SOLESENCE, INC. (SLSN)

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 risks discussed in 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 1, Item 1, of this Form 10-K.

Overview

Solésence
is a health-oriented, science-driven company, focused on various skin health and beauty markets. Our primary skin health products
are fully developed prestige skin care formulations with mineral-based UV protection enabled by our proprietary Active Pharmaceutical
Ingredients (“APIs”), which are also marketed as APIs for sale to manufacturers of other types of skin health products,
including sunscreens and daily care products. Additionally, we continue to sell products in legacy markets including medical diagnostics,
architectural coatings, industrial coating applications, abrasion-resistant additives, and plastics additives applications—
all of which currently fall into the advanced materials product category.

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Critical
Accounting Estimates

Management
also monitors the value of inventory for the effects of aging, obsolescence, and seasonality. Consistent with the provisions in
FASB ASC 330-10-35, we adjust inventory valuation upon management’s determination that the potential for obsolete materials
exist. The majority of the reserve is done by specific identification. Factors include inventory in quarantine, aging finished
goods or obsolete materials as identified by management. In the application of this policy in 2024, management deemed a portion
of inventory will likely experience such an impairment and elected to apply a $1,987,000 inventory reserve in anticipation. Some
of the materials in question are nearing expiration and therefore more difficult to sell, some represent soon-to-be obsolete products,
and some are raw materials that we no longer use regularly.

Certain
assumptions are necessary to assess the impact of risks and uncertainties on the financial information, such as cash flow projections,
availability of capital if needed to support the ongoing operations of the business, and our expected compliance with contractual
commitments. Any changes in those plans or assumptions could have a material impact on our liquidity and financial condition.
While we have seen costs continue to increase on an inflationary basis as we enter 2025, it is our belief that we will be able
to offset much of this cost as we gain greater production efficiencies and seek to increase our pricing where possible.

Results
of Operations

Years
Ended December 31, 2024 and 2023

Total
revenue increased to $52,347,000 in 2024, compared to $37,297,000 in 2023. A substantial majority of our revenue for each year
is from our largest customers, in particular, sales to our largest customer in skin care and sunscreen applications, finished
skin health products marketed through our consumer products. Product revenue, the primary component of our total revenue, increased
to $51,890,000 in 2024, compared to $36,641,000 in 2023. This increase was due to an increase in revenue from our consumer products
partially offset by decreased personal care ingredients and advanced materials products.

Current
Significant Customers

Cost
of revenue generally includes costs associated with commercial production and customer development arrangements. Cost of revenue
increased to $36,159,000 in 2024, compared to $29,472,000 in 2023. The increase in cost of revenue was primarily driven by higher
materials and direct labor costs related to the increased sales volume. Also contributing to the higher cost of revenue was increased
costs associated with supply chain and maintenance activities costs due to the increased sales volume. We expect to continue new
materials development and dispersion technologies for personal care applications and for our formulated Solésence products
during 2025 and beyond, as part of our business model. At current revenue levels we have generated a positive gross margin, though
margins can be impeded by the cyclicality of our demand, often leading to the Company not having enough revenue to efficiently
absorb manufacturing overhead that is required to work with current customers and expected future customers. We believe that our
current fixed manufacturing cost structure is sufficient to support higher levels of revenue volume. The extent to which margins
grow, as a percentage of total revenue, will be dependent upon revenue mix, revenue volume, our ability to cut costs and pass
commodity market-driven raw materials increases on to customers, and the speed and efficiency with which we are able to scale
up production for our Solésence products. We expect that, as product revenue volume increases, our fixed manufacturing
costs will be more efficiently absorbed, which should lead to increased margins as we grow. We expect to continue to focus on
reducing controllable variable product manufacturing costs, with potential variability related to the commodity metals markets
and cost and wage inflation but may or may not realize gross margin percentage growth through 2025 and beyond, 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 development or acquisition of new finished product formulations for skin care, new product applications
for our skin care ingredients, advancement of our medical diagnostics ingredient knowledge, and the cost of enhancing our manufacturing
processes. This includes legal fees related to intellectual property development, protection, and maintenance. As an example,
we are currently focusing the bulk of our resources on developing new product formulations, and related new technologies, as we
expand marketing and sales efforts relating to our Solésence products. This work has led to several new products and additional
potential new products. Our efforts in research and development, cosmetic formulating, process engineering and advanced engineering
groups are focused in three major areas: 1) application development for our products; 2) creating or obtaining additional core
materials technologies and/or materials that have the capability to serve multiple skin health-related markets; and 3) continuing
to improve our core technologies to improve manufacturing operations and reduce costs.

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Research
and development expense remained the same in 2024, totaling $3,837,000, the same as in 2023. In 2024 labor costs were higher than
2023 which were offset by lower legal and consulting costs in 2024 compared to 2023. We expect expenses for research and development
to increase slightly in 2025 depending on growth in our Solésence line of products, and related technologies. This expense
growth will be dependent upon the success we have in developing new products, which adds significantly to outside testing fees
to both enhance product development and comply with regulatory requirements.

Selling,
general and administrative expense decreased to $7,219,000 in 2024, compared to $7,534,000 in 2023. The net decrease was largely
attributed to a decrease in legal costs. We expect 2025 expenses in this area to be slightly higher due to expanding parts of
our administrative functions, including related staffing additions. The extent to which this increase occurs will be dependent
upon growth.

Interest
expense decreased to $670,000 in 2024, compared to $838,000 in 2023, due to lower interest rates in 2024 and decreased usage of
the debt facilities. The interest expense for 2024 and 2023 related to interest paid relating to our revolving lines of credit
for working capital funding and term loans supporting some of our equipment.

In
Company-wide operations, we believe inflation has not had a material effect on our operations or financial position for 2024,
although we have seen increases in our costs. We expect supplier price increases and wage and benefit inflation, both of which
represent a significant component of our costs of operations, may have a material effect on our operations and financial position
in 2025 and beyond. We will apply our best efforts to pass through cost increases to our customers. If we are unable to pass through
any increases due to contractual limitations or conditions in our markets specifically, this could reduce margins and net income.

Liquidity
and Capital Resources

Cash,
cash proceeds and use of cash for 2024 and 2023 were:

The
$3,977,000 year-over-year increase in cash provided by operating activities for the year ended December 31, 2024 was mainly due
to the Company earning $4,235,000 in net income in 2024 compared to $4,390,000 in net loss in 2023. Cash capital expenditures
amounted to approximately $4,558,000 and $1,051,000 for the years ended December 31, 2024 and 2023, respectively. We did not dispose
of or sell any assets during 2024 or 2023.

The
Company maintains a credit agreement with Libertyville to support our obligations under our leased manufacturing and warehouse
space in Bolingbrook, Illinois. As of December 31, 2024 there was no outstanding borrowings on this line of credit. This credit
agreement has a maturity of December 22, 2025.

On
January 28, 2022, to support the working capital demands created by the commercial growth of the Company and its wholly owned
subsidiary, Solésence, LLC, the Company entered into (i) an Amended and Restated Business Loan Agreement (the “A&R
Loan Agreement”), which amends and restates the Master Agreement, (ii) a Business Loan Agreement (the “New Term Loan
Agreement”) with Strandler, LLC, (iii) a Business Loan Agreement (the “New Revolving Loan Agreement” and together
with the A&R Loan Agreement and the New Term Loan Agreement, the “Loan Agreements”) with Beachcorp, LLC, and (iv)
three promissory notes in order to evidence the loans pursuant to the Loan Agreements (the “Notes”). Beachcorp, LLC
and Strandler, LLC are affiliates of Mr. Bradford T. Whitmore, who beneficially owns a majority of the Company’s common
stock and is the brother of Ms. R. Janet Whitmore, a director of the Company and the chair of the Company’s board of directors.

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The
Loan Agreements changed the terms of both the Company’s asset-based revolving loan facility (the “A/R Revolver Facility”)
and the secured advance (the “Term Loan”, which was assigned from Beachcorp, LLC to Strandler, LLC) under the Master
Agreement and provide a new asset-based revolving loan facility based on inventory (the “Inventory Facility”). The
maximum borrowing amount under the A/R Revolver Facility increases from $6,000,000 to $8,000,000, with a borrowing base consisting
of qualified accounts receivable of the Company. The maximum borrowing amount under the Inventory Facility is $4,000,000, with
a borrowing base consisting of up to 50% of the value of qualified inventory of the Company. The Loan Agreements also extended
the date for which all principal and accrued interest under the A&R Revolver Facility and the Term Loan are due from March
31, 2023 and March 31, 2022, respectively, to March 31, 2024, which was also the maturity date for the Inventory Facility. The
Loan Agreements reduce interest on outstanding borrowings under the A/R Revolver Facility and the Term Loan from the prime rate
plus 2% and 5.25% per year, to a floating rate equal to the prime rate plus 0.75%, which is also the interest rate for borrowings
under the Inventory Facility. The amount of the Term Loan remains $1,000,000. The A/R Revolver Facility, the Inventory Facility
and the Term Loan are all secured by all the unencumbered assets of the Company and subordinated to the Company’s revolving
line of credit with Libertyville Bank & Trust.

On
November 13, 2023 to support working capital demands the Company entered into (i) a new Promissory Note (“Bridge Note”)
with Strandler, LLC, with a maximum borrowing amount of $2,000,000, interest rate at the prime rate plus 0.75%, and set to mature
on May 13, 2024, and (ii) amendments to the Loan Agreements increasing the principal amount of the Inventory Facility to $5,200,000,
increased the borrowing base to 55% of eligible inventory, up from 50% and extending the maturity date under the Loan Agreement
to March 31, 2025. The Bridge Note was repaid in full in connection with the Purchase Agreement referred to below.

On
March 1, 2024, the Company entered into a Securities Purchase Agreement (the “Purchase Agreement”), between the Company
and Strandler, LLC (“Strandler”).

Pursuant
to the Purchase Agreement, the Company issued to Strandler 15,000 shares of the Company’s Series X Preferred Stock (the
“Series X Preferred Stock”) at a purchase price per share of $400, for total consideration of $6,000,000, in a transaction
exempt from registration under the Securities Act of 1933, as amended, pursuant to Section 4(a)(2) thereof. The terms of the Preferred
Stock are set forth in the Company’s Certificate of Designations to its Certificate of Incorporation, filed with the Secretary
of State of the State of Delaware on March 4, 2024 (the “Certificate of Designations”).

Under
the Purchase Agreement, the Company granted Strandler customary registration rights with respect to shares of the Company’s
common stock, par value $0.01 per share (the “Common Stock”), it may receive in connection with any conversion of
Series X Preferred Stock into Common Stock, as described below. For so long as any amount of Preferred Stock is outstanding, the
Purchase Agreement also (i) prevented the Company from paying any dividend on any shares of the Company’s capital stock
(other than dividends consisting solely of Common Stock or rights to purchase Common Stock), (ii) prevented the Company from repurchasing
any Common Stock, and (iii) subject to certain permitted exceptions, restricted the Company’s ability to permit any lien
or other encumbrance on Company assets.

At
any time and from time to time, in whole or in part, following the Company properly filing an amendment (the “Certificate
Amendment”) to its Certificate of Incorporation to increase the number of authorized shares of its Common Stock from 60,000,000
to 95,000,000, each share of Series X Preferred Stock was convertible, at the option of the holder, into 1,000 shares of Common
Stock at no additional cost. If the Company had not properly filed, upon shareholder approval, the Certificate Amendment on or
before August 1, 2024, then each share of Series X Preferred Stock would have been redeemable at the holder’s option, in
whole or in part, without penalty or premium, at a redemption price equal to $420 per share (each, a “Redemption”).
If the Company had failed to fully pay any Redemption within five days of receiving notice, all unpaid amounts will have born
interest at a rate of 10% per annum. In addition, in the event of a Change in Control (as defined in the Certificate of Designations)
of the Company, each share of the Series X Preferred Stock would have been redeemable at the option of the holder, without penalty
or premium, at a redemption price equal to $420 per share. Upon any conversion of Preferred Stock into Common Stock by Strandler,
Strandler is required to hold the Common Stock received in the conversion for a period of 12 months.

Holders
of Series X Preferred Stock (i) were not entitled to receive dividends, subject to customary anti-dilution protections, (ii) have
no voting rights, and (iii)receive a liquidation preference of $400 per share. The Series X Preferred Stock ranks senior in right
of payment to all securities designated as junior securities, including Common Stock.

On
June 18, 2024, the Company held a special meeting of stockholders where the Certificate Amendment was approved. The Certificate
Amendment was filed with the State of Delaware on June 19, 2024. On June 20, 2024, Strandler converted its 15,000 shares of Series
X Preferred Stock to 15,000,000 shares of Common Stock.

In
connection with the Company’s entry into the Purchase Agreement, the Company also entered into (i) a Second Amendment to
Business Loan Agreement (the “Term Loan Agreement Amendment”) with Strandler, LLC, (ii) a Second Amendment to Business
Loan Agreement (the “A&R Loan Agreement Amendment”) with Beachcorp, LLC, which is also an affiliate of our controlling
shareholder, Bradford T. Whitmore (“Beachcorp”), and (iii) a Second Amendment to Business Loan Agreement with Beachcorp
(the “Revolving Loan Agreement Amendment” and together with the Term Loan Agreement Amendment and the A&R Term
Loan Agreement Amendment, the “Loan Agreement Amendments”). The Loan Agreement Amendments extend the maturity date
under each respective loan agreement from March 31, 2025 to October 1, 2025. As of December 31, 2024, the Company’s A/R
Revolver, Inventory Facility and New Term Loan matured on October 1, 2025. Since then, the Company’s related party debt
holder for the A/R Revolver, Inventory Facility and New Term Loan has committed to refinancing the debt with a new maturity date
after April 1, 2026.

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On
December 31, 2024, the balance on the Term Loan was $1,000,000, the balance on the A/R Revolver Facility was $0, the balance on
the Inventory Facility was $4,000,000. On December 31, 2023, the balance on the Term Loan was $1,000,000, the balance on the Bridge
Load was $2,000,000, the balance on the A/R Revolver Facility was $2,810,000, and the balance on the Inventory Facility was $5,000,000.

For
more information regarding the New Business Loan Agreement, see Note 3 to our Financial Statements referred to in Part II, Item
8 of this Annual Report on Form 10-K.

Our
actual future capital requirements in 2025 and beyond will depend on many factors, including customer acceptance of our current
and potential consumer products, APIs sold as ingredients in to the skin health markets, medical diagnostics ingredients, and
other engineered materials, applications, and products, continued progress in research and development activities and product
testing programs, the magnitude of these activities and programs, and the costs necessary to increase and expand our manufacturing
capabilities and to market and sell these products and ingredients. 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 existing
customers. Depending on the success of certain projects, we expect that capital spending relating to currently known capital needs
for 2025 will be between $6 million and $8 million, to be funded by profit from operations, our existing loans and lines of credit,
and possible new financing. If those projects are delayed or ultimately prove unsuccessful, or if we fail to be able to support
the additional cost of funding them in the near term, we expect our capital expenditures may fall below the lower end of the range.
Similarly, substantial success in business development projects may cause the actual 2025 capital investment to exceed the top
of this range.

We
have federal net operating loss carryforwards for tax purposes of approximately $42 million on December 31, 2024 Because the Company
may experience “ownership changes” within the meaning of the U.S. Internal Revenue Code (“IRC”) in connection
with any future equity offerings, future utilization of this carryforward may be subject to certain limitations as defined by
the IRC. If not utilized, $36 million of this loss carryforward will expire between 2025 and 2037. Given changes to the IRC, net
operating loss carryforwards generated after January 1, 2018 do not expire, therefore, $6.8 million in net operating losses generated
since January 1, 2018 do not expire. We have Illinois net loss deduction carryforwards for tax purposes of approximately $18.2
million on December 31, 2024. Due to the provisions of Illinois Public Act 102-0669 signed November 16, 2021, Illinois net loss
deductions expire between 2030 and 2043.

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, we have concluded that it is likely that some portion of this carryforward will expire before ultimately
becoming available to reduce income tax liabilities.

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 risks discussed in 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 1, Item 1, of this Form 10-K.

Overview

Nanophase
is a health-oriented, science-driven company, which, along with its wholly owned subsidiary, Solésence, LLC (our “Solésence
beauty science subsidiary”), is focused on various beauty- and life-science markets. Our primary skin health products are
fully developed prestige skin care formulations with mineral-based UV protection, marketed and sold through our Solésence
beauty science subsidiary, enabled by our proprietary Active Pharmaceutical Ingredients (“APIs”), which are also marketed
as APIs for sale to manufacturers of other types of skin health products, including sunscreens and daily care products.
In terms of the balance of our life sciences focus, we have seen continued demand for our medical diagnostics ingredients, which
are used in testing for various viruses, most notably COVID-19.  Additionally, we continue to sell products in legacy markets
including architectural coatings, industrial coating applications, abrasion-resistant additives, plastics additives, and surface
finishing technologies (polishing) applications— all of which, along with medical diagnostics, currently fall into the advanced
materials product category.

Critical
Accounting Estimates

We
review long-lived assets for impairment whenever events or changes in circumstances indicate that the asset’s carrying amount
may not be recoverable. We conduct long-lived asset impairment analyses in accordance with Financial Accounting Standards Board
(“FASB”) Accounting Standards Codification (“ASC”) Topic 360-10-15, Impairment or Disposal of Long-Lived
Assets. ASC 360-10-15 requires us to group assets and liabilities at the lowest level for which identifiable cash flows are
largely independent of the cash flows of other assets and liabilities and evaluate the asset group against the sum of the undiscounted
future cash flows. If the undiscounted cash flows do not indicate the carrying amount of the asset is recoverable, an impairment
charge is measured as the amount by which the carrying amount of the asset group exceeds its fair value based on discounted cash
flow analysis or appraisals.

10

Other
critical estimates include the allowance for doubtful accounts applied against our receivables balance as well as an inventory
reserve. In the determination of a reserve to apply toward receivables, management considered provisions in FASB ASC 326 &
ASC 450-20-25 regarding the recognition of loss contingencies and applied a reserve balance against gross receivables to arrive
at the net reported balance. Under the guidance referenced above, management judgmentally applied an estimate of the portion of
gross receivables for which loss is both probable and can be reasonably estimated and accrued a loss contingency by a charge to
income. A bad debt reserve of $225,000 and $139,000 was applied to gross receivables for 2023 and 2022, respectively. Particularly
with respect to customers of our Solésence beauty science subsidiary, it can be difficult to estimate collectability. We
frequently require significant deposits from customers before ordering materials and scheduling production. This serves as a good
indicator of the customer’s wherewithal to pay for the balance of the product when shipped. In cases where it is difficult
to establish creditworthiness, we require payment of the full amount before we ship. Notwithstanding these credit security measures,
we frequently find that pay cycles get extended for reasons that can be outside of our control. The nature of the business is
that there are many product launches, often by smaller or start-up companies, that may not result in initial commercial success.
This has resulted in extensions of payment terms, but collectability has ultimately occurred in most cases. As our Solésence
beauty science subsidiary grows, we will monitor this closely and adjust estimates as necessary.

Management
also monitors the value of inventory for the effects of aging, obsolescence, and seasonality. Consistent with the provisions in
FASB ASC 330-10-35, we adjust inventory valuation upon management’s determination that the net realizable value of our inventory,
which applies the average cost method, is lower than its historic cost. In the application of this policy in 2023, management
deemed a portion of inventory will likely experience such an impairment and elected to apply a $677,000 inventory reserve in anticipation.
Some of the materials in question are nearing expiration and therefore more difficult to sell, some represent soon-to-be obsolete
products, and some are raw materials that we no longer use regularly.

Certain
assumptions are necessary to assess the impact of risks and uncertainties on the financial information, such as cash flow projections,
availability of capital if needed to support the ongoing operations of the business, and our expected compliance with contractual
commitments. Any changes in those plans or assumptions could have a material impact on our liquidity and financial condition.
While we have seen costs continue to increase on an inflationary basis as we enter 2024, it is our belief that we will be able
to offset much of this cost as we gain greater production efficiencies and seek to increase our pricing where possible.

Results
of Operations

Years
Ended December 31, 2023 and 2022

Total
revenue decreased to $37,297,000 in 2023, compared to $37,317,000 in 2022. A substantial majority of our revenue for each year
is from our largest customers, in particular, sales to our largest customer in skin care and sunscreen applications, finished
skin health products marketed through our Solésence beauty science subsidiary. Product revenue, the primary component of
our total revenue, decreased to $36,641,000 in 2023, compared to $36,731,000 in 2022. This slight decrease was due to a decrease
in revenue from our personal care business and a medical diagnostics materials customer (within our advanced materials business).

Current
Significant Customers

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Cost
of revenue generally includes costs associated with commercial production and customer development arrangements. Cost of revenue
increased to $29,472,000 in 2023, compared to $28,957,000 in 2022. The increase in cost of revenue was primarily driven by the
higher management costs related to the production processes. Lower-than-expected volume in the fourth quarter of 2023, write-downs
of obsolete inventory, reduction in contract revenue (which generally has little direct cost associated with it), and changes
in product mix, added to relative increases in cost of revenue. All of these factors contributed to a reduction of overall gross
margin percentage by 1% when compared to 2022. We expect to continue new materials development and dispersion technologies for
personal care applications and for our formulated Solésence products during 2024 and beyond, as part of our business model.
At current revenue levels we have generated a positive gross margin, though margins can be impeded by the cyclicality of our demand,
often leading to the Company not having enough revenue to efficiently absorb manufacturing overhead that is required to work with
current customers and expected future customers. We believe that our current fixed manufacturing cost structure is sufficient
to support higher levels of revenue volume. The extent to which margins grow, as a percentage of total revenue, will be dependent
upon revenue mix, revenue volume, our ability to cut costs and pass commodity market-driven raw materials increases on to customers,
and the speed and efficiency with which we are able to scale up production for our Solésence products. We expect that,
as product revenue volume increases, our fixed manufacturing costs will be more efficiently absorbed, which should lead to increased
margins as we grow. We expect to continue to focus on reducing controllable variable product manufacturing costs, with potential
variability related to the commodity metals markets and cost and wage inflation but may or may not realize gross margin percentage
growth through 2024 and beyond, 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 development or acquisition of new finished product formulations for skin care, new product applications
for our skin care ingredients, advancement of our medical diagnostics ingredient knowledge, and the cost of enhancing our manufacturing
processes. This includes legal fees related to intellectual property development, protection, and maintenance. As an example,
we are currently focusing the bulk of our resources on developing new product formulations, and related new technologies, as we
expand marketing and sales efforts relating to our Solésence products. This work has led to several new products and additional
potential new products. Our efforts in research and development, cosmetic formulating, process engineering and advanced engineering
groups are focused in three major areas: 1) application development for our products; 2) creating or obtaining additional core
materials technologies and/or materials that have the capability to serve multiple skin health-related markets; and 3) continuing
to improve our core technologies to improve manufacturing operations and reduce costs.

Research
and development expense increased to $3,837,000 in 2023, compared to $3,037,000 in 2022. The primary reasons for this were increases
in compensation expense and headcount, outside testing, and materials charges associated with the development and launch of our
Solésence line of personal care products and related capabilities. We expect expenses for research and development to continue
to increase depending on growth in our Solésence line of products, and related technologies. This expense growth will be
dependent upon the success we have in developing new products, which adds significantly to outside testing fees to both enhance
product development and comply with regulatory requirements.

Selling,
general and administrative expense decreased to $7,534,000 in 2023, compared to $7,581,000 in 2022. The net decrease was largely
attributed to a decrease in professional services. We expect 2024 expenses in this area to be slightly lower, even if growth continues
as planned due to expected decreased legal costs.  We will be expanding parts of our administrative functions, including
related staffing additions.  The extent to which this increase occurs will be dependent upon growth.

Interest
expense increased to $838,000 in 2023, compared to $382,000 in 2022, due to higher interest rates in 2023 and increased usage
of the debt facilities. The interest expense for 2023 and 2022 related to interest paid relating to our revolving lines of credit
for working capital funding, and finance leases and term loans supporting some of our equipment.

In
Company-wide operations, we believe inflation has not had a material effect on our operations or financial position for 2023,
although we have seen increases in our costs. We expect supplier price increases and wage and benefit inflation, both of which
represent a significant component of our costs of operations, may have a material effect on our operations and financial position
in 2024 and beyond. We will apply our best efforts to pass through cost increases to our customers. If we are unable to pass through
any increases due to contractual limitations or conditions in our markets specifically, this could reduce margins and net income.

Liquidity
and Capital Resources

Cash,
cash proceeds and use of cash for 2023 and 2022 were:

The
$354,000 year-over-year increase in cash used in operating activities for the year ended December 31, 2023 was mainly due to the
Company incurring $4,390,000 in net loss in 2023 compared to $2,623,000 in net income in 2022. Cash capital expenditures amounted
to approximately $1,051,000 and $2,823,000 for the years ended December 31, 2023 and 2022, respectively. We did not dispose of
or sell any assets during 2023 or 2022.

The
Company maintains a credit agreement with Libertyville to support our obligations under our newly leased manufacturing and warehouse
space in Bolingbrook, Illinois. As of December 31, 2023 there was no outstanding borrowings on this line of credit. This credit
agreement has a maturity of December 22, 2024.

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On
November 16, 2018, we entered into a Business Loan Agreement (the “Master Agreement”) with Beachcorp, LLC. The Master
Agreement relates to two loan facilities, each evidenced by a separate promissory note dated as of November 16, 2018: a term loan
to the Company of up to $500,000 to be disbursed in a single advance (the “Term Loan”) with a fixed annual interest
rate of 8.25%, payable quarterly, and with principal due on December 31, 2020; and an asset-based revolving loan facility for
the Company of up to $2,000,000 (the “A/R Revolver Facility”), with floating interest accruing at the prime rate plus
3% (8.25% minimum) per year, with a borrowing base consisting of qualified accounts receivable of the Company, and a maturity
of March 31, 2020, as amended. On March 23, 2020, the Company and Beachcorp, LLC executed the First Amendment to our Master
Agreement that extended the maturities of both the Term Loan and the A/R Revolver Facility to March 31, 2021. Effective September
8, 2020, the Company and Beachcorp, LLC executed the Second Amendment to our Master Agreement that expanded the limit on the A/R
Revolver Facility from $2,000,000 to $2,750,000.  On December 23, 2020, the Company and Beachcorp, LLC executed the Third
Amendment to our Master Agreement that expanded the limit on the A/R Revolver Facility from $2,750,000 to $4,000,000 and extended
the maturities of both the Term Loan and the A/R Revolver Facility to March 31, 2022. Effective April 21, 2021 the Company and
Beachcorp, LLC executed the Fourth Amendment to our Master Agreement that expanded the limit on the A/R Revolver Facility from
$4,000,000 to $6,000,000, changed the interest rate to fully floating and reduced the rate to the prime rate plus 2%, also extending
the maturity of the A/R Revolver Facility to March 31, 2023. This amendment also increased the amount of the Term Loan from $500,000
to $1,000,000, changed the interest rate to fully floating and reduced the rate to the prime rate plus 2%. The maturity of the
Term Loan remained March 31, 2022.

On
January 28, 2022, to support the working capital demands created by the commercial growth of the Company and its wholly owned
subsidiary, Solésence, LLC, the Company entered into (i) an Amended and Restated Business Loan Agreement (the “A&R
Loan Agreement”), which amends and restates the Master Agreement, (ii) a Business Loan Agreement (the “New Term Loan
Agreement”) with Strandler, LLC, (iii) a Business Loan Agreement (the “New Revolving Loan Agreement” and together
with the A&R Loan Agreement and the New Term Loan Agreement, the “Loan Agreements”) with Beachcorp, LLC, and (iv)
three promissory notes in order to evidence the loans pursuant to the Loan Agreements (the “Notes”). Beachcorp, LLC
and Strandler, LLC are affiliates of Mr. Bradford T. Whitmore, who beneficially owns a majority of the Company’s common
stock and is the brother of Ms. R. Janet Whitmore, a director of the Company and the chair of the Company’s board of directors.

The
Loan Agreements changed the terms of both the Company’s asset-based revolving loan facility (the “A/R Revolver Facility”)
and the secured advance (the “Term Loan”, which was assigned from Beachcorp, LLC to Strandler, LLC) under the Master
Agreement and provide a new asset-based revolving loan facility based on inventory (the “Inventory Facility”). The
maximum borrowing amount under the A/R Revolver Facility increases from $6,000,000 to $8,000,000, with a borrowing base consisting
of qualified accounts receivable of the Company. The maximum borrowing amount under the Inventory Facility is $4,000,000, with
a borrowing base consisting of up to 50% of the value of qualified inventory of the Company. The Loan Agreements also extended
the date for which all principal and accrued interest under the A&R Revolver Facility and the Term Loan are due from March
31, 2023 and March 31, 2022, respectively, to March 31, 2024, which was also the maturity date for the Inventory Facility. The
Loan Agreements reduce interest on outstanding borrowings under the A/R Revolver Facility and the Term Loan from the prime rate
plus 2% and 5.25% per year, to a floating rate equal to the prime rate plus 0.75%, which is also the interest rate for borrowings
under the Inventory Facility. The amount of the Term Loan remains $1,000,000. The A/R Revolver Facility, the Inventory Facility
and the Term Loan are all secured by all the unencumbered assets of the Company and subordinated to the Company’s revolving
line of credit with Libertyville Bank & Trust.

On
November 13, 2023 to support working capital demands the Company entered into (i) a new Promissory Note (“Bridge Note”)
with Strandler, LLC,. The maximum borrowing amount under the Bridge Note is $2,000,000. The interest rate for the Bridge Note
is at the prime rate plus 0.75%, and it matures on May 13, 2024, and (ii) amendments to the Loan Agreements increasing increasing
the principal amount of the Inventory Facility to $5,200,000 and extending the maturity date under the Loan Agreement to March
31, 2025.

On
December 31, 2023, the balance on the Term Loan was $1,000,000, the balance on the A/R Revolver Facility was $2,810,000, the balance
on the Inventory Facility was $5,000,000, and the balance on the Bridge Note was $2,000,000. On December 31, 2022, the balance
on the Term Loan was $1,000,000, the balance on the A/R Revolver Facility was $4,282,000, and the balance on the Inventory Facility
was $3,000,000.

On
March 1, 2024, the Company entered into a Securities Purchase Agreement (the “Purchase Agreement”), between the Company
and Strandler, LLC (“Strandler”).

Pursuant
to the Purchase Agreement, the Company issued to Strandler 15,000 shares of the Company’s Series X Preferred Stock (the
“Series X Preferred Stock”) at a purchase price per share of $400, for total consideration of $6,000,000, in a transaction
exempt from registration under the Securities Act of 1933, as amended, pursuant to Section 4(a)(2) thereof. The terms of the Preferred
Stock are set forth in the Company’s Certificate of Designations to its Certificate of Incorporation, filed with the Secretary
of State of the State of Delaware on March 4, 2024 (the “Certificate of Designations”).

13

Under
the Purchase Agreement, the Company granted Strandler customary registration rights with respect to shares of the Company’s
common stock, par value $0.01 per share (the “Common Stock”), it may receive in connection with any conversion of
Series X Preferred Stock into Common Stock, as described below. For so long as any amount of Preferred Stock is outstanding, the
Purchase Agreement also (i) prevents the Company from paying any dividend on any shares of the Company’s capital stock (other
than dividends consisting solely of Common Stock or rights to purchase Common Stock), (ii) prevents the Company from repurchasing
any Common Stock, and (iii) subject to certain permitted exceptions, restricts the Company’s ability to permit any lien
or other encumbrance on Company assets.

At
any time and from time to time, in whole or in part, following the Company properly filing an amendment (the “Certificate
Amendment”) to its Certificate of Incorporation to increase the number of authorized shares of its Common Stock from 60,000,000
to 95,000,000, each share of Series X Preferred Stock is convertible, at the option of the holder, into 1,000 shares of Common
Stock at no additional cost. If the Company has not properly filed, upon shareholder approval, the Certificate Amendment on or
before August 1, 2024, then each share of Series X Preferred Stock will be redeemable at the holder’s option, in whole or
in part, without penalty or premium, at a redemption price equal to $420 per share (each, a “Redemption”). If the
Company fails to fully pay any Redemption within five days of receiving notice, all unpaid amounts will bear interest at a rate
of 10% per annum. In addition, in the event of a Change in Control (as defined in the Certificate of Designations) of the Company,
each share of the Series X Preferred Stock is redeemable at the option of the holder, without penalty or premium, at a redemption
price equal to $420 per share. Upon any conversion of Preferred Stock into Common Stock by Strandler, Strandler is required to
hold the Common Stock received in the conversion for a period of 12 months.

Holders
of Series X Preferred Stock (i) are not entitled to receive dividends, subject to customary anti-dilution protections, (ii) have
no voting rights, and (iii)receive a liquidation preference of $400 per share. The Series X Preferred Stock ranks senior in right
of payment to all securities designated as junior securities, including Common Stock.

In
connection with the Company’s entry into the Purchase Agreement, the Company also entered into (i) a Second Amendment to
Business Loan Agreement (the “Term Loan Agreement Amendment”) with Strandler, LLC, (ii) a Second Amendment to Business
Loan Agreement (the “A&R Loan Agreement Amendment”) with Beachcorp, LLC, which is also an affiliate of our controlling
shareholder, Bradford T. Whitmore (“Beachcorp”), and (iii) a Second Amendment to Business Loan Agreement with Beachcorp
(the “Revolving Loan Agreement Amendment” and together with the Term Loan Agreement Amendment and the A&R Term
Loan Agreement Amendment, the “Loan Agreement Amendments”). The Loan Agreement Amendments extend the maturity date
under each respective loan agreement from March 31, 2025 to October 1, 2025.

For
more information regarding the New Business Loan Agreement, see Note 3 to our Financial Statements referred to in Part II, Item
8 of this Annual Report on Form 10-K.

Our
actual future capital requirements in 2024 and beyond will depend on many factors, including customer acceptance of our current
and potential finished Solésence  products, APIs sold as ingredients in to the skin health markets, medical
diagnostics ingredients, and other engineered materials, applications, and products, continued progress in research and development
activities and product testing programs, the magnitude of these activities and programs, and the costs necessary to increase and
expand our manufacturing capabilities and to market and sell these products and ingredients. 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 existing customers. Depending on the success of certain projects, we expect that capital spending relating
to currently known capital needs for 2024 will be between $1 million and $5 million, to be funded by profit from operations, our
existing loans and lines of credit, and possible new financing. If those projects are delayed or ultimately prove unsuccessful,
or if we fail to be able to support the additional cost of funding them in the near term, we expect our capital expenditures may
fall below the lower end of the range. Similarly, substantial success in business development projects may cause the actual 2024
capital investment to exceed the top of this range.

The
Company currently has two areas within its strategic plan that will result in material cash requirements that could have an impact
on operations. We have several operating leases (see note 6 to the financial statements) for our facilities that require us to
increase our cash outlays for facilities expenses significantly beginning in 2022. The 260,000 square foot facility we leased
in December 2021 exceeds our current needs for space considerably. We consequently have sublet a portion of the facility on shorter
term leases. We are growing rapidly and continue to expect significant growth going forward. We will also consolidate some of
our facilities to mitigate costs. Our view was that a lack of space would have hindered our ability to continue to grow, as well
as making it difficult to satisfy existing customer demands on a timely basis if we couldn’t expand our production footprint.
We have estimated our future growth through a combination of industry experience, customer feedback, market intelligence, and
our successful history in commercializing new products. Sales of our Solésence products have roughly tripled between 2019
and 2021, increased by 27% in 2022, and increased by 9% in 2023 to reach $25 million annually. We expect this growth to continue,
albeit at less than a multiple of each year’s sales going forward. Many of these estimates are qualitative in nature, but
are informed by experience. If we were to not grow more than incrementally in 2024, we would need to re-evaluate our expansion
strategy in light of the increases in our facilities costs that extend for as much as ten years into the future. Similarly, our
capital spending plan for 2024 will amount to between $1 million and $5 million. We expect our capital spending to increase further
in 2025 and 2026. At December 31, 2023, our commitments to equipment suppliers relate mainly to the $1 million of construction
in progress, much of which reflects deposits on to-be-delivered equipment. We estimate the unpaid committed capital relating to
capital spending to be less than $1 million as of December 31, 2023.

We
have federal net operating loss carryforwards for tax purposes of approximately $50 million on December 31, 2023. We have
section 179 carryforwards of approximately $0.2M at December 31, 2023. Because the Company may experience “ownership changes”
within the meaning of the U.S. Internal Revenue Code (“IRC”) in connection with any future equity offerings, future
utilization of this carryforward may be subject to certain limitations as defined by the IRC. If not utilized, $44 million of
this loss carryforward will expire between 2024 and 2037. Given changes to the IRC, net operating loss carryforwards generated
after January 1, 2018 do not expire, therefore, $5.6 million in net operating losses generated since January 1, 2018 do not expire.
We have Illinois net loss deduction carryforwards for tax purposes of approximately $21.3 million on December 31, 2023. Due to
the provisions of Illinois Public Act 102-0669 signed November 16, 2021, Illinois net loss deductions expire between 2029 and
2042.

14

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, we have concluded that it is likely that some portion of this carryforward will expire before ultimately
becoming available to reduce income tax liabilities.

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 risks discussed in 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 1, Item 1, of this Form 10-K.

Overview

Nanophase
is a health-oriented, science-driven company, which, along with its wholly owned subsidiary, Solésence, LLC (our “Solésence
beauty science subsidiary”), is focused in various beauty- and life-science markets. Our primary skin health products are
fully developed prestige skin care formulations with mineral-based UV protection, marketed and sold through our Solésence
beauty science subsidiary, enabled by our proprietary Active Pharmaceutical Ingredients (“APIs”), which are also marketed
as APIs for sale to manufacturers of other types of skin health products, including sunscreens and daily care products.
In terms of the balance of our life sciences focus, we have seen continued demand for our medical diagnostics ingredients, which
are used in testing for various viruses, most notably COVID-19.  Additionally, we continue to sell products in legacy markets
including architectural coatings, industrial coating applications, abrasion-resistant additives, plastics additives, and surface
finishing technologies (polishing) applications— all of which, along with medical diagnostics, currently fall into the advanced
materials product category.

10

Critical
Accounting Estimates

We
review long-lived assets for impairment whenever events or changes in circumstances indicate that the asset’s carrying amount
may not be recoverable. We conduct long-lived asset impairment analyses in accordance with Financial Accounting Standards Board
(“FASB”) Accounting Standards Codification (“ASC”) Topic 360-10-15, Impairment or Disposal of Long-Lived
Assets. ASC 360-10-15 requires us to group assets and liabilities at the lowest level for which identifiable cash flows are
largely independent of the cash flows of other assets and liabilities and evaluate the asset group against the sum of the undiscounted
future cash flows. If the undiscounted cash flows do not indicate the carrying amount of the asset is recoverable, an impairment
charge is measured as the amount by which the carrying amount of the asset group exceeds its fair value based on discounted cash
flow analysis or appraisals.

Other
critical estimates include the allowance for doubtful accounts applied against our receivables balance as well as an inventory
reserve. In the determination of a reserve to apply toward receivables, management considered provisions in FASB ASC 450-20-25
regarding the recognition of loss contingencies and applied a reserve balance against gross receivables to arrive at the net reported
balance. Under the guidance referenced above, management judgmentally applied an estimate of the portion of gross receivables
for which loss is both probable and can be reasonably estimated and accrued a loss contingency by a charge to income. A bad debt
reserve of $139,000 and $60,000 was applied to gross receivables for 2022 and 2021, respectively. Particularly with respect to
customers of our Solésence beauty science subsidiary, it can be difficult to estimate collectability. We frequently require
significant deposits from customers before ordering materials and scheduling production. This serves as a good indicator of the
customer’s wherewithal to pay for the balance of the product when shipped. In cases where it is difficult to establish creditworthiness,
we require payment of the full amount before we ship. Notwithstanding these credit security measures, we frequently find that
pay cycles get extended for reasons that can be outside of our control. The nature of the business is that there are many product
launches, often by smaller or start-up companies, that may not result in initial commercial success. This has resulted in extensions
of payment terms, but collectability has ultimately occurred in most cases. As our Solésence beauty science subsidiary
grows, we will monitor this closely and adjust estimates as necessary.

Management
also monitors the value of inventory for the effects of aging, obsolescence, and seasonality. Consistent with the provisions in
FASB ASC 330-10-35, we adjust inventory valuation upon management’s determination that the net realizable value of our inventory,
which applies the average cost method, is lower than its historic cost. In the application of this policy in 2022, management
deemed a portion of inventory will likely experience such an impairment and elected to apply a $500,000 inventory reserve in anticipation.
Some of the materials in question are nearing expiration and therefore more difficult to sell, some represent soon-to-be obsolete
products, and some are raw materials that we no longer use regularly.

Certain
assumptions are necessary to assess the impact of risks and uncertainties on the financial information, such as cash flow projections,
availability of capital if needed to support the ongoing operations of the business, and our expected compliance with contractual
commitments. Any changes in those plans or assumptions could have a material impact on our liquidity and financial condition.
While we have seen costs continue to increase on an inflationary basis as we enter 2023, it is our belief that we will be able
to offset much of this cost as we gain greater production efficiencies and seek to increase our pricing where possible.

Results
of Operations

Years
Ended December 31, 2022 and 2021

Total
revenue increased to $37,317,000 in 2022, compared to $29,475,000 in 2021. A substantial majority of our revenue for each year
is from our largest customers, in particular, sales to our largest customer in skin care and sunscreen applications, finished
skin health products marketed through our Solésence beauty science subsidiary. Product revenue, the primary component of
our total revenue, increased to $36,731,000 in 2022, compared to $29,325,000 in 2021. This increase was due to rapid growth in
the adoption of our Solésence® products, and growth in sales to our largest customer in our personal care ingredients
business, offset by a decrease in revenue from our medical diagnostics materials customer (within our advanced materials business).

Current
Significant Customers

11

Cost
of revenue generally includes costs associated with commercial production and customer development arrangements. Cost of revenue
increased to $28,957,000 in 2022, compared to $20,785,000 in 2021. The increase in cost of revenue was primarily driven by the
rapid increases in product revenue volume, with attendant inefficiencies caused by hitting capacity limits in various critical
processes. Lower-then-expected volume in the fourth quarter of 2022, write-downs of obsolete inventory, reduction in contract
revenue (which generally has little direct cost associated with it), and changes in product mix, added to relative increases in
cost of revenue. All of these factors contributed to a reduction of overall gross margin percentage by 7% when compared to 2021.
We expect to continue new materials development and dispersion technologies for personal care applications and for our formulated
Solésence products during 2022 and beyond, as part of our business model. At current revenue levels we have generated a
positive gross margin, though margins can be impeded by the cyclicality of our demand, often leading to the Company not having
enough revenue to efficiently absorb manufacturing overhead that is required to work with current customers and expected future
customers. We believe that our current fixed manufacturing cost structure is sufficient to support higher levels of revenue
volume. The extent to which margins grow, as a percentage of total revenue, will be dependent upon revenue mix, revenue volume,
our ability to cut costs and pass commodity market-driven raw materials increases on to customers, and the speed and efficiency
with which we are able to scale up production for our Solésence products. We expect that, as product revenue volume increases,
our fixed manufacturing costs will be more efficiently absorbed, which should lead to increased margins as we grow. We expect
to continue to focus on reducing controllable variable product manufacturing costs, with potential variability related to the
commodity metals markets and cost and wage inflation, but may or may not realize gross margin percentage growth through 2023 and
beyond, 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 development or acquisition of new finished product formulations for skin care, new product applications
for our skin care ingredients, advancement of our medical diagnostics ingredient knowledge, and the cost of enhancing our manufacturing
processes. This includes legal fees related to intellectual property development, protection, and maintenance. As an example,
we are currently focusing the bulk of our resources on developing new product formulations, and related new technologies, as we
expand marketing and sales efforts relating to our Solésence products. This work has led to several new products and additional
potential new products. Our efforts in research and development, cosmetic formulating, process engineering and advanced engineering
groups are focused in three major areas: 1) application development for our products; 2) creating or obtaining additional core
materials technologies and/or materials that have the capability to serve multiple skin health-related markets; and 3) continuing
to improve our core technologies to improve manufacturing operations and reduce costs.

Research
and development expense increased to $3,037,000 in 2022, compared to $2,235,000 in 2021. The primary reasons for this were increases
in compensation expense and headcount, outside testing, and materials charges associated with the development and launch of our
Solésence line of personal care products and related capabilities. We expect expenses for research and development to continue
to increase depending on growth in our Solésence line of products, and related technologies. This expense growth will be
dependent upon the success we have in developing new products, which adds significantly to outside testing fees to both enhance
product development and comply with regulatory requirements.

Selling,
general and administrative expense increased to $7,581,000 in 2022, compared to $3,896,000 in 2021. The net increase was largely
attributed to an increase in compensation expense and headcount, including consultants and increases due to the cyber fraud, legal
expenses, marketing and trade shows and insurance. We expect 2023 expenses in this area to be slightly higher, if growth continues
as planned.  We will be expanding our selling and marketing efforts, and parts of our administrative functions, including
related staffing additions.  The extent to which this increase occurs will be dependent upon growth.

Interest
expense decreased to $382,000 in 2022, compared to $1,154,000 in 2021, due largely to the remaining discount-related interest
expense, amounting to $814,000, taken on an accelerated basis in May 2021 at the early conversion of our $2,000,000 Convertible
Note, partially offset by higher interest rates in 2022. The balance of interest expense for 2021 and 2022 related to interest
paid relating to our revolving lines of credit for working capital funding, and finance leases and term loans supporting some
of our equipment.

In
Company-wide operations, we believe inflation has not had a material effect on our operations or financial position for 2022,
although we have seen increases in our costs. We expect supplier price increases and wage and benefit inflation, both
of which represent a significant component of our costs of operations, may have a material effect on our operations and financial
position in 2023 and beyond. We will apply our best efforts to pass through cost increases to our customers. If we are unable
to pass through any increases due to contractual limitations or conditions in our markets specifically, this could reduce margins
and net income.

Liquidity
and Capital Resources

Cash,
cash proceeds and use of cash for 2022 and 2021 were:

12

The
$3,971,000 year-over-year decrease in cash provided by operating activities for the year ended December 31, 2022 was mainly due
to the Company incurring $2,623,000 in net loss in 2022 compared to $2,320,000 in net income in 2021. Cash capital expenditures
amounted to approximately $2,823,000 and $1,874,000 for the years ended December 31, 2022 and 2021, respectively. We did not dispose
of or sell any assets during 2022 or 2021.

On
April 17, 2020, we received a loan of $952,000 from the Libertyville Bank and Trust Company (“Libertyville”) under
the Paycheck Protection Program (the “PPP”).  This loan was forgiven by the Small Business Administration (“SBA”)
in February 2021. These funds specifically were used to absorb a portion of the Company’s salary and benefit costs.

The
Company maintains a credit agreement with Libertyville to support our obligations under our newly leased manufacturing and warehouse
space in Bolingbrook, Illinois. As of December 31, 2022 there was no outstanding borrowings on this line of credit. This credit
agreement has a maturity of December 22, 2023.

On
November 16, 2018, we entered into a Business Loan Agreement (the “Master Agreement”) with Beachcorp, LLC. The Master
Agreement relates to two loan facilities, each evidenced by a separate promissory note dated as of November 16, 2018: a term loan
to the Company of up to $500,000 to be disbursed in a single advance (the “Term Loan”) with a fixed annual interest
rate of 8.25%, payable quarterly, and with principal due on December 31, 2020; and an asset-based revolving loan facility for
the Company of up to $2,000,000 (the “A/R Revolver Facility”), with floating interest accruing at the prime rate plus
3% (8.25% minimum) per year, with a borrowing base consisting of qualified accounts receivable of the Company, and a maturity
of March 31, 2020, as amended. On March 23, 2020, the Company and Beachcorp, LLC executed the First Amendment to our Master
Agreement that extended the maturities of both the Term Loan and the A/R Revolver Facility to March 31, 2021. Effective September
8, 2020, the Company and Beachcorp, LLC executed the Second Amendment to our Master Agreement that expanded the limit on the A/R
Revolver Facility from $2,000,000 to $2,750,000.  On December 23, 2020, the Company and Beachcorp, LLC executed the Third
Amendment to our Master Agreement that expanded the limit on the A/R Revolver Facility from $2,750,000 to $4,000,000 and extended
the maturities of both the Term Loan and the A/R Revolver Facility to March 31, 2022. Effective April 21, 2021 the Company and
Beachcorp, LLC executed the Fourth Amendment to our Master Agreement that expanded the limit on the A/R Revolver Facility from
$4,000,000 to $6,000,000, changed the interest rate to fully floating and reduced the rate to the prime rate plus 2%, also extending
the maturity of the A/R Revolver Facility to March 31, 2023. This amendment also increased the amount of the Term Loan from $500,000
to $1,000,000, changed the interest rate to fully floating and reduced the rate to the prime rate plus 2%. The maturity of the
Term Loan remained March 31, 2022.

On
January 28, 2022, to support the working capital demands created by the commercial growth of the Company and its wholly owned
subsidiary, Solésence, LLC, the Company entered into (i) an Amended and Restated Business Loan Agreement (the “A&R
Loan Agreement”), which amends and restates the Master Agreement, (ii) a Business Loan Agreement (the “New Term Loan
Agreement”) with Strandler, LLC, (iii) a Business Loan Agreement (the “New Revolving Loan Agreement” and together
with the A&R Loan Agreement and the New Term Loan Agreement, the “Loan Agreements”) with Beachcorp, LLC, and (iv)
three promissory notes in order to evidence the loans pursuant to the Loan Agreements (the “Notes”). Beachcorp, LLC
and Strandler, LLC are affiliates of Mr. Bradford T. Whitmore, who beneficially owns a majority of the Company’s common
stock and is the brother of Ms. R. Janet Whitmore, a director of the Company and the chair of the Company’s board of directors.

The
Loan Agreements change the terms of both the Company’s asset-based revolving loan facility (the “A/R Revolver Facility”)
and the secured advance (the “Term Loan”, which was assigned from Beachcorp, LLC to Strandler, LLC) under the Master
Agreement and provide a new asset-based revolving loan facility based on inventory (the “Inventory Facility”). The
maximum borrowing amount under the A/R Revolver Facility increases from $6,000,000 to $8,000,000, with a borrowing base consisting
of qualified accounts receivable of the Company. The maximum borrowing amount under the Inventory Facility is $4,000,000, with
a borrowing base consisting of up to 50% of the value of qualified inventory of the Company. The Loan Agreements also extend the
date for which all principal and accrued interest under the A&R Revolver Facility and the Term Loan are due from March 31,
2023 and March 31, 2022, respectively, to March 31, 2024, which is also the maturity date for the Inventory Facility. The Loan
Agreements reduce interest on outstanding borrowings under the A/R Revolver Facility and the Term Loan from the prime rate plus
2% and 5.25% per year, to a floating rate equal to the prime rate plus 0.75%, which is also the interest rate for borrowings under
the Inventory Facility. The amount of the Term Loan remains $1,000,000. The A/R Revolver Facility, the Inventory Facility and
the Term Loan are all secured by all the unencumbered assets of the Company and subordinated to the Company’s revolving
line of credit with Libertyville Bank & Trust.

On
December 31, 2022, the balance on the Term Loan was $1,000,000, the balance on the A/R Revolver Facility was $4,282,000, and the
balance on the Inventory Facility was $3,000,000. On December 31, 2021, the balances on the Term Loan was $1,000,000, and the
balance on the A/R Revolver Facility was $1,351,000.

In
November 2019, we entered in to a 2% Convertible Promissory Note in the original principal amount of $2,000,000. The maturity
date of this note was May 15, 2024, and was payable to our investor at that time in cash, or through conversion of the rights
to purchase up to 10,000,000 unregistered shares of the Company’s common stock at $0.20 per share.  Our investor chose
to exercise his conversion rights effective May 7, 2021.

13

For
more information regarding the New Business Loan Agreement, see Note 3 to our Financial Statements referred to in Part II, Item
8 of this Annual Report on Form 10-K.

Our
actual future capital requirements in 2023 and beyond will depend on many factors, including customer acceptance of our current
and potential finished Solésence  products, APIs sold as ingredients in to the skin health markets, medical
diagnostics ingredients, and other engineered materials, applications, and products, continued progress in research and development
activities and product testing programs, the magnitude of these activities and programs, and the costs necessary to increase and
expand our manufacturing capabilities and to market and sell these products and ingredients. 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 existing customers. Depending on the success of certain projects, we expect that capital spending relating
to currently known capital needs for 2023 will be between $3 million and $6 million, to be funded by profit from operations, our
existing loans and lines of credit, and possible new debt financing. If those projects are delayed or ultimately prove unsuccessful,
or if we fail to be able to support the additional cost of funding them in the near term, we expect our capital expenditures may
fall below the lower end of the range. Similarly, substantial success in business development projects may cause the actual 2023
capital investment to exceed the top of this range.

The
Company currently has two areas within its strategic plan that will result in material cash requirements that could have an impact
on operations. We have several operating leases (see note 6 to the financial statements) for our facilities that require us to
increase our cash outlays for facilities expenses significantly beginning in 2022. The new 260,000 square foot facility we leased
in December 2021 exceeds our current needs for space considerably. We consequently have sublet a portion of the facility on shorter
term leases. We are growing rapidly and continue to expect significant growth going forward. We will also consolidate some of
our facilities to mitigate costs. Our view was that a lack of space would have hindered our ability to continue to grow, as well
as making it difficult to satisfy existing customer demands on a timely basis if we couldn’t expand our production footprint.
We have estimated our future growth through a combination of industry experience, customer feedback, market intelligence, and
our successful history in commercializing new products. Sales of our Solésence products have roughly tripled between 2019
and 2021 and increased by 27% in 2022 to have reached $23 million annually. We expect this growth to continue, albeit at less
than a multiple of each year’s sales going forward. Many of these estimates are qualitative in nature, but are informed
by experience. If we were to not grow more than incrementally in 2023, we would need to re-evaluate our expansion strategy in
light of the increases in our facilities costs that extend for as much as ten years into the future. Similarly, our capital spending
plan for 2023 will amount to between $3 million and $6 million. We expect our capital spending to increase further in 2024 and
2025. At December 31, 2022, our commitments to equipment suppliers relate mainly to the $1 million of construction in progress,
much of which reflects deposits on to-be-delivered equipment. We estimate the unpaid committed capital relating to capital spending
to be less than $1 million as of December 31, 2022.

We
have federal net operating loss carryforwards for tax purposes of approximately $56 million on December 31, 2022. We have
section 179 carryforwards of approximately $0.5M at December 31,2022. Because the Company may experience “ownership
changes” within the meaning of the U.S. Internal Revenue Code (“IRC”) in connection with any future equity
offerings, future utilization of this carryforward may be subject to certain limitations as defined by the IRC. If not utilized, $51
million of this loss carryforward will expire between 2023 and 2037. Given changes to the IRC, net operating loss carryforwards
generated after January 1, 2018 do not expire, therefore, $5 million in net operating losses generated since January 1, 2018 do not
expire. We have Illinois net loss deduction carryforwards for tax purposes of approximately $21 million on December 31, 2022. Due to
the provisions of Illinois Public Act 102-0669 signed November 16, 2021, Illinois net loss deductions expire between 2029 and
2039.

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, we have concluded that it is likely that some portion of this carryforward will expire before ultimately
becoming available to reduce income tax liabilities.

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 risks discussed in 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 1, Item 1, of this Form 10-K.

Overview

Nanophase
is a health-oriented, science-driven company, which, along with its wholly owned subsidiary, Solésence, LLC (our “Solésence
beauty science subsidiary”), is focused in various beauty- and life-science markets. Our primary skin health products are
fully developed prestige skin care formulations with mineral-based UV protection, marketed and sold through our Solésence
beauty science subsidiary, enabled by our proprietary Active Pharmaceutical Ingredients (“APIs”) which are also marketed
as APIs for sale to manufacturers of other types of skin health products, including sunscreens and daily care products.
In terms of the balance of our life sciences focus, we have seen current conditions significantly increase demand for our medical
diagnostics ingredients, which are used in testing for various viruses, most notably COVID-19.  Additionally, we continue
to sell products in legacy markets including architectural coatings, industrial coating applications, abrasion-resistant additives,
plastics additives, and surface finishing technologies (polishing) applications— all of which, along with medical diagnostics,
currently fall into the advanced materials product category.

Critical
Accounting Estimates

We
review long-lived assets for impairment whenever events or changes in circumstances indicate that the asset’s carrying amount
may not be recoverable. We conduct long-lived asset impairment analyses in accordance with Financial Accounting Standards Board
(“FASB”) Accounting Standards Codification (“ASC”) Topic 360-10-15, Impairment or Disposal of Long-Lived
Assets. ASC 360-10-15 requires us to group assets and liabilities at the lowest level for which identifiable cash flows are
largely independent of the cash flows of other assets and liabilities and evaluate the asset group against the sum of the undiscounted
future cash flows. If the undiscounted cash flows do not indicate the carrying amount of the asset is recoverable, an impairment
charge is measured as the amount by which the carrying amount of the asset group exceeds its fair value based on discounted cash
flow analysis or appraisals.

Other
critical estimates include the allowance for doubtful accounts applied against our receivables balance as well as an inventory
reserve. In the determination of a reserve to apply toward receivables, management considered provisions in FASB ASC 450-20-25
regarding the recognition of loss contingencies and applied a reserve balance against gross receivables to arrive at the net reported
balance. Under the guidance referenced above, management judgmentally applied an estimate of the portion of gross receivables
for which loss is both probable and can be reasonably estimated and accrued a loss contingency by a charge to income. A $60,000
and $9,000 bad debt reserve was applied to gross receivables for 2021 and 2020, respectively. Particularly with respect to customers
of our Solésence beauty science subsidiary, it can be difficult to estimate collectability. We frequently require significant
deposits from customers before ordering materials and scheduling production. This serves as a good indicator of the customer’s
wherewithal to pay for the balance of the product when shipped. In cases where it is difficult to establish creditworthiness,
we require payment of the full amount before we ship. Notwithstanding these credit security measures, we frequently find that
pay cycles get extended for reasons that can be outside of our control. The nature of the business is that there are many product
launches, often by smaller or start-up companies, that may not result in initial commercial success. This has resulted in extensions
of payment terms, but collectability has ultimately occurred in most cases. As our Solésence beauty science subsidiary
grows, we will monitor this closely and adjust estimates as necessary.

Management
also monitors the value of inventory for the effects of aging, obsolescence, and seasonality. Consistent with the provisions in
FASB ASC 330-10-35, we adjust inventory valuation upon management’s determination that the net realizable value of our inventory,
which applies the average cost method, is lower than its historic cost. In the application of this policy in 2021, management
deemed a portion of inventory will likely experience such an impairment and elected to apply a $406,000 inventory reserve in anticipation.
Some of the materials in question are nearing expiration and therefore more difficult to sell, some represent soon-to-be obsolete
products, and some are raw materials that we no longer use regularly.

Certain
assumptions are necessary to assess the impact of risks and uncertainties on the financial information, such as cash flow projections,
availability of capital if needed to support the ongoing operations of the business, and our expected compliance with contractual
commitments. Any changes in those plans or assumptions could have a material impact on our liquidity and financial condition.
While we have seen costs increase on an inflationary basis as we enter 2022, it is our belief that we will be able to offset much
of this cost as we gain greater production efficiencies and seek to increase our pricing where possible.

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Results
of Operations

Years
Ended December 31, 2021 and 2020

Total
revenue increased to $29,475,000 in 2021, compared to $17,123,000 in 2020. A substantial majority of our revenue for each year
is from our largest customers, in particular, sales to our largest customer in skin care and sunscreen applications, finished
skin health products marketed through our Solésence beauty science subsidiary, and medical diagnostics. Product revenue,
the primary component of our total revenue, increased to $29,325,000 in 2021, compared to $16,422,000 in 2020. This increase was
due to rapid growth in the adoption of our Solésence® products, and growth in 2021 sales to our largest customer in
our personal care ingredients business, offset by a decrease in revenue from our medical diagnostics materials customer (within
our advanced materials business).

Current
Significant Customers

Cost
of revenue generally includes costs associated with commercial production and customer development arrangements. Cost of revenue
increased to $20,785,000 in 2021, compared to $11,133,000 in 2020. The increase in cost of revenue was primarily driven by the
rapid increases in product revenue volume, with attendant inefficiencies caused by hitting capacity limits in various critical
processes. Lower-then-expected volume in the fourth quarter of 2021, write-downs of obsolete inventory, reduction in contract
revenue (which generally has little direct cost associated with it), and changes in product mix added to relative increases in
cost of revenue. While gross margin dollars increased by approximately $2,700,000, all of these factors contributed to a reduction
of overall gross margin percentage by 6% when compared to 2020. We expect to continue new materials development and dispersion
technologies for personal care applications and for our formulated Solésence products during 2022 and beyond, as part of
our business model. At current revenue levels we have generated a positive gross margin, though margins can be impeded by the
cyclicality of our demand, often leading to the Company not having enough revenue to efficiently absorb manufacturing overhead
that is required to work with current customers and expected future customers. We believe that our current fixed manufacturing
cost structure is sufficient to support higher levels of revenue volume. The extent to which margins grow, as a percentage of
total revenue, will be dependent upon revenue mix, revenue volume, our ability to cut costs and pass commodity market-driven raw
materials increases on to customers, and the speed and efficiency with which we are able to scale up production for our Solésence
products. We expect that, as product revenue volume increases, our fixed manufacturing costs will be more efficiently absorbed,
which should lead to increased margins as we grow. We expect to continue to focus on reducing controllable variable product manufacturing
costs, with potential variability related to the commodity metals markets and cost and wage inflation, but may or may not realize
gross margin percentage growth through 2022 and beyond, 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 development or acquisition of new finished product formulations for skin care, new product applications
for our skin care ingredients, advancement of our medical diagnostics ingredient knowledge, and the cost of enhancing our manufacturing
processes. As an example, we are currently focusing the bulk of our resources on developing new product formulations, and related
new technologies, as we expand marketing and sales efforts relating to our Solésence products. This work has led to several
new products and additional potential new products. Our efforts in research and development, cosmetic formulating, process engineering
and advanced engineering groups are focused in three major areas: 1) application development for our products; 2) creating or
obtaining additional core materials technologies and/or materials that have the capability to serve multiple skin health-related
markets; and 3) continuing to improve our core technologies to improve manufacturing operations and reduce costs.

Research
and development expense increased to $2,235,000 in 2021, compared to $1,571,000 in 2020. The primary reasons for this were increases
in compensation expense and headcount, outside testing, and materials charges associated with the development and launch of our
Solésence line of personal care products and related capabilities. We expect expenses for research and development to expand
50% or more, depending on both growth in our Solésence line of products, and related technologies. This expense growth
will be dependent upon the success we have in developing new products, which adds significantly to outside testing fees to both
enhance product development and comply with regulatory requirements.

11

Selling,
general and administrative expense increased to $3,896,000 in 2021, compared to $2,934,000 in 2020. The net increase was primarily
attributed to an increase in compensation expense and headcount, including consultants, and increases in marketing and trade show
expense, which began again in late 2021. We expect 2022 expenses in this area to be higher, potentially as much as 30% to 35%,
if growth continues as planned.  We will be expanding our selling and marketing efforts, and parts of our administrative
functions, including related staffing additions.  The extent to which this increase occurs will be dependent upon growth.

Interest
expense was $1,154,000 in 2021, compared to $496,000 in 2020, due largely to the remaining discount-related interest expense,
amounting to $814,000, taken on an accelerated basis in May 2021 at the early conversion of our $2,000,000 Convertible Note. The
balance of interest expense for 2020 and 2021 related to interest paid relating to our revolving line of credit for working capital
funding, and finance leases and term loans supporting some of our equipment.

In
Company-wide operations, we believe inflation has not had a material effect on our operations or financial position for 2021,
although we have seen increases in our costs broadly, beginning in the fourth quarter. We expect supplier price increases and
wage and benefit inflation, both of which represent a significant component of our costs of operations, may have a material effect
on our operations and financial position in 2022 and beyond. We will apply our best efforts to pass through any significant cost
increases to our customers. If we are unable to pass through any increases due to contractual limitations or conditions in our
markets specifically, this could reduce margins and net income.

Liquidity
and Capital Resources

Cash,
cash proceeds and use of cash for 2021 and 2020 were:

The
$4,382,000 year-over-year increase in cash provided by operating activities for the year ended December 31, 2021 was mainly due
to the Company generating $2,320,000 in net income in 2021 compared to $989,000 in 2020. Cash capital expenditures amounted to
approximately $1,874,000 and $878,000 for the years ended December 31, 2021 and 2020, respectively. We did not dispose of or sell
any assets during 2021 or 2020.

On
April 17, 2020, we received a loan of $952,000 from the Libertyville Bank and Trust Company (“Libertyville”) under
the Paycheck Protection Program (the “PPP”).  This loan was forgiven by the Small Business Administration (“SBA”)
in February 2021. These funds specifically were used to absorb a portion of the Company’s salary and benefit costs.

The
Company maintains a credit agreement with Libertyville which most recently served the primary purpose of insuring that it met
its cash balance requirements at quarter end relating to a contract with the Company’s largest customer. Outstanding borrowings
were $500,000 on this line of credit as of December 31, 2020. On December 21, 2021, this facility was converted for use support
our obligations under our newly leased manufacturing and warehouse space in Bolingbrook, Illinois. This credit agreement has a
maturity of December 22, 2022.

On
November 16, 2018, we entered into a Business Loan Agreement (the “Master Agreement”) with Beachcorp, LLC. The Master
Agreement relates to two loan facilities, each evidenced by a separate promissory note dated as of November 16, 2018: a term loan
to the Company of up to $500,000 to be disbursed in a single advance (the “Term Loan”) with a fixed annual interest
rate of 8.25%, payable quarterly, and with principal due on December 31, 2020; and an asset-based revolving loan facility for
the Company of up to $2,000,000 (the “A/R Revolver Facility”), with floating interest accruing at the prime rate plus
3% (8.25% minimum) per year, with a borrowing base consisting of qualified accounts receivable of the Company, and a maturity
of March 31, 2020, as amended. On March 23, 2020, the Company and Beachcorp, LLC executed the First Amendment to our Master
Agreement that extended the maturities of both the Term Loan and the A/R Revolver Facility to March 31, 2021. Effective September
8, 2020, the Company and Beachcorp, LLC executed the Second Amendment to our Master Agreement that expanded the limit on the A/R
Revolver Facility from $2,000,000 to $2,750,000.  On December 23, 2020, the Company and Beachcorp, LLC executed the Third
Amendment to our Master Agreement that expanded the limit on the A/R Revolver Facility from $2,750,000 to $4,000,000 and extended
the maturities of both the Term Loan and the A/R Revolver Facility to March 31, 2022. Effective April 21, 2021 the Company and
Beachcorp, LLC executed the Fourth Amendment to our Master Agreement that expanded the limit on the A/R Revolver Facility from
$4,000,000 to $6,000,000, changed the interest rate to fully floating and reduced the rate to the prime rate plus 2%, also extending
the maturity of the A/R Revolver Facility to March 31, 2023. This amendment also increased the amount of the Term Loan from $500,000
to $1,000,000, changed the interest rate to fully floating and reduced the rate to the prime rate plus 2%. The maturity of the
Term Loan remained March 31, 2022.

12

The
Term Loan and A/R Revolver Facility are secured by all the unencumbered assets of the Company and subordinated to Libertyville’s
secured interest under the New Business Loan Credit Agreement. The Master Agreement substantially restricted the Company’s
ability to incur additional indebtedness during the terms of the Term Loan, the Revolver Facility, and the Convertible Promissory
Note.

In
November 2019, we entered in to a 2% Convertible Promissory Note in the original principal amount of $2,000,000. The maturity
date of this note was May 15, 2024, and was payable to our investor at that time in cash, or through conversion of the rights
to purchase up to 10,000,000 unregistered shares of the Company’s common stock at $0.20 per share.  Our investor chose
to exercise his conversion rights effective May 7, 2021.

On
December 31, 2021, the balances on the Term Loan and the Convertible Promissory Note were $1,000,000 and $0, respectively, and
the balance on the Revolver Facility was $1,351,000. On December 31, 2020, the balances on the Term Loan and the Convertible Promissory
Note were $500,000 and $2,000,000, respectively, and the balance on the A/R Revolver Facility was $2,155,000.

On
April 17, 2020, we received a loan of $952,000 from Libertyville under the PPP.  Under the PPP, the Company could apply for
forgiveness of the amount due on the loan in an amount equal to the sum of the following costs incurred during the 24-week period
beginning on the date of the first disbursement of the Loan: (a) payroll costs, (b) any payment of interest on a covered obligation
(which shall not include any prepayment of or payment of principal on a covered mortgage obligation), (c) any payment on a covered
rent obligation, and (d) any covered utility payment, calculated in accordance with the terms of the CARES Act. The principal
amount of the PPP Note would have accrued interest at the rate of 1.00% per year. Management applied for loan forgiveness in February
2021 and the loan was forgiven shortly thereafter during the first quarter of 2021. Under the terms of the PPP loan, it could
be subject to audit for six years from the date of forgiveness. If any portion of the PPP loan were to be deemed ineligible, the
Company could be required to repay the funds. On December 31, 2021, the balance under the PPP note was $0.

On
January 28, 2022, to support the working capital demands created by the commercial growth of the Company and its wholly owned
subsidiary, Solésence, LLC, the Company entered into (i) an Amended and Restated Business Loan Agreement (the “A&R
Loan Agreement”), which amends and restates the Master Agreement, (ii) a Business Loan Agreement (the “New Term Loan
Agreement”) with Strandler, LLC, (iii) a Business Loan Agreement (the “New Revolving Loan Agreement” and together
with the A&R Loan Agreement and the New Term Loan Agreement, the “Loan Agreements”) with Beachcorp, LLC, and (iv)
three promissory notes in order to evidence the loans pursuant to the Loan Agreements (the “Notes”). Beachcorp, LLC
and Strandler, LLC are affiliates of Mr. Bradford T. Whitmore, who beneficially owns a majority of the Company’s common
stock and is the brother of Ms. R. Janet Whitmore, a director of the Company and the chair of the Company’s board of directors.

The
Loan Agreements change the terms of both the Company’s asset-based revolving loan facility (the “A/R Revolver Facility”)
and the secured advance (the “Term Loan”, which was assigned from Beachcorp, LLC to Strandler, LLC) under the Master
Agreement and provide a new asset-based revolving loan facility based on inventory (the “Inventory Facility”). The
maximum borrowing amount under the A/R Revolver Facility increases from $6,000,000 to $8,000,000, with a borrowing base consisting
of qualified accounts receivable of the Company. The maximum borrowing amount under the Inventory Facility is $4,000,000, with
a borrowing base consisting of up to 50% of the value of qualified inventory of the Company. The Loan Agreements also extend the
date for which all principal and accrued interest under the A&R Revolver Facility and the Term Loan are due from March 31,
2023 and March 31, 2022, respectively, to March 31, 2024, which is also the maturity date for the Inventory Facility. The Loan
Agreements reduce interest on outstanding borrowings under the A/R Revolver Facility and the Term Loan from the prime rate plus
2% and 5.25% per year, to a floating rate equal to the prime rate plus 0.75%, which is also the interest rate for borrowings under
the Inventory Facility. The amount of the Term Loan remains $1,000,000. The A/R Revolver Facility, the Inventory Facility and
the Term Loan are all secured by all the unencumbered assets of the Company and subordinated to the Company’s revolving
line of credit with Libertyville Bank & Trust.

For
more information regarding the New Business Loan Agreement, see Note 3 to our Financial Statements referred to in Part II, Item
8 of this Annual Report on Form 10-K.

Our
supply agreements with our largest customer, BASF, contain certain financial covenants which could potentially impact our liquidity.
The most restrictive financial covenants under these agreements required that we maintain a minimum of $1,000,000 in certain current
assets; which may be composed of no less than $500,000 cash, cash equivalents, and certain investments, no more than a combined
$500,000 of certain related inventory, of which no more than $250,000 could be raw material, and certain receivables, and that
we not have the acceleration of any debt maturity having a principal amount of more than $10 million, in order to avoid triggering
the customer’s potential right to transfer certain technology and equipment to that customer at a contractually-defined
price.  We were in compliance with these covenants at December 31, 2020. This financial trigger was removed when the Company
achieved cumulative net earnings in excess of $1.5 million, as defined, during the second quarter of 2021. This supply agreement
and its covenants are more fully described in Note 12, and our line of credit is more fully described in Note 3, to our Financial
Statements referred to in Part II, Item 8, of this Annual Report on Form 10-K.

13

Our actual future capital requirements
in 2022 and beyond will depend on many factors, including customer acceptance of our current and potential finished Solésence
products, APIs sold as ingredients in to the skin health markets, medical diagnostics ingredients, and other
engineered materials, applications, and products, continued progress in research and development activities and product testing
programs, the magnitude of these activities and programs, and the costs necessary to increase and expand our manufacturing capabilities
and to market and sell these products and ingredients. 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 existing customers.
Depending on the success of certain projects, we expect that capital spending relating to currently known capital needs for 2022
will be between $4 million and $8 million, to be funded by profit from operations, our existing loans and lines of credit, and
possible new debt financing. If those projects are delayed or ultimately prove unsuccessful, or if we fail to be able to support
the additional cost of funding them in the near term, we expect our capital expenditures may fall below the lower end of the range.
Similarly, substantial success in business development projects may cause the actual 2022 capital investment to exceed the top
of this range.

The
Company currently has two areas within its strategic plan that will result in material cash requirements that could have an impact
on operations. We have several operating leases (see note 6 to the financial statements) for our facilities that require us to
increase our cash outlays for facilities expenses significantly beginning in 2022. The new 260,000 square foot facility we leased
in December 2021 exceeds our current needs for space considerably. We are growing rapidly and continue to expect significant growth
going forward. We will also consolidate some of our facilities to mitigate costs. Our view was that a lack of space would have
hindered our ability to continue to grow, as well as making it difficult to satisfy existing customer demands on a timely basis
if we couldn’t expand our production footprint. We have estimated our future growth through a combination of industry experience,
customer feedback, market intelligence, and our successful history in commercializing new products. Sales of our Solésence
products have roughly tripled between 2019 and 2021, and tripled again in 2021 to have reached $18 million annually. We expect
this growth to continue, albeit at less than a multiple of each year’s sales going forward. Many of these estimates are
qualitative in nature, but are informed by experience. If we were to not grow more than incrementally in 2022 and 2023, we would
need to re-evaluate our expansion strategy in light of the increases in our facilities costs that extend for as much as ten years
in to the future. Similarly, our capital spending plan for 2022 will amount to between $4 million and $8 million. We expect our
capital spending to increase further in 2023 and 2024. At December 31, 2021, our commitments to equipment suppliers relate mainly
to the $1.1 million of construction in progress, much of which reflects deposits on to-be-delivered equipment. We estimate the
unpaid committed capital relating to capital spending to be less than $1 million as of December 31, 2021.

We
have federal net operating loss carryforwards for tax purposes of approximately $62 million on December 31, 2021. Because
the Company may experience “ownership changes” within the meaning of the U.S. Internal Revenue Code (“IRC”)
in connection with any future equity offerings, future utilization of this carryforward may be subject to certain limitations
as defined by the IRC. If not utilized, $57 million of this loss carryforward will expire between 2022 and 2037. Given changes
to the IRC, net operating loss carryforwards generated after January 1, 2018 do not expire, therefore, $5 million in net operating
losses generated since January 1, 2018 do not expire. We have Illinois net loss deduction carryforwards for tax purposes of approximately
$21 million on December 31, 2021. Due to the provisions of Illinois Public Act 102-0669 signed November 16, 2021, Illinois net
loss deductions expire between 2029 and 2039.

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, we have concluded that it is likely that some portion of this carryforward will expire before ultimately
becoming available to reduce income tax liabilities.

14