999
      agreement and that Canon is improperly transferring its license rights
      under Nano-Proprietary's patents to the joint venture and Toshiba.





The
      suit
      also contained three additional claims related to a Lanham Act violation by
      Canon, tortious interference by Canon, and a breach of covenant of good faith
      and fair dealings against Canon. Canon filed its response in July 2005 denying
      liability in the matter. In September 2005, Canon filed a motion to dismiss
      Canon USA, Inc. from the case and dismiss the Lanham Act claim, the tortious
      interference claim, and the breach of covenant of good faith and fair dealings.
      In October 2005, the judge in the case denied Canon’s motion to dismiss Canon,
      USA, Inc. and the breach of covenant of good faith and fair dealings claim.
      The
      judge granted Canon’s motion, without prejudice, to dismiss the Lanham Act claim
      and the tortious interference claim. Dismissal without prejudice allows us
      to
      re-file these claims at any time if additional evidence supporting these claims
      becomes available to us in the discovery process. The first two claims described
      above were not at issue in the dismissal motion by Canon. The case is currently
      in the discovery phase and a trial may occur as soon as March 2007. We believe
      that the ultimate resolution of this matter will not have a negative 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 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 2005.















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**PART
      II**




**Item
      5.** **** ***Marketfor
      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**
            **Low****2004**
            First
                Quarter
            $3.23
            $1.98Second
                Quarter
            $2.70
            $1.38Third
                Quarter
            $2.14
            $1.29Fourth
                Quarter
            $2.52
            $1.80**2005**
            First
                Quarter
            $3.53
            $2.01Second
                Quarter
            $3.99
            $1.56Third
                Quarter
            $2.81
            $1.86Fourth
                Quarter
            $2.45
            $1.97**2006**
            First
                Quarter (through February 24, 2006)
            $2.68
            $2.05




On
      February 24, 2006, the closing sale price for our common stock as reported
      on
      the OTC Bulletin Board system was $2.55.  As of February 24, 2006, there
      were approximately 350 shareholders of record for our common stock. This does
      not include shareholders holding stock in street name in brokerage
      accounts.




We
      have
      never paid cash dividends on our common stock, nor do we have any plans to
      pay
      dividends. Our board of directors currently intends 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.
      It is
      unlikely that any dividends on our common stock will be paid in the foreseeable
      future.




**Recent
      Sales of Unregistered Securities**




In
      October 2005, we issued 482,393 shares of our common stock for $1,000,000 in
      a
      private placement under Rule 506 of Regulation D of the Securities Act of 1933
      to the Pinnacle Fund, LP.






















































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**Item
      6.**  ***SelectedFinancial
      Data***





**2005**
            
            **2004**
            
            **2003**
            
            **2002**
            
            **2001**Revenues
                from continuing operations
            $
            565,660
            $
            382,522
            $
            773,959
            $
            1,414,848
            $
            1,101,951Income
                (loss) from continuing operations
            $
            (4,661,534)
            $
            (4,612,026)
            $
            (4,214,202)
            $
            (4,683,419)
            $
            (4,850,770)Income
                (loss) from continuing operations per share
            $
            (0.05)
            $
            (0.05)
            $
            (0.05)
            $
            (0.07)
            $
            (0.07)Total
                assets
            $
            1,187,981
            $
            1,144,368
            $
            3,784,017
            $
            321,955
            $
            1,839,055Long-term
                obligations
            $
            —
            $
            5,944
            $
            27,353
            $
            46,283
            $
            121,651Net
                shareholders’ equity (deficit)
            $
            859,339
            $
            846,456
            $
            3,552,829
            $
            (2,460,595)
            $
            (945,614)Cash
                dividends per common share
            $
            —
            $
            —
            $
            —
            $
            —
            $
            —








In
      2002,
      we sold our Sign Builders of America, Inc. subsidiary. All information related
      to Sign Builders has been removed from this summary as a result of its
      presentation as a discontinued operation. Also in 2002, 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 and $10,000 in 2003 and 2002,
      respectively. There was no revenue from EBT in all other years presented.





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**Item
      7.**  ***Management’sDiscussion
      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, 2005, and the results of
      operations for the years ended December 31, 2005, 2004 and 2003. 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**




Nano-Proprietary,
      Inc. is 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 and many of its
      potential applications are 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 2006 to be approximately $6.0 million. We intend to fund
      those needs through a combination of sales, reimbursements for research, and
      license agreements. We anticipate receiving significantly more revenue in 2006
      than was received in 2005. We have developed a plan to enable us to achieve
      positive cash flow from operations with approximately $6.0 million of revenue.
      As of February 24, 2006, we have approximately $2.0 million in cash to cover
      any
      potential revenue shortfall that may occur for the year. Our cash balance
      includes $1.5 million from equity that we raised in February 2006. We do not
      expect to need to raise any additional equity in 2006.




Our
      plan
      is to generate sufficient revenues in 2006 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 2006.




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
      have granted stock options to employees and others. In addition, all employees
      have the opportunity to earn additional goal-based option awards each year.
      In
      December 2004, the FASB issued 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.
      Up
      until this time, we have accounted for stock based compensation under the
      provisions of APB 25 and disclosed pro-forma compensation expense calculated
      using the Black-Scholes model in the footnotes to the financial statements.







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We
      will
      be required to adopt the provisions of SFAS No. 123R in the financial statements
      for the quarter ended March 31, 2006. Under the provisions of SFAS No. 123R,
      pro-forma presentation is no longer allowed, and we will be required to record
      compensation expense for option grants in the financial statements. It is likely
      that implementation of SFAS No. 123R will have a material impact on our
      financial statements. The exact impact cannot be predicted because it is
      dependent on future factors that can not be determined at the present time,
      such
      as the volatility of our common stock and the number of options granted. Had
      we
      been accounting for stock based compensation using SFAS 123 during the period
      covered by the report, the effect would have been as shown in the following
      table:




**2005**
            ****
            **2004**
            ****
            **2003**Net
                LossAs
                reported
            $(4,661,534)
            
            $(4,612,026)
            
            $(4,214,202)SFAS
                No. 123 Charge
            1,182,482
            
            2,259,387
            
            552,927Pro
                Forma
            (5,844,016)
            
            (6,871,413)
            
            (4,767,129)Net
                income (loss) per common share - basic and
                dilutedAs
                reported
            $(0.05)
            
            $(0.05)
            
            $(0.05)Pro
                Forma
            $(0.06)
            
            $(0.07)
            
            $(0.05)




***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 recorded impairment
      charges in 2002, but did not identify any impaired items in 2003, 2004 or 2005.
      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, 2005 accounts
      receivable.






**LIQUIDITY
      AND CAPITAL RESOURCES**






Our
      cash
      balance was $897,247 at December 31, 2005, which was approximately the same
      as
      the cash balance of $901,585 at December 31, 2004. Our working capital was
      approximately $700,000 at both December 31, 2005 and 2004. During the same
      period, our current ratio remained relatively constant at approximately 3.3
      to
      1.






The
      principal source of our liquidity has been funds received from exempt offerings
      of common stock. Cash provided by financing activities was $4,519,913,
      $2,037,390, and $7,267,465 in 2005, 2004, and 2003, respectively. Of this,
      the
      majority came from private placements of our common stock in the amounts of
      $4,000,000, $1,065,000, and $4,812,943 in 2005, 2004, and 2003, 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. The larger than normal amount of fundraising activity in
      2003
      was the result of a conscious decision to raise money to solidify our financial
      condition and to insure that we had sufficient funds to last through the end
      of
      2004 regardless of the revenue received in 2004, which accounts for the
      relatively small amount of fundraising in 2004. The fundraising activity in
      2005
      was to provide operating funds for 2005.






We
      completed another private placement of our common stock in February 2006. We
      raised a total of $1.5 million by issuing 750,000 shares of our common stock
      to
      provide liquidity until we reach breakeven. As of February 24, 2006, our cash
      balance is approximately $2.0 million. This combined with expected revenue
      is
      enough for us to operate into 2007, even if there were no significant new
      positive developments. We may receive additional funds from the exercise of
      warrants, although there is no assurance that warrants will be exercised. 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 2005,
      2004 and 2003 was from former employees that had options expiring in 2003 and
      2004. There are no remaining options held by former employees and only minimal
      options expiring in 2006.






In
      the
      unlikely event that we need additional funds in 2006 beyond the amount that
      we
      have as of the date of this filing and those that we expect to receive as
      revenues, 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 $4,507,579 in 2005, $4,581,513 in 2004, and
      $3,716,964 in 2003. The cash used in operations was primarily the result of
      the
      net losses incurred in each year. We expect a reduction in cash used in
      operating activities in 2006 as the result of an expected increase in revenues.
      We have a plan to







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generate
      positive cash from operations; 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, or substantial research
      contracts. The cash used in operations was virtually unchanged from 2004 to
      2005. The increase in the cash used in operating activities from 2003 to 2004
      was primarily the result of three factors: A decrease in revenue of roughly
      $400,000, an increase in royalty payments of approximately $100,000, and
      generally increased spending on research and development, particularly related
      to prototype displays.






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 2006.
      No material commitments exist as of December 31, 2005, for future purchases
      of
      capital assets.






A
      summary
      of our contractual cash obligations at December 31, 2005 is as
      follows:




Contractual
                Obligations
            
            
            Total
            
            
            2006
            
            
            2007
            
            
            2008
            
            
            2009Notes
                payable including interest
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            —Long-term
                debt including interest
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —Operating
                leases
            
            
            207,003
            
            
            131,891
            
            
            34,862
            
            
            21,000
            
            
            19,250Capital
                leases including interest
            
            
            4,368
            
            
            4,368
            
            
            —
            
            
            —
            
            
            —Total
                contractual cash obligations
            
            $
            211,371
            
            $
            136,259
            
            $
            34,862
            
            $
            21,000
            
            $
            19,250




During
      2003, all convertible notes payable were converted into common stock and all
      long-term debt was paid in 2003 as well. We currently have no notes payable
      or
      long-term debt. We believe that we have currently have the cash available to
      meet our cash requirements for fiscal 2006.




**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 in 2004 was the variable
      option pricing effect of options held by former EBT employees.




Revenues. Following is a summary of revenues for the three years covered by this
      report.




2005
            
            2004
            
            2003Government
                Revenues
            
            $
            208,211
            
            $
            305,721
            
            $
            339,790Futaba
                Contract Research
            
            $
            —
            
            $
            —
            
            $
            400,000Total
                ANI Revenues
            
            $
            565,660
            
            $
            382,522
            
            $
            773,959Total
                EBT Revenues
            
            $
            —
            
            $
            —
            
            $
            —Total
                Revenues
            
            $
            565,660
            
            $
            382,522
            
            $
            773,959**Revenue
                backlog at December 31**
            
            $
            2,764,000
            
            $
            130,000
            
            $
            425,000









All
      of
      the revenues during the 3-year period came from ANI. The Government revenues
      in
      2003 and 2004 resulted from a project for the Department of Defense (“DOD”)
      being done in conjunction with Northrop Grumman. The Government revenues in
      2005
      came from the same Department of Defense grant plus two new SBIR Phase I grants
      from the Department of Defense. The Futaba revenues in 2003 resulted from the
      completion of a project started in 2001. EBT changed its business model in
      2002
      and no longer sells products. EBT is pursuing licenses for its technology,
      but
      is not currently actively pursuing further development of its technology. EBT
      had no revenue in any of the years presented.







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The
      revenue backlog as of December 31, 2005 results primarily from six government
      programs. In addition, we have a backlog of $180,000 related to a project being
      done for a large sporting goods manufacturer. The revenue backlog at both
      December 31, 2004 and 2003 consists of revenue related to our project being
      done
      in conjunction with Northrop Grumman for the Department of Defense.




We
      expect
      revenue to be significantly higher in 2006 than in 2005 and we plan to generate
      minimum revenues in 2006 of $5.0 million at ANI. We have specifically identified
      approximately $3.7 million of potential revenue for 2006, although there is
      no
      guarantee that these revenues will be obtained, and expect the remaining $1.3
      million to come from some of the many opportunities currently being explored.
      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 $3.7 million in revenue will be achieved. All of the $3.7 million
      in
      revenue is from customers with whom we have existing relationships and have
      previously recognized revenue of some amount. We are actively pursuing revenue
      producing contracts from numerous additional sources in several different areas.




Of
      the
      $3.7 million of specifically identified revenues, we expect a minimum of $1.7
      million to come from government contracts. There is approximately $100,000
      of
      revenue yet to be recognized on the three previously mentioned projects that
      resulted in revenue in 2005. In addition, we have been notified by the
      Department of Defense of its intent to award two SBIR Phase II awards as
      continuations to the two SBIR Phase I awards that we are currently in the
      process of completing. Each of these awards are expected to be approximately
      $750,000 and are expected to start in the second quarter of 2006. In addition,
      ANI received funding of $1 million to develop its Photoscru b TM concept.
      This project is expected to start no later than the second quarter of 2006.
      In
      addition, we have applied for, and expect to receive additional SBIR Phase
      I
      grants during 2006.




The
      non-governmental revenue specifically identified as part of the $3.7 million
      is
      expected to come from Kelman related to the sale of hydrogen sensors and
      royalties from Kelman products containing the sensors, from SME upon completion
      of the prototype line that it is building and from other existing customers.
      We
      have many additional opportunities beyond those quantified above and expect
      our
      revenues at ANI to exceed the minimum of $5.0 million for ANI to break
      even.




We
      also
      expect EBT to generate significant revenue in 2006 as a result of licensing
      its
      intellectual property. In particular, we expect to license the communication
      patent described in more detail in the description of Business section of this
      Annual Report on Form 10-K




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 three
      years.




2005
            
            2004
            
            2003ANI
                Research and development
            
            $
            2,525,292
            
            $
            2,611,583
            
            $
            1,861,660EBT
                Research and development
            
            $
            —
            
            $
            —
            
            $
            —Total
                Research and development
            
            $
            2,525,292
            
            $
            2,611,583
            
            $
            1,861,660




Company
      sponsored research and development expenses at Applied Nanotech, Inc. increased
      substantially from 2003 to 2004, but remained relatively constant from 2004
      to
      2005. This increase in 2004 was primarily the result of spending on two
      prototype carbon nanotube based field emission displays that we developed.
      One
      is a 14-inch prototype done entirely by us and the other is a 25-inch prototype
      that was done in conjunction with an international consortium of display
      component manufacturers. Even though the 25-inch prototype was done in
      conjunction with the consortium, we incurred a significant amount of expenses
      related to this prototype in 2005. In addition, we incurred significant expenses
      related to development of our sensor technologies.







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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 approximately $3.1 million in research related expenditures
      in
      2006. We expect our research expenditures to increase in 2006 because of the
      new
      research contracts that we have obtained for 2006. We may, however, incur more
      research and development expense in 2006 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.




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




2005
            
            2004
            
            2003Variable
                option pricing
            
            $
            25,200
            
            $
            (267,696
            )
            $
            749,755EBT
                related S, G, & A
            
            $
            3,734
            
            $
            —
            
            
            —Other
                S, G, & A
            
            $
            2,703,724
            
            $
            2,171,059
            
            $
            1,934,357Total
                selling, general, and administrative
            
            $
            2,732,658
            
            $
            1,903,363
            
            $
            2,684,112Pro-forma
                SFAS No. 123 Expense
            
            $
            1,182,482
            
            $
            2,259,387
            
            $
            552,927




Total
      selling, general and administrative expense declined significantly from 2003
      to
      2004 and then increased back to slightly above 2003 levels in 2005, however
      the
      total is significantly impacted by variable option pricing, which is dependent
      upon the market price of our common stock, as explained below.




As
      explained in greater detail in Note 8 to the financial statements, we repriced
      a
      total of 900,500 options in April 2001. These options, all with an exercise
      price greater than $1.50 per share, were repriced to $1.50 per share. At the
      time of the repricing our common stock was trading at approximately $0.95 per
      share. No compensation expense related to the employees was recorded at the
      time. The repricing of these options resulted in a new measurement date for
      accounting purposes and reclassification of these options as variable plan
      awards beginning on the date of the repricing. We previously accounted for
      these
      option grants as fixed plan awards. From the date of the repricing through
      December 31, 2002, the quoted value of our common stock did not exceed the
      exercise price of the options, and as such, no compensation expense was
      recognized at any period through that date. In 2003, our common stock price
      exceeded the exercise price and remained above it, closing at $2.73 per share
      on
      December 31, 2003, $2.17 on December 31, 2004, and $2.15 on December 31, 2005.
      We recorded $749,755 in non-cash option expense for the cumulative effects
      of
      the repricing in the year ended December 31, 2003. In the year ended December
      31, 2004, a total of $267,696 was recorded as a reduction in expense as a result
      of the reduction in our stock price in 2004. In the year ended December 31,
      2005
      we recorded additional expense of $25,200 related to a portion of these options
      that were exercised while the price was higher at an interim date during the
      year. As of December 31, 2005, a total of 167,500 of these options held by
      employees and 5,000 options held by a consultant remain
      outstanding.




The
      increase in other selling, general, and administrative expense from 2003 to
      2004
      is primarily related to payroll. Virtually all employees, including all
      officers, took salary reductions effective November 1, 2002. These reductions
      remained in effect until November 1, 2003, for employees, and December 1, 2003,
      for officers. As such, these reductions were in effect for the majority of
      2003.
      The reinstated levels were in effect for all of 2004. Non-payroll related
      expense remained relatively constant from year to year. The increase in other
      selling, general, and administrative expense from 2004 to 2005 of approximately
      $500,000 was primarily the result of two components. The first component was
      the
      litigation against Canon. While our attorney’s are handling this litigation on a
      contingency basis, we are still responsible for out-of-pocket costs. We incurred
      approximately $175,000 of cost related to this litigation in 2005. The remaining
      component of the increase related primarily to payroll. We hired an additional
      executive officer effective May 1, 2005. This officer also was a consultant
      for
      the Company during the first four months of the year. In addition to the
      increased number of employees, all administrative personnel received salary
      increases in 2005.




We
      expect
      selling, general and administrative expense in 2006 to be approximately $2.9
      million, before considering the effects of the implementation of SFAS No. 123R.
      The expected increase in selling, general, and administrative expense in 2006
      is
      the result of expected increased fringe benefit costs, the estimated cost of
      an
      annual meeting, an exchange listing fee, and the Canon litigation. The Canon
      litigation is set for trial in March 2007. If Canon does not choose to settle
      prior to that date, we would expect to incur approximately $250,000 in costs
      in
      2006 related to that litigation.







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As
      previously discussed, we will be required to implement SFAS No. 123R in our
      financial statements for the quarter ended March 31, 2006. Implementation will
      likely have a material impact on our selling, general, and administrative
      expense. The table presented in the Critical Accounting Policies section above
      shows the amount of expense that would have been recorded in the years ended
      December 31, 2005, 2004, and 2003, if we had recorded the amounts calculated
      under SFAS No. 123 in those years, rather than disclosing pro-forma information
      in the footnotes to the financial statements. It is not possible to accurately
      predict the exact effect of SFAS No. 123R on future periods because the expense
      to be calculated is dependent up on future events including the number of
      options granted, the number of options vested, volatility as impacted by changes
      in the price of our common stock, and others.




The
      largest single component of cost that we incur is payroll related expense.
      Excluding the cost related to variable option accounting, we incurred payroll
      related expense of approximately $1.7 million in 2003, $1.9 million in 2004,
      and
      $2.3 million in 2005. We expect payroll related expense in 2006 to be
      approximately $2.9 million as a result of anticipated new personnel. We expect
      our burn rate for 2006 to average about $500,000 per month, excluding revenues.
      Based on this we believe we can reach breakeven at a revenue level of $6.0
      million, but there is no assurance that this will occur, or that we can achieve
      that level of revenue.




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





2005
              
              2004
              
              2003Interest
                  expense
              
              $
              (2,590
              )
              $
              (4,584
              )
              $
              (56,065
              )Miscellaneous
                  other income
              
              $
              33,346
              
              $
              24,982
              
              $
              13,676





Interest
      expense decreased substantially from $56,065 in 2003 to $4,584 in 2004, and
      again to $2,590 in 2005. A significant portion of the interest expense in 2003
      resulted from the amortization of the value of beneficial conversion features
      associated with convertible debt and interest payments on that convertible
      debt.
      All of the convertible notes payable outstanding at December 31, 2002 were
      converted into common stock in 2003. We had no debt outstanding at December
      31,
      2003, 2004, or 2005, and expect to incur no debt in 2006. We expect our interest
      expense to continue to be negligible in 2006. The majority of the miscellaneous
      other income is interest income earned on excess cash balances. We expect
      miscellaneous other income to continue to be insignificant in 2005.




**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.




**ACCOUNTING
      PRONOUNCEMENTS**




In
      December 2004, the FASB issued 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.
      The
      Company currently accounts for stock-based compensation using APB 25 and
      discloses pro forma compensation expense quarterly and annually by calculating
      the stock option grants' fair value using the Black-Scholes model and disclosing
      the impact on net income and earnings (loss) per share in a Note to the
      Consolidated Financial Statements. Upon adoption, pro forma disclosure will
      no
      longer be an alternative. SFAS 123R is effective for the first annual period
      beginning after June 15, 2005. Accordingly, we will adopt this provision for
      its
      financial statements for the period ended March 31, 2006. The financial impact
      of adopting SFAS 123R can not be predicted; however it will likely have a
      material impact on the Company’s financial statements.





**Item
      7A.** ***Quantitativeand
      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.





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**Item
      8.*********Financial
      Statements***




**INDEX
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**OF
      NANO-PROPRIETARY, INC.**









**CONSOLIDATED
      FINANCIAL STATEMENTS**




Independent
                Auditor’s Report
            26Consolidated
                Balance Sheets - December 31, 2005 and 2004
            27Consolidated
                Statement of Operations - Years Ended December 31, 2005, 2004, and
                2003
            28Consolidated
                Statements of Shareholders’ Equity - Years Ended December 31, 2005, 2004,
                and 2003
            29Consolidated
                Statements of Cash Flows - Years Ended December 31, 2005, 2004, and
                2003
            30Notes
                to Consolidated Financial Statements
            31
























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            25
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**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, 2005 and 2004
      and the related consolidated statements of operations, shareholders’ equity and
      cash flows for each of the three years in the period ended December 31,
      2005.  These consolidated financial statements are the responsibility of
      the Company's management.  Our responsibility is to express an opinion on
      these 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, 2005 and 2004, and the results of its operations
      and its cash flows for each of the three years in the period ended December
      31,
      2005 in conformity with U.S. generally accepted accounting
      principles.








Sprouse
      & Anderson, L.L.P.


Austin,
      Texas


January
      27, 2006




































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            26
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**NANO-PROPRIETARY,
      INC. AND SUBSIDIARIES**


**CONSOLIDATED
      BALANCE SHEETS**




**ASSETS****December
                31,****2005**
            
            **2004**Current
                assets:Cash
                and cash equivalents
            
            $
            897,247
            
            $
            901,585Accounts receivable, trade - net of allowance for doubtful accounts
            
            
            94,103
            
            
            6,735Prepaid
                expenses and other current assets
            
            
            85,306
            
            
            85,135Total
                current assets
            
            
            1,076,656
            
            
            993,455Property
                and equipment, net
            
            
            101,785
            
            
            141,373Other
                assets
            
            
            9,540
            
            
            9,540Total
                assets
            
            $
            1,187,981
            
            $
            1,144,368**LIABILITIES
                AND SHAREHOLDERS' EQUITY**Current
                liabilities:Accounts
                payable
            
            $
            231,131
            
            $
            140,597Obligations
                under capital lease
            
            
            4,348
            
            
            21,430Accrued
                liabilities
            
            
            93,163
            
            
            74,956Deferred
                Revenue
            
            
            —
            
            
            54,985Total
                current liabilities
            
            
            328,642
            
            
            291,968Obligations
                under capital lease, long-term
            
            
            —
            
            
            5,944Commitments
                and contingencies
            
            
            —
            
            
            —Total
                liabilities
            
            
            328,642
            
            
            297,912Shareholders’
                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,
                99,746,440
              and
                97,246,422 shares issued and outstanding, respectively
            
            
            99,746
            
            
            97,246Additional
                paid-in capital
            
            
            85,494,542
            
            
            80,822,625Accumulated
                deficit
            
            
            (84,734,949
            )
            
            (80,073,415
            )Total
                shareholders’ equity
            
            
            859,339
            
            
            846,456Total
                liabilities and shareholders’ equity
            
            $
            1,187,981
            
            $
            1,144,368
































See
      notes
      to consolidated financial statements.


Page
            27
 Table
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**NANO-PROPRIETARY,
      INC. AND SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF OPERATIONS**


**Year
                ended December 31,****2005**
            
            **2004**
            
            **2003**RevenuesContract
                research
            
            $
            59,995
            
            $
            —
            
            $
            400,000Government
                contracts
            
            
            208,211
            
            
            305,721
            
            
            339,790License
                fees and royalties
            
            
            —
            
            
            10,852
            
            
            2,248Other
            
            
            297,454
            
            
            65,949
            
            
            31,921Total
                revenues
            
            
            565,660
            
            
            382,522
            
            
            773,959Operating
                costsResearch
                and development
            
            
            2,525,292
            
            
            2,611,583
            
            
            1,861,660Selling,
                general and administrative expenses
            
            
            2,732,658
            
            
            1,903,363
            
            
            2,684,112Royalty
                expense
            
            
            —
            
            
            500,000
            
            
            400,000Total
                operating costs
            
            
            5,257,950
            
            
            5,014,946
            
            
            4,945,772Income
                (loss) from operations
            
            
            (4,692,290
            )
            
            (4,632,424
            )
            
            (4,171,813
            )Other
                income (expense):Gain
                (loss) on disposal of assets
            
            
            —
            
            
            125
            
            
            4,695Interest
                income
            
            
            33,346
            
            
            24,857
            
            
            8,981Interest
                expense
            
            
            (2,590
            )
            
            (4,584
            )
            
            (56,065
            )Other
                income (loss)
            
            
            —
            
            
            —
            
            
            —Loss
                before taxes
            
            
            (4,661,534
            )
            
            (4,612,026
            )
            
            (4,214,202
            )Provision
                for taxes
            
            
            —
            
            
            —
            
            
            —Net
                (loss) applicable to common shareholders
            
            $
            (4,661,534
            )
            $
            (4,612,026
            )
            $
            (4,214,202
            )Earnings
                (loss) per shareBasic
                and diluted
            
            $
            (0.05
            )
            $
            (0.05
            )
            $
            (0.05
            )Weighted
                average common shares outstandingBasic
                and diluted
            
            
            98,957,812
            
            
            96,609,237
            
            
            87,366,507





















See
      notes to consolidated financial statements.


Page
            28
 Table
            of Contents










**NANO-PROPRIETARY,
      INC. AND SUBSIDIARIES**


**CONSOLIDATED****STATEMENTS
      OF SHAREHOLDERS’ EQUITY**





Preferred
            
            Common
            
            Additional
            
            AccumulatedShares
            
            Amount
            
            Shares
            
            Amount
            
            Paid-In
                Capital
            
            Deficit
            
            TotalBalance
                January 1, 2003
            
            
            -
            
            $
            -
            
            
            76,970,792
            
            $
            76,971
            
            $
            68,709,621
            
            $
            (71,247,187
            )
            $
            (2,460,595
            )Issuance
                  of common stockas
                  compensation
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            101,400
            
            
            -
            
            
            101,400Issuance
                of common stock for patents
            
            
            -
            
            
            -
            
            
            71,021
            
            
            71
            
            
            13,565
            
            
            -
            
            
            13,636Issuance
                    of common stockas
                    a result of the exercise ofemployee
                    stock options
            
            
            -
            
            
            -
            
            
            3,132,060
            
            
            3,132
            
            
            2,508,765
            
            
            -
            
            
            2,511,897Issuance
                of common stock for cash
            
            
            -
            
            
            -
            
            
            7,607,097
            
            
            7,607
            
            
            4,805,336
            
            
            -
            
            
            4,812,943Issuance
                  of common stockin
                  payment of accounts payable
            
            
            -
            
            
            -
            
            
            125,000
            
            
            125
            
            
            276,657
            
            
            -
            
            
            276,782Issuance
                  of common stock asresult
                  of convertible notes payable
            
            
            -
            
            
            -
            
            
            7,707,020
            
            
            7,707
            
            
            1,753,506
            
            
            -
            
            
            1,761,213Variable
                Option Pricing
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            749,755
            
            
            -
            
            
            749,755Net
                (loss)
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (4,214,202
            )
            
            (4,214,202
            )Balance
                December 31, 2003
            
            
            -
            
            
            -
            
            
            95,612,990
            
            
            95,613
            
            
            78,918,605
            
            
            (75,461,389
            )
            
            3,552,829Issuance
                  of common stockoptions
                  as compensation
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            116,600
            
            
            -
            
            
            116,600Issuance
                    of common stockas
                    a result of the exercise ofemployee
                    stock options
            
            
            -
            
            
            -
            
            
            1,211,545
            
            
            1,211
            
            
            972,138
            
            
            -
            
            
            973,349Issuance
                of common stock for cash
            
            
            -
            
            
            -
            
            
            421,887
            
            
            422
            
            
            1,082,978
            
            
            -
            
            
            1,083,400Variable
                Option Pricing
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (267,696
            )
            
            -
            
            
            (267,696
            )Net
                (loss)
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (4,612,026
            )
            
            (4,612,026
            )Balance
                December 31, 2004
            
            
            -
            
            
            -
            
            
            97,246,422
            
            
            97,246
            
            
            80,822,625
            
            
            (80,073,415
            )
            
            846,456Issuance
                  of common stockoptions
                  as compensation
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            106,278
            
            
            -
            
            
            106,278Issuance
                    of common stockas
                    a result of the exercise ofemployee
                    stock options
            
            
            -
            
            
            -
            
            
            817,625
            
            
            818
            
            
            542,121
            
            
            -
            
            
            542,939Issuance
                of common stock for cash
            
            
            -
            
            
            -
            
            
            1,682,393
            
            
            1,682
            
            
            3,998,318
            
            
            -
            
            
            4,000,000Variable
                Option Pricing
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            25,200
            
            
            -
            
            
            25,200Net
                (loss)
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (4,661,534
            )
            
            (4,661,534
            )Balance
                December 31, 2005
            
            
            -
            
            $
            -
            
            
            99,746,440
            
            $
            99,746
            
            $
            85,494,542
            
            $
            (84,734,949
            )
            $
            859,339


















See
      notes
      to consolidated financial statements.


Page
            29
 Table
            of Contents










**NANO-PROPRIETARY,
      INC. AND SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF** **CASH
      FLOWS**




**Year
                Ended**
              **December
                31,****2005**
            
            **2004**
            
            **2003**Cash
                flows from operating activities:Net
                loss
            
            $
            (4,661,534
            )
            $
            (4,612,026
            )
            $
            (4,214,202
            )Adjustments
                to reconcile loss to net
              cash
                used in operating activities:Depreciation
                and amortization expense
            
            
            56,260
            
            
            54,928
            
            
            44,419(Gain)
                loss on disposal of assets
            
            
            —
            
            
            (125
            )
            
            (4,695
            )Stock
                and options issued for services
            
            
            106,278
            
            
            116,600
            
            
            101,400Stock
                issued for patent option
            
            
            —
            
            
            —
            
            
            13,636Variable
                option accounting charge
            
            
            25,200
            
            
            (267,696
            )
            
            749,755Changes
                in assets and liabilities:Accounts
                receivable, trade
            
            
            (87,368
            )
            
            34,397
            
            
            (8,816
            )Prepaid
                expenses and other assets
            
            
            (171
            )
            
            6,326
            
            
            57,531Accounts
                payable
            
            
            90,534
            
            
            13,788
            
            
            (181,287
            )Accrued
                expenses
            
            
            18,207
            
            
            17,310
            
            
            (274,705
            )Customer
                deposits and other current liabilities
            
            
            (54,985
            )
            
            54,985
            
            
            —Total
                adjustments
            
            
            153,955
            
            
            30,513
            
            
            497,238Net
                cash used in operating activities
            
            
            (4,507,579
            )
            
            (4,581,513
            )
            
            (3,716,964
            )Cash
                flows from investing activities:Capital expenditures
            
            
            (16,672
            )
            
            (118,987
            )
            
            (6,494
            )Proceeds
                from sale of assets
            
            
            —
            
            
            125
            
            
            4,695Net
                cash provided by (used in) investing activities
            
            
            (16,672
            )
            
            (118,862
            )
            
            (1,799
            )Cash
                flows from financing activities:Proceeds
                from issuance of common stock
            
            
            4,542,939
            
            
            2,056,749
            
            
            7,324,840Repayment
                of long-term notes payable and capital lease
              obligations
            
            
            (23,026
            )
            
            (19,359
            )
            
            (57,375
            )Net
                cash provided by financing activities
            
            
            4,519,913
            
            
            2,037,390
            
            
            7,267,465Net
                increase (decrease) in cash and cash equivalents
            
            
            (4,338
            )
            
            (2,662,985
            )
            
            3,548,702Cash
                and cash equivalents, beginning of year
            
            
            901,585
            
            
            3,564,570
            
            
            15,868Cash
                and cash equivalents, end of year
            
            $
            897,247
            
            $
            901,585
            
            $
            3,564,570

























See
      notes
      to consolidated financial statements.


Page
            30
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            of Contents





**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. The Company has also developed patented electronic sign
      technology, sold products using that technology, but has now limited itself
      to
      licensing that technology to others. It intends to obtain development revenues
      for applying its technology to specific applications for customers and royalty
      revenues from licensing its technology to others.




Until
      the
      Company is able to operate profitably as a result of revenues from either
      reimbursed research or license agreements, it may continue to seek additional
      funds through the equity markets, or raise funds through debt instruments to
      allow it to maintain operations. There is no assurance that license agreements
      will be signed, that commercialization of the Company’s 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 it achieves profitability.




The
      principal source of the Company's liquidity since the time of its 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.  The Company will likely receive
      additional funds from the exercise of warrants or options. The Company may
      also
      seek to increase its liquidity through bank borrowings or other
      financings.  There can be no assurance that any of these financing
      alternatives can be arranged on commercially acceptable terms.  The Company
      believes that its success in reaching profitability will depend on the viability
      of its technology and products using that technology, their acceptance in the
      marketplace, and the Company’s ability to obtain additional debt or equity
      financings in the future.




A
      portion
      of the Company's 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 the Company.









**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, and nanomaterials which include composites. EBT was
      primarily involved in the commercialization of electronic digitized sign
      technology, but has now limited itself to licensing that 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, and litigation reserves.














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            31
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            of Contents





**NANO-PROPRIETARY,
      INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**




**2.** **Summary
      of Significant Accounting Policies (continued)** **:**




Revenue
      recognition




The
      Company's revenues include reimbursements under agreements to perform research
      and development for government agencies and others. The Company does 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
      the newly developed technology for its own purposes.  The Company retains
      all other rights to use, develop, and commercialize the technology and
      recognizes revenue when it is billed pursuant to the terms of the contract.
      Agreements with other entities generally allow the other entity to license
      the
      technology from the Company 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
      companies 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 total $500,000 to $1,000,000 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. Revenue from these projects is recognized as
      it is
      billed. 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
      usually billed at periodic intervals as specified in the contract. Revenue
      from
      this type of contract is generally recognized as billed, unless the billing
      terms specified by the contract would result in a distortion in the amount
      of
      revenue being recognized relative to the activity level. For example, if the
      grant called for one billing at the end of the grant, the revenue would be
      recognized based on the activity level incurred in the period as compared with
      total projected activity level. A situation like this would be unusual and
      rarely happens.




Other
      Research Contracts - Revenue from nongovernment 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, or notice of intended payment, is received. The Company recognizes
      royalty payments received at the time of the signing of a royalty agreement
      at
      the time of receipt, unless the terms of the agreement make it clear that the
      up-front payment was a prepayment of future royalties.




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.




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







Page
            32
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            of Contents





**NANO-PROPRIETARY,
      INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**











**2.** **Summary
      of Significant Accounting Policies (continued)** **:**




Cash
      and
      cash equivalents




The
      Company considers all highly liquid investments purchased with a maturity of
      approximately 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 losses. The Company considered
      no
      reserves to be necessary at December 31, 2005, 2004, or 2003.




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.







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            33
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            of Contents





**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.




2005
            
            2004
            
            2003Options
            
            6,703,151
            
            5,398,703
            
            5,253,175Warrants
            
            95,000
            
            95,000
            
            155,000Weighted
                average exercise price
            
            $1.57
            
            $1.29
            
            $1.10









Stock-based
      employee compensation




The
      Company uses the intrinsic value method to account for stock-based employee
      compensation. During the years presented, the Company did not incur any
      compensation cost under APB No. 25 for options granted under the Plans. Had
      the
      compensation cost for the Company’s compensation plans been determined
      consistent with SFAS No. 123 and SFAS No. 148 using the fair value method,
      the
      Company’s net loss and net loss per common share for 2005, 2004, and 2003 would
      approximate the pro forma amounts as shown below:




**2005**
            ****
            **2004**
            ****
            **2003**Net
                LossAs
                reported
            $(4,661,534)
            
            $(4,612,026)
            
            $(4,214,202)SFAS
                No. 123 Charge
            1,182,482
            
            2,259,387
            
            552,927Pro
                Forma
            (5,844,016)
            
            (6,871,413)
            
            (4,767,129)Net
                income (loss) per common share - basic and
                dilutedAs
                reported
            $(0.05)
            
            $(0.05)
            
            $(0.05)Pro
                Forma
            $(0.06)
            
            $(0.07)
            
            $(0.05)




The
      effects of applying SFAS No. 123 in this pro forma disclosure are not
      necessarily indicative of future amounts. SFAS No. 123 does not apply to awards
      prior to 1995, and the Company anticipates making awards in the future under
      its
      compensation plans. The Company also granted 50,000 options to a non-employee
      consultant in 2003, 100,000 options to a non-employee consultant in 2004, and
      120,000 options to non-employee consultants in 2005. We recorded expense of
      $101,400, $116,600, and $106,278 in 2003, 2004, and 2005, respectively, related
      to those options. These expenses were calculating using approximately the same
      assumptions used to determine the SFAS No. 123 charge in 2003 and 2004. In
      2005
      this charge was computed using volatility rates ranging from 72% to 78%, risk
      free interest rates of 3.5% to 4.35%, expected option terms of 1.5 to 2.5 years,
      and dividend and forfeiture rates of zero.







Page
            34
 Table
            of Contents








**NANO-PROPRIETARY,
      INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**










**2.**  **Summary
      of Significant Accounting Policies (continued)** **:**




The
      fair
      value of each stock option granted to employees in 2005, 2004, and 2003 is
      estimated on the date of the grant using the Black-Scholes option pricing-model
      with the following weighted-average assumptions:




2005
            
            2004
            
            2003Dividend
                Yield
            
            0%
            
            0%
            
            0%Risk
                Free Interest Rate
            
            3.5%
            
            3.5%
            
            3%Expected
                Option Life
            
            3.5
                Years
            
            5
                Years
            
            5
                YearsTurnover/Forfeiture
                Rate
            
            0%
            
            45%
            
            25%Volatility
            
            100%
            
            72%
            
            108%




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.




Recently
      issued accounting pronouncements




In
      December 2004, the FASB issued 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.
      The
      Company currently accounts for stock-based compensation using APB 25 and
      discloses pro forma compensation expense quarterly and annually by calculating
      the stock option grants' fair value using the Black-Scholes model and disclosing
      the impact on net income and earnings (loss) per share in a Note to the
      Consolidated Financial Statements. Upon adoption, pro forma disclosure will
      no
      longer be an alternative. The Statement is effective for the first annual
      reporting period beginning after June 15, 2005. Accordingly, the Company will
      adopt this provision for its financial statements for the period ended March
      31,
      2006. The financial impact of adopting this statement can not be predicted,
      however it will likely have a material impact on the Company’s financial
      statements.





**3.** **Operating
      Lease Obligations** **:**




The
      Company leases various facilities and equipment under operating lease agreements
      having terms expiring at various dates through 2009. Rental expense was
      $133,487, $115,217, and $124,425 for the years ended December 31, 2005,
      2004 and 2003,  respectively.




Future
      minimum lease payments under operating leases that have initial or remaining
      noncancelable lease terms in excess of one year at December 31, 2005, were
      as
      follows:




2006
            
            $
            131,8912007
            
            
            34,8622008
            
            
            21,0002009
                and thereafter
            
            
            19,250Total
                future minimum lease payments
            
            $
            207,003








Page
            35
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            of Contents





**NANO-PROPRIETARY,
      INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**








**4.** **Capital
      Lease Obligations** **:**




Capital
      leases payable at December 31, 2005 and 2004 consisted of the
      following:




**2005**
            
            **2004**Capital
                leases for copier equipment due in
              monthly
                installments  totaling $1,932 through 2006.
              The
                equipment value and lease obligation was determined
              using
                a discount rate of 10%.  The equipment is included in
              office
                equipment at December 31, 2005 at a cost of $94,383
              and
                with accumulated amortization of $91,018.
            
            $
            4,368
            
            $
            29,228Less
                interest
            
            
            (20
            )
            
            (1,854
            )Less
                current portion
            
            
            (4,348
            )
            
            (21,430
            )Capital
                Lease Obligations, long-term
            
            $
            —
            
            $
            5,944










**5.** **Details
      of Certain Balance Sheet Accounts** **:**




Additional
      information regarding certain balance sheet accounts at December 31, 2005 and
      2004 is as follows:




**December
                31,****2005**
            
            **2004**Property
                and equipment:Plant
                and equipment
            
            $
            755,436
            
            $
            755,436Furniture
                and office equipment
            
            
            199,184
            
            
            182,512Leasehold
                Improvements
            
            
            14,382
            
            
            14,382Total
                carrying cost
            
            
            969,002
            
            
            952,330Less
                accumulated depreciation
            
            
            (867,217
            )
            
            (810,957
            )$
            101,785
            
            $
            141,373Accrued
                liabilities:Payroll
                and related accruals
            
            $
            65,507
            
            $
            37,927Other
            
            
            27,656
            
            
            37,029Total
            
            $
            93,163
            
            $
            74,956








Depreciation
      for the years ended December 31, 2005, 2004, and 2003 was $56,260, $54,928,
      and
      $44,419, respectively.





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            36
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            of Contents





**NANO-PROPRIETARY,
      INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)**








**6.** **Income
      Taxes** **:**




The
      components of deferred tax assets (liabilities) at December 31, 2005 and 2004,
      were as follows:




**December
                31,****2005**
            
            **2004**Deferred
                tax assets:Net
                operating loss carry forwards
            
            $
            30,849,000
            
            $
            28,759,000Research
                and experimentation credits
            
            
            468,000
            
            
            469,000Capitalized
                intangible assets
            
            
            185,000
            
            
            223,000Depreciation
                assets
            
            
            6,000
            
            
            12,000Accrued
                expenses not deductible until paid
            
            
            24,000
            
            
            15,000Total
                deferred tax assets
            
            
            31,532,000
            
            
            29,478,000Deferred
                tax liabilities:
            
            
            —
            
            
            —Net
                deferred tax assets before valuation allowance
            
            
            31,532,000
            
            
            29,478,000Valuation
                allowance
            
            
            (31,532,000
            )
            
            (29,478,000
            )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, 2005, 2004, and 2003.




**December
                31,****2005**
            
            **2004**
            
            **2003**Expected
                income tax expense (benefit)
            
            $
            (1,585,000
            )
            $
            (1,568,000
            )
            $
            (1,433,000
            )Deductible
                expenses not charged against book income
            
            
            (528,000
            )
            
            (614,000
            )
            
            (1,158,000
            )Non-taxable
                income
            
            
            —
            
            
            (91,000
            )
            
            —Non-deductible
                expenses
            
            
            56,000
            
            
            7,000
            
            
            260,000Expiration
                of Tax Credit Carryforwards
            
            
            1,000
            
            
            556,000
            
            
            —Other
            
            
            2,000
            
            
            1,000
            
            
            11,000Increase
                in Valuation Allowance
            
            
            2,054,000
            
            
            1,709,000
            
            
            2,320,000Total
                Tax
            
            $
            —
            
            $
            —
            
            $
            —




As
      of
      December 31, 2005, the Company had net operating loss carry forwards of
      approximately $90 million that expire from 2006 through 2025, 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 $468,000 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.







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**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. As of December 31, 2005, 2004 and 2003, no preferred
      shares were outstanding.




Common
      stock




During
      2003, 2004, and 2005, 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 October 27,
      2005.




Shares
            
            Proceeds2005
            
            
            1,682,393
            
            $
            4,000,0002004
            
            
            401,887
            
            $
            1,065,0002003
            
            
            7,607,097
            
            $
            4,812,943




In
      a
      series of private placements of the Company’s common stock in exempt offerings
      under Regulation D of the Securities Act of 1933, the Company also issued 71,021
      shares in 2003, valued at $13,636 in payment for the Keesman patent described
      in
      more detail in Note 11. The Company also issued 125,000 shares of its common
      stock in 2003 in payment of accounts payable. These shares were valued at
      $276,782. The Company also issued 7,707,020 shares in 2003 as the result of
      the
      conversion of convertible notes payable issued in previous years and related
      accrued interest totaling $1,761,213.




At
      December 31, 2005, common stock was reserved for the following
      reasons:




Exercise
                of stock warrants
            
            
            95,000Exercise
                and future grants of stock options
            
            
            8,724,260Total
                shares reserved
            
            
            8,819,260










**8.** **Stock
      Options** **:**




The
      Company sponsors four stock-based incentive compensation plans (the “Plans”).
      The Company applies Accounting Principles Board (“APB”) Opinion No. 25 and
      related interpretations in accounting for the Plans. In 1995, the FASB issued
      SFAS No. 123 “Accounting for Stock-Based Compensation” which, if fully adopted
      by the Company, would change the methods the Company applies in recognizing
      the
      cost of the Plans. Adoption of the cost recognition provisions of SFAS No.
      123
      is optional and the Company has decided not to elect these provisions of SFAS
      No. 123. However, pro forma disclosures as if the Company adopted the cost
      recognition provisions of SFAS No. 123 are required by SFAS No. 123 and are
      presented in Note 2.







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      INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)**








**8.** **Stock
      Options (continued)** **:**




The
      plans
      allow the Company to grant either incentive stock options or non-qualified
      stock
      options. 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.
      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.




In
      April
      2001, the Company repriced a total of 900,500 options. All options with an
      exercise price greater than $1.50 per share, which was approximately 160% of
      the
      market price of the stock at the time of the repricing, held by individuals
      employed by the Company as of the repricing date, including one consultant
      under
      contract at the time, were repriced to $1.50 per share. No compensation expense
      related to the employees was recorded at the time. The repricing of these
      options resulted in a new measurement date for accounting purposes and
      reclassification of these options as variable plan awards beginning on the
      date
      of the repricing. The Company previously accounted for these option grants
      as
      fixed plan awards. From the date of the repricing through December 31, 2002,
      the
      quoted value of the Company’s common stock did not exceed the exercise price of
      the options, and as such, no compensation expense was recognized at any period
      through that date. In 2003, the Company’s common stock price exceeded the
      exercise price and remained above it, closing at $2.73 per share on December
      31,
      2003, $2.17 on December 31, 2004, and $2.15 on December 31, 2005. The Company
      recorded $749,755 in non-cash option expense for the cumulative effects of
      the
      repricing and increased additional paid in capital by the same amount in the
      year ended December 31, 2003. In the year ended December 31, 2004, a total
      of
      $267,696 was recorded as a reduction in expense and a reduction to paid in
      capital as a result of the reduction in the Company’s stock price in 2004. The
      Company recorded additional expense of $25,200 in the year ended December 31,
      2005. As of December 31, 2005, a total of 167,500 of these options held by
      employees and 5,000 options held by a consultant remain
      outstanding.




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, 2005, 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, 2005, 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 are granted at the discretion of the Board of Directors. No additional
      shares are currently available under this plan and no shares will be come
      available under this plan in the future.







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**NANO-PROPRIETARY,
      INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)**




**8.** **Stock
      Options (continued)** **:**




In
      September 2002, the Board of Directors of the Company established the 2002
      Equity Compensation Plan and reserved a total of 5,000,000 shares for issuance
      under the Plan, effective March 2002. The purpose of this plan was to replace
      the 1992 Employees Plan and the 1992 Directors Plan, both of which expired
      in
      March 2002. The plan was amended effective December 31, 2004 to increase the
      authorized shares to 8,000,000. A total of 2,010,109 shares remain available
      for
      grant under this at December 31, 2005.




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




Number
                of
              Shares
            
            Wgtd.
                Ave.
              Exercise
              PriceOptions
                outstanding at January 1, 2003
            
            
            6,965,629
            
            $0.79Granted
            
            
            1,496,995
            
            $1.88Exercised
            
            
            (3,132,060
            )
            $0.80Canceled
            
            
            (77,389
            )
            $0.82Options
                outstanding at December 31, 2003
            
            
            5,253,175
            
            $1.09Granted
            
            
            2,457,073
            
            $2.73Exercised
            
            
            (1,211,545
            )
            $0.80Cancelled
            
            
            (1,100,000
            )
            $2.94Options
                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
            
            $1.84







The
      following table summarizes information about stock options outstanding and
      exercisable under all four stock option plans at December 31, 2005:




**Options
                Outstanding**
            
            **Options
                Exercisable**Range
                of
              Exercise
                Prices
            
            Number
              Outstanding
              at
                12/31/05
            
            Wgtd.  Avg.
              Remaining
              Contractual
              Life
            
            Wgtd.
                Avg.
              Exercise
                Price
            
            Number
              Exercisable
              at
                12/31/05
            
            Wgtd.
                Avg.
              Exercise
                Price$0.00
                - $0.50
            
            804,089
            
            3.9
                Years
            
            $0.44
            
            804,089
            
            $0.44$0.51
                - $1.00
            
            1,124,083
            
            5.7
                Years
            
            $0.83
            
            1,124,083
            
            $0.83$1.01
                - $2.00
            
            745,833
            
            5.8
                Years
            
            $1.54
            
            745,833
            
            $1.54$2.01
                - $2.99
            
            4,029,146
            
            8.6
                Years
            
            $2.45
            
            1,929,146
            
            $2.49Total
            
            6,703,151
            
            7.3
                Years
            
            $1.84
            
            4,603,151
            
            $1.57





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**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)**







**8.** **Stock
      Options (continued)** **:**




The
      weighted-average fair values of options under the plans granted during 2005,
      2004, and 2003 were as follows:




2005
            
            2004
            
            2003Discounted
                options
            $0.00
            
            $0.00
            
            $0.00At-the-money
                options
            $1.50
            
            $1.71
            
            $1.58Premium
                options
            $1.41
            
            $1.28
            
            $0.38





**9.** **Stock
      Warrants** **:**




Common
      stock warrants




In
      1996,
      the Company issued 35,000 warrants to an advisor in connection with the
      Company’s fundraising activities. These warrants enable the holder to purchase
      shares of the Company’s common stock at a price of $2.00 per share through 2006.
      These warrants expired unexercised at the end of January 2006. In 1997, the
      Company issued 75,000 additional warrants to this advisor in connection with
      services related to a joint venture agreement. A total of 15,000 of these
      warrants were exercised in 1999. These warrants enable the holder to purchase
      shares of the Company’s Common Stock at a price of $1.00 per share through
      2007.




In
      1999,
      the Company issued a total of 60,000 warrants to three separate individuals
      in
      connection with services rendered to the Company. The exercise price of these
      warrants was based on the fair market value of the Company’s common stock at the
      time of issuance and ranged from $0.92 to $2.15 per share. These warrants were
      exercisable for a period of 5 years from the date of issuance and were either
      exercised or expired in 2004.




The
      following is a summary of outstanding warrants:




**Number
                of**
              **Shares**
            
            **Exercise
                Price**Warrants
                outstanding at January 1, 2003
            
            
            155,000
            
            $0.92-2.15Expired
                or canceled
            
            
            —
            
            —Warrants
                outstanding at December 31, 2003
            
            
            155,000
            
            $0.92-2.15Exercised
            
            
            (20,000
            )
            $0.92Expired
                or canceled
            
            
            (40,000
            )
            $2.15Warrants
                outstanding at December 31, 2004
            
            
            95,000
            
            $1.00-2.00Exercised
            
            
            —
            
            —Expired
            
            
            —
            
            —Warrants
                outstanding at December 31, 2005
            
            
            95,000
            
            $1.00-2.00





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      INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)**








**10.** **Supplemental
      Cash Flow Information** **:**




Cash
      paid
      for interest was $2,590, $4,584, and $10,503 for 2005, 2004, and 2003,
      respectively.  The following non-cash transactions have been excluded from
      the accompanying consolidated statement of cash flows:




2005
            
            2004
            
            2003Non-cash
                financing activities:Conversion
                of notes payable and interest into common shares
            
            
            —
            
            $
            —
            
            $
            1,761,213Issuance
                of common shares in payment of accounts payable
            
            
            —
            
            $
            —
            
            $
            276,782Non-cash
                investing activities:Common
                shares issued for patent
            
            
            —
            
            $
            —
            
            $
            13,636







**11.** **Commitments
      and Contingencies** **:**




Till
      Keesman Agreement




In
      May
      2000, the Company licensed the rights to 6 carbon nanotube patents that, at
      the
      time, had been applied for by Till Keesman in exchange for a payment of
      $250,000 payable in shares of the Company’s common stock. Under the terms of the
      agreement, the Company is obligated to pay license fees equal to 50% of any
      royalties received by the Company related to these patents. The Company is
      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. The Company
      is allowed to offset these minimum payments against future royalty payments,
      however once these minimum payments and the expenses have been offset, the
      Company may be liable for additional royalty payments.




Research
      and development commitments




As
      of
      December 31, 2005, the Company was in the process of a SBIR Phase II contract
      for research from the US Department of Defense. The total contract amount is
      $742,212 and $704,243 of the revenue was recognized as of December 31, 2005.
      In
      addition, the company had two SBIR Phase I contracts totaling $167,289 at
      December 31, 2005. A total of $117,000 of the revenue related to these contracts
      had been recognized as of December 31, 2005. The Company also had a $240,000
      contract with a large sporting goods manufacturer in process as of December
      31,
      2005. A total of $59,995 of revenue related to that contract has been recognized
      as of December 31, 2005. The revenue to be received from  these research
      contracts in 2006 is expected to exceed the cost of this research.




Agreements
      with MCC




The
      Company 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 the Company and the Company has agreed to pay a royalty fee of 2% of future
      commercial revenues related to the patents received. The Company has 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.







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**11.** **Commitments
      and Contingencies (continued)** **:**




Legal
      proceedings




In
      April
      2005, we filed suit against Canon, Inc. and Canon USA, Inc. in the U.S. District
      Court for the Western District of Texas, Austin Division. We are seeking a
      declaratory judgment that new SED color television products,
      scheduled to be manufactured by SED, Inc. and sold by Canon and/or Toshiba
      beginning in 2006, are not covered under a 1999 patent license agreement
      that we have with Canon.  We assert that Canon’s license does not cover its
      surface conductor electron emitter display screens (SED) for a new generation
      of
      flat screen color televisions. We also assert that SED,Inc., the joint venture
      formed by Canon and Toshiba Corporation to produce the SED display screens,
      is not a licensed subsidiary under the 1999 agreement and that Canon
      is improperly transferring its license rights under Nano-Proprietary's patents
      to the joint venture and Toshiba. The suit also contained three additional
      claims related to a Lanham Act violation by Canon, tortious interference by
      Canon, and a breach of covenant of good faith and fair dealings against Canon.
      Canon filed its response in July 2005 denying liability in the matter. In
      September 2005, Canon filed a motion to dismiss Canon USA, Inc. from the case
      and dismiss the Lanham Act claim, the tortious interference claim, and the
      breach of covenant of good faith and fair dealings. In October 2005, the judge
      in the case denied Canon’s motion to dismiss Canon, USA, Inc. and the breach of
      covenant of good faith and fair dealings claim. The judge granted Canon’s
      motion, without prejudice, to dismiss the Lanham Act claim and the tortious
      interference claim. Dismissal without prejudice allows us to re-file these
      claims at any time if additional evidence supporting these claims becomes
      available to us in the discovery process. The first two claims described above
      were not at issue in the dismissal motion by Canon. The case is currently in
      the
      discovery phase and a trial may occur as soon as March 2007. We believe that
      the
      ultimate resolution of this matter will not have a negative impact on the
      consolidated financial statements of the Company.




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. 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.




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.




**12.** **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 at December 31, 2005.
      At
      December 31, 2004 and 2003, amounts in excess of the FDIC limit of $175,058
      and
      $1,263,331, respectively, were held at JP Morgan Chase.







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**12.** **Concentrations
      of Credit Risk (continued):**




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.




**13.** **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:




2005
            
            2004
            
            2003Contract
                research revenues
            
            $
            268,206
            
            $
            305,721
            
            $
            739,790Costs
                incurred charged to operations included in research and
                development
            
            $
            254,656
            
            $
            278,928
            
            $
            405,962Amount
                of additional funding commitments at December 31
            
            $
            268,258
            
            $
            129,090
            
            $
            424,075







**14.** **Retirement
      Plan** **:**




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




**15.** **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. Net revenue from a project with one customer was $109,970
      in 2005. No revenue was received from this customer in 2004 or 2003. Net
      revenues for contract research with a different major customer of Applied
      Nanotech, Inc. totaled  $400,000 in 2003. No revenue was received from this
      customer in 2004 or 2005.







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      INC. AND SUBSIDIARIES**


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**16.** **Segment
      Information** **:**




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




****
            
            
            
            ******ANI**
            
            **EBT**
            
            **All
                Other**
            
            **Total****2005**Revenue
            
            $
            565,660
            
            $
            -
            
            $
            -
            
            $
            565,660Interest
                Expense
            
            
            2,193
            
            
            -
            
            
            397
            
            
            2,590Depreciation
                and Amortization
            
            
            52,242
            
            
            -
            
            
            4,018
            
            
            56,260Research
                and Development
            
            
            2,525,292
            
            
            -
            
            
            -
            
            
            2,525,292Income
                (Loss) from Continuing Operations
            
            
            (3,730,450
            )
            
            (3,734
            )
            
            (927,350
            )
            
            (4,661,534
            )Assets
            
            
            301,870
            
            
            -
            
            
            886,111
            
            
            1,187,981Capital
                Expenditures
            
            
            13,017
            
            
            -
            
            
            3,655
            
            
            16,672**2004**Revenue
            
            $
            382,522
            
            $
            -
            
            $
            -
            
            $
            382,522Interest
                Expense
            
            
            3,949
            
            
            -
            
            
            635
            
            
            4,584Depreciation
                and Amortization
            
            
            50,185
            
            
            -
            
            
            4,743
            
            
            54,928Research
                and Development
            
            
            2,611,583
            
            
            -
            
            
            -
            
            
            2,611,583Income
                (Loss) from Continuing Operations
            
            
            (4,030,353
            )
            
            106,251
            
            
            (687,924
            )
            
            (4,612,026
            )Assets
            
            
            310,005
            
            
            -
            
            
            834,363
            
            
            1,144,368Capital
                Expenditures
            
            
            116,613
            
            
            -
            
            
            2,374
            
            
            118,987**2003**Revenue
            
            
            773,959
            
            
            -
            
            
            -
            
            
            773,959Interest
                Expense
            
            
            5,999
            
            
            20
            
            
            50,046
            
            
            56,065Depreciation
                and Amortization
            
            
            37,653
            
            
            -
            
            
            6,766
            
            
            44,419Research
                and Development
            
            
            1,861,660
            
            
            -
            
            
            -
            
            
            1,861,660Loss
                from Continuing Operations
            
            
            (2,890,175
            )
            
            (361,784
            )
            
            (962,243
            )
            
            (4,214,202
            )Assets
            
            
            1,424,724
            
            
            527
            
            
            2,358,766
            
            
            3,784,017Capital
                Expenditures
            
            
            6,494
            
            
            -
            
            
            -
            
            
            6,494




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 is now limiting
      itself pursuing licenses for its technologies to others for use in display
      products. 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.







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**NANO-PROPRIETARY,
      INC. AND SUBSIDIARIES**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)**











**17.** **Subsequent
      Events** **:**




During
      the period from January 1, 2006 through February 24, 2006, the Company received
      $1,500,000 in proceeds and issued 750,000 shares of common stock in connection
      with a private placement of the Company’s common stock.





**18.** **Quarterly
      Financial Information (Unaudited)** **:**





First
            
            Second
            
            Third
            
            Fourth
            
            TotalQuarter
            
            Quarter
            
            Quarter
            
            Quarter
            
            Year2005Revenues
            
            $
            68,815
            
            $
            88,544
            
            $
            245,917
            
            $
            162,384
            
            $
            565,660Operating
                income (loss)
            
            
            (1,472,793
            )
            
            (984,223
            )
            
            (1,014,643
            )
            
            (1,220,631
            )
            
            (4,692,290
            )Net
                (loss)
            
            
            (1,469,192
            )
            
            (974,181
            )
            
            (1,005,078
            )
            
            (1,213,083
            )
            
            (4,661,534
            )Earnings
                (loss) per shareBasic
                and Diluted
            
            
            (0.02
            )
            
            (0.01
            )
            
            (0.01
            )
            
            (0.01
            )
            
            (0.05
            )2004Revenues
            
            $
            77,658
            
            $
            100,718
            
            $
            100,473
            
            $
            103,673
            
            $
            382,522Operating
                income (loss)
            
            
            (1,117,862
            )
            
            (1,269,201
            )
            
            (1,108,338
            )
            
            (1,137,023
            )
            
            (4,632,424
            )Net
                (loss)
            
            
            (1,111,641
            )
            
            (1,263,529
            )
            
            (1,100,534
            )
            
            (1,136,322
            )
            
            (4,612,026
            )Earnings
                (loss) per shareBasic
                and Diluted
            
            
            (0.01
            )
            
            (0.01
            )
            
            (0.01
            )
            
            (0.01
            )
            
            (0.05
            )2003Revenues
            
            
            444,452
            
            
            160,380
            
            
            88,195
            
            
            80,932
            
            
            773,959Operating
                income (loss)
            
            
            (749,524
            )
            
            (681,333
            )
            
            (1,200,627
            )
            
            (1,540,329
            )
            
            (4,171,813
            )Net
                (loss)
            
            
            (770,969
            )
            
            (696,056
            )
            
            (1,212,280
            )
            
            (1,534,897
            )
            
            (4,214,202
            )Earnings
                (loss) per shareBasic
                and Diluted
            
            
            (0.01
            )
            
            (0.01
            )
            
            (0.01
            )
            
            (0.02
            )
            
            (0.05
            )





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











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




None




**Item
      9A.** ***Controlsand
      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, 2005, 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, 2005.




Sprouse
      & Anderson, L.L.P., the independent registered public accounting firm that
      audited the consolidated financial statements of the Company included in this
      Annual Report on Form 10-K, has issued an attestation report on management’s
      assessment of the Company’s internal control over financial reporting as of
      December 31, 2005. The report, which expresses -unqualified opinions on
      management’s assessment and on the effectiveness of the Company’s internal
      control over financial reporting as of December 31, 2005, is included in
      this Item under the heading “Attestation Report of Independent Registered Public
      Accounting Firm.”







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**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 management’s assessment, included in the accompanying Report on
      Management’s Assessment of Internal Control over Financial Reporting, that
      Nano-Proprietary, Inc. maintained effective internal control over financial
      reporting as of December 31, 2005, based on criteria established in *Internal
      Control — Integrated Framework,* issued
      by
      the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
      Nano-Proprietary, Inc.’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. Our responsibility
      is to express an opinion on management’s assessment and an opinion on the
      effectiveness of 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, evaluating management’s assessment, testing and evaluating
      the design and operating effectiveness of internal control, and 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, management’s assessment that Nano-Proprietary, Inc. maintained
      effective internal control over financial reporting as of December 31, 2005,
      is
      fairly stated, in all material respects, based on criteria established
      in *Internal Control — Integrated Framework,* issued
      by
      the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
      Also in our opinion, Nano-Proprietary, Inc. maintained in all material respects,
      effective internal control over financial reporting as of December 31, 2005,
      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 balance sheets and the related statements
      of income, stockholders equity, and cash flows of Nano-Proprietary, Inc., and
      our report dated January 27, 2006 expresses an unqualified opinion.






Sprouse
      & Anderson, L.L.P.


Austin,
      Texas


January
      27, 2006







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**Item
      9B.** ***OtherInformation.***




Nano-Proprietary
      completed a private placement of $1,500,000 whereby it issued 750,000 shares
      of
      common stock to accredited investors at a price of $2.00 per share. The proceeds
      will be used for working capital. A total of 375,000 shares were acquired by
      Pinnacle Fund LP and 375,000 shares were acquired by Karrison Nichols, both
      participants in previous private placements of the Company’s stock.


















































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**PARTII** **I**




**Item
                10.**
            ***Directorsand
                Executive Officers of the
                Registrant***




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




***Name*********
            ***Age***
            ***Class***
            ***Position***
            ***Director/Officer
                Since***
            ***Term
                Expires***Marc
                W.  Eller
            50
            III
            Director,
                Chairman,Chief
                Executive Officer
            November
                1995
            2006Dr. Zvi
                Yaniv
            59
            II
            Director,
                President,Chief
                Operating Officer
            July
                1996
            2006Douglas
                P. Baker
            49
            N/A
            Chief
                Financial Officer
            June
                1996
            N/AJohn
                Ruberto
            60
            N/A
            Senior
                Vice President
            May
                2005
            N/ACharles
                C.  Bailey
            57
            I
            Director
            November
                1999
            2006Ronald
                J.  Berman
            49
            III
            Director
            May
                1996
            2006Eddie
                Lee
            43
            II
            Director
            October
                2001
            2006Dr.
                Robert Ronstadt
            64
            II
            Director
            January
                2003
            2006David
                R.  Sincox
            67
            I
            Director
            October
                1994
            2006




______________________




Marc
      W.
      Eller has served as the Company’s Chief Executive Officer since July 29, 1996.
      Mr. Eller is Chairman of the Board of Directors and has been a Director since
      November 1995. Prior to becoming CEO, Mr. Eller was involved in commercial
      real
      estate investment and in investment banking activities for publicly traded
      companies. Mr. Eller has a B.A. degree in Economics.




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. Mr. Baker is a C.P.A.
      and has both a B.B.A. and a M.B.A. Immediately prior to joining
      Nano-Proprietary, Inc., Mr. Baker was a divisional controller for MascoTech,
      Inc. from 1991 to 1996. Mr. Baker also had prior experience in public accounting
      and as CFO of a privately held company.




John
      Ruberto has been with the Company since May 1, 2005. From 2002 to 2005, Mr.
      Ruberto was an independent management consultant. During 2001 and 2002, Mr.
      Ruberto was Executive Vice President of Strategy and Development at Eagle Picher
      Technologies and President of Eagle Picher Power. Prior to 2001 Mr. Ruberto
      had
      extensive corporate development, program management and business development
      experience at United Technologies Corporation and Gen Corp. Mr. Ruberto also
      served as a Principal Deputy Assistant to the U.S. Secretary of Defense where
      he
      managed system acquisition responsibilities for many defense
      programs.




Charles
      C. Bailey has been an attorney in private practice since 1995. Prior to that
      Mr.
      Bailey had a 20-year career in government. Positions held include Assistant
      Criminal District Attorney and Chief Prosecutor in Lubbock County,  Texas;
      General Counsel for the Texas Department of Public Safety; Assistant General
      Counsel for Governor Bill Clements; and Director of Legal Services and Franchise
      Taxes for the Texas State Comptroller’s Office. His last position with the state
      of Texas, from 1993 to 1995, was Executive Assistant and General Counsel to
      Lt.
      Governor Bob Bullock.













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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.
      Prior to 1989, Mr. Berman was an attorney in private practice.




Eddie
      Lee
      is Chairman and CEO of Pacific Northern, Inc., a Company that he founded in
      1987.  Pacific Northern, Inc. is the largest visual display company serving
      the retail jewelry industry.




Dr.
      Robert Ronstadt has been a Director since January 2003. Dr. Ronstadt became
      Vice President of Technology Commercialization for Boston University in June
      2003.  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.




David
      R.
      Sincox has been a Director of the Company since October 1994. From 1987 through
      2000, Mr. Sincox  served as the Vice President of Administration of
      Ref-Chem Construction Corporation, an engineering and construction firm. Since
      January 2001, Mr. Sincox has been President of Clear Lake Business Services,
      Inc. a consulting firm.




***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.




***Committees***




The
      Board
      of Directors has four committees. The audit committee consists of Mr. Sincox
      and
      Mr. Bailey. The compensation committee consists of Mr. Lee and Mr. Berman.
      The
      nominating committee consists of Dr. Ronstadt and Mr. Bailey. The executive
      committee consists of Mr. Eller and Dr. Yaniv.







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***Audit
      Committee Financial Expert***




The
      Board
      of Directors has determined that David R. Sincox, a member of the audit
      committee, is an “audit committee financial expert” and “independent” as defined
      under applicable SEC rules. The board’s affirmative determination was based
      upon, among other things, his experience as Vice President of Administration
      of
      Ref-Chem Construction Company and his consulting practice.




***Code
      of Ethics***




We
      have
      adopted a Code of Ethics within the meaning of Item 406(b) of Regulation S-B
      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, and 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
      and NASDAQ. 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, 2005 through December 31, 2005, all Officers, Directors, and
      greater than 10% beneficial owners complied with all Section 16(a) filing
      requirements applicable to them, with the exception of Director Bailey as
      described below.




On
      October 11, 2005 Director Bailey exercised 25,000 options and sold the shares
      received from the exercise on the same day. The Form 4 for these transactions
      was due on October 13, 2005, but was not filed until October 14,
      2005.

























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**Item
      11.*********Executive
      Compensation***




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, 2005, 2004 and 2003 by the Chief Executive
      Officer and all executive officers whose total annual salary and bonus exceeded
      $100,000 for the fiscal year ended December 31, 2005 (the "Named Executive
      Officers"):






**SUMMARY
      COMPENSATION TABLE**






**Annual
                Compensation (1)**
            
            **Long-Term**
              **Compensation****Name
                and Principal Position**
            
            **Year**
            
            **Salary($)**
            
            **Bonus($)**
            
            **Securities**
              **Underlying**
              **Options(#)**Marc
                W.  Eller,
            
            
            2005
            
            
            $250,000
            
            
            -0-
            
            
            700,000Chief
                Executive Officer
            
            
            2004
            
            
            $200,000
            
            
            -0-
            
            
            750,0002003
            
            
            $145,000
            
            
            -0-
            
            
            280,000Zvi
                Yaniv, President and
            
            
            2005
            
            
            $250,000
            
            
            -0-
            
            
            700,000Chief
                Operating Officer
            
            
            2004
            
            
            $200,000
            
            
            -0-
            
            
            750,0002003
            
            
            $145,000
            
            
            $147,917
            
            
            280,000Douglas
                P. Baker,
            
            
            2005
            
            
            $180,000
            
            
            -0-
            
            
            350,000Chief
                Financial Officer
            
            
            2004
            
            
            $150,000
            
            
            -0-
            
            
            400,0002003
            
            
            $127,083
            
            
            -0-
            
            
            213,000John
                RubertoVice
                President
            
            
            2005
            
            
            $120,000
            
            
            -0-
            
            
            535,000




______________________




(1)
            No
                Named Executive Officers received perquisites that exceeded in value
                the
                lesser of $50,000 or 10% of such officers' salary and bonus.(2)
            Mr.
                Ruberto started employment on May 1,
                2005.









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**EMPLOYMENT
      AGREEMENTS**




The
      Company currently has no employment agreements with any of its executive
      officers.




**OPTION
      GRANTS IN LAST FISCAL YEAR**




In
      2002,
      Nano-Proprietary established its 2002 Equity Compensation Plan, which may be
      used to grant employees, including officers of Nano-Proprietary, incentive
      stock
      options designed to qualify under Section 422 of the Internal Code of 1986,
      or
      non-qualified stock options. The following table sets forth information
      concerning stock-option grants to the Named Executive Officers in
      2005.




**Name**
            **Number
                of**
              **Securities
                Underlying**
              **Options**
              **Granted(#)(1)**
            **Percent
                of Total**
              **Options
                Granted to**
              **Employees
                in**
              **Fiscal
                Year 2005**
            **Exercise**
              **or
                Base Price ($/Sh)**
            **Expiration
                Date**
            **Grant
                Date**
              **Present
                Value (5)**Marc
                W. Eller
            400,000 (2)
            13.93%
            $2.17
            1/1/15
            $583,960300,000
                (3)
            10.45%
            $2.30
            11/17/15
            $421,470Dr.
                Zvi Yaniv
            400,000 (2)
            13.93%
            $2.17
            1/1/15
            $583,960300,000
                (3)
            10.45%
            $2.30
            11/17/15
            $421,470Douglas
                P. Baker
            200,000 (2)
            6.96%
            $2.17
            1/1/15
            $291,980150,000
                (3)
            5.22%
            $2.30
            11/17/15
            $210,735John
                Ruberto
            535,000
                (4)
            18.63%
            $2.30
            4/25/15
            $827,806




_____________


(1)
            The
                options were granted for a term of ten (10) years, subject to earlier
                termination in certain events related to termination of
                employment.(2)
            For
                Mr. Eller and Dr. Yaniv, these options vest as follows: 200,000 if
                royalty
                or other agreements that will result in revenues totaling $3 million
                are
                executed in 2005 or 2006 and 200,000 options if the Company achieves
                profitability in 2005. The options for Mr. Baker vest according to
                the
                same milestones, but the amounts are 100,000 for each milestone.
                Since the
                Company did not achieve profitability in 2005, all options related
                to that
                milestone did not vest and expired December 31, 2005. The present
                value
                includes all options granted, including those which expired at the
                end of
                2005.(3)
            These
                options will vest if the Company achieves profitability in
                2006.(4)
            A
                total of 35,000 of these options vested on the grant date. The remaining
                500,000 options are performance based options that vest when the
                Company
                receives commitments for future revenues related to specific sources.
                A
                total of 150,000 of these options vested by December 31, 2005. The
                remaining 350,000 may still vest in the future.(5)
            The
                fair value of these options at the date of grant was estimated using
                a
                Black-Scholes option pricing model. The following weighted average
                assumptions were used to estimate the value of the options: a 3.5
                year
                expected life of the options, a dividend yield of 0%, expected volatility
                for the shares of 100%, a turnover/forfeiture percentage of 0%, and
                a risk
                free rate of return of 3.5%.








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**AGGREGATED
      OPTION EXERCISES IN LAST FISCAL YEAR**


**AND
      FISCAL YEAR-END OPTION VALUES**




The
      following table sets forth certain information concerning (i) the exercise
      of
      stock options by each of the Named Executive Officers during the last fiscal
      year ended December 31, 2005 and (ii) the number and intrinsic value of the
      options held by the Named Executive Officers at December 31, 2005. Year-end
      values are based on the closing price of $2.15 per share of the common stock
      on
      December 31, 2005, on the OTC Bulletin Board System. They do not reflect the
      actual amounts, if any, which may be realized upon the future exercise of
      remaining stock options and should not be considered indicative of future stock
      performance.




**Name**
            
            **Shares**
              **Acquired**
              **on
                Exercise (#)**
            
            **Value**
              **Realized
                ($)**
            
            **Number
                of**
              **Unexercised**
              **Securities**
              **Underlying**
              **Options
                at**
              **December
                31, 2005 (#)**
              **Exercisable/**
              **Unexercisable**
            
            **Value
                of**
              **Unexercised**
              **In-the-Money**
              **Options
                at**
              **December
                31, 2005 ($)**
              **Exercisable/**
              **Unexercisable**Marc
                W.  Eller
            
            
            0
            
            
            0
            
            
            230,000
                / 700,000
            
            
            $0
                / $0Dr. Zvi
                Yaniv
            
            
            0
            
            
            0
            
            
            560,000
                / 700,000
            
            
            $185,200
                / $0Douglas
                P. Baker
            
            
            0
            
            
            0
            
            
            725,000
                / 350,000
            
            
            $605,210
                / $0John
                Ruberto
            
            
            0
            
            
            0
            
            
            185,000
                / 350,000
            
            
            $0
                / $0




**DIRECTOR
      COMPENSATION FOR 2005**






All
      Directors who are not employees of the Company receive $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.




All of
      Nano-Proprietary’s outside Directors participate in the 2002 Equity Compensation
      Plan, under which Nano-Proprietary may grant stock options to any Director.
      On
      July 25, 2005, each of the five outside Directors was granted an automatic
      grant
      of 50,000 options under the 2002 Equity Compensation Plan at a price of $2.12.
      These grants became exercisable in full on the date of the grant.




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.




**Compensation
      Committee Interlocks and Insider Participation**





The
      Compensation Committee currently consists of Mr. Lee and Mr. Berman, neither
      of
      which is or has been an officer or employee of Nano-Proprietary. No interlocking
      relationship existed during the fiscal year ended December 31, 2005, between
      Nano-Proprietary’s Board of Directors or Compensation Committee and the board of
      directors or compensation committee of any other company.











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**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 24, 2006, 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.




BeneficialOwnership
            
            Percent
                of OutstandingCommon
                StockPinnacle
                Fund, L.P.
            
            6,821,461
            
            6.84%Barry
                Kitt, General Partner
              4965
                Preston Park Blvd.,Suite 240
              Plano,
                TX 75093Jeffrey
                L. Feinberg
            
            5,955,350
            
            5.97%JLF
                Asset Management LLC
              2775
                Via de la Valle, Suite 204
              Del
                Mar, CA 92014




**SECURITY
      OWNERSHIP OF MANAGEMENT**




Set
      forth
      below is certain information with respect to beneficial ownership of
      Nano-Proprietary’s common stock as of February 24, 2006, 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
                Included**
              **in
                Beneficial**
              **Ownership
                (1)**
            
            **Common
                Stock**
              **Beneficial**
              **Ownership**
            
            **Percentage**
              **of
                Class**Dr.
                Robert Ronstadt
            
            
            125,000
            
            
            125,000
            
            
            *David
                R. Sincox
            
            
            445,000
            
            
            570,000
            
            
            *Charles
                C. Bailey
            
            
            218,333
            
            
            218,333
            
            
            *Marc
                W. Eller
            
            
            230,000
            
            
            247,500
            
            
            *Eddie
                Lee
            
            
            216,667
            
            
            216,667
            
            
            *Ronald
                J. Berman
            
            
            689,383
            
            
            1,104,925
            
            
            1.10%Dr.
                Zvi Yaniv
            
            
            560,000
            
            
            596,000
            
            
            *Douglas
                P. Baker
            
            
            725,000
            
            
            734,500
            
            
            *John
                Ruberto
            
            
            185,000
            
            
            185,000
            
            
            *All
                Executive Officers and
              Directors
                as a group (9 persons)
            
            
            3,394,383
            
            
            3,997,925
            
            
            3.88%




_________________________




*
            Less
                than 1%(1)
            This
                column lists shares that are subject to options exercisable within
                sixty
                (60) days of February 24, 2006, and are included in common stock
                beneficial ownership pursuant to Rule 13d-3(d)(1) of the Exchange
                Act.









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**SECURITIES
      AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION
      PLANS**





**Equity
                Compensation**
              **Plans
                Not Approved by**
              **the
                Shareholders of**
              **the
                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
                (3)**(a)
            (b)
            (c)1992
                Employee Plan (1)
            977,000
            $1.01
            -1992
                Outside Directors
              Plan (2)
            327,716
            $1.09
            -1998
                Directors and
              Officers Plan
            550,000
            $0.47
            -2002
                Equity
              Compensation Plan
            4,848,435
            $2.21
            2,010,109Total
            6,703,151
            $1.57
            2,010,109









(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.(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)
            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.







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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 increased the authorized shares by 3,000,000 to a total
      of
      8,000,000 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***




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 is entitled to receive a royalty of 5%
      of
      gross revenue related to products using this patent. EBT may terminate this
      assignment at any time upon 30 days written notice to ATI. The assignment may
      be
      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
      have
      not totaled $500,000, or if payments do not equal $500,000 in any one-year
      period following this initial two-year period. If the assignment is terminated
      by ATI, EBT will be 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 result in minimum payments being due has not yet
      started.





**Item
      14****.*********Principal
      Accountant Fees and Services***




**Audit
      Fees**




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, 2005 and 2004 totaled $42,700 and $24,650,
      respectively.




**Audit-Related
      Fees**




Nano-Proprietary
      did not incur or pay any fees to Sprouse & Anderson, L.L.P., and Sprouse
& Anderson, L.L.P. did not provide any services related to audit-related
      fees in the last two fiscal years.




**Tax
      Fees**




There
      were no fees billed to Nano-Proprietary by 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 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 Sprouse &
Anderson, L.L.P. All services provided by Sprouse & Anderson, L.L.P. during
      the years ended December 31, 2005 and 2004 were pre-approved by the audit
      committee.




As
      of the
      date of this filing, Nano-Proprietary current policy is to not engage Sprouse
      & Anderson, 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 Sprouse & Anderson, L.L.P. to provide audit,
      tax, and other assurance services, such as review of SEC reports or filings.






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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.






**PARTIV**




**Item
      1****5.*********Exhibits
      and Financial Statement Schedules***




(a)
            Exhibits:
                See Index to Exhibits on page 60 for a descriptive response to this
                item.




(b)
            None






**SIGNATURES**




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








**NANO-PROPRIETARY,
                INC.**
              
              By:/s/
                Marc W.
                Eller
              Marc
                W.  Eller,
              Chief
                Executive Officer
              March
                2, 2006




In
      accordance with the Exchange Act, 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/**Marc
                W. Eller
              Marc
                W.  Eller
            Chairman,
                Chief Executive
              Officer
                (Principal Executive Officer and
              Director)
            March
                2, 2006/s/
                Douglas P.  Baker
              Douglas
                P.  Baker
            Vice
                President and
              Chief
                Financial Officer
              (Principal
                Financial Officer and Principal Accounting Officer)
            March
                2, 2006Dr.
                Robert Ronstadt*
              David
                R.  Sincox*
              Eddie
                Lee*
              Ronald
                J.  Berman*
              Charles
                G.  Bailey*
              Dr. Zvi
                Yaniv*
            Directors
            March
                2, 2006




*By: //s// Douglas P. Baker


(Douglas P. Baker,


Attorney-in-Fact)









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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 EXHIBIT**3(i).1
            Restated
                Articles of Incorporation of Company, as filed March 1, 2006 with
                the
                Secretary of State for the State of Texas.3(ii).1
            Amended
                and Restated Bylaws of the Company.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 10.4.to the
                Company’s
                Annual Report on Form 10-K for the fiscal year ended December 31,
                2004)10.5*
            Patent
                Assignment and Royalty Agreement between Electronic Billboard Technology,
                Inc. and Advanced Technology, Incubator, Inc. dated as of October
                6, 1998.
                (Exhibit 10.18 to the Company’s Current Report on Form 10-KSB dated as of
                March 31, 1999).10.6*
            Lease
                agreement between the Company and Industrial Properties Corporation
                dated
                as of February 15, 2004. (Exhibit 10.11 to the Company’s Annual Report on
                Form 10-KSB for the fiscal year ended December 31,
                2004).10.7*
            Patent
                License Agreement, dated as of March 26, 1999, by and between the
                Company
                and Canon, Inc. (Exhibit 10.1 to the Company’s amended Current Report on
                Form 8-K/A dated as of April 16, 1999).10.8*
            Agreement
                of Research and Development by and between the Applied Nanotech,
                Inc. and
                Futaba Corporation (Exhibit 10.1 to the Company’s Current Report on Form
                8-K dated as of January  1, 2001)10.9*
            Agreement
                of Research and Development by and between the Applied Nanotech,
                Inc. and
                Futaba Corporation for Phase II development (Exhibit 10.14 to the
                Company’s Annual Report on From 10-KSB for the fiscal year ended December
                31, 2001).10.10*
            Agreement
                for HyFEDTM Development Team Phase II by and between Field Emission Picture
                Element Technology, Inc. and Electrovac Ges.m.b.H. (Exhibit 10.2
                to the
                Company’s Current Report on Form S-2 date August 24,
                2001)





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**EXHIBIT**
              **NUMBER**
            **DESCRIPTION
                OF EXHIBIT**10.11*
            Agreement
                for HyFEDTM Development Team Phase II by and between Field Emission Picture
                Element Technology, Inc. and Imaging System Technology, Inc. (Exhibit
                10.3
                to the Company’s Current Report on Form S-2 date August 24,
                2001)10.12*
            Agreement
                for HyFEDTM Development Team Phase II by and between Field Emission Picture
                Element Technology, Inc. and Supertex, Inc. (Exhibit 10.4 to the
                Company’s
                Current Report on Form S-2 date August 24, 2001)10.13*
            Agreement
                for HyFEDTM Development Team Phase II by and between Field Emission Picture
                Element Technology, Inc. and Schott Fiber Optics. (Exhibit 10.5 to
                the
                Company’s Current Report on Form S-2 date August 24,
                2001)10.14*
            Agreement
                for HyFEDTM Development Team Phase II by and between Field Emission Picture
                Element Technology, Inc. and Lead Sangyo Co., Ltd. (Exhibit 10.6
                to the
                Company’s Current Report on Form S-2 date August 24,
                2001)10.15*
            Agreement
                for HyFEDTM Development Team Phase II by and between Field Emission Picture
                Element Technology, Inc. and Shanghai Novel Color Picture Tube Co.,
                Ltd.
                (Exhibit 10.7 to the Company’s Current Report on Form S-2 date August 24,
                2001)10.16*
            Agreement
                for HyFEDTM Development Team Phase II by and between Field Emission Picture
                Element Technology, Inc. and Shanghai Vacuum Electron Devices Co.,
                Ltd.
                (Exhibit 10.8 to the Company’s Current Report on Form S-2 date August 24,
                2001)10.17*
            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)10.18
            Nano-Proprietary,
                Inc. Compensation Committee Charter10.19
            Nano-Proprietary,
                Inc. Nominating Committee Charter10.21*
            Research/Development
                and License Agreement entered into by Applied Nanotech, Inc. dated
                as of
                September 11, 2002 (Exhibit 10.1 to the Company’s Current Report on Form
                8-K dated as of September 27, 2002).10.22*
            Patent
                License Agreement between SI Diamond Technology, Inc. and Till Keesman
                (Exhibit 10 to the Company’s Quarterly Report on Form 10-QSB for the
                quarter ended June 30, 2000)10.23*
            Second
                Addendum to Patent License Agreement by and among Nano-Proprietary,
                Inc.
                and Till Keesman (Exhibit 10.1 to the Company’s Current Report on Form 8-K
                dated as of November 18, 2002).10.24*
            Development,
                Purchase, and License Agreement for Hydrogen Sensor Products and
                related
                Services between, Nano-Proprietary, Inc. Applied Nanotech, Inc. and
                Kelman
                Ltd. (Exhibit 10.1 to the Company’s Current Report on Form 8-K dated as of
                July 13, 2005).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 Attorney.31.1
            Rule
                13a-14(a)/15d-14(a) Certificate of Marc W. Eller, Chief Executive
                Officer31.2
            Rule
                13a-14(a)/15d-14(a) Certificate of Douglas P. Baker, Chief Financial
                Officer32.1
            Section
                1350 Certificate of Marc W. Eller, Chief Executive
                Officer32.2
            Section
                1350 Certificate of Douglas P. Baker, Chief Financial
                Officer







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