SOLESENCE, INC. (SLSN) FY 2022 MD&A

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.

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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

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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:

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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.

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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.