NANOPHASE TECHNOLOGIES Corp - Annual Report: 2002 (Form 10-K)

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

x    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2002

Commission File Number 0-22333

NANOPHASE TECHNOLOGIES CORPORATION

(Exact name of registrant as specified in its charter)

1319 Marquette Drive, Romeoville, Illinois 60446

(Address of principal executive offices) (zip code)

Registrant’s telephone number, including area code: (630) 771-6708

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

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

Common Stock, par value $.01 per share

Preferred Stock Purchase Rights

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x    No ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, 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. Yes x    No ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12B-2). Yes ¨    No x

The aggregate market value of the registrant’s voting stock held by non-affiliates of the registrant, based upon the last reported sale price of the registrant’s Common Stock on June 28, 2002 was $67,918,991.

The number of shares outstanding of the registrant’s Common Stock, par value $.01, as of March 25, 2003 was 15,137,877.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s Definitive Proxy Statement in connection with the registrant’s 2003 Annual Meeting of Stockholders are incorporated by reference into Part III of this Report on Form 10-K.

PART I

Item 1.    Business

General

Nanotechnology, as practiced by Nanophase Technologies Corporation (“Nanophase” or the “Company”), involves creating nanostructured materials by controlling matter at the nanometer-size scale—at the level of atoms and molecules. Because these “nanostructures” are made with molecular building blocks, they can be designed to exhibit novel and significantly improved physical, chemical and mechanical properties.

When the structural features are sized between individual molecules and bulk materials—in the range of about 10 to 100 nanometers—the objects often display physical attributes substantially different from those found in bulk materials. As a result, the properties of nanocrystalline materials often cannot be predicted from those seen at larger sizes, and nanoparticles can exhibit novel properties. When it is possible to control particle size and shape, it also is possible to enhance material properties and devise functions beyond those normally found in a material.

The Company’s objective is to exploit its capabilities to efficiently engineer and manufacture nanocrystalline materials. Nanophase does this by providing value-enhanced solutions for commercial applications in multiple global markets. Recognizing a need to offer enhanced performance and assist customers with their product improvements, Nanophase targets markets in which a practical solution may be found through using nanoengineered products. The Company works closely with leaders in these target markets to identify their material and performance requirements.

Many of the raw materials used in the Company’s various processes are commercially available. In some cases, Nanophase relies on sole-source processors of materials who rely on an array of worldwide sources for the materials that they process to the Company’s specifications. As the Company’s product mix changes, there may be more reliance on sole-source processors and suppliers.

The Company was incorporated in Illinois on November 30, 1989 and merged into a Delaware corporation on November 25, 1997. The Company’s Common Stock trades on the Nasdaq National Market under the symbol NANX.

Nanocrystalline Materials

Nanocrystalline materials generally are made of particles that are less than 100 nanometers (billionths of a meter) in diameter. They contain only 1,000s or 10,000s of atoms, rather than the millions or billions of atoms found in larger size particles. The properties of nanocrystalline materials depend upon the composition, size, shape, structure, and surface of the individual particles. Nanophase’s methods for engineering and manufacturing nanocrystalline materials result in particles with a controlled size and shape, and surface characteristics that behave differently from conventionally produced larger-sized materials.

The Company’s current products include, among others, coated materials as ingredients for sunscreens, Nanophase’s largest current application, and uncoated materials as ingredients for personal care applications including anti-fungal aids, automotive catalytic converters, and abrasion-resistant flooring. A growing new product area for Nanophase is the production of engineered nanomaterials, and their dispersion in a variety of media, for various electronics polishing applications.

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The Company’s Technologies

Nanophase intends to maintain and grow its intellectual property position in the rapidly emerging science of nanotechnology. The Company uses its technologies to engineer and produce nanocrystalline materials designed for specific product applications. These technologies include methods for the synthesis, surface-treatment, coating, and dispersion of nanocrystals. Nanophase also is engaged in ongoing research and technology-licensing activities that add to its core technologies or provide complementary technologies. Nanophase believes in exploiting any technologies available that may help the Company to increase its market efficacy and may ultimately lead to greater market acceptance. Part of the Company’s strategy involves the continuous review of new technologies outside of the Company as well as its internal research and development efforts. From time to time, in areas that are complimentary to its growth strategies, the Company will license outside technology to augment its internally developed technologies.

Nanophase has been steadily expanding both its patented technologies and its ability to successfully practice these technologies. Through large-scale manufacturing of its materials utilized by others in the manufacture of consumer sunscreen and personal care products, the Company has developed a level of production expertise that has allowed it to continuously improve its processes relating to other materials as well. With the commercialization of the Company’s new NanoArc Synthesis ^™ reactor and new dispersion technologies in 2002, Nanophase has been able to successfully begin to penetrate the chemical-mechanical-planarization (“CMP”) market. CMP is the process of polishing various types of integrated circuits or chips to be used in various commercial electronics applications. Management believes that the inroads made in the CMP market would have been impossible without the Company being able to produce its materials to exacting specifications verified by rigorous in-house and customer-based testing. Almost all of the research that Nanophase does is directly related to applications development. The Company endeavors to either meet specific stated customer needs or to develop applications solutions to unmet needs in the marketplace where its materials may offer a distinct performance advantage, typically resulting in a lower system cost to customers. Management believes that aggressively pursuing applications, inventions and patents will help it maintain a technical and commercial leadership position.

Marketing

The Company markets and sells its products through a combination of business development and sales activities in close collaborative relationships with one (or sometimes several) lead customer in various markets. Business development activities include evaluation and qualification of potential markets, identification of the lead customers within each market, and development of a business strategy for successful market penetration. Nanophase then forms a technical/marketing team that offers the customer an engineered solution to meet that company’s specific requirements. Nanophase tailors materials to provide specific solutions required by its customers. Once a solution is established, application and customer management is moved to a sales team that is organized along market lines. The sales team is expected to increase revenue by selling product and process solutions and broadening the customer base. These collaborations often begin with sample requests from potential customers, then mature to open discourse regarding the needs of those potential customers and the capabilities of Nanophase. A logical next step is frequently a formal agreement to collaborate on specific applications technology where both Nanophase and the customer share ideas to develop specific products for specific fields of use. The ideal outcome for this type of collaboration is the mutual development and introduction of a product that results in significant revenue to both Nanophase and the customer. In the case of BASF Corporation (“BASF”), much of our collaboration has involved sharing information and developing the current product and next generation products to better perform within their existing customers’ various products and systems with a focus on product and application development for their potential customers in new and existing markets.

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The Company’s largest customer is currently BASF. Nanophase and BASF have entered into a supply agreement that requires BASF to buy a minimum of seventy percent of its annual requirement of nanoscale zinc oxide for use in sunscreen and personal care products from Nanophase in order for BASF to retain exclusive rights to use the Company’s products in the sunscreen and personal care markets. This agreement can be terminated by either party with two years notice under certain conditions. In October of 2000, BASF agreed to lend the Company approximately $1.3 million to construct a powder coating facility at its Romeoville, Illinois location. See Note 6 to the Financial Statements.

The Company leverages its resources through relationships with organizations and individuals focused on market-specific or geography-specific areas. These relationships enhance Nanophase’s ability to quickly develop lead customers and applications for its products. For example, to promote a more rapid penetration into Japanese markets, the Company continues to maintain its relationship with C. I. Kasei, a division of Itochu Corporation (“CIK”). CIK develops, engineers and manufactures products under license from the Company for use in multiple industrial markets. This agreement stipulates a minimum annual royalty of the greater of $300,000 or 4% of CIK’s sales of licensed product, payable to the Company until 2013, to guarantee CIK an exclusive license. After that time, the agreement calls for a royalty of 2% of CIK’s sales of licensed product, at which time CIK would become a non-exclusive licensee.

A limited number of key customers account for a substantial portion of the Company’s commercial revenue. In particular, revenue from BASF and CIK constituted approximately 72.6% and 6.8%, respectively, of the Company’s 2002 total revenue. The Company’s customers are significantly larger than, and are able to exert a high degree of influence over the Company. While the Company has long-term agreements with its major customers, the loss of one of these key customers or the failure to attract new customers could have a material adverse effect on the Company’s business, results of operations and financial condition.

The Company, from time to time, employs a number of marketing representatives and third-party sales agents focused in specific application areas. Nanophase also markets itself and its capabilities by sponsoring, attending and presenting at advanced materials symposia and industry trade shows for its target markets, and by publishing articles in a variety of scientific and trade journals. The Company also uses its Website, advertises in selected industry and trade journals, and provides specification sheets, and other marketing materials. In addition, Nanophase routinely networks with Fortune 500 companies to display its technology and uncover potential applications. The Company often makes technical presentations at various events where the Company’s scientists and business development people meet with their counterparts at other companies and pursue technical relationships and collaborative applications research. The goal of these collaborations is to solve specific customer’s problems and enable customers to access new markets.

Technology and Engineering

The Company’s Technology and Engineering Group includes the research and development and advanced engineering functions. The near-term objective of Nanophase’s research and process-development activities is to gather core technologies that have the capability to serve multiple markets commercially, continue to improve and evolve the Company’s manufacturing technologies, and develop nanomaterials applications, usually working directly with potential customers.

Nanophase’s total research and development expense, which includes all expenses relating to the technology and advanced engineering group, during the years ended December 31, 2002, 2001, and 2000 were $1,572,997, $1,601,671, and $1,837,036, respectively. The Company’s future success will depend in large part upon its ability to keep pace with evolving advanced materials technologies and industry standards, and the Company may be unable to do so. Through the five-year period ended December 31, 2002, the Company has had cumulative research and development expenses of approximately $8.0

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million and cumulative expenditures on equipment and leasehold improvements of approximately $9.7 million. These investments in technology and production capacity and capability have helped to take Nanophase from a development stage company to commercialization.

Manufacturing Operations    The Company’s manufacturing operations include the production of nanomaterials in the form of powders utilizing two different methods, physical-vapor-synthesis (“PVS”) and NanoArc Synthesis ^™. The Company also has a large quantity powder coating operation to support its sunscreen business as well as a dispersion line in support of its CMP and polishing businesses. Management is committed to a lean manufacturing approach where, to the extent possible given a certain measure of irregular demand, the Company keeps labor, inventory, and supply levels to a practical minimum in order to minimize working capital demands.

Intellectual Property and Proprietary Rights

Nanophase relies on a combination of copyright, trademark, trade secret and other intellectual property law, nondisclosure agreements and other protective measures to protect its intellectual property. In addition to obtaining patent and trademarks based on the Company’s inventions and products, Nanophase also licenses third-party patents to expand its technology base. The Company currently owns or licenses 21 United States patents and patent applications, consisting of 8 owned United States patents, 7 owned United States patent applications, and 6 licensed United States patents. The Company also has 21 foreign patents and patent applications, consisting of 9 owned foreign patents and 12 owned foreign patent applications, all of which are counterparts to domestic filings covering its platform of nanotechnologies. Nanophase’s intellectual property rights, however, could be challenged, invalidated or circumvented. The Company does not believe that its products or processes infringe the intellectual property rights of others, but such claims, if they are established, could result in material liabilities or loss of business.

The Company requires its employees, consultants, outside scientific collaborators and other advisors to sign confidentiality and, when appropriate, non-compete agreements when their employment or consulting relationships begin. These agreements generally provide that all confidential information developed or made known to the individual during the course of that person’s relationship with the Company will be kept confidential, and not be disclosed to third parties except in specific circumstances. In the case of research employees, the agreements also provide that all inventions made by the individual shall be the exclusive property of Nanophase. There can be no assurances, however, that these agreements will provide meaningful protection for the Company’s trade secrets, know-how or patent rights, or will provide Nanophase with adequate remedies in the event of unauthorized use or disclosure of such information. In addition, the Company’s employees who have not entered into non-compete agreements may become competitors when their employment at Nanophase ends.

Competition

Within each of its targeted markets and product applications, Nanophase faces current and potential competition from many advanced materials and chemical companies, as well as the in-house capabilities of several of its current and potential customers. In many markets, the Company has major competitors, some of which are larger and more diversified than the Company. Although management believes its materials and technologies are superior to those of its competitors, competitive companies pose risks to Nanophase because they may have substantially greater financial and technical resources, larger research and development staffs, and greater manufacturing and marketing capabilities.

In addition, the global number of development-stage companies involved in nanocrystalline materials continues to grow, posing significant and increasing competitive risks. Many of these companies are associated with university or national laboratories, and use chemical and physical methods to produce nanocrystalline materials. Management believes that most of these companies are engaged

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primarily in funded research, and is not aware that any of them have commercial production capabilities; however, they may represent competitive risks in the future. Some of these development stage companies, especially in other countries, are receiving significant government assistance.

Governmental Regulations

The manufacture and use of certain of the products that contain the Company’s nanocrystalline materials are subject to governmental regulations. As a result, the Company is required to adhere to the current Good Manufacturing Practices (“cGMP”) requirements of the U.S. Food and Drug Administration (“FDA”) and similar regulations in other countries that include testing, control and documentation requirements enforced by periodic inspections.

In addition, the Company’s facilities and all of its operations are subject to the plant and laboratory safety requirements of various occupational safety and health laws. To date, those regulations have not materially restricted or impeded operations.

Employees

On December 31, 2002, the Company had a total of 53 full-time employees, 12 of whom hold advanced degrees. Nanophase has no collective bargaining arrangements.

On December 19, 2002, the Company announced that Dr. Gina Kritchevsky, its Chief Technology Officer, had decided to pursue other interests and was returning to Arizona. The Company has retained Dr. Kritchevsky’s services through 2003 as a consultant. On February 21, 2003, the Company announced that Dr. Donald J. Freed, its Vice President of Business Development, was retiring effective February 28, 2003. On March 24, 2003, the Company hired Dr. Edward Ludwig as its Vice President of Business Development.

Forward-Looking Statements

Nanophase Technologies Corporation wants to provide investors with more meaningful and useful information. As a result, this Annual Report on Form 10-K (the “Form 10-K”) contains and incorporates by reference certain “forward-looking statements”, as defined in Section 21E of the Securities Exchange Act of 1934, as amended. These statements reflect the Company’s current expectations on the future results of its operations, performance and achievements. Forward-looking statements are covered under the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. The Company has tried, wherever possible, to identify these statements by using words such as “anticipates”, “believes”, “estimates”, “expects”, “plans”, “intends” and similar expressions. These statements reflect management’s current beliefs and are based on information now available to it. Accordingly, these statements are subject to certain risks, uncertainties and contingencies that could cause the Company’s actual results, performance or achievements in 2003 and beyond to differ materially from those expressed in, or implied by, such statements. These risks, uncertainties and factors include, without limitation: a decision by a customer to cancel a purchase order or supply agreement; uncertain demand for, and acceptance of, the Company’s nanocrystalline materials; the Company’s dependence on a limited number of key customers; the Company’s limited manufacturing capacity and product mix flexibility; the Company’s limited marketing experience; changes in development and distribution relationships; the impact of competitive products and technologies; the Company’s dependence on patents and protection of proprietary information; the resolution of litigation the Company is involved in; the possible disruption of commercial activities occasioned by terrorist activity and armed conflict; and other risks set forth under the Company’s previous filings with the Securities and Exchange Commission. Readers of this Annual Report on Form 10-K should not place undue reliance on any forward-looking statements. Except as required by federal securities laws, the Company undertakes no obligation to update or revise these forward-looking statements to reflect new events or uncertainties.

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Investor Information

The Company is subject to the informational requirements of the Securities Exchange Act of 1934 (the Exchange Act) and, accordingly, files periodic reports, proxy statements and other information with the Securities and Exchange Commission (the SEC). Such reports, proxy statements and other information may be obtained by visiting the Public Reference Room of the SEC at 450 Fifth Street, NW, Washington, DC 20549 or by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an Internet site (http://www.sec.gov) that contains reports, proxy and information statements and other information regarding issuers that file electronically.

Financial and other information may also be accessed at the Company’s web site. The address is www.nanophase.com. The Company makes available, free of charge, copies of its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after filing such material electronically or otherwise furnishing it to the SEC, and intends to make all such reports and amendments to reports available free of charge on its web site as soon as appropriate changes in its web site can be made.

Item 2.    Properties

Nanophase operates a 36,000 square-foot production, research and headquarters facility in Romeoville, Illinois and a 20,000 square-foot production facility in Burr Ridge, Illinois, both are Chicago suburbs. The Company also leases a 6,000 square-foot offsite warehouse. The Company’s operations in Burr Ridge are registered under ISO 9001, and its manufacturing operations are essentially in compliance with the cGMP requirements of the FDA.

The Romeoville facility houses the Company’s headquarters, advanced manufacturing function (surface treatment and pilot-scale manufacturing) and research and development laboratories, and will be used for additional commercial manufacturing space in 2003. Nanophase leases its Romeoville facility under an agreement whose initial term will expire in July 2006, with an option to extend the lease for two additional periods of five years each. The Burr Ridge facility has a quality control laboratory designed for the dual purposes of validating operations to cGMP and ISO standards, and production process control. This laboratory is equipped to handle many routine analytical and in-process techniques the Company currently requires. Nanophase leases its Burr Ridge facility under an agreement whose initial term expired in September 1999. The Company has options to extend the lease for up to five additional one-year terms and is currently in the fourth additional one-year term, which expires in September 2003.

Management believes that the Company’s leased facilities provide sufficient capacity to fulfill current known customer demand as well as providing additional space to enable expansion of key production processes. Management also believes that the Company’s capital expenditures in 2002 will support currently anticipated demand from existing customers. The Company’s actual future capacity requirements will depend on many factors, including new and potential customer acceptance of the Company’s current and potential nanocrystalline materials and product applications, unknown and currently unplanned growth from existing customers, continued progress in the Company’s research and development activities and product testing programs, and the magnitude of these activities and programs.

Item 3.    Legal Proceedings

See Note 19 to the Financial Statements for additional information.

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

No matters were submitted to a vote of the Company’s security holders during the fourth quarter of 2002.

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PART II

Item 5.    Market for Registrant’s Common Equity and Related Stockholder Matters

The Company’s Common Stock is traded on the Nasdaq National Market under the symbol NANX. The following table sets forth, for the periods indicated, the range of high and low sale prices for the Common Stock on the Nasdaq National Market:

On March 25, 2003, the last reported sale price of the Common Stock was $3.63 per share, and there were approximately 152 holders of record of the Common Stock.

The Company has never declared or paid any cash dividends on its Common Stock and does not currently anticipate paying any cash dividends or other distributions on its Common Stock in the foreseeable future. The Company intends instead to retain any future earnings for reinvestment in its business. Any future determination to pay cash dividends will be at the discretion of the Company’s Board of Directors and will be dependent upon the Company’s financial condition, results of operations, capital requirements and such other factors deemed relevant by the Board of Directors.

In January 2001, the Company granted 1,361 shares of Common Stock to each of the following directors of the Company for services performed in their capacity as directors: Donald Perkins, Edward Hagenlocker, James McClung, Jerry Pearlman, and Richard Siegel. In January 2002, the Company granted 2,540 shares of Common Stock to each of the following directors of the Company for services performed in their capacity as directors: Donald Perkins, James Henderson, James McClung, Jerry Pearlman, and Richard Siegel. In January 2003, the Company granted 4,870 shares of Common Stock to each of the following directors of the Company for services performed in their capacity as directors: Donald Perkins, James Henderson, James McClung, Jerry Pearlman, and Richard Siegel. Each of the preceding issuances were made in reliance on the exemption from registration found in section 4(2) of the Securities Act of 1933. None of these preceding issuances were for any form of monetary consideration. On November 26, 1997 the Company’s Registration Statement on Form S-1 (File No. 333-36937) relating to the Company’s initial public offering of common stock (the “Offering”) was declared effective by the Securities and Exchange Commission. The market price established for the Company’s initial public offering was $8.00 per share. On May 29, 2002, the Company issued 1,370,000 shares of common stock in a private placement offering, taken collectively with the Company’s November 26, 1997 Offering as “the Offerings.” Since November 26, 1997, of its $35,033,231 of net proceeds from the Offerings, the Company has used approximately $10,562,000 for capital expenditures primarily related to the further expansion of the Company’s existing manufacturing facility and the purchase of operating equipment and approximately $16,963,000 for working capital and other general corporate purposes. The remainder of the net proceeds has been invested by the Company, pending its use, in short-term, investment grade, interest-bearing obligations. At December 31, 2002, the Company had approximately $7,508,000 in cash, cash equivalents and investments.

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On May 29, 2002, the Company sold, in a private placement to qualified accredited investors, 1.37 million shares of common stock at $5.00, an approximate 3% discount from market, per share and received gross proceeds of $6.85 million. The closing market price of Nanophase’s stock was $5.15 per share on May 29, 2002. Net proceeds were approximately $6.2 million after commissions, legal, accounting, and other costs. The Company intends to use the proceeds to fund expected growth in new markets as well as to provide for expanded working capital needs expected to arise as sales volume grows. The preceding issuance was made in reliance on the exemption from registration found in section 4(2) of the Securities Act of 1933.

Item 6.    Selected Financial Data

The following selected financial data is qualified by reference to, and should be read in conjunction with, the financial statements and related notes thereto appearing elsewhere in this Form 10-K and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The selected financial data set forth below as of, and for, each of the years in the five-year period ended December 31, 2002 have been derived from the audited financial statements of the Company.

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

The following discussion and analysis should be read in conjunction with “Item 6. Selected Financial Data,” risks discussed in other filings made by the Company with the Securities and Exchange Commission, and the financial statements and related notes thereto appearing elsewhere in this Form 10-K. When used in the following discussions, the words “anticipates,” “believes,” “estimates,” “expects,” “plans,” “intends” and similar expressions are intended to identify forward-looking statements. Such statements are subject to certain risks, uncertainties and contingencies that could cause actual results, performance or achievements to differ materially from those expressed in, or implied by, such statements.

Overview

From its inception in November 1989 through December 31, 1996, the Company was in the development stage. During that period, the Company primarily focused on the development of its manufacturing processes in order to transition from laboratory-scale to commercial-scale production. As a result, the Company developed an operating capacity to produce significant quantities of its nanocrystalline materials for commercial sale. The Company was also engaged in the development of commercial applications and formulations and the recruiting of marketing, technical and administrative personnel. Since January 1, 1997, the Company has been engaged in commercial production and sales of its nanocrystalline materials, and the Company no longer considers itself in the development stage. From inception through December 31, 2002, the Company was primarily capitalized through the private offering of approximately $25.8 million of equity securities and its initial public offering of $28.8 million of Common Stock in November of 1997 and $6.2 million of Common Stock in a private placement offering in May of 2002, each net of issuance costs. The Company has incurred cumulative losses of $39.9 million from inception through December 31, 2002.

Critical Accounting Policies

We utilize certain accounting measurements under applicable generally accepted accounting principles, which involve the exercise of management’s judgment about subjective factors and estimates about the effect of matters which are inherently uncertain. The following is a summary of those accounting measurements which we believe are most critical to our reported results of operations and financial condition. Our significant accounting policies are more fully described in Note 2 to our financial statements.

Revenue Recognition. Product revenue consists of sales of product that are recognized when realized and earned. This generally occurs when persuasive evidence of an arrangement exists, delivery has occurred, the price is fixed or determinable, and collectibility is reasonably assured. Other revenue consists of revenue from research and development arrangements with non-governmental entities, fees from the transfer of technology and, principally, for the years 2000 through 2002, related royalties. Research and development arrangements include both cost-plus and fixed fee agreements and such revenue is recognized when specific milestones are met under the arrangements. Fees related to the transfer of technology are recognized when the transfer of technology to the acquiring party is completed and the Company has no further significant obligation. Royalties are recognized when earned pursuant to the contractual arrangement.

Inventory Valuation. Cost is determined on a first-in, first-out basis. Inventory is stated at the lower of cost, maintained on a first in, first out basis, or market. The Company has recorded allowances to reduce inventory relating to excess quantities of certain materials. Write-downs of inventories

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establish a new cost basis, which is not increased for future increases in market value of inventories or changes in estimated excess quantities.

Trade Accounts Receivable. Trade accounts receivable are carried at original invoice amount less an estimate made for doubtful receivables based on a review of all outstanding amounts on a monthly basis. Management determines the allowance for doubtful accounts by identifying troubled accounts and by using historical experience applied to an aging of accounts. Trade accounts receivable are written off when deemed uncollectible. Recoveries of trade accounts receivable previously written off are recorded when received.

Results of Operations

Years Ended December 31, 2002 and 2001

Total revenue increased to $5,401,215 in 2002, compared to $4,055,488 in 2001. The increase in total revenue between 2002 and 2001 was mainly attributed to growth with existing customers, particularly, an increase of approximately 29% in total product derived from the Company’s largest customer. Product revenue increased to $5,002,986 in 2002, compared to $3,650,914 in 2001. Other revenue decreased to $398,229 in 2002, compared to $404,574 in 2001. The majority of the revenue generated during 2002 was from customers in the healthcare, wear-resistant materials, Chemical Mechanical Planarization (CMP) and catalyst markets. Revenue from BASF and CIK, the Company’s two largest customers constituted approximately 72.6% and 6.8%, respectively, of the Company’s 2002 revenue.

Cost of revenue generally includes costs associated with commercial production and customer development arrangements. Cost of revenue increased to $5,095,019 in 2002, compared to $4,906,716 in 2001. The increase in cost of revenue was generally attributed to increased product sales volume and increased depreciation expense resulting from the completion, and placement in service at the beginning of the current year and throughout the current year of the majority of the Company’s build out of its manufacturing and powder coating facilities, somewhat offset by efficiencies in the manufacture of the Company’s products. Cost of revenue as a percentage of total revenue decreased from 121% in 2001, compared to 94% in 2002. Improvements to gross profit are primarily due to increased revenues, continued gains in operating efficiencies, and nonrecurring other revenue in the amount of $65,000 received in the second quarter. For the year 2002, the Company recognized a contribution of approximately $10,000 due to inventory being sold for which an allowance for excess inventory quantities had previously been recorded. The Company expects to remain operating at a positive annual gross profit margin for the foreseeable future.

Research and development expense, which includes all expenses relating to the technology and advanced engineering groups, primarily consists of costs associated with the Company’s development or acquisition of new product applications and coating formulations and the cost of enhancing the Company’s manufacturing processes. The Company is currently engaged in research to enhance its ability to disperse its material in a variety of organic and inorganic media for use as coatings and polishing materials. A recent technical success was related to the Company’s ability to engineer some of its nanomaterials to remain relatively uniformly dispersed in liquid systems over extended periods of time. The Company’s June 2002 announcement regarding its new CMP partner, Rodel, came about as a direct result of this successful research and subsequent application development. The Company also has an ongoing advanced engineering effort that is primarily focused on the development of new nanomaterials as well as the refinement of existing nanomaterials. Research and development expense decreased to $1,572,997 in 2002, compared to $1,601,671 in 2001. The decreases in research and development expense was largely attributed to decreased outside testing, materials and supplies, and travel expenses being incurred in 2002. These reductions were somewhat offset by increased depreciation on assets completed and placed in service during 2002, increased advanced engineering salaries due to

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lower capitalization of payroll (approximately $149,000) in 2002 than in 2001 (approximately $180,000), and increased spending on electricity and equipment expenses.

Selling, general and administrative expense increased to $3,854,051 in 2002, compared to $3,798,543 in 2001. The net increase was primarily attributed to increases in salary expenses incurred relating to the hiring of a company executive, legal costs, real estate taxes, and bad debt expense which, was zero at December 31, 2002, compared to a credit balance at December 31, 2001. These increases were partially offset by a reduction in investor relations, telephone, consulting fees, and travel expenditures.

Interest income decreased to $152,626 in 2002, compared to $585,782 in 2001. This decrease was primarily due to a reduction in average monthly funds available for investment and, to a lesser extent, reduced investment yields.

Years Ended December 31, 2001 and 2000

Total revenue decreased to $4,055,488 in 2001, compared to $4,273,353 in 2000. The decrease in total revenue between 2001 and 2000 was principally due to soft customer demand and extended times to market given the general state of the manufacturing economy, exacerbated by the terrorist attack on the United States of America on September 11, 2001. Product revenue decreased to $3,650,914 in 2001, compared to $3,824,159 in 2000. Other revenue decreased to $404,574 in 2001, compared to $449,194 in 2000. Revenue from BASF and CIK, the Company’s two largest customers constituted approximately 75.5% and 9.4%, respectively, of the Company’s 2001 revenue.

Cost of revenue generally includes costs associated with commercial production, customer development arrangements and licensing fees. Cost of revenue increased to $4,906,716 in 2001, compared to $4,754,485 in 2000. The increase in cost of revenue was primarily attributed to a net increase in the allowance for excess inventory quantities of $539,415, somewhat offset by efficiencies in the manufacture of the Company’s products. The majority of the increase in the allowance for excess inventory quantities related to a write-down of raw materials and finished goods relating to the Company’s catalyst business. These inventories were built in support of a purchase order and in anticipation of upcoming order volumes from a customer in the United Kingdom that subsequently reneged on its legal obligations. Management felt that, although Nanophase has a current customer for this material, current volumes and limited predictability of future demand made this adjustment prudent. Cost of revenue as a percentage of total revenue increased in 2001, compared to the same period in 2000, due primarily to the inventory adjustment discussed above.

Research and development expense, which includes all expenses relating to the technology and advanced engineering groups, primarily consists of costs associated with the Company’s development or acquisition of new product applications and coating formulations and the cost of enhancing the Company’s manufacturing processes. Research and development expense decreased to $1,601,671 in 2001, compared to $1,837,036 in 2000. The decrease in research and development expense was largely attributed to the capitalization of approximately $180,000 of advanced engineering salaries attributed to the build out of the Company’s new pilot manufacturing and powder coating facilities, a reduction in fees and expenses paid to outside consultants in 2001, more research personnel being hired in 2000, to whom the Company paid negotiated bonuses and recruiting and relocation costs, and fewer travel expenses being incurred in 2001.

Selling, general and administrative expense increased to $3,798,543 in 2001, compared to $3,388,758 in 2000. The net increase was primarily attributed to increases in salaries and costs incurred relating to the hiring of two company employees, costs of insurance, rent and associated expenses relating to the Company’s new facility, and printing costs. These increases were partially offset by a reduction in bad debt expense, consulting fees, and travel expenditures.

13

Interest income decreased to $585,782 in 2001, compared to $1,234,054 in 2000. This decrease was primarily due to a reduction in funds available for investment and reduced investment yields.

Liquidity and Capital Resources

The Company’s cash, cash equivalents and investments amounted to $7,508,492 at December 31, 2002, compared to $7,425,535 at December 31, 2001. The net cash used in the Company’s operating activities was $4,164,144, $5,040,478 and $5,127,473 for the years ended December 31, 2002, 2001, and 2000, respectively. Net cash used in investing activities, which is due to net investment activity for held-to-maturity investments and capital expenditures, amounted to $2,535,296 for the year ended December 31, 2002 compared to $4,523,068 and $2,560,824 of net cash provided by investing activities for the years ended December 31, 2001 and 2000, respectively. Capital expenditures, primarily related to the build out of the Company’s new pilot manufacturing and powder blending facilities within its Romeoville, Illinois facility and further expansion of the Company’s existing manufacturing facility and the purchase of related operating equipment, amounted to $1,749,177. This amount included $200,362 in non-cash items incurred for accounts payable relating to capital expenditures and $65,007 in capital lease obligations incurred for use of equipment for the year ended December 31, 2002 compared to $6,437,958, including $833,824 in non-cash items incurred for accounts payable relating to capital expenditures and $138,437 in capital lease obligations incurred for use of equipment for the year ended December 31, 2001, and $1,823,623 for the year ended December 31, 2000. Net cash provided by financing activities, is primarily due to the Company securing financing through a private placement in 2002 and other financing agreements, and to a lesser extent by the issuance of shares of Common Stock pursuant to the exercise of options and warrants, partially offset by principal payments on debt and capital lease obligations, amounting to $6,562,545 for the year ended December 31, 2002, compared to $626,953 and $2,415,176 for the years ended December 31, 2001and 2000, respectively.

On May 29, 2002, the Company secured equity funding through a private placement offering. The Company issued 1.37 million shares of additional common stock at $5.00 per share and received gross proceeds of $6.85 million. Net proceeds were approximately $6.2 million after commissions, legal, accounting, and other costs. The Company intends to use the proceeds to fund expected growth in new markets as well as to provide for expanded working capital needs expected to arise as sales volume grows.

The Company’s supply agreement with its largest customer contains several financial covenants which could potentially impact the Company’s liquidity. The most restrictive financial covenants under this agreement require the Company to maintain a minimum of $2.0 million in cash and investments, and no more than $10.0 million in debt, in order to avoid an event which could trigger a transfer of technology and equipment to the Company’s largest customer in the event that the Company’s cash, cash equivalents and investment balances drop below $2.0 million. The Company had approximately $7.5 million in cash and investments and debt of less than $2.0 million at December 31, 2002. Management expects that the proceeds received from the May, 2002 private placement offering should be sufficient to enable the Company to comply with these financial covenants for at least the next twelve months. This supply agreement and its covenants are more fully described in Note 16 of the Company’s financial statements.

The Company believes that cash from operations and cash, cash equivalents and investments on hand, together with the remaining net proceeds from the Company’s initial public offering of Common Stock (“the Offering”), and with its most recent funding received through a private placement offering, and interest income thereon, will be adequate to fund the Company’s operating plans for the next twelve months. The Company’s actual future capital requirements will depend, however, on many factors, including customer acceptance of the Company’s current and potential nanocrystalline materials and product applications, continued progress in the Company’s research and development activities and product testing programs, the magnitude of these activities and programs, and the costs necessary to increase and expand the Company’s manufacturing capabilities and to market and sell the Company’s

14

materials and product applications. Other important issues that will drive future capital requirements will be the development of new markets and new customers as well as the potential for significant unplanned growth with the Company’s existing customers. The Company expects capital spending in 2003 to be approximately $525,000, of which $200,000 relates to payments of accounts payable incurred in 2002 but not payable until 2003.

The following table highlights the Company’s contractual obligations:

At December 31, 2002, the Company had a net operating loss carryforward of approximately $45.2 million for income tax purposes. Because the Company may have experienced “ownership changes” within the meaning of the U.S. Internal Revenue Code in connection with its various prior equity offerings, future utilization of this carryforward may be subject to certain limitations as defined by the Internal Revenue Code. If not utilized, the carryforward expires at various dates between 2005 and 2022. As a result of the annual limitation and uncertainty as to the amount of future taxable income that will be earned prior to the expiration of the carryforward, the Company has concluded that it is likely that some portion of this carryforward will expire before ultimately becoming available to reduce income tax liabilities. At December 31, 2002, the Company also had a foreign tax credit carryforward of $246,000, which could be used as an offsetting tax credit to reduce U.S. income taxes. The foreign tax credit will expire at various dates between 2005 and 2022, if not utilized before that date.

Should events arise that make it appropriate for the Company to seek additional financing, it should be noted that additional financing may not be available on acceptable terms or at all, and any such additional financing could be dilutive to the Company’s stockholders. Such a financing could be necessitated by such things as; the loss of existing customers; currently unknown capital requirements which may be needed to retain existing business or remain competitive in the seeking of new business; new regulatory requirements that are outside the Company’s control; or various other circumstances coming to pass that are currently not anticipated by the Company.

Item 7A.    Quantitative and Qualitative Disclosures About Market Risk

The Company does not have any material market risk sensitive instruments.

Item 8.    Financial Statements and Supplementary Data

The financial statements and financial statement schedule, with the report of independent auditors listed in Item 15 are included in this Form 10-K.

15

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

At a meeting held on November 27, 2001, the Board of Directors of the Company approved the engagement of McGladrey & Pullen, LLP as its independent auditors for the fiscal year ending December 31, 2001 to replace the firm of Ernst & Young LLP, as auditors of the Company. This change was effective December 3, 2001. The audit committee of the Board of Directors approved the change in auditors.

The reports of Ernst & Young LLP on the Company’s financial statements for the year ended December 31, 2000 did not contain an adverse opinion or a disclaimer of opinion and were not qualified or modified as to uncertainty, audit scope, or accounting principles.

In connection with the audits of the Company’s financial statements for each of the two fiscal years ended December 31, 2000, and in the subsequent interim period, there were no disagreements with Ernst & Young LLP on any matters of accounting principles or practices, financial statement disclosure, or auditing scope and procedures which, if not resolved to the satisfaction of Ernst & Young LLP would have caused Ernst & Young LLP to make references to the matter in their report.

The Company engaged McGladrey & Pullen, LLP as its new independent accountants as of December 3, 2001. Prior to this date, the Company did not consult with McGladrey & Pullen, LLP regarding the (i) application of accounting principles to a specified transaction, either completed or proposed, (ii) the type of audit opinion that might be rendered on the Company’s financial statements, or (iii) any other matter that was the subject of a disagreement between the Company and its former auditor as defined in paragraph 304(a)(1)(iv) of Regulation S-K.

16

PART III

Item 10.    Directors and Executive Officers of the Registrant

The information in response to this item is incorporated by reference from the “Proposal No. 1—Election of Directors,” “Executive Officers” and “Section 16(a) Beneficial Ownership Compliance” sections of the Definitive Proxy Statement to be filed with the Commission in connection with the Company’s 2003 Annual Meeting of Stockholders (the “2003 Proxy Statement”).

Item 11.    Executive Compensation

The information in response to this item is incorporated by reference from the section of the 2003 Proxy Statement captioned “Executive Compensation and Certain Transactions.”

Item 12.    Security Ownership of Certain Beneficial Owners and Management

The information in response to this item is incorporated by reference from the section of the 2003 Proxy Statement captioned “Security Ownership of Management and Principal Stockholders.”

Item 13.    Certain Relationships and Related Transactions

The information in response to this item is incorporated by reference from the section of the 2003 Proxy Statement captioned “Executive Compensation and Certain Transactions.”

Item 14.    Controls and Procedures

Within 90 days prior to the filing date of this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Acting Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures pursuant to Rules 13a-14 and 15d-14 of the Securities Exchange Act of 1934, as amended. Based upon that evaluation, the Company’s Chief Executive Officer and Acting Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective. It should be noted that in designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management, necessarily, was required to apply its judgement in evaluating the cost-benefit relationship relating to possible controls and procedures.There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect internal controls subsequent to the date of the evaluation referred to above.

17

PART IV

Item 15.    Exhibits, Financial Statement Schedules and Reports on Form 8-K

Report of McGladrey & Pullen, LLP, Independent Auditors

Report of Ernst & Young, LLP, Independent Auditors

Balance Sheets as of December 31, 2002 and 2001

Statements of Operations for the Years Ended December 31, 2002, 2001 and 2000

Statements of Stockholders’ Equity for the Years Ended December 31, 2002, 2001 and 2000

Statements of Cash Flows for the Years Ended December 31, 2002, 2001 and 2000

Notes to Financial Statements

Schedule II — Valuation and Qualifying Accounts

All other financial schedules are omitted because such schedules are not required or the information required has been presented in the aforementioned financial statements.

Exhibit

Number

18

19

20

None.

21

NANOPHASE TECHNOLOGIES CORPORATION

INDEX TO FINANCIAL STATEMENTS

F-1

Report of Independent Auditors

The Board of Directors and Stockholders

Nanophase Technologies Corporation

We have audited the accompanying balance sheets of Nanophase Technologies Corporation as of December 31, 2002 and 2001, and the related statements of operations, stockholders’ equity, and cash flows for the years then ended. Our audits also included the 2002 and 2001 data in the financial statement schedule, Schedule II – Valuation and Qualifying Accounts, listed in the index at Item 15(a). These financial statements and the schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. 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 financial statements referred to above present fairly, in all material respects, the financial position of Nanophase Technologies Corporation at December 31, 2002 and 2001, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the 2002 and 2001 data in the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set therein.

/s/    McGladrey & Pullen, LLP

McGladrey & Pullen, LLP

Schaumburg, Illinois

January 31, 2003, except for the

first paragraph of Note 17, for

which the date is March 17, 2003

F-2

Report of Independent Auditors

The Board of Directors and Stockholders

Nanophase Technologies Corporation

We have audited the accompanying statements of operations, stockholders’ equity, and cash flows of Nanophase Technologies Corporation for the year ended December 31, 2000. Our audit also included the financial statement schedule for the period ended December 31, 2000, listed in the index at Item 15 (a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audit.

We conducted our audit in accordance with auditing standards generally accepted in the 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 audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of Nanophase Technologies Corporation for the year ended December 31, 2000, in conformity with accounting principles generally accepted in the United States. Also in our opinion, the related financial statement schedule for the year ended December 31, 2000, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

/s/    Ernst & Young LLP

Ernst & Young LLP

Chicago, Illinois

February 2, 2001

F-3

NANOPHASE TECHNOLOGIES CORPORATION

BALANCE SHEETS

(See accompanying Notes to Financial Statements)

F-4

NANOPHASE TECHNOLOGIES CORPORATION

STATEMENTS OF OPERATIONS

(See accompanying Notes to Financial Statements)

F-5

NANOPHASE TECHNOLOGIES CORPORATION

STATEMENTS OF STOCKHOLDERS’ EQUITY

(See accompanying Notes to Financial Statements)

F-6

NANOPHASE TECHNOLOGIES CORPORATION

STATEMENTS OF CASH FLOWS