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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

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  x    No  ¨

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 30, 2004 was $93,918,685 as of such date.

The number of shares outstanding of the registrant’s common stock, par value $.01, as of March 14, 2005 was 17,912,852.

DOCUMENTS INCORPORATED BY REFERENCE

None.

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PART I

Item 1. Business

General

Nanophase Technologies (“Nanophase” or the “Company”) is a nanomaterials (also referred to as nanocrystalline materials or nanoparticles) developer and commercial manufacturer. Nanophase employs patented, patent-pending and proprietary technology to create nanomaterials, typically in the range of 5-100 nanometers, which may be singular or multi-element oxides, including rare earth materials. Nanophase applies its technologies to modify the nanoparticle and nanoparticle surface to manipulate electrical, mechanical, optical and other properties, while precisely controlling the particle size and other physical parameters. The Company also uses its technologies to create materials, not normally found naturally, that offer special performance attributes.

Nanophase has created an integrated platform of nanomaterial technologies that are designed to deliver, typically in the metric ton range, an engineered nanomaterial solution for a particular target market or specific customer application. Nanophase’s technologies consist of two distinct nanoparticle or nanomaterial manufacturing processes (physical vapor synthesis (“PVS”) and NanoArc^™ synthesis), nanoparticle surface treatment(s) technologies and dispersion technologies. The Company delivers various nanomaterials at commercial quality and quantity. Nanophase’s products are available as nanoparticles, surface-treated nanoparticles and stable nanoparticle dispersions in aqueous or organic media, providing customers with nanomaterials in readily usable forms. The diverse markets Nanophase currently serves include personal care, sunscreens, abrasion-resistant applications, environmental catalysts, antimicrobial products and a variety of polishing applications, including semiconductors and optics. New markets and applications also are being developed. The Company’s customers include multinational corporations and Fortune 500 companies.

Nanophase reduces the cycle time for innovation by working with certain customers to jointly develop optimal nanoengineered solutions for particular market needs or specific customer applications. The Company has complete capability from application development and laboratory samples through pilot quantities and commercial production. The Company has extensive research and development facilities and application laboratories, as well as manufacturing capacity based in two locations in the Chicago area. This capability allows Nanophase to develop and supply nanomaterials in quantities ranging from grams to metric tons. Nanophase’s business model is based on strategic partnerships, typically with companies who currently occupy a targeted market channel(s), and supplying nanomaterials to individual customer-specific needs.

Most 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.

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 or Nanomaterials

Nanomaterials generally are made of particles (nanoparticles) that are less than 100 nanometers in diameter. A nanometer is a billionth of a meter. To put this in perspective, a six foot tall person is approximately two billion nanometers tall. Viewing the same analogy differently, if every person in the U.S. was only one nanometer tall, and all of these people were stacked one on top of the other, they would result in a figure less than 12 inches in height.

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Nanomaterials are in the diverse field of nanotechnology, but are a distinct area of the field. Nanomaterial properties depend upon the composition, size, shape, structure and surface of the individual particles, as well as other possible parameters. 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 control of nanoparticles, and many of their attributes, allows it to engineer materials at a very small level to meet relatively precise application or performance requirements.

Typical uses for nanomaterials are in manufactured products (sunscreens and other personal care products) or in manufacturing processes (fine polishing, coatings and catalysts). In many applications, nanomaterials offer advantages such as improved performance, lower overall product cost, or the development of new products or processes.

The Company’s Technologies

Nanophase intends to maintain and grow its intellectual property position in the emerging science of nanomaterials through the development of new materials and processes, many of which management expects to result in the issuance of future patents (see “Item 1. Business–Intellectual Property and Proprietary Rights”). Nanophase has created an integrated platform of nanomaterial technologies that are patented, patent-pending or proprietary and designed to deliver a nanomaterial solution for a particular market or specific customer application. Nanophase’s technologies consist of two distinct nanoparticle, or nanomaterial, manufacturing processes (PVS and NanoArc^™ synthesis), nanoparticle surface treatment(s) technologies and dispersion technologies. These technologies define the equipment and methods used for the commercial manufacture of nanoparticles, surface-treatment and coating of nanoparticles and dispersion of nanparticles in a variety of media. The Company’s technologies have been demonstrably scalable and robust, having produced more than a hundred metric tons of nanomaterials during each of the last five years.

The Company uses its technologies to engineer and produce nanocrystalline materials designed for specific product applications. Currently, the Company’s major nanomaterials are: coated zinc oxide for sunscreens, dispersed ceria for fine polishing applications, uncoated zinc oxide for personal care applications and various nanomaterials for coatings and sealant applications. Nanophase has various other nanomaterials that it is selling to existing markets at lower volume levels. The Company hopes to expand the sales of some of these materials considerably, in terms of revenue, over time. Nanophase also is engaged in ongoing research, technology development and where appropriate, technology-licensing activities that add to its core technologies or provide complementary technologies. Part of the Company’s strategy involves reviewing new technologies outside of the Company to potentially add to its internal research and development efforts. From time to time, in areas that are complementary to its growth strategies, the Company may license or procure outside technology to augment its internally developed technologies. The Company’s goal is to remain at the forefront of nanomaterials technologies.

Nanophase has been steadily expanding both its patented technologies and its ability to successfully practice these technologies. Through large-scale manufacturing of nanomaterials utilized in the manufacture of consumer sunscreen and personal care products, the Company has developed production expertise that has allowed it to improve processes relating to those nanomaterials, as well as processes relating to other nanomaterials. This experience has translated into additional patents and pending patents and improvement of the Company’s technologies and manufacturing processes to reduce variable manufacturing cost and improve future gross margins.

Newer developed technologies have opened the capability for certain new products and new markets. With the commercialization of the Company’s new NanoArc^™ synthesis and new dispersion technologies in 2002, and the expansion of these capabilities in 2003 and 2004, Nanophase is focusing on penetrating the chemical-mechanical-planarization (“CMP”) and fine polishing markets. CMP is the

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process of polishing various types of integrated circuits or chips to be used in various commercial electronics applications. Management believes that Nanophase’s inroads in the CMP and fine polishing markets would have been very difficult without the Company being able to produce its materials to exacting specifications verified by in-house and customer-based testing. The Company is also exploiting these capabilities in focusing on the coatings and sealants markets through its partnership with Altana Chemie, AG (“Altana”).

Essentially all of the research and development at Nanophase is directly related to product development for applications. The Company endeavors to either meet specific stated customer needs or to develop applications solutions to unmet needs in a particular market 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 its position as a technical and commercial innovator in the nanomaterials field.

Marketing

The Company markets and sells its products through a combination of business development and sales activities in collaborative relationships with lead customers 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 typically forms a technical/marketing team that offers the customer an engineered solution to meet that customer’s specific requirements. Nanophase tailors its 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 through horizontal marketing. These collaborations often begin with sample requests from potential customers, followed by an open dialog regarding the needs of those potential customers and the capabilities of Nanophase. 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 the Company’s collaboration has involved sharing information and developing the current product and next generation products to better perform within BASF’s existing customers’ various products and systems. BASF is currently the Company’s largest customer. Nanophase and BASF have entered into a supply agreement that requires BASF to buy a minimum of 70% 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 its exclusive worldwide rights to use the Company’s zinc oxide products in the sunscreen and personal care markets. This agreement, which has no set expiration date, can currently be terminated by either party with two years notice under certain conditions. In November of 2000, BASF agreed to lend the Company approximately $1.3 million to construct a nanoparticle coating facility at its Romeoville, Illinois location. See Note 7 to the Financial Statements and the “Liquidity and Capital Resources” section of “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

In the case of Rohm and Haas Electronic Materials (“RHEM”), formerly known as Rodel, the Company has collaborated in selling current generation ceria-based chemical-mechanical-planarization (“CMP”) materials to RHEM’s customers. RHEM and Nanophase have entered into a supply agreement which requires RHEM to purchase 100% of its annual requirements for, and specified minimum dollar amounts of, nanocrystalline ceria for use in CMP of semiconductors in order for RHEM to retain its exclusive worldwide rights to the Company’s nanocrystalline ceria products in this field of use. In February of 2004, the Company amended its original agreement with RHEM. This amendment allowed for RHEM to maintain exclusivity based upon it purchasing lower dollar amounts of nanocrystalline materials, while extending the agreement through 2009. This amendment did not require RHEM to

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purchase any materials from the Company in 2004, but it did require an aggregate of $600,000 in development funding be paid to Nanophase in four equal quarterly installments in 2004 to support its efforts in joint slurry product development with RHEM for current and future semiconductor technologies. In October of 2004, the Company amended its original agreement with RHEM a second time. This amendment reduced the minimum purchase requirements necessary to maintain the Company’s exclusivity obligations to RHEM by approximately 44% during 2005. The reduction reflects the parties’ recognition of the difficulty in precisely estimating the timing of product development and sales in the semiconductor polishing market.

In an additional smaller volume fine polishing application, the Company was selected as the recommended nanoparticle dispersion polishing supplier by a leading manufacturer of optical polishing equipment. Management believes that this vote of confidence, while not relating to substantial direct revenue, will help to establish Nanophase as a supplier of quality materials in the fine polishing market in general.

The Company leverages its resources through relationships with organizations focused on market-specific (e.g., BASF, RHEM) or geography-specific areas. These relationships enhance Nanophase’s ability to quickly develop lead customers and applications for its products. Another of these relationships is with C. I. Kasei, a division of Itochu Corporation (“CIK”). CIK develops, engineers and manufactures products under license from the Company (specifically for the Company’s PVS technology) for use in multiple industrial markets. The Company’s agreement with CIK stipulates a minimum royalty every twelve months 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 in designated parts of Asia. After that time, the agreement calls for a royalty of 2% of CIK’s sales of licensed product, at which time CIK’s license of Nanophase’s PVS technology in designated parts of Asia would become non-exclusive. CIK may terminate its agreement with the Company at any time upon 90 days prior written notice. Management does not believe that revenue related to the CIK agreement will contribute significantly, beyond the levels it has in the past, to the near-term growth of the Company.

On March 23, 2004, the Company received $10,000,000 in gross proceeds in the form of an equity investment from Altana, a large German chemical company. Altana received 1,256,281 shares of Nanophase common stock. Altana and Nanophase have agreed that the shares will remain unregistered, and therefore not freely saleable, until March 23, 2006. Simultaneous to this transaction, the Company executed a joint development agreement with Altana in order to explore new product applications in fields that are mutually beneficial to both companies. Pursuant to the agreement, the Company and Altana have granted each other, subject to limited exceptions, exclusive rights for the development and purchase of nanomaterials for use in paints, coatings, inks, polymers and plastics, varnishes and similar applications.

Management believes that this agreement will be beneficial to the Company in several ways. Altana is a prominent ingredient supplier to many industries that the Company has had limited success in approaching in the past (including paint and industrial coatings companies). By approaching these companies at the ingredient-supplier level, with the Company’s materials already compounded into Altana’s ingredient products, the Company expects a higher likelihood of success in various applications and in these industries.

Secondly, Altana has global sales, technical support, capabilities for basic research, additional application development capability to incorporate nanomaterials, and an existing customer base and market relationships. Nanophase expects that this new partnership will help Nanophase to address markets at an entry point that should allow for quicker and broader adoption of nanomaterials in composite coatings and plastics. This mutually exclusive agreement is separate and distinct from the Company’s existing agreements with BASF and RHEM, as the fields of application do not intersect. Management expects Altana to continue to develop new products and market them on an ongoing basis. They should become a significant customer of Nanophase during 2006. The agreement with Altana has an initial term of eight years, with one-year renewal provisions.

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A limited number of key customers account for a substantial portion of the Company’s commercial revenue. In particular, revenue from BASF, RHEM and CIK constituted approximately 69.7%, 12.9% and 6.2%, respectively, of the Company’s 2004 total revenue. The Company’s customers are significantly larger than the Company and are able to exert a high degree of influence over the Company. While the Company’s agreements with its three largest customers are long-term agreements, they may be terminated by the customer with reasonable notice and do not provide any guarantees that these customers will continue to buy the Company’s products. 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 marketing representatives or 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 markets itself and its capabilities through its Web site, by advertising in selected industry and trade journals and by providing specification sheets and other marketing materials to prospective customers. In addition, Nanophase networks with certain 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 explore potential technical relationships and collaborative applications research.

Technology and Engineering

The Company’s Technology and Engineering Group includes the research and development, process engineering and advanced engineering functions. Consistent with the Company’s goal to remain at the forefront of nanomaterials technologies, the 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 new nanomaterials and associated applications, usually working directly with potential and current customers.

Nanophase’s total research and development expense (which doesn’t take in to account amounts spent by our largest customers in support of our partnerships), which includes all expenses relating to the technology and advanced engineering groups, during the years ended December 31, 2004, 2003 and 2002 was $1,929,348, $1,906,791 and $1,572,997, 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. Through the five-year period ended December 31, 2004, the Company has had cumulative research and development expenses of approximately $8.8 million and cumulative expenditures on equipment and leasehold improvements of approximately $10.5 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 nanoparticles, utilizing two different methods: “PVS” and NanoArc^™ synthesis. The Company also has a large quantity nanoparticle coating operation to support its sunscreen business, as well as dispersion equipment to support its CMP and polishing initiatives and other product and market areas.

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The Company has manufacturing capacity based in two locations in the Chicago area. At each of these facilities, Nanophase is able to develop and supply its nanomaterials in quantities ranging from grams to metric tons. Nanophase’s facilities are certified to ISO 9001:2000 international standards and are current Good Manufacturing Practices (cGMP) compliant for applicable bulk pharmaceutical manufacturing. All processes are controlled under Six-Sigma discipline with the capability to manufacture precisely to application requirements. Unlike traditional quality control, Six Sigma provides methods to reengineer processes to eliminate non-value added steps and create a system that minimizes errors and defects. Nanophase’s operations employ a cellular team-based manufacturing approach, where workers operate in work “cells,” under a Lean Manufacturing environment to continuously advance production capabilities.

Management is committed to a Lean Manufacturing approach where, to the extent possible given a certain measure of irregular demand, the Company is able to avoid excess labor, inventory and supply levels in order to minimize working capital demands. This approach complements our production management in the sense that two of the Company’s major production goals are to increase nanomaterials output without adding to existing equipment and the continuous reduction of production costs.

Intellectual Property and Proprietary Rights

Nanophase relies primarily on a combination of patent, trademark, copyright, 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 certain third-party patents to expand its technology base. During 2004, Nanophase continued to strengthen its intellectual property portfolio by adding to its patents, pending patents, and proprietary knowledge. As of the date of this report, Nanophase owns or licenses 25 US patents and patent applications consisting of 9 owned US patents, 10 pending US patent applications, 2 licenses to pending US patent applications and 4 licensed US patents. The 9 owned US patents consist of 6 for its nanoparticle synthesis technologies, 2 for its surface treatment technologies and 1 for its nanoparticle applications in coating. The Company’s pending US patents consist of 3 in nanoparticle synthesis, 3 in nanoparticle surface treatments involving dispersion of nanoparticles in various media and 4 in nanoparticle applications. Correspondingly, the Company has 49 foreign patents and pending patent applications consisting of 15 owned foreign patents and 34 pending foreign patents. All of the pending and owned foreign patents are counterparts to domestic filings covering its platform of nanotechnologies. In addition, the Company’s management believes that, based on its past experience, up to 3 of its currently pending patent applications will be issued in 2005. The Company’s oldest patents will begin to expire in 2009.

See the “Risk Factors” section of “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a discussion of risks related to our intellectual property and proprietary rights.

Competition

Within each of its targeted markets and product applications, Nanophase faces current and potential competition from many advanced materials and chemical companies, suppliers of traditional materials and the in-house capabilities of several of its current and potential customers. In many markets, the Company’s competitors are larger and more diversified than the Company, although management believes its materials and related technologies are superior to those of its competitors in terms of their ability to be readily engineered to meet specific performance requirements. With respect to traditional suppliers, however, the Company competes against lower priced traditional materials where the benefits of using nanomaterials do not always outweigh their typically higher costs. With respect to larger producers of nanomaterials, while many of these producers do not currently offer competitive products, these companies have greater financial and technical resources, larger research and development staffs

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and greater manufacturing and marketing capabilities and could soon begin to compete directly against Nanophase. In addition, the number of development-stage companies involved in nanocrystalline materials continues to grow on a global basis, 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 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 development stage companies, especially in other countries, receive significant local 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 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, other than creating additional expense due to their reach and complexity, those regulations have not materially restricted or impeded operations.

Employees

On December 31, 2004, the Company had a total of 51 full-time employees, 12 of whom hold advanced degrees. Nanophase has no collective bargaining arrangements.

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 23, 2003, the Company hired Dr. Edward G. Ludwig as its Vice President of Business Development.

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 retained Dr. Kritchevsky’s services through December 2003 as a consultant.

Backlog

Nanophase does not believe that a backlog as of any particular date is indicative of future results. The Company’s sales are made primarily pursuant to purchase orders for delivery of nanomaterials. Nanophase has some agreements that give customers the right to purchase a specific quantity of nanomaterials during a specified time period. These agreements, however, often do not obligate the customers either to purchase any particular quantity of such nanomaterials at all, or in the case where an obligation exists, the risk to the customer for not purchasing nanomaterials is the loss of exclusivity. The quantity actually purchased by the customer, as well as the shipment schedules, are frequently revised during the agreement term to reflect changes in the customer’s needs. The Company does not believe that such agreements are meaningful for determining backlog amounts.

Business Segment and Geographical Information

See Note 17 to the Financial Statements for additional information.

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Forward-Looking Statements

Nanophase 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 of 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 2005 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 in light of the Company’s dependence on a limited number of key customers; uncertain demand for, and acceptance of, the Company’s nanocrystalline materials; the Company’s manufacturing capacity and product mix flexibility in light of customer demand; 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 in which the Company may become involved; and other risks set forth under the caption “Risk Factors” below. 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.

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 with, 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.

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 locations are in Chicago suburbs. The Company also leases a 6,000 square-foot offsite warehouse in the same vicinity.

The Company’s manufacturing operations in Burr Ridge are registered under ISO 9001:2000, and the Company’s management believes that its manufacturing operations are within the current Good

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Manufacturing Practices (cGMP) requirements of the FDA for products that require such compliance. 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.

The Romeoville facility houses the Company’s headquarters, advanced engineering, manufacturing (nanoparticle coating, nanoparticle dispersion, and pilot-scale manufacturing) and three research and development laboratories, and was used for additional commercial manufacturing space in 2004. All Romeoville manufacturing processes are certified to ISO 9001:2000 and the Company’s management believes that the nanoparticle coating used for sunscreens and personal care is in compliance with the cGMP requirements of the FDA.

Nanophase leases its Romeoville facility under an agreement. The initial term of the lease expires in July 2006, but the Company has an option to extend the lease for two additional periods of five years each. Nanophase also leases its Burr Ridge facility. The Company renewed its Burr Ridge facility lease in September 2004. The initial term of the lease expires in September 2007, but the Company has options to extend the lease for up to three additional one-year terms.

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 made in 2004 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.

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 2004.

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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 1, 2005, the last reported sale price of the common stock was $7.16 per share, and there were approximately 160 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.

Prior to 2004, the Company paid outside directors with a combination of common stock grants and cash. Under the pre-2004 compensation model, the annual compensation paid to each outside director had a value of approximately $25,000. In January 2003, the Company granted 4,870 restricted shares of common stock to each of Donald Perkins, James Henderson, James McClung, Jerry Pearlman and Richard Siegel for services performed in their capacity as directors. Beginning in 2004, the Company has paid $6,250 as quarterly compensation, which will amount to an annual total of $25,000 per outside director, for services performed in their capacity as directors. The Company did not grant any common stock to its directors in 2004. Beginning in 2004, Mr. McClung’s cash compensation is being paid to Lismore International, Incorporated.

On March 23, 2004, the Company sold, in a private placement to Altana Chemie AG (“Altana”), 1,256,281 shares of common stock at $7.96 per share and received gross proceeds of $10.0 million. On January 22, 2004, the Company filed a universal shelf registration statement with the Securities and Exchange Commission to allow Nanophase to offer up to $15.0 million of Nanophase securities, in the form of common stock or various types of debt securities, in the future. In August 2004, the Company withdrew its universal shelf offering due to unfavorable market conditions and the Company’s adequate cash position to cover expected growth through 2006.

On September 8, 2003, the Company secured equity funding through a private placement offering with Grace Brothers, Ltd., its largest investor. The Company issued 453,001 shares of additional common stock at $4.415 per share and received gross proceeds of $2.0 million. Grace Brothers, Ltd. also had the right to purchase an additional 453,001 shares for an additional $2.0 million pursuant to the terms of a warrant issued in such private placement. In accordance with the terms of such private placement, on June 7, 2004, the Company filed a registration statement for such 453,001 shares and the additional 453,001

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shares issuable upon exercise of the warrant which registration statement was declared effective on August 13, 2004. On September 2, 2004, Grace Brothers, Ltd. exercised its warrant rights to acquire 453,001 newly issued shares of common stock and the Company received $2 million in gross proceeds.

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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, 2004 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. See the “Forward Looking Statements” section in Part I., Item 1.

Overview

Nanophase Technologies is a nanocrystalline materials developer and commercial manufacturer with an integrated family of nanomaterial technologies. Nanophase produces engineered nanomaterials for use in a variety of diverse markets: sunscreens, personal care, abrasion-resistant applications, environmental catalysts, antimicrobial products and a variety of polishing applications, including semiconductors, hard disk drives and optics. The Company targets markets in which it feels practical solutions may be found using nanoengineered products. The Company works closely with leaders in these target markets to identify their material and performance requirements. Newer developed technologies have made certain new products possible and opened potential new markets. With the commercialization of the Company’s new NanoArc^™ synthesis and new dispersion technologies in 2002, and the expansion of these capabilities in 2003 and 2004, Nanophase is focusing on penetrating the chemical-mechanical-planarization (“CMP”) and fine polishing markets. 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 Company’s inroads in the CMP and fine polishing markets would have been very difficult without the Company being able to produce its materials to exacting specifications verified by in-house and customer-based testing. Management expects growth in end-user (customers of Nanophase’s customers) adoption in 2005 and revenue growth beginning in 2005 in both of these areas. Additionally, the Company feels that its exclusive relationship with Altana Chemie (“Altana”), a global ingredients supplier to various coatings industries, will lead to growth in several of its abrasion-resistant applications in the marketplace. Nanophase shipped initial quantities of material to Altana in the second, third and fourth quarters of 2004. Management expects this relationship to continue to develop in 2005.

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, 2004, the Company was primarily capitalized through the private offering of approximately $32.0 million of equity securities prior to its initial public offering, its initial public offering of $28.8 million of common stock in November of 1997, its private offering of $6.2 million of common stock in May of 2002, its private offering of $1.95 million of common stock in September of 2003, its equity investment of $9.2 million in March 2004 and its private offering of $1.95 million of common stock in September of 2004, each net of issuance costs. The Company has incurred cumulative losses of $52.2 million from inception through December 31, 2004.

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Critical Accounting Policies

Nanophase utilizes certain accounting measurements under applicable generally accepted accounting principles that involve the exercise of management’s judgment about subjective factors and estimates about the effect of matters which are inherently uncertain. Actual results may differ from these estimates. The following is a summary of those accounting measurements that involve business judgments 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 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 development funding (see RHEM discussion in Note 1), technology license fees and the sale of production equipment that is designed and built by the Company. Such sale of equipment last occurred in the first quarter of 2003. These types of equipment sales occur on occasion and are also treated as other revenue. This transaction is discussed in further detail below. Technology license fees 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 establish a new cost basis, which is not increased for future increases in market value of inventories or changes in estimated excess quantities. If expected demand were either to unexpectedly accelerate or diminish for materials currently in inventory, this could cause management’s estimates to become inaccurate resulting in potential increases in inventory allowances (in the case of diminished demand), reducing gross margins or potential enhancements to gross margins caused by demand for items previously thought to have reduced near-term marketability.

Trade Accounts Receivable. Trade accounts receivable are carried at original invoice amount less an estimate made for doubtful receivables, typically 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.

Impairment or Disposal of Long-Lived Assets. Reviews are regularly performed to determine whether facts and circumstances exist which indicate that the carrying amount of assets may not be recoverable or that the useful life is shorter than originally estimated. The Company assesses the recoverability of its assets by comparing the projected undiscounted net cash flows associated with the related asset or group of assets over their remaining lives against their respective carrying amounts. Impairment, if any, is based on the excess of the carrying amount over the fair value of those assets. If assets are determined to be recoverable, but the useful lives are shorter than originally estimated, the net book value of the assets is depreciable over the newly determined remaining useful lives.

Asset Retirement Obligations. The Company records the fair value of a liability for an asset retirement obligation which was recognized in the period it was incurred. The associated retirement costs are capitalized as a component of the carrying amount of the long-lived asset and allocated to expense over the useful life of the asset.

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Results of Operations

Years Ended December 31, 2004 and 2003

Total revenue decreased to $5,207,934 in 2004, compared to $5,446,661 in 2003. A substantial majority of the Company’s revenue for the year ended December 31, 2004 is from the Company’s three largest customers. See Note 16 to the Financial Statements for additional information regarding the revenue the Company derived from these three customers for the year ended December 31, 2004. Product revenue decreased to $4,253,478 in 2004, compared to $4,880,313 in 2003. The decrease in product revenue was primarily attributed to decreased sales of CMP materials to Rohm and Haas Electronic Materials CMP, Inc. (“RHEM,” formerly known as Rodel, Inc.), the Company’s second largest customer in 2004. The decrease was partially offset by increased product sales to the Company’s largest customer and to a lesser extent its new customer Altana Chemie AG. The Company and its largest customer currently have a technology agreement in place to jointly develop the second generation of sunscreen nanomaterials and for other potential personal care applications. Management anticipates the launch of one or more new sunscreen or personal care applications in 2005.

Other revenue increased to $954,456 in 2004, compared to $566,348 in 2003. The increase was largely due to revenue in the amount of $600,000 for the year ended December 31, 2004 in technology development funding from RHEM. This technology development funding from RHEM is part of its $600,000 commitment in 2004 described below. This increase in revenue was offset in part by $226,450 from the sale of a physical-vapor-synthesis (“PVS”) reactor in March of 2003 to C.I. Kasei, the Company’s Japanese licensee (and third largest customer in 2004) that was not repeated in 2004. These types of equipment sales occur on occasion (not on a regular basis) and are treated as other revenue.

In February of 2004, the Company amended its original agreement with RHEM. This amendment allows for RHEM to maintain exclusivity based upon it purchasing lower dollar amounts of nanocrystalline materials, while extending the agreement through 2009. This amendment did not require RHEM to purchase any materials from the Company in 2004, but it did require an aggregate of $600,000 in development funding be paid to Nanophase in four equal quarterly installments in 2004 to support its efforts in joint slurry product development with RHEM for current and future semiconductor technologies. In October of 2004, the Company amended its original agreement with RHEM a second time. This amendment reduced the minimum purchase requirements necessary to maintain the Company’s exclusivity obligations to RHEM by approximately 44% during 2005. The reduction reflects the parties’ recognition of the difficulty in precisely estimating the timing of product development and sales in the semiconductor polishing market.

In an additional smaller volume fine polishing application, the Company was selected as the recommended nanoparticle dispersion polishing supplier by a leading manufacturer of optical polishing equipment. Management believes that this vote of confidence, while not relating to substantial direct revenue, will help to establish Nanophase as a supplier of quality materials in the fine polishing market in general.

The majority of the total revenue generated during the year ended December 31, 2004 was from customers and development partners in the healthcare (sunscreens) and CMP markets, including the development funding discussed in the preceding paragraph, and came principally from the Company’s current two largest customers described above.

Cost of revenue generally includes costs associated with commercial production and customer development arrangements. Cost of revenue decreased to $5,125,216 in 2004, compared to $5,205,065 in

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2003. The decrease in cost of revenue was generally attributed to lower product revenue volume, decreased depreciation expense and the Company’s continued efficiencies in reducing its variable manufacturing costs on nanomaterials. The Company is completing a series of process improvements that are targeted to increase PVS reactor output by 20-30% in conjunction with a re-engineering program that has reduced the expected operational labor cost by 25% on high volume PVS-produced nanomaterials. Nanophase expects to maintain an aggressive schedule for new nanomaterial development, primarily using its NanoArc^™ synthesis and dispersion technologies, for targeted applications and new markets throughout 2005. The decreases were partially offset by increased health care costs and changes in product mix. At current revenue levels, with the contribution from other revenue, the Company has generated a modest positive gross margin. The Company’s margins have been impeded by not having enough revenue to absorb the manufacturing overhead that is required to work with current customers and the new ones the Company expects to have. The extent to which the Company’s margins remain positive, as a percentage of total revenue, will be dependent upon revenue mix, revenue volume and the Company’s ability to continue to cut costs. As product revenue volume increases, this will result in more of the Company’s fixed manufacturing costs being absorbed, leading to increased margins. The Company expects to continue reducing its product manufacturing costs in 2005 but may not necessarily continue to operate at a positive gross margin in 2005, dependent upon the factors 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. For example, the Company has been and continues to be 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. Much of this work has led to new potential products for use by Altana. Now that the Company has demonstrated the capability to produce pilot quantities of mixed-metal oxides in a single crystal phase, the Company does not expect development of further variations on these materials to present material technological challenges. Many of these materials exhibit performance characteristics that can enable them to serve in various catalytic applications. This development has been driven largely by customer demand. Management is now working on several related commercial applications. The Company expects that this technique should not be difficult to scale to large quantity commercial volumes once application viability and firm demand are established. 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. The Company is not certain when or if any significant revenue will be generated from the production of the materials described above. Research and development expense increased to $1,929,348 in 2004, compared to $1,906,791 in 2003. The increases in research and development expense was largely attributed to increased salaries, repairs and maintenance and health insurance expenses. These increases were partially offset by decreased spending in consulting fees relating to the ending of a one-year consulting agreement between the Company and its former Chief Technology Officer in December 2003. The Company does not expect research and development expense to increase significantly in 2005.

Selling, general and administrative expense increased to $4,361,357 in 2004, compared to $4,095,877 in 2003. The net increase was primarily attributed to increases in audit fees, health insurance, investor relations, compensation and travel expenses. These increases were partially offset by decreases in director and officers insurance expense and legal fees.

Interest income increased to $171,582 in 2004, compared to $67,992 in 2003. These increases were primarily due to an increase of funds available for investment, largely composed of the March 23, 2004 equity investment from Altana which resulted in net proceeds of approximately $9.2 million.

Other expenses increased to $306,273 in 2004, compared to $5,319 of other income in 2003. The

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increases were primarily due to the Company taking a one-time charge in the amount of $288,000 for accounting and legal costs associated from the withdrawal of the Company’s universal shelf registration in August 2004.

Years Ended December 31, 2003 and 2002

Total revenue increased to $5,446,661 in 2003, compared to $5,401,215 in 2002. The increase in total revenue between 2003 and 2002 was mainly attributed to the sale of production equipment to an existing customer as discussed below. Product revenue decreased to $4,880,313 in 2003, compared to $5,002,986 in 2002. The decrease in product revenue was primarily attributed to approximately $1.1 million in decreased sales from three sources; the Company’s largest customer in the sunscreen and personal care markets and two other existing customers in the abrasion-resistant flooring and automotive catalyst markets. The Company and its largest customer currently have a technology agreement in place to jointly develop the second generation of sunscreen nanomaterials and for other potential personal care applications. The decrease in sales from these three sources was somewhat offset by approximately $900,000 in increased revenue from RHEM, a customer since 2002, in the CMP market.

In February of 2004, the Company amended its original agreement with RHEM. This amendment allows for RHEM to maintain exclusivity based upon it purchasing lower dollar amounts of nanocrystalline materials, while extending the agreement through 2009. This amendment does not require RHEM to purchase any materials from the Company in 2004, but it does require an aggregate of $600,000 in development funding be paid to Nanophase in four equal quarterly installments in 2004 to support Nanophase’s efforts in joint slurry product development with RHEM for current and future semiconductor technologies.

Other revenue increased to $566,348 in 2003, compared to $398,229 in 2002. This increase was largely due to revenue in the amount of $226,450 from the sale of a PVS reactor to CIK in 2003. These types of equipment sales occur on occasion (not on a regular annual basis) and are treated as other revenue.

The majority of the revenue generated during 2003 was from customers in the healthcare (sunscreens) and CMP markets. Revenue from BASF, RHEM and CIK, the Company’s three largest customers, constituted approximately 61.0%, 22.4% and 10.7%, respectively, of the Company’s 2003 total revenue.

Cost of revenue generally includes costs associated with commercial production and customer development arrangements. Cost of revenue increased to $5,205,065 in 2003, compared to $5,095,019 in 2002. The increase in cost of revenue was generally attributed to increased depreciation expense resulting from the completion of the Company’s build-out of its manufacturing and powder coating facilities and increased facility costs. Cost of revenue as a percentage of total revenue increased from 94% in 2002 to 96% in 2003 due primarily to the effects of the completion of the Company’s build-out of its manufacturing and powder coating facilities. Nanophase continued to reduce variable manufacturing costs on nanomaterials in 2003 with reductions ranging from 4% to 27%, depending upon the specific material. In 2003, Nanophase also successfully completed ISO9001:2000 certification (the current standard at the time) for its facilities in Romeoville and Burr Ridge, Illinois. The extent to which the Company’s margins remain positive, as a percentage of total revenue, will be dependent upon revenue mix, revenue volume and the Company’s ability to continue to cut costs. As product revenue volume increases, this will result in more of the Company’s fixed manufacturing costs being absorbed, leading to increased margins.

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

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acquisition of new product applications and coating formulations and the cost of enhancing the Company’s manufacturing processes. For example, 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. Recently, the Company has demonstrated the capability to produce pilot quantities of mixed-metal oxides in a single crystal phase. These materials include cerium/zirconium oxide, cerium/lanthanum/zirconium oxide, cerium/praeseodymium/zirconium oxide, and cerium/samarium oxide. We do not expect development of further variations on these materials to present material technological challenges. Many of these materials exhibit performance characteristics that can enable them to serve in various catalytic applications. This development has been driven largely by customer demand. Management is now working on several related commercial applications. The Company expects that this technique should not be difficult to scale to large quantity commercial volumes once application viability and firm demand are established. 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. The Company has recently expanded its palette of materials to include nanoscale copper oxide and bismuth oxide for potential use in a variety of applications. The Company is not certain when or if any significant revenue will be generated from the production of the materials described above. Research and development expense increased to $1,906,791 in 2003, compared to $1,572,997 in 2002. The increases in research and development expense was largely attributed to increased salaries due to no capitalization of labor in 2003 compared to approximately $149,000 in 2002, product development costs, depreciation and travel expenses. In 2002, the capitalization of payroll occurred with several employees in the advanced engineering group relating to the build-out of its facilities. These increases were partially offset by decreased spending in repairs and maintenance expense.

Selling, general and administrative expense increased to $4,095,877 in 2003, compared to $3,854,051 in 2002. The net increase was primarily attributed to business insurance, amortization expense relating to SFAS No. 143, Accounting for Asset Retirement Obligations adopted in 2003, consulting fees for various professional services not related to accounting fees, travel, accounting and legal expenses, both relating to the Company’s then-current securities litigation and more general legal issues. These increases were partially offset by decreases in director compensation due to recognition of this expense in a lump sum, when it was paid in January 2002 and additionally, as a monthly accrual throughout 2002. This treatment effectively resulted in twice as much total director compensation expense being recognized in 2002, the year of the change in recording convention, than in 2003.

Interest income decreased to $67,992 in 2003, compared to $152,626 in 2002. This decrease was primarily due to a reduction in funds available for investment and, to a lesser extent, reduced investment yields.

Liquidity and Capital Resources

The Company’s cash, cash equivalents and investments amounted to $11,630,311 on December 31, 2004, compared to $4,962,363 on December 31, 2003. The net cash used in the Company’s operating activities was $4,866,797, $4,446,093 and $4,091,187 for the years ended December 31, 2004, 2003 and 2002, respectively. Net cash used in investing activities, which is due to purchases of securities and to a lesser extent capital expenditures offset partially by maturities of securities, amounted to $7,277,335 for the year ended December 31, 2004 compared to $2,001,764 of net cash provided by and $2,608,253 of net cash used in investing activities for the years ended December 31, 2003 and 2002, respectively. Capital expenditures, primarily related to the continued 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 in Burr Ridge, Illinois and the purchase of related operating equipment, amounted to $529,498, $220,611 and $1,483,808 for the years ended December 31, 2004, 2003 and 2002, respectively. In 2005 the Company expects to complete implementation of a PVS process innovation started in late 2003, within the current capital budget, that is

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expected to increase PVS reactor output by approximately 20%. The Company expects that this innovation should result in the need for less future capital as the Company’s PVS reactor-produced business grows. Currently, all sunscreen and personal care nanomaterials are manufactured via the PVS process. Net cash provided by financing activities, is primarily due to the Company securing financing through an equity investment in March 2004 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 $12,219,318 for the year ended December 31, 2004, compared to $2,398,644 and $6,562,545 for the years ended December 31, 2003 and 2002, respectively.

On March 23, 2004, the Company sold, in a private placement to Altana Chemie AG (“Altana”), 1,256,281 shares of common stock at $7.96 per share and received gross proceeds of $10.0 million. On January 22, 2004, the Company filed a universal shelf registration statement with the Securities and Exchange Commission to allow Nanophase to offer up to $15.0 million of Nanophase securities, in the form of common stock or various types of debt securities, in the future. In August 2004, the Company withdrew its universal shelf offering due to unfavorable market conditions and the Company’s adequate cash position to cover expected growth through 2006. The Company incurred expenses in 2004 relating to the filing and subsequent withdrawal of its universal shelf offering of approximately $288,000. On September 8, 2003, the Company secured equity funding through a private placement offering with Grace Brothers, Ltd., its largest investor. The Company issued 453,001 shares of additional common stock at $4.415 per share and received gross proceeds of $2.0 million. Grace Brothers, Ltd. also has the right to purchase an additional 453,001 shares for an additional $2.0 million pursuant to the terms of a warrant issued in such private placement. In accordance with the terms of such private placement, on June 7, 2004, the Company filed a registration statement for such 453,001 shares and the additional 453,001 shares issuable upon exercise of the warrant which registration statement was declared effective on August 13, 2004. On September 2, 2004, Grace Brothers, Ltd. exercised its warrant rights to acquire 453,001 newly issued shares of common stock and the Company received $2 million in gross proceeds. 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 remaining proceeds from the foregoing offerings to fund expected growth in new markets as well as to provide for expanded working capital needs expected to arise as sales volume grows and pay existing debts.

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, cash equivalents and investments and that the Company not have the acceleration of any debt maturity having a principal amount of more than $10,000,000, in order to avoid triggering a transfer of technology and equipment to the Company’s largest customer. The Company had approximately $11.6 million in cash, cash equivalents and investments and debt of less than $592,000 on December 31, 2004. Management expects that the proceeds received from the September 2003 private placement offering and the exercise of the warrant issued in such offering, as well as the proceeds from the March 23, 2004 equity investment from Altana, should be sufficient to enable the Company to comply with these financial covenants for the foreseeable future. This supply agreement and its covenants are more fully described in Note 16 to the Company’s Financial Statements. See “Risk Factors—We may need to raise additional capital in the future”.

In November 2000, the Company executed a three-year promissory note, held by the Company’s largest customer, in the amount of $1,293,895 for the construction of additional production capabilities at the Company’s Romeoville, Illinois facility. Borrowings against this note amounted to $579,472 on December 31, 2004. The note bears interest at 8.45% per annum and is collateralized by certain powder coating, packaging, lab and related equipment. Contractually, the Company has five months to pay back this note, based on a rate per kilogram of product shipped, with any remaining outstanding balance on June 1, 2005 becoming payable on demand.

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The Company believes that cash from operations and cash, cash equivalents and investments on hand and interest income thereon, will be adequate to fund the Company’s operating plans for the foreseeable future. The Company’s actual future capital requirements in 2005 and beyond 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 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 that capital spending relating to currently known capital needs in 2005 will be lower than the Company’s $529,498 in capital expenditures in 2004, but could be even greater due to the factors discussed above.

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 in light of the factors described above; new regulatory requirements that are outside the Company’s control; the need to meet previously discussed cash requirements to avoid a triggering event; or various other circumstances coming to pass that are currently not anticipated by the Company.

The following table highlights the Company’s contractual obligations as of December 31, 2004:

On December 31, 2004, the Company had a net operating loss carryforward of approximately $60.4 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 2014. 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. On December 31, 2004, the Company also had a foreign tax credit carryforward of $156,000, which could be used as an offsetting tax credit to reduce U.S. income taxes. The foreign tax credit will expire in 2014, if not utilized before that date.

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Risk Factors

The following risks, uncertainties, and other factors could have a material adverse affect on our business, financial condition, operating results and growth prospects.

We have a limited operating history and may not be able to address difficulties encountered by early stage companies in new and rapidly evolving markets.

We have only a limited operating history. We were formed in November 1989 and began our commercial nanocrystalline materials operations in January 1997. We have not yet generated a significant amount of revenue from our nanocrystalline materials operations. Because of our limited operating history and the early stage of development of our rapidly evolving market, we have limited insight into trends that may emerge and adversely affect our business and cannot be certain that our business strategy will be successful or that it will successfully address these risks. In addition, our efforts to address any of these risks may distract personnel or divert resources from other more important initiatives, such as attracting and retaining customers and responding to competitive market conditions.

We have a history of losses that may continue in the future.

We have incurred net losses in each year since our inception with net losses of $5.16 million in 2002, $5.83 million in 2003 and $6.45 million in 2004. As of December 31, 2004, we had an accumulated deficit of approximately $52.18 million and presently expect to continue to incur losses on an annual basis through at least the end of 2005. We believe that our business depends, among other things, on our ability to significantly increase revenue. If revenue fails to grow at anticipated rates or if operating expenses increase without a commensurate increase in revenue, or if we fail to adjust operating expense levels accordingly, then the imbalance between revenue and operating expenses will negatively impact our cash balances and our ability to achieve profitability in future periods.

We depend on a small number of customers for a high percentage of our sales, and the loss of orders from a significant customer could cause a decline in revenue and/or increases in the level of losses incurred.

Sales to our customers are executed pursuant to purchase orders and annual supply contracts; however, customers can cease doing business with us at any time with limited advance notice. We expect a significant portion of our future sales to remain concentrated within a limited number of strategic customers. We may not be able to retain our strategic customers, such customers may cancel or reschedule orders, or in the event of canceled orders, such orders may not be replaced by other sales or by sales that are on as favorable terms. In addition, sales to any particular customer may fluctuate significantly from quarter to quarter, which could affect our ability to achieve anticipated revenues on a quarterly basis.

Revenue from BASF Corporation, Rohm and Haas Electronic Materials (formerly known as “Rodel”) and C.I. Kasei, a division of Itochu Corporation, accounted for approximately 89% of total revenue for the year ended December 31, 2004, and revenue to the same three customers accounted for approximately 94% of total revenue in 2003. For the years ended December 31, 2004 and 2003, BASF accounted for 70% and 61% of our total revenue, respectively. If we were to lose, or receive significantly decreased orders from, any of these three customers, then our results of operations would be materially harmed. While our agreements with our three largest customers are long-term agreements, they may be terminated by the customer with reasonable notice and do not provide any guarantees that these customers will continue to buy our products. In addition, while our agreements with our three largest customers contain minimum order requirements, the only repercussion under the agreements for missing the minimum order requirement is that we would be freed from the exclusivity obligations under these contracts.

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We have been consistently expanding both our marketing and business development efforts and our production efficiency in order to address the issues of our dependence upon a limited amount of customers, enhancement of gross profit and operating cash flows, and the achievement of profitability. We currently have customers that may grow to the point where they generate significant revenues and margins as relationships expand. Given the special nature of our products, and the fact that markets for them are not yet fully developed, it is difficult to accurately predict when additional large customers will materialize. Going forward, the Company’s margins, as a percentage of revenue, will be dependent upon revenue mix, revenue volume and the Company’s ability to continue to cut costs. The extent of the growth in revenue volume and the related gross profit that this revenue generates, will be the main drivers in generating positive operating cash flows and, ultimately, net income.

Any downturn in the markets served by us would harm our business.

A majority of our products are incorporated into products such as sunscreens, polishing slurries, personal care, and to a lesser extent abrasion-resistant coatings for flooring, and catalytic converters. These markets have from time to time experienced cyclical, depressed business conditions, often in connection with, or in anticipation of, a decline in general economic conditions. These industry downturns have resulted in reduced product demand and declining average selling prices. Our business would be harmed by any future downturns in the markets that we serve.

Our products often have long adoption cycles, which could make it difficult to achieve market acceptance and makes it difficult to forecast revenues.

Due to their often novel characteristics and the unfamiliarity with them that exists in the marketplace, our nanocrystalline materials often exhibit longer adoption cycles than existing materials technologies. Our nanomaterials have to receive appropriate attention within any potential customer’s organization, then they must be tested to prove a performance advantage over existing materials, typically on a systems-cost basis. Once we have proven initial commercial viability, pilot scale production runs must be completed by the customer, followed by further testing. Once production-level commercial viability is established, then our nanomaterials can be introduced, often to a downstream marketplace that needs to be familiarized with them. If we are unable to convince our potential customers of the performance advantages and economic value of our nanocrystalline materials over existing and competing materials and technologies, we will be unable to generate significant sales. Our long adoption cycle makes it difficult to predict when sales will occur.

We depend on collaborative development relationships with our customers and do not have a substantial direct sales force or an established distribution network. If we are unable to initiate or sustain such collaborative relationships or if the terms of these relationships limit the distribution of our products, then we may be unable to independently develop, manufacture or market our current and future nanocrystalline materials or applications.

We have established, and will continue to pursue, collaborative relationships with many of our customers and do not have a substantial direct sales force or an established distribution network. Through these relationships, we seek to develop new applications for our nanocrystalline materials and share development and manufacturing resources. We also seek to coordinate the development, manufacture and marketing of our nanocrystalline products. Future success will depend, in part, on our continued relationships with these customers and our ability to enter into similar collaborative relationships with other customers. Our customers may not continue in these collaborative development relationships, may not devote sufficient resources to the development or sale of our materials or may enter into collaborative development relationships with our competitors. These customers may also require a share of control of these collaborative programs. Some of our agreements with these customers limit our ability to license our technology to others and/or limit our ability to engage in certain product development or marketing activities. These relationships generally can be terminated unilaterally by customers.

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Additionally, these customers generally require exclusive distribution arrangements within the field of application covered by our agreement with these customers, and the very nature of these collaborative relationships limits the distribution of our products to the distribution networks available to our collaborative relationship partners. In addition, the development agreements with some of our larger customers contain provisions that require us to license our intellectual property to these customers on disadvantaged terms and/or transfer equipment to these customers in the event that we materially breach these agreements or fail to satisfy certain financial covenants. For example, see “Risk Factors—We may need to raise additional capital in the future.”

If we are unable to initiate or sustain such collaborative relationships or if the terms of these relationships materially limit our access to distribution channels for our products, then we may be unable to independently develop, manufacture or market our current and future nanocrystalline materials or applications.

If a catastrophe strikes either of our manufacturing facilities or if we were to lose our lease for either facility due to non-renewal or other unforeseen events, we may be unable to manufacture our materials to meet customers’ demands.

Our manufacturing facilities are located in Romeoville and Burr Ridge, Illinois. These facilities and some of our manufacturing and testing equipment would be difficult to replace in a timely manner. Therefore, any material disruption at one of our facilities due to a natural or man-made disaster or a loss of lease due to non-renewal or other unforeseen events could have a material adverse effect on our ability to manufacture products to meet customers’ demands. While we maintain customary property insurance, this insurance may not adequately compensate us for all losses that we may incur and would not compensate us for any interruption in our business.

If we are unable to expand our production capabilities to meet unexpected demand, we may be unable to manage our growth and our business would suffer.

Our success will depend, in part, on our ability to manufacture nanocrystalline materials in significant quantities, with consistent quality and in an efficient and timely manner. We expect to continue to expand our current facilities or obtain additional facilities in the future in order to respond to unexpected demand for existing materials or for new materials that we do not currently make in quantity. Such unplanned demand, if it resulted in rapid expansion, could create a situation where growth could become difficult to manage, which could cause us to lose potential revenue.

Protection of our intellectual property is limited and uncertain.

Our intellectual property is important to our business. We seek to protect our intellectual property through patent, trademark, trade secret protection and confidentiality or license agreements with our employees, customers, suppliers and others. Our means of protecting our intellectual property rights in the United States or abroad may not be adequate and others, including our competitors, may use our proprietary technology without our consent. We may not receive the necessary patent protection for any applications pending with the U.S. Patent and Trademark Office (“USPTO”) and any of the patents that we currently own or license may not be sufficient to keep competitors from using our materials or processes. In addition, patents that we currently own or license may not be held valid if subsequently challenged by others and others may claim rights in the patents and other proprietary technology that we own or license. Additionally, others may have already developed or may subsequently develop similar products or technologies without violating any of our proprietary rights. If we fail to obtain patent protection or preserve our trade secrets, we may be unable to effectively compete against others offering similar products and services. In addition, if we fail to operate without infringing the proprietary rights of others or lose any license to technology that we currently have or will acquire in the future, we may be unable to continue making the products that we currently make.

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Moreover, at times, attempts may be made to challenge the prior issuance of our patents. For example, the USPTO has granted a third-party request for re-examination with respect to one patent relating to one of our nanoparticle manufacturing processes. While we will vigorously defend our patent position, we may not be successful in maintaining the scope of the claims of this patent during re-examination. If our patent claims are narrowed substantially by the USPTO, the patent coverage afforded our nanoparticle manufacturing process could be impaired. While we would not expect such impairment to affect the value of our manufacturing trade secrets that have not been disclosed in the patent, it could impede the extent of our legal protection of the invention that is subject to this patent and potentially harm our business and operating results.

Furthermore, litigation may be necessary to enforce our intellectual property rights, to protect our trade secrets, to determinate the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity. Such litigation could result in substantial costs and diversion of resources and could harm our business, operating results and financial condition. In addition, if others assert that our technology infringes their intellectual property rights, resolving the dispute could divert our management team and financial resources.

In the future, we may license certain of our intellectual property, such as trademarks or copyrighted material, to third parties. While we would attempt to ensure that any licensees maintain the quality and value of our brand, these licenses might diminish this quality and value.

We may be subject to claims that one or more of the business methods used by us infringe upon patents held by others. The defense of any claims of infringement made against us by third parties could involve significant legal costs and require our management to divert time and other resources from our business operations. Either of these consequences of an infringement claim could have a material adverse effect on our operating results. If we are unsuccessful in defending any claims of infringement, we may be forced to obtain licenses or pay royalties to continue to use our technology. We may not be able to obtain any necessary licenses on commercially reasonable terms or at all. If we fail to obtain necessary licenses or other rights, or if these licenses are costly, our operating results may suffer either from reductions in revenue through our inability to serve clients or from increases in costs to license third-party technology.

Our industry is experiencing rapid changes in technology. If we are unable to keep pace with these changes, our business will not grow.

Rapid changes have occurred, and are likely to continue to occur, in the development of advanced materials and processes. Our success will depend, in large part, upon our ability to keep pace with advanced materials technologies, industry standards and market trends and to develop and introduce new and improved products on a timely basis. We expect to commit substantial resources to develop our technologies and product applications and, in the future, to expand our commercial manufacturing capacity as volume grows. Our development efforts may be rendered obsolete by the research efforts and technological advances of others and other advanced materials may prove more advantageous than those we produce.

Our market is highly competitive, and if we are unable to compete effectively, then our business will not grow.

The advanced materials industry is new, rapidly evolving and intensely competitive, and we expect competition to intensify in the future. The market for materials having the characteristics and potential uses of our nanocrystalline materials is the subject of intensive research and development efforts

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by both governmental entities and private enterprises around the world. We believe that the level of competition will increase further as more product applications with significant commercial potential are developed. The nanocrystalline product applications that we are developing will compete directly with products incorporating both conventional and advanced materials and technologies. While we are not currently aware of the existence of commercially available competitive products with the same attributes as those we offer, other companies may develop and introduce new or competitive products. Our competitors may succeed in developing or marketing materials, technologies and better or less expensive products than the ones we offer. In addition, many of our potential competitors have substantially greater financial and technical resources, and greater manufacturing and marketing capabilities than we do. If we fail to improve our current and potential nanocrystalline product applications at an acceptable price, or otherwise compete with producers of conventional materials, we will lose market share and revenue to our competitors.

We may need to raise additional capital in the future. If we are unable to obtain adequate funds, we may be required to delay, scale-back or eliminate some of our manufacturing and marketing operations or we may need to obtain funds through arrangements on less favorable terms or we may be required to transfer equipment to our largest customer.

We expect to expend significant resources on research, development and product testing, and in expanding current capacity or capability for new business. In addition, we may incur significant costs in preparing, filing, prosecuting, maintaining and enforcing our patents and other proprietary rights. If necessary, we may seek funding through public or private financing and through contracts with government or other companies. Additional financing may not be available on acceptable terms or at all. If we are unable to obtain adequate funds, we may be required to delay, scale-back or eliminate some of our manufacturing and marketing operations or we may need to obtain funds through arrangements on less favorable terms. If we obtain funding on unfavorable terms, we may be required to relinquish rights to some of our intellectual property.

To raise additional funds in the future, we would likely sell our equity or debt securities or enter into loan agreements. To the extent that we issue debt securities or enter into loan agreements, we may become subject to financial, operational and other covenants that we must observe. In the event that we were to breach any of these covenants, then the amounts due under such loans or debt securities could become immediately payable by us, which could significantly harm us. To the extent that we sell additional shares of our equity securities, our stockholders may face economic dilution and dilution of their percentage ownership.

We currently have a supply agreement with BASF that contains provisions which could potentially result in a mandatory transfer of technology and sale of production equipment to BASF providing capacity sufficient to meet BASF’s production needs. The transfer and related sale would be “triggered” only in the event that one of the following occurs:

In the event of a triggering event where we are required to sell to BASF production equipment providing capacity sufficient to meet BASF’s production needs, the equipment would be sold at 115% of the equipment’s net book value.

We believe that we have complied with all contractual requirements and that we have not had a

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“triggering event.” We further believe that the proceeds of the May 29, 2002 and September 8, 2003 private placements, the warrants exercised on September 2, 2004 relating to the September 8, 2003 private placement, in addition to the proceeds from the equity investment by Altana on March 23, 2004, should provide sufficient cash balances to avoid the first triggering event referenced above for the foreseeable future. If a triggering event were to occur and BASF elected to proceed with the transfer and related sale mentioned above, we would lose both significant revenue and the ability to generate significant revenue to replace that which was lost in the near term. Replacement of necessary equipment that would be purchased and removed by BASF pursuant to this triggering event could take six months to a year. Any additional capital outlays required to rebuild capacity would probably be greater than the proceeds from the purchase of the assets pursuant to our agreement with BASF. This shortfall might put us in a position where it would be difficult to secure additional funding given what would then be an already tenuous cash position. Such an event would also result in the loss of many of our key staff and line employees due to economic realities. We believe that our employees are a critical component of our success and would be difficult to quickly replace and train. Given the occurrence of such an event, we might not be able to hire and retrain skilled employees given the stigma relating to such an event and its impact on us. We might elect to effectively reduce our size and staffing to a point where we could remain a going concern in the near term.

We depend on key personnel, and their unplanned departure could harm our business.

Our success will depend, in large part, upon our ability to attract and retain highly qualified research and development, management, manufacturing, marketing and sales personnel on favorable terms. Due to the specialized nature of our business, we may have difficulty locating, hiring and retaining qualified personnel on favorable terms. If we were to lose the services of any of our key executive officers or other key personnel, or if we are unable to attract and retain other skilled and experienced personnel on acceptable terms in the future, or if we are unable to implement a succession plan to prepare qualified individuals to assume key roles upon any loss of our key personnel, then our business, results of operations and financial condition would be materially harmed. In addition, we do not currently have “key-man” life insurance policies covering all of our executive officers or key employees, nor do we presently have any plans to purchase such policies.

We face potential product liability risks which could result in significant costs that exceed our insurance coverage, damage our reputation and harm our business.

We may be subject to product liability claims in the event that any of our nanocrystalline product applications are alleged to be defective or cause harmful effects. Because our nanocrystalline materials are used in other companies’ products, to the extent our customers become subject to suits relating to their products, such as cosmetic and skin-care products and medical implants, these claims may also be asserted against us. We may incur significant costs including payment of significant damages, in defending or settling product liability claims. We currently maintain insurance coverage in the amount of $10 million for product liability claims, which may prove not to be sufficient. Even if a suit is without merit and regardless of the outcome, claims can divert management time and attention, injure our reputation and adversely affect demand for our nanocrystalline materials.

We are subject to governmental regulations. The costs of compliance and liability for noncompliance with governmental regulations could have a material adverse effect on our business, results of operations and financial condition.

Current and future laws and regulations may require us to make substantial expenditures for preventive or remedial action. Our operations, business or assets may be materially and adversely affected by governmental interpretation and enforcement of current or future environmental, health and safety laws and regulations. In addition, our coating operations pose a risk of accidental contamination or injury.

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The damages in the event of an accident or the costs to prevent or remediate a related event could exceed our resources or otherwise have a material adverse effect on our business, results of operations and financial condition.

In addition, both of our facilities and all of our operations are subject to the plant and laboratory safety requirements of various occupational safety and health laws. We believe we have complied in all material respects with regard to governmental regulations applicable to us. However, we may have to incur significant costs in defending or settling future claims of alleged violations of governmental regulations and these regulations may materially restrict or impede our operations in the future. In addition, our efforts to comply with or contest any regulatory actions may distract personnel or divert resources from other more important initiatives.

The manufacture and use of certain products that contain our nanocrystalline materials are subject to intense governmental regulation, including regulations promulgated by the U.S. Food and Drug Administration, the U.S. Environmental Protection Agency and the U.S. Occupational Safety and Health Administration. As a result, we are required to adhere to the requirements of the regulations of governmental authorities in the United States and other countries. These regulations could increase our cost of doing business and may render some potential markets prohibitively expensive.

We have implemented anti-takeover provisions which could discourage or prevent a takeover, even if an acquisition could be beneficial to our stockholders.

In October 1998, we entered into a Rights Agreement, commonly referred to as a “poison pill.” The provisions of this agreement and some of the provisions of our certificate of incorporation, our bylaws and Delaware law could, together or separately:

In particular, our board of directors is authorized to issue up to 24,088 shares of preferred stock (less any outstanding shares of preferred stock) with rights and privileges that might be senior to our common stock, without the consent of the holders of the common stock, including up to 2,500 shares of Series A Junior Participating Preferred Stock issuable under the 1998 Rights Agreement.

In addition, Section 203 of the Delaware General Corporations Law and the terms of our stock option plans may discourage, delay or prevent a change in control of our company.

Future sales of our common stock by existing stockholders could negatively affect the market price of our stock and make it more difficult for us to sell stock in the future.

Sales of our common stock in the public market, or the perception that such sales could occur, could result in a decline in the market price of our common stock and make it more difficult for us to complete future equity financings. A substantial number of shares of our common stock and shares of common stock subject to outstanding warrants and options may be resold pursuant to currently effective registration statements. As of March 1, 2005, there are:

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We cannot estimate the number of shares of common stock that may actually be resold in the public market because this will depend on the market price for our common stock, the individual circumstances of the sellers, and other factors. If stockholders sell large portions of their holdings in a relatively short time, for liquidity or other reasons, the market price of our common stock could decline significantly.

Bradford T. Whitmore has significant influence on all matters requiring stockholder approval because he beneficially owns a large percentage of our common stock, and he may vote the common stock in ways with which our other stockholders disagree.

As of March 1, 2005, Bradford T. Whitmore, together with his affiliates, Grace Brothers, Ltd. and Grace Investments, Ltd., beneficially owned approximately 19.9% of the outstanding shares of our common stock. As a result, he has significant influence on matters submitted to our stockholders for approval, including proposals regarding:

The ownership position of Mr. Whitmore could delay, deter or prevent a change of control or adversely affect the price that investors might be willing to pay in the future for shares of our common stock. Mr. Whitmore’s interests may be significantly different from the interests of our other stockholders and he may vote the common stock he beneficially owns in ways with which our other stockholders disagree. Investors in the Company should also note that R. Janet Whitmore, one of our directors, is the sister of Mr. Whitmore.

We have been involved in litigation. If we are involved in similar litigation in the future, the expense of defending such litigation and the potential costs of judgments against us and the costs of maintaining insurance coverage could have a material adverse effect on our financial performance.

We have been involved in three securities class action lawsuits, one of which was a consolidation of several related lawsuits. While all of these lawsuits have been settled and dismissed with all settlements funded by our directors and officers liability insurance, we may be the target of additional securities lawsuits in the future. If we are involved in similar litigation in the future, the expense of defending such litigation, the potential costs of judgments against us, the costs of maintaining insurance coverage and the diversion of management’s attention could have a material adverse effect on our financial performance.

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Our stock price is volatile.

The stock markets in general, and the stock prices of technology-based companies in particular, have experienced extreme volatility that often has been unrelated to the operating performance of any specific public company. The market price of our common stock has fluctuated in the past and is likely to fluctuate in the future as well. Our future financial performance and stock price may be subject to significant volatility, particularly on a quarterly basis. Shortfalls in our revenues in any given period relative to the levels expected by investors could immediately, significantly and adversely affect the trading price of our common stock.

Dilutive Effect of Private Placements.

On May 29, 2002 we sold 1,370,000 shares of our common stock to selected accredited investors at a purchase price of $5.00 per share. On May 29, 2002 the closing sale price of our common stock, as reported on NASDAQ, was $5.15 per share. On September 8, 2003 we sold 453,001 shares of our common stock to Grace Brothers, Ltd. at a purchase price of $4.415 per share together with a warrant to purchase a like number of shares of common stock during the next twelve months also at a price of $4.415 per share. This warrant was exercised on September 2, 2004 to acquire 453,001 newly issued shares of common stock. The share price for the common stock was determined based on the fifteen-day market closing average for our stock ending September 5, 2003. On September 8, 2003 and September 2, 2004 the closing sale price of our common stock as reported on NASDAQ, was $5.50 and $5.49 respectively, per share. On March 23, 2004 we sold 1,256,281 shares of our common stock to Altana at a purchase price of $7.96 per share. On March 23, 2004 the closing sale price of our common stock, as reported on NASDAQ, was $8.26 per share. Each of these issuances of stock at below the then-current market price had a dilutive effect on existing common stockholders.

We have never paid dividends.

We currently intend to retain earnings, if any, to support our growth strategy. We do not anticipate paying dividends on our stock in the foreseeable future.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

The only financial instruments that the Company holds are of short duration and are held-to-maturity. Given these factors, management does not believe that the Company currently has material market risk relating to its investments.

Item 8. Financial Statements and Supplementary Data

The financial statements and financial statement schedule, with the report of independent auditors, listed in Item 16 are included in this Form 10-K.

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

Not applicable.

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Item 9A. Controls and Procedures

As of the end of the period covered by this report, the Company conducted an evaluation, under the supervision and with the participation of the principle executive officer and principle financial officer, of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”). Based on this evaluation, the principle executive officer and principle financial officer concluded that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. There was no change in the Company’s internal control over financial reporting during the Company’s most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Management’s Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control-Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2004.

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 and procedures may deteriorate.

Our management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2004 has been audited by McGladrey & Pullen LLP, an independent registered public accounting firm, as stated in their report which is included herein.

Item 9B. Other Information

In September 2004, the Company renewed its Burr Ridge facility lease. The initial term of the lease expires in September 2007, but the Company has options to extend the lease for up to three additional one-year terms.

PART III

Item 10. Directors and Executive Officers of the Registrant

Set forth below is certain information regarding the directors of the Company.

Mr. Henderson has served as a director of the Company since July 2001. He retired as Chairman and Chief Executive Officer of Cummins Engine Company in December 1999, after joining the company in 1964. Mr. Henderson became President and Chief Operating Officer of Cummins in 1977, was promoted to President and Chief Executive Officer in 1994 and served as Chairman and Chief Executive Officer from 1995 until his retirement in 1999. Mr. Henderson attended Culver Military Academy, holds an A.B. in public and international affairs from Princeton University and an M.B.A. from Harvard Business School. Mr. Henderson currently serves as Chairman of the Board of The Culver Education Foundation, member of the Board of Directors of International Paper, Rohm and Haas Company, Ryerson Tull, Inc., SBC Communications, Inc. and is a member of the Washington, D.C. Business Council.

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Mr. McClung has served as a director of the Company since February 2000. He is currently Vice Chairman of Charter Consulting and former Senior Vice President and executive officer for FMC Corporation, a leading producer of a diversified portfolio of chemicals and machinery. He has over 30 years of international business development experience in over 75 countries, having managed and developed new technologies and production processes for diversified global businesses, including specialized chemicals and machinery, while living in the United States, Europe and Africa. Mr. McClung currently serves as Corporate Board member of Alticor (Amway), Beaulieu of America Corporation, NCCI Holdings, Turtle Wax and Hu-Friedy. He was a founding member of the U.S.-Russia Business Council and is active in other international business organizations, such as the Japan American Society, Chicago Council of Foreign Relations and the Economic Club of Chicago. He serves as a board director at Thunderbird: The Garvin School of International Management and the College of Wooster (Ohio). Mr. McClung earned a Bachelor’s degree from the College of Wooster, a Master’s degree from the University of Kansas and a Doctorate from Michigan State University.

Ms. Whitmore joined the board in November 2003. She is currently a director of Silverleaf Resorts, Inc., where she serves as Chairman of the Compensation Committee and as a member of the Audit Committee. Ms. Whitmore is Founder of Benton Consulting, LLC, which specializes in business development and processes. From 1976 through 1999, Ms. Whitmore held numerous engineering and finance positions at Mobil Corporation, including Mobil’s Chief Financial Analyst and Controller of Mobil’s Global Petrochemicals Division. Ms. Whitmore holds a Bachelor of Science degree in Chemical Engineering from Purdue University and an M.B.A. from Lewis University.

Mr. Cross has served as Chief Executive Officer of the Company since December 1998 and President and a director of the Company since joining the Company in November 1998. Prior to joining the Company in November 1998, Mr. Cross served as President and Chief Executive Officer of Aptech, a manufacturer of measurement, metering and control devices for the utility industry, from August 1996 to October 1998. From December 1993 to July 1996, Mr. Cross served as President of Aegis Technologies, an interactive telecommunications company. He holds a B.S. degree from Southwest Missouri University and attended the M.B.A. program at Southwest Missouri University.

Dr. Siegel is a co-founder of the Company and has served as a director of the Company since 1989. Dr. Siegel served as a consultant to the Company from 1990 to 2002 with regard to the application and commercialization of nanocrystalline materials. Dr. Siegel is an internationally recognized scientist in the field of nanocrystalline materials. During his tenure on the research staff at Argonne National Laboratory from July 1974 to May 1995, he was the principal scientist engaged in research with the laboratory-scale synthesis process that was the progenitor of the Company’s physical-vapor-synthesis production system. Dr. Siegel has been the Robert W. Hunt Professor in Materials Science and Engineering at Rensselaer Polytechnic Institute since June 1995, and served as Department Head from 1995 to 2000. In April 2001, Dr. Siegel became the founding Director of the newly created Rensselaer Nanotechnology Center at the Institute. During 1995-1998, he was also a visiting professor at the Max Planck Institute for Microstructure Physics in Germany on an Alexander von Humboldt Research Prize received in 1994. During 2003-2004 he was a visiting professor in Japan on a RIKEN Eminent Scientist Award. He chaired the World Technology Evaluation Center worldwide study of nanostructure science and technology for the U.S. government, has served on the Council of the Materials Research Society and as Chairman of the International Committee on Nanostructured Materials. He also served on the Committee on Materials with Sub-Micron Sized Microstructures of the National Materials Advisory Board and was the co-chairman of the Study Panel on Clusters and Cluster-Assembled Materials for the U.S. Department of Energy. He currently serves on the Nanotechnology Technical Advisory Group to the U.S. President’s Council of Advisors on Science and Technology. Dr. Siegel holds an A.B. degree in physics from Williams College and an M.S. degree and Ph.D. from the University of Illinois at Urbana-Champaign.

Mr. Perkins has served as a director of the Company since February 1998. Mr. Perkins retired from Jewel Companies, Inc., the retail supermarket and drug chain, in 1983. He had been with Jewel since 1953, serving as President from 1965 to 1970, as Chairman of the Board of Directors from 1970 to 1980, and as Chairman of the Executive Committee until his retirement. He has served on a number of corporate boards and is currently a director of LaSalle Hotel Properties and La Salle U.S. Realty Income and Growth Funds I, II and III. For more than 30 years, he has served on corporate boards including AT&T, Aon, Corning, Cummins Engine, Eastman Kodak, Firestone, Inland Steel Industries, Kmart, Lucent Technologies, The Putnam Funds, Springs Industries and Time-Warner, Inc. He is Honorary Chairman of the Illinois Coalition and Protector of the Thyssen-Bornemisza Continuity Trust. He has served as a Trustee of The Ford Foundation and The Brookings Institution and as a member of The Business Council. Mr. Perkins is a life trustee and was Vice Chairman of the Board of Trustees of Northwestern University. He co-chaired Campaign/Northwestern, a university-wide effort which has raised more than $1.5 billion. He is also a member of the Civic Committee of The Commercial Club of Chicago, a Director of Leadership for Quality Education and a member of RoundTable Healthcare Partners L.P. Advisory Boards, Northwestern University’s School of Communication and its School of Education and Social Policy Advisory Boards. Mr. Perkins holds a B.A. degree from Yale University and an M.B.A. degree from the Harvard Graduate School of Business Administration.

Mr. Pearlman has served as a director of the Company since April 1999. Mr. Pearlman retired as Chairman of Zenith Electronics Corporation in November 1995. He joined Zenith as controller in 1971 and served as chief executive officer from 1983 through April 1995. Mr. Pearlman is a director of Smurfit Stone Container Corporation and Ryerson-Tull, Inc. He is a trustee of Northwestern

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University and a director and past chairman of the board of Evanston Northwestern Healthcare. Mr. Pearlman graduated from Princeton with honors from the Woodrow Wilson School and from Harvard Business School with highest honors.

Director Compensation — Upon first being elected to the Board of Directors, each director of the Company who is not an employee or consultant of the Company (an “Outside Director”) is granted stock options to purchase 10,000 shares of common stock at the fair market value of the common stock, as determined by a committee appointed by the Board of Directors, as of the date of issuance of such stock options. This initial option grant to Nanophase’s directors vests over five years. On or after the date of each annual meeting of the stockholders of the Company, each Outside Director who is re-elected or continues to serve as a director because his or her term has not expired is typically granted stock options to purchase 2,000 shares of common stock provided that such grant is typically not made to an Outside Director who was first elected to the Board of Directors within three months prior to such annual meeting. The options granted annually to Outside Directors vest in three equal annual installments beginning on the first anniversary of the date of grant. All options granted to Outside Directors expire ten years from the date of grant. No stock options were granted to any directors during 2004. In January 2004, the Company paid $6,250 as quarterly compensation, which will amount to an annual total of $25,000 per outside director for services performed in their capacity as directors. Prior to 2004, the Company paid outside directors with a combination of common stock grants and cash as outlined below. The Company did not grant any common stock to its directors in 2004. Under the pre-2004 compensation model, the annual compensation paid to each outside director had a value of approximately $25,000. Beginning in 2004, Mr. McClung’s cash compensation is being paid to Lismore International, Incorporated.

Effective January 17, 2003, the Company granted 4,870 restricted shares of common stock to each of Donald Perkins, Richard Siegel, Jerry Pearlman, James McClung and James Henderson. The Company also agreed to issue a cash payment of $10,000 to reimburse these Directors for personal income tax liabilities relating to this grant of common stock. In addition, the Company entered into a consulting agreement in March 2001 with Richard Siegel, Ph.D. pursuant to which the Company paid Dr. Siegel $2,000 per month for consulting services over a twelve-month term. This most recent agreement expired in July 2002.

All Outside Directors are reimbursed for their reasonable out-of-pocket expenses incurred in attending board and committee meetings.

Meetings of the Board and Committees — During the year ended December 31, 2004, the Board of Directors held nine formal meetings. Five of the Company’s current directors attended 100% of the total board and committee meetings held during 2004 and no director attended less than 75% of the aggregate number of board and committee (for all committees on which a particular director served) meetings held during 2004.

Committees of the Board of Directors — The Board of Directors has established an Audit and Finance Committee, Compensation and Governance Committee and a Nominating Committee each comprised entirely of independent directors who are not officers or employees of the Company. The members of the Audit and Finance Committee are Mr. McClung (Chairman), Mr. Henderson, Mr. Pearlman and Mr. Perkins. The members of the Compensation and Governance Committee are Mr. Pearlman (Chairman), Mr. Henderson and Mr. Perkins. The members of the Nominating Committee are Mr. Henderson (Chairman), Mr. McClung, Mr. Pearlman, Mr. Perkins and Dr. Siegel.

The Audit and Finance Committee generally has responsibility for retaining the Company’s independent public auditors, reviewing the plan and scope of the accountants’ annual audit, reviewing the Company’s internal control functions and financial management policies and reporting to the Board of Directors regarding all of the foregoing. The Audit and Finance Committee held five formal meetings in 2004. The Board of Directors has determined that Mr. Pearlman, Mr. Perkins and Mr. Henderson, all of whom serve on the Audit and Finance Committee, are “audit committee financial experts” as described in applicable SEC rules. Each member of the Audit and Finance Committee is independent, as defined in Rule 4200(a) (15) of the National Association of Securities Dealers’ listing standards and applicable SEC rules.

The Compensation and Governance Committee generally has responsibility for recommending to the Board of Directors guidelines and standards relating to the determination of executive and key employee compensation, reviewing the Company’s executive compensation and general corporate governance policies and reporting to the Board of Directors regarding the foregoing. The Compensation and Governance Committee also has responsibility for administering the 2004 Equity Compensation Plan, determining the number of options, if any, to be granted to the Company’s employees and consultants pursuant to the 2004 Equity Compensation Plan and reporting to the Board of Directors regarding the foregoing. The Compensation and Governance Committee held four formal meetings in 2004.

The Nominating Committee generally has responsibility for nominating candidates to serve on the Board of Directors. All members of the Nominating Committee are independent. The Nominating Committee was formed in 2004 and has not yet held any formal meetings, other than an organizational meeting when the committee was formed.

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EXECUTIVE OFFICERS

Set forth below is certain information regarding the executive officers of the Company who are not identified above as directors.

Mr. Jankowski has served as Controller of the Company since joining in 1995. He was elected Secretary and Treasurer in November 1999, Acting Chief Financial Officer in January 2000 and Vice President in April of 2002 and Vice President of Finance and Chief Financial Officer in April of 2004. From 1990-1995 he served as Controller for two building contractors in the Chicago area. From 1986 to 1990 he worked for Kemper Financial Services in their accounting control corporate compliance unit, serving as unit supervisor during his last two years. Mr. Jankowski holds a B.S. in accountancy from Northern Illinois University, an M.B.A. from Loyola University, and received his certified public accountant certificate from the State of Illinois. He has served on the advisory board of WESTEC, an Illinois Technology Enterprise Center focusing on the commercialization of advanced manufacturing technologies, since 2003. Mr. Jankowski was also recently appointed to the Romeoville Economic Development Commission.

Mr. Haines joined Nanophase Technologies in January 2001 as Vice President of Operations. Beginning in 1996 and prior to joining Nanophase, he served as Corporate Director of Quality at Legrand North America. Previous experience includes two years as Vice President of Operations for Aegis Technologies and eight years with Digital Equipment Corporation. Mr. Haines has a B.S. in Chemistry/Engineering Physics from East Tennessee State University.

Mr. Bilicki has served as Vice President — Sales and Marketing of the Company since joining the Company in March 1999. From January 1996 until March 1999, Mr. Bilicki served as President/Director of PT Crosfield Indonesia in Jakarta, Indonesia, a subsidiary of Crosfield Company, which is a global chemical company. From January 1994 to December 1995, Mr. Bilicki held the position of President/Director North America of Crosfield Company. He holds a B.S. degree from Indiana Institute of Technology and an M.B.A. degree from Winthrop University.

Dr. Brotzman joined the Company in July 1994 as a senior scientist and has served as Vice President — Research and Development of the Company since July 1996. He is the inventor of much of the Company’s coating technology. Dr. Brotzman has 15 years experience in research and development of advanced materials leading to new products. His technical areas of expertise include interfacial adhesion and chemistry, self-assembled polymeric coatings, nanosized inorganic powders, powder processing, reactive coupling agents, solgel derived protective coatings, non-destructive evaluation of composites, neo-debye relaxation in green inorganic gels, asymmetric membranes and plasma processing. From January 1991 to July 1994, Dr. Brotzman served as Director of Research at TPL, Inc., an advanced materials company. He holds a B.S. degree in chemical engineering from Lafayette College, an M.S. degree in engineering and applied science from the University of California, Davis and a Ph.D. in chemistry from the University of Washington.

The Board of Directors elects executive officers annually and such executive officers, subject to the terms of certain employment agreements, serve at the discretion of the Board of Directors. Messrs. Cross, Jankowski, Bilicki, Haines and Dr. Brotzman each have employment agreements with the Company. See Item 11 below. There are no family relationships among any of the directors or officers of the Company.

SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE

Section 16 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), requires the Company’s officers (as defined under Section 16), directors and persons who beneficially own greater than 10% of a registered class of the Company’s equity securities to file reports of ownership and changes in ownership with the Securities and Exchange Commission. Based solely on a review of the forms it has received and on written representations from certain reporting persons that no such forms were required for them, the Company believes that during 2004, all Section 16 filing requirements applicable to its officers, directors and 10% beneficial owners were complied with by such persons.

CODE OF ETHICS

The Company has adopted a Code of Business Conduct and Ethics (“Code of Ethics”) that applies to, among others, the Company’s principal executive officer, principal financial officer and principal accounting officer or controller, or persons performing

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similar functions. A copy of the Code of Ethics is posted on its Internet web site www.nanophase.com under the “Investor Relations” section. In the event that the Company makes any amendment to, or grants any waiver from, a provision of the Code of Ethics that requires disclosure under applicable SEC rules, the Company intends to disclose such amendment or waiver on its web site.

Item 11. Executive Compensation

EXECUTIVE COMPENSATION

The following table provides information concerning the annual and long-term compensation for services in all capacities to the Company for the years ended December 31, 2004, 2003 and 2002 of those persons who were (1) during 2004, the chief executive officer of the Company and (2) on December 31, 2004, the four other most highly compensated (based upon combined salary and bonus) executive officers of the Company whose total salary and bonus exceeded $100,000 during 2004 (collectively, the “Named Officers”).

SUMMARY COMPENSATION TABLE

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OPTION GRANTS IN 2004 — The following table provides information on grants of stock options to the Named Officers during 2004. No stock appreciation rights were granted to the Named Officers during 2004.

AGGREGATED OPTION EXERCISES IN 2004 AND YEAR-END 2004 OPTION VALUES – The following table provides information regarding each of the Named Officers’ option exercises in 2004 and unexercised options on December 31, 2004.

Aggregated Option Exercises in 2004 and

Year-End 2004 Option Values

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Employment

The Company entered into an employment agreement with Joseph E. Cross dated November 9, 1999, which provides for an annual base salary of not less than $220,000. In addition, Mr. Cross received a lump sum payment of $50,000 on the first anniversary of the commencement of this agreement. The Company also granted to Mr. Cross options to purchase up to 100,000 shares of common stock at an exercise price of $2.9375 per share and options to purchase up to 50,000 shares of common stock at an exercise price of $2.1875, with options for one-fifth of such shares becoming exercisable on each of the first five anniversaries of the dates of grant. No term has been assigned to Mr. Cross’ employment agreement. If Mr. Cross is terminated other than for “cause” (as such term is defined in Mr. Cross’ employment agreement), Mr. Cross will receive severance benefits in an amount equal to Mr. Cross’ base salary for 52 weeks.

Effective as of November 2, 2000, the Company also entered into an employment agreement with Robert Haines providing for an annual base salary of not less than $160,000. The Company also granted to Mr. Haines options to purchase up to 30,000 shares of common stock at an exercise price of $10.1875. No term has been assigned to Mr. Haines employment agreement. If Mr. Haines is terminated other than for “cause” (as such term is defined in Mr. Haines’s employment agreement), Mr. Haines will receive severance benefits in an amount equal to Mr. Haines’s base salary for 52 weeks.

Effective as of February 17, 2000, the Company also entered into an employment agreement with Daniel Bilicki providing for an annual base salary of not less than $165,000. In addition, Mr. Bilicki was granted options to purchase up to 50,000 shares of common stock at an exercise price of $2.375. No term has been assigned to Mr. Bilicki’s employment agreement. If Mr. Bilicki is terminated other than for “cause” (as such term is defined in Mr. Bilicki’s employment agreement), Mr. Bilicki will receive severance benefits in an amount equal to Mr. Bilicki’s base salary for 52 weeks.

Effective as of September 26, 2001, the Company also entered into an employment agreement with Dr. Richard Brotzman providing for an annual base salary of not less than $146,250. No term has been assigned to Dr. Brotzman’s employment agreement. If Dr. Brotzman is terminated other than for “cause” (as such term is defined in Dr. Brotzman’s employment agreement), Dr. Brotzman will receive severance benefits in an amount equal to Dr. Brotzman’s base salary for 26 weeks.

Effective as of February 17, 2000, the Company also entered into an employment agreement with Mr. Jess Jankowski providing for an annual base salary of not less than $95,000. No term has been assigned to Mr. Jankowski’s employment agreement. If Mr. Jankowski is terminated other than for “cause” (as such term is defined in Mr. Jankowski’s employment agreement), Mr. Jankowski will receive severance benefits in an amount equal to Mr. Jankowski’s base salary for 26 weeks.

Item 12. Security Ownership of Certain Beneficial Owners and Management

SECURITY OWNERSHIP OF MANAGEMENT

AND PRINCIPAL STOCKHOLDERS

The following table sets forth, as of March 16, 2005 certain information with respect to the beneficial ownership of the common stock by (1) each person known by the Company to own beneficially more than 5% of the outstanding shares of common stock, (2) each Company director, (3) each of the Named Officers and (4) all Company executive officers and directors as a group.

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Unless otherwise indicated below, the persons address is the same as the address for the Company.

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Equity Compensation Plan Information

The following table gives information about our common stock that may be issued upon the exercise of options, warrants, and rights under all of our existing compensation plans as of December 31, 2004, including the 1992 Amended and Restated Stock Option Plan and the 2001 and 2004 Equity Compensation Plan.

Item 13. Certain Relationships and Related Transactions

See Item 12 above. In addition, on September 5, 2003, in anticipation of the September 8, 2003 private placement to Grace Brothers Ltd. discussed below, the Company amended its existing Stockholder Rights Agreement to revise the beneficial ownership threshold at which a person or group of persons becomes an “acquiring person” and triggers certain provisions under the Stockholder Rights Agreement. As revised, a person or group would become an “acquiring person” if that person or group becomes the beneficial owner of 35% or more of the outstanding shares of the Company’s stock. Prior to such amendment, the beneficial ownership threshold was 25%. On September 8, 2003, the Company issued 453,001 shares of its common stock to Grace Brothers Ltd. at a purchase price of $4.415 per share together with a warrant to purchase a like number of shares of common stock during the next twelve months also at a price of $4.415 per share. The share price for the common stock was determined based on the fifteen-day market closing average for the Company’s stock ending September 5, 2003. On September 2, 2004 the warrants were exercised to acquire 453,001 newly issued shares of common stock. Grace Brothers, Ltd. beneficially owns approximately 19.9% of the Company’s outstanding common stock. Ms. R. Janet Whitmore is a sister of Bradford Whitmore who serves as the general partner of Grace Brothers, Ltd.

On March 23, 2004, the Company entered into a joint development agreement with Altana described in “Item 1. Business—Marketing.” In connection with this agreement the Company sold, in a private placement to Altana, 1,256,281 shares of common stock at $7.96 per share and received gross proceeds of $10 million. Altana beneficially owns approximately 7% of the Company’s outstanding common stock.

Item 14. Principal Accountant Fees and Services

Audit Fees. The aggregate amount billed by our principal accountant, McGladrey & Pullen, LLP, for audit services performed during the fiscal years ended December 31, 2004 and 2003 was $339,140 and $127,420, respectively. Audit services include the auditing of financial statements, quarterly reviews, statutory audits and the preparation of consents and review of registration statements.

Audit Related Fees. McGladrey & Pullen, LLP did not perform audit related services during the fiscal years ended December 31, 2004 and 2003. Audit related services would include employee benefit plan audits, due diligence assistance, internal control review assistance and audit or attestation services not required by statute or regulation.

Tax Fees. Total fees billed by RSM McGladrey, Inc. (an affiliate of McGladrey & Pullen, LLP) for tax related services for the fiscal years ended December 31, 2004 and 2003 were $6,500 and $7,840, respectively. These services include tax related research and general tax services in connection with transactions and legislation.

All Other. Other than those fees described above, during the fiscal year ended December 31, 2004 and 2003 there were no other fees billed for services performed by McGladrey & Pullen, LLP.

All of the fees described above were approved by Nanophase’s audit committee.

Audit Committee Pre-Approval Policies and Procedures. Nanophase’s audit committee pre-approves the audit and non-audit services performed by McGladrey & Pullen, LLP, our principal accountants, and RSM McGladrey, Inc. (an affiliate of McGladrey &

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Pullen, LLP) in order to assure that the provision of such services does not impair McGladrey & Pullen, LLP’s independence. Unless a type of service to be provided by McGladrey & Pullen, LLP and RSM McGladrey, Inc. (an affiliate of McGladrey & Pullen, LLP) has received general pre-approval, it will require specific pre-approval by the audit committee. In addition, any proposed services exceeding pre-approval cost levels will require specific pre-approval by the audit committee.

The term of any pre-approval is 12 months from the date of pre-approval, unless the audit committee specifically provides for a different period. The audit committee will periodically revise the list of pre-approved services, based on subsequent determinations, and has delegated pre-approval authority to the Chairman and Vice Chairman of the audit committee. In the event the Chairman or Vice Chairman exercise such delegated authority, they shall report such pre-approval decisions to the audit committee at its next scheduled meeting. The audit committee does not delegate its responsibilities to pre-approve services performed by the independent auditor to management.

PART IV

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

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On October 22, 2004, the Company furnished a Current Report on Form 8-K reporting under Items 1.01 and 9.01 that on October 22, 2004 it issued a press release announcing the Company and Rohm and Haas Electronic Materials CMP Inc. (“RHEM”) entered into a letter agreement, further amending the Cooperation Agreement between the Company and RHEM dated June 24, 2002 and initially amended February 25, 2004.

On November 1, 2004, the Company furnished a Current Report on Form 8-K reporting under Items 2.02 and 9.01 that on October 28, 2004 it issued a press release announcing its financial results for the quarter ended September 30, 2004.

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NANOPHASE TECHNOLOGIES CORPORATION

INDEX TO FINANCIAL STATEMENTS

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Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Nanophase Technologies Corporation

Romeoville, Illinois

We have audited the accompanying balance sheets of Nanophase Technologies Corporation as of December 31, 2004 and 2003, and the related statements of operations, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2004. We also have audited management’s assessment, included in the accompanying Annual Report on the Form 10-K, that Nanophase Technologies Corporation maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control— Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Nanophase Technologies Corporation’s management is responsible for these financial statements, 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 these financial statements, an opinion on management’s assessment, and an opinion on the effectiveness of the company’s internal control over financial reporting 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 audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting 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 audits provide a reasonable basis for our opinions.

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, the financial statements referred to above present fairly, in all material respects, the financial position of Nanophase Technologies Corporation as of December 31, 2004 and 2003, and the

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results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, management’s assessment that Nanophase Technologies Corporation maintained effective internal control over financial reporting as of December 31, 2004, 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).

Schaumburg, Illinois

January 21, 2005

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NANOPHASE TECHNOLOGIES CORPORATION

BALANCE SHEETS

(See accompanying Notes to Financial Statements)

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NANOPHASE TECHNOLOGIES CORPORATION

STATEMENTS OF OPERATIONS