UNITED
      STATES SECURITIES AND EXCHANGE COMMISSION


Washington,
      D.C. 20549




FORM
      10-K




(Mark
      One)




x
            ANNUAL
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
                EXCHANGE ACT OF 1934




For
      the
      fiscal year ended December 31, 2005




OR




o
            TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
                OF 1934




For
      the
      transition period from ______________ to _____________




Commission
      file number: 0-11635




PHOTOMEDEX,
      INC.


(Exact
      name of registrant as specified in its charter)


Delaware
                (State
                  or other jurisdiction
                of
                  incorporation or organization)
              
              59-2058100
                (I.R.S.
                  Employer
                Identification
                  No.)







147
      Keystone Drive, Montgomeryville, Pennsylvania 18936


(Address
      of principal executive offices, including zip code)




(215)
      619-3600


(Issuer’s
      telephone number, including area code)


Securities
      registered under Section 12(b) of the Exchange Act:





Title
                of each class
              None
            
            Name
                of each exchange
              on
                which registered
              None





Securities
      registered under Section 12(g) of the Exchange Act:




Common
      Stock, $0.01 par value per share


(Title
      of
      Class)




Indicate
        by check mark if the registrant is a well-known seasoned issuer, as defined
        in
        Rule 405 of the Securities Act.
 Yes
        [ _ ]
        No
        [X]
 
 Indicate
        by check mark if the registrant is not required to file reports pursuant
        to
        Section 13 or Section 15(d) of the Exchange Act.
 Yes
        [ _ ]
        No
        [X]
 
 Indicate
        by check mark whether the registrant: (i)  has filed all reports required
        to be filed by Section  13 or 15(d)  of the Securities Exchange Act of
        1934 during the preceding 12 months (or for such shorter period that the
        registrant was required to file such reports), and (ii)  has been subject
        to such filing requirements for the past 90 days.
 Yes
        [ X ]
        No
        [_]
 
 Indicate
        by check mark if disclosure of delinquent filers pursuant to Item 405 of
        Regulation S-K is not contained herein and will not be contained, to the
        best of
        registrant’s knowledge, in definitive proxy or information statements
        incorporated by reference in Part III of this Form 10-K or any amendment
        to this
        Form 10-K. [_]
 
 
 Indicate
        by check mark whether the registrant is a large accelerated filer, an
        accelerated filer, or a non-accelerated filer. See definition of "accelerated
        filer and large accelerated filer" in Rule 12b-2 of the Exchange
        Act.
 
 Large
        accelerated filer [_] Accelerated
        filer [ X ] Non-accelerated
        filer [_]
 
 
 Indicate
        by check mark whether the registrant is a shell company (as defined in Rule
        12b-2 of the Act).
 Yes
        [ _ ]
        No
        [X]




The
        number of shares outstanding of our common stock as of March 15, 2006, was
        52,319,294 shares.
        The aggregate market value of the common stock held by non-affiliates
        (43,717,655 shares), based on the closing market price $1.98 of the
        common stock as of March 15, 2006 was $86,560,957





**Table
      of Contents**




**Page****Part I**Item 1.
            
            Business
            1Item
              1A.
            
            Risk
              Factors
            18Item
              1B.
            
            Unresolved
              Staff Comments
            30Item 2.
            
            Properties
            30Item 3.
            
            Legal
                Proceedings
            31Item 4.
            
            Submission
                of Matters to a Vote of Security Holders
            32**Part II**Item 5.
            
            Market
                for Registrant's Common Equity, Related Stockholder Matters and Issuer
                Purchases of Equity Securities
            32Item 6.
            
            Selected
                Financial Data
            36Item 7.
            
            Management's
                Discussion and Analysis of Financial Condition and Results of
                Operations
            37Item 7A.
            
            Quantitative
                and Qualitative Disclosure About Market Risk
            56Item 8.
            
            Financial
                Statements and Supplementary Data
            56Item 9.
            
            Changes
                in and Disagreements with Accountants on Accounting and Financial
                Disclosure
            57Item 9A.
            
            Controls
                and Procedures
            57Item
              9B.
            
            Other
              Information
            58**Part III**Item 10.
            
            Directors
                and Executive Officers of Registrant
            59Item 11.
            
            Executive
                Compensation
            64Item 12.
            
            Security
                Ownership of Certain Beneficial Owners and Management and Related
                Stockholder Matters
            84Item 13.
            
            Certain
                Relationships and Related Transactions
            85Item 14.
            
            Principal
                Accountant Fees and Services
            86**Item IV**Item 15.
            
            Exhibits
            88Signatures
            92







i


***Certain
      statements in this Annual Report on Form 10-K, or the Report, are
      "forward-looking statements." These forward-looking statements include, but
      are
      not limited to, statements about the plans, objectives, expectations and
      intentions of PhotoMedex, Inc., a Delaware corporation, (referred to in this
      Report as “we,” “us,” “our” or “registrant”) and other statements contained in
      this Report that are not historical facts. Forward-looking statements in this
      Report or hereafter included in other publicly available documents filed with
      the Securities and Exchange Commission, or the Commission, reports to our
      stockholders and other publicly available statements issued or released by
      us
      involve known and unknown risks, uncertainties and other factors which could
      cause our actual results, performance (financial or operating) or achievements
      to differ from the future results, performance (financial or operating) or
      achievements expressed or implied by such forward-looking statements. Such
      future results are based upon management's best estimates based upon current
      conditions and the most recent results of operations. When used in this Report,
      the words "expect," "anticipate," "intend," "plan," "believe," "seek,"
      "estimate" and similar expressions are generally intended to identify
      forward-looking statements, because these forward-looking statements involve
      risks and uncertainties. There are important factors that could cause actual
      results to differ materially from those expressed or implied by these
      forward-looking statements, including our plans, objectives, expectations and
      intentions and other factors discussed under "Risk
      Factors."***




**PART
      I**




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




We
      are a
      medical device and specialty pharmaceutical company focused on facilitating
      the
      cost-effective use of technologies for doctors, hospitals and surgery centers
      to
      enable their patients to achieve a higher quality of life.




Our
      business operates in five distinct business units; three in Dermatology and
      two
      in Surgical. Business units, or segments, are distinguished by our management
      structure, products and services offered, markets served or types of customers.




The
      Domestic XTRAC segment derives revenues from procedures performed by
      dermatologists in the United States. Our XTRAC system is placed in a
      dermatologist’s office without any initial capital cost and then we charge a
      fee-per-use to treat skin disease. The International XTRAC segment, in
      comparison, generates revenues from the sale of equipment to dermatologists
      outside the United States through a network of distributors. The Skin Care
      segment generates revenues by selling physician-dispensed skincare products
      worldwide and by earning royalties on licenses for our patented copper peptide
      compound.




The
      Surgical Services segment generates revenues by providing fee-based procedures
      typically using our mobile surgical laser equipment delivered and operated
      by a
      technician at hospitals and surgery centers in the United States. The Surgical
      Products segment generates revenues by selling laser products and disposables
      to
      hospitals and surgery centers on both a domestic and international basis.




The
      XTRAC
      is designed and manufactured by us to phototherapeutically treat psoriasis,
      vitiligo, atopic dermatitis and leukoderma. In January 2000, we received the
      first Food and Drug Administration (“FDA”) clearance to market an excimer laser
      system, the XTRAC® system, for the treatment of psoriasis. It was followed by
      FDA 510(k) clearance to treat vitiligo in March 2001, atopic dermatitis in
      August 2001, and leukoderma in May 2002. The first XTRAC phototherapy treatment
      systems were commercially distributed in the United States in August 2000 prior
      to any of its procedures being approved for medical insurance reimbursement.
      In
      the last several years, we have sought to obtain reimbursement for psoriasis
      and
      other inflammatory skin disorders. Obtaining reimbursement for new technologies
      is a major challenge for any company and in the latter part of 2005 we
      experienced many approvals for the reimbursement for use of the XTRAC
      system. Our manufacturing facility for the XTRAC is located in Carlsbad,
      California.




Our
      Skin
      Care business resulted from the acquisition of ProCyte Corporation (“ProCyte”)
      on March 18, 2005. ProCyte, located in Redmond, Washington markets products
      for
      skin health, hair care and wound care. Many of these products incorporate
      patented copper peptide technologies. In addition to our diversified product
      line, ProCyte has provided a national sales force and increased our marketing
      department for us.




1


The
      Surgical businesses were acquired on December 27, 2002 as a result of the
      acquisition of Surgical Laser Technologies, Inc. (“SLT”), located in
      Montgomeryville, Pennsylvania. In the Surgical business, we also
      develop, manufacture and market proprietary lasers and delivery systems for
      both
      contact and non-contact surgery and provide surgical services utilizing these
      and other manufacturers’ products. The Montgomeryville facility also serves as
      our corporate headquarters.




**Our
      Business Strategy: The Dermatology Businesses**




Our
      short-term goal is to establish the XTRAC system as a preferred treatment
      modality for psoriasis and other inflammatory skin disorders through persuasive
      clinical evidence and widespread private healthcare reimbursement. Our
      acquisition of ProCyte has added a skin care business to our company and
      provided a broadened complementary product line marketed to the same customer
      base through a national sales force and marketing organization. Our longer-term
      goal is to be a world-class provider of the highest-quality, cost-effective,
      medical technologies, including phototherapy and surgical procedures delivered
      in doctors’ offices, hospitals and surgical centers. The following are the key
      elements of our strategy:




***Establish
      Our XTRAC System as a Preferred Treatment Modality for Psoriasis and Other
      Inflammatory Skin Disorders.*** Several
      opinion leaders in the dermatological community have endorsed our XTRAC system
      as a preferred treatment modality for the majority of psoriasis and vitiligo
      patients. We are using these endorsements to accelerate the acceptance of our
      XTRAC system among dermatologists. We have also developed a set of medical
      practice tools, such as patient education videos, patient letters, sample press
      releases, point-of-sale displays and other advertising literature, to assist
      the
      dermatologists in marketing our XTRAC system.




***Achieve
      Widespread Private Healthcare Reimbursement.*** The
      Centers for Medicare and Medicaid Services (CMS) published national Medicare
      rates, effective January 1, 2003, for the newly established laser reimbursement
      codes for inflammatory skin disorders such as psoriasis. We mailed a data
      compendium of clinical and economic evidence establishing the XTRAC
      system as safe, efficacious, and cost-effective, to virtually all insurance
      plans in the United States between December 2003 and February 2004. A critical
      component of the mailing was a psoriasis health economic study, which concluded
      that the overall clinical impact of the XTRAC system has proven to be
      outstanding for expected treatment-free days and remission days. Further, it
      stated the expected costs are lower than those for other phototherapies and
      comparable to the most commonly used second-step topical alternatives. Because
      total expected annual per-patient costs, with or without the XTRAC system,
      are
      equivalent for patients who start on combination first-step therapy, payers
      bear
      no incremental procedure cost if the excimer laser is included in the overall
      mix of second-step care. The data contained therein supports the establishment
      of medical policies by private healthcare reimbursement plans for the treatment
      of mild to moderate psoriasis. As of March 15, 2006, we estimate that more
      than
      75% of people in the United States who are covered by a health insurance program
      have plans that reimburse for the treatment of psoriasis by means of the XTRAC
      system. We are continuing to try to develop wider private healthcare
      reimbursement arrangements through this marketing effort, but can give you
      no
      assurances to increasing such arrangements.




***Build
      Broad Consumer Awareness Program to Attract Those Not Currently Seeking
      Treatment*** .
      Of the
      4.5 million adults in the United States who have been diagnosed with psoriasis,
      only about 1.5 million seek regular care. Many do not seek care, largely due
      to
      the frustration caused by the limited effectiveness, inconvenience and negative
      side effects of treatment alternatives other than treatment with the XTRAC
      system. We have expended funds in print, radio and/or Internet advertising
      to
      educate this frustrated segment of the population about how our XTRAC system
      enables more convenient and effective psoriasis treatment. As a result of recent
      substantive improvement in regional insurance reimbursement, we have initiated
      direct-to-consumer advertising efforts in targeted geographic regions that
      have
      benefited by this improvement. We are evaluating the cost-effectiveness of
      the
      various components of the program.




***Increase
      Installed Base of Our XTRAC Systems by Minimizing Economic Risk to the
      Dermatologists*** .
      In the
      United States, we place our XTRAC system in dermatologists' offices free of
      charge to the physician. This creates an opportunity for dermatologists to
      utilize our system without any up-front capital costs, thereby eliminating
      an
      inherent economic risk to them. Longer term, we also intend to ultimately market
      our XTRAC system in this manner outside of the United States in combination
      with
      continuing to sell XTRAC systems directly to dermatologists in foreign markets
      through distributors.




2


***Generate
      Recurring Revenue by Charging the Dermatologist a Per-Treatment
      Fee*** .
      Because
      there is no known cure for psoriasis, which is a chronic condition, we generate,
      and expect to continue to generate recurring revenue in the United States from
      patients utilizing our XTRAC system. We charge the dermatologist a per-treatment
      fee. Additionally, we intend to increase our recurring revenue by targeting
      dermatologists whose practices are located in geographic regions with the
      largest concentration of psoriasis and vitiligo patients and areas with
      favorable private healthcare reimbursement.




***Sell
      the XTRAC System in Foreign Countries to be Utilized to Treat Patients on a
      Wider Basis.*** We have
      entered into a number of distribution relationships or agreements with respect
      to the sale of the XTRAC system on an international basis. We have chosen this
      marketing approach over a direct marketing approach because of the varying
      economic, regulatory, insurance reimbursement and selling channel environments
      outside of the United States. We intend to enter into additional agreements
      in
      other countries. However, we cannot be certain that our international
      distributors will be successful in marketing the XTRAC system outside of the
      United States or that our distributors will purchase more than the minimum
      contractual requirements or expected purchase levels under these agreements
      or
      relationships. Our international strategy also includes placing XTRAC systems
      with dermatologists to provide us a usage-based revenue stream. To date, no
      units have been placed in international markets that provide a usage-based
      revenue stream. In addition, we have added a non-laser based product line to
      our
      international offering, called the VTRACTM. This product line is a result of
      licensed technologies from Stern Laser srl, our distributor in Italy. The
      purpose of this product offering is to provide a best-in-class non-laser
      purchase option to compete against the lower priced lamp-based international
      competitors.




**Our
      Solution for Psoriasis**




The
      XTRAC
      308 nanometer (nm) excimer laser has emerged as an important treatment option
      for patients with stable localized mild-to-moderate plaque psoriasis (about
      80%
      of psoriasis cases), especially for patients whose plaques are recalcitrant
      to
      topical therapy. We believe our XTRAC system should become a preferred treatment
      modality for the majority of patients suffering from psoriasis. The XTRAC
      excimer laser offers numerous benefits to the patient, the physician, and the
      third-party insurance payer, including:




·
            At
                308 nanometers, the excimer laser utilizes an ultra-narrow wavelength
                in
                the narrowband UVB spectrum with a proven anti-psoriatic action.
                In
                addition, by focusing the energy exclusively to the psoriasis plaques,
                the
                laser avoids potentially detrimental exposure of normal skin to UVB
                energy, and with fewer side effects than other treatment
                methods.




·
            Unlike
                most other lasers, our XTRAC system emits a pulsating beam of light
                that
                is neither hot nor cold to the touch, resulting in no pain or discomfort
                to virtually all patients. Clinical studies have demonstrated the
                XTRAC
                system to have equal or greater efficacy than the most effective
                treatment
                alternatives presently available for psoriasis with fewer treatment
                visits
                than conventional phototherapy.




·
            Our
                XTRAC system enables the physician to deliver concentrated doses
                of
                ultraviolet light to the psoriasis-affected skin at a higher intensity
                than is possible with traditional ultraviolet light therapy. As a
                result,
                physicians can use the XTRAC system to treat all degrees of psoriasis
                from
                mild to moderate cases. The XTRAC system has also proven effective
                to
                treat hinged body areas (elbows and knees), which previously have
                been the
                most difficult areas of the body to effectively treat with topical
                treatments and other ultraviolet light
                therapy.




·
            Most
                patients (84%) will obtain significant improvement (>75%) with 6 to 10
                treatments (2 treatments per week for 3 to 5 weeks). These results
                have
                been demonstrated to be long lasting as well, with mean remission
                rates
                reported from 3.5 to 6 months.




·
              The
                  excimer laser also has an established cost-effectiveness profile.
                  A
                  clinical economic analysis, which was completed in 2003, has demonstrated
                  that the addition of excimer laser treatment results in no expected
                  cost
                  increase to the payer. Additionally, the annual cost of excimer
                  laser
                  treatment is comparable to or less than other standard “Step 2” psoriasis
                  treatment modalities, such as phototherapy treatment alternatives
                  or
                  alternative topical therapies. In addition, the cost-effectiveness
                  of the
                  excimer laser is superior due to the increased number of expected
                  clear
                  days.
  ·
                  The
                      acceptance of this procedure has been established by the American
                      Medical
                      Association through the establishment of three specific CPT
                      codes
                      describing this procedure (96920, 96921 and 96922), as well
                      as the
                      establishment of Relative Value Units adopted by
                      CMS.
  ·
                  Numerous
                        private payers and CMS carriers have recognized the clinical
                        and economic
                        merits of this treatment and have adopted medical coverage
                        policies
                        endorsing its use. In addition, approximately 60,000 excimer
                        laser
                        psoriasis procedures have been performed in the United States
                        in 2005 and
                        approximately 53,000 in 2004 (since the issuance of relevant
                        CPT
                        codes).






3


**Our
      Solution for Vitiligo**




In
      March
      2001, the FDA granted 501(k) clearance to market our XTRAC system for the
      treatment of vitiligo. Vitiligo is a disease in which the skin loses pigment
      due
      to destruction of the pigment cells, causing areas of the skin to become lighter
      in color than adjacent healthy skin. This condition can be distressing to
      patients. Between 1% and 2% of the population suffers from the condition, and
      there is no known cure. The principal conventional treatments for symptoms
      are
      PUVA radiation and, to a lesser extent, topical steroids and combination
      therapies. According to the National Vitiligo Foundation, or NVF, the cost
      of
      PUVA treatments, over a 12 to 18 month period, can run $6,000 or more and
      involve 120 clinic visits. Moreover, according to the NVF, current conventional
      treatment methods are unsatisfactory and many patients tend to lose the pigment
      they were successful in gaining through PUVA therapy. Our XTRAC system can
      effectively re-pigment a patient's skin, allowing treated areas to become
      homogeneous in pigment to healthy surrounding skin and restore the patient's
      skin to its original condition. As
      treatment levels of psoriasis increase, we intend to promote use of the XTRAC
      for treatment of vitiligo. As part of that promotion, we shall explore whether
      CPT codes specific to vitiligo can be established as well as whether CMS and/or
      private insurance plans will establish reimbursement rates for the treatment
      of
      vitiligo.






**Our
      Solution for Atopic Dermatitis**




In
      August
      2001, the FDA granted 510(k) clearance to market our XTRAC system for the
      treatment of atopic dermatitis. Atopic dermatitis is a common, potentially
      debilitating condition that can compromise the quality of life for those it
      affects. The condition appears as chronic inflammation of the skin that occurs
      in persons of all ages, but is reported to be more common in children. Skin
      lesions observed in atopic dermatitis vary greatly, depending on the severity
      of
      inflammation, different stages of healing, chronic scratching and frequent
      secondary infections. It is reported that atopic dermatitis affects some 10%
      of
      children in the United States alone, and more than $364 million is spent
      annually in the treatment of this disease. Treatment options include
      corticosteroids, which can have negative side effects, and UVB phototherapy.
      The
      use of UVB phototherapy in the treatment of atopic dermatitis has been shown
      effective in published studies. Because of the controlled and targeted
      application provided by our XTRAC system, large areas of healthy skin are not
      exposed to UVB light from the XTRAC system and the corresponding
      potentially carcinogenic effect of other phototherapy treatments. We believe
      that the XTRAC system could be an alternative protocol for treating atopic
      dermatitis effectively. However, we do not intend to undertake clinical research
      that would clarify such an alternative protocol until we have secured our
      primary goal - wider private-payer reimbursement and treatment levels for
      psoriasis.




**Our
      Solution for Leukoderma**




In
      May
      2002, the FDA granted 510(k) clearance to market our XTRAC system for the
      treatment of leukoderma, commonly known as white spots, and skin discoloration
      from surgical scars, stretch marks, burns or injury from trauma. The XTRAC
      system utilizes UVB light to stimulate melanocytes, or pigment cells, deep
      in
      the skin. As these cells move closer to the outer layer of skin, re-pigmentation
      occurs. As with atopic dermatitis, we do not intend to undertake clinical
      research for leukoderma that would clarify such an alternative protocol until
      we
      have secured our primary goal - wider private-payer reimbursement and treatment
      levels for psoriasis.




**Our
      XTRAC System**




Our
      XTRAC
      system combines the technology of an excimer laser, or "cold" laser system
      (already in use for a variety of medical and cosmetic treatments), with the
      use
      of ultraviolet light therapy. The XTRAC system applies a concentrated dose
      of
      UVB radiation directly to diseased skin at a higher intensity than traditional
      ultraviolet light therapy. Our XTRAC system utilizes a 308 nm light wavelength,
      which studies have shown to be the optimal wavelength to treat psoriasis
      effectively. Our XTRAC system consists of the laser, which is mobile, and a
      hand
      piece attached to the laser by a liquid light guide or by a fiber optic cable,
      which are designed to permit direct application of the ultraviolet light to
      psoriasis-affected skin.




4


Between
      March 1998 and November 1999, we initiated five seminal clinical
      trials of our XTRAC system at Massachusetts General Hospital. Our objective
      in
      these clinical trials was to compare our XTRAC laser technology with standard
      ultraviolet light therapy in the treatment of psoriasis. In January 2000, we
      received a 510(k) clearance to market the XTRAC system from the FDA based on
      the
      clinical results from these trials. The Massachusetts General Hospital clinical
      trial, which involved 13 patients, concluded that our XTRAC laser made it
      possible to treat psoriasis effectively in one session with moderately long
      remission. The study also concluded that the number of treatments to remission
      depended largely on the intensity of the ultraviolet light used, finding that
      medium intensities seemed to provide the best results with a superior balance
      between quick clearing and patient comfort. We supported the clinical trials
      with research grants of approximately $954,000.




To
      support our commercialization strategy, we completed an additional clinical
      trial in 2000. The trial was designed to validate the results obtained in
      the Massachusetts General Hospital clinical study in mainstream dermatologists'
      offices. We established five Beta sites throughout the United States using
      our
      XTRAC system in a clinical trial of 124 persons. This study examined various
      aspects of excimer laser therapy, including the number of treatments necessary
      for clearing, the ultraviolet light intensity necessary for clearing and overall
      patient satisfaction. Our Beta-Site Clinical Study indicated that:




·
            approximately
                72% of the subjects treated were 75% improved in slightly more than
                six
                sessions, with minimal and well-tolerated side
                effects;




·
            some
                subjects were cleared in as little as one session;
                and




·
            subjects
                were successfully treated who had psoriasis in the hinged body areas
                (knees and elbows), which have proven the most difficult for other
                alternative therapies to demonstrate any significant remedial
                impact.




In
      the
      following year, we received clearance to market our XTRAC system for the
      treatment of vitiligo and atopic dermatitis, and in 2002 for the treatment
      of
      leukoderma. Overall, approximately 44 clinical publications have validated
      the
      clinical efficacy of our phototherapy treatments for the cleared indications
      of
      use and have advanced the insurance reimbursement process.




**Background
      on Psoriasis**




Psoriasis
      is believed to be a non-contagious, autoimmune medical disorder and a chronic
      inflammatory skin disease diagnosed in more than 4.5 million adult Americans
      and
      between 1% and 3% of the world's population. There is no known cure for
      psoriasis. Although clinical symptoms and severity vary greatly between
      individuals over periods of time, psoriasis appears most commonly as inflamed
      swollen lesions covered with silvery white scales. Psoriasis patients often
      suffer from debilitating and painful swelling, itching, bleeding, cracking
      and
      burning, resulting in decreased mobility, depression and low self-esteem. The
      National Psoriasis Foundation, or NPF, estimates that, in the United States,
      dermatologists treat over 1.5 million psoriasis patients each year.




While
      the
      exact cause of the disease remains unknown, the emerging consensus among
      scientists and physicians characterizes psoriasis as an autoimmune medical
      disorder in which excessive "T" cell stimulation in skin cells activates an
      inflammatory response and excessive skin cell production. The disease causes
      the
      rate at which skin cells are produced and pushed to the outer skin layer to
      increase seven-fold, from every 28 days to every two to four days. The body
      cannot shed the skin cells fast enough and this process results in patches,
      or
      "lesions," forming on the skin's surface . Psoriasis cases are classified as mild (less than 2% of the body's surface
      area
      affected and usually localized on the knees, elbows, scalp, hands and feet),
      moderate (between 2% and 10% of the body's surface area affected and usually
      appearing on the arms, legs, torso and head) and severe (greater than 10% of
      the
      body's surface area affected and potentially involving all areas of the skin).
      Our initial target market is patients with mild to moderate psoriasis that
      represent 80% of all psoriasis cases.




5


**Domestic
      Commercialization of Our XTRAC System**




For
      the
      past five years, we have sought to clear the path of obstacles and barriers
      to a
      smooth and orderly roll-out of the XTRAC system in dermatology. In 2000, the
      technology, which was originally designed for cardiology applications, was
      found
      to have significant therapeutic advantages for psoriasis patients who were
      treated with the UVB light emitted from the excimer based laser system. For
      the
      first two years we invested in establishing the clinical efficacy of the product
      and mechanical reliability of the equipment. In the last three years we pursued
      - and in a number of regions, have substantially achieved - widespread
      reimbursement commencing with obtaining newly created CPT reimbursement codes.




We
      believe, based on our analysis, that the XTRAC system should become a preferred
      treatment modality for patients afflicted with psoriasis. Although existing
      treatments provide some relief to psoriasis sufferers, they are inconvenient
      and
      may involve negative side effects. We believe that our patent-protected XTRAC
      system will enable more effective and convenient treatment with minimal side
      effects.




Treatment
      of psoriasis commonly follows a step approach with topical therapy as a
      first-step, phototherapy as second-step, and systemic medications reserved
      for
      when all other treatments fail. The clinical body of evidence developed
      by us and others supports the use of the 308-nm excimer laser as safe and
      effective for localized plaque-type psoriasis recalcitrant to other first-step
      therapies, such as topical creams and ointments. In addition, an economic
      analysis completed in December 2003 has demonstrated that the addition of
      excimer laser treatment results in no expected cost increase to the payer.
      Further, this analysis demonstrates the cost-effectiveness of the excimer laser
      is superior due to the increased number of expected disease-free days and
      remission days.




In
      the
      United States, we are commercializing our XTRAC system in a manner designed
      to
      provide a recurring revenue stream not only to us, but also to the attending
      dermatologist, who would otherwise refer the patient for alternative treatment
      and thereby forego associated revenues. We place units in the offices of
      dermatologists with high-volume psoriasis practices at no up-front capital
      cost
      to the dermatologists. We own the equipment and charge the dermatologist on
      a
      per-treatment basis for the use of the XTRAC system.




A
      dermatologist generally takes delivery of our XTRAC system under the terms
      of
      our standard usage agreement. Our agreements do not provide the dermatologist
      with any purchase options. Title to the lasers remains either in our name or
      in
      the name of a third-party who may hold title as a security device within the
      context of an equipment financing transaction. There is no fixed amount that
      is
      to be paid over pre-set intervals of time by the dermatologist. We reserve
      the
      right to remove the laser unit from a dermatologist’s office if the parties’
economic expectations from the onset of the placement are not borne
      out.




Our
      agreements do not require the purchases of disposable products or similar items
      from us. We make available various accessory products (e.g. canisters of xenon
      chloride gas, subject to a special, proprietary formula tied to the
      specifications of the XTRAC system), but do not require the purchase of set
      amounts of such items. However, we insist that only our qualified technicians
      maintain the lasers and that the physicians observe the instructions for use
      for
      the laser.




The
      dermatologist has the right to purchase pre-paid treatments, which are generally
      ordered telephonically and added to the laser’s computer by way of a random
      access code obtained from us and input by the dermatologist. These purchased
      treatments may be used for multiple treatments for the same or different
      patients, for psoriasis, vitiligo, atopic dermatitis or leukoderma. A single
      treatment is then deducted from the laser’s computer upon patient treatment.
      Payment for access codes is usually set for 60 days. The agreement does not
      provide for delay in payment based on third-party reimbursement. The
      dermatologist retains any revenue received from patients or their medical
      insurance providers.




Generally,
      dermatologists who treat psoriasis patients refer their patients to independent
      treatment centers for ultraviolet light or write prescriptions for topical
      creams or systemic drugs. In such cases, the physician does not ordinarily
      share
      in any of the revenue generated from providing treatments to the patient.
      However, physicians using our XTRAC system will treat the patient in their
      own
      office and, therefore, will retain revenue that would otherwise be lost to
      outside providers. In addition, in most states, a trained technician, rather
      than the physician, may, under the physician’s supervision, apply the treatment,
      thus allowing the dermatologist to continue treating other patients, while
      at
      the same time increasing revenue from treatments using our XTRAC system. We
      believe that this will create an attractive incentive for the dermatologists
      to
      use our XTRAC system. We designed the XTRAC system to make such delegations
      safe.




6


We
      have
      promoted our XTRAC system through trade shows, advertising in scientific
      journals, industry magazines, radio, TV and newsprint, as well as direct mail
      programs. Our marketing campaign has been designed to accelerate market
      acceptance of our XTRAC system by increasing physician and patient awareness
      for
      our new technology. In November 2005, we increased our level of direct to
      consumer advertising initiatives, given that we had made substantive progress
      in
      obtaining private health plan reimbursement approvals.




**International
      Commercialization of Our XTRAC System**




Our
      international dermatology equipment marketing plan is based on the sale of
      our
      XTRAC system and the newly developed VTRAC system through independent, exclusive
      distributors. We have relationships with distributors and end users in more
      than
      30 countries in Europe, the Middle East, the Far East and Southeast Asia, and
      in
      Australia, South Africa and parts of Central and South America. We intend to
      expand our products in more countries in these markets. In some countries in
      the
      longer term, we anticipate developing relationships similar to those in the
      United States, whereby we, acting through our distributors, place a laser system
      in the doctor's office for free or at minimal cost and charge the doctor a
      per-procedure fee.




**Skin
      Care**




**General**




On
      March
      18, 2005, we completed the acquisition of ProCyte Corporation (“ProCyte”).
      ProCyte generates revenues from the sale of skin health, hair care and wound
      care products; the sale of copper peptide compound in bulk; and royalties on
      licenses for the patented copper peptide compound.




ProCyte’s
      focus since 1996 had been to bring unique products, primarily based upon
      patented technologies such as GHK and AHK copper peptide, to selected markets.
      We currently sell products directly to the dermatology, plastic and cosmetic
      surgery, and spa markets. We have also expanded the use of our novel copper
      peptide technologies into the mass retail market for skin and hair care through
      specifically targeted technology licensing and supply agreements.




**Products**




Our
      products address the growing demand for skin health and hair care products,
      including products designed to address the effects aging has on the skin and
      hair and to enhance appearance. Our products are formulated, branded for and
      targeted at specific markets. Our initial products were developed to be
      dispensed by physicians in the dermatology, plastic and cosmetic surgery markets
      for use following various medical procedures. Anti-aging skin care products
      were
      added to form a comprehensive approach for a patients’ skin care regimen.
      Certain of these products incorporate our patented technologies, while others
      complement the product line such as our advanced sunscreen products that reduce
      the effects of sun damage and aging on the skin.




Our
      products are well suited for use in the medical specialties of dermatology,
      plastic and cosmetic surgery. Many of the products developed by ProCyte
      incorporate our clinically tested copper peptide technologies. Several recent
      studies presented at the American Academy of Dermatology and other medical
      symposia have confirmed the advantages of products containing copper peptide
      formulations versus such other formulations as tretinoin, vitamin C, and other
      popular anti-aging and skin rejuvenation products. The actions of wound care
      gels and creams containing copper peptide have been documented in the scientific
      literature for their ability to stimulate collagen synthesis, new blood vessel
      growth and tissue repair. This has led to the development of a variety of
      products designed to treat the skin following certain cosmetic procedures such
      as microdermabrasion, laser resurfacing and hair transplantation. There are
      an
      increasing number of these cosmetic procedures performed each year as the baby
      boomer population ages and has a strong desire to look good and feel good.
      We
      have a series of products tailored to the needs of these types of procedures,
      including the GraftCyte ® System
      and the Complex Cu 3 ® System,
      and have developed a series of daily use products that contain our patented
      copper peptide compounds to aid in maintaining the quality of the skin and
      hair
      following these procedures.




7


*Skin
      Care.* Our
      GraftCyte ® System
      was created to address the special tissue repair needs of patients following
      hair transplant surgery. This system continues to be the only complete solution
      addressing post-procedure care in the hair restoration market. We have continued
      to emphasize our Complex Cu 3 ® Post
      Laser Lotion, Intensive Repair Crème, Cleanser and Hydrating Gel products used
      to treat patients following chemical peels, microdermabrasion and laser
      treatments. The Complex Cu 3 ® products
      provide a comprehensive approach to post-procedure care and allow us to
      differentiate our line of skin care products on the basis of our proprietary
      copper peptide technologies. Studies have indicated that the skin heals more
      quickly with the use of copper peptide compounds.




We
      launched the successful Neova ® Therapy
      line of anti-aging products in response to demand from physician customers
      for a
      comprehensive approach to medically directed skin care. The Neova ® Therapy
      line of GHK Copper Peptide Complex ® products
      showcase elegant moisturizers and serums complemented by supporting cleansers,
      toners, and masks for an integrated approach to anti-aging skin care. Each
      year
      we have added new products to the product line including Neova ® Microdermabrasion Scrub and Neova ® Therapy
      Crème de la Copper added in 2003 and the Neova ® Therapy
      Dual Action Lotion, a combination of GHK Copper Peptide Complex ® +
      Retinol in March 2004. The Neova ® Therapy
      line is designed to offer high-performance, cosmetically elegant lifestyle
      products that are premium-priced in the market.




Our
      line
      of advanced sun protection products, marketed under the brand names of
      Ti-Silc ® and
      Z-Silc ® ,
      are
      recommended by dermatologists and plastic surgeons to assist in the prevention
      of sun exposure that can lead to a number of problems including age spots,
      hyperpigmentation, premature aging and melanoma.




*Hair
      Care* .
      We have
      marketed our Tricomin ® line of
      Triamino Copper ComplexTM-containing hair care products since 1998
      (Tricomin ® Shampoos, Conditioners and Follicle Therapy Solution) as a program for the
      maintenance of thinning hair in men and women. Hair follicles require high
      concentrations of biological copper and the Tricomin ® products
      deliver copper along with amino acids for nourishing and stimulating the hair
      and scalp for improved health, strength and appearance. These products provide
      physicians with a non-drug alternative to the problem of thinning hair care
      for
      their patients. We also sell Tricomin ® products
      directly via the website, www.tricomin.com. We are currently working on the
      next
      generation of products to increase the effectiveness of the Triamino Copper
      Nutritional ComplexTM delivery.




*Chronic
      Wound Care.* Our
      chronic wound care product, marketed under the Iamin ® name,
      has met with varying degrees of market success. The wound care market is highly
      fragmented, with many competitors, price constraints, and inadequate Medicare
      reimbursement. The wound care market also requires a significant investment
      in
      supporting a large sales organization. For these reasons, ProCyte had
      historically attempted to collaborate with partners to market its chronic wound
      care product and we will continue to do so. Additionally, we have looked for
      other methods of distribution and include Iamin ® as one
      of the products in the GraftCyte ® System
      used by patients following hair transplant surgery. A number of other programs
      have been initiated in an effort to increase utilization of the
      Iamin ® product;
      however, none have resulted in meaningful revenue increases to
      date.




**Markets
      and Distribution**




The
      markets for skin care, hair care and wound care products are global. There
      are
      numerous distinct markets where we have a presence through our own direct sales
      efforts or through agreements with others. These include dermatology, plastic
      and cosmetic surgery, spa, catalog, and direct mail. We sell our products to
      customers utilizing a direct sales force and also generate revenues from
      technology licensing.




We
      emphasize high-quality products and services, technical knowledge, and
      responsiveness to customer needs in our marketing activities. We educate our
      distributors, customers and prospective customers about our products through
      a
      series of detailed marketing brochures, technical bulletins and pamphlets,
      presentations, news releases and direct mail pieces. We also conduct a series
      of
      one-day educational symposia around the country to provide product updates
      and
      marketing ideas to current and potential physician customers. These activities
      are supplemented by advertising in industry publications, technical
      presentations, and exhibitions at over 30 local, national and international
      trade shows.




8


**Technology
      Licensing**




Technology
      licensing generated $459,967, representing 1.6% percent of our total revenues
      in
      2005. We are continuously seeking partners in the prestige, direct-to-consumer,
      specialty retail and home shopping categories. ProCyte’s strategy is to identify
      skin care markets that would be best served by more established companies and
      then target a significant partner in each market to license our
      technology.




We
      have
      operated under a worldwide license agreement with Neutrogena Corporation, a
      Johnson & Johnson company (“Neutrogena”), for worldwide use of our patented
      copper peptide  technology
      in products for skin health in the mass retail market. Our current license
      agreement has a two-year term remaining. Neutrogena develops, manufactures
      and
      markets skin and hair care products domestically and internationally. Neutrogena
      launched its two initial products using our technology under the brand name
      of
      Visibly FirmTM with Active CopperTM in April 2001. Since that time, it has
      continued to add new products using ProCyte’s patented copper peptide
      technology. Neutrogena began expanding the sale of these products into some
      of
      its international markets during 2003 and has indicated plans to continue such
      expansion. We receive royalty payments, based on product sales by Neutrogena
      and
      revenue from the sale of the copper peptide compound used in Neutrogena’s
      products.




**Our
      Business Strategy: Surgical Products and Services**




We
      market
      lasers used in surgery in such venues as hospitals, surgi-centers and doctors
      offices under the trademark of SLT and trade name of Surgical Innovations &
Services. We market many of our surgical laser products using a similar business
      model to the marketing of our excimer laser products by charging a per-procedure
      fee, thereby limiting the initial outlay to the customer for capital
      expenditure, while ensuring continued revenue flow to us. We offer a wide range
      of laser services in various specialties, including urology, gynecology,
      orthopedics and general surgery. We are currently marketing such services under
      the trade name PhotoMedex Surgical Services. We also provide products that
      we
      manufacture for use in our surgical services business.




We
      also
      engage in the development, manufacture and sale of surgical products, including
      proprietary Contact and free-beam Laser Systems for surgery and in the provision
      of surgical services on a turnkey procedural basis. We introduced Contact LaserTM
surgery by combining proprietary Contact Laser Delivery Systems with an Nd:YAG
      laser unit to create a multi-specialty surgical instrument that can cut,
      coagulate or vaporize tissue. Our Contact Laser Delivery Systems can be used
      effectively with any wavelength of laser between 532nm and 1064nm, including
      the
      KTP laser (532nm), diode laser (various wavelengths) and Nd:YAG laser (1064nm).
      We are currently marketing such products under the trade name PhotoMedex
      Surgical Products.




Our
      proprietary Contact Laser probe and scalpel surface treatments provide the
      ability to alter selectively the temperature profile of tissue, replicating
      the
      clinical effect of many different types of lasers. Through our patented Contact
      Laser Delivery Systems, we are able to produce a wide range of temperature
      gradients, which address a broad range of surgical procedures within multiple
      specialties. Our multiple-specialty capability reduces a hospital’s need to
      purchase several lasers to meet its specialists’ varied requirements. These
      factors, coupled with the precision, hemostasis, tactile feedback and control
      that our Contact Laser Delivery Systems provide, are our primary competitive
      strengths in surgical products.




During
      2001, we introduced the LaserPro CTH holmium laser, a versatile and compact
      holmium laser for lithotripsy, or fragmentation of calculi of the genito-urinary
      tract, as well as a broad range of other surgical applications. We also
      introduced a line of fiber-optic laser delivery systems to be used with the
      holmium laser. This laser has been used in the provision of surgical services
      and has also been offered for sale. In 2004, we introduced our new CO2 laser
      system as well as our own diode laser system, which we anticipate over time
      will
      replace the Nd:YAG laser.




Our
      surgical revenues will thus continue to be generated primarily
      from:


·
              providing
                  surgical services;
  ·
              the
                  sale of Contact Laser Delivery Systems and related
                  accessories;
  ·
              the
                  sale of Nd:YAG and CTH holmium laser units;
                  and
  ·
              the
                  sale of CO2 and diode units, and related
                  service.
  9


Our
      Contact Laser Delivery Systems consist of proprietary fiberoptic delivery
      systems which deliver the laser beam from our Nd:YAG or diode laser unit via
      an
      optical fiber to the tissue, either directly or through a proprietary Laser
      Probe or Laser Scalpel. These delivery systems can also be used with the laser
      systems of certain other manufacturers. Our holmium laser delivery systems
      consist of fiber-optic delivery systems, which deliver the laser beam from
      our
      CTH holmium laser unit to the surgical site. The CO2 laser system does not
      use a
      fiberoptic and therefore will have less of a recurrent revenue steam. However,
      we anticipate that in conjunction with sales of the CO2 laser, we will sell
      more
      of our CO2-related accessories.




**Surgical
      Services**




We
      provide our customers with the ability to utilize our laser systems, as well
      as
      those of other companies, on a per-procedure basis. We provide these services
      through field technicians, called clinical support specialists, for a variety
      of
      surgical procedures utilizing various laser technologies. The per-procedure
      prices we charge for surgical services vary based on the surgical procedure
      performed.




Our
      primary competitive strengths in surgical services are in the training we
      provide to our clinical service specialists, our adherence to quality standards
      and our ability to integrate products that we manufacture into the range of
      services we provide. These strengths allow us to provide multiple specialty
      capability on a cost-effective basis, which in turn reduces or eliminates a
      hospital’s need to purchase laser systems, associated delivery systems and
      clinical support to meet its professionals’ requirements.




Most
      of
      our operations in surgical services are in the southeastern states of the United
      States. We also have operations in Milwaukee, Baltimore-Washington DC and
      Philadelphia areas. We intend to continue to expand the territory where we
      provide such services and shall explore how we may expand the range of surgical
      procedures, which we can support. We see surgical services as a business with
      favorable prospects for revenue growth.




**Surgical
      Products**




The
      following is a summary of our major surgical products:




***Fiberoptic
      Delivery Systems*** *.* We ** have
      designed disposable optical quartz fibers **** to
      channel the laser beam from our laser unit to the fiber end, the Laser Probe
      or
      the Laser Scalpel or to one of 24 interchangeable, application-specific
      handpieces that hold the Laser Scalpel or Laser Probe. Many of these proprietary
      optical fibers and handpieces are intended for single use, while others are
      designed to be reusable.




***Laser
      Probes and Laser Scalpels*** *.* Our
      proprietary Laser Probes and Laser Scalpels are made of either synthetic
      sapphire or fused silica and have high mechanical strength, high melting
      temperature and appropriate thermal conductivity. Most of these Laser Probes
      and
      Laser Scalpels use our patented Wavelength Conversion Effect treatments. We
      offer more than 60 interchangeable Laser Probes and Laser Scalpels that provide
      different power densities through various geometric configurations appropriate
      for cutting, coagulation or vaporization. Our Laser Probes and Laser Scalpels
      are made with varying distal tip diameters and surface treatments, each with
      a
      different balance between cutting and coagulation, so that the instrument can
      be
      suited to the particular tissue effect desired. Additionally, but at much lesser
      volumes, we market side-firing and direct-firing free-beam laser probes. Instead
      of changing laser units, surgeons may choose a different Laser Probe or Laser
      Scalpel to perform a different procedure. The Laser Probes and Laser Scalpels
      can be re-sterilized and reused.




***Disposable
      Gas or Fluid Cartridge Systems*** *.* Our
      proprietary cartridge system provides gas or fluid to cool the junction between
      the optical fiber and the Laser Scalpel or the Laser Probe. These cartridges
      are
      sterile and used in one set of procedures.




10


***Reusable
      Laser Aspiration Handpieces.*** ** Our
      reusable stainless steel handpieces are all used with interchangeable laser
      aspiration wands and flexible endoscopic fibers. **** These
      proprietary handpieces are intended for intra-nasal/endoscopic sinus and
      oropharyngeal procedures requiring smoke and/or fluid evacuation.




***Laser
      Units*** *.* We
      market
      the CLMD line of Nd:YAG laser units for use with our Contact Laser Delivery
      Systems. The line consists of 4 units:




·
              the
                  CLMD 25-watts to tissue, on 110
                  volts;
  ·
              the
                  CLMD 40-watts to tissue, on 110
                  volts;


·
            the
                CLMD Dual which operates up to 40-watts to tissue on 110 volts and
                up to
                60-watts to tissue on 220 volts; and




·
              the
                  CLMD 100-watts to tissue, on 220
                  volts.




The
      laser
      units feature a modular design that allows the customer to upgrade from the
      25-watt laser to the 40-watt or Dual laser and from the 40-watt laser to the
      Dual laser. This modularity provides the customer the flexibility and
      versatility to change its laser system easily to meet its changing surgery
      needs. We have discontinued production of the 100-watt unit but will continue
      in
      the near term to refurbish such units. In 2004, we began phasing out the other
      CLMD units and replacing the line with our diode laser unit.




We
      market
      the CTH holmium laser unit for use with fiber-optic laser delivery systems.
      The
      laser unit delivers 20-watts to tissue, and includes a variable speed foot
      pedal for improved control of energy. It has a superior duty cycle. The delivery
      systems are re-useable.




The
      diode
      laser unit can provide up to 20 watts of power to tissue. The laser has three
      versions, depending on which wavelength the user desires to be installed in
      the
      laser. The wavelengths are 810-nm, 940-nm and 980-nm. The laser unit is small
      and portable, but also is designed to be rugged and dependable. Acting as an
      original equipment manufacturer (OEM), we have provided the diode laser to
      third
      parties to market in specialties lying outside our area of focus. We expect
      to
      cultivate more such relationships in the future.




The
      CO2
      laser unit can provide up to 30 watts of power to tissue at a wavelength of
      10,600-nm. Like the diode, the CO2 laser is readily transportable and has been
      designed for dependable use. This laser was also designed to work seamlessly
      with a line of premiere CO2 accessories, including the Unimax® micromanipulator,
      which we acquired from Reliant Technologies. As in the case of the diode laser,
      we have in the case of the CO2 laser undertaken discussions to supply the laser
      on an OEM basis to third parties.




The
      holmium, diode and CO2 lasers are marketed under the trademark
”LaserPro.”




We
      manufacture virtually all of our laser systems and laser delivery systems (other
      than those manufactured by other companies that are utilized in the provision
      of
      surgical services) at our Montgomeryville, Pennsylvania facility. The raw
      materials we use are generally available in adequate supply from multiple
      suppliers. We obtain all of our partially finished Laser Probes and Laser
      Scalpels from three suppliers in the United States. We perform materials
      processing and final assembly on the Laser Probes and Laser Scalpels using
      proprietary and patented treatment processes. We also manufacture the fiberoptic
      delivery systems, with and without handpieces. A domestic supplier manufactures
      our sterile gas and fluid cartridge systems on an exclusive basis in accordance
      with our specifications.




***Handheld
      Sinus Instrumentation*** **.** We
      market
      a line of 27 precision thru-cutting instruments used for minimally invasive
      sinus surgery. The line includes instruments with cutting tips at several
      different angles to allow for convenient access to difficult-to-reach anatomy.




11


***Irrigation
      and Suction System.*** We
      manufacture ClearESS®, which provides convenient and effective irrigation and
      suction to remove blood and debris for enhanced visualization during endoscopic
      sinus surgery. We supplied this product to Linvatec Corporation, but have now
      brought the line back for us to market.




**Our
      Operating Strategies:**




**Sales
      and Marketing**




As
      of
      March 15, 2006, our sales and marketing organization contains the following
      full-time positions. These have expanded significantly as a result of the
      ProCyte acquisition:





·
              Executive
                  Level
              2·
              XTRAC
                  Regional Sales Managers
              2·
              Skin
                  Care Regional Sales Managers
              2·
              XTRAC
                  Account Representatives
              8·
              XTRAC
                  Clinical Support Staff
              2·
              Skin
                  Care Representatives
              20·
              Marketing
                  Support
              7·
              International
                  Skin Care Sales Director
              1·
              International
                  Dermatology Equipment Director
              1·
              Worldwide
                  Surgical Sales
              1·
              Surgical
                  Services Director and Regional Mgrs
              5·
              Customer
                  Service Representatives
              8




Our
      sales
      organization provides consultation and assistance to customers on the effective
      use of our products, whether in phototherapy or in surgery. The consultative
      sales effort varies depending on many factors, which include the nature of
      the
      specialty involved and complexity of the procedures. Maintaining this
      consultative effort allows us to develop a long-term relationship with our
      customers.




The
      time
      between identifying a U.S. customer for the XTRAC system and placing a unit
      with
      the customer can be from one to several months. The length of the sales cycle
      for a laser unit, whether an excimer unit sold internationally or one of our
      surgical lasers, varies from one month to one year, with the average sale or
      placement requiring approximately six months. The length of the sales cycle
      for
      the provision of surgical services can range from immediate to several months
      depending on the services desired.




Our
      sale
      and post-sale support personnel includes regional managers and clinical support
      specialists and marketing and technical personnel. We train the regional
      managers and clinical support specialists in the utilization of our products
      and
      services, which allows them to provide clinical consultation regarding safety,
      efficacy and clinical protocols. Our marketing and technology personnel provide
      our link to the customer to create innovative solutions and identify new
      applications and product opportunities. In some areas of the United States,
      we
      use independent distributors to provide this support for surgical products.




We
      sell
      our surgical products and services to hospitals and surgery centers as well
      as
      to individual practitioners. We design our products to be cost-effective and,
      where applicable, to be accessible and easy to use with various other
      technologies or products. Our marketing efforts include activities designed
      to
      educate physicians and nurses in the use of our products and
      services.




12


**Manufacturing**




We
      manufacture our phototherapy products at our 8,000 sq. ft. facility in Carlsbad,
      California and our
      surgical products at our 42,000 sq. ft. facility in Montgomeryville,
      Pennsylvania .
      Our
      California and Pennsylvania facilities are ISO 13485 certified. We believe
      that
      our present manufacturing capacity at these facilities is sufficient to meet
      foreseeable demand for our products. We substantially outsource the manufacture
      of our Skin care products. Our facility in Redmond, Washington is the final
      assembly center and primary warehouse for our skin care products, and likewise
      is operated in conformance with a quality system.




We
      manufacture most of our own components and utilize certain suppliers for the
      manufacture of selected standard components and subassemblies, which are
      manufactured, to our specifications. Most major components and raw materials,
      including optics and electro-optic devices, are available from a variety of
      sources. We conduct all final testing and inspection of our products. We have
      established a quality control program, including a set of standard manufacturing
      and documentation procedures intended to ensure that, where required, our
      instruments are manufactured in accordance with FDA Quality System Requirements
      and the comparable requirements of the European Community.




**Research
      and Development**




As
      of
      March 15, 2006, our research and development team included four full-time
      research employees and 10 engineers. We conduct research and development
      activities at all three of our facilities: Carlsbad, California, Redmond,
      Washington and Montgomeryville, Pennsylvania. Our research and development
      expenditures were approximately $1.1 million in 2005, $1.8 million in 2004
      and
      $1.8 million in 2003.




Our
      research and development activities are focused on:




·
            the
                application of our XTRAC system to the treatment of other inflammatory
                skin disorders;




·
            the
                development of additional devices to further improve the phototherapy
                treatments performed with our XTRAC system;




·
            the
                development of new lines of phototherapy products for medical
                treatments;




·
            the
                development of new skin health and hair care
                products;




·
            the
                improvement of surgical products through tissue effect technologies
                that
                include laser and non-laser based technologies focused on improving
                our
                product and service offerings;




·
            the
                development of new lines of surgical lasers and related delivery
                systems
                for medical treatments;




·
            the
                development of additional products and applications, whether in
                phototherapy or surgery, by working closely with medical centers,
                universities and other companies worldwide;
                and




·
            the
                development of new applications in minimally invasive and open surgery
                procedures where precision and hemeostasis are critical to the procedure
                being performed and where our products and services can demonstrate
                distinct clinical advantages and cost-effectiveness relative to
                traditional surgical methods.




**Patents
      and Proprietary Technologies**




We
      intend
      to protect our proprietary rights from unauthorized use by third parties to
      the
      extent that our proprietary rights are covered by valid and enforceable patents
      or are effectively maintained as trade secrets.




Patents
      and other proprietary rights are an element of our business. Our policy is
      to
      file patent applications and to protect technology, inventions and improvements
      to inventions that are commercially important to the development of our
      business. As patents expire and expose our inventions to public use, we seek
      to
      mitigate the impact of such expirations by improvements on the inventions
      embodied in the expiring patents. The patents in our Skin Care segment relate
      to
      use of our copper peptide-based technology for a variety of healthcare
      applications, and to the composition of certain biologically active, synthesized
      compounds. Our strategy has been to apply for patent protection for certain
      compounds and their discovered uses that are believed to have potential
      commercial value in countries that offer significant market potential. As of
      March 15, 2006, we have more than 130 domestic and foreign issued patents,
      which
      serve to help protect the technology of our businesses in phototherapy, skin
      health and hair care, and surgical products and services. To the same purpose,
      we have more than 70 patent applications pending in the United States and
      abroad.




13


We
      have
      licensed certain of our proprietary technology in phototherapy to Komatsu,
      Ltd.
      in connection with its manufacture of semi-conductor lithography equipment,
      for
      which we are entitled to receive royalty fees. We have licensed our copper
      peptide technology to Neutrogena. for which we currently receive royalties.
      Conversely, from time to time, we seek licenses from third parties for
      technology that can broaden our product and service offerings, as for example
      a
      license we secured from Massachusetts General Hospital related to the treatment
      of psoriasis.




We
      also
      rely on trade secrets, employee and third-party nondisclosure agreements and
      other protective measures to protect our intellectual property rights pertaining
      to our products and technology.




Many
      of
      our products and services are offered under trademarks and service marks, both
      registered and unregistered. We believe our trademarks encourage customer
      loyalty and aid in the differentiation of our products from competitors’
products, especially in our skin care products. Accordingly, we have registered
      in the United States 34 of our trademarks in the United States. We have other
      registrations for our skin care products in foreign jurisdictions.




**Government
      Regulation**




Our
      products and research and development activities are regulated by numerous
      governmental authorities, principally the FDA and corresponding state and
      foreign regulatory agencies. Any device manufactured or distributed by us will
      be subject to pervasive and continuing regulation by the FDA. The Federal Food,
      Drug and Cosmetics Act and other federal and state laws and regulations govern
      the pre-clinical and clinical testing, design, manufacture, use and promotion
      of
      medical devices and drugs, including our XTRAC system, surgical lasers and
      other
      products currently under development by us. Product development and approval
      within this regulatory framework takes a number of years and involves the
      expenditure of substantial resources.




In
      the
      United States, medical devices are classified into three different classes,
      Class I, II and III, on the basis of controls deemed reasonably necessary
      to ensure the safety and effectiveness of the device. Class I devices are
      subject to general controls, such as labeling, pre-market notification and
      adherence to the FDA's good manufacturing practices, and quality system
      regulations. Class II devices are subject to general as well as special
      controls, such as performance standards, post market surveillance, patient
      registries and FDA guidelines. Class III devices are those which must
      receive pre-market approval by the FDA to ensure their safety and effectiveness,
      such as life-sustaining, life-supporting and implantable devices, or new
      devices, which have been found not to be substantially equivalent to legally
      marketed devices.




Before
      a
      new medical device can be marketed, marketing clearance must be obtained through
      a pre-market notification under Section 510(k) of the Food and Drug
      Modernization Act of 1997, or the FDA Act, or a pre-market approval application
      under Section 515 of such FDA Act. The FDA will typically grant a 510(k)
      clearance if it can be established that the device is substantially equivalent
      to a predicate device that is a legally marketed Class I or II device or
      certain Class III devices. We have received FDA 510(k) clearance to market
      our XTRAC system for the treatment of psoriasis, vitiligo, atopic dermatitis
      and
      leukoderma. Additionally, the FDA has issued clearances to commercially market
      our Contact Laser System, including the laser unit, Laser Probes and Laser
      Scalpels and Fiberoptic Delivery System, in a variety of surgical specialties
      and procedures in gynecology, gastroenterology, urology, pulmonology, general
      and plastic surgery, cardio-thoracic surgery, ENT surgery, ophthalmology,
      neurosurgery and head and neck surgery. The FDA granted these clearances under
      Section 510(k) on the basis of substantial equivalence to other laser or
      electrosurgical cutting devices that had received prior clearances or were
      otherwise permitted to be used in such areas. We have also received FDA
      clearance under Section 510(k) to market our holmium laser system, including
      the
      laser unit and fiberoptic delivery systems, in a variety of surgical specialties
      and procedures in urology, otorhinolaryngology, discectomy and percutaneous
      laser disc decompression.




14


For
      any
      devices that are cleared through the 510(k) process, modifications or
      enhancements that could significantly affect the safety or effectiveness, or
      that constitute a major change in the intended use of the device, will require
      new 510(k) submissions. In August 2003, the FDA granted 510(k) clearance for
      modifications that had been made to the XTRAC laser, which we have marketed
      as
      the XTRAC XL Plus excimer laser system. In October 2004, the FDA granted
      clearance for the UltraTM (AL 8000) excimer laser system. We also received in
      2004, 510(k) marketing clearance for our diode and CO2 surgical laser
      systems.




A
      pre-market approval application may be required if a proposed device is not
      substantially equivalent to a legally marketed Class I or II device, or for
      certain Class III devices. A pre-market approval application must be
      supported by valid scientific evidence to demonstrate the safety and
      effectiveness of the device, typically including the results of clinical trials,
      bench tests and laboratory and animal studies. In addition, the submission
      must
      include the proposed labeling, advertising literature and any training
      materials. The pre-market approval process can be expensive, uncertain and
      lengthy, and a number of devices for which FDA approval has been sought by
      other
      companies have never been approved for marketing.




We
      are
      subject to routine inspection by the FDA and have to comply with a number of
      regulatory requirements that usually apply to medical devices marketed in the
      United States, including labeling regulation, good manufacturing process
      requirements, medical device reporting regulation (which requires a manufacturer
      to report to the FDA certain types of adverse events involving its products),
      and the FDA's prohibitions against promoting products for unapproved or
      off-label uses.




We
      are
      also subject to the Radiation Control for Health and Safety Act with laser
      radiation safety regulations administered by the Center for Devices and
      Radiological Health, or CDRH, of the FDA. These regulations require laser
      manufacturers to file new product reports and annual reports, to maintain
      quality control, product testing and sales records, to incorporate certain
      design and operating features in lasers sold to end users and to certify and
      label each laser sold, except those sold to private-label customers, as
      belonging to one of four classes, based on the level of radiation from the
      laser
      that is accessible to users. Various warning labels must be affixed and certain
      protective devices installed, depending on the class of product. The CDRH is
      empowered to seek fines and other remedies for violations of the regulatory
      requirements. To date, we have filed the documentation with the CDRH for our
      laser products requiring such filing, and have not experienced any difficulties
      or incurred significant costs in complying with such regulations.




We
      have
      received ISO 13485/EN46001 certification for our XTRAC system and our Nd:YAG,
      holmium, diode and CO2 laser systems. This certification authorizes us to affix
      a CE Mark to our products as evidence that they meet all European Community,
      or
      EC, quality assurance standards and compliance with applicable European medical
      device directives for the production of medical devices. This will enable us
      to
      market our approved products in all of the member countries of the European
      Union, or EU. We also will be required to comply with additional individual
      national requirements that are outside the scope of those required by the EU.
      Our products have also met the discrete requirements for marketing in various
      other countries. Failure to comply with applicable regulatory requirements
      can
      result in fines, injunctions, civil penalties, recalls or seizures of products,
      total or partial suspensions of production, refusals by foreign governments
      to
      permit product sales and criminal prosecution.




As
      to our
      products in the Skin Care business segment, the Federal Food, Drug and Cosmetic
      Act, and the regulations promulgated thereunder, and other federal and state
      statutes govern the testing, manufacture, safety, labeling, storage,
      record-keeping, advertising and promotion of cosmetic products as well. Our
      products and product candidates in the Skin Care segment may be regulated by
      any
      of a number of divisions of the FDA and in other countries by similar health
      and
      regulatory authorities. The process of obtaining and maintaining regulatory
      approvals for the manufacturing or marketing of our existing and potential
      skin
      care products is costly and time-consuming and is subject to unanticipated
      delays. Regulatory requirements ultimately imposed could also adversely affect
      our ability to clinically test, manufacture or market products.




In
      the
      United States, products that do not seek to make effectiveness claims based
      on
      human clinical evaluation may be subject to review and regulation under the
      FDA’s cosmetic, drug or 510(k) medical device guidelines. Similar guidelines
      exist for such products in other countries. Such 510(k) products, which include
      wound care dressings and certain ointments and gels, must show safety and
      substantial equivalency with predicate products already cleared by the FDA
      to be
      marketed. There can be no assurance that product applications submitted to
      the
      FDA or similar agencies in other countries will receive clearance to be
      marketed, or that the labeling claims sought will be approved, or that, if
      cleared, such products will be commercially successful or free from third party
      claims relating to the effectiveness or safety of such products.




15


We
      are
      also or may become subject to various other federal, state, local and foreign
      laws, regulations and policies relating to, among other things, safe working
      conditions, good laboratory practices, and the use and disposal of hazardous
      or
      potentially hazardous substances used in connection with research and
      development. Failure to obtain regulatory approvals where appropriate for our
      product candidates or to attain or maintain compliance with quality system
      regulations or other manufacturing requirements would have a material adverse
      effect on our business, financial condition and results of
      operations.




**Third-Party
      Reimbursement**




Our
      ability to market our phototherapy products successfully will depend in large
      part on the extent to which various third parties are willing to reimburse
      patients or providers for the cost of medical procedures utilizing our treatment
      products. These third parties include government authorities, private health
      insurers and other organizations, such as health maintenance organizations.
      Third-party payers are systematically challenging the prices charged for medical
      products and services. They may deny reimbursement if they determine that a
      prescribed device is not used in accordance with cost-effective treatment
      methods as determined by the payer, or is experimental, unnecessary or
      inappropriate. Accordingly, if less costly drugs or other treatments are
      available, third-party payers may not authorize or may limit reimbursement
      for
      the use of our products, even if our products are safer or more effective than
      the alternatives. Additionally, they may require changes to our pricing
      structure and revenue model before authorizing reimbursement.




Reimbursement
      systems in international markets vary significantly by country and by region
      within some countries, and reimbursement approvals must be obtained on a
      country-by-country basis. Many international markets have government-managed
      healthcare systems that control reimbursement for new devices and procedures.
      In
      most markets, there are private insurance systems, as well as government-managed
      systems. Our XTRAC products remain substantially without approval for
      reimbursement in any international markets under either government or private
      reimbursement systems. Reimbursement for the products and services provided
      by
      our Surgical Services and Surgical Products segments has been generally well
      established and is not viewed as an obstacle to growth in those segments. Since
      the skin care products are primarily for cosmetic applications, reimbursement
      is
      not a critical factor in growing revenues for this product segment.




Our
      primary focus in 2005 was to amplify our efforts on third-party reimbursement
      in
      our domestic XTRAC business segment. In February 2002, the Current Procedural
      Terminology Editorial Board of the American Medical Association, or AMA,
      approved the request by the American Academy of Dermatology to issue
      reimbursement codes for laser therapies in the treatment of psoriasis and other
      inflammatory skin diseases, which would include laser therapy using our XTRAC
      system to treat such conditions. In December 2002, the Centers for Medicare
      and
      Medicaid Services, or CMS, published the relative values and national Medicare
      reimbursement rates for each of the CPT codes. These reimbursement rates were
      effective January 1, 2003. However, they could not be paid sooner than March
      1,
      2003. The designation for laser treatment for inflammatory skin disease
      (psoriasis) was broken into three distinct codes, based on the total skin
      surface area being treated:




· 96920 -
      designated for: the total area less than 250 square centimeters. CMS assigned
      a
      2006 national payment of approximately $141.00 per treatment;




· 96921 -
      designated for: the total area 250 to 500 square centimeters. CMS assigned
      a
      2006 national payment of approximately $144.00 per treatment; and




· 96922 -
      designated for: the total area over 500 square centimeters. CMS assigned a
      2006
      national payment of approximately $213.00 per treatment.




16


The
      state
      rates will vary by overhead factors applicable to each state.




In
      addition to Medicare and Medicaid, consistent domestic private healthcare
      reimbursement is critical for significant growth in XTRAC system procedures.
      There were more than 60,000 XTRAC procedures in 2005 and more than 50,000 XTRAC
      procedures in 2004 with the majority being covered by third-party reimbursement.
      Historically, it has been our belief that a rapid increase in widespread
      adoption of private healthcare reimbursement was being thwarted by a perception
      that the XTRAC therapy, although widely publicized as clinically safe and
      efficacious, was not economically cost-effective compared to other existing
      therapies. We sponsored the completion of an economic and clinical study to
      review the clinical and economic effectiveness of the XTRAC laser as a
      second-step therapy for the treatment of psoriasis. The conclusions of the
      study
      are: there is no additional cost of adding XTRAC as second-line therapy in
      a
      managed care plan; XRAC is a cost-effective second-line treatment for
      mild-to-moderate plaque psoriasis; XTRAC provides the greatest number of
      treatment-free days in one year among all therapies, except for intralesional
      corticosteroid injections (“ICI”); XTRAC is the lowest cost per
      treatment-free-day with the exception of ICI; XTRAC has the lower cost per
      remission day among all phototherapies; and XTRAC has the highest number of
      remission days among all therapies. The results of this study were compiled
      in a
      data compendium and distributed to all the major health insurers; the results
      have also been published in a peer-review journal. In 2005 substantive progress
      was made in connection with obtaining approvals for covering medically necessary
      targeted UVB therapy for psoriasis. As a result of certain national insurers
      approving the XTRAC excimer laser therapy in the latter part of 2005, we
      initiated a direct-to-consumer advertising campaign in certain geographic
      regions.




**Competition**




The
      market for our XTRAC system is highly competitive. We compete with other
      products and methodologies used to treat the symptoms of psoriasis, vitiligo,
      atopic dermatitis and leukoderma, including topical treatments, systemic
      medications and other phototherapies. We believe that our XTRAC system will
      compete with alternative treatments for these disorders primarily on the basis
      of its effectiveness, as well as on the basis of the lower out-of-pocket costs,
      as compared to costs associated with alternative treatments. Market acceptance
      of our XTRAC system treatment for these diseases is dependent on our ability
      to
      establish, with the medical and patient communities, the efficacy of our XTRAC
      system as a preferred treatment modality. In addition, all or a portion of
      patient costs for many of the alternative treatments are paid or are
      reimbursable by health insurance coverage or other third-party payers, such
      as
      Medicaid and Medicare. Patient costs for treatments utilizing our XTRAC system
      may not be initially eligible for health care coverage or reimbursement by
      third-party payers until such payers approve reimbursement. This may cause
      some
      patients or physicians to choose alternative treatments offered by our
      competitors.




We
      also
      face direct competition from other companies, including large pharmaceutical
      companies, engaged in the research, development and commercialization of
      treatments for psoriasis, atopic dermatitis, vitiligo and leukoderma. In some
      cases, those companies have already received FDA approval or commenced clinical
      trials for such treatments. Many of these companies have significantly greater
      financial resources and expertise in research and development, manufacturing,
      conducting pre-clinical studies and clinical trials, and marketing than we
      do.




Various
      other companies are now marketing laser-based phototherapy treatment products.
      One former competitor had received FDA clearance to market an excimer laser
      for
      the treatment of psoriasis in the United States, and another competitor has
      asserted that it has such clearance - an assertion we are disputing. At least
      three foreign-based companies are currently marketing an excimer laser for
      the
      treatment of skin disorders outside of the United States. Two others have
      developed pulse-dye lasers, which are being explored as treatments for
      psoriasis. Another company has announced FDA clearance for a standard UVB light
      based system using a fiber-optic delivery system for the treatment of skin
      disorders. All of these technologies will continue to evolve with time. We
      cannot say how much these technologies will impact on us, but we anticipate
      that
      competitors that enter the US market will predominantly not use a
      fee-per-procedure model but will use an outright sales model, and will sell
      not
      on claims of superior quality, but on claims of lower prices and better economic
      returns.




Competition
      in the wound care, skin health and hair care markets is intense. Our competitors
      include well-established pharmaceutical, cosmetic and healthcare companies
      such
      as Obagi, La Roche Posay, Allergan, Pevonia, Declore and Murad. These
      competitors have substantially more financial and other resources, larger
      research and development staffs, and more experience and capabilities in
      researching, developing and testing products in clinical trials, in obtaining
      FDA and other regulatory approvals and in manufacturing, marketing and
      distribution than us. In addition, a number of smaller companies are developing
      or marketing competitive products. Our competitors may succeed in developing
      and
      commercializing products or obtaining patent protection or other regulatory
      approvals for products more rapidly than us. In addition, competitive products
      may be manufactured and marketed more successfully than our potential products.
      Such developments could render our existing or potential products less
      competitive or obsolete and could have a material adverse effect on our
      business, financial condition and results of operations.




17


With
      regard to surgical lasers, we face substantial competition from other
      manufacturers of surgical laser systems, whose identity varies depending on
      the
      medical application for which the surgical system is being used, and from
      traditional surgical methods. Other companies are developing competitive
      surgical systems and related technologies. Many of these companies are
      substantially larger and have substantially greater resources than we do. These
      efforts could result in additional competitive pressures on our
      operations.




In
      addition, we face competition from other surgical services companies and from
      product manufacturers who may offer their products through a similar
      per-procedure method. Additionally, we face substantial competition from
      well-established manufacturers of non-laser products. These well-established
      companies have substantially greater resources than we do and could exert
      considerable competitive pressure on us. We continue to monitor the concepts
      or
      products and services some companies have introduced into the market that draw
      on Contact Laser technology. We do not believe, however, that such concepts
      or
      products will have a significant impact on our sales.




In
      addition, our competitors compete with us in recruiting and retaining qualified
      scientific, management and marketing personnel.




**Employees**




As
      of
      March 15, 2006, we had 180 full-time employees, which consisted of 7 executive
      personnel (6 executive personnel at our Montgomeryville, Pennsylvania facility
      and 1 at our Carlsbad, California facility), 55 sales and marketing staff,
      80
      people engaged in manufacturing of lasers and laser-related products, 8
      customer-field service personnel, 4 people engaged in research and development,
      10 engineers and 16 finance and administration staff. We intend to hire
      additional personnel as the development of our business makes such action
      appropriate. The loss of the services of key employees could have a material
      adverse effect on our business. Since there is intense competition for qualified
      personnel knowledgeable in our industry, no assurances can be given that we
      will
      be successful in retaining and recruiting needed personnel.




Our
      employees are not represented by a labor union nor covered by a collective
      bargaining agreement. We believe that we have good relations with our employees.
      We provide our employees with certain benefits, including health
      insurance.




**Item
      1A. Risk Factors**




**Certain
      statements in this Report are "forward-looking statements." These
      forward-looking statements include, but are not limited to, statements about
      our
      plans, objectives, expectations and intentions and other statements contained
      in
      this Report that are not historical facts. Forward-looking statements in this
      Report or hereafter included in other publicly available documents filed with
      the Securities and Exchange Commission, or the Commission, reports to our
      stockholders and other publicly available statements issued or released by
      us
      involve known and unknown risks, uncertainties and other factors which could
      cause our actual results, performance (financial or operating) or achievements
      to differ from the future results, performance (financial or operating) or
      achievements expressed or implied by such forward-looking statements. Such
      future results are based upon management's best estimates based upon current
      conditions and the most recent results of operations. When used in this Report,
      the words "expect," "anticipate," "intend," "plan," "believe," "seek,"
      "estimate" and similar expressions are generally intended to identify
      forward-looking statements, because these forward-looking statements involve
      risks and uncertainties. There are important factors that could cause actual
      results to differ materially from those expressed or implied by these
      forward-looking statements, including our plans, objectives, expectations and
      intentions and other factors discussed in the risk factors, described
      below.**




18


**Risks
      Related to Our Business**




**We
      have a history of losses, expect future losses and cannot assure you that we
      will become or remain profitable.**




Historically,
      we have incurred significant losses and have had negative cash flows from our
      phototherapy operations. Our surgical products and services business also has
      generated losses in recent years. To date, we have dedicated most of our
      financial resources to research and development and selling, general and
      administrative expenses. As of December 31, 2005, our accumulated deficit was
      approximately $80.2 million.




Our
      future revenues and success depend significantly upon acceptance of our excimer
      laser systems for the treatment principally of psoriasis, but also of vitiligo,
      atopic dermatitis and leukoderma. Our XTRAC system for the treatment of these
      conditions generates revenues, but those revenues are presently insufficient
      to
      generate positive cash flows from our operations in the two XTRAC-related
      business segments. Our future revenues and success also depends on the continued
      revenue growth of the revenue from the skin health and hair care products of
      our
      skincare products and of our surgical services business and revenue stability
      within our surgical products business. Our ability to market our products and
      services successfully and the expected benefits to be obtained from our products
      and services may be adversely affected by a number of factors, such as
      unforeseen costs and expenses, technological changes, economic downturns,
      competitive factors or other events beyond our control.




We
      expect
      to incur losses as we move into fiscal 2006 because we plan to spend substantial
      amounts on expanding, in controlled fashion, our operations in phototherapy.
      We
      cannot assure you that we will market any products successfully, operate
      profitably in the future, or that we will not require significant additional
      financing in order to accomplish our business plan.




**We
      may need additional financing to maintain and expand our business, and such
      financing may not be available on favorable terms, if at
      all.**




We
      have
      historically financed our activities through working capital provided from
      operations, the private placement of equity securities and from lines of credit.
      We believe that our cash balance, together with access to lease financing for
      capital expenditures and other existing financial resources, and revenues from
      sales, distribution, licensing and manufacturing relationships, should be
      sufficient to meet our operating and capital requirements into the second
      quarter of 2007. However, we may have to raise substantial additional capital
      if:




·
            operating
                losses continue, if anticipated demand for the XTRAC system for the
                treatment of psoriasis or surgical laser systems do not meet our
                current
                expectations;




·
            we
                fail to maintain existing or develop new customers or corporate partners
                for the marketing and distribution of our skincare products;




·
            the
                geographic expansion of our surgical services is stymied by competition
                and revenue increases do not materialize;




·
            we
                need to maintain or accelerate favorable, but costlier, growth of
                our
                revenues; or




·
            changes
                in our research and development plans necessitate unexpected, large
                future
                expenditures.




**If
      we need additional financing, we cannot assure you that such financing will
      be
      available on favorable terms, if at all. In addition, any future issuance may
      result in substantial dilution to existing stockholders. If we need funds and
      cannot raise them on acceptable terms, we may not be able
      to:**




·
            execute
                our growth plan for the XTRAC system, surgical services and skincare
                products;




·
            expand
                our manufacturing facilities, if necessary, based on increased demand
                for
                the XTRAC system or other surgical products or new skincare products,
                which may be introduced;




·
            take
                advantage of future opportunities, including synergistic
                acquisitions;




·
            respond
                to customers, competitors or violators of our proprietary and contractual
                rights; or




·
            remain
                in operation.






19


**Our
      laser treatments of psoriasis, vitiligo, atopic dermatitis and leukoderma,
      our
      skincare products and our surgical laser products and any of our future products
      or services may fail to gain market acceptance, which could adversely affect
      our
      competitive position.**




No
      independent studies with regard to the feasibility of our proposed business
      plan
      have been conducted by third parties with respect to our present and future
      business prospects and capital requirements. We have generated limited
      commercial distribution for our XTRAC system and our other products. Skincare
      products sales are dependent on existing strategic partners for distributing
      and
      marketing its products. We may be unsuccessful in continuing existing or
      developing new strategic partners in order to maintain or expand the markets
      for
      the skincare business’ existing or future products. Our surgical services may
      fail to gain market acceptance in new territories into which we expand. In
      addition, our infrastructure to enable such expansion, though stronger than
      in
      the past, is still limited. Even if adequate financing is available and our
      products are ready for market, we cannot assure you that our products and
      services will find sufficient acceptance in the marketplace to fulfill our
      long
      and short-term goals. We cannot assure you that the marketplace will be
      receptive to our excimer laser technology, skincare products, or our surgical
      services over competing products, services and therapies or that a cure will
      not
      be found for the underlying diseases we are focused on treating. Failure of
      our
      products and surgical services to achieve market acceptance could have a
      material adverse effect on our business, financial condition and results of
      operations.




While
      we
      have engaged in clinical studies for our psoriasis treatment, and based on
      these
      studies, we have gained FDA clearance, appropriate CPT reimbursement codes
      for
      treatment and suitable reimbursement rates from CMS for those codes, we may
      face
      other hurdles to market acceptance if, for example, practitioners in significant
      numbers wait to see longer-term studies or if it becomes necessary to conduct
      studies corroborating the role of the XTRAC system as a second-line therapy
      for treating psoriasis or if patients do not elect to undergo psoriasis
      treatment using the XTRAC system. We have not had sufficient time to observe
      the
      long-term effectiveness or potential side effects of our treatment system for
      psoriasis, vitiligo, atopic dermatitis or leukoderma nor to gauge what marketing
      and sales programs, if any, are effective in increasing patients’ demand for the
      treatment of psoriasis with the XTRAC system.




In
      2003,
      we improved the reliability and functionality of the XTRAC system and upgraded
      such lasers both in the United States and overseas. In 2004, we obtained FDA
      510(k) marketing clearance for a smaller and faster XTRAC system known as the
      Ultra. These efforts should help us gain market acceptance for the XTRAC
      system both in the United States and abroad, but do not guarantee such
      acceptance or that we may not encounter further problems in reliability. We
      have
      designed the XTRAC system to be user-friendly, such that a properly in-serviced
      medical technician in a physician’s office may, under the physician’s
      supervision, safely and effectively administer treatments to a patient. In
      fact,
      the CMS reimbursement rates are based on the lower labor rates achieved through
      such delegation. Nevertheless, whether a treatment may be delegated, and if
      so
      to whom and to what extent, are matters that may vary state by state, as these
      matters are within the province of the state medical boards. In states that
      may
      be more restrictive in such delegation, a physician may decline to adopt the
      XTRAC system into his or her practice, deeming it to be too much fraught
      with too many constraints and finding other outlets for the physician’s time and
      staff time to be more remunerative. There can be no assurance that we will
      be
      successful in persuading such medical boards that a liberal standard for
      delegation is appropriate for the XTRAC system, given its design for ease and
      safety of use. If we are not successful, we may find that even if a geographic
      region has wide insurance reimbursement, the region’s physicians may yet balk at
      adopting the XTRAC system into their practices.




**Our
      success is dependent on intellectual property rights held by us, and our
      business will be adversely affected by direct competition if we are unable
      to
      protect these rights.**




Our
      success will depend, in part, on our ability to maintain and defend our patents.
      However, we cannot give you any assurances that the technologies and processes
      covered by all of our patents may not be found to be obvious or substantially
      similar to prior work, which could render these patents unenforceable. Moreover,
      as our patents expire, competitors may utilize the technology found in such
      patents to commercialize their own laser systems. In offset to the expiring
      patents, we endeavor to secure additional patents on critical, commercially
      desirable improvements to the inventions of the expiring patents. There can
      be
      no assurance that we will be successful in securing such additional patents,
      or
      that such additional patents will adequately offset the effect of the expiring
      patents.




20


Of
      particular note is US Patent No. 4,891,818, the so-called “ ‘818 Patent”, which
      covers, among other things, the design of the gas chamber in the XTRAC
      system. The ‘818 Patent will expire on August 31, 2007 and will thereafter no
      longer serve as a barrier to entry to the relatively reimbursement-rich US
      market. The additional patent rights we seek may serve less to bar competitors
      from entry and may serve more, when aggregated with other clinical and
      competitive strengths, to differentiate and distinguish our product (e.g. the
      Ultra), in both its utility and its range of applications, from those of
      competitors. We may therefore choose in the US market to broaden our
      fee-per-procedure business model to include a direct sales option, as we have
      done and continue to do in the international market. Where a competitor
      infringes on our patent and other proprietary rights, we are prepared, our
      financial condition permitting, to defend those rights vigorously in the US
      courts. If we unable through these innovations to preserve our proprietary
      rights, our ability to market the XTRAC system could be materially and adversely
      affected.




A
      U.S.
      patent relating to a copper peptide compound manufactured and used in products
      distributed by Neutrogena under the Neutrogena license agreement expired on
      February 5, 2005. Upon expiration of this patent, the agreement specifies that
      lower royalty percentages from sales of such products be used for the remaining
      term, the impact of which is a reduction in the average effective royalty rate
      of approximately 50%. The actual amount of royalty income recognized in future
      periods is dependent upon the royalty percentages in effect during the period
      and the actual applicable sales reported by Neutrogena, which can vary from
      quarter to quarter. The expiration of the patent would also allow others,
      including Neutrogena, to apply the technology covered by that patent in their
      products.




Trade
      secrets and other proprietary information which are not protected by patents
      are
      also critical to our business. We attempt to protect our trade secrets by
      entering into confidentiality agreements with third parties, employees and
      consultants. However, these agreements can be breached and, if they are and
      even
      if we are able to prove the breach or that our technology has been
      misappropriated under applicable state law, there may not be an adequate remedy
      available to us. In addition, it is costly and time-consuming litigation may
      be
      necessary to enforce and determine the scope of our proprietary rights, and
      even
      if we prevail in litigation, the party we prevail over may have scant resources
      available to satisfy a judgment.




Further,
      our skin care business seeks to establish customer loyalty, to in part, by
      means
      of our use of trademarks. It can be difficult and costly to defend trademarks
      from encroachment or misappropriation overseas. Third parties may also challenge
      the validity of certain of our trademarks. In either eventuality, our customers
      may become confused and direct their purchases to competitors.




Third
      parties may independently discover trade secrets and proprietary information
      that allow them to develop technologies and products that are substantially
      equivalent or superior to our own. Without the protection afforded by our
      patent, trade secret and proprietary information rights, we may face direct
      competition from others commercializing their products using our technology,
      which may have a material adverse effect on our business and our
      prospects.




**Defending
      against intellectual property infringement claims could be time-consuming and
      expensive, and if we are not successful, could cause substantial expenses and
      disrupt our business.**




We
      cannot
      be sure that the products, services, technologies and advertising we employ
      in
      our business do not or will not infringe valid patents, trademarks, copyrights
      or other intellectual property rights held by third parties. We may be subject
      in the ordinary course of our business to legal proceedings and claims from
      time
      to time relating to the intellectual property of others. Any legal action
      against us claiming damages or seeking to enjoin commercial activities relating
      to the affected products or our methods or processes could have a material
      adverse effect on our business and prospects by:




21




·
            requiring
                us, or our collaborators, to obtain a license to continue to use,
                manufacture or market the affected products, methods or processes,
                and
                such a license may not be available on commercially reasonable terms,
                if
                at all;




·
            preventing
                us from making, using or selling the subject matter claimed in patents
                held by others and subject us to potential liability for
                damages;




·
            consuming
                a substantial portion of our managerial and financial resources;
                or




·
            resulting
                in litigation or administrative proceedings that may be costly, whether
                we
                win or lose.




**Our
      success depends on third-party reimbursement of patients' costs for our XTRAC
      system, which could result in potentially reduced prices or reduced
      demand.**




Our
      ability to market the XTRAC system and other treatment products successfully
      will depend in large part on the extent to which various third parties are
      willing to reimburse patients or providers for the costs of medical procedures
      utilizing such products. These third parties include government authorities,
      private health insurers and other organizations, such as health maintenance
      organizations. Third-party payers are systematically challenging the prices
      charged for medical products and services. They may deny reimbursement if they
      determine that a prescribed device is not used in accordance with cost-effective
      treatment methods as determined by the payer, or is experimental, unnecessary
      or
      inappropriate. Further, although third-parties may approve reimbursement, such
      approvals may be under terms and conditions that discourage use of the XTRAC
      laser system. Accordingly, if less costly drugs or other treatments are
      available, third-party payers may not authorize or may limit reimbursement
      for
      the use of its products, even if our products are safer or more effective than
      the alternatives.




Although
      we have received reimbursement approvals from an increased number of private
      healthcare plans, we cannot give assurance that private plans will continue
      to
      adopt or maintain favorable reimbursement policies or to accept the XTRAC
      system in its clinical role as a second-line therapy in the treatment of
      psoriasis. Additionally, third party payers may require further clinical studies
      or changes to our pricing structure and revenue model before authorizing
      reimbursement.




As
      of
      March 16, 2006, we estimate, based on published coverage policies and on payment
      practices of private and Medicare insurance plans, that more than 75% of the
      insured population in the United States are covered by the insurance coverage
      or
      payment policies that reimburse physicians for using the XTRAC system for
      treatment of psoriasis. Based on these reports and estimates, we are continuing
      the implementation of a rollout strategy for the XTRAC system in the United
      States in selected areas of the country where reimbursement is widely available.
      The success of the rollout depends on increasing physician and patient demand
      for the treatment. We can give no assurance that health insurers will not
      adversely modify their reimbursement policies for the use of the XTRAC
      system in the future.




We
      intend
      to seek coverage and reimbursement for the use of the XTRAC system to treat
      other inflammatory skin disorders, after additional clinical studies are
      completed. There can be no assurances that we will be in position to expand
      coverage for vitiligo or to seek reimbursement for the use of the XTRAC system
      to treat atopic dermatitis or leukoderma, or, if we do, that any health insurers
      will agree to any reimbursement policy.




**Cost
      containment measures and any general healthcare reform could adversely affect
      our ability to market our products.**




Cost
      containment measures instituted by healthcare providers and insurers and any
      general healthcare reform could affect our ability to receive revenue from
      the
      use of our XTRAC system or to market our skincare products, and surgical laser
      products, and may have a material adverse effect on us. We cannot predict the
      effect of future legislation or regulation concerning the healthcare industry
      and third-party coverage and reimbursement on our business. In addition,
      fundamental reforms in the healthcare industry in the United States and the
      EU
      continue to be considered, although we cannot predict whether or when any
      healthcare reform proposals will be adopted and what impact such proposals
      might
      have on demand for our products.




**The
      XTRAC system will continue to be the most promising product that is currently
      marketed. If physicians do not adopt the XTRAC system, we will not achieve
      anticipated revenue growth.**




22


We
      commercially introduced the XTRAC system in August 2000, but decelerated that
      introduction while we sought appropriate CPT codes and suitable rates of
      reimbursement from CMS. After we obtained CPT codes and reimbursement rates
      from
      CMS for the CPT codes, we began a rollout strategy for the XTRAC system in
      the
      United States. To achieve increasing revenue, this product must also gain
      recognition and adoption by physicians who treat psoriasis and other skin
      disorders. The XTRAC system represents a significant departure from conventional
      psoriasis treatment methods. We believe that the recognition and adoption of
      the
      XTRAC system would be expedited if there were long-term clinical data
      demonstrating that the XTRAC system provides an effective and attractive
      alternative to conventional means of treatment for psoriasis. Currently,
      however, there are still only limited peer-reviewed clinical reports and
      short-term clinical follow-up data on the XTRAC system. Physicians are
      traditionally cautious in adopting new products and treatment practices,
      partially due to the anticipation of liability risks and partially due to
      uncertainty of third-party reimbursement. If physicians do not adopt the XTRAC
      system, we may never achieve significant revenues or profitability.




**If
      the effectiveness and safety of our products are not supported by long-term
      data, our revenues could decline.**




Our
      products may not be accepted if we do not produce clinical data supported by
      the
      independent efforts of clinicians. We received clearance from the FDA for the
      use of the XTRAC system to treat psoriasis based upon our study of a limited
      number of patients. Safety and efficacy data presented to the FDA for the XTRAC
      system was based on studies on these patients. For the treatment of vitiligo,
      atopic dermatitis and leukoderma, we have received clearance from the FDA for
      the use of the XTRAC system based primarily on equivalence of predicate devices;
      we may discover that physicians will expect clinical data on such treatments
      with the XTRAC system. We may find that data from longer-term psoriasis patient
      follow-up studies may be inconsistent with those indicated by our relatively
      short-term data. If longer-term patient studies or clinical experience indicate
      that treatment with the XTRAC system does not provide patients with sustained
      benefits or that treatment with our product is less effective or less safe
      than
      our current data suggests, our revenues could decline. We can give no assurance
      that we may find that our data is not substantiated in studies involving more
      patients; in such a case we may never achieve significant revenues or
      profitability.




**Any
      failure in our physician education efforts could significantly reduce product
      marketing.**




It
      is
      important to the success of our marketing efforts to educate physicians and
      technicians in the techniques of using the XTRAC system. We rely on physicians
      to spend their time and money to attend our pre-sale educational sessions.
      Positive results using the XTRAC system are highly dependent upon proper
      physician and technician technique. If physicians and technicians use the XTRAC
      system improperly, they may have unsatisfactory patient outcomes or cause
      patient injury, which may give rise to negative publicity or lawsuits against
      us, any of which could have a material adverse effect on our reputation as
      a
      medical device company and our revenues and profitability.




Similarly,
      it is important to our success that we educate and persuade hospitals, surgery
      centers and practitioners of the clinical and economic benefits of our surgical
      products and services. If we fail to educate and persuade our customers, we
      may
      suffer adversely in our reputation and our revenues and our
      profitability.




**If
      revenue from a significant customer continues to decline, we may have difficulty
      replacing the lost revenue.**




Neutrogena,
      one of the customers for the skin health and hair care products segment that
      we
      acquired from ProCyte, accounts for a significant portion of our net revenue
      in
      that business segment. ProCyte’s net revenues from Neutrogena in 2004 were
      $2,768,072, or approximately 20.8% of ProCyte’s gross revenues of $13,320,200
      (revenues which pre-date our acquisition and which are not reflected in our
      financial statements), and for the year ended December 31, 2005, Skin Care’s
      (ProCyte) net revenues from Neutrogena were $1,421,946, or approximately 10.9%
      of Skin Care’s (ProCyte) gross revenues of $13,011,694 (revenues which are
      reflected in our financial statements to the extent that they were
      earned since March 19, 2005). We receive royalty revenues on sales of
      products by Neutrogena under the terms of a license agreement with
      Neutrogena. The royalties from Neutrogena for 2004 and for the year ended
      December 31, 2005, were $1,214,073 and $609,946, respectively. The license
      agreement expires in April 2010. A U.S. patent related to the Neutrogena license
      agreement expired February 5, 2005, the effect of which was a reduction in
      the
      percentage paid as a royalty during the remaining royalty period under the
      license agreement. We also receive revenues from sales of copper peptide
      compound to Neutrogena pursuant to a related supply agreement. ProCyte’s sales
      to Neutrogena under the supply agreement for 2004 and for the year ended
      December 31, 2005, were $1,553,999 and $812,000, respectively. Neutrogena has
      agreed to an extension of the supply agreement through October 5, 2007, on
      terms
      that we regard as generally favorable to us.




23


Excluding
      niche marketing efforts, the Skin Care segment targets its sales in the US
      market to physicians, who then mark the products up for sale to their patients.
      No single practice in itself is generally responsible for a significant
      disproportion of our sales. However, a number of practices, specializing in
      hair
      transplants, are united under the management of a single group, and this group
      accounts for a disproportion of our hair care products aimed at the care of
      a
      scalp that has received a hair transplant.




In
      the
      International XTRAC segment (as well as in the Surgical Products segment),
      we
      depend in the international arena for a material portion of our sales on several
      key distributors, as for example our master distributor in the Pacific Rim.
      If
      we lose one of these distributors, our sales of phototherapy and surgical lasers
      are likely to suffer in the short term.




In
      the
      Surgical Services segment, we find that our model works best if we have several
      accounts in a territory that have sufficient volume to allow us to be efficient
      in the delivery of our services. If we lose one of these anchor accounts, then
      we may become less efficient and therefore less competitive.




We
      have
      acted as contract developer of a system designed to detect cancerous cells
      in
      human tissue and act as an OEM manufacturer of surgical lasers and/or delivery
      systems. Development work is fraught with financial risk and technological
      uncertainties. OEM work is usually limited to a contracted period of time,
      at
      the end of which there may be no extension or renewal. In either case, our
      aim
      to create a strategic partnership may be frustrated.




The
      loss
      or reduction of business from any of our significant customers or strategic
      partners in that business segment, Neutrogena in particular, or the failure
      to
      develop new significant customers or strategic partners could have a material
      adverse effect on the results of operations and our overall financial
      condition.




**We
      may not be able to protect our intellectual property rights outside the United
      States.**




Intellectual
      property law outside the United States is uncertain and in many countries is
      currently undergoing review and revision. The laws of some countries do not
      protect our intellectual property rights to the same extent as laws in the
      United States. The intellectual property rights we enjoy in one country or
      jurisdiction may be rejected in other countries or jurisdictions, or, if
      recognized there, the rights may be significantly diluted. It may be necessary
      or useful for us to participate in proceedings to determine the validity of
      our
      foreign intellectual property rights, or those of our competitors, which could
      result in substantial cost and divert our resources, efforts and attention
      from
      other aspects of our business. If we are unable to defend our intellectual
      property rights internationally, we may face increased competition outside
      the
      United States, which could materially and adversely affect our future business,
      prospects, operating results and financial results and financial
      condition.




**Our
      failure to obtain or maintain necessary FDA clearances or approvals could hurt
      our ability to distribute and market our products in the United
      States.**




Our
      laser
      products are considered medical devices and are subject to extensive regulation
      in the United States and in foreign countries where we intend to do business.
      In
      addition, certain of our skincare products and product candidates may be
      regulated by any of a number of divisions of the FDA and in other countries
      by
      similar health and regulatory authorities. Unless an exemption applies, each
      medical device that we wish to market in the United States and certain skincare
      products that we may wish to market must first receive either 510(k) clearance
      or pre-market approval from the FDA. Either process can be lengthy and
      expensive. The FDA's 510(k) clearance process may take from four to twelve
      months, or longer. The pre-market application approval process is much more
      costly, lengthy and uncertain. It may take one to three years or even longer.
      Delays in obtaining regulatory clearance or approval could adversely affect
      our
      revenues and profitability.




24


Although
      we have obtained 510(k) clearances for our XTRAC system for use in treating
      psoriasis, vitiligo, atopic dermatitis and leukoderma, and 510(k) clearances
      for
      our surgical products, our clearances can be revoked if post-marketing data
      demonstrates safety issues or lack of effectiveness. Further, more stringent
      regulatory requirements and/or safety and quality standards may be issued in
      the
      future with an adverse effect on our business. Although we believe that we
      are
      in compliance with all material applicable regulations of the FDA, current
      regulations depend heavily on administrative interpretation. Future
      interpretations made by the FDA or other regulatory bodies, with possible
      retroactive effect, may vary from current interpretations and may adversely
      affect our business and prospects.




**Even
      if we obtain the necessary regulatory approvals for our phototherapy products
      from foreign governments, market acceptance in international markets may depend
      on third party reimbursement of participants’ costs.**




We
      have
      introduced our XTRAC system through our distributors and to end users into
      markets in more than 35 countries in Europe, the Middle East, the Far East
      and
      Southeast Asia, and in Australia, South Africa and parts of Central and South
      America. We intend to expand the number of countries in these markets where
      we
      distribute our products. We cannot be certain that our distributors will be
      successful in marketing XTRAC systems in these or other countries or that our
      distributors will purchase more than their contractual obligations or in
      accordance with our expectations.




Underlying
      our approvals in a number of countries are our quality systems. We are regularly
      audited on the compliance of our quality systems with applicable requirements,
      which can be extensive and complex and subject to change due to evolving
      interpretations and changing requirements. Adverse audit findings could
      negatively affect our ability to market our products.




Even
      if
      we obtain and maintain the necessary foreign regulatory registrations or
      approvals, market acceptance of our products in international markets may be
      dependent, in part, upon the availability of reimbursement within applicable
      healthcare payment systems. Reimbursement and healthcare payment systems in
      international markets vary significantly by country, and include both
      government-sponsored healthcare and private insurance. We may seek international
      reimbursement approvals for our products, but we cannot assure you that any
      such
      approvals will be obtained in a timely manner, if at all. Failure to receive
      international reimbursement approvals in any given market could have a material
      adverse effect on the acceptance of our products in that market or
      others.




**We
      have limited marketing experience, and our failure to build and manage our
      marketing force or to market and distribute our products effectively will hurt
      our revenues and profits.**




We
      have
      limited marketing experience and limited marketing resources. However, we expect
      that we will have to expand the number of our sales and marketing personnel
      in
      order to implement our marketing programs and strategy so as to increase
      utilization of the XTRAC system in the United States. Different programs
      may call for different strategies and talents. While we may be able to draw
      on
      currently available personnel within our organization, we also expect that
      we
      will have to increase the number of representatives devoted to the sales and
      marketing programs and broaden, through such representatives, the talents we
      have at our disposal. In some cases, we may look outside our organization for
      assistance in marketing our products, as for example in a program to market
      our
      surgical diode laser through the internet. We cannot predict whether the
      anticipated sales and marketing programs will be successful, either in design
      or
      implementation.




In
      similar fashion, we cannot predict how successful we may be in expanding our
      skincare products or surgical services in the United States, nor can we predict
      the success of new skincare or surgical products that we may introduce. There
      are, for example, skincare products and diode and CO2 lasers already in the
      market against which our comparable products must compete. No assurance can
      be
      given that we will be successful in marketing and selling our skin health and
      hair care products or our diode and CO2 lasers.




25


There
      are
      significant risks involved in building and managing our marketing force and
      marketing our products, including our ability:




·
            to
                hire, as needed, a sufficient number of qualified marketing people
                with
                the skills and understanding to market the XTRAC system, our skincare
                products and our surgical products services and
                effectively;




·
            to
                adequately train our marketing force in the use and benefits of our
                products and services, making them more effective promoters;




·
            to
                set the prices and other terms and conditions for treatments using
                an
                XTRAC system and our surgical services in a complex legal environment
                so
                that they will be accepted as attractive and appropriate alternatives
                to
                conventional service modalities and treatments; and




·
            to
                cope with employee turnover among the sales force in the skin care
                business, which is highly competitive for talented sales
                representatives.




**We
      have limited experience manufacturing our products in commercial quantities,
      which could adversely impact the rate at which we grow.**




We
      may
      encounter difficulties manufacturing our products for the following reasons:




·
            we
                have limited experience manufacturing our products in commercial
                quantities; and




·
            we
                will, in order to increase our manufacturing output significantly,
                have to
                attract and retain qualified employees, who are in short supply,
                for
                assembly and testing operations.




Although
      we believe that our current manufacturing facilities are adequate to support
      our
      commercial manufacturing activities for the foreseeable future, we may be
      required to expand our manufacturing facilities to increase capacity
      substantially. If we are unable to provide customers with high-quality products
      in a timely manner, we may not be able to achieve market acceptance for our
      XTRAC system, to maintain the benefits of vertical integration in the delivery
      of our surgical services or to achieve market acceptance for our skincare
      products. Our inability to manufacture or commercialize our devices successfully
      could have a material adverse effect on our revenue.




**We
      may have difficulty managing our growth.**




If
      additional private carriers approve favorable reimbursement policies for
      psoriasis and our marketing programs are successful in increasing utilization
      of
      the XTRAC system, we expect to experience growth in the number of our employees
      and customers and the scope of our operations. This growth may place a strain
      on
      our management and operations. Our ability to manage this growth will depend
      upon our ability to broaden our management team and our ability to attract,
      hire
      and retain skilled employees. We also expect that compliance with the
      requirements of governmental and quasi-governmental bodies will grow more
      complex and burdensome. Our success will also depend on the ability of our
      officers and key employees to continue to implement and improve our operational,
      financial and other systems, to manage multiple, concurrent customer
      relationships, to respond to increasing compliance requirements and to hire,
      train and manage our employees. Our future success is heavily dependent upon
      growth and acceptance of our products. If we cannot scale our business
      appropriately or otherwise adapt to anticipated growth and complexity and new
      product introductions, a key part of our strategy may not be
      successful.




In
      addition, we may acquire additional companies in the medical products and
      services industry. Accordingly, in the ordinary course of our business, we
      regularly consider, evaluate and enter into negotiations related to potential
      acquisition opportunities. We may pay for these acquisitions in cash or
      securities, including equity securities, or a combination of both. We cannot
      assure you that attractive acquisition targets will be available at reasonable
      prices or that we will be successful in any such transaction. Acquisitions
      involve a number of special risks, including:




·
            diversion
                of our management’s attention;




·
            integration
                of the acquired business with our business;
                and




·
            unanticipated
                legal liabilities and other circumstances or
                events.






26


**The
      XTRAC system and other laser systems we manufacture for surgery require
      specific component parts that may not be readily available or cost effective,
      which may adversely affect our competitive position or profitability. Our skin
      care products may require compounds that can be efficiently produced by a
      limited number of suppliers.**




Production
      of our XTRAC system requires specific component parts obtained from our
      suppliers. Production of our surgical laser systems requires some component
      parts that will become harder to procure, as the design of the system ages.
      Similarly, our skin care products may require compounds that can be efficiently
      produced only by a limited number of suppliers. In the event that our suppliers
      cannot meet our needs, we believe that we could find alternative suppliers.
      However, a change in suppliers or any significant delay in our ability to have
      access to such resources would have a material adverse effect on our delivery
      schedules, business, operating results and financial condition.




**Our
      failure to respond to rapid changes in technology and its applications and
      intense competition in the medical devices industry or the development of a
      cure
      for skin conditions treated by our products could make our treatment system
      obsolete.**




The
      medical devices industry is subject to rapid and substantial technological
      development and product innovations. To be successful, we must respond to new
      developments in technology, new applications of existing technology and new
      treatment methods. Our response may be stymied if we require, but cannot secure,
      rights to essential third-party intellectual property. We compete against
      numerous companies offering alternative treatment systems to ours, some of
      which
      have greater financial, marketing and technical resources to utilize in pursuing
      technological development and new treatment methods. Our financial condition
      and
      operating results could be adversely affected if our medical devices fail to
      compete favorably with these technological developments, or if we fail to be
      responsive on a timely and effective basis to competitors’ new devices,
      applications, treatments or price strategies. The development of a cure for
      psoriasis, vitiligo, atopic dermatitis or leukoderma would eliminate the need
      for our XTRAC system for these diseases and would require us to focus on other
      uses of our technology, which would have a material adverse effect on our
      business or prospects.




In
      addition, competition in the skin health and hair care markets is intense.
      Our
      skincare competitors include well-established pharmaceutical, cosmetic and
      healthcare companies such as Obagi, La Roche Posay, Allergan, Pevonia, Declore
      and Murad. These competitors have substantially more financial and other
      resources, larger research and development staffs, and more experience and
      capabilities in researching, developing and testing products in clinical trials,
      in obtaining FDA and other regulatory approvals and in manufacturing, marketing
      and distribution than we do. Further, a number of smaller companies are
      developing or marketing competitive products. Our skincare competitors may
      succeed in developing and commercializing products or obtaining patent
      protection or other regulatory approvals for products more rapidly than we
      can.
      Further, competitive products may be manufactured and marketed more successfully
      than our potential skincare products. Such developments could render our
      existing or potential skincare products less competitive or obsolete and could
      have a material adverse effect on our business, financial condition and results
      of operations.




As
      we
      develop new products or improve our existing products, we may accelerate the
      economic obsolescence of the existing, unimproved products, and their
      components. The obsolescent products and related components may have little
      to
      no resale value, leading to an increase in the reserves we have against our
      inventory. On the other side, there is a risk that the new products or improved
      existing products may not achieve market acceptance and therefore also lead
      to
      an increase in the reserves against our inventory.




**Our
      products may be found defective or physicians and technicians may misuse our
      products and damages may exceed our insurance coverage.**




One
      or
      more of our products may be found to be defective after they have been shipped
      in volume, and require product replacement. Product returns and the potential
      need to remedy defects or provide replacement products or parts could result
      in
      substantial costs and have a material adverse effect on our business and results
      of operations. The clinical testing, manufacturing, marketing and use of our
      products and procedures may also expose us to product liability claims. In
      addition, the fact that we train technicians whom we do not supervise in the
      use
      of our XTRAC system when patients are treated and that we train and provide
      our
      technicians as part of our surgical services business may expose us to
      third-party claims if those doing the training are accused of providing
      inadequate training or if a technician is accused of negligently applying such
      training. We presently maintain liability insurance with coverage limits of
      at
      least $5,000,000 per occurrence. Continuing insurance coverage may not be
      available at an acceptable cost, if at all. We may not be able to obtain
      insurance coverage that will be adequate to satisfy any liability that may
      arise. Regardless of merit or eventual outcome, product liability claims may
      result in decreased demand for a product, injury to its reputation, withdrawal
      of clinical trial volunteers and loss of revenues. As a result, regardless
      of
      whether we are insured, a product liability claim or product recall may result
      in losses that could have a material adverse effect upon our business, financial
      condition and results of operations.




27


**If
      we use hazardous materials in a manner that causes injury or violates laws,
      our
      business and operations may suffer.**




Our
      XTRAC
      system utilizes a xenon chloride gas mixture under high pressure, which is
      extremely corrosive. While methods for proper disposal and handling of this
      gas
      are well-known, we cannot completely eliminate the risk of accidental
      contamination, which could cause:




·
            an
                interruption of our research and development
                efforts;




·
            injury
                to our employees, physicians, technicians or patients which could
                result
                in the payment of damages; or




·
            liabilities
                under federal, state and local laws and regulations governing the
                use,
                storage, handling and disposal of these materials and specified waste
                products.




From
      time
      to time, customers return to us surgical products that appear not to have
      performed to specification. Such products must be decontaminated before being
      returned to us. If they are not, our employees may be exposed to dangerous
      diseases.




**We
      depend on our executive officers and key personnel to implement our business
      strategy and could be harmed by the loss of their
      services.**




We
      believe that our growth and future success will depend in large part upon the
      skills of our management and technical team. The competition for qualified
      personnel in the laser industry is intense, and the loss of our key personnel
      or
      an inability to continue to attract, retain and motivate key personnel could
      adversely affect our business. We cannot assure you that we will be able to
      retain our existing key personnel or to attract additional qualified personnel.
      We do not have key-person life insurance on any of our employees.




Our
      success depends in part upon the continued service and performance
      of:




·
            Jeffrey
                F. O’Donnell, President and Chief Executive Officer;




·
            Dennis
                M. McGrath, Chief Financial Officer;




·
            Michael
                R. Stewart, Executive Vice President and Chief Operating
                Officer;




·
            John
                F. Clifford, Executive Vice President Dermatology
                and




·
            Robin
                L. Carmichael, Vice President -
                Marketing






28


Although
      we have employment agreements with Mr. O’Donnell, Mr. McGrath, Mr.
      Stewart, Mr. Clifford and Ms. Carmichael, the loss of the services of one or
      more of our officers could adversely affect our ability to develop and
      introduce our new products.




**We
      may be unsuccessful in integrating the operations of ProCyte with our other
      business segments.**




We
      acquired ProCyte with the following goals in mind:




·
            that
                ProCyte's presence in the skin health and hair care products market
                would
                present a growth opportunity for PhotoMedex to market its existing
                products;




·
            that
                the addition of ProCyte's sales and marketing personnel would enhance
                our
                ability to market the XTRAC system;




·
            that
                the addition of ProCyte's operations and existing cash balances would
                enhance PhotoMedex's operating results and balance
                sheet;




·
            that
                the combination of the senior management of ProCyte and PhotoMedex
                would
                allow complementary skills to strengthen the overall management team;
                and




·
            that
                the combined company may reap short-term cost savings and have the
                opportunity for additional longer-term cost efficiencies, thus providing
                additional cash flow for
                operations.




While
      we
      have begun to realize each of these goals, we have not fully realized on all
      of
      the goals. For example, we are seeking the optimal balance and cross-integration
      of the ProCyte sales and marketing personnel into the sales and marketing of
      the
      XTRAC system. If we fail to attain some of the goals, our overall business
      and
      financial health could be materially and adversely affected.




**Delaware
      law and our charter documents have anti-takeover provisions that could delay
      or
      prevent actual and potential changes in control, even if they would benefit
      stockholders.**




We
      are
      subject to Section 203 of the Delaware General Corporation Law, which
      prohibits a business combination between a corporation and an interested
      stockholder within three years of the stockholder becoming an interested
      stockholder, except in limited circumstances. In addition, our bylaws contain
      certain provisions which require stockholders' actions to be taken at meetings
      and not by written consent, and also require supermajority votes of stockholders
      to amend our bylaws and to notice special meetings of stockholders. These
      anti-takeover provisions could delay or prevent actual and potential changes
      in
      control, even if they would benefit our stockholders **.**




**Potential
      fluctuations in our operating results could lead to fluctuations in the market
      price for our common stock.**




Our
      results of operations are expected to fluctuate significantly from
      quarter-to-quarter, depending upon numerous factors, including:




·
            healthcare
                reform and reimbursement policies;




·
            demand
                for our products;




·
            changes
                in our pricing policies or those of our
                competitors;




·
            increases
                in our manufacturing costs;




·
            the
                number, timing and significance of product enhancements and new product
                announcements by ourselves and our competitors;




·
            the
                termination or expiration of significant royalty-generating licensing
                contracts to which we are party;




·
            the
                expiration of certain of our key
                patents;




·
            our
                ability to develop, introduce and market new and enhanced versions
                of our
                products on a timely basis considering, among other things, delays
                associated with the FDA and other regulatory approval processes and
                the
                timing and results of future clinical trials;
                and




·
            product
                quality problems, personnel changes, and changes in our business
                strategy.




Our
      quarter-to-quarter operating results could also be affected by the timing and
      usage of individual laser units in the treatment of patients, since our revenue
      model for the excimer laser system for the treatment of psoriasis patients
      and
      for our surgical services is based on a payment per usage plan.




29


**Our
      stock price has been and continues to be volatile.**




The
      market price for our common stock could fluctuate due to various factors. These
      factors include:




·
            announcements
                related to our efforts to secure favorable reimbursement policies
                from
                private carriers concerning the treatment of psoriasis with the XTRAC
                system or to our efforts to increase utilization of the
                XTRAC;




·
            acquisition-related
                announcements;




·
            announcements
                by us or our competitors of new contracts, technological innovations
                or
                new products;




·
            changes
                in government regulations;




·
            fluctuations
                in our quarterly and annual operating results;
                and




·
            general
                market conditions.




In
      addition, the stock markets have, in recent years, experienced significant
      price
      fluctuations. These fluctuations often have been unrelated to the operating
      performance of the specific companies whose stock is traded. Market
      fluctuations, as well as economic conditions, have adversely affected, and
      may
      continue to adversely affect, the market price of our common stock.




**Our
      ability to pay dividends on our common stock may be
      limited.**




We
      do not
      expect to pay any cash dividends in the foreseeable future. We intend to retain
      earnings, if any, to provide funds for the expansion of our
      business.




**Limitations
      on director liability may discourage stockholders from bringing suit against
      a
      director.**




Our
      certificate of incorporation provides, as permitted by governing Delaware law,
      that a director shall not be personally liable to us or our stockholders for
      monetary damages for breach of fiduciary duty as a director, with certain
      exceptions. These provisions may discourage stockholders from bringing suit
      against a director for breach of fiduciary duty and may reduce the likelihood
      of
      derivative litigation brought by stockholders on our behalf against a director.
      In addition, our certificate of incorporation and bylaws provide for mandatory
      indemnification of directors and officers to the fullest extent permitted by
      Delaware law. In addition, we have agreed to indemnify the past and present
      directors, officers and employees of ProCyte for certain matters, to the same
      extent such individuals are indemnified by ProCyte, for a period of six years
      following the effective date of the merger.


**Item
                1B.**
              **Unresolved
                    Staff Comments**


There
        are
        no unresolved comments from the staff of the Securities and Exchange Commission.




**Item
              2.**
            **Properties**




We
      lease
      an 8,000 sq. ft. facility consisting of office, manufacturing and warehousing
      space located at 2375 Camino Vida Roble, Suite B, Carlsbad, California 92009.
      The lease expires on June 15, 2012. We have, however, a right to cancellation
      after 5 years, provided we pay off any remaining obligation for tenant
      improvements. The base rent is $6,640 per month. Our Carlsbad facility houses
      the manufacturing and development operations for our excimer laser business.




We
      lease
      a 42,000 sq. ft. facility in Montgomeryville, Pennsylvania that houses our
      executive offices and surgical laser manufacturing operations. The term of
      the
      lease runs until July 2006, and has an option to renew for an additional five
      years. We are presently negotiating the renewal. In addition to this facility,
      we also lease several offices throughout the southeastern United States and
      other locations elsewhere. Our marketing and sales representatives use these
      offices to perform their sales and training responsibilities. These offices
      consist of small one-room facilities and are leased for various terms and
      amounts. The base rent is $20,475 per month.




We
      lease
      a 12,182 sq. ft facility consisting of office and warehousing space located
      at
      8511 154 th Avenue
      NE, Building A, Redmond, Washington 98052. The lease expires on June 30, 2007.
      The base rent is $15,240 per month. Our Redmond facility houses the warehousing
      operations for our skincare business.




We
      lease
      a 2,500 sq. ft. facility consisting of warehousing space located at 120 Francis
      Street, Unit #10, Keyport, New Jersey 07735. The lease has been extended until
      May 31, 2006. The base rent is $1,269 per month. Our Keyport facility houses
      our
      warehouse for our spa skincare business. In the short term, we intend to move
      the operations of this facility and incorporate them into the Montgomeryville
      operations.




30




**Item
              3.**
            **Legal
                Proceedings**




In
      the
      action we brought against Edwards LifeSciences Corporation and Baxter Healthcare
      Corporation in January 2004, the parties reached a settlement in December
      2005,
      terminating all prior dealings between the parties with respect to
      transmyocardial revascularization, and providing for payment to us of an amount
      that may not be disclosed in accordance with the confidentiality restrictions
      of
      the settlement.




In
      the
      matter brought against us by City National Bank of Florida, our former landlord
      in Orlando, Florida, our motion for summary judgment was heard in limine and
      denied. Judgment was awarded to the landlord in the amount of $77,023.
      Offsetting the judgment are proceeds, approximating $45,000, which are held
      by
      the landlord from the sale of assets left on the leased premises by the party
      that bought the assets from us. We have paid the net judgment amount pursuant
      to
      a settlement that was reached with the landlord which embodies terms which
      we
      deem favorable and which have mooted post-trial motions and
      appeals.




In
      the
      matter brought by us against RA Medical Systems, Inc. and Dean Stewart Irwin
      in
      the United States District Court for the Southern District of California, a
      new
      magistrate judge appointed in 2005 to the case has ruled that discovery will
      continue to be stayed until the trial judge rules on the defendants’ motion for
      summary judgment, based on a theory of res judicata. Notwithstanding the
      abeyance of the case, we have brought in March 2006 a motion for partial summary
      judgment, based on a theory that defendants have not had, until January 2006,
      a
      license from the State of California to manufacture or market their medical
      devices, and therefore have unfairly competed against us by unlawfully
      manufacturing, marketing and selling medical devices that were misbranded.




In
      the
      matter brought by us against RA Medical Systems, Inc. and Dean Stewart Irwin
      in
      the Superior Court for San Diego County, California, we have elected in February
      2006 to discontinue our motions and appeals in the matter, and thus bring
      closure to this action.




On
      January 25, 2005, RA Medical Systems, Inc. and Dean Stewart Irwin brought an
      action against PhotoMedex, Inc., Jeffrey Levatter Ph.D. (our Chief Technology
      Officer), Jenkens & Gilchrist, LLP (our outside counsel) and Michael R.
      Matthias, Esq. (litigation partner at our outside counsel). The action was
      brought in the Superior Court for San Diego County, California and based on
      allegations that we and the other defendants had engaged in malicious
      prosecution in bringing and maintaining the action brought by PhotoMedex in
      April 2003. We and the other defendants filed a motion to strike the actions,
      based on California Code of Civil Procedure section 425.16, their, so-called
      SLAPP statute. Our motion to strike was denied; we appealed the denial. The
      appellate court heard oral argument on the matter on March 14, 2006, taking
      the matter under advisement. We are being defended by our insurance
      carrier.




On
      May
      13, 2005, Vida Brown brought suit in the Circuit Court, 20 th Judicial
      Circuit for Charlotte County, Florida, for injuries sustained during a surgical
      laser procedure on her lower back. Ms. Brown has sued, among others, the
      surgeon, the anesthesiologist, the supplier of the laser delivery system (viz.
      Clarus Medical LLC), a person holding himself out as a representative of Clarus,
      and the supplier of the holmium laser system and technician (viz. our former
      subsidiary, Surgical Innovations & Services, Inc.). The laser delivery
      system supplied by Clarus proved defective in the course of the procedure,
      notwithstanding which the surgeon continued to perform the procedure. The
      holmium laser provided by SIS did not perform deficiently. Ms. Brown has alleged
      that we failed to provide a properly trained operator for the holmium laser
      and
      that our operator failed to warn the surgeon of the danger of continuing to
      use
      a defective laser delivery system, allegations which we deny. Our insurance
      carrier is providing a defense for us in this matter.




We
      are
      involved in certain other legal actions and claims arising in the ordinary
      course of business. We believe, based on discussions with legal counsel, that
      such litigation and claims will be resolved without a material effect on our
      consolidated financial position, results of operations or
      liquidity.




31




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




We
      held
      our Annual Meeting of Stockholders on December 28, 2005. Richard J. DePiano,
      Jeffrey F. O’Donnell, Alan R. Novak, Warwick Alex Charlton, Anthony J. Dimun and
      David Anderson, the director nominees set forth in the Notice of Annual Meeting,
      were elected to serve as directors. The vote tally is set forth below:




**Votes
                For**
            
            **Votes
                Against**
            
            **Votes
                Abstaining**Richard
                J. DePiano
            
            44,258,351
            
            0
            
            2,545,117Jeffrey
                F. O’Donnell
            
            44,759,140
            
            0
            
            2,044,328Warwick
                Alex Charlton
            
            44,852,104
            
            0
            
            1,951,364Alan
                R. Novak
            
            45,016,265
            
            0
            
            1,787,203Anthony
                J. Dimun
            
            45,025,510
            
            0
            
            1,777,958David
                W. Anderson
            
            45,016,544
            
            0
            
            1,786,924




Amper,
      Politziner & Mattia, P.C. was ratified to be our independent auditors for
      the year ending December 31, 2005, with 46,320,693 votes for, 417,563 votes
      against and 65,210 votes abstaining.




An
      amendment to the Amended and Restated 2000 Non-Employee Director Stock Option
      Plan to increase the number of shares of our common stock reserved for issuance
      thereunder from 1,000,000 to 1,400,000 was approved with 19,450,508 votes for,
      2,849,026 votes against and 288,804 votes abstaining.




The
      2005
      Equity Compensation Plan was adopted to reserve up to 3,160,000 shares of common
      stock for issuance under the Plan, with 19,312,983 votes for, 3,023,256 votes
      against and 252,099 votes abstaining. The 2005 Investment Plan was adopted
      to
      reserve up to 400,000 shares of common stock for issuance under the Plan, with
      19,402,038 votes for, 2,851,646 votes against and 334,654 votes
      abstaining.




An
      award
      under the 2005 Equity Compensation Plan of 525,000 and 335,000 restricted shares
      of our common stock to Messrs. O’Donnell and McGrath, respectively, and a grant
      under the 2005 Equity Compensation Plan of an incentive stock option of 200,000
      shares of our common stock to Mr. O’Donnell, at an exercise price no less than
      $2.50 per share, was approved with 17,518,407 votes for, 4,770,054 votes against
      and 299,877 votes abstaining. The award and grant were made on January 15,
      2006,
      in conformance with the intentions set forth in our Proxy
      Statement.




**PART
      II**




**Item
              5.**
            **Market
                for Registrant's Common Equity, Related Stockholder Matters and Issuer
                Purchases of Equity
                Securities**




As
      of
      March 15, 2006, we had 52,319,294 shares of common stock issued and outstanding.
      Further, we had issued and outstanding options to purchase 6,176,646 shares
      of
      common stock, of which 3,632,220 were vested as of March 15, 2006, and warrants
      to purchase up to 2,100,309 shares of common stock.




32




Our
      common stock is listed on the Nasdaq National Market under the symbol "PHMD."
      The following table sets forth, for the periods indicated, the high and low
      closing sale prices of our common stock,






**High**
            
            **Low**Year
                Ended December 31, 2005:Fourth
                Quarter
            
            $
            2.33
            
            $
            1.50Third
                Quarter
            
            
            2.82
            
            
            1.98Second
                Quarter
            
            
            3.09
            
            
            2.00First
                Quarter
            
            
            2.88
            
            
            2.16Year
                Ended December 31, 2004:Fourth
                Quarter
            
            $
            2.73
            
            $
            1.86Third
                Quarter
            
            
            3.26
            
            
            1.89Second
                Quarter
            
            
            3.99
            
            
            2.54First
                Quarter
            
            
            2.69
            
            
            1.63Year
                Ended December 31, 2003:Fourth
                Quarter
            
            $
            2.54
            
            $
            1.66Third
                Quarter
            
            
            2.95
            
            
            2.15Second
                Quarter
            
            
            2.30
            
            
            1.39First
                Quarter
            
            
            1.85
            
            
            1.22




On
      March
      15, 2006, the closing market price for our common stock in The Nasdaq National
      Market System was $1.98 per
      share. As of March 15, 2006, we had approximately 945 stockholders of
      record, without giving effect to determining the number of stockholders who
      hold
      shares in “street name” or other nominee accounts.




The
      following is a summary of all of our equity compensation plans, including plans
      that were assumed through acquisitions and individual arrangements that provide
      for the issuance of equity securities as compensation, as of December 31, 2005.
      See Notes 1 and 13 to the consolidated financial statements for additional
      discussion. The awards of restricted stock to Messrs. O’Donnell and McGrath were
      made on January 15, 2006 and therefore are not included in the table
      below.




**(A)**
            
            **(B)**
            
            **(C)****Number
                  of Securities to be Issued Upon Exercise of Outstanding Options,
                  Warrants
                  and Rights**
            
            
            **Weighted-Average
                  Exercise Price of Outstanding Options, Warrants and
                  Rights**
            
            
            **Number
                  of Securities Remaining Available for Future Issuance Under Equity
                  Compensation Plans (excluding securities reflected in column
                  (A))****Equity
                  compensation plans**approved
                by security holders
            
            
            4,947,646
            
            $
            2.12
            
            
            2,021,750**Equity
                  compensations plan not**approved
                by security holders
            
            
            130,000
            
            $
            1.88
            
            
            —**Total**
            
            
            5,077,646
            
            $
            2.11
            
            
            2,021,750




As
      of
      January 1, 2006, no options will be granted to employees or consultants out
      of
      any plans except the 2005 Equity Compensation Plan. Options to our outside
      directors will be made from the 2000 Non-Employee Director Stock Option Plan;
      options under the 2005 Investment Plan may be made only to executive officers.
      Most warrants issued by us have been to investors and none have been issued
      pursuant to equity compensation plans. Additionally, virtually all options
      have
      been granted as compensation for benefits inuring to us other than for benefits
      from capital-raising activities. With limited exceptions under Nasdaq membership
      requirements, we intend in the future to issue options pursuant to equity
      compensation plans which have already been approved by our stockholders without
      necessity of further, special approval by our stockholders.




33


**Dividend
      Policy**




We
      have
      not declared or paid any dividend since inception on our common stock. We do
      not
      anticipate that any dividends will be declared or paid in the future on our
      common stock.




**Certain
      Business Combinations and Other Provisions of the Certificate of
      Incorporation**




As
      a
      Delaware corporation, we are currently subject to the anti-takeover provisions
      of Section 203 of the Delaware General Corporation Law. Section 203 provides,
      with certain exceptions, that a Delaware corporation may not engage in any
      of a
      broad range of business combinations with a person or an affiliate, or associate
      of such person, who is an interested stockholder for a period of three years
      from the date that such person became an interested stockholder
      unless:




·
            the
                transaction resulting in a person becoming an interested stockholder,
                or
                the business combination, is approved by the Board of Directors of
                the
                corporation before the person becomes an interested
                stockholder;




·
            the
                interested stockholder acquired 85% or more of the outstanding voting
                stock of the corporation in the same transaction that makes such
                person an
                interested stockholder (excluding shares owned by persons who are
                both
                officers and directors of the corporation, and shares held by certain
                employee stock ownership plans); or




·
            on
                or after the date the person becomes an interested stockholder, the
                business combination is approved by the corporation's board of directors
                and by the holders of at least 66-2/3% of the corporation's outstanding
                voting stock at an annual or special meeting, excluding shares owned
                by
                the interested stockholder.




Under
      Section 203, an interested stockholder is defined as any person: (i) who is
      the
      owner of 15% or more of the outstanding voting stock of the corporation; or
      (ii)
      who is an affiliate or associate of the corporation and who was the owner of
      15%
      or more of the outstanding voting stock of the corporation at any time within
      the three-year period immediately prior to the date on which it is sought to
      be
      determined whether such person is an interested stockholder.




A
      corporation may, at its option, exclude itself from the coverage of Section
      203
      by amending its certificate of incorporation or bylaws by action of its
      stockholders to exempt itself from coverage, provided that such amendment to
      its
      certificate of incorporation or bylaws shall not become effective until 12
      months after the date it is adopted. We have not adopted such an amendment
      to
      our certificate of incorporation or bylaws.




In
      addition, our bylaws contain certain provisions which require stockholders'
      actions to be taken at meetings and not by written consent, and also require
      supermajority votes of stockholders to amend our bylaws and to notice special
      meetings of stockholders. These anti-takeover provisions could delay or prevent
      actual and potential changes in control, even if they would benefit our
      stockholders.




**Recent
      Issuances of Unregistered Securities**




On
      September 7, 2004, the Company closed the transactions set forth in a Master
      Asset Purchase Agreement (the “Master Agreement”) with Stern Laser srl
      (“Stern”). We have issued to Stern in June and December 2005 248,395 and 126,582
      shares, respectively, of our restricted common stock; as of December 31, 2005,
      we have issued to Stern an aggregate 488,854 shares of our restricted common
      stock in connection with the Master Agreement. We have also agreed to pay Stern
      up to an additional $450,000 based on the achievement of certain remaining
      milestones relating to the development and commercialization of certain licensed
      technology and the licensed products which may be developed under such
      arrangement and may have certain other obligations to Stern under these
      arrangements. We retain the right to pay all of these conditional sums in cash
      or in shares of its common stock, in our discretion. To secure the latter
      alternative, we have reserved for issuance, and placed into escrow, 211,146
      shares of our unregistered stock. The per-share price of any future issued
      shares will be based on the closing price of our common stock during the 10
      trading days ending on the date of achievement of a particular milestone under
      the terms of the Master Agreement. Stern also has served as the distributor
      of
      the XTRAC laser system in South Africa and Italy since 2000. The primary asset,
      which we have acquired from Stern, is a license, which was carried on our books
      at $942,422, net as of December 31, 2005. Amortization of this intangible is
      on
      a straight-line basis over 10 years, which began in January 2005. As Stern
      completes further milestones under the Master Agreement, we expect that the
      carrying value of the license will increase.




34


In
      2005,
      we issued to GE Capital Corporation 14,714, 13,191 and 15,860 warrants to
      purchase our common stock issued on June 28, 2005, September 26, 2005 and
      December 27, 2005, respectively, in connection with draws we made against a
      Master Lease Agreement.




We
      believe that all of the foregoing issuances of securities were made solely
      to
      accredited investors in transactions exempt from registration under Section
      4(2)
      of the Securities Act.




**Shares
      Eligible for Future Sale**




As
      of
      March 15, 2006, we had 52,319,294 issued and outstanding shares of common stock.
      All of these shares are either covered by currently effective registration
      statements or are eligible for resale in accordance with the provisions of
      Rule
      144. Further, as of March 15, 2006, we had issued and outstanding options to
      purchase 6,170,646 shares of common stock, of which 3,626,220 were vested,
      and
      currently exercisable warrants to purchase up to 2,100,309 shares of common
      stock.




Holders
      of restricted securities must comply with the requirements of Rule 144 in order
      to sell their shares in the open market. In general, under Rule 144, as
      currently in effect, any of our affiliates and any person (or persons whose
      sales are aggregated) who has beneficially owned his or her restricted shares
      for at least one year, may be entitled to sell in the open market, within any
      three-month period, in brokerage transactions or to market makers a number
      of
      shares that does not exceed the greater of: (i) 1% of the then outstanding
      shares of our common stock (now approximately 401,685 shares), or (ii) the
      average weekly trading volume reported in the principal market for our common
      stock during the four calendar weeks preceding such sale. Sales under Rule
      144
      are also subject to certain limitations on manner of sale, a notice requirement
      and the availability of current public information about us. Non-affiliates
      who
      have held their restricted shares for two years are entitled to sell their
      shares under Rule 144(k), without regard to any of the above limitations,
      provided they have not been one of our affiliates for the three months preceding
      such sale.




We
      can
      make no prediction as to the effect, if any, that sales of shares of common
      stock or the availability of shares for sale will have on the market price
      of
      our common stock. Nevertheless, sales of significant amounts of our common
      stock
      could adversely affect the prevailing market price of the common stock, as
      well
      as impair our ability to raise capital through the issuance of additional equity
      securities.




As
      of
      March 15, 2006, the average weighted exercise prices of our outstanding and
      fully vested options and warrants were $2.12 and $1.98, respectively. The shares
      underlying all of the warrants and the options granted to employees, directors
      and other non-employees and outstanding as of December 31, 2005 have been
      registered with the SEC. In April 2005, we filed a registration statement with
      the SEC for stock option plans we assumed from ProCyte Corporation. We expect
      to
      register in 2006 the 3,160,000 shares authorized under the 2005 Equity
      Compensation Plan and the 400,000 shares authorized to the 2005 Investment
      Plan.
      The exercise of the options and warrants and the sale of the underlying shares
      in the public market may cause additional dilution to our existing stockholders
      and may cause the price of our common stock to fluctuate.




35




**Item
              6.**
            **Selected
                Financial Data**




You
      should read the following selected historical consolidated financial data in
      conjunction with our consolidated financial statements included elsewhere in
      this Report and “Management’s Discussion and Analysis of Financial Condition and
      Results of Operations,” beginning in Item 7 below. The selected historical
      consolidated statement of operations data for the five-year period ended
      December 31, 2005 and the selected historical consolidated balance sheet data
      as
      of December 31, 2001, 2002, 2003, 2004 and 2005 have been derived from our
      consolidated financial statements:






**Year
                Ended December 31,**
              **(In
                thousands, except per share data)**




**2005**
            
            **2004**
            
            **2003**
            
            **2002**
            
            **2001****Statement
                of Operations Data:**Revenues
            
            $
            28,384
            
            $
            17,745
            
            $
            14,319
            
            $
            3,274
            
            $
            4,730Costs
                of revenues
            
            
            15,675
            
            
            10,363
            
            
            10,488
            
            
            4,425
            
            
            4,952Gross
                profit (loss)
            
            
            12,709
            
            
            7,382
            
            
            3,831
            
            
            (1,151
            )
            
            (222
            )Selling,
                general and administrative
            
            
            16,477
            
            
            10,426
            
            
            9,451
            
            
            6,191
            
            
            10,519Research
                and development
            
            
            1,128
            
            
            1,802
            
            
            1,777
            
            
            1,757
            
            
            3,329Asset
                impairment charge
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            1,958Loss
                from operations before interest and other income, net
            
            
            (4,896
            )
            
            (4,846
            )
            
            (7,397
            )
            
            (9,099
            )
            
            (16,028
            )Interest
                income
            
            
            61
            
            
            43
            
            
            50
            
            
            42
            
            
            238Interest
                expense
            
            
            (403
            )
            
            (181
            )
            
            (96
            )
            
            (16
            )
            
            (25
            )Other
                income, net
            
            
            1,302
            
            
            —
            
            
            —
            
            
            1
            
            
            77Net
                loss
            
            
            ($3,936
            )
            
            ($4,984
            )
            
            ($7,443
            )
            
            ($9,072
            )
            
            ($15,738
            )Basic
                and diluted net loss per share
            
            
            ($0.08
            )
            
            ($0.13
            )
            
            ($0.21
            )
            
            ($0.34
            )
            
            ($0.80
            )Shares
                used in computing basic and diluted net loss per share (1)
            
            
            48,786
            
            
            38,835
            
            
            35,134
            
            
            26,566
            
            
            19,771**Balance
                Sheet Data (At Period End):**Cash
                and cash equivalents
            
            $
            5,610
            
            $
            3,997
            
            $
            6,633
            
            $
            4,008
            
            $
            4,067Working
                capital
            
            
            11,151
            
            
            6,119
            
            
            8,678
            
            
            6,578
            
            
            5,546Total
                assets
            
            
            48,675
            
            
            22,962
            
            
            22,753
            
            
            21,513
            
            
            15,585Long-term
                debt (net of current portion)
            
            
            2,437
            
            
            1,399
            
            
            457
            
            
            900
            
            
            —Stockholders’
                equity
            
            $
            38,417
            
            $
            14,580
            
            $
            15,978
            
            $
            13,309
            
            $
            12,710




(1)
            Common
                stock equivalents and convertible issues are antidilutive and, therefore,
                are not included in the weighted shares outstanding during the years
                in
                which we incurred net losses.






36




**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 the
      Consolidated Financial Statements and related notes included elsewhere in this
      Report.***




**Introduction,
      Outlook and Overview of Business Operations**




We
      view
      our business as comprised of the following five business segments:




·
            Domestic
                XTRAC,




·
            International
                XTRAC,




·
            Skin
                Care (ProCyte),




·
            Surgical
                Services, and




·
            Surgical
                Products.




**Domestic
      XTRAC**




The
      Domestic XTRAC segment is a U.S. business with revenues derived from procedures
      performed by dermatologists. We are engaged in the development, manufacturing
      and marketing of our proprietary XTRAC® excimer laser and delivery systems and
      techniques used in the treatment of inflammatory skin disorders, **** including
      psoriasis, vitiligo, atopic dermatitis and leukoderma. In January 2000, we
      received approval of our 510(k) submission from the Food and Drug
      Administration, or FDA, establishing that our XTRAC system is substantially
      equivalent to currently marketed devices for the treatment of
      psoriasis.




As
      part
      of our commercialization strategy in the United States, we provide the XTRAC
      system to targeted dermatologists at no initial capital cost to them. We
      maintain ownership of the laser and earn revenue each time the physician treats
      a patient with the equipment. We believe that this strategy will create
      incentives for these dermatologists to adopt the XTRAC system and will increase
      market penetration.




For
      the
      past five years, we have sought to clear the path of obstacles and barriers
      to a
      smooth and orderly roll-out of the XTRAC system in dermatology. In 2000 the
      technology, which was originally designed for cardiology applications, was
      found
      to have significant therapeutic advantages for psoriasis patients who were
      treated with the UVB light emitted from the excimer based laser system. For
      the
      first two years the company invested in establishing the clinical efficacy
      of
      the product and mechanical reliability of the equipment. In the last three
      years
      we pursued widespread reimbursement commencing with obtaining newly created
      CPT
      reimbursement codes that became effective in 2003. This was followed by the
      lengthy process of persuading private medical insurers to adopt a positive
      reimbursement policy for the procedure. Substantive progress on reimbursement
      was achieved in the second half of 2005. We increased our dermatology sales
      force as part of the acquisition of ProCyte in March 2005. In November 2005,
      we
      commenced an advertising campaign in selected regions to make consumers aware
      of
      the technology and therapeutic benefits of targeted UVB laser treatment for
      psoriasis.




**International
      XTRAC**




In
      the
      international market, we derive revenues from the XTRAC system by selling
      the dermatology laser system to distributors and directly to physicians. In
      this
      market, we have benefited from both our clinical studies and from the improved
      reliability and functionality of the XTRAC system.  Compared
      to the domestic segment, the international XTRAC business is more influenced
      by
      competition from similar laser technologies as well as non-laser lamp
      alternatives. Over time, this competition has reduced the prices we charge
      to
      international distributors for our XTRAC products.




While
      the
      number of lasers sold was the same for the year ended December 31, 2005 compared
      to the same period for 2004, the average price per laser system and parts was
      less in the 2005 period ($54,004) than in the 2004 period ($62,563). For the
      year ended December 31, 2004, the number of lasers sold was greater compared
      to
      the same period in 2003, although the average price per laser system and parts
      was greater in 2004 ($62,563) compared to 2003 ($64,807). In addition, of the
      26
      lasers recognized as sold in the year ended December 31, 2004, six of those
      lasers had been shipped in 2003, but were not recognized as sales in
      2003 due to the application of the criteria of Staff Accounting Bulletin
      No. 104.




37


Due
      to
      the significant financial investment requirements,  we
      were
      reluctant previously to implement an international XTRAC fee-per-use revenue
      model, similar to the domestic revenue model. However, as reimbursement in
      the
      domestic market has become more widespread, we have recently started to offer
      a version of this model overseas, but have not to date concluded such an
      arrangement.




In
      2005,
      as a result of the acquisition of worldwide rights to certain proprietary
      light-based technology from Stern Laser, we also explored new product offerings
      in the treatment of dermatological conditions to our international customers.
      We
      intend to expand the international marketing of this product, called the VTRACTM,
      in 2006. The VTRAC is designed to be a best-in-class lamp-based UVB targeted
      therapy, positioned at a price point lower than the XTRAC so that it will
      effectively compete with other non-laser based therapies for psoriasis and
      vitiligo.




**Skin
      Care (ProCyte)**




On
      March
      18, 2005, we completed the acquisition of ProCyte. ProCyte generates revenues
      from the sale of skin health, hair care and wound care products; the sale of
      copper peptide compound in bulk; and royalties on licenses for the patented
      copper peptide compound.




The
      operating results of ProCyte for the year ended December 31, 2005 are included
      from March 19, 2005 through December 31, 2005. Under purchase accounting rules,
      the operating results of ProCyte for prior periods are not included in our
      Statement of Operations. A description of the transaction and proforma operating
      results are disclosed as part of Note 2, *Acquisitions* to the
      financial statements.




ProCyte’s
      focus has been to provide unique products, primarily based upon patented
      technologies for selected applications in the dermatology, plastic and cosmetic
      surgery and spa markets. ProCyte has also expanded the use of its novel copper
      peptide technologies into the mass retail market for skin and hair care through
      targeted technology licensing and supply agreements.




ProCyte’s
      products are aimed at the growing demand for skin health and hair care products,
      including products to enhance appearance and address the effects of aging on
      skin and hair. ProCyte’s products are formulated, branded and targeted at
      specific markets. ProCyte’s initial products addressed the dermatology, plastic
      and cosmetic surgery markets for use after various procedures. Anti-aging skin
      care products were added to offer a comprehensive approach for a patient’s skin
      care regimen.




Our
      goals
      for this acquisition are summarized below:




·
            the
                addition of ProCyte's sales and marketing personnel should enhance
                our
                ability to market the XTRAC system;




·
            ProCyte's
                presence in the skin health and hair care products market should
                present a
                growth opportunity for PhotoMedex to market its existing
                products;




·
            the
                addition of ProCyte's operations and existing cash balances would
                improve
                PhotoMedex's operating results and strengthen its balance
                sheet;




·
            the
                combination of the senior management of ProCyte and PhotoMedex should
                allow complementary skills to strengthen the overall management team;
                and




·
            the
                combined company may reap short-term cost savings and have the opportunity
                for additional longer-term cost efficiencies.****






38


Since
      the
      acquisition date, we have made progress toward the achievement of these goals.
      Financial and administrative functions were transferred from Redmond to
      Montgomeryville in June 2005. Integration of and coordination between the sales
      forces of the Skin Care and Domestic XTRAC business units is an ongoing process.




**Surgical
      Services**




The
      Surgical Services segment generates revenues by providing fee-based procedures
      typically using our mobile surgical laser equipment delivered and operated
      by a
      technician at hospitals and surgery centers in the United States. Although
      we
      intend to increase our investment in this business segment for 2006, we will
      continue to pursue a very cautious growth strategy in order to conserve our
      cash
      resources for the XTRAC business segments.




We
      have
      limited marketing experience in expanding our surgical services business. The
      majority of this business is in the southeastern part of the United States.
      New
      procedures and geographical expansion, together with new customers and different
      business habits and networks, will likely pose different challenges compared
      to
      those that we have encountered in the past. There can be no assurance that
      we
      will be able to overcome such challenges.




**Surgical
      Products**




The
      Surgical Products segment generates revenues by selling laser products and
      disposables to hospitals and surgery centers both inside and outside of the
      United States. Although surgical product revenues increased in 2005 compared
      to
      2004, we expect that sales of surgical laser systems and the related disposable
      base may begin to erode as hospitals continue to seek outsourcing solutions
      instead of purchasing lasers and related disposables for their operating rooms.
      We are working at offsetting this erosion by expanding our surgical services
      segment and by increasing sales from the CO2 and diode surgical lasers
      introduced in 2004.




In
      the
      second quarter 2004, we received from the FDA concurrence to market two new
      surgical lasers: the LaserPro® Diode Laser System and the LaserPro® CO2 Laser
      System. Each system has been designed for rugged use in our Surgical Services
      business and will assist us in finding end-user buyers domestically and
      overseas. We are also actively exploring opportunities to supply on an OEM
      basis
      or under manufacturing-marketing collaborations.




In
      July
      2004, we entered into an agreement with AzurTec, Inc. to develop a device that
      rapidly and accurately detects the presence of cancerous cells in excised
      tissue. We assisted in the development of FDA-compliant prototypes for AzurTec’s
      product and have collected payments under the agreement aggregating $240,000
      through December 31, 2005. Continuing development of this project requires
      additional investment by AzurTec. We will resume development once this
      investment has been satisfied.




In
      March
      2005, we entered into a Sales and Marketing Agreement with GlobalMed (Asia)
      Technologies Co., Inc. Under this Agreement, GlobalMed will act as master
      distributor in the Pacific Rim for our XTRAC excimer laser, including the UltraTM
excimer laser, as well as for our LaserPro® diode surgical laser system. The
      diode laser will be marketed for, among other things, use in a gynecological
      procedure pioneered by David Matlock, MD. We have engaged Dr. Matlock as our
      consultant to explore further business opportunities. In connection with this
      engagement, he has received options to purchase 25,000 shares of our common
      stock.




In
      July
      2005, we entered a four year Marketing Agreement with KDS Marketing, Inc. Using
      money invested by each party, KDS will research market opportunities for our
      LaserPro® diode laser and related delivery systems; based on such research, KDS
      will market the diode laser, subject to guidelines which we establish. The
      hub
      of the marketing program will be a website which physicians may access for
      information about the laser and which they may use to purchase the laser. KDS’s
      return on its investment will be based primarily on commissions earned on diode
      lasers that are sold under the program.




**Critical
      Accounting Policies**




The
      discussion and analysis of our financial condition and results of operations
      in
      this Report are based upon our Consolidated Financial Statements, which have
      been prepared in accordance with accounting principles generally accepted in
      the
      United States. The preparation of financial statements requires management
      to
      make estimates and judgments that affect the reported amounts of assets and
      liabilities, revenues and expenses and disclosures at the date of the financial
      statements. On an on-going basis, we evaluate our estimates, including, but
      not
      limited to, those related to revenue recognition, accounts receivable,
      inventories, impairment of property and equipment and of intangibles and
      accruals for warranty claims. We use authoritative pronouncements, historical
      experience and other assumptions as the basis for making estimates. Actual
      results could differ from those estimates. Management believes that the
      following critical accounting policies affect our more significant judgments
      and
      estimates in the preparation of our Consolidated Financial Statements. These
      critical accounting policies and the significant estimates made in accordance
      with these policies have been discussed with our Audit Committee.




39


***Revenue
      Recognition***




*XTRAC-Related
      Operations*




We
      have
      two distribution channels for our phototherapy treatment equipment. We either
      (i) sell the laser through a distributor or directly to a physician, or (ii)
      place the laser in a physician’s office (at no charge to the physician) and
      charge the physician a fee for an agreed upon number of treatments. When we
      sell
      an XTRAC laser to a distributor or directly to a physician, revenue is
      recognized when the following four criteria under Staff Accounting Bulletin
      No.
      104 have been met: (i) the product has been shipped and we have no significant
      remaining obligations; (ii) persuasive evidence of an arrangement exists; (iii)
      the price to the buyer is fixed or determinable; and (iv) collection is probable
      (“SAB 104 Criteria”). At times, units are shipped, but revenue is not recognized
      until all of the criteria are met, and until that time, the unit is carried
      on
      our books as inventory.




We
      ship
      most of our products FOB shipping point, although from time to time certain
      customers, for example, governmental customers, will insist on FOB destination.
      Among the factors we take into account in determining the proper time at which
      to recognize revenue are when title to the goods transfers and when the risk
      of
      loss transfers. Shipments to the distributors that do not fully satisfy the
      collection criteria are recognized when invoiced amounts are fully
      paid.




Under
      the
      terms of the distributor agreements, our distributors do not have the right
      to
      return any unit that they have purchased. However, we allow products to be
      returned by our distributors in redress of product defects or other claims.




When
      we
      place a laser in a physician’s office, we recognize service revenue based on the
      number of patient treatments used by the physician. Treatments in the form
      of
      random laser-access codes that are sold to physicians, but not yet used, are
      deferred and recognized as a liability until the physician performs the
      treatment. Unused treatments remain our obligation inasmuch as the treatments
      can only be performed on equipment made by us. Once the treatments are delivered
      to a patient, this obligation has been satisfied.




The
      calculation of unused treatments prior to 2004 was based upon an estimate that
      at the end of each accounting period, 15 unused treatments existed at each
      laser
      location. This was based upon the reasoning that we generally sell treatments
      in
      packages of 30 treatments. Fifteen treatments generally represent about one-half
      the purchase quantity by a physician or approximately a one-week supply for
      6-8
      patients. This policy had been used on a consistent basis. We believed this
      approach to have been reasonable and systematic given that: (a) physicians
      have
      little motivation to purchase quantities (which they are obligated to pay for
      irrespective of actual use and are generally unable to seek a refund for unused
      treatments) that will not be used in a relatively short period of time,
      particularly since in most cases they can obtain incremental treatments
      instantaneously over the phone; and (b) senior management regularly reviews
      purchase patterns by physicians to identify unusual buildup of unused treatment
      codes at a laser site. Moreover, we continually look at our estimation model
      based upon data received from our customers.




In
      the
      fourth quarter of 2004, we updated the calculations for the estimated amount
      of
      unused treatments to reflect recent purchasing patterns by physicians near
      year-end. We estimated the amount of unused treatments at December 31, 2004
      to
      include all sales of treatment codes made within the last two weeks of the
      period. We believe this approach more closely approximates the actual amount
      of
      unused treatments that existed at that date than the previous approach. APB
      No.
      20 provides that accounting estimates change as new events occur, as more
      experience is acquired, or as additional information is obtained and that the
      effect of the change in accounting estimate should be accounted for in the
      current period and the future periods that it affects. We accounted for this
      change in the estimate of unused treatments in accordance with APB No. 20 and
      SFAS No. 48. Accordingly, our change in accounting estimate was reported in
      revenues for the fourth quarter of 2004 and was not accounted for by restating
      amounts reported in financial statements of prior periods or by reporting
      proforma amounts for prior periods.




40


We
      have
      continued this approach or method for estimating the amount of unused treatments
      at December 31, 2005. Had we applied the approach used in 2003 to estimating
      unused treatments, XTRAC domestic revenues would have increased by $73,000
      for
      the year ended December 31, 2005 and decreased by $271,000 for the year ended
      December 31, 2004, as compared to the prior method of estimation.




In
      the
      first quarter of 2003, we implemented a program to support certain physicians
      in
      addressing treatments with the XTRAC system that may be denied reimbursement
      by
      private insurance carriers. We recognize service revenue from the sale of
      treatment codes to physicians participating in this program only if and to
      the
      extent the physician has been reimbursed for the treatments. For the year ended
      December 31, 2005, we deferred revenues of $57,300 under this program as all
      the
      criteria for revenue recognition had not been met. At December 31, 2005, we
      had
      net deferred revenues of $107,860 under this program.




Under
      this program, we may reimburse qualifying doctors for the cost of our fee but
      only if they are ultimately denied reimbursement after appeal of their claim
      with the insurance company. The key components of the program are as
      follows:




·
            The
                physician practice must be in an identified location where there
                are still
                challenges by insurance companies to reimbursing the
                procedure;




·
            The
                program only covers medically necessary treatments of psoriasis as
                determined by the treating
                physician;




·
            The
                patient must have medical insurance and a claim for the treatment
                must be
                timely filed with the patient’s insurance company;




·
            Upon
                denial by the insurance company (generally within 30 days of filing
                the
                claim), a standard insurance form called an EOB (“Explanation of
                Benefits”) must be submitted to our in-house appeals group, who will then
                prosecute the appeal. The appeal process can take 6-9
                months;




·
            After
                all appeals have been exhausted by us and the claim remains unpaid,
                the
                physician is entitled to receive credit for the treatment he or she
                purchased from us (our fee only) on behalf of the patient;
                and




·
            Physicians
                are still obligated to make timely payments for treatments purchased,
                irrespective of whether reimbursement is paid or denied. Future sale
                of
                treatments to the physician can be denied if timely payments are
                not made,
                even if a patient’s appeal is still in
                process.




Prior
      to
      2004, we estimated a contingent liability for potential refunds under this
      program by estimating when the physician was paid for the insurance claim.
      In
      the absence of a two-year historical trend and a large pool of homogeneous
      transactions to reliably predict the estimated claims for refund as required
      by
      Staff Accounting Bulletin Nos. 101 and 104, we previously deferred revenue
      recognition of 100% of the current quarter revenues from the program to allow
      for the actual denied claims to be identified after processing with the
      insurance companies. After more than 144,000 treatments in the last 3 years
      and
      detailed record keeping of denied insurance claims and appeals processed, we
      have estimated that approximately 4% of the revenues under this program for
      the
      quarter ended December 31, 2005 are subject to being credited or refunded to
      the
      physician. We estimated that 11% of the revenues under this program for the
      quarter ended December 31, 2004 were subject to being credited or refunded
      to
      the physician.




We
      updated our analysis to reflect this level of estimated refunds. This change
      from the past process of deferring 100% of the current quarter revenues from
      the
      program represents a change in accounting estimate, and we recorded this change
      in accordance with the relevant provisions of SFAS No. 48 and APB No. 20. These
      pronouncements state that the effect of a change in accounting estimate should
      be accounted for in the current period and the future periods that it affects.
      A
      change in accounting estimate should not be accounted for by restating amounts
      reported in financial statements of prior periods or by reporting proforma
      amounts for prior periods. Due to this updated approach in estimates, domestic
      XTRAC revenues were increased by $261,000 and $98,000 for the years ended
      December 31, 2005 and 2004, respectively as compared to the prior method of
      estimation.




41


The
      net
      impact on revenue recognized for the XTRAC domestic segment as a result of
      the
      above two changes in accounting estimate was to increase revenues by
      approximately $333,000 for the year ended December 31, 2005 and decrease
      revenues $278,000 for the year ended December 31, 2004. We expect that this
      program will wind down in those geographic regions where there is a high
      percentage of covered lives.




*Skin
      Care Operations*




Through
      the acquisition of ProCyte, we generate revenues primarily through product
      sales
      for skin health, hair care and wound care; sales of the copper peptide compound,
      primarily to Neutrogena; and royalties generated by our licenses, principally
      to
      Neutrogena.




We
      recognize revenues on the products and copper peptide compound when they are
      shipped. We ship the products FOB shipping point. Royalty revenues are based
      upon sales generated by our licensees. We recognize royalty revenue at the
      applicable royalty rate applied to shipments reported by our
      licensee.




*Surgical
      Products and Service Operations*




We
      recognize revenues from surgical lasers and other product sales, including
      sales
      to distributors, when the SAB 104 Criteria have been met. At times, units are
      shipped but revenue is not recognized until all of the criteria are met, and
      until that time, the unit is carried on our books of as inventory. We ship
      most
      of our products FOB shipping point, although from time to time certain
      customers, for example governmental customers, will insist on FOB destination.
      Among the factors we take into account in determining the proper time at which
      to recognize revenue are when title to the goods transfers and when the risk
      of
      loss transfers.




For
      per-procedure surgical services, we recognize revenue upon the completion of
      the
      procedure. Revenue from maintenance service agreements is deferred and
      recognized on a straight-line basis over the term of the agreements. Revenue
      from billable services, including repair activity, is recognized when the
      service is provided.




***Inventory*** **.** We
      account for inventory at the lower of cost (first-in, first-out) or market.
      Cost
      is determined to be purchased cost for raw materials and the production cost
      (materials, labor and indirect manufacturing cost) for work-in-process and
      finished goods. Throughout the laser manufacturing process, the related
      production costs are recorded within inventory. Work-in-process is immaterial,
      given the typically short manufacturing cycle, and therefore is disclosed in
      conjunction with raw materials. We perform full physical inventory counts for
      XTRAC and cycle counts on the other inventory to maintain controls and obtain
      accurate data.




Our
      XTRAC
      laser is either (i) sold to distributors or physicians directly or (ii) placed
      in a physician's office and remains our property. The cost to build a laser,
      whether for sale or for placement, is accumulated in inventory. When a laser
      is
      placed in a physician’s office, the cost is transferred from inventory to
“lasers in service” within property and equipment. At times, units are shipped
      to distributors, but revenue is not recognized until all of the SAB No. 104
      criteria have been met, and until that time, the unit is carried on our books
      as
      inventory. Revenue is not recognized from these distributors until payment
      is
      either assured or paid in full.




Reserves
      for slow moving and obsolete inventories are provided based on historical
      experience and product demand. Management evaluates the adequacy of these
      reserves periodically based on forecasted sales and market trend.




***Allowance
      for Doubtful Accounts*** **.** Accounts
      receivable are reduced by an allowance for amounts that may become uncollectible
      in the future. The majority of receivables related to phototherapy sales are
      due
      from various distributors located outside of the United States and from
      physicians located inside the United States. The majority of receivables related
      to skin care products, surgical services and surgical product are due from
      various customers and distributors located inside the United States. From time
      to time, our customers dispute the amounts due to us, and, in other cases,
      our
      customers experience financial difficulties and cannot pay on a timely basis.
      In
      certain instances, these factors ultimately result in uncollectible accounts.
      The determination of the appropriate reserve needed for uncollectible accounts
      involves significant judgment. A change in the factors used to evaluate
      collectibility could result in a significant change in the reserve needed.
      Such
      factors include changes in the financial condition of our customers as a result
      of industry, economic or customer-specific factors.




42


***Property
      and Equipment.*** As of
      December 31, 2005 and 2004, we had net property and equipment of $7,044,713
      and
      $4,996,688, respectively. The most significant component of these amounts
      relates to the XTRAC lasers placed by us in physicians’ offices. We own the
      equipment and charge the physician on a per-treatment basis for use of the
      equipment. The recoverability of the net carrying value of the lasers is
      predicated on increasing revenues from the physicians’ use of the lasers. XTRAC
      lasers-in-service are depreciated on a straight-line basis over the estimated
      useful life of three-years. Surgical lasers-in-service are depreciated on a
      straight-line basis over an estimated useful life of seven years if new, five
      years or less if used equipment. The straight-line depreciation basis for
      lasers-in-service is reflective of the pattern of use. For other property and
      equipment, including property and equipment acquired from ProCyte, depreciation
      is calculated on a straight-line basis over the estimated useful lives of the
      assets, primarily three to seven years for computer hardware and software,
      furniture and fixtures, automobiles, and machinery and equipment. Leasehold
      improvements are amortized over the lesser of the useful lives or lease terms.
      Useful lives are determined based upon an estimate of either physical or
      economic obsolescence.




***Intangibles*** **.** Our
      balance sheet includes goodwill and other intangible assets which affect the
      amount of future period amortization expense and possible impairment expense
      that we will incur. Management’s judgments regarding the existence of impairment
      indicators are based on various factors, including market conditions and
      operational performance of our business. As of December 31, 2005 and 2004,
      we
      had $22,420,563 and $3,873,857, respectively, of goodwill and other intangibles,
      accounting for 46% and 17% of our total assets at the respective dates. The
      determination of the value of such intangible assets requires management to
      make
      estimates and assumptions that affect our consolidated financial statements.
      We
      test our goodwill for impairment, at least annually. This test is usually
      conducted in December of each year in connection with the annual budgeting
      and
      forecast process. Also, on a quarterly basis, we evaluate whether events have
      occurred that would negatively impact the realizable value of our intangibles
      or
      goodwill.




There
      has
      been no change in 2005 and 2004 to the carrying value of goodwill that is
      allocated to the XTRAC domestic segment and the XTRAC international segment
      in
      the amounts of $2,061,096 and $883,327, respectively. The allocation of goodwill
      to each segment was based upon the relative fair values of the two segments
      as
      of August 2000, when we bought out the minority interest in Acculase and thus
      recognized the goodwill. In connection with the acquisition of ProCyte on March
      18, 2005, we acquired certain intangibles recorded at fair value as of the
      date
      of acquisition and allocated fully to the Skin Care (ProCyte) segment. Included
      in these acquired intangibles were the following:




ProCyte
                Neutrogena Agreement
            
            $
            2,400,000ProCyte
                Customer Relationships
            
            
            1,700,000ProCyte
                Tradename
            
            
            1,100,000ProCyte
                Developed Technologies
            
            
            200,000Goodwill
            
            
            13,430,961Total
            
            $
            18,830,961




***Deferred
      Income Taxes.*** We
      have a
      deferred tax asset that is fully reserved by a valuation allowance. We have
      not
      recognized the deferred tax asset, given our historical losses and the lack
      of
      certainty of future taxable income. However, if and when we become profitable
      and can reasonably foresee continuing profitability, then under SFAS No. 109
      we
      may recognize some of the deferred tax asset. The****recognized
      portion may variously reduce acquired goodwill, increase stockholders’ equity
      directly and/or benefit the statement of operations.




***Warranty
      Accruals*** **.** We
      establish a liability for warranty repairs based on estimated future claims
      for
      XTRAC systems and based on historical analysis of the cost of the repairs for
      surgical laser systems. However, future returns on defective laser systems
      and
      related warranty liability could differ significantly from estimates, and
      historical patterns, which would adversely affect our operating
      results.




43


**Results
      of Operations**




***Revenues***




The
      following table illustrates revenues from our five business segments for the
      periods listed below:




For
                the Years Ended December 31,2005
            
            2004
            
            2003Dermatology:XTRAC
                Domestic Services
            
            $
            3,498,235
            
            $
            3,256,164
            
            $
            1,325,024XTRAC
                International Products
            
            
            1,404,096
            
            
            1,626,646
            
            
            1,166,520Skin
                Care (ProCyte) Revenues
            
            
            10,042,132
            
            
            —
            
            
            —Total
                Dermatology Revenues
            
            $
            14,944,463
            
            $
            4,882,810
            
            $
            2,491,544Surgical:Surgical
                Services
            
            $
            7,719,529
            
            $
            7,826,519
            
            $
            5,953,462Surgical
                Products
            
            
            5,720,514
            
            
            5,035,852
            
            
            5,873,787Total
                Surgical Revenues
            
            $
            13,440,043
            
            $
            12,862,371
            
            $
            11,827,249Total
                Revenues
            
            $
            28,384,506
            
            $
            17,745,181
            
            $
            14,318,793




***Domestic
      XTRAC Segment***




Recognized
      revenue for the years ended December 31, 2005, 2004 and 2003 for domestic XTRAC
      procedures was $3,498,235, $3,256,164 and $1,325,024, respectively, reflecting
      billed procedures of 54,255, 47,915 and 29,113, respectively. In addition,
      6,371, 4,928 and 2,566 procedures were performed for the years ended December
      31, 2005, 2004 and 2003, respectively, without billing from us, in connection
      with clinical research and customer evaluations of the XTRAC laser. The increase
      in procedures in the year ended December 31, 2005 compared to the comparable
      periods in 2004 and 2003 was largely related to our continuing progress in
      securing favorable reimbursement policies from private insurance plans.
      Increases in these levels are dependent upon more widespread adoption of the
      CPT
      codes with comparable rates by private healthcare insurers and on instilling
      confidence in our physician partners that the XTRAC procedures will benefit
      their patients and be generally reimbursed to their practices.




In
      the
      first quarter of 2003, we implemented a program to support certain physicians
      who may be denied reimbursement by private insurance carriers for XTRAC
      treatments. In accordance with the requirements of SAB No. 104, we recognize
      service revenue during the program only to the extent the physician has been
      reimbursed for the treatments. For the year ended December 31, 2005, we deferred
      revenues of $57,302 (873 procedures) net, under this program, compared to the
      year ended December 31, 2004, when we recognized revenues of $303,027 from
      revenues (4,562 procedures) which had been previously deferred under this
      program. For the year ended December 31, 2003, we deferred revenues of
      $744,830, (10,737 procedures) net, under this program. The change in deferred
      revenue under this program is presented in the table below.




In
      the
      years ended December 31, 2005 and 2004, recognized revenues for the domestic
      XTRAC segment increased by approximately $261,000 and $98,000, respectively,
      due
      to a change in accounting estimate for potential credits or refunds under the
      reimbursement program. In addition, in the years ended December 31, 2005 and
      2004, recognized revenues for the domestic XTRAC segment increased by
      approximately $73,000 and decreased by approximately $271,000, respectively,
      due
      to a change in the accounting estimate for unused physician treatments that
      existed for the same periods. The net impact on revenue recognized for the
      XTRAC
      domestic segment as a result of the above two changes in accounting estimate
      was
      to increase revenues by approximately $334,000 for the year ended December
      31,
      2005 and decrease revenues by approximately $173,000 for the year ended December
      31, 2004.




44


The
      following table illustrates the above analysis for the Domestic XTRAC segment
      for the periods reflected below:




For
                the Years Ended December 31,2005
            
            2004
            
            2003Recognized
                revenue
            
            $
            3,498,235
            
            $
            3,256,164
            
            $
            1,325,024Change
                in deferred program revenue
            
            
            57,302
            
            
            (303,027
            )
            
            744,830Change
                in deferred unused treatments
            
            
            5,371
            
            
            229,300
            
            
            (50,225
            )Net
                billed revenue
            
            $
            3,560,908
            
            $
            3,182,437
            
            $
            2,019,629Procedure
                volume total
            
            
            60,626
            
            
            52,843
            
            
            31,679Less:
                Non-billed procedures
            
            
            6,371
            
            
            4,928
            
            
            2,566Net
                billed procedures
            
            
            54,255
            
            
            47,915
            
            
            29,113Avg.
                price of treatments sold
            
            $
            65.63
            
            $
            66.42
            
            $
            69.37Procedures
                with deferred/(recognized)program
                revenue, net
            
            
            873
            
            
            (4,562
            )
            
            10,737Procedures
                with deferred/(recognized)unused
                treatments, net
            
            
            82
            
            
            3,452
            
            
            (724
            )




The
      average price for a treatment varies based upon the mix of mild and moderate
      psoriasis patients treated by our physician partners. We charge a higher price
      per treatment for moderate psoriasis patients due to the increased body surface
      area required to be treated, although there are fewer patients with moderate
      psoriasis than there are with mild psoriasis. Due to the length of treatment
      time required, it has not been generally practical to use our therapy to treat
      severe psoriasis patients. This may change going forward, as our new product,
      the XTRAC Ultra, has shorter treatment times.




***International
      XTRAC Segment***




International
      XTRAC sales of our excimer laser system and related parts were $1,404,096 for
      the year ended December 31, 2005 compared to $1,626,646 and $1,166,520 for
      the years ended December 31, 2004 and 2003, respectively. We sold 26 laser
      systems in the year ended December 31, 2005 compared to 26 and 18 laser
      systems in the years ended December 31, 2004 and 2003, respectively.
      Compared to the domestic business, the international XTRAC operations are more
      widely influenced by competition from similar laser technology from other
      manufacturers and from non-laser lamps which over time, has also served to
      reduce the prices we charge international distributors for our excimer products.
      While the average revenue per laser was less in the year ended December 31,
      2005 than in the same period of 2004, the number of lasers sold was the same
      as
      in the prior period.




Contributing
      to the overall average selling price decrease in 2005 was the sale of certain
      used lasers which were previously deployed in the US operations and sold at
      a
      discount to the list price for new equipment. We sold 6 of these used lasers
      at
      an average price of $27,000. While the average revenue per laser was less in
      the
      year ended December 31, 2004 than in the same period of 2003, the number of
      lasers sold was greater than in the prior period. In addition, of the 26 lasers
      recognized as sales in the year ended December 31, 2004, six of those
      lasers had been shipped in 2003, but not recognized as sales at that time due
      to
      the application of the recognition criteria of Staff Accounting Bulletin No.
      104. Four of the six lasers were recognized in the first quarter of 2004 and
      the
      other two lasers were recognized in the second quarter of 2004.




45


The
      following table illustrates the key changes in the International XTRAC segment
      for the periods reflected below:




For
                the Years Ended December 31,2005
            
            2004
            
            2003Revenues
            
            $
            1,404,096
            
            $
            1,626,646
            
            $
            1,166,520Laser
                systems sold
            
            
            26
            
            
            26
            
            
            18Average
                revenue per laser
            
            $
            54,004
            
            $
            62,563
            
            $
            64,807




***Skin
      Care (ProCyte) Segment***




For
      the
      year ended December 31, 2005, ProCyte revenues were $10,042,132. Inasmuch as
      ProCyte was acquired on March 18, 2005, there are no corresponding revenues
      accruing to us for the years ended December 31, 2004 or 2003. Skin Care revenues
      are generated from the sale of various skin and hair care products, from the
      sale of copper peptide compound and from royalties on licenses, mainly from
      Neutrogena. For the full year 2005, unaudited Skin care revenues were
      approximately $13 million compared to unaudited revenues of $13.3 million for
      2004.




The
      following table illustrates the key changes in the Skin Care (ProCyte) segment
      for the periods reflected below:




For
                the Year Ended December 31,2005
            
            2004
            
            2003Product
                sales
            
            $
            8,902,615
            
            $
            —
            
            $
            —Bulk
                compound sales
            
            
            679,550
            
            
            —
            
            
            —Royalties
            
            
            459,967
            
            
            —
            
            
            —Total
                Skincare revenue
            
            $
            10,042,132
            
            $
            —
            
            $
            —




***Surgical
      Services Segment***




In
      the
      years ended December 31, 2005, 2004 and 2003, surgical service revenues
      were $7,719,529, $7,826,519 and $5,953,462, respectively. Revenues in surgical
      services stayed relatively flat for the year ended December 31, 2005 compared
      to
      2004. During 2005 we closed four geographic areas of business due to
      unacceptable operating profit, which we had revenues in 2004. In addition,
      we
      have suffered business interruption due to hurricanes in New Orleans and Alabama
      territories, in the third and fourth quarter of 2005. Revenues in surgical
      services grew for the year ended December 31, 2004 from 2003 by 31.5%,
      primarily due to growth in urological procedures performed with laser systems
      purchased from a third-party manufacturer. Such procedures included a charge
      for
      the use of the laser and the technician to operate it, as well as a charge
      for
      the third party’s proprietary fiber delivery system.




The
      following table illustrates the key changes in the Surgical Services segment
      for
      the periods reflected below:




For
                the Years Ended December 31,2005
            
            
            2004
            
            
            2003Revenues
            
            $
            7,719,529
            
            
            $
            7,826,519
            
            
            $
            5,953,462Percent
                (decrease)/ increase
            
            
            (1.4
            %)
            
            
            31.5
            %Cost
                of revenues
            
            
            5,675,787
            
            
            
            5,000,226
            
            
            
            3,899,714Gross
                profit
            
            $
            2,043,742
            
            
            $
            2,826,293
            
            
            $
            2,053,748




46


***Surgical
      Products Segment***




Surgical
      Products revenues include revenues derived from the sales of surgical laser
      systems together with sales of related laser fibers and laser disposables.
      Sales
      of laser systems create recurring sales of laser fibers and laser disposables
      that are more profitable than laser systems.




For
      the
      year ended December 31, 2005, surgical products revenues were $5,720,514
      compared to $5,035,832 in the year ended December 31, 2004. The increase was
      almost entirely due to $685,000 in additional laser system revenues reflecting
      the increase in the number of systems sold (47 vs. 17), partially offset by
      a
      decline in the average price per laser sold.




For
      the
      year ended December 31, 2004, surgical products revenues were $5,035,832
      compared to $5,873,787 in the year ended December 31, 2003. The decrease was
      due
      to fewer laser systems sold (17 vs. 38) partially offset by an increase in
      the
      average price per laser sold.




The
      decrease in average price per laser was largely due to the mix of lasers sold.
      Included in the laser sales for the years ended December 31, 2005 and 2004
      were
      sales of $532,995 and $40,000 diode lasers, respectively, which have
      substantially lower list sales prices than the other types of surgical lasers.
      There were no sales of these lasers for the year ended December 31, 2003, since
      they were introduced in June 2004.




Disposables
      and fiber sales were relatively level between the comparable years ended
      December 31, 2005 and 2004. We have expected that the disposables base may
      continue to erode over time as hospitals continue to seek outsourcing solutions
      instead of purchasing lasers and related disposables for their operating rooms.
      We have continued to seek to offset this erosion through expansion of our
      surgical services. Similarly, we believe there will be continuing pressure
      on
      laser system sales as hospitals continue to outsource their laser-assisted
      procedures to third parties, such as our surgical services business. With the
      introduction of our CO2 and diode surgical lasers in the second quarter of
      2004,
      we hope to offset the decline in laser and disposables revenues.




The
      following table illustrates the key changes in the Surgical Products segment
      for
      the periods reflected below:




For
                the Year Ended December 31,2005
            
            
            2004
            
            
            2003Revenues
            
            $
            5,720,514
            
            
            $
            5,035,832
            
            
            $
            5,873,787Percent
                increase/(decrease)
            
            
            13.6
            %
            
            
            (14.3
            %)Laser
                systems sold
            
            
            47
            
            
            
            17
            
            
            
            38Laser
                system revenues
            
            $
            1,594,000
            
            
            $
            989,000
            
            
            $
            1,611,000Average
                revenue per laser
            
            $
            33,915
            
            
            $
            58,203
            
            
            $
            42,395




***Cost
      of Revenues***




Cost
      of
      revenues divides into product cost of revenues and service cost of revenues.
      Within product costs of revenues are the costs of products sold in the
      International XTRAC segment, the Skin Care segment (with royalties being
      transferred over to the Services side), and the Surgical Products segment (with
      laser maintenance being transferred over to the services side). Within services
      cost of revenues are the costs associated with the Domestic XTRAC segment and
      the Surgical Services segment, as well as costs associated with the royalties
      and maintenance.




Product
      cost of revenues during the year ended December 31, 2005 were $7,219,504,
      compared to $3,324,564 for the year ended December 31, 2004. The $3,894,940
      increase reflected the inclusion of $3,132,532 of costs for the ProCyte business
      acquired in 2005, and an increase of $1,009,503 for surgical products, due
      to
      increased laser system sales offset, in part, by a $246,796 decrease in costs
      associated with sales of XTRAC laser equipment sold outside the United
      States.




47


Product
      cost of revenues during the year ended December 31, 2004 were $3,324,564,
      compared to $3,732,109 for the year ended December 31, 2003. The $407,843
      decrease reflected a decrease of $768,139 for surgical products, due to a
      decrease in surgical laser sales. This decrease was offset by an increase in
      product cost of sales for the international XTRAC revenues for the year ended
      December 31, 2004. This increase was primarily related to an increase in
      sales for the year. Additionally, we implemented a planned quality upgrade
      of
      all units in the field during 2003. The impact of this upgrade served to reduce
      field service costs and warranty claims for 2004.




Services
      cost of revenues was $8,456,001 and $7,038,705 in the years ended December
      31,
      2005 and 2004, respectively. Contributing to the $1,417,296 increase was a
      $616,236 increase in the surgical services business associated with the increase
      in urological procedures performed with laser systems purchased from a
      third-party manufacturer, which carry a higher cost of sale due to the
      disposable fiber purchased from the third-party manufacturer than a fiber which
      we manufacture. In addition, cost of revenues in the Domestic XTRAC business
      segment increased $801,060 due to manufacturing inefficiencies, an increase
      in
      excess and obsolete inventory reserve and increased depreciation on the lasers
      compared to the same period in 2004.




Services
      cost of revenues was $7,038,705 and $6,755,499 in the years ended December
      31,
      2004 and 2003, respectively. Contributing to the $283,206 increase was a
      $1,288,545 increase in the surgical services business associated with the
      increase in urological procedures performed with laser systems purchased from
      a
      third-party manufacturer, which carry a higher cost of sale due to the
      disposable fiber purchased from the third-party manufacturer than a fiber which
      we manufacture. In addition, cost of revenues in the Domestic XTRAC business
      segment decreased $1,005,339 due to the improvements made to the
      lasers.




Certain
      allocable XTRAC manufacturing overhead costs are charged against the XTRAC
      service revenues. The manufacturing facility in Carlsbad, California is used
      exclusively for the production of the XTRAC lasers, which are placed in
      physicians’ offices domestically or sold internationally. The unabsorbed costs,
      relating to excess capacity, are allocated to the Domestic XTRAC and the
      International XTRAC segments based on actual production of lasers for each
      segment. Included in these allocated manufacturing costs are unabsorbed labor
      and direct plant costs.




***Gross
      Margin Analysis***




Gross
      margin increased to $12,709,001 during the year ended December 31, 2005
      from $7,381,912 during the same period in 2004, primarily reflecting the impact
      of the ProCyte acquisition on March 18, 2005. As a percentage of revenues,
      the
      gross margins for the year ended December 31, 2005, increased to 44.8% compared
      to 41.6% for the same period in 2004, largely as a result of the ProCyte’s gross
      margin contribution which approximates 68.8%.




Gross
      margin increased to $7,381,912 during the year ended December 31, 2004 from
      $3,831,185 during the same period in 2003. As a percentage of revenues, the
      gross margins for the year ended December 31, 2004, increased to 41.6% compared
      to 26.8% for the same period in 2003.




The
      following table analyzes changes in our gross profit for the periods reflected
      below:




**Company
                Margin Analysis**
            
            For
                the Year Ended December 31,2005
            
            
            2004
            
            
            2003Revenues
            
            $
            28,384,506
            
            
            $
            17,745,181
            
            
            $
            14,318,793Percent
                increase
            
            
            60.0
            %
            
            
            23.9
            %Cost
                of revenues
            
            
            15,675,505
            
            
            
            10,363,269
            
            
            
            10,487,608Percent
                increase (decrease)
            
            
            51.3
            %
            
            
            (1.2
            %)Gross
                profit
            
            $
            12,709,001
            
            
            $
            7,381,913
            
            
            $
            3,831,185Percent
                of revenue
            
            
            44.8
            %
            
            
            41.6
            %
            
            
            26.8
            %






48


The
      primary reasons for changes in gross profit for the year ended December 31,
      2005, compared to the same period in 2004 were as follows:




·
            We
                acquired ProCyte on March 18, 2005, so only the activity after that
                date
                is recorded in our financial statements. Consequently, there was
                no
                activity recorded in our financial statements in 2004 and 2003 from
                the
                skin care business. Additionally, the skin care business has the
                highest
                gross profit margin percentage of any of our business
                segments.




·
            We
                increased sales on surgical laser systems due to the introduction
                of the
                diode laser.




·
            Offsetting
                the above was an increase in depreciation included with the XTRAC
                domestic
                cost of sales as a result of increasing the overall placements of
                new
                lasers in 2005. In addition, the XTRAC plant was relocated in the
                middle
                of 2005 causing some inefficiencies in the third quarter. Further,
                we
                introduced the XTRAC Ultra, a smaller, faster excimer laser. As a
                result
                of this introduction we increased our reserve for obsolete inventory
                related to the older generation
                laser.




The
      primary reasons for improvement in gross margin for the year ended
      December 31, 2004, compared to the same period in 2003, were as
      follows:




·
            We
                increased treatment procedures and lowered field service costs for
                the
                XTRAC system. The increase in procedure volume was a direct result
                of
                improving insurance reimbursement. The lower field service costs
                were a
                direct result of the planned quality upgrades in 2003 for all
                lasers-in-service.




·
            We
                continued to increase the volume of sales to existing customers and
                add
                new customers to our existing base.




The
      following table analyzes the gross profit for our Domestic XTRAC segment for
      the
      periods reflected below:




**XTRAC
                Domestic Segment**
            
            For
                the Year Ended December 31,2005
            
            2004
            
            2003Revenues
            
            $
            3,498,235
            
            $
            3,256,164
            
            $
            1,325,024Percent
                increase
            
            
            7.4
            %
            
            145.7
            %Cost
                of revenues
            
            
            2,691,506
            
            
            1,890,446
            
            
            2,795,786Percent
                increase (decrease)
            
            
            42.4
            %
            
            (32.4
            %)Gross
                profit (loss)
            
            $
            806,729
            
            $
            1,365,718
            
            
            ($1,470,762
            )Percent
                of revenue
            
            
            23.1
            %
            
            41.9
            %
            
            (111.0
            %)




The
      gross
      margin decreased for this segment for the year ended December 31, 2005 from
      the
      comparable periods in 2004 by $558,989. The key factors were as
      follows:




·
            A
                key driver in increased revenue in this segment is insurance
                reimbursement. In 2004, we focused on encouraging private health
                insurance
                plans to adopt the XTRAC laser therapy as an approved medical procedure
                for the treatment of psoriasis. Since January 2004, several major
                health
                insurance plans instituted medical policies to pay claims for the
                XTRAC
                therapy, including Regence, Wellpoint, Aetna, Anthem, Cigna, United
                Healthcare, Highmark Blue Cross and Independence Blue Cross of
                Pennsylvania.




·
            Procedure
                volume increased 14.7% from 52,843 to 60,626 billed procedures in
                the year
                ended December 31, 2005 compared to the same period in 2004.




·
            Price
                per procedure was not a meaningful component of the revenue change
                between
                the periods.




·
            The
                cost of revenues increased by $801,060 for the year ended December
                31,
                2005. This increase was due to the fact that in 2004, our California
                engineering resources dedicated much of their time to product development
                for the Ultra, the new smaller and faster excimer laser. For the
                year
                ended December 31, 2005, the development of the Ultra was completed,
                thus
                allowing these California resources to devote more time to manufacturing
                (included in cost of revenues).






49


The
      most
      significant improvement for the year ended December 31, 2004 came from our
      Domestic XTRAC segment. We increased the gross profit for this segment for
      the
      year ended December 31, 2004 over the comparable period in 2003 by
      $2,836,480, primarily due to increases in revenues and decreases in the costs
      in
      the two periods.




·
            A
                key driver in increased revenue in Domestic XTRAC segment is insurance
                reimbursement. In 2004, we focused on private health insurance plans’
                adopting the XTRAC laser therapy for psoriasis as an approved medical
                procedure. In 2004, several major health insurance plans instituted
                medical policies to pay claims for the XTRAC therapy including Regence,
                Wellpoint, Aetna and Anthem.




·
            Procedure
                volume increased 65% from 29,113 to 47,915 billed procedures in the
                year
                ended December 31, 2004 compared to the same period in
                2003.




·
            Price
                per procedure was not a meaningful component of the revenue change
                between
                the periods.




·
            In
                the first quarter of 2003, we implemented a limited program to support
                certain physicians in addressing treatments with the XTRAC system
                that may
                be denied reimbursement by private insurance carriers. We recognize
                service revenue under the program for the sale of treatment codes
                to
                physicians participating in this program only if and to the extent
                the
                physician has been reimbursed for the treatments. For the year ended
                December 31, 2004, we recognized revenues of $303,027, net, from
                revenues under the program which had been previously deferred but
                which
                could be recognized in the current year’s revenues as all the criteria for
                revenue recognition had been met. For the year ended December 31,
                2003, we deferred revenues of $744,830 under this program.




·
            The
                cost of revenues decreased by $905,340 for the year ended
                December 31, 2004. An incremental procedure at a physician’s office
                does not substantively increase our operating costs associated with
                that
                laser. This, combined with the improvement in the reliability of
                the
                lasers in 2004 from 2003 and the resulting reduction in field service
                costs, served to reduce costs associated with the domestic
                segment.




The
      following table analyzes the gross profit for our International XTRAC segment
      for the periods reflected below:




**XTRAC
                International Segment**
            
            For
                the Year Ended December 31,2005
            
            
            2004
            
            
            2003Revenues
            
            $
            1,404,096
            
            
            $
            1,626,646
            
            
            $
            1,166,520Percent
                (decrease) increase
            
            
            (13.7
            %)
            
            
            39.4
            %Cost
                of revenues
            
            
            930,574
            
            
            
            1,177,371
            
            
            
            817,075Percent
                (decrease) increase
            
            
            (21.0
            %)
            
            
            44.1
            %Gross
                profit
            
            $
            473,522
            
            
            $
            449,275
            
            
            $
            349,445Percent
                of revenue
            
            
            33.7
            %
            
            
            27.6
            %
            
            
            30.0
            %




The
      gross
      profit for the years ended December 31, 2005 and 2004 increased by $24,247
      and $99,830, respectively, from the comparable prior year periods. The key
      factors in this business segment were as follows:




·
            We
                sold 26 XTRAC systems during both the year ended December 31, 2005
                and
                2004. We sold 26 XTRAC systems during the year ended December 31,
                2004 and 18 lasers in the comparable period in 2003. We shipped $541,000
                of lasers to a master distributor in 2003, but did not recognize
                revenue
                at the time. We recognized revenue in the amount of $420,000 in 2004
                when
                all collections from the shipments became
                certain.




·
            The
                International XTRAC operations are more widely influenced by competition
                from similar laser technology from other manufacturers and from non-laser
                lamp alternatives for treating inflammatory skin disorders, which
                has
                served to reduce the prices we charge international distributors
                for our
                excimer products. After adjusting the revenue for parts sales of
                approximately $209,000, the average price for lasers sold in the
                year
                ended December 31, 2005 was approximately $46,000, down from $56,800
                in
                the comparable period in 2004. Contributing to the overall average
                selling
                price decrease in 2005 was the sale of certain used lasers which
                were
                previously deployed in the US operations and sold at a discount to
                the
                list price for new equipment. We sold 6 of these used lasers at an
                average
                price of $27,000. Each of these lasers had a net book value of less
                than
                standard cost of a new XTRAC system. After adjusting the revenue
                for the
                year ended December 31, 2004 for parts sales of approximately $149,000,
                the average price for lasers sold during this period was approximately
                $56,800 compared to $62,400 in the same period in 2003.




50


The
      following table analyzes our gross margin for our SkinCare (ProCyte) segment
      for
      the periods presented below:




**Skin
                Care (ProCyte) Segment**
            
            For
                the Year Ended December 31,2005
            
            2004
            
            2003Produce
                revenues
            
            $
            8,902,615
            
            $
            —
            
            $
            —Bulk
                compound revenues
            
            
            679,550
            
            
            —
            
            
            —Royalties
            
            
            459,967
            
            
            —
            
            
            —Total
                revenues
            
            
            10,042,132
            
            
            —
            
            
            —Product
                cost of revenues
            
            
            2,664,959
            
            
            —
            
            
            —Bulk
                compound cost of revenues
            
            
            467,573
            
            
            —
            
            
            —Total
                cost of revenues
            
            
            3,132,532
            
            
            —
            
            
            —Gross
                profit
            
            $
            6,909,600
            
            $
            —
            
            $
            —Percent
                of revenue
            
            
            68.8
            %
            
            —
            
            
            —




The
      key
      factors in skincare business segment were as follows:




·
            Copper
                Peptide bulk compound is sold at a substantially lower gross margin
                than
                skin care products, while revenues generated from licensees have
                no
                significant costs associated with this revenue
                stream.




·
            Product
                revenues come primarily from U.S.
                dermatologists.




·
            Lesser
                product revenues come from sales directed to consumers at spas and
                from
                marketing directly to the consumer (e.g.
                infomercials).




The
      following table analyzes the gross profit for our Surgical Services segment
      for
      the periods reflected below:




**Surgical
                Services Segment**
            
            For
                the Year Ended December 31,2005
            
            2004
            
            2003Revenues
            
            $
            7,719,529
            
            $
            7,826,519
            
            $
            5,953,462Percent
                (decrease) increase
            
            
            (1.4
            %)
            
            31.5
            %Cost
                of revenues
            
            
            5,675,787
            
            
            5,000,226
            
            
            3,899,714Percent
                increase
            
            
            13.5
            %
            
            28.2
            %Gross
                profit
            
            $
            2,043,742
            
            $
            2,826,293
            
            $
            2,053,748Percent
                of revenue
            
            
            26.5
            %
            
            36.1
            %
            
            34.5
            %






51


Gross
      margin in the Surgical Services segment for year ended December 31, 2005
      decreased by $782,551, from the comparable period in 2004. The key factors
      impacting gross margin for the Surgical Services business were as
      follows:




·
            A
                significant part of the revenue was in urological procedures performed
                with laser systems we purchased from a third party manufacturer.
                Such
                procedures included a charge for the use of the laser and the technician
                to operate it, as well as a charge for the third party’s proprietary fiber
                delivery system. This procedure has a lower gross margin as a percent
                of
                revenues than other types of procedures. As the volume of these procedures
                increases, the overall gross margin percentage decreases. In 2005,
                there
                was a 25% price increase on the third party’s proprietary fiber delivery
                system, which also contributed to the decrease in gross margin in
                2005.
                Revenues for this procedure were $2.4 million for the year ended
                December
                31, 2005 compared to $1.7 million for the same period in
                2004.




·
            We
                have closed four geographic areas of business due to unacceptable
                operating profit. Although closing these territories will save costs
                and
                improve profitability over time, the costs saved for the year ended
                December 31, 2005 have not kept pace with the revenues lost by closing
                these territories during the year ended December 31, 2005.




·
            We
                have suffered business interruption due to hurricanes in the New
                Orleans
                and Alabama territories.




Gross
      profit in the Surgical Services segment for the year ended December 31,
      2004 increased by $775,545 from the comparable period in 2003. The key factors
      impacting gross margin for the Surgical Services business were as
      follows:




·
            Increased
                procedure volume was the primary reason for improvements in this
                business.
                We continue to experience growth in our surgical services business,
                particularly within existing customers and existing
                geographies.




·
            A
                significant part of the growth was an increase in urological procedures
                performed with laser systems we have purchased from a third party
                manufacturer. Such procedures included a charge for the use of the
                laser
                and the technician to operate it, as well as a charge for the third
                party’s proprietary fiber delivery system. In the year ended
                December 31, 2004, we increased the amount we charge customers for
                the fibers used with this procedure without a commensurate increase
                in the
                cost of these fibers. This accounted for the increase in the margin
                to
                36.1% from 34.5% in the year ended December 31, 2004 from the
                comparable period in 2003.




The
      following table analyzes our gross profit for our Surgical Products segment
      for
      the periods reflected below:




**Surgical
                Products Segment**
            
            For
                the Year Ended December 31,2005
            
            2004
            
            2003Revenues
            
            $
            5,720,514
            
            $
            5,035,852
            
            $
            5,873,787Percent
                increase (decrease)
            
            
            13.6
            %
            
            (14.3
            %)Cost
                of revenues
            
            
            3,245,103
            
            
            2,295,226
            
            
            2,975,034Percent
                increase (decrease)
            
            
            41.4
            %
            
            (22.9
            %)Gross
                profit
            
            $
            2,475,411
            
            $
            2,740,626
            
            $
            2,898,753Percent
                of revenue
            
            
            43.3
            %
            
            54.4
            %
            
            49.4
            %




The
      gross
      profit for the year ended December 31, 2005 decreased by $265,215 from the
      comparable prior year period. The key factors in this business segment were
      as
      follows:




·
            This
                segment includes product sales of surgical laser systems and laser
                disposables. Disposables are more profitable than laser systems.
                However,
                the sale of laser systems generates future recurring sales of laser
                disposables.






52




·
            Revenues
                for the year ended December 31, 2005 increased by $684,662 from the
                year
                ended December 31, 2004 while cost of revenues increased by $949,877
                between the same periods. There were 30 more laser systems sold in
                the
                year ended December 31, 2005 than in the comparable period of 2004.
                However, the lasers sold in the 2004 period were at higher prices
                than in
                the comparable period in 2005. The decrease in average price per
                laser was
                largely due to the mix of lasers sold. Included in the laser sales
                for the
                years ended December 31, 2005 and 2004 were sales of $532,995 and
                $40,000
                diode lasers, respectively, which have substantially lower list sales
                prices than the other types of surgical lasers. There were no sales
                of
                these lasers for the year ended December 31, 2003, since they were
                introduced in June 2004.




·
            The
                laser revenue increase was partly offset by a decrease in sales
                disposables between the periods. Disposables, which have a higher
                gross
                margin than lasers, represented a lower percentage of revenue in
                the year
                ended December 31, 2005 compared to the year ended December 31,
                2004.




The
      gross
      profit for the year ended December 31, 2004 decreased by $158,127 from the
      comparable prior year period. The key factors in this business segment were
      as
      follows:




·
            This
                segment includes product sales of surgical laser systems and laser
                disposables. Disposables are more profitable than laser systems.
                However,
                the sale of laser systems generates the sale of laser
                disposables.




·
            Revenues
                for the year ended December 31, 2004 decreased by $837,935 from the
                year
                ended December 31, 2003 while cost of revenues decreased by $679,808
                between the same periods. There were 11 fewer laser systems sold
                in the
                year ended December 31, 2004 than in the comparable period of 2003.
                However, the lasers sold in the 2004 period were at higher prices
                than in
                the comparable period in 2005.




·
            Disposables,
                which have a higher gross margin than lasers, represented a higher
                percentage of revenue in the year ended December 31, 2004 compared to
                the year ended December 31,
                2003.




***Selling,
      General and Administrative Expenses***




For
      the
      year ended December 31, 2005, selling, general and administrative expenses
      increased to $16,477,322 from $10,426,256 for the year ended December 31, 2004.
      Selling, general and administrative expenses related to the Skin Care business
      accounted for $5,331,764 of the increase. The remaining increase related to
      a
      $485,000 increase in salaries, benefits and travel expenses associated with
      an
      increase in the sales force, particularly in the Domestic XTRAC segment, a
      $151,000 increase in salaries and benefits for general and administrative
      expenses and increases in consulting expenses of $161,000 and in corporate
      insurance of $229,000. Offsetting some of the increases for the year ended
      December 31, 2005, were reductions in bonus expense of $134,000 and in bad
      debt
      expense of $117,000 in the current year compared to the prior year
      period.




For
      the
      year ended December 31, 2004, selling, general and administrative expenses
      increased to $10,426,256 from $9,451,224 for the year ended December 31, 2003.
      The overall increase related to several expenses during the 2004 year. We have
      incurred $400,000 in expenses with respect to compliance obligations under
      Sarbanes Oxley. We had incremental bad debt expense and legal expense of
      $159,000 and $200,000, respectively, over the 2003 levels. The bad debt expense
      relating to the international XTRAC sales has been lower due to the lower sales
      volume which contributes to lower potential sales at risk of collection. In
      addition, more of our international sales have been paid with cash in advance
      or
      letters of credit inasmuch as such payment terms are more suitable for the
      geographic mix of countries where we presently do business. This decrease was
      offset by an increase in bad debt expense relating to the domestic XTRAC. These
      expenses related to prior insurance reimbursement issues.




Selling,
      general and administrative expenses as a percentage of revenues have improved
      over the past three years from 66% in 2003, 59% in 2004 and 58% in
      2005.




53


***Engineering***  ***and
      Product Development***




Engineering
      and product development expenses for the years ended December 31, 2005 decreased
      to $1,127,961 from $1,801,438 for the year ended December 31, 2004. The decrease
      was mainly in the XTRAC segments due to product development expenses in 2004
      for
      the Ultra. In 2005, the development of the Ultra was completed, thus allowing
      these California resources to devote more time to manufacturing. This decrease
      was offset, in part, by the engineering and product development expenses related
      to the Skin Care business of $442,368. Engineering and product development
      expenses for the years ended December 31, 2004 increased to $1,801,438 from
      $1,776,480 for 2003.




***Other
      Income***




Other
      income for the year ended December 31, 2005 was $1,302,537 reflecting the
      following components: a litigation settlement, net of expenses of $968,882,
      a
      non-monetary exchange of assets during June 2005 of two depreciable engineering
      development prototypes in exchange for four product units to be held for sale
      for $88,667 and the expiration of the liability for SLT subordinated notes
      of
      $244,988. There was no other income in the comparable periods in 2004 and 2003.




***Interest
      Expense, Net***




Net
      interest expense for the year ended December 31, 2005 increased to $342,299,
      as
      compared to $138,414 for the year ended December 31, 2004. The increase in
      net
      interest expense was the result of the draws on the lease line of credit during
      the second, third and fourth quarters of 2004 and the second and third quarters
      of 2005.




Net
      interest expense for the year ended December 31, 2004 increased to $138,414,
      as
      compared to $46,330 for the year ended December 31, 2003. The increase in net
      interest expense is a direct result of the draws on our lease line of credit
      during 2004. The initial draw on the lease line of credit in the second quarter
      of 2004 was used to replace the expired $1,000,000 bank line of credit.




***Net
      Loss***




The
      aforementioned factors resulted in a net loss of $3,936,044 during the year
      ended December 31, 2005, as compared to a net loss of $4,984,196 for the year
      ended December 31, 2004, a decrease of 21.0%. This decrease was primarily the
      result of the other income for the year ended December 31, 2005.




The
      aforementioned factors resulted in a net loss of $4,984,196 during the year
      ended December 31, 2004, as compared to a net loss of $7,442,849 during the
      year
      ended December 31, 2003, a decrease of 33%. This decrease was primarily the
      result of the increase in revenues and resulting gross margin.




Income
      taxes were immaterial, given our current period losses and operating loss
      carryforwards.




**Liquidity
      And Capital Resources**




We
      have
      historically financed our operations with cash provided from equity financing
      and lines of credit and, recently, from cash-flow positive results from
      operations.




On
      March
      18, 2005, we acquired ProCyte. The skincare products and royalties provided
      by
      ProCyte increased revenues for the year ended December 31, 2005 as compared
      to
      2004. We expect to realize cost savings from the consolidation of the
      administrative and marketing infrastructure of the combined company.
      Additionally, once the consolidated infrastructure is in place, we expect our
      revenues to grow without proportionately increasing the rate of growth in our
      fixed costs.




At
      December 31, 2005, the ratio of current assets to current liabilities was 2.42
      to 1.00 compared to 1.88 to 1.00 at December 31, 2004. As of December 31, 2005,
      we had $11,120,992 of working capital compared to $6,119,248 as of December
      31,
      2004. Cash and cash equivalents were $5,609,967 as December 31, 2005, as
      compared to $3,997,017 as of December 31, 2004. These increases were mainly
      due
      to the acquisition of ProCyte. Cash of $206,931 was classified as restricted
      as
      of December 31, 2005 compared to $112,200 at December 31, 2004. Restricted
      cash increased due to collaterization of a stand-by letter of credit securing
      for the landlord at the Carlsbad facility our obligation to fund our share
      of
      the tenant improvements.






54


We
      believe that our existing cash balance together with our other existing
      financial resources, including access to lease financing for capital
      expenditures, and revenues from sales, distribution, licensing and manufacturing
      relationships, will be sufficient to meet our operating and capital requirements
      into the second quarter of 2007. The 2006 operating plan reflects costs savings
      from the integration of ProCyte and PhotoMedex as well as increases in
      per-treatment fee revenues for use of the XTRAC system based on wider insurance
      coverage in the United States. In addition, the 2006 operating plan calls for
      increased revenues and profits from our newly acquired Skin Care business.
      We
      cannot give assurances that our business plan will not encounter obstacles
      which
      may require us to obtain additional equity or debt financing to meet our working
      capital requirements or capital expenditure needs. Also, if our growth exceeds
      the business plan projections, we may require additional equity or debt
      financing. There can be no assurance that additional financing, if needed,
      will
      be available when required or, if available, will be on terms satisfactory
      to
      us.




In
      addition, there may be insufficient authorized shares available for issuance
      in
      connection with additional equity financing. As of March 15, 2006, we had
      75,000,000 shares of common stock authorized, 52,319,294 shares issued and
      outstanding, and approximately 10,599,307 shares reserved for expected or
      possible issuances. Potential issuances include: (i) 10,347,705 shares reserved
      for issuance in connection with outstanding PhotoMedex warrants and options
      granted or grantable under the PhotoMedex stock option plans, (ii) 211,146
      shares reserved for issuance in connection with the technology license from
      Stern Laser, and (iii) nearly 40,456 warrants that may be issued to GE Capital
      Corporation in connection with additional draws under our lease line of credit.




In
      any of
      such events, we would be forced to modify our plans and operations to seek
      to
      balance cash inflows and outflows or increase our authorized
      capital.




Set
      forth
      below is a summary of current obligations as of December 31, 2005 to make future
      payments due by the period indicated below, excluding payables and accruals.
      We
      expect to be able to meet our obligations in the ordinary course. The
      obligations under the credit facility from GE Capital Corporation are capital
      leases. The other capital lease obligations are from transactions entered into
      before we entered the credit facility with GE. Operating lease and rental
      obligations are respectively for personal and real property which we use in
      our
      business.




Payments
                due by periodContractual
                Obligations
            
            Total
            
            Less
                than 1 year
            
            1
                -
                3 years
            
            3
                -
                5 yearsCredit
                facility obligations
            
            $
            3,726,130
            
            $
            1,548,838
            
            $
            2,177,293
            
            $
            —Other
                capital lease obligations
            
            
            302,709
            
            
            179,993
            
            
            122,716
            
            
            —Operating
                lease obligations
            
            
            78,672
            
            
            30,017
            
            
            48,655
            
            
            —Rental
                lease obligations
            
            
            1,033,982
            
            
            569,146
            
            
            366,228
            
            
            98,608Notes
                payable
            
            
            387,611
            
            
            228,398
            
            
            81,974
            
            
            77,239Total
            
            $
            5,529,104
            
            $
            2,556,392
            
            $
            2,796,866
            
            $
            175,847




On
      June
      25, 2004, we entered into a leasing credit facility from GE Capital Corporation
      (“GE”). The credit facility has a commitment term of three years, expiring on
      June 25, 2007. We account for each draw as funded indebtedness taking the form
      of a capital lease with equitable ownership in the lasers remaining with us.
      GE
      retains title as a form of security over the lasers. Each draw against the
      credit facility has a repayment period of three years and is secured by
      specified lasers, which we have sold to GE and leased back for deployment in
      the
      field. A summary of the activity under the GE leasing credit facility is
      presented in Note 9 “*Long-term Debt.*”




The
      obligations under capital leases are at fixed interest rates and are
      collateralized by the related property and equipment (see Note 4).




Net
      cash
      used in operating activities was $1,729,841 for the year ended December 31,
      2005, compared to $2,765,221 for the same period in 2004. The decrease was
      mostly due to the payment of various previously recorded costs associated with
      the acquisition and increases in inventory.




55


Net
      cash
      used in operating activities was $2,765,221 for the year ended December 31,
      2004, compared to $5,134,161 for the same period in 2003. The decrease was
      mostly due to the decrease in net loss and increases in accounts receivables
      and
      inventory, offset by decreases in accounts payable.




Net
      cash
      provided by investing activities was $1,993,412 for the year ended December
      31,
      2005 compared to cash used of $2,677,670 for the year ended December 31, 2004.
      During the year ended December 31, 2005, we received cash of $5,578,416, net
      of
      acquisition costs, in the ProCyte acquisition and used $3,461,803 for production
      of our lasers in service compared to $1,683,528 for the same period in 2004.




Net
      cash
      provided by investing activities was $2,677,670 for the year ended December
      31,
      2004 compared to cash used of $1,607,757 for the year ended December 31, 2004.
      During the year ended December 31, 2004, we used $1,683,528 for production
      of
      our lasers in service compared to $1,556,654 for the same period in 2003. In
      2004, we had net acquisition costs of $882,823 related to the Stern and ProCyte
      acquisitions.




The
      retirements of lasers from service have been minor or immaterial over the last
      three years and therefore, we have reported them on a net basis.




Net
      cash
      provided by financing activities was $1,254,649 for the year ended December
      31,
      2005 compared to $2,694,240 for the year ended December 31, 2004. In the year
      ended December 31, 2005 we made payments of $1,145,474 on certain notes payable
      and capital lease obligations and incurred $169,524 in registration costs.
      These payments were offset, in part, by the advances under the lease line of
      credit, net of payments, of $1,889,487 and by receipts of $774,891 from the
      exercise of common stock options and warrants. In the year ended December 31,
      2004, we received $3,296,751 from the exercise of common stock options and
      warrants and a net increase of $527,548 from the lapse of the bank line of
      credit and the initiation of the leasing line of credit from GE. These cash
      receipts were offset by $879,001 for the payment of certain notes payable and
      capital lease obligations.




Our
      ability to expand our business operations is currently dependent in significant
      part on financing from external sources. There can be no assurance that changes
      in our manufacturing and marketing, research and development plans or other
      changes affecting our operating expenses and business strategy will not require
      financing from external sources before we will be able to develop profitable
      operations. There can be no assurance that additional capital will be available
      on terms favorable to us, if at all. To the extent that additional capital
      is
      raised through the sale of additional equity or convertible debt securities,
      the
      issuance of such securities could result in additional dilution to our
      stockholders. Moreover, our cash requirements may vary materially from those
      now
      planned because of marketing results, product testing, changes in the focus
      and
      direction of our marketing programs, competitive and technological advances,
      the
      level of working capital required to sustain our planned growth, litigation,
      operating results, including the extent and duration of operating losses, and
      other factors. In the event that we experience the need for additional capital,
      and are not able to generate capital from financing sources or from future
      operations, management may be required to modify, suspend or discontinue our
      business plan.




**Impact
      of Inflation**




We
      have
      not operated in a highly inflationary period, and we do not believe that
      inflation has had a material effect on sales or expenses.




**Item
      7A.**  **Quantitative
      and Qualitative Disclosure About Market Risk**




We
      are
      not currently exposed to market risks due to changes in interest rates and
      foreign currency rates and, therefore, we do not use derivative financial
      instruments to address risk management issues in connection with changes in
      interest rates and foreign currency rates.




**Item
              8.**
            **Financial
                Statements and Supplementary
                Data.**




The
      financial statements required by this Item 8 are included elsewhere in this
      Report and incorporated herein by this reference.




56




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




At
      the
      direction and approval of our Audit Committee, we terminated the engagement
      of
      KPMG LLP (“KPMG”) as our principal independent accountants, to take effect June
      9, 2004.




In
      connection with the audit for the year ended December 31, 2003 and the
      subsequent interim period through June 9, 2004, except as described in the
      following paragraph, there were no disagreements with KPMG on any matter of
      accounting principles or practices, financial statement disclosure, or auditing
      scope or procedures, which if not resolved to the satisfaction of KPMG, would
      have caused KPMG to make reference to the subject matter of such disagreements
      in connection with its reports on our consolidated financial statements for
      such
      years. Management and the Audit Committee have adhered, and will adhere, to
      the
      policy to issue only financial reports which conform to the accounting positions
      recommended by our independent accountants.




During
      its review of our interim consolidated financial statements for the quarter
      ended September 30, 2003, KPMG identified an issue related to material
      transactions for which we had initially recorded revenue on shipments of lasers
      to an international distributor. Based on its review and analysis of the
      collectibility of the revenue from such shipments, KPMG determined that the
      revenue related to these particular shipments should be accounted for utilizing
      the “sell-through” method of accounting, provided the other criteria for revenue
      recognition under applicable accounting standards were met. The issue was
      discussed with management and with our Audit Committee. Upon consideration
      of
      additional facts relevant to the issue, management and the Audit Committee
      agreed with KPMG’s position. Consistent with our Company policy, this issue was
      resolved to the satisfaction of KPMG, and, in accordance with the “sell-through”
method, we did not include the revenue under discussion in the reported
      quarterly results. If this issue had not been resolved to the satisfaction
      of
      KPMG, it would have caused KPMG to make reference to the subject matter of
      such
      disagreement in connection with its reports on our consolidated financial
      statements for applicable periods.




There
      were no reportable events as defined in Item 304(a)(1)(v) of Regulation S-K,
      except for an event related to the “sell-through” method of accounting discussed
      above. KPMG issued a letter identifying a material weakness in our internal
      controls as a result of our 2003 audit. The material weakness in our internal
      controls related to recognition of revenue on the sale of lasers under the
      collectibility criterion of Staff Accounting Bulletin No. 104. While we believed
      that we had adequate policies for proper recognition of revenue, we agreed
      with
      KPMG that our implementation of those policies, especially in evaluating the
      collectibility of discrete sales of laser units, needed to be improved. We
      re-evaluated the various factors, and the relative weights we ascribe to the
      factors, which we take into account in determining collectibility. By December
      31, 2003, we had implemented these and additional procedures to evaluate not
      only new distributors and customers, but past customers as well.




The
      reports of KPMG on our consolidated financial statements, as of and for the
      year
      ended December 31, 2003, did not contain any adverse opinion or disclaimer
      of
      opinion, nor were they qualified or modified as to uncertainty, audit scope
      or
      accounting principles.




The
      Audit
      Committee of our Board of Directors recommended and approved the engagement
      of
      Amper, Politziner & Mattia, P.C. as our independent accountants, effective
      June 9, 2004. The stockholders ratified the engagement of Amper, Politziner
      & Mattia at the annual meeting on December 28, 2004.




During
      the year ended December 31, 2003 and through June 9, 2004, neither we nor anyone
      on our behalf consulted Amper, Politziner & Mattia, P.C. regarding the
      application of accounting principles to a specified transaction, either
      completed or proposed, or the type of audit opinion that might be rendered
      on
      our financial statements, or any other matters or reportable events, as set
      forth in Items 304(a)(2)(i) and (ii) of Regulation S-K.




**Item
      9A.**  **Controls
      and Procedures**




**Controls
      and Procedures**




As
      of
      December 31, 2005, we carried out an evaluation, under the supervision and
      with the participation of our chief executive officer and chief financial
      officer, of the effectiveness of the design and operations of our disclosure
      controls and procedures, as defined in Rule 13a-15(e) under the Securities
      Exchange Act of 1934.




57


In
      making
      this evaluation, we considered the material weakness identified by our
      independent auditors relating to our internal controls as they relate to
      recognition of revenue on the sale of lasers under the collectibility criterion
      of Staff Accounting Bulletin No. 104. In connection with this evaluation, we
      also considered the development and implementation of improvements in our
      internal control procedures described above with respect to the identified
      weakness.




Our
      chief
      executive officer and chief financial officer concluded that as of the
      evaluation date, such disclosure controls and procedures were effective to
      ensure that information required to be disclosed by us in the reports we file
      or
      submit under the Exchange Act are recorded, processed, summarized and reported
      within the time periods specified in the rules and forms of the Securities
      and
      Exchange Commission, and is accumulated and communicated to our management,
      including our chief executive officer and chief financial officer, as
      appropriate to allow timely decisions regarding required disclosure.




With
      regard to the material weakness identified in 2003, we did not restate any
      financial results for any prior periods and believe that the identified material
      weakness did not have any material effect on the accuracy of our financial
      statements prepared with respect to any prior fiscal period.




There
      were no changes in our internal controls over financial reporting during the
      quarter ended December 31, 2005 that materially affected, or were
      reasonably likely to materially affect, our internal controls over financial
      reporting, except for the addition of ProCyte’s internal control structures.
      Management processed ProCyte transactions through existing ProCyte internal
      control structures through the second quarter of 2005, and began to process
      such
      transactions through existing PhotoMedex internal control structures in the
      third quarter of the year. Management evaluated in 2005 the other ProCyte
      internal control structures and determined what structures should be adopted,
      conformed or eliminated.




Management’s
      report on our internal controls over financial reporting can be found with
      the
      attached financial statements. The Independent Registered Public Accounting
      Firm’s attestation report on management’s assessment of the effectiveness of our
      internal control over financial reporting can also be found with the attached
      financial statements.




**Management's
      Report on Internal Control Over Financial Reporting**





Our
      management is responsible for establishing and maintaining an adequate system
      of
      internal control over financial reporting. Our system of internal control over
      financial reporting is designed to provide reasonable assurance regarding the
      reliability of financial reporting and the preparation of financial statements
      for external purposes in accordance with accounting principles generally
      accepted in the United States of America.




Our
      internal control over financial reporting includes those policies and procedures
      that:




·
            pertain
                to the maintenance of records that, in reasonable detail, accurately
                and
                fairly reflect our transactions and dispositions of  our
                assets;




·
            provide
                reasonable assurance that our transactions are recorded as necessary
                to
                permit preparation of our financial statements in accordance with
                accounting principles generally accepted in the United States of
                America,
                and that our receipts and expenditures are being made only in accordance
                with authorizations of our management and our directors;
                and




·
            provide
                reasonable assurance regarding prevention or timely detection of
                unauthorized acquisition, use, or disposition of our assets that
                could
                have a material effect on the financial statements.




Because
      of its inherent limitations, a system of internal control over financial
      reporting can provide only reasonable assurance and may not prevent or detect
      misstatements. Further, because of changes in conditions, effectiveness of
      internal controls over financial reporting may vary over time. Our system
      contains self-monitoring mechanisms, and actions are taken to correct
      deficiencies as they are identified.




Our
      management conducted an evaluation of the effectiveness of the system of
      internal control over financial reporting based on the framework in *Internal Control-Integrated Framework* issued
      by the Committee of Sponsoring Organizations of the Treadway Commission. Based
      on this evaluation, our management concluded that our system of internal control
      over financial reporting was effective as of December 31, 2005. Our management's
      assessment of the effectiveness of our internal control over financial reporting
      has been audited by Amper, Politziner & Mattia, P.C., an independent
      registered public accounting firm, as stated in their report which is included
      herein.




**Item
        9B. Other Information**
  There
        is
        nothing to report under “Other Information.”




58


**PART
      III**




**Item
      10.**  **Directors
      and Executive Officers of Registrant**




Our
      directors currently have terms which will end at our next annual meeting of
      the
      stockholders or until their successors are elected and qualify, subject to
      their
      prior death, resignation or removal. Officers serve at the discretion of the
      Board of Directors. There are no family relationships among any of our directors
      and executive officers. Our Board members are encouraged to attend meetings
      of
      the Board of Directors and the Annual Meeting of Stockholders. The Board of
      Directors held nine meetings and three unanimous written consents in lieu of
      meetings in 2005.




The
      following sets forth certain biographical information concerning our directors
      and our current executive officers.




**Name**
            
            **Position**
            
            **Age**Richard
                J. DePiano
            
            Non-Executive
                Chairman of the Board of Directors
            
            64Jeffrey
                F. O'Donnell
            
            Director,
                President and Chief Executive Officer
            
            46Dennis
                M. McGrath
            
            Chief
                Financial Officer and Vice President - Finance and
                Administration
            
            49Michael
                R. Stewart
            
            Executive
                Vice President and Chief Operating Officer
            
            48John
                F. Clifford
            
            Executive
                Vice President, Dermatology
            
            63Alan
                R. Novak
            
            Director
            
            71Warwick
                Alex Charlton
            
            Director
            
            46Anthony
                J. Dimun
            
            Director
            
            62David
                W. Anderson
            
            Director
            
            53




**Directors
      and Executive Officers**




***Richard
      J. DePiano*** was
      appointed to our Board of Directors in May 2000 and was unanimously elected
      to
      serve as Non-Executive Chairman of the Board on January 31, 2003. Mr. DePiano
      has been a director of Escalon Medical Corp., a publicly traded healthcare
      business specializing in the development and marketing of ophthalmic devices
      and
      pharmaceutical and vascular access products, since February 1996, and has served
      as its Chairman and Chief Executive Officer since March 1997. Mr. DePiano has
      been the Chief Executive Officer of the Sandhurst Company, L.P. and Managing
      Director of the Sandhurst Venture Fund since 1986. Mr. DePiano was also the
      Chairman of the Board of Directors of SLT prior to our acquisition of
      SLT.




***Jeffrey
      F. O’Donnell*** joined
      PhotoMedex in 1999 as President and CEO and has served as a member of the Board
      of Directors since that date. Prior to PhotoMedex, he joined Radiance Medical
      Systems (originally Cardiovascular Dynamics) as Vice President of Sales and
      Marketing from 1995 to 1997; from 1997 to 1999 he served as its President and
      CEO and subsequently assumed a role as non-executive chairman of the board.
      Previously, from 1994 to 1995 Mr. O’Donnell held the position of President and
      CEO of Kensey Nash Corporation. Additionally, he has held several senior sales
      and marketing management positions at Boston Scientific, Guidant and Johnson
      & Johnson Orthopedic. In addition to sitting on the Board of Directors for
      PhotoMedex, Mr. O’Donnell is currently an outside Board Member of Endologix,
      Inc., Cardiac Sciences and Replication Medical, Inc. and had served until
      December 28, 2004 on the Board of Escalon Medical Corp. He had served as an
      outside Board member of AzurTec, Inc. but resigned from that board in 2003.
      Mr.
      O’Donnell graduated from LaSalle University in 1982 with a B.S. in business
      administration.




59


***Dennis
      M. McGrath*** was
      appointed Chief Financial Officer and Vice President-Finance and Administration
      in January 2000. Mr. McGrath has held several senior level positions including
      from February 1999 to January 2000 serving as the Chief Operating Officer of
      Internet Practice, the largest division for AnswerThink Consulting Group, Inc.,
      a public company specializing in business consulting and technology integration.
      Concurrently, from August 1999 until January 2000, Mr. McGrath assumed the
      role
      of Chief Financial Officer of Think New Ideas, Inc., a public company
      specializing in interactive marketing services and business solutions. In
      addition to the financial reporting responsibilities, Mr. McGrath was
      responsible for the merger integration of Think New Ideas, Inc. and AnswerThink
      Consulting Group, Inc. From September 1996 to February 1999, Mr. McGrath was
      the
      Chief Financial Officer and Executive Vice-President-Operations of TriSpan,
      Inc., an internet commerce solutions and technology consulting company, which
      was acquired by AnswerThink. Mr. McGrath is a certified public accountant and
      graduated with a B.S. in accounting from LaSalle University in 1979. Mr. McGrath
      holds a license from the states of Pennsylvania and New Jersey as a certified
      public accountant.




***Michael
      R. Stewart*** was
      appointed as our Executive Vice President of Corporate Operations on December
      27, 2002, immediately following the acquisition of SLT and on July 19, 2005,
      he
      was appointed our Chief Operating Officer. From July 1999 to the acquisition,
      Mr. Stewart was the President and Chief Executive Officer of SLT, and from
      October 1990 to July 1999 he served as SLT’s Vice President Finance and Chief
      Financial Officer. Mr. Stewart graduated from LaSalle University with a B.S.
      in
      accounting and received an M.B.A. from LaSalle University in 1986. Mr. Stewart
      passed the CPA examination in New York in 1986.




***John
      F Clifford*** was
      appointed as our Executive Vice President on March 18, 2005, immediately
      following the acquisition of ProCyte Corporation. Mr. Clifford manages the
      sales
      of the domestic XTRAC business segment and the skincare business segment we
      acquired from ProCyte Corporation. Mr. Clifford was President and Chief
      Executive Officer and the Chairman of the Board of Directors of ProCyte
      Corporation prior to March 18, 2005. He joined ProCyte in August 1996. Before
      joining ProCyte, Mr. Clifford was from 1994 to 1996 the President of Orthofix,
      Inc. and American Medical Electronics, Dallas-area healthcare companies in
      the
      orthopedic market. From 1984 to 1994, he was employed by American Cyanamid’s
      Davis and Geck Division, a medical device company, initially as the Vice
      President of Sales and Marketing and later as Division Vice President. From
      1964
      to 1989, Mr. Clifford held various sales and marketing positions in Ethicon,
      Inc. and Iolab Corp., both Johnson & Johnson companies. Mr. Clifford holds a
      B.S. in Economics from Villanova University and an M.B.A in Finance from Drexel
      University.




***Alan
      R. Novak*** **** was
      appointed to our Board of Directors in October 1997. Mr. Novak is Chairman
      of
      Infra Group, L.L.C., an international project finance and development company.
      He is also Chairman of Lano International, Inc., a real estate development
      company. Mr. Novak is a graduate of Yale University, Yale Law School, and
      Oxford University as a Marshall Scholar. Mr. Novak practiced law at Cravath,
      Swaine & Moore and Swidler & Berlin, Chartered. His public service
      includes three years as an officer in the United States Marine Corps, a U.S.
      Supreme Court clerkship with Justice Potter Stewart, Senior Counsel to Senator
      Edward M. Kennedy, Senior Executive Assistant to Undersecretary of State, Eugene
      Rostow, and the Executive Director of President Johnson’s Telecommunications
      Task Force. Mr. Novak was appointed by President Carter and served for five
      years as Federal Fine Arts Commissioner.




***Warwick
      Alex Charlton*** was
      appointed to our Board of Directors and served as the Non-Executive Chairman
      of
      the Board of Directors from March 8, 1999 to January 31, 2003.
      Mr. Charlton is the Managing Director of True North Partners L.L.C., a
      venture capital firm with a specialty in the healthcare field. Mr. Charlton
      has 20 years of business experience, of which ten years were line management
      experience and nine years were in the consulting profession (previously with
      Booz Allen & Hamilton and the Wilkerson Group). Mr. Charlton
      received an honors degree in Marketing from the University of Newcastle and
      an
      M.B.A. from Cranfield Institute of Technology. Mr. Charlton was formerly a
      Vice President of CSC Healthcare, Inc. and serves as a member of the Board
      of
      Directors of Intercure, Inc. and as an advisor to the Board of Directors of
      Balance Pharmaceuticals, Inc. ****




***Anthony
      J. Dimun*** was
      appointed to our Board of Directors on October 3, 2003. He has served since
      May
      2001 as Chairman of Nascent Enterprises, L.L.C., a medical device venture
      advisory firm. He also has served since 1987 as the Managing Director and Chief
      Executive Officer of Strategic Concepts, Inc., a financial advisory company
      with
      specific focus on venture capital and acquisition transactions. From March
      1991
      to May 2001, Mr. Dimun served as Executive Vice President and Chief Financial
      Officer of Vital Signs, Inc., a publicly held anesthesia and respiratory medical
      device company. Mr. Dimun also serves as a member of the Board of Trustees
      of
      the New Jersey Center for Biomaterials, a non-profit collaboration of the three
      leading New Jersey universities. Prior to 1991, Mr. Dimun held positions as
      a
      Certified Public Accountant with several national accounting firms and served
      as
      Senior Vice President for an international merchant-banking firm.




60


***David
      W. Anderson*** was
      appointed to our Board of Directors on September 28, 2004. Mr. Anderson has
      been
      the President and Chief Executive Officer of Gentis, Inc since November 2004.
      He
      has over twenty years of entrepreneurial management experience in the medical
      device, orthopedics and pharmaceutical field. He has served as President and
      CEO
      of Sterilox Technologies, Inc., the world’s leader in the development and
      marketing of non-toxic biocides; Bionx Implants, Inc., a publicly traded
      orthopedic sports medicine and trauma company, and Kensey Nash Corporation,
      a
      publicly traded cardiology and biomaterials company. In addition, Mr. Anderson
      was previously Vice President of LFC Financial Corp., a venture capital and
      leasing company, where he was responsible for LFC’s entry into the healthcare
      market; and was a founder and Executive Vice President of Osteotech, Inc.,
      a
      high-technology orthopedic start-up.




**Director
      Compensation**




Directors
      who are also our employees receive no separate compensation for serving as
      directors or as members of Board committees. Directors who are not our employees
      are compensated under the 2000 Non-Employee Director Plan. Each director
      receives non-qualified options to purchase up to 35,000 shares of common stock
      on an annual basis. Each outside director receives an annual cash retainer
      of
      $20,000 and is also paid $1,000 for personal attendance at each meeting of
      the
      Board and each committee meeting held not in conjunction with meetings of the
      Board itself, and $500 for telephonic attendance at each Board or committee
      meeting, excluding meetings of limited scope and duration. We pro-rate the
      retainer for a director serving less than a full year.




**Compensation,
      Nominations and Corporate Governance and Audit Committees**




**General** .
      The
      Board maintains charters for select committees. In addition, the Board has
      adopted a written set of corporate governance guidelines and a code of business
      conduct and ethics and a code of conduct for our chief executive and senior
      financial officers that generally formalize practices that we already have
      in
      place. We have adopted a Code of Ethics on Interactions with Health Care
      Professionals and have adopted a related Comprehensive Compliance Program.
      To
      view the charters of the Audit, Compensation and Nominations and Corporate
      Governance Committees, the Code of Ethics and Comprehensive Compliance Program,
      the corporate governance guidelines and the codes of conduct and our whistle
      blower policy, please visit our website at *www.photomedex.com* (this
      website address is not intended to function as a hyperlink, and the information
      contained on our website is not intended to be a part of this Report). The
      Board
      has determined in 2005 that all members of the Board are independent under
      the
      revised listing standards of The Nasdaq Stock Market, Inc. (“Nasdaq”), except
      for Mr. O'Donnell, who is also our Chief Executive Officer.




**Compensation
      Committee** .
      Our
      Compensation Committee discharges the Board’s responsibilities relating to
      compensation of our Chief Executive Officer, other executive officers and
      directors, produces an annual report on executive compensation for inclusion
      in
      our annual proxy statement, and provides general oversight of compensation
      structure. Other specific duties and responsibilities of the Compensation
      Committee include:




·
            reviewing
                and approving objectives relevant to executive officer
                compensation;




·
            evaluating
                performance and determining the compensation of our Chief Executive
                Officer and other executive officers in accordance with those
                objectives;




·
            reviewing
                employment agreements for executive
                officers;




·
            recommending
                to the Board the compensation for our
                directors;




·
            administering
                our stock option plans (except the 2000 Non-Employee Director Stock
                Option
                Plan); and




·
            evaluating
                human resources and compensation
                strategies.




Our
      Board
      of Directors has adopted a written charter for the Compensation Committee.
      The
      Compensation Committee is composed of Messrs. Novak, Charlton, DePiano and
      Dimun. Mr. Dimun serves as the Chairman of the Compensation Committee. The
      Board
      determined in 2005 that each member of the Compensation Committee is
      "independent" under the revised listing standards of Nasdaq. The Compensation
      Committee held 14 meetings during 2005.




61


The
      Compensation Committee reviews executive compensation from time to time and
      reports to the Board of Directors, which makes all decisions. The Compensation
      Committee adheres to several guidelines in carrying out its responsibilities,
      including performance by the employees, our performance, enhancement of
      stockholder value, growth of new businesses and new markets and competitive
      levels of fixed and variable compensation. The Compensation Committee reviews
      and approves the annual salary and bonus for each executive officer (consistent
      with the terms of any applicable employment agreement), provides oversight
      for
      employee benefit plans (and changes thereto) and administers our stock option
      plans and such other employee benefit plans as may be adopted by us from time
      to
      time. The report of the Compensation Committee for 2005 is presented
      below.




**Nominations
      and Corporate Governance**  **Committee** .
      Our
      Board has established a Nominations and Corporate Governance Committee for
      the
      purpose of reviewing all Board-recommended and stockholder-recommended nominees,
      determining each nominee’s qualifications and making a recommendation to the
      full Board as to which persons should be our Board’s nominees. Our Board has
      adopted a written charter for the Nominations and Corporate Governance
      Committee. The Nominations and Corporate Governance Committee is composed of
      Messrs. Novak, DePiano and Anderson. Mr. Anderson serves as the Chairman of
      the
      Nominations and Corporate Governance Committee, Mr. McAtee having retired from
      the Board in December 2005. The Board of Directors determined in 2005 that
      each
      member of the Nominations and Corporate Governance Committee satisfies the
      independence requirements of the Commission and Nasdaq. The Nominations and
      Corporate Governance Committee held 3 meetings during 2005.




The
      duties and responsibilities of the Nominations and Corporate Governance
      Committee include:




·
            identifying
                and recommending to our Board individuals qualified to become members
                of
                our Board and to fill vacant Board
                positions;




·
            overseeing
                the compensation of non-employee directors, including administering
                the
                2000 Non-Employee Director Stock Option
                Plan;




·
            recommending
                to our Board the director nominees for the next annual meeting of
                stockholders;




·
            recommending
                to our Board director committee
                assignments;




·
            reviewing
                and evaluating succession planning for our Chief Executive Officer
                and
                other executive officers;




·
            monitoring
                the independence of our board
                members;




·
            developing
                and overseeing our corporate governance principles applicable to
                our Board
                members, officers and employees;




·
            monitoring
                the continuing education program for our directors;
                and




·
            evaluating
                annually the Nominations and Corporate Governance Committee
                charter.




Our
      Board
      of Directors believes that it is necessary that the majority of our Board of
      Directors be comprised of independent directors and that it is desirable to
      have
      at least one audit committee financial expert serving on the Audit Committee.
      The Nominations and Corporate Governance Committee considers these requirements
      when recommending Board nominees. Our Nominations and Corporate Governance
      Committee utilizes a variety of methods for identifying and evaluating nominees
      for director. Our Nominations and Corporate Governance Committee will regularly
      assess the appropriate size of the Board, and whether any vacancies on the
      Board
      are expected due to retirement or other circumstances. When considering
      potential director candidates, the Nominations and Corporate Governance
      Committee also considers the candidate’s character, judgment, diversity, age,
      skills, including financial literacy, and experience in the context of our
      needs, the needs of PhotoMedex and the existing directors. While the Nominations
      and Corporate Governance Committee has the authority to do so, we have not,
      as
      of the date of this Report, paid any third party to assist in identifying and
      evaluating Board nominees.




62


**Audit
      Committee** .
      Our
      Board of Directors has established an Audit Committee to assist the Board in
      fulfilling its responsibilities for general oversight of the integrity of our
      consolidated financial statements, compliance with legal and regulatory
      requirements, the independent auditors’ qualifications and independence, the
      performance of independent auditors and our internal audit function, and risk
      assessment and risk management. The duties of the Audit Committee
      include:




·
            appointing,
                evaluating and determining the compensation of our independent
                auditors;




·
            reviewing
                and approving the scope of the annual audit, the audit fee and the
                financial statements;




·
            reviewing
                disclosure controls and procedures, internal control over financial
                reporting, the internal audit function and corporate policies with
                respect
                to financial information;




·
            reviewing
                other risks that may have a significant impact on our financial
                statements;




·
            preparing
                the Audit Committee report for inclusion in the annual proxy
                statement;




·
            establishing
                procedures for the receipt, retention and treatment of complaints
                regarding accounting and auditing matters;
                and




·
            evaluating
                annually the Audit Committee
                charter.




The
      Audit
      Committee works closely with management as well as our independent auditors.
      The
      Audit Committee has the authority to obtain advice and assistance from, and
      receive appropriate funding from us for, outside legal, accounting or other
      advisors as the Audit Committee deems necessary to carry out its
      duties.




Our
      Board
      of Directors has adopted a written charter for the Audit Committee meeting
      applicable standards of the Commission and Nasdaq. The members of the Audit
      Committee are Messrs. DePiano, Dimun and Anderson. Mr. DePiano serves as
      Chairman of the Audit Committee. The Audit Committee meets regularly and held
      8
      meetings during 2005.




The
      Board
      of Directors determined in 2005 that each member of the Audit Committee
      satisfies the independence and other composition requirements of the Commission
      and NASDAQ. Our Board has determined that each member of the Audit Committee
      qualifies as an “audit committee financial expert” under Item 401(h) of
      Regulation S-K under the Exchange Act, and has the requisite accounting or
      related financial expertise required by applicable Nasdaq rules.




**Committee
      Interlocks and Insider Participation**




No
      interlocking relationship exists between any member of our Board or Compensation
      Committee and any member of the board of directors or compensation committee
      of
      any other companies, nor has such interlocking relationship existed in the
      past.
      However, Mr. DePiano, the Chief Executive Officer of Escalon Medical Corp.
      and
      Mr. O’Donnell, our Chief Executive Officer, also have served on the board of
      directors of Escalon Medical Corp. Neither of Mr. DePiano nor Mr. O'Donnell
      has
      served on the compensation committee of the board of directors of either
      PhotoMedex, Inc. or Escalon Medical Corp. Mr. O’Donnell resigned from the board
      of directors of Escalon on December 28, 2004.




**Stockholder
      Communications with the Board of Directors**




Our
      Board
      of Directors has established a process for stockholders to communicate with
      the
      Board of Directors or with individual directors. Stockholders who wish to
      communicate with our Board of Directors or with individual directors should
      direct written correspondence to Davis Woodward, Corporate Counsel at
      dwoodward@photomedex.com or to the following address (our principal executive
      offices): Board of Directors, c/o Corporate Secretary, 147 Keystone Drive,
      Montgomeryville, Pennsylvania 18936. Any such communication must
      contain:




·
            a
                representation that the stockholder is a holder of record of our
                capital
                stock;




·
            the
                name and address, as they appear on our books, of the stockholder
                sending
                such communication; and




·
            the
                class and number of shares of our capital stock that are beneficially
                owned by such stockholder.






63


Mr.
      Woodward or the Corporate Secretary, as the case may be, will forward such
      communications to our Board of Directors or the specified individual director
      to
      whom the communication is directed unless such communication is unduly hostile,
      threatening, illegal or similarly inappropriate, in which case Mr. Woodward
      or
      the Corporate Secretary, as the case may be, has the authority to discard the
      communication or to take appropriate legal action regarding such
      communication.




**Compliance
      with Section 16 of the Securities Exchange Act of 1934**




Section
      16(a) of the Securities Exchange Act of 1934, as amended, (the "Exchange Act")
      requires our directors and executive officers and beneficial holders of more
      than 10% of our common stock to file with the Commission initial reports of
      ownership and reports of changes in ownership of our equity securities. As
      of
      March 15, 2006, we believe that all reports needed to be filed have been filed
      for the year ended December 31, 2005. In one instance, a report evidencing
      a
      director’s exercise of warrants was not filed within the two business days
      prescribed by SEC rules.




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




**Summary
      Compensation Table**




The
      following table sets forth certain information concerning compensation of our
      Chief Executive Officer and each of the other highly compensated executive
      officers whose total compensation exceeds $100,000 (the “Named Executive
      Officers”), for the years ended December 31, 2005, 2004 and 2003:




**Annual
                Compensation**
            
            
            **Long
                  Term Compensation Awards****Name**
            
            
            **Year**
            
            
            **Salary
                ($)**
            
            
            **Bonus ($)**
            
            
            **Other**
              **Annual
                Compensation ($)**
            
            
            **Restricted
                Stock Awards ($)**
            
            
            **Securities**
              **Underlying**
              **Options/**
              **SARs
                (#)**
            
            
            **LTIP**
              **Payouts**
              **($)**
            
            
            **Payouts**
              **All
                other**
              **Compensation**
              **($)**Jeffrey
                F. O'Donnell (CEO)
            
            
            2005
            
            
            350,000
            
            
            92,000
            
            
            12,000
            
            
            0
            
            
            150,000
            
            
            0
            
            
            02004
            
            
            350,000
            
            
            150,000
            
            
            12,000
            
            
            0
            
            
            150,000
            
            
            0
            
            
            02003
            
            
            350,000
            
            
            150,000
            
            
            12,000
            
            
            0
            
            
            125,000
            
            
            0
            
            
            0Dennis
                M. McGrath
            
            
            2005
            
            
            285,000
            
            
            60,000
            
            
            12,000
            
            
            0
            
            
            140,000
            
            
            0
            
            
            02004
            
            
            285,000
            
            
            100,000
            
            
            12,000
            
            
            0
            
            
            125,000
            
            
            0
            
            
            02003
            
            
            285,000
            
            
            100,000
            
            
            12,000
            
            
            0
            
            
            110,000
            
            
            0
            
            
            0Michael
                R. Stewart
            
            
            2005
            
            
            255,671
            
            
            43,750
            
            
            12,000
            
            
            0
            
            
            140,000
            
            
            0
            
            
            02004
            
            
            235,000
            
            
            70,000
            
            
            12,000
            
            
            0
            
            
            75,000
            
            
            0
            
            
            02003
            
            
            235,000
            
            
            70,000
            
            
            12,000
            
            
            0
            
            
            75,000
            
            
            0
            
            
            0John
                F. Clifford
            
            
            2005
            
            
            228,860
            
            
            0
            
            
            9,000
            
            
            0
            
            
            250,000
            
            
            0
            
            
            0




“Bonus”
      in the foregoing table is the bonus earned in the period, even though it will
      have been paid in a subsequent period. “Other Annual Compensation” includes a
      car allowance. **** “Stock
      Options” are reflected in the year in which the options were granted.




**Employment
      Agreement with Jeffrey F. O'Donnell** ***.*** In
      November 1999, we entered into an employment agreement with Jeffrey F. O'Donnell
      to serve as our President and Chief Executive Officer and amended and restated
      that agreement in August 2002. This agreement has been renewed through December
      31, 2006 and will expire then if due notice is given by December 1, 2006. If
      due
      notice is not given, then the agreement will renew for an additional year and
      thereafter on an annual basis.  Mr.
      O'Donnell's current base salary is $350,000 per year. If we terminate Mr.
      O'Donnell other than for "cause" (which definition includes nonperformance
      of
      duties or competition of the employee with our business), then he will receive
      severance pay equal to $350,000, payable over 12 months. If a change of control
      occurs, Mr. O’Donnell becomes entitled to severance pay by virtue of provisions
      related to the change of control, then he may become entitled to severance
      equal
      to 200% of his then base salary in a lump sum.




64


On
      January 15, 2006, Mr. O’Donnell was granted 200,000 incentive stock options
      (having an exercise price of $2.50 and a life of 10 years, vesting ratably
      over
      the first 5 years from the 2005 Equity Compensation Plan. In the event of a
      sale
      of the Company, the options will become fully vested and exercisable). He was
      also awarded from the 2005 Equity Compensation Plan and as of the same date
      525,000 restricted shares of our common stock, having a purchase price
      at $0.01 per share. Shares that are purchased will be held in escrow by us
      for
      as long as they are subject to our right of repurchase. Our right of repurchase
      will continue for so long as the shares remain subject to performance
      restrictions and time restrictions.




As
      to the
      performance restrictions, our repurchase right will lapse if the trading price
      of our common stock attains certain targets above the 2005 Average Price, which
      by contract was set at $2.50, being higher than the average fair market value
      (generally the closing price of our common stock) for each of the trading days
      in the 90-day period ending on December 28, 2005. For the years 2006 through
      2010, the Average Price will mean the average fair market value of our common
      stock for each of the trading days in the last three months of the calendar
      year. Our right of repurchase shall lapse with respect to 20% of the purchased
      shares if the 2006 Average Price equals or exceeds the 2006 Target Price, where
      the term “2006 Target Price” will equal 125% of the 2005 Average Price, or
      $3.13, and where the lapsing shall be effective as of December 31, 2006.
      Likewise, our right of repurchase will lapse with respect to 20% of the
      purchased shares if the 2007 Average Price equals or exceeds the 2007 Target
      Price, where the term “2007 Target Price” will equal 125% of the 2006 Target
      Price, or $3.91, and so on. For 2010, if the 2010 Average Price equals or
      exceeds the 2010 Target Price of $7.64, then our right of repurchase will lapse
      with respect to all of the purchased shares for which our repurchase right
      has
      not previously lapsed, and such lapsing will be effective as of December 31,
      2010. As to time restrictions, to the extent that any of the purchased shares
      remain subject to our right of repurchase and therefore are unvested, they
      will
      vest ratably (i.e. one-third) on the fifth, sixth and seventh anniversaries
      of
      the award of the restricted shares.




However,
      in the event of a transaction that constitutes a change in control of the
      Company, our right of repurchase will lapse with respect to the performance
      restrictions on the restricted shares that are unvested immediately prior to
      the
      consummation of such transaction as follows. Where the per-share purchase price
      paid or deemed paid in connection with such change in control is equal to or
      greater than a Target Price described above, then it shall be deemed that the
      Target Price has been attained as of the change in control, and our repurchase
      rights applicable to such Target Price will lapse. Shares that have not vested
      on a change of control will remain subject to such repurchase restriction.
      Such
      shares still subject to repurchase shall vest ratably and monthly over the
      period of time (but not greater than 36 months) that the acquirer in the change
      in control event contracts for Mr. O’Donnell's services. If the acquirer opts
      not to contract for such services, then the unvested balance of shares will
      vest
      as of the change in control event.




**Employment
      Agreement with Dennis M. McGrath.** *.* In
      November 1999, we entered into an employment agreement with Dennis M. McGrath
      to
      serve as our Chief Financial Officer and Vice President-Finance and
      Administration and amended and restated that agreement in August 2002. This
      agreement has been renewed through December 31, 2006 and will expire then if
      due
      notice is given by December 1, 2006. If due notice is not given, then the
      agreement will renew for an additional year and thereafter on an annual basis.
      Mr. McGrath's current base salary is $285,000 per year.  If
      we
      terminate Mr. McGrath other than for "cause" (which definition includes
      nonperformance of duties or competition of the employee with our business),
      then
      he will receive severance pay equal to $285,000, payable over 12 months. If
      a
      change of control occurs, Mr. McGrath becomes entitled to severance pay by
      virtue of provisions related to the change of control, then he may become
      entitled to severance equal to 200% of his then base salary in a lump sum.




On
      January 15, 2006, Mr. McGrath was awarded from the 2005 Equity Compensation
      Plan
      335,000 restricted shares of our common stock, having a purchase price at $0.01
      per share. The terms and conditions applicable to Mr. McGrath’s award of
      restricted stock are the same as the terms and conditions applicable to the
      award to Mr. O’Donnell, which are discussed above.




65


**Employment
      Agreement with Michael R. Stewart.** Effective
      December 27, 2002, Michael R. Stewart became the Company’s Executive Vice
      President of Corporate Operations, pursuant to an employment agreement. Mr.
      Stewart became our Chief Operating Officer on July 19, 2005, at which time
      he
      was granted 40,000 options. Mr. Stewart’s current base salary is $250,000 per
      year. This agreement has renewed through December 31, 2006  and
      will
      expire then if due notice is given by December 1, 2006. If due notice is not
      given, then the agreement will renew for an additional year and thereafter
      on an
      annual basis. If we terminate Mr. Stewart other than for “cause” (which
      definition includes nonperformance of duties or competition of the employee
      with
      our business), then he will receive severance pay equal to his base pay, payable
      over 12 months. If a change of control occurs, Mr. Stewart becomes entitled
      to
      severance pay by virtue of provisions related to the change of control, then
      he
      may become entitled to severance equal to 200% of his then base salary, payable
      over 12 months.




**Employment
      Agreement with John F. Clifford.** Effective
      March 18, 2005, **** John
      F.
      Clifford became our Executive Vice President, Dermatology, pursuant to a
      three-year employment agreement. Mr. Clifford’s base salary is $300,000. He will
      be eligible to receive an annual bonus of up to 50% of his annual base salary,
      subject to criteria established by the Board of Directors, and an automobile
      allowance of $1,000 per month. If Mr. Clifford's employment is terminated due
      to
      expiration of the three-year employment term under the agreement, he will,
      in
      addition to compensation and benefits due on the last day of actual employment,
      receive $300,000 in twelve monthly installments. In the event that his
      employment is terminated before the end of the three-year employment term,
      other
      than for cause, death, disability, or resignation without good reason (in each
      case, as those terms are defined in the agreement), Mr. Clifford would be
      entitled, absent other circumstances, to receive severance benefits,
      including: payment of an amount equal to the greater of the amount of two years'
      base salary at the date of termination or the remaining amount of unpaid base
      salary that he would have received if the agreement did not terminate before
      the
      end of the three-year employment term; payment of the amount of bonus that
      would
      have been due during the year of termination; payment or reimbursement of health
      care benefits for the remainder of the three-year employment term; and immediate
      vesting of all incentive stock options. In the event that a change of control
      of
      the Company occurs during the three-year employment term and Mr. Clifford is
      thereafter terminated other than for cause or voluntarily resigns within 60
      days
      after there occurs a material reduction in compensation or benefits, a material
      change in status, working conditions or management, or a material change in
      business objectives and policies, Mr. Clifford would be entitled to receive,
      as
      severance, a payment over twelve months equal to 200%, of his current
      compensation, including the base salary, bonus and other benefits.




**Termination
      of Employment and Change of Control Agreements**




We
      have
      employment agreements with Messrs. O'Donnell, McGrath, Stewart and Clifford.
      These agreements provide for severance upon termination of employment, whether
      in context of a change of control or not. We also have arrangements with other
      key employees under which we would be obliged to pay compensation upon their
      termination outside a context of change of control, and, for a lesser number
      of
      key employees, by virtue of a change of control. If all such executive officers
      and key employees were terminated other than for cause and not within a change
      of control, we would have had an aggregate commitment of approximately
      $2,460,000 at December 31, 2005 for severance and related compensation. However,
      the obligation for such compensation that would arise in favor of the executive
      officers and certain key employees by virtue of a change of control would have
      been approximately $2,549,000 at December 31, 2005.




66


**Option/SAR
      Grants Table**




The
      following table sets forth certain information concerning grants of stock
      options to our executive officers for the year ended December 31, 2005. It
      does
      not include restricted shares of common stock which were granted to Messrs.
      O’Donnell and McGrath on January 15, 2006:




**Individual
                Grants**
            
            
            
            
            
            
            
            
            
            **Potential
                Realizable Value**
              **at
                Assumed Annual Rate of**
              **Stock
                Price Appreciation**
              **For
                Option Term (1)****(a)**
            
            
            **(b)**
            
            
            **(c)**
            
            
            
            **(d)**
            
            
            **(e)**
            
            
            **(f)**
            
            
            **(g)****Name**
            
            
            **Number
                of Securities Underlying Options/SARs Granted
                (#)**
            
            
            **%
                of Total Options/SARs Granted to Employees In**
              **Fiscal
                Year**
            
            
            
            **Exercise
                Or**
              **Base
                Price ($/Share)**
              **(1)**
            
            
            **Expiration**
              **Date
                (1)**
            
            
            **5%
                ($)**
            
            
            **10%
                ($)**Jeffrey
                F. O’Donnell
            
            
            150,000
            
            
            10.27%
            
            
            $
            2.45
            
            
            3/1/10
            
            $
            —
            
            $
            55,716Dennis
                M. McGrath
            
            
            140,000
            
            
            9.59%
            
            
            $
            2.45
            
            
            3/1/10
            
            $
            —
            
            $
            51,889Michael
                R. Stewart
            
            
            100,000
            
            
            6.85%
            
            
            $
            2.45
            
            
            3/1/10
            
            $
            —
            
            $
            37,063Michael
                R. Stewart
            
            
            40,000
            
            
            2.45%
            
            
            $
            2.63
            
            
            7/19/10
            
            $
            —
            
            $
            3,301John
                F. Clifford
            
            
            250,000
            
            
            17.12%
            
            
            $
            2.78
            
            
            4/4/10
            
            $
            —
            
            $
            4,802





1.
            This
                chart assumes a market price of $1.78 for the common stock, the closing
                sale price for our common stock in the Nasdaq National Market System
                as of
                December 31, 2005, as the assumed market price for the common stock
                with
                respect to determining the "potential realizable value" of the shares
                of
                common stock underlying the options described in the chart, as reduced
                by
                any lesser exercise price for such options. Further, the chart assumes
                the
                annual compounding of such assumed market price over the relevant
                periods,
                without giving effect to commissions or other costs or expenses relating
                to potential sales of such securities. Our common stock has a limited
                trading history. These values are not intended to forecast the possible
                future appreciation, if any, price or value of the common
                stock.




**Option
      Exercises and Year-End Values**




The
      following table sets forth information with respect to the exercised and
      unexercised options to purchase shares of common stock for our executive
      officers held by them at December 31, 2005:




**Number
                  of Securities**
                **Underlying
                  Unexercised**
                **Options
                  at**
                **December
                  31, 2005**
            
            
            **Value
                  of Unexercised**
                **In
                  the Money Options at**
              **December
                31, 2005****(2)****Name**
            
            
            **Shares**
                  **Acquired
                    on Exercise**
            
            
            **Value**
              **Realized****(1)**
            
            
            **Exercisable**
            
            
            **Unexercisable**
            
            
            **Exercisable**
            
            
            **Unexercisable**Jeffrey
                F. O’Donnell
            
            
            0
            
            
            0
            
            
            300,000
            
            
            250,000
            
            $
            98,750
            
            $
            7,500Dennis
                M. McGrath
            
            
            0
            
            
            0
            
            
            196,250
            
            
            288,750
            
            $
            86,900
            
            $
            6,600Michael
                R. Stewart
            
            
            0
            
            
            0
            
            
            225,000
            
            
            215,000
            
            $
            —
            
            $
            —John
                F. Clifford
            
            
            0
            
            
            0
            
            
            397,320
            
            
            250,000
            
            $
            112,905
            
            $
            —




(1)
              Represents
                an amount equal to the number of options multiplied by the difference
                between the closing price for the common stock in the Nasdaq National
                Market System on the date of exercise and any lesser exercise
                price.(2)
              Represents
                an amount equal to the number of options multiplied by the difference
                between the closing price for the common stock in the Nasdaq National
                Market System on December 31, 2005 ($1.78 per share) and any lesser
                exercise price. Only “in the money” options are
                included.




67


**Compensation
      Committee Report on Executive Compensation**




The
      Compensation Committee of the Board of Directors is composed solely of directors
      who are not our current or former employees, and each is independent under
      the
      revised listing standards of The Nasdaq Stock Market, Inc. The Board of
      Directors has delegated to the Compensation Committee the responsibility to
      review and approve our compensation and benefits plans, programs and policies,
      including the compensation of the chief executive officer and our other
      executive officers as well as middle-level management and other key employees.
      The Compensation Committee administers all of our executive compensation
      programs, incentive compensation plans and equity-based plans and provides
      oversight for all of our other compensation and benefit programs.




The
      Compensation Committee intends to govern and administer compensation plans
      to
      support the achievement of our long-term strategic objectives, to enhance
      stockholder value, to attract, motivate and retain highly qualified employees
      by
      paying them competitively and rewarding them for their own and our success,
      and,
      to the extent consistent with these objectives, to maximize the deductibility
      of
      compensation for tax purposes. However, the Compensation Committee may decide
      to
      exceed the tax deductible limits established under Section 162(m) of the
      Internal Revenue Code of 1986, as amended (the "Code") when such a decision
      appears to be warranted based upon competitive and other factors.




The
      key
      components of the compensation program for executive officers are base salary
      and bonus, and long-term incentives in the form of stock options and now, under
      the 2005 Equity Compensation Plan, in the form of restricted shares of our
      common stock. These components are administered with the goal of providing
      total
      compensation that is competitive in the marketplace, recognizes meaningful
      differences in individual performance and offers the opportunity to earn
      superior rewards when merited by individual and corporate
      performance.




***Base
      Salaries*** Base
      salaries for our executive officers are designed to provide a base pay
      opportunity that is appropriately competitive within the marketplace. As an
      officer's level of responsibility increases, a greater proportion of his or
      her
      total compensation will be dependent upon our financial performance and stock
      price appreciation rather than base salary. Adjustments to each individual’s
      base salary are made in connection with annual performance reviews in addition
      to the assessment of market competitiveness.




***Bonus*** At
      the
      outset of a fiscal year, the Compensation Committee establishes a bonus program
      for executive officers and other managers and key employees eligible to
      participate in the program. The program is based on a financial plan for the
      fiscal year and other business factors. The amount of bonus, if any, hinges
      on
      corporate performance and financial condition and on the performance of the
      participant in the program. A program will typically allow some partial or
      discretionary awards based on an evaluation of the relevant factors. Provision
      for bonus expense is typically made over the course of a fiscal year. The
      provision becomes fixed based on the final review of the Committee, which is
      usually made after the financial results of the fiscal year have been reviewed
      by our independent accountants.




***Long-Term
      Incentives*** **** Grants
      of
      stock options under our stock option plans are designed to provide executive
      officers and other managers and key employees with an opportunity to share,
      along with stockholders, in our long-term performance. Stock option grants
      are
      generally made annually to all executive officers, with additional grants being
      made following a significant change in job responsibility, scope or title or
      a
      significant achievement. The size of the option grant to each executive officer
      is set by the Compensation Committee at a level that is intended to create
      a
      meaningful opportunity for stock ownership based upon the individual's current
      position with us, the individual's personal performance in recent periods and
      his or her potential for future responsibility and promotion over the option
      term. The Compensation Committee also takes into account the number of unvested
      options held by the executive officer in order to maintain an appropriate level
      of equity incentive for that individual. The relevant weight given to each
      of
      these factors varies from individual to individual. Stock options granted under
      the various stock option plans generally have had a four-year vesting schedule
      depending upon the size of the grant, and generally have been set to expire
      five
      years from the date of grant. Going forward, the Committee intends that such
      grants will be for 10 years and vest over 5 years. The exercise price of options
      granted under the stock option plans is at no less than 100% of the fair market
      value of the underlying stock on the date of grant. The number of stock options
      granted to each executive officer is determined by the Compensation Committee
      based upon several factors, including the executive officer’s salary grade,
      performance and the estimated value of the stock at the time of grant, but
      the
      Compensation Committee has the flexibility to make adjustments to those factors
      at its discretion. Similar criteria are applied in making awards of restricted
      shares of our common stock for the 2005 Equity Compensation Plan. To encourage
      our executive officers to have a greater stake in the equity of the Company,
      the
      Committee recommended, and the Board of Directors and the Company stockholders
      approved, the 2005 Investment Plan.




68


***CEO
      Compensation*** **** For
      2005,
      Mr. O'Donnell's base salary and stock option grant were determined in accordance
      with the criteria described above. Mr. O'Donnell earned $350,000 in base salary
      compensation during 2005. He was awarded a bonus of $92,000 for
      2005.




In
      March
      2005, Mr. O'Donnell was granted an option to purchase 150,000 shares of our
      common stock at 100% of fair market value on the date of grant, or $2.45 per
      share. The grant reflects the Compensation Committee’s assessment of the
      substantial contributions made by Mr. O'Donnell to the long-term growth and
      performance of the Company. During 2005, options granted to Mr. O’Donnell in
      1999 and 2000, amounting to 650,000 options, expired. The Committee recommended,
      and the Board of Directors and Company stockholders approved, an award of
      525,000 restricted shares of our common stock and a grant of 200,000 options
      form the 2005 Equity Compensation Plan. The award and grant were effected on
      January 15, 2006.




***Tax
      Deductibility Considerations*** Section
      162(m) of the Code places a $1,000,000 limit on the amount of other than
      performance-based compensation for the chief executive officer and each of
      the
      other four most highly compensated executed officers that we may deduct for
      tax
      purposes. It is the Compensation Committee's general objective to administer
      compensation programs that are in compliance with the provisions of Section
      162(m). The Compensation Committee has been advised that based upon prior
      stockholder approval of the material terms of our stock option plans,
      compensation under these plans is excluded from this limitation, provided that
      the other requirements of Section 162(m) are met. However, when warranted based
      upon competitive and other factors, the Compensation Committee may decide to
      exceed the tax deductible limits established under Section 162(m) Code. The
      base
      salary provided to Mr. O'Donnell in 2005 did not exceed the limits under Section
      162(m) for tax deductibility, and he exercised no options in 2005 or 2004.




**Compensation
      Committee**




Anthony
                  J. Dimun
              Richard
                  DePiano
              Warwick
                  Alex Charlton
              Alan
                  R. Novak




**Stock
      Option Plans - General**




At
      the
      Annual Meeting of Stockholders on December 28, 2005, the stockholders adopted
      the 2005 Equity Compensation Plan, which will be the principal means by which
      officers, other employees and consultants will receive equity-based compensation
      in PhotoMedex. The stockholders also adopted the 2005 Investment Plan, which
      is
      reserved for executive officers. The 2000 Non-Employee Director Stock Option
      Plan will continue as the means by which outside directors are granted
      equity-based compensation. With respect to all other equity-based plans were,
      as
      of December 28, 2005, we intend that such plans will continue until they expire
      or all options outstanding under than have either expired or been canceled
      or
      exercised and that no new grants may be made from these plans in the future.
      All
      plans were amended to conform to the requirements of Section 409A of the Code.
      The Compensation Committee administers all plans, but for the 2000 Non-Employee
      Director Stock Option Plan, which is administered by the Nominations and
      Corporate Governance Committee.




**2005
      Equity Compensation Plan**




***General
      Purpose.*** The
      general purposes of the 2005 Equity Compensation Plan (the “2005 Equity Plan”)
      are to establish incentives designed to attract, recognize, reward and retain
      competent executive and key employees, as well as independent consultants,
      whose
      performance, contribution and skills are critical to us, and to promote the
      increased ownership of common stock among our executives and key employees
      in
      order to increase their proprietary interest in our business. Our independent
      directors will not receive awards under the 2005 Equity Plan, but rather will
      continue to be compensated under the 2000 Non-Employee Director Stock Option
      Plan. The 2005 Equity Plan was adopted by the Board of Directors on November
      9,
      2005 and approved by the stockholders on December 28, 2005. The Plan will
      continue for ten years after it was first approved by the stockholders, i.e.
      until December 28, 2015. The following discussion summarizes certain aspects
      of
      the 2005 Equity Plan, but is qualified in its entirety by reference to the
      2005
      Equity Compensation Plan, which was attached as “Exhibit A” to our Proxy
      Statement filed with the Commission on November 15, 2005.




69


***Shares
      Subject to the 2005 Equity Plan.*** We have
      reserved for issuance up to 3,160,000 shares of common stock under the 2005
      Equity Plan. If shares of common stock are forfeited for any reason, prior
      to
      the lapsing of the applicable restrictions, the forfeited shares will become
      available for new awards in accordance with the terms of the 2005 Equity Plan.
      If any award granted under the 2005 Equity Plan for any reason expires or
      otherwise terminates without having vested in full, the common stock not vested
      under such award will again become available for new awards under the 2005
      Equity Plan. We have awarded 860,000 shares of restricted stock and 200,000
      stock options out of the 2005 Equity Plan on March 15, 2006, and have
      granted various consultants and employees 882,000 stock options between January
      1, 2006 and March 15, 2006.




***Administration
      of and Eligibility under 2005 Equity Plan.*** The 2005
      Equity Plan, as adopted, provides for the award of shares of common stock to
      our
      executive and other key employees, including those of our subsidiaries, as
      an
      incentive to remain in the employ of or to provide services to us and our
      subsidiaries, as well as awards to independent consultants. The 2005 Equity
      Plan
      authorizes the issuance of awards to be awarded by a committee (the “Plan
      Committee”) established by the Board of Directors to administer the 2005 Equity
      Plan. The Plan Committee will be the Compensation Committee of the Board of
      Directors or such other similar committee as may in the future be designated
      by
      the Board of Directors to perform those functions presently being performed
      by
      the Compensation Committee. The Plan Committee will consist of at least three
      members, each of whom will be a non-employee director, as such term is defined
      under Rule 16b-3 of the Exchange Act, will qualify as an outside director,
      for
      purposes of Section 162(m) of the Code and will comply with the listing
      standards of the primary trading market or securities exchange on which the
      common stock then trades.




The
      terms
      and conditions of each award will be determined by the Plan Committee, in its
      sole and absolute discretion, and may change from time to time. Our officers
      and
      key employees, as well as independent consultants, are eligible to receive
      awards under the 2005 Equity Plan. However, the Plan Committee will have sole
      and absolute discretion to determine the persons to whom awards will be made.
      The terms and conditions of separate awards need not be identical, but awards
      will include (through incorporation of provisions of the 2005 Equity Plan by
      reference in the agreement embodying the award or otherwise) the substance
      of
      the terms and conditions of the 2005 Equity Plan.




Subject
      to the terms and conditions of the 2005 Equity Plan, the Plan Committee will
      have the sole authority to: (a) interpret conclusively the provisions of the
      2005 Equity Plan and decide all questions of fact arising in its application;
      (b) adopt, amend and rescind rules and regulations relating to the 2005 Equity
      Plan; (c) determine the executive and other key employees, as well as
      independent consultants, to whom awards may be made and the timing, method
      and
      amount of each such award; and (d) make any other determinations, exercise
      such
      powers and perform such acts the Plan Committee deems necessary or advisable,
      subject only to those determinations, powers and acts which may be reserved
      to
      the Board of Directors. The Board of Directors, in the exercise of this power,
      may correct any defect, omission or inconsistency in the 2005 Equity Plan or
      in
      any award, in a manner and to the extent it deems necessary or expedient to
      conform them to applicable provisions of law or to make the 2005 Equity Plan
      fully effective.




***Recipient
      Agreements.*** The Plan
      Committee may require that each recipient enter into a written agreement with
      us, which will set forth all the terms and conditions of the award. The award
      agreement will contain such other terms, provisions and conditions not
      inconsistent herewith, as shall be determined by the Plan Committee. Following
      is a description of terms and conditions that are expected to apply to the
      various forms of awards.




*Stock
      Options.* The
      Plan
      Committee may grant incentive stock options (“ISOs”) under Section 422 of the
      Code. ** Except
      for ISOs granted to stockholders possessing more than ten percent (10%) of
      the
      total combined voting power of all classes of the securities of PhotoMedex
      or
      its subsidiaries to whom such ownership is attributed on the date of grant
      ("Ten
      Percent Stockholders"), the exercise price of each ISO must be at least 100%
      of
      the fair market value of our common stock, based on the closing sales price
      of
      the common stock as of the date prior to the date of grant. ISOs granted to
      Ten
      Percent Stockholders must be at an exercise price of not less than 110% of
      such
      fair market value. ISOs will vest in accordance with a schedule set by the
      Plan
      Committee; if the Committee sets no schedule, then the 2005 Equity Plan provides
      as a benchmark that ISOs will vest ratably as of the first five anniversaries
      of
      the date of grant. Each ISO must be exercised, if at all, within ten (10) years
      from the date of grant, but, within five (5) years of the date of grant in
      the
      case of ISO's granted to Ten Percent Stockholders. The aggregate fair market
      value (determined as of the time of the grant of the ISO) of the common stock
      with respect to which the ISOs are exercisable for the first time by the
      optionee during any calendar year shall not exceed $100,000. If this threshold
      is exceeded, the ISOs accounting for the excess are automatically converted
      to
      non-statutory (non-qualified) stock options (“NSOs”).




70


The
      Plan
      Committee may also grant NSOs. Consistent with Section 409A of the Code, the
      exercise price of a NSO will never be less than 100% of the fair market value,
      based on the closing sales price of the common stock on the date prior to the
      date of grant of the option. The exercise period for each NSO will be determined
      by the Committee at the time such option is granted, but in no event will such
      exercise period exceed 10 years from the date of grant. NSOs will vest in
      accordance with a schedule set by the Plan Committee; if the Committee sets
      no
      schedule, then the 2005 Equity Plan provides as a benchmark that NSOs will
      vest
      ratably as of the first five anniversaries of the date of grant.




The
      Committee may allow an optionee to pay the exercise price of any option, and
      any
      associated withholding taxes, not only by means of cash but also by means of
      shares of our common stock.




*Stock
      Appreciation Rights.* Each
      stock appreciation right (“SAR”) granted under the 2005 Equity Plan will entitle
      the holder thereof, upon the exercise of the SAR, to receive from the Company,
      in exchange therefore, an amount equal in value to the excess of the fair market
      value of one share of common stock on the date of exercise over the fair market
      value of one share of our common stock on the date of grant (or in the case
      of
      an SAR granted in connection or tandem with an option, the excess of the fair
      market of one share of common stock at the time of exercise over the option
      exercise price per share under the option to which the SAR relates), multiplied
      by the number of shares of common stock covered by the SAR or the option, or
      portion thereof, that is surrendered.




SARs
      will
      be exercisable only at the time or times established by the Plan Committee.
      If
      an SAR is granted in connection with an option, the SAR will be exercisable
      only
      to the extent and on the same conditions that the related option could be
      exercised. The Plan Committee may impose any conditions upon the exercise of
      an
      SAR or adopt rules and regulations from time to time affecting the rights of
      holders of SARs.




*Restricted
      Stock.* The Plan
      Committee may award shares of our common stock to participants in the 2005
      Equity Plan. The purchase price of the stock, if any, will be set by the
      Committee, but shall never be less than the par value of the shares. Awards
      may
      be subject to restrictions conditioned on the lapse of time and/or conditioned
      on the attainment of performance standards, and if both types of conditions
      are
      imposed, the Plan Committee may provide that upon the fulfillment of the
      performance conditions, the time conditions may lapse. Subject to the discretion
      of the Committee, the conditions applicable to an award of shares will lapse
      ratably (i.e. one-third) on the fifth, sixth and seventh anniversaries of the
      award. Although we will hold restricted shares in escrow so long as the shares
      remain subject to forfeiture, the shares may be voted by the recipient and
      will
      be treated as outstanding.




*Stock
      Purchase Rights* .
      The
      Plan Committee may award to a participant the right to purchase shares of our
      common stock. We shall retain the right to repurchase any such shares, at the
      same price paid by the recipient, after the recipient is terminated. Our
      retained repurchase right will lapse ratably over the first five anniversaries
      of the award of the purchase right to the recipient. Notwithstanding the above,
      we shall have no rights to repurchase any such shares if such rights or such
      repurchase would trigger taxation to the participant under Section 409A of
      the
      Code. The Committee shall not enter into any such repurchase arrangement except
      upon the written advice of counsel.




*Unrestricted
      Stock.* The
      Committee may award to a participant shares of our common stock, with no
      restrictions. **




71


***Adjustments
      Resulting from Changes in Capitalization.*** If any
      change is made in the common stock subject to the 2005 Equity Plan, or subject
      to any award granted under the 2005 Equity Plan (through reclassification,
      stock
      dividend, stock split, combination of shares, exchange of shares, change in
      corporate structure or other transaction not involving the receipt of
      consideration by us), the maximum number of shares subject to the 2005 Equity
      Plan, the maximum number of shares which may be granted to a recipient in a
      calendar year, and the class(es) and number of shares and price per share of
      stock subject to outstanding awards shall be proportionately adjusted. Such
      adjustment shall be made by the Board of Directors or the Plan Committee, the
      determination of which shall be final, binding and conclusive. (The conversion
      of any of our convertible securities will not be treated as a “transaction not
      involving the receipt of consideration.”)




***Termination
      and Amendment of the 2005 Equity Plan.*** The
      Board of Directors may terminate or amend the 2005 Equity Plan at any time,
      except that awards then outstanding will not be adversely affected thereby
      without the written consent of the respective recipients holding such awards.
      The Board of Directors may make such amendments to the 2005 Equity Plan as
      it
      shall deem advisable, except that the approval by our stockholders in accordance
      with the laws of Delaware within 12 months after the adoption of the amendment
      will be required for any amendment which would: (i) materially modify the
      requirements as to eligibility for awards under the 2005 Equity Plan; (ii)
      materially increase the benefits accruing to recipients under the 2005 Equity
      Plan; or (iii) be required under applicable law or the listing standards of
      the
      market or exchange on which the common stock then trades. The Board may in
      its
      sole discretion submit any other amendment to the 2005 Equity Plan for
      stockholder approval, including, but not limited to, amendments to the Plan
      intended to satisfy the requirements of Section 162(m) of the Code regarding
      the
      exclusion of performance-based compensation from the limit on corporate
      deductibility of compensation to certain executive officers.




In
      the
      event of a transaction involving our dissolution or liquidation, recipients
      of
      options, SARs or stock purchase rights may exercise their rights until 10 days
      before the transaction. The Committee in its discretion may provide that any
      restrictions on shares acquired from such exercise will lapse and may further
      provide that rights not otherwise exercisable may become so. Any rights not
      exercised by the transaction will terminate immediately before the
      transaction.




In
      the
      event of a change in control of PhotoMedex, all rights of recipients of awards
      shall become fully exercisable and immediately vested, except that in the case
      of restricted stock that is subject to a performance restriction based on the
      price (the “Milestone Price”) of our common stock, our repurchase rights
      applicable to such restricted stock shall lapse with respect to a change in
      control event only if the price per share to be paid in connection with such
      change in control event is equal to or greater than the Milestone Price. 
The unvested balance of such shares shall vest ratably and monthly over the
      period of time (but not greater than 36 months) that the acquirer in the change
      in control event contracts for the services of the person who was awarded the
      restricted stock. If the acquirer opts not to contract for such services, then
      the unvested balance of shares shall vest as of the change in control event.
      A
      change in control results from the acquisition by any one person, or group
      of
      persons acting in concert, of more than 50% of the voting power of our capital
      stock. A change in control also results from a “Sale of the Company.” A Sale of
      the Company occurs on: (a) our consolidation or merger into or with a successor
      entity such that our stockholders own less than a majority of the shares of
      stock of such entity; or (b) a sale or other disposition of all, or
      substantially all, of our assets to a successor entity. In the event of a Sale
      of the Company, awards made under the 2005 Equity Plan are to be assumed, or
      substituted with equivalent rights, by the successor entity. If the successor
      entity declines to do so, then each holder of an award shall have not less
      than
      20 days before the consummation of the Sale of the Company to exercise his
      or
      her rights, and all such rights shall become fully exercisable during such
      20
      day period.




***Effect
      of Termination of Recipient.*** An award
      under the 2005 Equity Plan is generally subject to the condition that the
      recipient continue to provide services to us. For purposes of the 2005 Equity
      Plan, the term “termination” means the ceasing to be a service provider to us,
      whether as an employee or as a consultant.




*Options.* If a
      recipient is terminated for cause, all unexercised options are forfeited. If
      a
      recipient is terminated under other circumstances, he or she will have generally
      three months in which to exercise any vested options, except in the case of
      termination due to disability or death, in which cases the vested options many
      be exercised for 12 months.




72


*Stock
      Appreciation Rights.* The
      Committee has the power to terminate any SARs in the event of a recipient’s
      termination.




*Restricted
      Stock.* If a
      recipient voluntarily terminates his or her employment or consultancy with
      us or
      if we terminate such employment or consultancy for cause, then any shares of
      restricted stock still subject to forfeiture shall revert to us; if the
      employment or consultancy is terminated for any other reason, then any shares
      still subject to forfeiture shall also revert to us, unless the Plan Committee,
      in its discretion, decides otherwise.




*Stock
      Purchase Rights.* Under
      the 2005 Equity Plan, we have the right, in the event of a recipient’s voluntary
      or involuntary termination to repurchase stock which a recipient purchased
      under
      a stock purchase agreement. We may do so at the same consideration paid by
      the
      recipient to the extent that the purchased shares remain subject to our right
      of
      repurchase.




***Certain
      Federal Income Tax Considerations.*** Awards
      granted under the 2005 Equity Plan generally have the federal income tax
      consequences discussed below.




*Corporate
      business deduction.* Generally,
      we will be entitled to a tax deduction in the same amount as the ordinary income
      recognized by a recipient with regard to the award. In order to secure such
      deduction in the case of the exercise of NSOs, we must fulfill such withholding
      tax obligations as may be imposed on us.




However,
      Section 162(m) of the Code imposes a limit on corporate tax deductions for
      compensation in excess of $1 million per year paid by a public company to its
      Chief Executive Officer or any of the next four highest paid executive officers
      as listed in the proxy statement. For this purpose, compensation includes gains
      arising from stock option exercises, vesting of restricted stock and the award
      of stock bonuses. An exception to this limitation is provided for “qualified
      performance-based compensation.” The Section 162(m) provisions generally require
      that affected executives’ compensation satisfy certain conditions in order to
      qualify as “qualified performance-based compensation.” Section 162(m) denies a
      deduction to any publicly held corporation for compensation paid to certain
      employees in a taxable year to the extent that compensation exceeds $1,000,000.
      It is possible that compensation attributable to awards made under this Plan,
      when combined with all other types of compensation received by a covered
      employee from us, may cause this limitation to be exceeded in any particular
      year.




Accordingly,
      in order to permit the Board of Directors and the Plan Committee to grant awards
      that qualify as “qualified performance-based compensation” under Section 162(m)
      and therefore to be deductible by us without regard to the $1 million deduction
      limit of Section 162(m), the 2005 Equity Plan provides, subject to stockholder
      approval, for authority in the Board of Directors or the Plan Committee to
      condition the grant or vesting of such awards and authorizes the Board of
      Directors or the Plan Committee to establish any other terms and conditions
      required to qualify such awards as “qualified performance-based compensation.”
The Board of Directors may in its sole discretion submit any other amendment
      to
      the Plan for stockholder approval, including, but not limited to, amendments
      to
      the Plan intended to satisfy the requirements of Section 162(m) regarding the
      exclusion of performance-based compensation from the limit on corporate
      deductibility of compensation to certain executive officers.




In
      order
      to exclude compensation resulting from options granted under the 2005 Equity
      Plan from the $1,000,000 limit on deductibility, the Board of Directors has
      approved a provision in the Plan which will place a 500,000 share limit on
      the
      number of options and SARs that may be granted under the Plan to a service
      provider in any fiscal year. This is subject to appropriate adjustment in
      the case of stock splits, reverse stock splits and the like. The purpose of
      this
      provision, which is intended to comply with Section 162(m) of the Code and
      the
      regulations thereunder, is to preserve our ability to deduct in full any
      compensation expense related to stock options and SARs.




*Tax
      consequences of deferred compensation* . 
      The American Jobs Creation Act of 2004 added Section 409A to the Internal
      Revenue Code, generally effective January 1, 2005. In September 2005, the
      Treasury Department issued detailed Proposed Regulations under this statute,
      but
      a number of issues remain unresolved. Section 409A covers most programs that
      defer the receipt of compensation to a succeeding year. It provides strict
      rules
      for elections to defer (if any) and for timing of payouts. There are significant
      penalties placed on the individual employee for failure to comply with Section
      409A. However, it generally does not affect our ability to deduct deferred
      compensation at some point in time.




73


Section
      409A does not apply to incentive stock options, non-qualified stock options
      (that are not and can never later be discounted) and restricted stock (provided
      there is no deferral of income beyond the vesting date). Section 409A also
      does
      not cover stock appreciation right (SAR) plans if (i) the exercise price can
      never be less than the fair market value of the underlying stock on the date
      of
      grant (ii) no features defer the recognition of income beyond the exercise
      date,
      and (iii) there are no other rights granted beyond the SAR itself.




Section
      409A does apply to restricted stock units, performance units and performance
      shares. Grants under such plans will continue to be taxed at vesting but will
      be
      subject to new limits on plan terms governing when vesting may
      occur.




*Tax
      consequences to recipient from ISOs.* An
      optionee who is granted an incentive stock option will not recognize taxable
      income either at the time the option is granted or upon its exercise, although
      the exercise may subject the optionee to the alternative minimum tax. Upon
      the
      sale or exchange of the shares more than two years after grant of the option
      and
      one year after exercising the option, any gain or loss will be treated as
      long-term capital gain or loss. If these holding periods are not satisfied,
      the
      optionee will recognize ordinary income at the time of sale or exchange equal
      to
      the difference between the exercise price and the lower of: (i) the fair market
      value of the shares at the date of the option exercise, or (ii) the sale price
      of the shares. A different rule for measuring ordinary income upon such a
      premature disposition may apply if the optionee is also an officer, director
      or
      Ten Percent Stockholder of the Company. Generally, the Company will be entitled
      to a deduction in the same amount as the ordinary income recognized by the
      optionee. Any gain or loss recognized on such a premature disposition of the
      shares in excess of the amount treated as ordinary income will be characterized
      as long-term or short-term capital gain or loss, depending on the holding
      period.




*Tax
      consequences to recipient from NSOs and SARs.* All
      other options that do not qualify as incentive options are referred to as
      nonstatutory options. An optionee will not recognize any taxable income at
      the
      time he or she is granted a non-statutory option. However, upon its exercise,
      the optionee will recognize taxable income generally measured as the excess
      of
      the then fair market value of the shares purchased over the purchase price.
      Any
      taxable income recognized in connection with an option exercise by an optionee
      who is also our employee will be subject to tax withholding by us. Upon the
      resale of such shares by the optionee, any difference between the sale price
      and
      the optionee's purchase price, to the extent not recognized as taxable income
      as
      described above, will be treated as long-term capital gain or loss, depending
      on
      the holding period. The tax consequences to the holder of a SAR will be similar
      to the consequences from an NSO.




*Tax
      consequences from award of stock and from stock purchase
      rights.* Upon
      acquisition of stock under an award made under this Plan, the recipient normally
      will recognize taxable ordinary income equal to the excess of the stock’s fair
      market value over the purchase price, if any. However, to the extent the stock
      is subject to certain types of vesting restrictions, the taxable event will
      be
      delayed until the vesting restrictions lapse and the shares become transferable,
      unless the recipient makes a specific tax election to be taxed on receipt of
      the
      stock. The tax consequences to the holder of a stock purchase right who has
      exercised his or her right will generally be similar to those of a holder of
      restricted stock.




*Later
      disposition of stock.* Upon
      disposition of stock, the recipient will recognize a capital gain or loss equal
      to the difference between the selling price and the sum of the amount paid
      for
      such stock, if any, plus any amount recognized as ordinary income upon
      acquisition (or vesting) of the stock. Such gain or loss will be long or
      short-term depending on whether the stock was held for more than one year from
      the date ordinary income is measured. Slightly different rules may apply to
      persons who are subject to Section 16(b) of the Exchange Act.




The
      foregoing is only a summary of the effect of federal income taxation upon a
      recipient under the 2005 Equity Plan. It does not purport to be complete, and
      does not discuss the tax consequences of the recipient’s death or the income tax
      laws of any municipality, state or foreign country in which a recipient may
      reside. Recipients of options, rights and awards granted under the 2005 Equity
      Plan are advised to consult their personal tax advisors before exercising an
      option, right or award or disposing of any stock received pursuant to the
      exercise of an option right or award.




**Circular
      230 Disclaimer.** Nothing
      contained in this discussion of certain federal income tax considerations is
      intended or written to be used, and cannot be used, for the purpose of (i)
      avoiding tax-related penalties under the Code or (ii) promoting, marketing,
      or
      recommending to another party any transactions or tax-related matters addressed
      herein.




74


***Performance
      Measures.*** The
      Board of Directors or the Plan Committee will have the power to condition the
      grant or vesting of awards under the 2005 Equity Plan upon the attainment of
      performance goals, determined by the Board of Directors or the Plan Committee
      in
      their respective sole discretion. With respect to any awards granted to persons
      who are or who may be “covered employees” within the meaning of Section 162(m)
      of the Code, the Board of Directors or the Plan Committee will have the power
      to
      grant such awards upon terms and conditions that qualify such awards as
“qualified performance-based compensation” within the meaning of Section 162(m)
      of the Code.




***Restrictions
      on Transfer.*** In
      addition to the restrictions set forth under applicable law, the shares of
      common stock awarded pursuant to the 2005 Equity Plan are subject to the
      following additional restrictions: (i) stock certificates evidencing such shares
      will be issued in the sole name of the recipient (but shall be held by us,
      subject to the terms and conditions of the award) and may bear any legend which
      the Plan Committee deems appropriate to reflect any rights of repurchase or
      forfeiture or other restrictions on transfer hereunder or under the award
      agreement, or as the Plan Committee may otherwise deem appropriate; and (ii)
      no
      awards granted under the 2005 Equity Plan may be assignable by any recipient
      under the 2005 Equity Plan, either voluntarily or by operation of law, except
      by
      will or by the laws of descent and distribution or where such assignment is
      expressly authorized by the terms of the recipient agreement embodying the
      terms
      and conditions of the award. Participants are also obliged to comply with our
      Securities Trading Policy and rules of the Securities and Exchange Commission.




**2005
      Investment Plan**




***General
      Description.*** The
      PhotoMedex, Inc. 2005 Investment Plan (the “2005 Investment Plan”) was adopted
      by the Board of Directors on November 9, 2005 and approved by the stockholders
      on December 28, 2005. We have reserved for issuance thereunder an aggregate
      of
      400,000 shares of common stock. The 2005 Investment Plan provides for the award
      to our executive officers of shares of our common stock in the form of
      non-statutory (non-qualified) stock options. The award matches with options
      an
      executive officer’s purchase of our common stock in the open market on a share
      for share basis, where the options will have an exercise price equal to the
      purchase price of the matched stock. However, an executive officer will not,
      during the life of the Investment Plan, receive matching options for open market
      purchases that exceed, in the aggregate, $250,000. The 2005 Investment Plan
      will
      expire 10 years after its approval by the stockholders, namely on December
      28,
      2015.




The
      purpose of the 2005 Investment Plan is to promote the success of our business
      and to enhance the value of the business by linking the personal interests
      of
      the executive officers participating in the Plan to the interests of our
      stockholders. Our Board of Directors believes that the reservation of 400,000
      shares of common stock for issuance under the 2005 Investment Plan would provide
      an adequate reserve of shares for issuance under the 2005 Investment Plan in
      order to achieve the aims of the Plan.




A
      description of the 2005 Investment Plan is set forth below. The description
      is
      intended to be a summary of the material provisions of the 2005 Investment
      Plan
      and does not purport to be complete. The following discussion summarizes certain
      aspects of the 2005 Investment Plan, but is qualified in its entirety by
      reference to the 2005 Investment Plan, which was attached as “Exhibit B” to our
      Proxy Statement filed with the Commission on November 15, 2005.




***General
      Purpose.***  The
      general purpose of the 2005 Investment Plan is to link the personal interests
      of
      our executive officers to the success of our business and thereby to the value
      of our business. Our independent directors will not receive awards under the
      2005 Investment Plan, but rather will continue to be compensated under the
      2000
      Non-Employee Director Plan. The 2005 Investment Plan provides that, subject
      to
      an overall limit for each participating executive officer, non-statutory options
      may be granted to executive officers, on a share for share basis, for shares
      of
      our common stock that the executive officer may purchase in the open market.




***Shares
      Subject to the 2005 Investment Plan.*** We have
      reserved for issuance up to 400,000 shares of common stock under the 2005
      Investment Plan. If shares of common stock underlying the matching options
      are
      forfeited for any reason, prior to exercise, the forfeited shares will become
      available for new awards in accordance with the terms of the 2005 Investment
      Plan. No awards have been awarded under the 2005 Investment Plan as of the
      date
      of this Report.




75


***Administration
      of and Eligibility under 2005 Investment Plan.*** The 2005
      Investment Plan, as adopted, provides for the grant of options to those
      executive officers who are subject to reporting to the Commission under Section
      16(a) of the Exchange Act. The 2005 Investment Plan authorizes the grant of
      options by a committee (the “Plan Committee”) to be established by the Board of
      Directors to administer the 2005 Investment Plan. The Plan Committee will be
      the
      Compensation Committee of the Board of Directors or such other similar committee
      as may in the future be designated by the Board of Directors to perform those
      functions presently being performed by the Compensation Committee. The Plan
      Committee will consist of at least three members, each of whom will be a
      non-employee director, as such term is defined under Rule 16b-3 of the Exchange
      Act, will qualify as an outside director, for purposes of Section 162(m) of
      the
      Code and will comply with the listing standards of the primary trading market
      or
      securities exchange on which the common stock then trades.




The
      Plan
      Committee will determine the terms and conditions of options granted under
      the
      2005 Investment Plan, consistent with the terms of the Plan, will interpret
      the
      Plan and establish rules for the Plan’s administration.




***Matching
      Provision.*** Each
      executive officer may purchase shares of our common stock in the open market
      (the “Open Market Shares”). Upon due notification to the Plan Committee,
      non-statutory options will be granted under the Plan to the officer. The grant
      will match in the number of options the number of Open Market Shares; each
      option will have an exercise price equal to the price paid by the executive
      officer for his or her Open Market Shares, subject to the following limitations:
      (a) options covering no more than 200,000 shares may be granted to any one
      executive officer in any one calendar year, (b) each executive officer will
      not
      be granted options for open market purchases that exceed $250,000 in the
      aggregate during the term of the Plan, and (c) matching options will otherwise
      be issued on a “first come, first served” basis: the Plan is not required to
      increase the number of shares of common stock authorized under the Plan in
      the
      event that the demand for matching options exceeds the supply.




Open
      Market Shares will be held by us in escrow for a holding period equal to the
      lesser of three years from the date the Shares were purchased in the open market
      or the occurrence of a change in control of PhotoMedex. If the officer sells
      any
      Open Market Shares before the completion of the holding period, he or she may
      do
      so, but the matching options will thereupon be canceled. At the end of the
      holding period, the Open Market Shares will be released from escrow and the
      matching options will be fully vested and exercisable.




***Recipient
      Agreements.*** The Plan
      Committee may require that each recipient enter into a written agreement with
      us, which will set forth all the terms and conditions of the grant. The award
      agreement will contain such other terms, provisions and conditions not
      inconsistent herewith, as shall be determined by the Plan Committee. Unless
      the
      Committee determines otherwise, each matching option will have a life of 10
      years. The Committee may allow payment of the exercise price of the matching
      options, and of any associated withholding taxes, by means of shares of our
      common stock.




***Adjustments
      Resulting from Changes in Capitalization.*** If any
      change is made in the common stock subject to the 2005 Investment Plan, or
      subject to any option granted under the 2005 Investment Plan (through merger,
      consolidation, reorganization, recapitalization, stock dividend, stock split,
      liquidating dividend, combination of shares, exchange of shares, or other change
      in corporate structure or other transaction not involving the receipt of
      consideration by us), the class(es) and maximum number of shares subject to
      the
      2005 Investment Plan, the maximum number of shares which may be granted to
      a
      recipient in a calendar year, the class(es) and number of shares and exercise
      price per share of outstanding options shall be adjusted to prevent the dilution
      or enlargement of rights. Such adjustment shall be made by the Board of
      Directors or the Plan Committee, the determination of which shall be final,
      binding and conclusive. (The conversion of any of our convertible securities
      will not be treated as a “transaction not involving the receipt of
      consideration.”)




***Termination
      and Amendment of the 2005 Investment Plan.*** The
      Board of Directors may terminate or amend the 2005 Investment Plan at any time,
      except that options then outstanding will not be adversely affected thereby
      without the written consent of the respective recipients holding such options.
      The Board of Directors may make such amendments to the 2005 Investment Plan
      as
      it shall deem advisable, except that the approval by our stockholders in
      accordance with the laws of Delaware within 12 months after the adoption of
      the
      amendment will be required for any amendment which would: (i) materially modify
      the requirements as to eligibility for option under the 2005 Investment Plan;
      (ii) materially increase the benefits accruing to recipients under the 2005
      Investment Plan; or (iii) be required under applicable law or the listing
      standards of the market or exchange on which the common stock then trades.
      The
      Board may in its sole discretion submit any other amendment to the Plan for
      stockholder approval, including, but not limited to, amendments to the Plan
      intended to satisfy the requirements of Section 162(m) of the Code regarding
      the
      exclusion of performance-based compensation from the limit on corporate
      deductibility of compensation to certain executive officers.




76


In
      the
      event of a transaction involving our dissolution or liquidation, recipients
      of
      matching options may exercise their rights as soon as practicable before the
      effective date of the transaction. The Committee in its discretion may provide
      that any restrictions on matching options may lapse and may further provide
      that
      options not otherwise exercisable may become so. Any options not exercised
      by
      the transaction will terminate immediately before the transaction.




In
      the
      event of a change in control of PhotoMedex, all options granted under the 2005
      Investment Plan shall become fully exercisable and immediately vested. A change
      in control results from the acquisition by any one person, or group of persons
      acting in concert, of more than 50% of the voting power of our capital stock.
      A
      change in control also results from a “Sale of the Company.” A Sale of the
      Company occurs on: (a) our consolidation or merger into or with a successor
      entity such that our stockholders own less than a majority of the shares of
      stock of such entity; or (b) a sale or other disposition of all, or
      substantially all, of our assets to a successor entity. In the event of a Sale
      of the Company, options granted under the 2005 Investment Plan are to be
      assumed, or substituted with equivalent rights, by the successor entity. If
      the
      successor entity declines to do so, then each holder of an option shall have
      not
      less than 20 days before the consummation of the Sale of the Company to exercise
      his or her options, and all such rights shall become fully exercisable during
      such 20-day period.




***Effect
      of Termination of Recipient.*** A grant
      of matching options under the 2005 Investment Plan is generally subject to
      the
      condition that the executive officer continue to remain in our employ, whether
      as an executive officer or otherwise. Unless a different period is provided
      by
      the Plan Committee, a vested matching option shall be exercisable for three
      months following the optionee’s termination of employment, subject to the
      following exceptions. In the event of the optionee’s termination due to
      disability or death, the exercise period will be 12 months; in event of the
      optionee’s termination for cause, the matching options shall cease to be
      exercisable in any respect as of the date of termination. For purposes of the
      2005 Investment Plan, the term “termination” means the ceasing to be an employee
      of ours.




***Certain
      Federal Income Tax Considerations.*** Awards
      granted under the 2005 Investment Plan generally have the federal income tax
      consequences discussed below.




*Corporate
      business deduction.* Generally,
      we will be entitled to a tax deduction in the same amount as the ordinary income
      recognized by a recipient with regard to the award. In order to secure such
      deduction in the case of exercise of the matching options, we must fulfill
      such
      withholding tax obligations as may be imposed on us.




However,
      Section 162(m) of the Code imposes a limit on corporate tax deductions for
      compensation in excess of $1 million per year paid by a public company to its
      Chief Executive Officer or any of the next four highest paid executive officers
      as listed in the proxy statement. For this purpose, compensation includes gains
      arising from stock option exercises, vesting of restricted stock and the award
      of stock bonuses. An exception to this limitation is provided for “qualified
      performance-based compensation.” The Section 162(m) provisions generally require
      that affected executives’ compensation satisfy certain conditions in order to
      qualify as “qualified performance-based compensation.” Section 162(m) denies a
      deduction to any publicly held corporation for compensation paid to certain
      employees in a taxable year to the extent that compensation exceeds $1,000,000.
      It is possible that compensation attributable to awards made under this Plan,
      when combined with all other types of compensation received by a covered
      employee from us, may cause this limitation to be exceeded in any particular
      year.




Accordingly,
      in order to permit the Board of Directors and the Plan Committee to grant awards
      that qualify as “qualified performance-based compensation” under Section 162(m)
      and therefore to be deductible by us without regard to the $1 million deduction
      limit of Section 162(m), the 2005 Investment Plan provides, subject to
      stockholder approval, for authority in the Board of Directors or the Plan
      Committee to condition the grant or vesting of such awards and authorizes the
      Board of Directors or the Plan Committee to establish any other terms and
      conditions required to qualify such awards as “qualified performance-based
      compensation.” The Board of Directors may in its sole discretion submit any
      other amendment to the Plan for stockholder approval, including, but not limited
      to, amendments to the Plan intended to satisfy the requirements of Section
      162(m) regarding the exclusion of performance-based compensation from the limit
      on corporate deductibility of compensation to certain executive officers. In
      conformance to the provisions of Section 162(m), the Committee will grant
      matching options in a given year on no more than 200,000 shares of our common
      stock reserved for issuance under the 2005 Investment Plan. In addition, as
      noted above, each executive officer will be granted no more than $250,000 of
      options under the Plan, where the value of an option is based on the exercise
      price of the option.




77


*Tax
      consequences of deferred compensation* . 
      The American Jobs Creation Act of 2004 added Section 409A to the Internal
      Revenue Code, generally effective January 1, 2005. In September, 2005, the
      Treasury Department issued detailed Proposed Regulations under this statute,
      but
      a number of issues remain unresolved. Section 409A covers most programs that
      defer the receipt of compensation to a succeeding year. It provides strict
      rules
      for elections to defer (if any) and for timing of payouts. There are significant
      penalties placed on the individual employee for failure to comply with Section
      409A. However, it generally does not affect our ability to deduct deferred
      compensation at some point in time.




Section
      409A does not apply to incentive stock options, non-qualified stock options
      (that are not and can never later be discounted) and restricted stock (provided
      there is no deferral of income beyond the vesting date). Section 409A also
      does
      not cover stock appreciation right (SAR) plans if (i) the exercise price can
      never be less than the fair market value of the underlying stock on the date
      of
      grant (ii) no features defer the recognition of income beyond the exercise
      date,
      and (iii) there are no other rights granted beyond the SAR itself.




Section
      409A does apply to restricted stock units, performance units and performance
      shares. Grants under such plans will continue to be taxed at vesting but will
      be
      subject to new limits on plan terms governing when vesting may
      occur.




*Tax
      consequences to recipient from NSOs.* An
      optionee will not recognize any taxable income at the time he or she is granted
      a non-statutory option. However, upon its exercise, the optionee will recognize
      taxable income generally measured as the excess of the then fair market value
      of
      the shares purchased over the purchase price, if any. Any taxable income
      recognized in connection with an option exercise by an optionee who is also
      our
      employee will be subject to tax withholding by us. Upon the resale of such
      shares by the optionee, any difference between the sale price and the optionee's
      purchase price, to the extent not recognized as taxable income as described
      above, will be treated as long-term capital gain or loss, depending on the
      holding period.




*Later
      disposition of stock.* Upon
      disposition of stock acquired from exercise of a matching option, the recipient
      will recognize a capital gain or loss equal to the difference between the
      selling price and the sum of the amount paid for such stock, if any, plus any
      amount recognized as ordinary income upon acquisition (or vesting) of the stock.
      Such gain or loss will be long or short-term depending on whether the stock
      was
      held for more than one year from the date ordinary income is measured. Slightly
      different rules may apply to persons who are subject to Section 16(b) of the
      Exchange Act.




The
      foregoing is only a summary of the effect of federal income taxation upon a
      recipient under the 2005 Investment Plan. It does not purport to be complete,
      and does not discuss the tax consequences of the recipient’s death or the income
      tax laws of any municipality, state or foreign country in which a recipient
      may
      reside. Recipients of options granted under the 2005 Investment Plan are advised
      to consult their personal tax advisors before exercising an option or disposing
      of any stock received pursuant to the exercise of an option.




**Circular
      230 Disclaimer.** Nothing
      contained in this discussion of certain federal income tax considerations is
      intended or written to be used, and cannot be used, for the purpose of (i)
      avoiding tax-related penalties under the Code or (ii) promoting, marketing,
      or
      recommending to another party any transactions or tax-related matters addressed
      herein.




78


*Restrictions
      on Transfer.* **** In
      addition to the restrictions set forth under applicable law, the Open Market
      Shares and the options granted pursuant to the 2005 Investment Plan are subject
      to the following additional restrictions: (i) stock certificates evidencing
      such
      Open Market Shares will be issued in the sole name of the recipient (but shall
      be held by us, subject to the terms and conditions of 2005 Investment Plan)
      and
      may bear any legend which the Plan Committee deems appropriate to reflect any
      restrictions on transfer under the Plan, or as the Plan Committee may otherwise
      deem appropriate; and (ii) no options granted under the 2005 Investment Plan
      may
      be assignable by any recipient under the Plan, either voluntarily or by
      operation of law, except by will or the laws of descent and distribution or
      with
      the approval of the Plan Committee. Participants are also obliged to comply
      with
      our Securities Trading Policy and rules of the Securities and Exchange
      Commission.




**2000
      Non-Employee Director Stock Option Plan**




**General** .
      The
      2000 Non-Employee Director Stock Option Plan, or the Non-Employee Director
      Plan,
      was adopted by the Board of Directors on May 15, 2000, to be effective as of
      June 1, 2000, and was approved by our stockholders on July 18, 2000. We
      initially reserved for issuance an aggregate of 250,000 shares of common stock
      under the Non-Employee Director Plan. We increased this to 650,000 shares of
      common stock, pursuant to the affirmative vote of the stockholders on June
      10,
      2002 and increased this number to 1,000,000 shares of common stock, pursuant
      to
      the affirmative vote of the stockholders on December 16, 2003. We further
      increased this number to 1,400,000 shares of common stock, pursuant to the
      affirmative vote of the stockholders on December 28, 2005. It continues as
      an
      active plan.




A
      description of the Non-Employee Director Plan is set forth below. The
      description is intended to be a summary of the material provisions of the
      Non-Employee Director Plan and does not purport to be complete.




**Purpose
      of the Plan** .
      The
      purposes of the Non-Employee Director Plan are to enable us to attract, retain,
      and motivate our non-employee directors and to create a long-term mutuality
      of
      interest between the non-employee directors and our stockholders by granting
      options to purchase common stock.




**Administration** .
      The
      Non-Employee Director Plan will be administered by a committee of the Board
      of
      Directors, appointed from time to time by the Board of Directors. The
      Nominations and Corporate Governance Committee has been charged with this task.
      The Committee has full authority to interpret the Non-Employee Director Plan
      and
      decide any questions under the Non-Employee Director Plan and to make such
      rules
      and regulations and establish such processes for administration of the
      Non-Employee Director Plan as it deems appropriate subject to the provisions
      of
      the Non-Employee Director Plan.




**Available
      Shares** .
      The
      Non-Employee Director Plan authorizes the issuance of up to 1,000,000 shares
      of
      common stock upon the exercise of non-qualified stock options granted to our
      non-employee directors. In general, if options are for any reason canceled,
      or
      expire or terminate unexercised, the shares covered by such options will again
      be available for the grant of options.




The
      Non-Employee Director Plan provides that appropriate adjustments will be made
      in
      the number and kind of securities receivable upon the exercise of options in
      the
      event of a stock split, stock dividend, merger, consolidation or
      reorganization.




**Eligibility** .
      All of
      our non-employee directors are eligible to be granted options under the
      Non-Employee Director Plan. A non-employee director is a director serving on
      the
      Board of Directors who is not then one of our current employees, as defined
      in
      Sections 424(e) and 424(f) of the Code.




**Grant
      of Options** .
      As of
      each January 1 following the effective date of the Non-Employee Director Plan,
      commencing January 1, 2001, or the Initial Grant Date, each non-employee
      director was automatically granted an option to purchase 20,000 shares of common
      stock in respect of services to be rendered to us as a director during the
      forthcoming calendar year, subject to the terms of the Non-Employee Director
      Plan. Each non-employee director who was first elected to the Board of Directors
      after June 1, 2000, but prior to January 1, 2001, was granted, as of the date
      of
      his election, or First Grant Date, an option to purchase that number of shares
      equal to the product of (i) 5,000 and (ii) the number of fiscal quarters
      remaining in our then current fiscal year (including the quarter in which the
      date of such director's election falls), subject to the terms of the
      Non-Employee Director Plan. As of January 1, 2002 or the First Grant Date,
      as
      the case may be, each non-employee director was automatically granted an option
      to purchase 20,000 shares of common stock, or the Annual Grant. Commencing
      January 1, 2003, the annual grant was to be a nonqualified stock option of
      35,000 shares of common stock, pursuant to the approval of the stockholders
      on
      June 10, 2002. In other respects, the Plan will operate as before January 1,
      2003. As of March 15, 2006, we have granted 886,250 options to our eligible
      directors under the Non-Employee Director Plan. We have 513,750 shares available
      for grant under option under the plan as of the date of this
      Report.




79


The
      purchase price per share deliverable upon the exercise of an option will be
      100%
      of the fair market value of such shares as follows:




(i)  For
      options issued on the Initial Grant Date, the fair market value will be measured
      by the closing sales price of the common stock as of the last trading date
      of
      the fiscal quarter prior to the Initial Grant Date;




(ii)  For
      options issued on the First Grant Date, the fair market value will be measured
      by the closing sales price of the common stock as of the First Grant Date;
      and




(iii)  For
      grants of options issued as of January 1 of any fiscal year, the fair market
      value will be measured by the closing sales price of the common stock as of
      the
      last trading date of the prior year.




**Vesting
      of Options** .
      Options
      granted under the Non-Employee Director Plan will vest and become exercisable
      to
      the extent of 5,000 shares for each fiscal quarter prior to fiscal 2003, in
      which such director shall have served at least one day as our director and
      8,750
      shares for each quarter in fiscal 2003 and beyond.




Options
      that are exercisable upon a non-employee director's termination of directorship
      for any reason excluding termination for cause or in the event of a
      reorganization (both as described below) prior to the complete exercise of
      an
      option (or deemed exercise thereof), will remain exercisable following such
      termination for the remaining term of the option. Upon a non-employee director's
      removal from the Board of Directors for cause or failure to be re-nominated
      for
      cause, or if we obtain or discover information after termination of directorship
      that such non-employee director had engaged in conduct during such directorship
      that would have justified a removal for cause during such directorship, all
      outstanding options of such non-employee director will immediately terminate
      and
      will be null and void. The 2000 Non-Employee Director Plan also provides that
      all outstanding options will terminate effective upon the consummation of a
      merger, liquidation or dissolution, or consolidation in which we are not the
      surviving entity, subject to the right of non-employee director to exercise
      all
      outstanding options prior to the effective date of the merger, liquidation,
      dissolution or consolidation. All options granted to a non-employee director
      and
      not previously exercisable become vested and fully exercisable immediately
      upon
      the occurrence of a change in control (as defined in the 2000 Non-Employee
      Director Plan).




**Amendments** .
      The
      Non-Employee Director Plan provides that it may be amended by the Committee
      or
      the Board of Directors at any time, and from time to time to effect (i)
      amendments necessary or desirable in order that the Non-Employee Director Plan
      and the options granted thereunder conform to all applicable laws, and (ii)
      any
      other amendments deemed appropriate. Notwithstanding the foregoing, to the
      extent required by law, no amendment may be made that would require the approval
      of our stockholders under applicable law or under any regulation of a principal
      national securities exchange or automated quotation system sponsored by the
      National Association of Securities Dealers unless such approval is obtained.
      The
      Non-Employee Director Plan may be amended or terminated at any time by our
      stockholders.




**Miscellaneous** .
      Non-employee directors may be limited under Section 16(b) of the Exchange Act
      to
      certain specific exercise, election or holding periods with respect to the
      options granted to them under the Non-Employee Director Plan. Options granted
      under the Non-Employee Director Plan are subject to restrictions on transfer
      and
      exercise. No option granted under the Non-Employee Director Plan may be
      exercised prior to the time period for exercisability, subject to acceleration
      in the event of our change in control (as defined in the Non-Employee Director
      Plan). Although options will generally be nontransferable (except by will or
      the
      laws of descent and distribution), the Committee may determine at the time
      of
      grant or thereafter that an option that is otherwise nontransferable is
      transferable in whole or in part and in such circumstances, and under such
      conditions, as specified by the committee.




80


**2000
      Stock Option Plan**




This
      Plan
      was frozen as of December 28, 2005. As of March 15, 2006, we had 2,632,304
      options outstanding under the 2000 Stock Option Plan. All underlying shares
      have
      been registered with the SEC. Any unexpired options granted under this Plan
      will
      terminate: (a) in the event of death or disability, pursuant to the terms of
      the
      option agreement, but not less than 6 months or more than 12 months after the
      applicable date of such event, (b) in the event of retirement, pursuant to
      the
      terms of the option agreement, but not less than 30 days or more than 3 months
      after such retirement date, or (c) in the event of termination of such person
      other than for death, disability or retirement, until 30 days after the date
      of
      such termination. However, the Committee may in its sole discretion accelerate
      or extend the exercisability of any or all options upon termination of
      employment or cessation of services. The 2000 Stock Option Plan will terminate
      on May 14, 2010, the 10th anniversary date of the effectiveness of the 2000
      Stock Option Plan.




**1995
      Non-Qualified Option Plan**




On
      January 2, 1996, we adopted our 1995 Non-Qualified Option Plan for key
      employees, officers, directors and consultants, and reserved up to 500,000
      options to be granted thereunder. The option exercise price is not less than
      100% of market value on the date granted; 40% of granted options vest
      immediately; 30% vest beginning one year after grant; and the remaining 30%
      vest
      and may be exercised beginning two years from grant. No options may be exercised
      more than 10 years after grant, options are not transferable (other than at
      death), and in the event of complete termination for cause (other than death
      or
      disability) or voluntary termination, all unvested options automatically
      terminate. Options are no longer granted out of this Plan and as of March 15,
      2006 no options remain outstanding under this plan, which is otherwise inactive
      and remains frozen.




**Other
      Non-Employee Director Stock Option Plan**




On
      April
      10, 1998, our Board of Directors adopted a resolution creating a stock option
      plan for outside/non-employee members of the Board of Directors. Pursuant to
      the
      stock plan, each outside/non-employee director is to receive an annual grant
      of
      options, in addition to any other consideration he or she may receive, to
      purchase up to 20,000 shares of common stock as compensation, at an exercise
      price equal to the market price of the common stock on the last trading day
      of
      the preceding year. The options granted pursuant to this plan vest at the rate
      of 5,000 options per quarter during each quarter in which such person has served
      as a member of the Board of Directors. Since we have adopted the 2000
      Non-Employee Director Stock Option Plan, we no longer grant options to members
      of our Board of Directors under this plan, and as of March 15, 2006 15,000
      options remain outstanding under this plan, which is otherwise inactive and
      remains frozen.




**2004
      Stock Option Plan**




The
      2004
      Stock Option Plan was adopted by the Board of Directors of ProCyte on April
      l2,
      2004, and was approved by ProCyte shareholders on May 19, 2004. An aggregate
      of
      2,000,000 shares of ProCyte common stock were reserved under the 2004 Stock
      Option Plan. PhotoMedex assumed the 2004 Stock Option Plan as part of the
      acquisition on March 18, 2005. The number of shares reserved under the plan
      was
      adjusted downward to 1,324,400 shares of PhotoMedex common stock, to reflect
      the
      acquisition exchange ratio of 0.6622 shares of PhotoMedex common stock for
      each
      share of ProCyte common stock. The number of options then outstanding under
      the
      plan and their exercise prices were also adjusted in accordance with the
      exchange ratio.




As
      of
      March 15, 2006, we had 419,500 options outstanding under the 2004 Stock Option
      Plan. This Plan was frozen as of December 28, 2005. Unless sooner terminated
      by
      the Board of Directors, the Plan will terminate on April 12, 2014, the 10th
      anniversary date of its effective date. In general, any unexpired options
      granted under this Plan will terminate: (a) immediately on optionee’s
      termination from service for cause; (b) in the event of retirement, pursuant
      to
      the terms of the option agreement, and generally three months after the
      termination of service to us; and (c) in the event of death or disability,
      pursuant to the terms of the option agreement, and generally 12 months after
      the
      termination of service to us. In the event of our merger, consolidation or
      other
      reorganization in which we are not the surviving or continuing corporation
      (as
      determined by the Committee) or in the event of our liquidation or dissolution,
      all options granted under this Plan will terminate on the effective date of
      the
      merger, consolidation, reorganization, liquidation or dissolution, unless there
      is an agreement with respect to such transition which expressly provides for
      the
      assumption of such options by the continuing or surviving corporation. Options
      that are not assumed by the surviving corporation will become 100% vested before
      the effective date. If the surviving corporation assumes the options of a
      participant, and within two years of the effective date the employment or
      services of the participant should terminate (excluding termination for cause
      or
      termination initiated by the participant for certain reasons), then the
      participant’s assumed options will become 100% vested as of such
      termination.




81


**1996
      Stock Option Plan**




The
      1996
      Stock Option Plan was adopted by the Board of Directors of ProCyte on July
      23,
      1996 and was approved by ProCyte shareholders on May 15, 1997. The plan was
      amended on March 2, 1999 and May 26, 1999 to provide for grants to non-employee
      directors of ProCyte Corporation. An aggregate of 1,750,000 shares of ProCyte
      common stock were reserved under the 1996 Stock Option Plan. PhotoMedex assumed
      the 1996 Stock Option Plan as part of the acquisition on March 18, 2005. The
      number of shares reserved under the plan was adjusted downward to 1,088,500
      shares of PhotoMedex common stock, to reflect the acquisition exchange ratio
      of
      0.6622 shares of PhotoMedex common stock for each share of ProCyte common stock.
      The number of options then outstanding under the Plan and their exercise prices
      are also adjusted in accordance with the exchange ratio.




As
      of
      March 15, 2006, we had 783,472 options outstanding under the 1996 Stock Option
      Plan. This Plan was frozen as of December 28, 2005. Unless sooner terminated
      by
      the Board of Directors, the 1996 Stock Option Plan will terminate on July 23,
      2006, the 10th anniversary date of its effective date. Any unexpired options
      granted under this Plan will terminate: (a) immediately on an optionee’s
      termination from service for cause; (b) in the event of retirement, pursuant
      to
      the terms of the option agreement, and generally three months after the
      termination of service to us; (c) in the event of disability, pursuant to the
      terms of the option agreement, and generally 12 months after the termination
      of
      service to us; and (d) in the event of death, pursuant to the terms of the
      option agreement, and generally 12 months from the date of death. In the event
      of our merger, consolidation or other reorganization in which we are not the
      surviving or continuing corporation (as determined by the Committee) or in
      the
      event of our liquidation or dissolution, all options granted under the 1996
      Stock Option Plan will terminate on the effective date of the merger,
      consolidation, reorganization, liquidation or dissolution, unless there is
      an
      agreement with respect to such transition which expressly provides for the
      assumption of such options by the continuing or surviving corporation. Options
      that are not assumed by the surviving corporation will become 100% vested before
      the effective date. If the surviving corporation assumes the options of a
      participant, and within two years of the effective date the employment or
      services of the participant should terminate (excluding termination for cause
      or
      termination initiated by the participant for certain reasons), then the
      participant’s assumed options will become 100% vested as of such termination.




**1991
      Restated Stock Option Plan for Non Employee Directors**




On
      September 27, 1991, the Board of Directors of ProCyte Corporation adopted the
      1991 Stock Option Plan for Non-employee Directors. The Plan was later amended
      and restated on February 24, 1994 and September 4, 1996, and each restatement
      was approved by the shareholders. The Plan has expired. Any former director
      of
      ProCyte Corporation holding options under this Plan may exercise his other
      options for three years following the date of resignation from the Board of
      ProCyte, but in no event later than 10 years from the date of grant of an option
      granted to him or her. Options are no longer granted out of this Plan and as
      of
      March 15, 2006, 22,514 options remain outstanding (and are fully vested) under
      this Plan, which is otherwise inactive and remains frozen.




**1989
      Restated Stock Option Plan**




On
      September 15, 1989, the Board of Directors of ProCyte Corporation adopted the
      1989 Stock Option Plan. The Plan was restated on February 21, 1992 and was
      approved by the shareholders. The Plan has expired. Options are no longer
      granted out of this Plan and as of March 15, 2006, 305,606 options remain
      outstanding (and are fully vested) under this Plan, which is otherwise inactive
      and remains frozen.




**Other
      Stock Options**




As
        of
        March 15, 2006, we had granted, net of cancellations, options to purchase
        up to
        3,684.962 shares of common stock to certain of our employees, directors and
        consultants outside of a formal plan, of which 3,554,962 had been exercised
        and
        130,000 remained unexercised. There
        were no grants of options outside of a formal plan in 2005




82


**Limitation
      on Directors' Liabilities; Indemnification of Officers and
      Directors**




Our
      Certificate of Incorporation and Bylaws designate the relative duties and
      responsibilities of our officers, establish procedures for actions by directors
      and stockholders and other items. Our Certificate of Incorporation and Bylaws
      also contain extensive indemnification provisions, which will permit us to
      indemnify our officers and directors to the maximum extent, provided by Delaware
      law. Pursuant to our Certificate of Incorporation and under Delaware law, our
      directors are not liable to us or our stockholders for monetary damages for
      breach of fiduciary duty, except for liability in connection with a breach
      of
      duty of loyalty, for acts or omissions not in good faith or which involve
      intentional misconduct or a knowing violation of law, for dividend payments
      or
      stock repurchases illegal under Delaware law or any transaction in which a
      director has derived an improper personal benefit.




We
      have
      adopted a form of indemnification agreement, which provides the indemnitee
      with
      the maximum indemnification allowed under applicable law. Since the Delaware
      statutes are non-exclusive, it is possible that certain claims beyond the scope
      of the statute may be indemnifiable. The indemnification agreement provides
      a
      scheme of indemnification, which may be broader than that specifically provided
      by Delaware law. It has not yet been determined, however, to what extent the
      indemnification expressly permitted by Delaware law may be expanded, and
      therefore the scope of indemnification provided by the indemnification agreement
      may be subject to future judicial interpretation.




The
      indemnification agreement provides that we are to indemnify an indemnitee,
      who
      is or was a party or becomes a party or is threatened to be made a party to
      any
      threatened, pending or completed action or proceeding whether civil, criminal,
      administrative or investigative by reason of the fact that the indemnitee is
      or
      was one of our directors, officers, key employees or agents. We are to advance
      all expenses, judgments, fines, penalties and amounts paid in settlement
      (including taxes imposed on indemnitee on account of receipt of such payouts)
      incurred by the indemnitee in connection with the investigation, defense,
      settlement or appeal of any civil or criminal action or proceeding as described
      above. The indemnitee is to repay such amounts advanced only if it shall be
      ultimately determined that he or she is not entitled to be indemnified by us.
      The advances paid to the indemnitee by us are to be delivered within 20 days
      following a written request by the indemnitee. Any award of indemnification
      to
      an indemnitee, if not covered by insurance, would come directly from our assets,
      thereby affecting a stockholder's investment.




**Directors'
      and Officers' Liability Insurance**




We
      have
      obtained directors' and officers' liability insurance which expires on February
      24, 2007.




83


**Item
      12.**  **Security
      Ownership of Certain Beneficial Owners and Management and Related Stockholder
      Matters**




The
      following table reflects, as of March 15, 2006, the beneficial common stock
      ownership of: (a) each of our directors, (b) each executive officer (See Item
      11, "Executive Compensation"), (c) each person known by us to be a beneficial
      holder of five percent (5%) or more of our common stock, and (d) all of our
      executive officers and directors as a group:




**Name
                and Address Of****Beneficial
                Owner****(1)**
            
            **Number
                of Shares**
              **Beneficially
                Owned**
            
            **Percentage
                of Shares**
              **Beneficially
                Owned****(1)**Richard
                J. DePiano(2)
            
            209,300
            
            *Jeffrey
                F. O’Donnell(3)
            
            859,250
            
            1.64Dennis
                M. McGrath(4)
            
            629,000
            
            1.21Michael
                R. Stewart(5)
            
            298,940
            
            *John
                F. Clifford(6)
            
            699,079
            
            1.35Alan
                R. Novak(7)
            
            191,101
            
            *David
                Anderson(8)
            
            70,000
            
            *Warwick
                Alex Charlton(9)
            
            332,500
            
            *Anthony
                J. Dimun(10)
            
            191,250
            
            *Corsair
                Reporting Persons(11)
            
            3,418,794
            
            6.61Wellington
                Management Co., L.P.(12)
            
            7,180,002
            
            13.96All
                directors and officers as a group (9 persons)(13)
            
            3,480,420
            
            6.40







*
            Less
                than 1%.




(1)
            Beneficial
                ownership is determined in accordance with the rules of the SEC.
                Shares of
                common stock subject to options or warrants currently exercisable
                or
                exercisable within 60 days of March 15, 2006, are deemed outstanding
                for
                computing the percentage ownership of the stockholder holding the
                options
                or warrants, but are not deemed outstanding for computing the percentage
                ownership of any other stockholder. Unless otherwise indicated in
                the
                footnotes to this table, we believe stockholders named in the table
                have
                sole voting and sole investment power with respect to the shares
                set forth
                opposite such stockholder's name. Unless otherwise indicated, the
                officers, directors and stockholders can be reached at our principal
                offices. Percentage of ownership is based on 52,319,294 shares of
                common
                stock outstanding as of March 15,
                2006.




(2)
            Includes
                31,800 shares and options to purchase up to 177,500 shares of common
                stock. Does not include options to purchase up to 17,500 shares of
                common
                stock, which may vest more than 60 days after March 15, 2006. Mr.
                DePiano's address is 351 East Conestoga Road, Wayne, Pennsylvania
                19087.




(3)
            Includes
                3,000 shares, 525,000 additional shares subject to restriction agreement
                with us and options to purchase up to 331,250 shares of common stock.
                Does
                not include options to purchase up to 418,750 shares of common stock,
                which may vest more than 60 days after March 15, 2006.




(4)
            Includes
                4,000 shares, 335,000 additional shares subject to restriction agreement
                with us and options to purchase up to 290,000 shares of common stock.
                Does
                not include options to purchase up to 335,000 shares of common stock,
                which may vest more than 60 days after March 15,
                2006.




(5)
            Includes
                1,440 shares and options to purchase 297,500 shares of common stock.
                Does
                not include options to purchase up to 242,500 shares of common stock,
                which may vest more than 60 days after March 15,
                2006.




(6)
            Includes
                227,796 shares and options to purchase up to 471,283 shares of common
                stock. Does not include options to purchase up to 176,037 shares
                of common
                stock, which may vest more than 60 days after March 15, 2006.




84




(7)
            Includes
                28,601 shares of common stock and options to purchase up to 162,500
                shares
                of common stock. Does not include options to purchase up to 17,500
                shares
                of common stock, which may vest more than 60 days after March 15,
                2006.
                Mr. Novak's address is 3050 K Street, NW, Suite 105, Washington, D.C.
                20007.




(8)
            Includes
                options to purchase up to 70,000 shares of common stock. Does not
                include
                options to purchase up to 17,500 shares of common stock, which may
                vest
                more than 60 days after March 15, 2006. Mr. Anderson's address is
                147
                Keystone Drive, Montgomeryville, PA
                18936.




(9)
            Includes
                170,000 shares of common stock owned by True North Partners, L.L.C.,
                of
                which Mr. Charlton may be deemed to be an affiliate, and options
                to
                purchase 162,500 shares of common stock. Does not include options
                to
                purchase up to 17,500 shares of common stock, which may vest more
                than 60
                days after March 15, 2006. Mr. Charlton's address is 444 Madison
                Avenue, Suite 605, New York, New York
                10022.




(10)
            Includes
                95,000 shares of common stock owned by Mr. Dimun and his wife and
                options
                to purchase up to 96,250 shares of common stock. Does not include
                options
                to purchase up to 17,500 shares of common stock, which may vest more
                than
                60 days after March 15, 2006. Mr. Dimun’s address is 46 Parsonage Hill
                Road, Short Hills, New Jersey
                07078.




(11)
            Includes
                3,158,500shares of common stock and warrants to purchase up to 260,294
                shares. Certain of the shares are held in various denominations by
                Corsair
                Capital Partners, L.P., a Delaware limited partnership ("Corsair
                Capital
                Partners"), Corsair Long Short International, Ltd., a Cayman Islands
                exempted company ("Corsair International"), Corsair Select, L.P.,
                a
                Delaware limited partnership ("Corsair Select"), Corsair Capital
                Partners
                100, L.P., a Delaware limited partnership ("Corsair 100"), Corsair
                Capital
                Investors, Ltd., a Cayman Islands exempted company ("Corsair Investors",
                and together with Corsair Capital Partners, Corsair International,
                Corsair
                Select and Corsair 100, the "Corsair Entities"), each of which are
                private
                investment funds. Corsair Capital Management, L.L.C. ("Corsair Capital
                Management") is the investment manager of each of the Corsair Entities,
                and also is the manager of certain other separately managed accounts
                which
                hold 487,307 additional shares. As the investment manager of the
                Corsair
                Entities, and the manager of such other separate accounts, Corsair
                Capital
                Management has the power to vote and/or dispose of those shares of
                common
                stock held by such persons and accordingly, may be deemed to be the
                beneficial owner of such shares. Jay R. Petschek ("Petschek") and
                Steven
                Major ("Major," and together with the Corsair Entities, Corsair Capital
                Management and Petschek, the "Corsair Reporting Persons") are the
                controlling principals of Corsair Capital Management. Mr. Major
                beneficially owns 21,100 additional shares of common stock. Accordingly,
                the Corsair Reporting Persons may collectively be deemed to be the
                beneficial owners of 3,418,794 shares of common stock, including
                3,158,500
                shares of common stock and warrants to purchase up to 260,294 shares.
                Neither the use of the terms "Corsair Entities" or "Corsair Reporting
                Persons" nor the aggregation of ownership interests by the Corsair
                Reporting Persons, as described herein, necessarily implies the existence
                of a group forpurposes
                of Section 13(d)(3) of the Exchange Act or any other purpose. The
                foregoing information has been derived from a Schedule 13G filed
                on behalf
                of certain of the Corsair Reporting Persons, on February 14, 2006.




(12)
            Wellington
                Management Company, LLP is an investment adviser which has shared
                voting
                powers with respect to 7,180,002 shares of common stock owned of
                record by
                its clients. The foregoing information has been derived from a Schedule
                13G filed on behalf of Wellington Management on February 14, 2006.




(13)
            Includes 561,637
                unrestricted shares, 860,000 restricted shares and options to purchase
                2,058,783 shares of common stock. Does not include options to purchase
                up
                to 1,259,787 shares of common stock, which may vest more than 60
                days
                after March 15, 2006.




**Item
      13.**  **Certain
      Relationships and Related Transactions**




In
      the
      year ended December 31, 2002, we engaged True North Partners, LLC, or True
      North Partners, to perform marketing consulting services for us, and we also
      engaged True North Capital Ltd., or True North Capital, to perform financial
      consulting services for us. In the year ended December 31, 2003, we incurred
      charges of $18,128 and $20,000 for the marketing and financial services from
      True North Partners and True North Capital, respectively. We are advised that
      the aggregate fees paid to True North Partners and True North Capital in the
      year December 31, 2003 constituted less than 5% of the consolidated revenues
      of
      each of True North Partners and True North Capital during the same period.
      We
      did not pay any fees to True North Partners or True North Capital in 2004.
      True
      North Capital is a fund management group which provides management and
      acquisition advisory services with a specialty in the healthcare industry,
      and
      True North Partners is a consulting group which has served as the fund advisor
      for True North Capital. We are advised that True North Partners and True North
      Capital have common equity ownership, but separate management groups and
      operations.




85


We
      entered into an agreement with True North Capital (the "TNC Agreement"), dated
      as of October 28, 2003, pursuant to which True North Capital agreed to assist
      us
      in identifying and evaluating proposed strategic growth transactions relating
      to
      the healthcare industry and under that agreement TNC North Capital could earn
      a
“success fee.” In 2003, we paid True North Capital a one-time $20,000 expense
      reimbursement for the deployment of its personnel and resources in the
      fulfillment of the goals set forth in the TNC Agreement. In May 2004, the TNC
      Agreement was modified to provide that any success fee under the agreement
      would
      be divided equally between True North Capital and True North Partners. However,
      we canceled the TNC Agreement in October 2004 in accordance with the terms
      of
      the agreement. No success fee was earned or paid under the TNC Agreement. We
      have no plans to enter such an agreement in the future with True North Capital
      or True North Partners.




During
      the relevant periods from 2003 through 2004, one of our directors, Warwick
      Alex
      Charlton, was a senior member of the executive management staff of True North
      Partners and also of True North Capital until November 10, 2003. Mr. Charlton
      also held approximately 20.3% equity interests in each of True North Partners
      and True North Capital. During the relevant periods from 2002 through 2004,
      another of our directors, John J. McAtee, Jr., held equity interests of less
      than 1.0% in each of True North Partners and True North Capital. Mr. McAtee
      resigned from the Investment Advisory Board of True North Capital on April
      14,
      2003.




As
      of
      March 15, 2006, Messrs. Michael R. Matthias and Jeffrey P. Berg, shareholders
      in
      Jenkens & Gilchrist, LLP, our outside counsel, held in the aggregate hold
      43,563 shares of our common stock. Messrs. Matthias and Berg acquired such
      shares through the exercise of stock options which they accepted from us in
      exchange for legal services performed from July 1998 to May 2000.




We
      believe that all transactions with our affiliates have been entered into on
      terms no less favorable to us than could have been obtained from independent
      third parties. We intend that any transactions with officers, directors and
      5%
      or greater stockholders will be on terms no less favorable to us than could
      be
      obtained from independent third parties and will be approved by a majority
      of
      our independent, disinterested directors and will comply with the Sarbanes
      Oxley
      Act and other securities laws and regulations.




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




Our
      Audit
      Committee has appointed Amper, Politziner & Mattia, P.C. as our independent
      auditors for the fiscal year ending December 31, 2005.




The
      Audit
      Committee had appointed KPMG LLP to be our independent auditors for 2004.
      However, after reviewing the costs incurred in the audit of the 2003 financial
      statements and the costs forecasted for the audit of the 2004 financial
      statements, the Audit Committee terminated the engagement of KPMG LLP as our
      independent auditors, effective June 9, 2004. The Audit Committee recommended
      and approved the engagement of Amper, Politziner & Mattia, P.C. as our
      principal independent accountants, effective June 9, 2004. Accordingly, we
      engaged Amper, Politziner & Mattia, P.C. as our principal independent
      accountants for 2004. The following table shows the fees paid or accrued by
      us
      for the audit and other services provided by Amper, Politziner & Mattia for
      2005 and 2004:





86




2005
            
            2004Audit
                Fees
            
            $
            343,000
            
            $
            201,000Audit-Related
                Fees
            
            
            20,000
            
            
            —Tax
                Fees
            
            
            —
            
            
            —All
                Other Fees
            
            
            23,000
            
            
            —Total
            
            $
            386,000
            
            $
            201,000




The
      following table shows the fees paid or accrued by us for the audit and other
      services provided by KPMG, LLP for 2005 and 2004:




2005
            
            2004Audit
                Fees
            
            $
            $
                —
            
            $
            23,000Audit-Related
                Fees
            
            
            41,250
            
            
            74,000-Tax
                Fees
            
            
            —
            
            
            —All
                Other Fees
            
            
            —
            
            
            —Total
            
            $
            41,250
            
            $
            97,000




As
      defined by the Commission, (i) “audit fees” are fees for professional services
      rendered by our principal accountant for the audit of our annual financial
      statements and review of financial statements included in our Form 10-Q, or
      for
      services that are normally provided by the accountant in connection with
      statutory and regulatory filings or engagements for those fiscal years; (ii)
      “audit-related fees” are fees for assurance and related services by our
      principal accountant that are reasonably related to the performance of the
      audit
      or review of our financial statements and are not reported under “audit fees”;
      (iii) “tax fees” are fees for professional services rendered by our principal
      accountant for tax compliance, tax advice, and tax planning; and (iv) “all other
      fees” are fees for products and services provided by our principal accountant,
      other than the services reported under audit fees,” “audit-related fees,” and
“tax fees.”




***Audit
      Fees*** *.* The
      aggregate fees billed to us in 2005 by the independent auditors, Amper,
      Politziner & Mattia, P.C., for professional services rendered in connection
      with our Quarterly Reports on Form 10-Q and for the audits of our financial
      statements and internal controls included in this Annual Report on Form 10-K
      for
      2005, totaled approximately $343,000.




The
      aggregate fees billed to us in 2004 by the independent auditors, Amper,
      Politziner & Mattia, P.C., for professional services rendered in connection
      with our Quarterly Reports on Form 10-Q and for the audits of our financial
      statements and internal controls included in this Annual Report on Form 10-K
      for
      2004, totaled approximately $201,000.




We
      incurred fees to KPMG for services rendered for the year ended December 31,
      2004, of which approximately $23,000 that was incurred in fiscal
      2004 related to the audit and review work for the year ended December
      31, 2003.




***Audit-Related
      Fees.*** ** The
      aggregate fees billed to us by Amper, Politziner & Mattia for assurance and
      related services that are reasonably related to the performance of the audit
      and
      review of our financial statements that are not already reported in the
      paragraph immediately above totaled approximately $20,000 for 2005. The
      aggregate fees billed to us by KPMG for assurance and related services that
      are
      not related to the performance of the audit and review of our financial
      statements that are already reported in the paragraph immediately above totaled
      approximately $41,250 and $74,000 for 2005 and 2004, respectively. These costs
      primarily related to services provided in connection with the filing of
      registration statements.




***All
      Other Fees.*** ** The
      aggregate fees billed to us by Amper, Politziner & Mattia for products and
      services rendered by Amper, Politziner & Mattia for tax consulting and other
      services were for $23,000 for 2005 and negligible for 2004. The aggregate fees
      billed to us by KPMG for products and services rendered by KPMG for tax
      consulting were negligible for 2004.




87


***Engagement
      of the Independent Auditor*** *.* The
      Audit Committee is responsible for approving every engagement of Amper,
      Politziner & Mattia to perform audit or non-audit services for us before
      Amper, Politziner & Mattia is engaged to provide those services. Under
      applicable Commission rules, the Audit Committee is required to pre-approve
      the
      audit and non-audit services performed by the independent auditors in order
      to
      ensure that they do not impair the auditors’ independence. The Commission’s
      rules specify the types of non-audit services that an independent auditor may
      not provide to its audit client and establish the Audit Committee’s
      responsibility for administration of the engagement of the independent
      auditors.




Consistent
      with the Commission’s rules, the Audit Committee Charter requires that the Audit
      Committee review and pre-approve all audit services and permitted non-audit
      services provided by the independent auditors to us or any of our subsidiaries.
      The Audit Committee may delegate pre-approval authority to a member of the
      Audit
      Committee and if it does, the decisions of that member must be presented to
      the
      full Audit Committee at its next scheduled meeting.




The
      Audit
      Committee’s pre-approval policy provides as follows:




·  First,
      once a year when the base audit engagement is reviewed and approved, management
      will identify all other services (including fee ranges) for which management
      knows it will engage Amper, Politziner & Mattia for the next 12 months.
      Those services typically include quarterly reviews, specified tax matters,
      certifications to the lenders as required by financing documents, consultation
      on new accounting and disclosure standards and, in future years, reporting
      on
      management’s internal controls assessment.




·  Second,
      if any new “unlisted” proposed engagement arises during the year, the engagement
      will require approval of the Audit Committee.




***Auditor
      Selection for Fiscal 2006*** Amper,
      Politziner & Mattia **** has
      been
      selected to serve as our independent auditors for the year ending December
      31,
      2006, subject to conclusion of an engagement letter and ratification by our
      stockholders at the next Annual Meeting.




**PART
      IV**




**Item
      15**   **Exhibits**




(a)(1)
            Financial
                Statements




Consolidated
      balance sheet of PhotoMedex, Inc. and subsidiaries as of December 31, 2005
      and
      2004, and the related consolidated statements of operations, stockholders'
      equity, and cash flows for each of the years in the 3-year period ended December
      31, 2005.




(a)(2)  Financial
      Statement Schedules




All
      schedules have been omitted because they are not required, not applicable,
      or
      the information is otherwise set forth in the consolidated financial statements
      or notes thereto.




(a)(3)  Other
      Exhibits




2.1
            Agreement
                and Plan of Merger, dated September 25, 2002, between PhotoMedex,
                Inc., J
                Merger Corp., Inc. and Surgical Laser Technologies, Inc.
                (1)2.2
            Agreement
                and Plan of Merger, dated December 1, 2004, between PhotoMedex, Inc.,
                Gold
                Acquisition Merger Corp. and ProCyte Corporation (2)3.1(a)
            Certificate
                of Incorporation, filed on November 3, 1987 (3)3.1(b)
            Amendment
                to Certificate of Incorporation, filed on July 19, 1999
                (3)3.1(c)
            Amendment
                to Certificate of Incorporation, filed on July 22, 1999
                (3)3.1(d)
            Restated
                Certificate of Incorporation, filed on August 8, 2000
                (4)3.1(e)
            Amendment
                to Restated Certificate of Incorporation, filed on January 6, 2004.
                (11)


3.2
            Amended
                and Restated Bylaws (5)




88




10.1
            Lease
                Agreement (Carlsbad, California) dated August 4, 1998
                (3)10.2
            Patent
                License Agreement between the Company and Patlex Corporation
                (6)10.3
            Clinical
                Trial Agreement between Massachusetts General Hospital, R. Rox Anderson
                and the Company, dated March 17, 1998 (3)10.4
            Consulting
                Agreement dated as of January 21, 1998 between the Company and R. Rox
                Anderson, M.D. (3)10.5
            Amended
                and Restated Employment Agreement with Jeffrey F. O'Donnell, dated
                August
                1, 2002 (1)10.6
            Amended
                and Restated Employment Agreement with Dennis M. McGrath, dated August
                1,
                2002 (1)10.7
            Lease
                between the Company and Radnor Center Associates, dated April 1, 2000
                (3)10.8
            Healthworld
                Agreement, dated May 11, 1999 (3)10.9
            Clinical
                Trial Agreement, dated July 27, 1999 (Scalp Psoriasis)
                (3)10.10
            Clinical
                Trial Agreement, dated July 27, 1999, and Amendment dated
                March 1, 2000(Plaque
                Psoriasis) (3)10.11
            Clinical
                Trial Agreement, dated July 27, 1999 (High Fluence)
                (3)10.12
            Clinical
                Trial Agreement, dated November 15, 1999 (Vitiligo)
                (3)10.13
            Massachusetts
                General Hospital License Agreement, dated November 26, 1997
                (3)10.14
            Asset
                Purchase Agreement with Laser Components GmbH, dated February 29,
                2000 (3)10.15
            Amended
                and Restated 2000 Stock Option Plan (1)10.16
            Amended
                and Restated 2000 Non-Employee Director Stock Option Plan
                (1)10.17
            Revolving
                Loan Agreement, dated May 31, 2000, between Surgical Laser Technologies,
                Inc. and AmSouth Bank (7)10.18
            First
                Amendment to Revolving Loan Agreement, dated February 20, 2002, between
                Surgical Laser Technologies, Inc. and AmSouth Bank (7)10.19
            Second
                Amendment to Revolving Loan Agreement, dated June 26, 2002, between
                Surgical Laser Technologies, Inc. and AmSouth Bank (7)10.20
            Third
                Amendment to Revolving Loan Agreement, dated February 27, 2003, between
                Surgical Laser Technologies, Inc. and AmSouth Bank (7)10.21
            Fourth
                Amendment to Revolving Loan Agreement, dated February 27, 2003, between
                Surgical Laser Technologies, Inc. and AmSouth Bank (7)10.22
            Fifth
                Amendment to Revolving Loan Agreement, dated February 27, 2003, between
                Surgical Laser Technologies, Inc. and AmSouth Bank (7)10.23
            Sixth
                Amendment to Revolving Loan Agreement, dated February 27, 2003, between
                Surgical Laser Technologies, Inc. and AmSouth Bank (7)10.24
            Note
                for Business and Commercial Loans, dated March 26, 2003, made by
                Surgical
                Laser Technologies, Inc. in favor of AmSouth Bank (7)10.25
            Addendum
                to Note for Business and Commercial Loans LIBOR rate, dated March
                26,
                2003, made by Surgical Laser Technologies, Inc. in favor of AmSouth
                Bank
                (7)10.26
            Security
                Agreement (Accounts, Inventory and General Intangibles), dated May
                31,
                2000, granted by Surgical Laser Technologies, Inc. to AmSouth Bank
                (7)10.27
            Security
                Agreement for Tangible Personal Property, dated May 31, 2000, granted
                by
                Surgical Laser Technologies, Inc. to AmSouth Bank (7)10.28
            Limited
                Security Agreement (Alabama), dated May 31, 2000, granted by Surgical
                Laser Technologies, Inc. to AmSouth Bank (7)10.29
            Letter
                of waiver from AmSouth Bank, dated February 27, 2003
                (6)10.30
            Continuing
                Guaranty Agreement, dated March 26, 2003, by PhotoMedex, Inc. in
                favor of
                AmSouth Bank (7)10.31
            Lease
                Agreement dated May 29, 1996, between Surgical Laser Technologies,
                Inc.
                and Nappen & Associates (Montgomeryville, Pennsylvania)
                (7)10.32
            Lease
                Renewal Agreement, dated January 18, 2001, between Surgical Laser
                Technologies, Inc. and Nappen & Associates (7)10.33
            License
                and Development Agreement, dated May 22, 2002, between Surgical Laser
                Technologies, Inc. and Reliant Technologies, Inc. (7)10.34
            Secured
                Promissory Note, dated May 22, 2002, between Surgical Laser Technologies,
                Inc. and Reliant Technologies, Inc. (7)10.35
            Security
                Agreement, dated May 22, 2002, between Surgical Laser Technologies,
                Inc.
                and Reliant Technologies, Inc. (7)




89




10.36
            Agreement
                as to Collateral, dated May 22, 2002, among Surgical Laser Technologies,
                Inc., Reliant Technologies, Inc. and AmSouth Bank (7)10.37
            Employment
                Agreement of Michael R. Stewart, dated December 27, 2002
                (7)10.38
            Seventh
                Amendment to Revolving Loan Agreement and related agreements, dated
                March
                10, 2004, among Surgical Laser Technologies, Inc., PhotoMedex, Inc
                and
                AmSouth Bank (11)10.39
            Note
                for Business and Commercial Loans, dated May 13, 2003, made by Surgical
                Laser Technologies, Inc. in favor of AmSouth Bank (8)10.40
            Addendum
                to Note for Business and Commercial Loans, LIBOR rate, dated May
                13, 2003,
                made by Surgical Laser Technologies, Inc. in favor of AmSouth Bank
                (8)10.41
            Letter
                Agreement dated October 28, 2003 between PhotoMedex and True North
                Capital
                Ltd. (9)10.42
            Employment
                Agreement of John F. Clifford, dated March 18, 2005 (2)10.43
            Employment
                Agreement of Robin L. Carmichael, dated March 18, 2005
                (2)10.44
            Restricted
                Stock Purchase Agreement of Jeffrey F. O’Donnell, dated January 15,
                200610.45
            Restricted
                Stock Purchase Agreement of Dennis M. McGrath, dated January 15,
                200610.46
            2005
                Equity Compensation Plan, approved December 28, 2005
                (13)10.47
            2005
                Investment Plan, approved December 28, 2005 (13)10.48
            2004
                Stock Option Plan, assumed from ProCyte (12)10.49
            1996
                Stock Option Plan, assumed from ProCyte (12)10.50
            1991
                Restated Stock Option Plan for Non-Employee Directors, assumed from
                ProCyte (12)10.51
            1989
                Restated Stock Option Plan, assumed from ProCyte (12)10.52
            Standard
                Industrial/Commercial Multi-Tenant Lease - Net, dated March 17, 2005
                (Carlsbad, California)10.53
            Industrial
                Real Estate Lease, dated August 30, 1993, as amended five times (Redmond,
                Washington)10.54
            Master
                  Purchase Agreement, dated September 7, 2004, between PhotoMedex,
                  Inc. and
                  Stern Laser,srl
                  (14)10.55
            Master
                  Lease Agreement, dated June 25, 2004, between PhotoMedex, Inc.
                  and GE
                  Capital Corporation.(15)16.1
            Letter
                re Change in Certifying Accountant (10)22.1
            List
                of subsidiaries of the Company23.1
            Consent
                of Amper, Politziner & Mattia P.C.23.2
            Consent
                of KPMG LLP31.1
            Rule
                13a-14(a) Certificate of Chief Executive Officer31.2
            Rule
                13a-14(a) Certificate of Chief Financial Officer32.1
            Certificate
                of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as
                adopted
                pursuant to Section 906 of the Sarbanes-Oxley Act of
                200232.2
            Certificate
                of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as
                adopted
                pursuant to Section 906 of the Sarbanes-Oxley Act of
                2002





(1)
            Filed
                as part of our Registration Statement on Form S-4, as filed with
                the
                Commission on October 18, 2002, and as
                amended.




(2)
            Filed
                as part of our Registration Statement on Form S-4/A filed with the
                Commission on January 21, 2005, and as
                amended.




(3)
            Filed
                as part of our Registration Statement on Form S-1, as filed with
                the
                Commission on January 28, 1998, and as
                amended.




(4)
            Filed
                as part of our Quarterly Report on Form 10-Q for the quarter ended
                June
                30, 2000.




(5)
            Filed
                as part of our Quarterly Report on Form 10-Q for the quarter ended
                March
                31, 2003.




(6)
            Filed
                as part of our Annual Report on Form 10-K for the year ended
                December 31, 1987.




(7)
            Filed
                as part of our Annual Report on Form 10-K for the year ended December
                31,
                2002.




(8)
            Filed
                as part of our Quarterly Report on Form 10-Q for the quarter ended
                June
                30, 2003.




(9)
            Filed
                as part of our Quarterly Report on Form 10-Q for the quarter ended
                September 30, 2003.




(10)
            Filed
                as part of our Current Report on Form 8-K, dated May 9, 2000, and as
                amended.




(11)
            Filed
                as part of our Annual Report on Form 10-K for the year ended December
                31,
                2003.




(12)
            Filed
                as part of our Registration Statement on Form S-8, as filed with
                the
                Commission on April 13, 2005.




(13)
              Filed
                  as part of our Definitive Proxy Statement on Schedule 14A, as filed
                  with
                  the Commission on November 15, 2005.
 
 (14)
              Filed
                  as part of our Current Report on Form 8-K, dated September 10,
                  2004.
 
 (15)
              Filed
                  as part of our Quarterly Report on Form 10-Q for the quarter ended
                  June
                  30, 2004.




90


**AVAILABLE
      INFORMATION**




We
      are a
      reporting company and file annual, quarterly and special reports, proxy
      statements and other information with the Commission. You may inspect and copy
      these materials at the Public Reference Room maintained by the Commission at
      Room 1024, 450 Fifth Street, N.W., Washington, D.C. 20549. Please call the
      Commission at 1-800-SEC-0330 for more information on the Public Reference Room.
      You can also find our Commission filings at the Commission's website at
      www.sec.gov. You may also inspect reports and other information concerning
      us at
      the offices of the Nasdaq Stock Market at 1735 K Street, N.W., Washington,
      D.C.
      20006. We intend to furnish our stockholders with annual reports containing
      audited financial statements and such other periodic reports as we may determine
      to be appropriate or as may be required by law.




Our
      primary Internet address is www.photomedex.com .
      Corporate information can be located by clicking on the “Investor Relations”
link in the top-middle of the page, and then clicking on “SEC Filing” in the
      menu. We make our periodic Commission Reports (Forms 10-Q and Forms 10-K) and
      current reports (Form 8-K) available free of charge through our Web site as
      soon
      as reasonably practicable after they are filed electronically with the
      Commission. We may from time to time provide important disclosures to investors
      by posting them in the Investor Relations section of our Web site, as allowed
      by
      Commission’s rules.









**DOCUMENTS
      INCORPORATED BY REFERENCE**




Certain
      documents listed above in Part IV, Item 15 of this Report, as exhibits to this
      Report on Form 10-K, are incorporated by reference from other documents
      previously filed by us.




91


**SIGNATURES**




Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Act of
      1934, the registrant has duly caused this Report to be signed on its behalf
      by
      the undersigned, thereunto duly authorized.




PHOTOMEDEX,
              INC.Date: March
              16, 2006
            By:
            /s/ 
              Jeffrey F. O’DonnellJeffrey
              F. O’DonnellPresident,
              Chief Executive Officerand
              Director




Pursuant
      to the requirements of the Securities Exchange Act of 1934, this Report has
      been
      signed below by the following persons on behalf of the registrant and in the
      capacities and on the dates indicated.




Signature
            
            Capacity
                in Which Signed
            
            Date/s/
                Richard J. DePiano
            
            Chairman
                of the Board of Directors
            
            March
                16, 2006Richard
                J. DePiano/s/
                Jeffrey F. O’Donnell
            
            President,
                Chief Executive Officer and Director
            
            March
                16, 2006Jeffrey
                F. O'Donnell/s/
                Dennis M. McGrath
            
            Chief
                Financial Officer
            
            March
                16, 2006Dennis
                M. McGrath/s/
                Alan R. Novak
            
            Director
            
            March
                16, 2006Alan
                R. Novak/s/
                David W. Anderson
            
            Director
            
            March
                16, 2006David
                W. Anderson/s/
                Warwick Alex Charlton
            
            Director
            
            March
                16, 2006Warwick
                Alex Charlton/s/
                Anthony J. Dimun
            
            Director
            
            March
                16, 2006Anthony
                J. Dimun







92


PHOTOMEDEX,
      INC. AND SUBSIDIARIES




Index
      to
      Consolidated Financial Statements


PageReport
                of Independent Registered Public Accounting Firm
            F-2Report
                of Independent Registered Public Accounting Firm
            F-3Report
                of Independent Registered Public Accounting Firm
            F-4Consolidated
                Balance Sheets, December 31, 2005 and 2004
            F-5Consolidated
                Statements of Operations, Years ended December 31, 2005, 2004 and
                2003
            F-6Consolidated
                Statements of Stockholders’ Equity, Years ended December 31,
                2005,2004
                and 2003
            F-7Consolidated
                Statements of Cash Flows, Years ended December 31, 2005, 2004 and
                2003
            F-8Notes
                to Consolidated Financial Statements
            F-9







Report
      of
      Independent Registered Public Accounting Firm











Board
      of
      Directors and shareholders


PhotoMedex,
      Inc. and Subsidiaries





We
      have
      audited the accompanying consolidated balance sheets of PhotoMedex, Inc. and
      Subsidiaries as of December 31, 2005 and 2004, and the related consolidated
      statements of operations, stockholders’ equity, and cash flows for the years
      ended December 31, 2005 and 2004. These financial statements are the
      responsibility of the Company’s management. Our responsibility is to express an
      opinion on these financial statements based on our audits.





We
      conducted our audits in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether the financial
      statements are free of material misstatement. An audit includes examining,
      on a
      test basis, evidence supporting the amounts and disclosures in the financial
      statements. An audit also includes assessing the accounting principles used
      and
      significant estimates made by management, as well as evaluating the overall
      financial statement presentation. We believe that our audits provide a
      reasonable basis for our opinion.





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the financial position of PhotoMedex, Inc. and
      Subsidiaries as of December 31, 2005 and 2004, and the results of its operations
      and its cash flows for the years ended December 31, 2005 and 2004, in conformity
      with United States generally accepted accounting principles.





We
      also
      have audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the effectiveness of PhotoMedex, Inc. and
      Subsidiary’s internal control over financial reporting as of December 31, 2005,
      based on criteria established in Internal Control—Integrated Framework issued by
      the Committee of Sponsoring Organizations of the Treadway Commission and our
      report dated March 10, 2006 expressed an unqualified opinion
      thereon.


/s/
                Amper, Politziner & Mattia, P. C.March
                  10, 2006
                Edison,
                  New Jersey





F-2





REPORT
      OF
      INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM




Board
      of
      Directors and shareholders


PhotoMedex,
      Inc. and Subsidiaries





We
      have
      audited management’s assessment, included in the accompanying Management’s 2005
      Annual Report on Internal Controls, that PhotoMedex, Inc. and Subsidiaries
      (the
      Company) maintained effective internal control over financial reporting as
      of
      December 31, 2005, based on criteria established in Internal Control—Integrated
      Framework issued by the Committee of Sponsoring Organizations of the Treadway
      Commission (COSO). The Company’s management is responsible for maintaining
      effective internal control over financial reporting and for its assessment
      of
      the effectiveness of internal control over financial reporting. Our
      responsibility is to express an opinion on management’s assessment, and an
      opinion on the effectiveness of the Company’s internal control over financial
      reporting based on our audit.





We
      conducted our audits in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether effective
      internal control over financial reporting was maintained in all material
      respects. Our audit included obtaining an understanding of internal control
      over
      financial reporting, evaluating management’s assessment, testing and evaluating
      the design and operating effectiveness of internal control, and performing
      such
      other procedures as we considered necessary in the circumstances. We believe
      that our audits provide a reasonable basis for our opinion.





A
      company’s internal control over financial reporting is a process designed to
      provide reasonable assurance regarding the reliability of financial reporting
      and the preparation of financial statements for external purposes in accordance
      with generally accepted accounting principles. A company’s internal control over
      financial reporting includes those policies and procedures that (1) pertain
      to
      the maintenance of records that, in reasonable detail, accurately and fairly
      reflect the transactions and dispositions of the assets of the company; (2)
      provide reasonable assurance that transactions are recorded as necessary to
      permit preparation of financial statements in accordance with generally accepted
      accounting principles, and that receipts and expenditures of the company are
      being made only in accordance with authorizations of management and directors
      of
      the company; and (3) provide reasonable assurance regarding prevention or timely
      detection of unauthorized acquisition, use, or disposition of the Company’s
      assets that could have a material effect on the financial
      statements.





Because
      of its inherent limitations, internal control over financial reporting may
      not
      prevent or detect misstatements. Also, projections of any evaluation of
      effectiveness to future periods are subject to the risk that controls may become
      inadequate because of changes in conditions, or that the degree of compliance
      with the policies or procedures may deteriorate.





In
      our
      opinion, management’s assessment that the Company maintained effective internal
      control over financial reporting as of December 31, 2005, is fairly stated,
      in
      all material respects, based on control criteria established in Internal
      Control—Integrated Framework issued by the Committee of Sponsoring Organizations
      of the Treadway Commission (COSO). Also in our opinion, the Company maintained,
      in all material respects, effective internal control over financial reporting
      as
      of December 31, 2005, based on the criteria established in Internal
      Control—Integrated Framework issued by the Committee of Sponsoring Organizations
      of the Treadway Commission (COSO).





We
      have
      also audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the consolidated balance sheet of PhotoMedex,
      Inc. and Subsidiaries as of December 31, 2005 and the related consolidated
      statements of operations, stockholders’ equity and cash flows for the years
      ended December 31, 2005 in our report dated March 10, 2006, expressed an
      unqualified opinion.


/s/
              Amper, Politziner & Mattia, P. C.March
                10, 2006
              Edison,
                New Jersey




F-3




REPORT
        OF
        INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
  To
        Board
        of Directors and Stockholders
 PhotoMedex,
        Inc. and Subsidiaries:
  
  We
        have
        audited the 2003 consolidated financial statements of PhotoMedex, Inc. and
        subsidiaries as listed in the accompanying index. These consolidated financial
        statements are the responsibility of the Company's management. Our
        responsibility is to express an opinion on these consolidated financial
        statements based on our audit.
  We
        conducted our audit in accordance with the standards of the Public Company’s
        Accounting Oversight Board (United States). Those standards require that
        we plan
        and perform the audit to obtain reasonable assurance about whether the financial
        statements are free of material misstatement. An audit includes examining,
        on a
        test basis, evidence supporting the amounts and disclosures in the financial
        statements. An audit also includes assessing the accounting principles used
        and
        significant estimates made by management, as well as evaluating the overall
        financial statement presentation. We believe that our audit provides a
        reasonable basis for our opinion.
  In
        our
        opinion, the 2003 consolidated financial statements referred to above present
        fairly, in all material respects, the results of the operations, changes
        in
        stockholders’ equity, and cash flows of PhotoMedex, Inc. and subsidiaries for
        the year ended December 31, 2003 in conformity with United States generally
        accepted accounting principles.
  As
        discussed in Note 1 to the consolidated financial statements, effective January
        1, 2002, the Company adopted Statement of Financial Accounting Standards
        No.
        142, “Goodwill and Other Intangible Assets.”
  /s/
        KPMG
        LLP
 
 Philadelphia,
        Pennsylvania
 February
        18, 2004 (except with respect to the eleventh paragraph
 of
        note
        10, as to which the date is March 10, 2004)




F-4


PHOTOMEDEX,
      INC. AND SUBSIDIARIES




CONSOLIDATED
      BALANCE SHEETS




ASSETS
            
            December
                31,2005
            
            2004Current
                assets:Cash
                and cash equivalents
            
            $
            5,403,036
            
            $
            3,884,817Restricted
                cash
            
            
            206,931
            
            
            112,200Accounts
                receivable, net of allowance for doubtful accounts of $765,440 and
                $736,505
            
            
            4,651,080
            
            
            4,117,399Inventories
            
            
            8,047,444
            
            
            4,585,631Prepaid
                expenses and other current assets
            
            
            621,372
            
            
            401,989Total
                current assets
            
            
            18,929,863
            
            
            13,102,036Property
                and equipment, net
            
            
            7,044,713
            
            
            4,996,688Patents
                and licensed technologies, net
            
            
            1,577,554
            
            
            929,434Goodwill,
                net
            
            
            16,375,384
            
            
            2,944,423Other
                intangible assets, net
            
            
            4,467,625
            
            
            —Capitalized
                acquisition costs
            
            
            —
            
            
            762,477Other
                assets
            
            
            280,467
            
            
            226,868Total
                assets
            
            $
            48,675,606
            
            $
            22,961,926LIABILITIES
                AND STOCKHOLDERS' EQUITYCurrent
                liabilities:Current
                portion of notes payable
            
            $
            228,398
            
            $
            69,655Current
                portion of long-term debt
            
            
            1,749,969
            
            
            873,754Accounts
                payable
            
            
            3,572,077
            
            
            3,515,293Accrued
                compensation and related expenses
            
            
            867,427
            
            
            963,070Other
                accrued liabilities
            
            
            924,968
            
            
            924,054Deferred
                revenues
            
            
            466,032
            
            
            636,962Total
                current liabilities
            
            
            7,808,871
            
            
            6,982,788Notes
                payable, net of current maturities
            
            
            159,213
            
            
            26,736Long-term
                debt, net of current maturities
            
            
            2,278,871
            
            
            1,372,119Other
                liabilities
            
            
            11,623
            
            
            —Total
                liabilities
            
            
            10,258,578
            
            
            8,381,643Commitment
                and contingenciesStockholders'
                Equity:Common
                Stock, $.01 par value, 75,000,000 shares authorized; 51,414,294 and
                40,075,019 shares
              issued
                and outstanding at December 31, 2005 and 2004,
                respectively
            
            
            514,143
            
            
            400,750Additional
                paid-in capital
            
            
            118,140,838
            
            
            90,427,632Accumulated
                deficit
            
            
            (80,182,606
            )
            
            (76,246,562
            )Deferred
                compensation
            
            
            (55,347
            )
            
            (1,537
            )Total
                stockholders'
                equity
            
            
            38,417,028
            
            
            14,580,283Total
                liabilities and stockholders’ equity
            
            $
            48,675,606
            
            $
            22,961,926




The
      accompanying notes are an integral part of these consolidated financial
      statements.




F-5


PHOTOMEDEX,
      INC. AND SUBSIDIARIES




CONSOLIDATED
      STATEMENTS OF OPERATIONS





For
                the Year Ended December 31,2005
            
            2004
            
            2003Revenues:Product
                sales
            
            $
            16,544,894
            
            $
            6,497,397
            
            $
            6,870,570Services
            
            
            11,839,612
            
            
            11,247,784
            
            
            7,448,22328,384,506
            
            
            17,745,181
            
            
            14,318,793Cost
                of revenues:Product
                cost of revenues
            
            
            7,219,504
            
            
            3,324,564
            
            
            3,732,109Services
                cost of revenues
            
            
            8,456,001
            
            
            7,038,705
            
            
            6,755,49915,675,505
            
            
            10,363,269
            
            
            10,487,608Gross
                profit
            
            
            12,709,001
            
            
            7,381,912
            
            
            3,831,185Operating
                expenses:Selling,
                general and administrative
            
            
            16,477,322
            
            
            10,426,256
            
            
            9,451,224Engineering
                and product development
            
            
            1,127,961
            
            
            1,801,438
            
            
            1,776,48017,605,283
            
            
            12,227,694
            
            
            11,227,704Loss
                from operations
            
            
            (4,896,282
            )
            
            (4,845,782
            )
            
            (7,396,519
            )Interest
                expense, net
            
            
            (342,299
            )
            
            (138,414
            )
            
            (46,330
            )Other
                income, net
            
            
            1,302,537
            
            
            —
            
            
            —Net
                loss
            
            
            ($
                3,936,044
            )
            
            ($
                4,984,196
            )
            
            ($
                7,442,849
            )Basic
                and diluted net loss per share
            
            
            ($0.08
            )
            
            ($0.13
            )
            
            ($0.21
            )Shares
                used in computing basic and diluted net loss per share
            
            
            48,786,109
            
            
            38,835,356
            
            
            35,134,378





The
      accompanying notes are an integral part of these consolidated financial
      statements






F-6


PHOTOMEDEX,
      INC. AND SUBSIDIARIES


CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS’ EQUITY





Common
                StockShares
            
            Amount
            
            Additional
                  Paid-In
                  Caital
            
            AccumulatedDeficit
            
            DeferredCompensation
            
            TotalBALANCE,
                DECEMBER 31, 2002
            
            
            31,439,058
            
            $
            314,391
            
            $
            76,828,582
            
            
            ($63,819,517
            )
            
            ($14,834
            )
            $
            13,308,622Sale
                of stock, net of expenses
            
            
            5,982,352
            
            
            59,824
            
            
            9,417,722
            
            
            —
            
            
            —
            
            
            9,477,546Exercise
                of warrants
            
            
            253,271
            
            
            2,532
            
            
            460,316
            
            
            —
            
            
            —
            
            
            462,848Exercise
                of stock options
            
            
            61,458
            
            
            614
            
            
            63,918
            
            
            —
            
            
            —
            
            
            64,532Stock
                options issued to consultants for services
            
            
            —
            
            
            —
            
            
            38,164
            
            
            —
            
            
            —
            
            
            38,164Stock
                options issued to former employee
            
            
            —
            
            
            —
            
            
            62,713
            
            
            —
            
            
            —
            
            
            62,713Amortization
                of deferred compensation
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            6,499
            
            
            6,499Net
                loss
            
            
            —
            
            
            —
            
            
            —
            
            
            (7,442,849
            )
            
            —
            
            
            (7,442,849
            )BALANCE,
                DECEMBER 31, 2003
            
            
            37,736,139
            
            
            377,361
            
            
            86,871,415
            
            
            (71,262,366
            )
            
            (8,335
            )
            
            15,978,075Sale
                of stock, net of expenses
            
            
            —
            
            
            —
            
            
            11,199
            
            
            —
            
            
            —
            
            
            11,199Exercise
                of warrants
            
            
            2,104,138
            
            
            21,041
            
            
            3,065,427
            
            
            —
            
            
            —
            
            
            3,086,468Exercise
                of stock options
            
            
            120,865
            
            
            1,209
            
            
            209,074
            
            
            —
            
            
            —
            
            
            210,283Stock
                options issued to consultants for services
            
            
            —
            
            
            —
            
            
            98,435
            
            
            —
            
            
            —
            
            
            98,435Reversal
                of unamortized portion of deferred compensation
              for
                terminated employee
            
            
            —
            
            
            —
            
            
            (532
            )
            
            —
            
            
            532
            
            
            —Registration
                expense for acquisition
            
            
            —
            
            
            —
            
            
            (125,914
            )
            
            —
            
            
            —
            
            
            (125,914
            )Issuance
                of stock for Stern laser assets acquisition, net of
                expenses
            
            
            113,877
            
            
            1,139
            
            
            218,066
            
            
            —
            
            
            —
            
            
            219,205Issuance
                of warrants for draws under line of credit
            
            
            —
            
            
            —
            
            
            80,462
            
            
            —
            
            
            —
            
            
            80,462Amortization
                of deferred compensation
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            6,266
            
            
            6,266Net
                loss
            
            
            —
            
            
            —
            
            
            —
            
            
            (4,984,196
            )
            
            —
            
            
            (4,984,196
            )BALANCE,
                DECEMBER 31, 2004
            
            
            40,075,019
            
            
            400,750
            
            
            90,427,632
            
            
            (76,246,562
            )
            
            (1,537
            )
            
            14,580,283Exercise
                of warrants
            
            
            73,530
            
            
            735
            
            
            146,3254
            
            
            —
            
            
            —
            
            
            147,060Exercise
                of stock options
            
            
            350,189
            
            
            3,502
            
            
            624,329
            
            
            —
            
            
            —
            
            
            627,831Issuance
                of stock for ProCyte merger, net of expense
            
            
            10,540,579
            
            
            105,406
            
            
            26,197,732
            
            
            —
            
            
            (132,081
            )
            
            26,171,057Stock
                options issued to consultants for services
            
            
            —
            
            
            —
            
            
            123,257
            
            
            —
            
            
            —
            
            
            123,257Reversal
                of unamortized portion of deferred compensation for terminated
                employee
            
            
            —
            
            
            —
            
            
            (1,534
            )
            
            —
            
            
            1,534
            
            
            —Amortization
                of deferred compensation
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            76,737
            
            
            76,737Issuance
                of stock for Stern laser assets acquisition, net of
                expenses
            
            
            374,977
            
            
            3,750
            
            
            723,300
            
            
            —
            
            
            —
            
            
            727,050Registration
                expense
            
            
            —
            
            
            —
            
            
            (161,739
            )
            
            —
            
            
            —
            
            
            (161,739
            )Issuance
                of warrants for draws under line of credit
            
            
            —
            
            
            —
            
            
            61,536
            
            
            —
            
            
            —
            
            
            61,536Net
                loss
            
            
            —
            
            
            —
            
            
            —
            
            
            (3,936,044
            )
            
            —
            
            
            (3,936,044
            )BALANCE,
                DECEMBER 31, 2005
            
            
            51,414,294
            
            $
            514,143
            
            $
            118,140,838
            
            
            ($80,182,606
            )
            
            ($55,347
            )
            $
            38,417,028




The
      accompanying notes are an integral part of these consolidated financial
      statements.




F-7


PHOTOMEDEX,
      INC. AND SUBSIDIARIES


CONSOLIDATED
      STATEMENTS OF CASH FLOWS




For
                the Year Ended December 31,2005
            
            2004
            
            2003**Cash
                Flows From Operating Activities:**Net
                loss
            
            
            ($3,936,044
            )
            
            ($4,984,196
            )
            
            ($7,442,849
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Depreciation
                and amortization
            
            
            3,217,200
            
            
            1,765,944
            
            
            2,186,743Loss
                on disposal of property and equipment
            
            
            101,009
            
            
            —
            
            
            7,574Provision
                for doubtful accounts
            
            
            373,964
            
            
            459,861
            
            
            254,429Stock
                options issued to former employee
            
            
            —
            
            
            —
            
            
            62,713Stock
                options and warrants issued to
              consultants
                for services
            
            
            123,257
            
            
            98,435
            
            
            38,164Non-monetary
                exchange
            
            
            (88,667
            )
            
            —
            
            
            —Amortization
                of deferred compensation
            
            
            76,737
            
            
            6,266
            
            
            6,499Changes
                in operating assets and liabilities, net of acquisition:Accounts
                receivable
            
            
            229,768
            
            
            (1,094,230
            )
            
            (1,201,125
            )Inventories
            
            
            (782,880
            )
            
            (628,257
            )
            
            485,694Prepaid
                expenses and other assets
            
            
            1,011,340
            
            
            541,170
            
            
            436,672Accounts
                payable
            
            
            (518,289
            )
            
            1,273,300
            
            
            (443,368
            )Accrued
                compensation and related expenses
            
            
            (246,950
            )
            
            22,718
            
            
            117,353Other
                accrued liabilities
            
            
            (1,023,921
            )
            
            (51,482
            )
            
            (270,897
            )Deferred
                revenues
            
            
            (266,366
            )
            
            (174,750
            )
            
            628,237Net
                cash used in operating activities
            
            
            (1,729,842
            )
            
            (2,765,221
            )
            
            (5,134,161
            )**Cash
                Flows From Investing Activities:**Purchases
                of property and equipment
            
            
            (123,201
            )
            
            (111,319
            )
            
            (51,103
            )Lasers
                placed into service
            
            
            (3,461,803
            )
            
            (1,683,528
            )
            
            (1,556,654
            )Cash
                received from acquisition of ProCyte, net of acquisition
                costs
            
            
            5,578,416
            
            
            (882,823
            )
            
            —Net
                cash provided by (used in) investing activities
            
            
            1,993,412
            
            
            (2,677,670
            )
            
            (1,607,757
            )**Cash
                Flows From Financing Activities:**Proceeds
                from issuance of common stock, net
            
            
            (169,524
            )
            
            (138,858
            )
            
            9,477,546Proceeds
                from exercise of options
            
            
            627,831
            
            
            210,283
            
            
            64,532Proceeds
                from exercise of warrants
            
            
            147,060
            
            
            3,086,468
            
            
            462,848Payments
                on long-term debt
            
            
            (263,442
            )
            
            (291,840
            )
            
            (218,829
            )Payments
                on notes payable
            
            
            (882,032
            )
            
            (587,161
            )
            
            (648,494
            )Net
                advances (repayments) on line of credit
            
            
            1,889,487
            
            
            527,548
            
            
            (1,770,268
            )(Increase)
                decrease in restricted cash, cash equivalents and short-term
                investments
            
            
            (94,731
            )
            
            (112,200
            )
            
            2,000,000Net
                cash provided by financing activities
            
            
            1,254,649
            
            
            2,694,240
            
            
            9,367,335Net
                increase (decrease) in cash and cash equivalents
            
            
            1,518,219
            
            
            (2,748,651
            )
            
            2,625,417Cash
                and Cash Equivalents, Beginning of Year
            
            
            3,884,817
            
            
            6,633,468
            
            
            4,008,051Cash
                and Cash Equivalents, End of Year
            
            $
            5,403,036
            
            $
            3,884,817
            
            $
            6,633,468




The
      accompanying notes are an integral part of these consolidated financial
      statements.




F-8


PHOTOMEDEX,
      INC. AND SUBSIDIARIES




NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS





*Note
      1*


**The
      Company and Summary of Significant Accounting Policies:**




**The
      Company:**




***Background***


PhotoMedex,
      Inc. and subsidiaries (the “Company”) is a medical device and specialty
      pharmaceutical company focused on facilitating the cost-effective use of
      technologies for doctors, hospitals and surgery centers to enable their patients
      to achieve a higher quality of life. The Company develops, manufactures and
      markets excimer-laser-based instrumentation designed to phototherapeutically
      treat psoriasis, vitiligo, atopic dermatitis and leukoderma. In January 2000,
      the Company received the first Food and Drug Administration (“FDA”) clearance to
      market an excimer laser system, the XTRAC® system, for the treatment of
      psoriasis. In March 2001, the Company received FDA clearance to treat vitiligo;
      in August 2001, the Company received FDA clearance to treat atopic dermatitis;
      and in May 2002, the FDA granted 510(k) clearance to market the XTRAC system
      for
      the treatment of leukoderma. The Company launched the XTRAC phototherapy
      treatment system commercially in the United States in August 2000.




As
      a
      result of the acquisition of Surgical Laser Technologies, Inc. (“SLT”) on
      December 27, 2002, the Company also develops, manufactures and markets
      proprietary lasers and delivery systems for both contact and non-contact surgery
      and provides surgical services utilizing these and other manufacturers’
products.




Through
      the acquisition of ProCyte Corporation (“ProCyte”) on March 18, 2005, the
      Company also develops, manufactures and markets products for skin health, hair
      care and wound care.  Many of the Company’s products incorporate its
      patented copper peptide technologies. See *Note
      2* .




The
      Company operates in five segments (as described in *Note
      17* ):
      Domestic XTRAC, International XTRAC, Skin Care (ProCyte), surgical services
      (SLT) and surgical products and other (SLT).




***Liquidity
      and Going Concern***


The
      Company has incurred significant losses and negative cash flows from operations
      since emerging from bankruptcy in May 1995. As of December 31, 2005, the Company
      had an accumulated deficit of $80,182,606. The Company has reduced its net
      loss
      for 2005 by $1,048,152, a 21% improvement, compared to 2004. The Company has
      historically financed its activities from operations, the private placement
      of
      equity securities and from lines of credit. To date, the Company has dedicated
      most of its financial resources to research and development, marketing and
      general and administrative expenses.




Cash
      and
      cash equivalents as of December 31, 2005 were $5,609,967, including restricted
      cash of $206,931. Management believes that the existing cash balance together
      with its existing financial resources, including the leasing credit line
      facility with a remaining availability of $2,229,960 (see *Note
      10* ),
      and
      any revenues from sales, distribution, licensing and manufacturing
      relationships, will be sufficient to meet the Company’s operating and capital
      requirements into the second quarter of 2007. The 2006 operating plan reflects
      anticipated growth from an increase in per-treatment fee revenues for use of
      the
      XTRAC system based on wider insurance coverage in the United States and
      continuing cost savings from the integration of business operations acquired
      from ProCyte. In addition, the 2006 operating plan calls for increased revenues
      and profits from the Domestic XTRAC segment and the continued growth of our
      skin
      care products. However, depending upon the Company’s rate of growth and other
      operating factors, the Company may require additional equity or debt financing
      to meet its working capital requirements or capital expenditure needs for 2006.
      There can be no assurance that additional financing, if needed, will be
      available when required or, if available, can be obtained on terms satisfactory
      to the Company.




Since
      2002, the Company has made significant progress in obtaining more extensive
      reimbursement approval from the Centers for Medicare and Medicaid Services
      and
      various private health plans for the treatment of skin disorders using the
      XTRAC
      system.




The
      Company plans to continue to focus on securing reimbursement from more private
      insurers and to devote sales and marketing efforts where such reimbursement
      has
      become available. As approvals for reimbursement are obtained, the Company
      will
      increase spending on the marketing of its psoriasis, vitiligo, atopic dermatitis
      and leukoderma treatment products and, if necessary, expansion of its
      manufacturing facilities. Notwithstanding the approval for reimbursement by
      Centers for Medicare and Medicaid Services and recent approvals by certain
      private insurers, the Company may continue to face resistance from some private
      healthcare insurers to adopt the excimer-laser-based therapy as an approved
      procedure or to provide adequate levels of reimbursement. Management cannot
      provide assurance that the Company will market the product successfully or
      operate profitably in the future, or that it will not require significant
      additional financing in order to accomplish its business plan objectives.




F-9


The
      Company’s future success depends in part upon increased patient acceptance of
      its excimer-laser-based systems for the treatment of a variety of skin
      disorders. The Company’s ability to introduce successful new products may be
      adversely affected by a number of factors, such as unforeseen costs and
      expenses, technological change, economic downturns, increased competition or
      other factors beyond the Company’s control. Consequently, the Company’s
      historical operating results cannot be relied on to be an indicator of future
      performance, and management cannot predict whether the Company will obtain
      or
      sustain positive operating cash flow or generate net income in the
      future.




**Summary
      of Significant Accounting Policies:**




***Principles
      of Consolidation***


The
      consolidated financial statements include the accounts of the Company and its
      wholly-owned subsidiaries. All significant intercompany balances and
      transactions have been eliminated.




***Use
      of Estimates***


The
      preparation of the consolidated financial statements in conformity with
      accounting principles generally accepted in the United States requires
      management to make estimates and assumptions that affect amounts reported in
      the
      financial statements and accompanying notes. Actual results could differ from
      those estimates and be based on events different from those assumptions. Future
      events and their effects cannot be perceived with certainty; estimating,
      therefore, requires the exercise of judgment. Thus, accounting estimates change
      as new events occur, as more experience is acquired, or as additional
      information is obtained. See ***Revenue
      Recognition*** for
      discussion of updates and changes in estimates for XTRAC domestic revenues
      in
      accordance with Staff Accounting Bulletin Nos. 101 and 104 and SFAS No.
      48.




***Cash
      and Cash Equivalents and Restricted Cash***


The
      Company invests its excess cash in highly liquid short-term investments. The
      Company considers short-term investments that are purchased with an original
      maturity of three months or less to be cash equivalents. Cash and cash
      equivalents consisted of cash and money market accounts at December 31, 2005
      and
      2004. Cash that is pledged to secure obligations is disclosed separately as
      restricted cash. The Company maintains its cash and cash equivalents in accounts
      in several banks, the balances which at times may exceed federally insured
      limits.




***Accounts
      Receivable***


The
      majority of the Company’s accounts receivables are due from distributors
      (domestic and international), hospitals, universities and physicians and other
      entities in the medical field. Credit is extended based on evaluation of a
      customer’s financial condition and, generally, collateral is not required.
      Accounts receivable are most often due within 30 to 90 days and are stated
      at
      amounts due from customers net of an allowance for doubtful accounts. Accounts
      outstanding longer than the contractual payment terms are considered past due.
      The Company determines its allowance by considering a number of factors,
      including the length of time trade accounts receivable are past due, the
      Company’s previous loss history, the customer’s current ability to pay its
      obligation to the Company, and the condition of the general economy and the
      industry as a whole. The Company writes-off accounts receivable when they become
      uncollectible, and payments subsequently received on such receivables are
      credited to the allowance for doubtful accounts. The Company does not accrue
      interest on accounts receivable past due.




***Inventories***


Inventories
      are stated at the lower of cost (first-in, first-out basis) or market. Cost
      is
      determined to be purchased cost for raw materials and the production cost
      (materials, labor and indirect manufacturing cost) for work-in-process and
      finished goods. Throughout the laser manufacturing process, the related
      production costs are recorded within inventory. Work-in-process is immaterial,
      given the typically short manufacturing cycle, and therefore is disclosed in
      conjunction with raw materials.




The
      Company's skin disorder treatment equipment will either (i) be sold to
      distributors or physicians directly or (ii) be placed in a physician's office
      and remain the property of the Company. The cost to build a laser, whether
      for
      sale or for placement, is accumulated in inventory. When a laser is placed
      in a
      physician’s office, the cost is transferred from inventory to “lasers in
      service” within property and equipment. At times, units are shipped to
      distributors, but revenue is not recognized until all of the criteria of Staff
      Accounting Bulletin No. 104 have been met, and until that time, the unit is
      carried on the books of the Company as inventory. Revenue is not recognized
      from
      these distributors until payment is either assured or paid in full. Until this
      time, the cost of these shipments continues to be recorded as finished goods
      inventory.




F-10


Reserves
      for slow moving and obsolete inventories are provided based on historical
      experience and product demand. Management evaluates the adequacy of these
      reserves periodically based on forecasted sales and market trend.




***Property,
      Equipment and Depreciation***


Property
      and equipment are recorded at cost. Excimer lasers-in-service are depreciated
      on
      a straight-line basis over the estimated useful life of three years. Surgical
      lasers-in-service are depreciated on a straight-line basis over an estimated
      useful life of seven years if new, and five years or less if used equipment.
      The
      straight-line depreciation basis for lasers-in-service is reflective of the
      pattern of use. For other property and equipment, depreciation is calculated
      on
      a straight-line basis over the estimated useful lives of the assets, primarily
      three to seven years for computer hardware and software, furniture and fixtures,
      automobiles, and machinery and equipment. Leasehold improvements are amortized
      over the lesser of the useful lives or lease terms. Expenditures for major
      renewals and betterments to property and equipment are capitalized, while
      expenditures for maintenance and repairs are charged to operations as incurred.
      Upon retirement or disposition, the applicable property amounts are deducted
      from the accounts and any gain or loss is recorded in the consolidated
      statements of operations. Useful lives are determined based upon an estimate
      of
      either physical or economic obsolescence.




Laser
      units and laser accessories located at medical facilities for sales evaluation
      and demonstration purposes or those units/accessories used for development
      and
      medical training are included in property and equipment under the caption
“machinery and equipment”. These units and accessories are being depreciated
      over a period of up to five years. Laser units utilized in the provision of
      surgical services are included in property and equipment under the caption
      “lasers in service” and are depreciated over a five year life, given the
      additional wear and tear that is incurred with movement from site to site.




Management
      evaluates the realizability of property and equipment based on estimates of
      undiscounted future cash flows over the remaining useful life of the asset.
      If
      the amount of such estimated undiscounted future cash flows is less than the
      net
      book value of the asset, the asset is written down to the net realizable value.
      As of December 31, 2005, no such write-down was required (see ***Impairment
      of Long-Lived Assets*** below).




***Patent
      Costs and Licensed Technologies***


Costs
      incurred to obtain or defend patents and licensed technologies are capitalized
      and amortized over the shorter of the remaining estimated useful lives or eight
      to 12 years. Developed technology was recorded in connection with the purchase
      in August 2000 of the minority interest of Acculase, a former subsidiary of
      the
      Company, and is being amortized on a straight-line basis over seven years.
      Developed technology was also recorded in connection with the acquisition of
      ProCyte in March 2005 and is being amortized on a straight-line basis over
      seven
      years.




Management
      evaluates the realizability of intangible assets based on estimates of
      undiscounted future cash flows over the remaining useful life of the asset.
      If
      the amount of such estimated undiscounted future cash flows is less than net
      book value of the asset, the asset is written down to fair value. As of December
      31, 2005, no such write-down was required (see ***Impairment
      of Long-Lived Assets*** below).




***Other
      Intangible Assets***


Other
      intangible assets were recorded in connection with the acquisition of ProCyte
      in
      March 2005. The assets are being amortized on a straight-line basis over 5
      to 10
      years.




Management
      evaluates the recoverability of such other intangible assets based on estimates
      of undiscounted future cash flows over the remaining useful life of the asset.
      If the amount of such estimated undiscounted future cash flows is less than
      the
      net book value of the asset, the asset is written down to fair value. As of
      December 31, 2005, no such write-down was required.




F-11


***Accrued
      Warranty Costs***


The
      Company offers a warranty on product sales generally for a one to two-year
      period. The Company provides for the estimated future warranty claims on the
      date the product is sold. The activity in the warranty accrual during the years
      ended December 31, 2005 and 2004 is summarized as follows:




December
                31,2005
            
            2004Accrual
                at beginning of year
            
            $
            196,890
            
            $
            316,714Additions
                charged to warranty expense
            
            
            105,000
            
            
            408,093Claims
                paid and expiring warranties
            
            
            (97,182
            )
            
            (527,917
            )Accrual
                at end of year
            
            $
            204,708
            
            $
            196,890




***Revenue
      Recognition***


The
      Company has two distribution channels for its phototherapy treatment equipment.
      The Company either (i) sells the laser through a distributor or directly to
      a
      physician or (ii) places the lasers in physician’s offices (at no charge to the
      physician) and charges the physician a fee for an agreed upon number of
      treatments. When the Company sells an XTRAC laser to a distributor or directly
      to a physician, revenue is recognized when the following four criteria under
      Staff Accounting Bulletin No. 104 have been met: (i) the product has been
      shipped and the Company has no significant remaining obligations; (ii)
      persuasive evidence of an arrangement exists; (iii) the price to the buyer
      is
      fixed or determinable; (iv) and collection is probable (the “SAB 104 Criteria”).
      At times, units are shipped, but revenue is not recognized until all of the
      criteria are met, and until that time, the unit is carried on the books of
      the
      Company as inventory.




The
      Company ships most of its products FOB shipping point, although from time to
      time certain customers, for example governmental customers, will insist upon
      FOB
      destination. Among the factors the Company takes into account in determining
      the
      proper time at which to recognize revenue are when title to the goods transfers
      and when the risk of loss transfers. Shipments to distributors that do not
      fully
      satisfy the collection criteria are recognized when invoiced amounts are fully
      paid.




Under
      the
      terms of the distributor agreements, the distributors do not have the right
      to
      return any unit that they have purchased. However, the Company does allow
      products to be returned by its distributors in redress of product defects or
      other claims.




When
      the
      Company places a laser in a physician’s office, it recognizes service revenue
      based on the number of patient treatments used by the physician. Treatments
      in
      the form of random laser-access codes that are sold to physicians, but not
      yet
      used, are deferred and recognized as a liability until the physician performs
      the treatment. Unused treatments remain an obligation of the Company inasmuch
      as
      the treatments can only be performed on Company-owned equipment. Once the
      treatments are delivered to a patient, this obligation has been satisfied.




The
      calculation of unused treatments prior to the fourth quarter of 2004 was based
      upon an estimate that at the end of each accounting period, 15 unused treatments
      existed at each laser location. This was based upon the reasoning that the
      Company generally sells treatments in packages of 30 treatments. Fifteen
      treatments generally represents about one-half the quantity purchased by a
      physician or approximately a one-week supply for 6 to 8 patients. This policy
      had been used on a consistent basis, prior to the fourth quarter of 2004. The
      Company believed this approach to have been reasonable and systematic given
      that: (a) physicians have little motivation to purchase quantities (which they
      are obligated to pay for irrespective of actual use and are generally unable
      to
      seek a credit or refund for unused treatments) that will not be used in a
      relatively short period of time, particularly since in most cases they can
      obtain incremental treatments instantaneously over the phone; and (b) senior
      management regularly reviews purchase patterns by physicians to identify unusual
      buildup of unused treatment codes at a laser site. Moreover, the Company
      continually looks at its estimation model based upon data received from its
      customers.




In
      the
      fourth quarter of 2004, the Company updated the calculations for the estimated
      amount of unused treatments to reflect recent purchasing patterns by physicians
      near year-end. The Company estimated the amount of unused treatments at December
      31, 2004 to include all sales of treatment codes made within the last two weeks
      of the period. Management believes this approach more closely approximates
      the
      actual amount of unused treatments that existed at that date than the previous
      approach. Accounting Principles Board (“APB”) Opinion No. 20 provides that
      accounting estimates change as new events occur, as more experience is acquired,
      or as additional information is obtained and that the effect of the change
      in
      accounting estimate should be accounted for in the current period and the future
      periods that it affects. The Company accounted for this change in the estimate
      of unused treatments in accordance with APB No. 20 and SFAS No. 48. Accordingly,
      the Company’s change in accounting estimate was reported in revenues for the
      fourth quarter of 2004, and was not accounted for by restating amounts reported
      in financial statements of prior periods or by reporting pro-forma amounts
      for
      prior periods.




F-12


The
      Company has continued this approach or method for estimating the amount of
      unused treatments at December 31, 2005. Had the Company applied the
      approach used in 2003 to estimating unused treatments, XTRAC domestic revenues
      would have increased by $73,000 for the year ended December 31, 2005 and
      decreased by $271,000 for the year ended December 31, 2004 as compared to the
      prior method of estimation.




In
      the
      first quarter of 2003, the Company implemented a program to support certain
      physicians in addressing treatments with the XTRAC system that may be denied
      reimbursement by private insurance carriers. The Company recognizes service
      revenue from the sale of treatment codes to physicians participating in this
      program only if and to the extent the physician has been reimbursed for the
      treatments. For the year ended December 31, 2005, the Company deferred an
      additional $57,300, under this program as all the criteria for revenue
      recognition had not been met.




Under
      this program, the Company may reimburse qualifying doctors for the cost of
      the
      Company’s fee but only if they are ultimately denied reimbursement after appeal
      of their claim with the insurance company. The key components of the program
      are
      as follows:




·
            The
                physician practice must be in an identified location where there
                are still
                challenges by insurance companies to reimbursing the
                procedure;




·
            The
                program only covers medically necessary treatments of psoriasis as
                determined by the treating
                physician;




·
            The
                patient must have medical insurance and a claim for the treatment
                must be
                timely filed with the patient’s insurance company;




·
            Upon
                denial by the insurance company (generally within 30 days of filing
                the
                claim), a standard insurance form called an EOB (“Explanation of
                Benefits”) must be submitted to the Company’s in-house appeals group, who
                will then prosecute the appeal. The appeal process can take 6 to
                9
                months;




·
            After
                all appeals have been exhausted by the Company and the claim remains
                unpaid, the physician is entitled to receive credit for the treatment
                he
                or she purchased from the Company (our fee only) on behalf of the
                patient
                and




·
            Physicians
                are still obligated to make timely payments for treatments purchased,
                irrespective of whether reimbursement is paid or denied. Future sale
                of
                treatments to a physician can be denied if timely payments are not
                made,
                even if a patient’s appeal is still in
                process.




Prior
      to
      the fourth quarter of 2004, the Company estimated its liability for potential
      refunds under this program by estimating when the physician would be paid for
      the insurance claim. In the absence of a two-year historical trend and a large
      pool of homogeneous transactions to reliably predict the estimated claims for
      refund as required by Staff Accounting Bulletin Nos. 101 and 104, the Company
      previously deferred revenue recognition of 100% of the current quarter revenues
      from the program to allow for the actual denied claims to be identified after
      processing with the insurance companies.




As
      of
      December 31, 2004, the Company updated its analysis of its estimated refunds
      liability. After more than 143,000 treatments in the last 3 years and detailed
      record keeping of denied insurance claims and appeals processed, the Company
      has
      estimated that approximately 4% of the revenues under this program for the
      quarter ended December 31, 2005 are subject to being credited or refunded to
      the
      physician. The Company estimated that the 11% of the revenues under this program
      for the quarter ended December 31, 2004 were subject to being credited or
      refunded to the physician. This change from the past process of deferring 100%
      of the current quarter revenues from the program represents a change in
      accounting estimate, and management recorded this change in accordance with
      the
      relevant provisions of SFAS No. 48 and APB No. 20. These pronouncements state
      that the effect of a change in accounting estimate should be accounted for
      in
      the current period and the future periods that it affects. A change in
      accounting estimate should not be accounted for by restating amounts reported
      in
      financial statements of prior periods or by reporting proforma amounts for
      prior
      periods. Due to this updated approach in estimates, XTRAC domestic revenues
      were
      increased by $260,000 and $98,000 for the years ended December 31, 2005 and
      2004
      as compared to the prior method of estimation.




F-13


The
      net
      impact on revenue recognized for the XTRAC domestic segment as a result of
      the
      above two changes in accounting estimate was to increase revenues by
      approximately $333,000 for the year ended December 31, 2005 and decreased
      revenues $173,000 for the year ended December 31,2004.




The
      Company generates revenues from the acquired business of ProCyte primarily
      through three channels. The first is through product sales for skin health,
      hair
      care and wound care; the second is through sales of the copper peptide compound,
      primarily to Neutrogena; a Johnson & Johnson Company, and the third is
      through royalties generated by our licenses, principally to Neutrogena. The
      Company recognizes revenues on the products and copper peptide compound when
      they are shipped, net of returns and allowances. The Company ships the products
      FOB shipping point. Royalty revenues are based upon sales generated by our
      licensees. The Company recognizes royalty revenue at the applicable royalty
      rate
      applied to shipments reported by the Company's licensee.




Through
      its surgical businesses, the Company generates revenues primarily from two
      channels. The first is through product sales of laser systems, related
      maintenance service agreements, recurring laser delivery systems and laser
      accessories; the second is through per-procedure surgical services. The Company
      recognizes revenues from surgical laser and other product sales, including
      sales
      to distributors, when the criteria of SAB 104 have been met. For per-procedure
      surgical services, the Company recognizes revenue upon the completion of the
      procedure. Revenue from maintenance service agreements is deferred and
      recognized on a straight-line basis over the term of the agreements. Revenue
      from billable services, including repair activity, is recognized when the
      service is provided.




***Product
      Development Costs***


Costs
      of
      research, new product development and product redesign are charged to expense
      as
      incurred.




***Income
      Taxes***


The
      Company accounts for income taxes in accordance with SFAS No. 109, “Accounting
      for Income Taxes.” Under SFAS No. 109, the liability method is used for income
      taxes. Under this method, deferred tax assets and liabilities are determined
      based on differences between the financial reporting and tax basis of assets
      and
      liabilities and are measured using enacted tax rates and laws that are expected
      to be in effect when the differences reverse.




The
      Company’s deferred tax asset has been fully reserved under a valuation
      allowance, reflecting the uncertainties as to realizability evidenced by the
      Company’s historical results and restrictions on the usage of the net operating
      loss carryforwards. Consistent with the rules of purchase accounting, the
      historical deferred tax asset of ProCyte was valued at zero when the Company
      acquired ProCyte. If and when components of that asset are realized in future,
      the acquired goodwill of ProCyte will be reduced.




***Net
      Loss Per Share***


The
      Company computes net loss per share in accordance with SFAS No. 128, "Earnings
      per Share." In accordance with SFAS No. 128, basic net loss per share is
      calculated by dividing net loss available to common stockholders by the weighted
      average number of common shares outstanding for the period. Diluted net loss
      per
      share reflects the potential dilution from the conversion or exercise of
      securities into common stock, such as stock options and warrants.




In
      these
      consolidated financial statements, diluted net loss per share is the same as
      basic net loss per share. No additional shares for the potential dilution from
      the conversion or exercise of securities into common stock are included in
      the
      denominator since the result would be anti-dilutive. Common stock options and
      warrants of 7,177,955, 6,464,140 and 8,381,279 as of December 31, 2005, 2004
      and
      2003, respectively, were thus excluded from the calculation of fully diluted
      earnings per share.




***Exchanges
      of Nonmonetary Assets***


Exchanges
      under SFAS No. 153, “Exchanges of Nonmonetary Assets,” are measured based on the
      fair value of the assets exchanged. Further, SFAS No. 153 eliminates the
      previous narrow exception for nonmonetary exchanges of similar productive assets
      and replaces it with a broader exception for exchanges of nonmonetary assets
      that do not have “commercial substance.” Although SFAS No. 153 is generally
      effective for financial statements for fiscal years beginning after June 15,
      2005, the Company elected to adopt this Statement for the current fiscal year.
      For 2005, the Company has recognized $88,667 recorded as Other Income in
      accordance with this Statement.




F-14


***Reclassifications***


The
      2003
      consolidated statements of operations have been revised to present product
      and
      services cost of revenues and operating expenses to the current presentation
      format.




***Fair
      Value of Financial Instruments***


The
      estimated fair values for financial instruments under SFAS No. 107, “Disclosures
      about Fair Value of Financial Instruments,” are determined at discrete points in
      time based on relevant market information. These estimates involve uncertainties
      and cannot be determined with precision. The fair value of cash is based on
      its
      demand value, which is equal to its carrying value. The fair values of notes
      payable are based on borrowing rates that are available to the Company for
      loans
      with similar terms, collateral and maturity. The estimated fair values of notes
      payable approximate the carrying values. Additionally, the carrying value of
      all
      other monetary assets and liabilities is estimated to be equal to its fair
      value
      due to the short-term nature of these instruments.




***Impairment
      of Long-Lived Assets***


In
      accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of
      Long-Lived Assets,” long-lived assets, such as property and equipment, and
      purchased intangibles subject to amortization, are reviewed for impairment
      whenever events or changes in circumstances indicate that the carrying amount
      of
      an asset may not be recoverable. Recoverability of assets to be held and used
      is
      measured by a comparison of the carrying amount of an asset to estimated
      undiscounted future cash flows expected to be generated by the asset. If the
      carrying amount of an asset exceeds its estimated future cash flows, an
      impairment charge is recognized by the amount by which the carrying amount
      of
      the asset exceeds the fair value of the asset. Assets to be disposed of would
      be
      separately presented in the balance sheet and reported at the lower of the
      carrying amount or fair value less costs to sell, and would no longer be
      depreciated. The assets and liabilities of a disposed group classified as held
      for sale would be presented separately in the appropriate asset and liability
      sections of the balance sheet. As of December 31, 2005, no such impairment
      exists.




***Stock
      Options***


The
      Company applies the intrinsic-value-based method of accounting prescribed by
      APB
      Opinion No. 25, “Accounting for Stock Issued to Employees,” and related
      interpretations, to account for its fixed-plan stock options. Under this method,
      compensation expense is recorded on the date of grant only if the current market
      price of the underlying stock exceeds the exercise price. Under the provisions
      of SFAS No. 123 (revised 2004), “Share Based Payment,” the Company will,
      starting January 1, 2006, discontinue intrinsic-value-based accounting and
      recognize compensation expense for stock options under fair-value-based
      accounting.




Options
      that were assumed from ProCyte and that were unvested as of March 18, 2005
      were
      re-measured as of March 18, 2005 under intrinsic-value-based accounting.
      Unearned compensation of $132,081 was recorded and will be amortized over the
      remaining vesting period, which is an average of two years.




Had
      stock
      compensation cost for the Company’s common stock options been determined based
      upon the fair value of the options at the date of grant, as prescribed under
      SFAS No. 123, the Company’s net loss and net loss per share would have been
      increased to the following pro-forma amounts:




Year
                Ended December 31,2005
            
            2004
            
            2003Net
                loss:As
                reported
            
            
            ($3,936,044
            )
            
            ($4,984,196
            )
            
            ($7,442,849
            )Less:
                stock-based employee compensation expense
              included
                in reported net loss
            
            
            76,737
            
            
            6,266
            
            
            6,499Impact
                of total stock-based compensation expense determined
              under
                fair value based method for all awards
            
            
            (1,718,296
            )
            
            (1,540,636
            )
            
            (1,485,378
            )Pro-forma
            
            
            ($5,577,603
            )
            
            ($6,518,566
            )
            
            ($8,921,728
            )Net
                loss per share:As
                reported
            
            
            ($0.08
            )
            
            ($0.13
            )
            
            ($0.21
            )Pro-forma
            
            
            ($0.11
            )
            
            ($0.17
            )
            
            ($0.25
            )




The
      above
      pro forma amounts may not be indicative of future amounts because future options
      are expected to be granted.




F-15


The
      fair
      value of the options granted is estimated using the Black-Scholes option-pricing
      model with the following weighted average assumptions applicable to options
      granted during the years:




Year
                Ended December 31,2005
            
            2004
            
            2003Risk-free
                interest rate
            
            
            4.04
            %
            
            3.20
            %
            
            2.98
            %Volatility
            
            
            97.81
            %
            
            99.3
            %
            
            98.9
            %Expected
                dividend yield
            
            
            0
            %
            
            0
            %
            
            0
            %Expected
                option life
            
            
            5
                years
            
            
            5
                years
            
            
            5
                years




We
      account for stock options granted to non-employees on a fair value basis in
      accordance with SFAS No. 123 and Emerging Issues Task Force No. 96-18,
      "Accounting for Equity Instruments that are issued to other than employees
      for
      acquiring or in conjunction with selling goods or services," and recognize
      expense over the applicable service period.




***Supplemental
      Cash Flow Information***


In
      connection with the purchase of ProCyte in March 2005, the Company issued
      10,540,579 shares of common stock and assumed options of 1,354,973 shares of
      common stock (see *Note
      2* ).




During
      the year ended December 31, 2005, the Company financed insurance policies
      through notes payables for $978,252, financed leasehold improvements through
      a
      note payable for $195,000, financed certain credit facility costs for $102,988
      and issued warrants to a leasing credit facility which were valued at $61,536,
      and which offset the carrying value of debt. The Company issued 374,977 shares
      of common stock to Stern Laser srl (“Stern”) upon attainment of certain
      milestones under a Master Purchase Agreement, which is included in patents
      and
      licensed technologies.




During
      the year ended December 31, 2004, the Company financed insurance policies
      through notes payables for $530,977, financed vehicle purchases of $181,578
      under capital leases, financed certain credit facility costs for $217,695 and
      issued warrants to a leasing credit facility which were valued at $80,462,
      and
      which offset the carrying value of debt. In connection with the purchase of
      the
      Stern license and prototypes, the Company issued 113,877 shares of common
      stock.




During
      the year ended December 31, 2003, the Company financed vehicle and equipment
      purchases of $703,482 under capital leases, financed insurance policies through
      notes payable for $479,788 and financed certain acquisition costs which were
      included in accounts payable at December 31, 2002, through a note payable for
      $171,000.




For
      the
      years ended December 31, 2005, 2004 and 2003, the Company paid interest of
      $403,376, $181,115, and $105,634, respectively. Income taxes paid in 2005,
      2004
      and 2003 were immaterial.




***Recent
      Accounting Pronouncements***


In
      May
      2005, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 154,
“Accounting Changes and Error Corrections - replacement of APB Opinion No. 20
      and FASB Statement No. 3,” was issued. SFAS No. 154 changes the accounting for
      and reporting of a change in accounting principle by requiring retrospective
      application to prior periods’ financial statements of changes in accounting
      principle unless impracticable. SFAS No. 154 is effective for accounting changes
      made in fiscal years beginning after December 15, 2005. Management believes
      the
      adoption of this Statement will not have an effect on the consolidated financial
      statements.




On
      December 16, 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment,” which
      is a revision of SFAS No. 123 and supersedes APB Opinion No. 25. In March 2005
      the SEC issued Staff Accounting Bulletin No. 107 (“SAB 107”). SAB 107 expresses
      views of the SEC staff regarding the interaction between SFAS No. 123(R) and
      certain SEC rules. SFAS No. 123(R) requires all share-based payments to
      employees, including grants of employee stock options, to be valued at fair
      value on the date of grant, and to be expensed over the applicable vesting
      period. Pro-forma disclosure of the income statement effects of share-based
      payments will no longer be an alternative. SFAS No. 123(R) is effective for
      all
      stock-based awards granted on or after January 1, 2006. In addition, companies
      must also recognize compensation expense related to any awards that are not
      fully vested as of the effective date. Compensation expense for the unvested
      awards will be measured based on the fair value of the awards previously
      calculated in developing the pro-forma disclosures in accordance with the
      provisions of SFAS No. 123.




F-16


The
      Company plans to adopt SFAS No. 123(R) on January 1, 2006 and to conform to
      SAB
      No. 107. As of December 31, 2005, there are 1,969,267 unvested options,
      approximately $2.6 million in fair value, which will be amortized to expense
      pro
      rata over the next three years. The
      Company intends to account for the effect of forfeited options as the
      forfeitures are incurred, on a quarter by quarter basis.The Company
      currently accounts for share-based payments to its employees using the intrinsic
      value method; consequently, the results of operations have not included the
      recognition of compensation expense for the issuance of stock option awards
      to
      employees, but only to consultants or in connection with respect of unvested
      stock options assumed by the Company from ProCyte.




On
      November 24, 2004, the FASB issued SFAS No. 151, “Inventory Costs,” which is an
      amendment to ARB No. 43, Chapter 4. It clarifies the accounting for abnormal
      amounts of idle facility expense, freight, handling costs, and wasted material
      (spoilage). Under this Statement, these costs should be expensed as incurred
      and
      not included in overhead. Further, SFAS No. 151 requires that allocation of
      fixed production overheads to conversion costs should be based on normal
      capacity of the production facilities. SFAS No. 151 is effective for inventory
      costs incurred during fiscal years beginning after June 15, 2005. Management
      believes the adoption of this Statement will not have a material effect on
      the
      consolidated financial statements.




In
      December 2003, the FASB issued FASB Interpretation No. 46 (revised December
      2003), “Consolidation of Variable Interest Entities,” (“VIEs”) (“FIN 46R”) which
      addresses how a business enterprise should evaluate whether it has a controlling
      financial interest in an entity through means other than voting rights and
      accordingly should consolidate the entity. FIN 46R replaces FASB Interpretation
      No. 46, “Consolidation of Variable Interest Entities,” which was issued in
      January 2003. For any VIEs that were created before January 1, 2004 and that
      must therefore be consolidated under FIN 46R, the assets, liabilities and
      noncontrolling interests of the VIE initially would be measured at their
      carrying amounts with any difference between the net amount added to the balance
      sheet and any previously recognized interest being recognized as the cumulative
      effect of an accounting change. If determining the carrying amounts is not
      practicable, fair value at the date FIN 46R first applies may be used to measure
      the assets, liabilities and noncontrolling interest of the VIE. The Company
      has
      adopted FIN 46R as of March 31, 2004. The adoption of FIN 46R did not have
      an
      effect on the consolidated financial statements inasmuch as the Company has
      no
      interests in any VIEs.




*Note
      2*


**Acquisitions:**




***ProCyte
      Transaction***


On
      March
      18, 2005, the Company completed the acquisition of ProCyte Corporation, which
      was organized in 1986. ProCyte develops, manufactures and markets products
      for
      skin health, hair care and wound care. Many of the Company’s products
      incorporate its patented copper peptide technologies.  ProCyte’s
      focus since 1996 has been to provide unique products primarily based upon
      patented technologies for selected applications in the dermatology, plastic
      and
      cosmetic surgery and spa markets. The Company has also expanded the use of
      its
      novel copper peptide technologies into the mass retail market for skin and
      hair
      care through targeted technology licensing and supply agreements.




ProCyte’s
      products address the growing demand for skin health and hair care products,
      including products designed to enhance appearance and to address the effects
      of
      aging on the skin and hair. ProCyte’s products are formulated, branded for and
      targeted at specific markets. ProCyte’s initial products addressed the
      dermatology, plastic and cosmetic surgery markets for use after various
      procedures. Anti-aging skin care products were later added to expand into a
      comprehensive approach for incorporation into a patient’s skin care regimen.




The
      aggregate purchase price of $27,543,784 consisted of the issuance of 10,540,579
      shares of common stock valued at $2.29 per share, the assumption of 1,354,973
      common stock options valued at $2,033,132 net of deferred compensation of
      $132,081, and $1,372,726 of transaction costs. The merger consideration resulted
      in the equivalent of a fixed ratio of 0.6622 shares of PhotoMedex common stock
      for each share of ProCyte common stock. As the exchange ratio was fixed, the
      fair value of PhotoMedex common stock for accounting purposes was based upon
      a
      five-day average stock price of $2.29 per share. The five-day average included
      the closing prices on the date of the announcement of the planned merger and
      the
      two days prior and afterwards.




F-17


Based
      on
      the purchase price allocation, the following table summarizes the estimated
      fair
      value of the assets acquired and liabilities assumed at the date of acquisition:




Cash
                and cash equivalents
            
            $
            6,272,540Accounts
                receivable
            
            
            1,137,413Inventories
            
            
            2,845,698Prepaid
                expenses and other current assets
            
            
            134,574Property
                and equipment
            
            
            340,531Patents
                and licensed technologies
            
            
            200,000Other
                intangible assets
            
            
            5,200,000Other
                assets
            
            
            38,277Total
                assets acquired
            
            
            16,169,033Accounts
                payable
            
            
            (605,520
            )Accrued
                compensation and related expenses
            
            
            (158,610
            )Other
                accrued liabilities
            
            
            (1,143,761
            )Deferred
                revenues
            
            
            (95,436
            )Other
                liabilities
            
            
            (52,883
            )Total
                liabilities assumed
            
            
            (2,056,210
            )Net
                assets acquired
            
            $
            14,112,823




The
      purchase price exceeded the fair value of the net assets acquired by
      $13,430,961, which was recorded as goodwill.




The
      accompanying consolidated financial statements do not include any revenues
      or
      expenses related to the acquisition on or prior to March 18, 2005, the closing
      date. Following are the Company’s unaudited pro-forma results for the year ended
      December 31, 2005 and 2004, assuming the acquisition had occurred on January
      1,
      2004:




Year
                Ended December 31,2005
            
            2004Net
                revenues
            
            $
            31,354,068
            
            $
            31,066,181Net
                loss
            
            
            ($4,038,193
            )
            
            ($5,507,196
            )Basic
                and diluted loss per share
            
            
            ($0.08
            )
            
            ($0.11
            )Shares
                used in calculating basic and diluted loss per share
            
            
            50,932,410
            
            
            49,375,935




These
      unaudited pro-forma results have been prepared for comparative purposes only
      and
      do not purport to be indicative of the results of operations which would have
      actually resulted had the acquisition occurred on January 1, 2004, nor to be
      indicative of future results of operations.




**Stern
      Laser Transaction**


On
      September 7, 2004, the Company closed the transactions set forth in a Master
      Asset Purchase Agreement (the “Master Agreement”) with Stern Laser srl
      (“Stern”). As of December 31, 2005, the Company has issued to Stern in June and
      December 2005 248,395 and 126,582 shares, respectively, of its restricted common
      stock; as of December 31, 2005, the Company has issued to Stern an aggregate
      488,854 shares of its restricted common stock in connection with the Master
      Agreement. The Company also agreed to pay Stern up to an additional $450,000
      based on the achievement of certain remaining milestones relating to the
      development and commercialization of certain licensed technology and the
      licensed products which may be developed under such arrangement and may have
      certain other obligations to Stern under these arrangements. The Company retains
      the right to pay all of these conditional sums in cash or in shares of its
      common stock, in its discretion. To secure the latter alternative, the Company
      has reserved for issuance, and placed into escrow, 211,146 shares of its
      unregistered stock. The per-share price of any future issued shares will be
      based on the closing price of the Company’s common stock during the 10 trading
      days ending on the date of achievement of a particular milestone under the
      terms
      of the Master Agreement. Stern also has served as the distributor of the
      Company’s XTRAC laser system in South Africa and Italy since 2000. The primary
      asset which the Company have acquired from Stern is a license, which was carried
      on the Company’s books at $942,422 as of December 31, 2005. Amortization of this
      intangible is on a straight-line basis over 10 years, which began in January
      2005. In 2005, Stern Laser purchased $183,000 of product from the
      Company.




F-18


*Note
      3*


**Inventories:**




Set
      forth
      below is a detailed listing of inventories.




December
                31,2005
            
            2004Raw
                materials and work-in-process
            
            $
            4,998,847
            
            $
            2,968,728Finished
                goods
            
            
            3,048,597
            
            
            1,616,903Total
                inventories
            
            $
            8,047,444
            
            $
            4,585,631




Work-in-process
      is immaterial given the typically short manufacturing cycle, and therefore
      is
      disclosed in conjunction with raw materials. Finished goods includes $69,963
      and
      $84,000 as of December 31, 2005 and 2004, respectively, for laser systems
      shipped to distributors, but not recognized as revenue until all the criteria
      of
      Staff Accounting Bulletin No. 104 have been met. At times, units are shipped
      but
      revenue is not recognized until all of the criteria are met, and until that
      time, the unit is carried on the books of the Company as inventory. The Company
      ships most of its products FOB shipping point, although from time to time
      certain customers, for example governmental customers, will insist on FOB
      destination. Among the factors the Company takes into account in determining
      the
      proper time at which to recognize revenue are when title to the goods transfers
      and when the risk of loss transfers. Shipments to the distributors that do
      not
      fully satisfy the collection criteria are recognized when invoiced amounts
      are
      fully paid. As of December 31, 2005 and December 31, 2004, the
      Company carried reserves against our inventories of $931,719 and $770,989,
      respectively.




*Note
      4*


**Property
      and Equipment:**




Set
      forth
      below is a detailed listing of property and equipment.




December
                31,2005
            
            2004Lasers
                in service
            
            $
            12,657,701
            
            $
            9,333,591Computer
                hardware and software
            
            
            334,490
            
            
            256,340Furniture
                and fixtures
            
            
            338,089
            
            
            239,520Machinery
                and equipment
            
            
            755,565
            
            
            522,643Autos
                and trucks
            
            
            382,690
            
            
            400,570Leasehold
                improvements
            
            
            238,276
            
            
            110,44114,706,811
            
            
            10,863,105Accumulated
                depreciation and amortization
            
            
            (7,662,098
            )
            
            (5,866,417
            )Property
                and equipment, net
            
            $
            7,044,713
            
            $
            4,996,688




Depreciation
      expense was $2,226,933 in 2005, $1,596,154 in 2004 and $2,011,596 in 2003.
      At
      December 31, 2005 and 2004, net property and equipment included $530,191 and
      $666,326, respectively, of assets recorded under capitalized lease arrangements,
      of which $302,710 and $565,245, respectively, of the capital lease obligation
      was included in long-term debt at December 31, 2005 and 2004 (see *Note
      10* ).




F-19


*Note
      5*


**Patents
      and Licensed Technologies:**




Set
      forth
      below is a detailed listing of patents and licensed technology.




December
                31,2005
            
            2004Patents,
                owned and licensed, at gross costs of $438,940 and $403,023 net of
                accumulated
              amortization
                of $194,660 and $155,522, respectively
            
            $
            244,280
            
            $
            247,501Other
                licensed and developed technologies, at gross costs of $2,047,665
                and
                $1,177,568,
              net
                of accumulated amortization of $714,391 and $495,635,
                respectively
            
            
            1,333,274
            
            
            681,933Total
                patents and licensed technologies, net
            
            $
            1,577,554
            
            $
            929,434




As
      of
      December 31, 2004, the Company had assigned $809,515 to the license it acquired
      from Stern Laser, which is included in other licensed and developed
      technologies. Amortization of this intangible is on a straight-line basis over
      10 years, which began in January 2005. As Stern Laser completes further
      milestones under the Master Agreement, the Company expects to increase the
      carrying value of the license. As of December 31, 2005 the assigned value of
      the
      Stern license is $1,010,665. Amortization expense was $257,894 in 2005, $169,790
      in 2004 and $175,147 in 2003. Estimated amortization expense for amortizable
      intangible assets for the next five years is $298,000 in 2006, $256,000 in
      2007,
      $170,000 in 2008, $170,000 in 2009, $170,000 in 2010 and $513,000
      thereafter.




*Note
      6*


**Other
      Intangible Assets:**




Set
      forth
      below is a detailed listing of other intangible assets, all of which were
      acquired from ProCyte and which have been recorded at their appraised fair
      market values:




December
                31,2005
            
            2004Neutrogena
                Agreement, at gross cost of $2,400,000 net
              of
                accumulated amortization of $378,000.
            
            $
            2,022,000
            
            $
            —Customer
                Relationships, at gross cost of $1,700,000 net of
              accumulated
                amortization of $267,747.
            
            
            1,432,253
            
            
            —Tradename,
                at gross cost of $1,100,000 net of accumulated amortization of
                $86,628.
            
            
            1,013,372
            
            
            —$
            4,467,625
            
            $
            —




Related
      amortization expense was $732,375 for 2005. Estimated amortization expense
      for
      amortizable intangible assets for the next five years is $930,000 in 2006,
      $930,000 in 2007, $930,000 in 2008, $930,000 in 2009, $284,000 in 2010 and
      $463,000 thereafter. Under the Neutrogena Agreement, the Company has licensed
      to
      Neutrogena rights to its copper peptide technology and for which the Company
      receives royalties. Customer Relationships embody the value to the Company
      of
      relationships that ProCyte had formed with its customers. Tradename includes
      the
      name of “ProCyte” and various other trademarks associated with ProCyte’s
      products.




*Note
      7*


**Capitalized
      Acquisition Costs:**




The
      balance of capitalized acquisition costs as of December 31, 2004 of $762,477
      was
      transferred to Goodwill upon the completion of the merger of ProCyte (see *Note
      2* ).




F-20


*Note
      8*


**Other
      Accrued Liabilities:**




Set
      forth
      below is a detailed listing of other accrued liabilities.




December
                31,2005
            
            2004Accrued
                professional and consulting fees
            
            $
            437,396
            
            $
            412,019Accrued
                warranty
            
            
            204,708
            
            
            196,890Accrued
                liability from matured notes
            
            
            —
            
            
            245,849Accrued
                sales taxes
            
            
            184,764
            
            
            61,142Other
                accrued expenses
            
            
            98,100
            
            
            8,154Total
                other accrued liabilities
            
            $
            924,968
            
            $
            924,054




During
      2002, SLT resumed direct control of $223,000 of funds previously set aside
      for
      the payment of SLT’s subordinated notes, which matured and ceased to bear
      interest on July 30, 1999, and $31,000 of funds set aside to pay related accrued
      interest. As of December 31, 2005 and 2004, the matured principal and related
      interest was $0 and $245,849, respectively. The Company’s liability expired as
      of July 30, 2005 and the balance was recorded as other income in the year ended
      December 31, 2005.




*Note
      9*


**Notes
      Payable:**




Set
      forth
      below is a detailed listing of notes payable. The stated interest rate
      approximates the effective cost of funds from the notes.




December
                31,2005
            
            
            
            2004Note
                payable - secured creditor, interest at 16.47%, payable
              in
                monthly principal and interest installments of $2,618 through December
                2006.
            
            $
            26,736
            
            
            $
            51,489Note
                payable - unsecured creditor, interest at 7.42%, payable
              in
                monthly principal and interest installments of $61,493 through March
                2006.
            
            
            177,450
            
            
            
            —Note
                payable - unsecured creditor, interest at 5.75%, payable
              in
                monthly principal and interest installments of $44,902 through January
                2005.
            
            
            —
            
            
            
            44,902Note
                payable - unsecured creditor, interest at 6%, payable
              in
                monthly principal and interest installments of $2,880 through June
                2012.
            
            
            183,425
            
            
            
            —387,611
            
            
            
            96,391Less:
                current maturities
            
            
            (228,398
            )
            
            
            (69,655
            )Notes
                payable, net of current maturities
            
            $
            159,213
            
            
            $
            26,736




Aggregate
      maturities of the notes payable as of December 31, 2005 are $228,398 in 2006,
      $25,706 in 2007, $27,292 in 2008, $28,975 in 2009 and $77,239
      thereafter.






F-21


*Note
      10*


**Long-term
      Debt:**




Set
      forth
      below is a detailed listing of the Company’s long-term debt.




December
                31,2005
            
            2004Borrowings
                on a credit facility
            
            $
            3,726,130
            
            $
            1,680,627Capital
                lease obligations (see Note 4)
            
            
            302,710
            
            
            565,246Less:
                current portion
            
            
            (1,749,969
            )
            
            (873,754
            )Total
                long-term debt
            
            $
            2,278,871
            
            $
            1,372,119





*Credit
      Facility*


The
      Company entered into a leasing credit facility with GE Capital Corporation
      (“GE”) on June 25, 2004. The credit facility has a commitment term of three
      years, expiring on June 25, 2007 expiring
      on June 25, 2007; for each year of the term, called a “tranche”, various
      parameters are set or re-set. The Company accounts for each draw as
      funded indebtedness taking the form of a capital lease, with equitable ownership
      in the lasers remaining with the Company. GE retains title as a form of security
      over the lasers. The Company depreciates the lasers over their remaining useful
      lives, as established when originally placed into service. Each draw against
      the
      credit facility has a self-amortizing repayment period of three years and is
      secured by specified lasers, which the Company has sold to GE and leased back
      for continued deployment in the field.




Under
      the
      first tranche, GE made available $2,500,000 under the line. A draw under that
      tranche is set at an interest rate based on 522 basis points above the
      three-year Treasury note rate. Each such draw is discounted by 7.75%; the first
      monthly payment is applied directly to principal. With each draw, the Company
      agreed to issue warrants to purchase shares of the Company’s common stock equal
      to 5% of the draw. The number of warrants is determined by dividing 5% of the
      draw by the average closing price of the Company’s common stock for the ten days
      preceding the date of the draw. The warrants have a five-year term from the
      date
      of each issuance and bear an exercise price set at 10% over the average closing
      price for the ten days preceding the date of the draw.




As
      of
      December 31, 2005, the Company had made three draws under the first tranche
      of
      the line.




Draw
                1
            
            Draw
                2
            
            Draw
                3Date
                of draw
            
            June
                30, 2004
            
            September
                24, 2004
            
            December
                30, 2004Amount
                of draw
            
            $
            1,536,950
            
            $
            320,000
            
            $
            153,172Stated
                interest rate
            
            
            8.47
            %
            
            7.97
            %
            
            8.43
            %Effective
                interest rate
            
            
            17.79
            %
            
            17.41
            %
            
            17.61
            %Number
                of warrants issued
            
            
            23,903
            
            
            6,656
            
            
            3,102Exercise
                price of warrants per share
            
            $
            3.54
            
            $
            2.64
            
            $
            2.73Fair
                value of warrants
            
            $
            62,032
            
            $
            13,489
            
            $
            5,946







The
      fair
      value of the warrants granted is estimated using the Black-Scholes
      option-pricing model with the following weighted average assumptions applicable
      to the warrants granted:




Warrants
                granted under:Draw
                1
            
            Draw
                2
            
            Draw
                3Risk-free
                interest rate
            
            
            3.81
            %
            
            3.70
            %
            
            3.64
            %Volatility
            
            
            99.9
            %
            
            100
            %
            
            99.3
            %Expected
                dividend yield
            
            
            0
            %
            
            0
            %
            
            0
            %Expected
                warrant life
            
            
            5
                years
            
            
            5
                years
            
            
            5
                years




For
      reporting purposes, the carrying value of the liability is reduced at the time
      of each draw by the value ascribed to the warrants. This reduction will be
      amortized at the effective interest rate to interest expense over the term
      of
      the draw.




The
      Company obtained from GE a second tranche under the leasing credit facility
      for
      $5,000,000 on June 28, 2005. The Company accounts for draws under this second
      tranche in the same manner as under the first tranche except that: (i) the
      stated interest rate is set at 477 basis points above the three-year Treasury
      note rate; (ii) each draw is discounted by 3.50%; and (iii) with each draw,
      the
      Company has agreed to issue warrants to purchase shares of the Company’s common
      stock equal to 3% of the draw. The number of warrants is determined by dividing
      3% of the draw by the average closing price of the Company’s common stock for
      the ten days preceding the date of the draw. The warrants have a five-year
      term
      from the date of each issuance and bear an exercise price set at 10% over the
      average closing price for the ten days preceding the date of the draw.




F-22


As
      of
      December 31, 2005, the Company had made 3 draws against the second tranche,
      as
      follows:




Draw
                4
            
            Draw
                5
            
            Draw
                6Date
                of draw
            
            June
                28, 2005
            
            September
                26, 2005
            
            December
                27, 2005Amount
                of draw
            
            $
            1,113,326
            
            $
            914,592
            
            $
            914,592Stated
                interest rate
            
            
            8.42
            %
            
            8.42
            %
            
            9.14
            %Effective
                interest rate
            
            
            12.63
            %
            
            12.94
            %
            
            13.36
            %Number
                of warrants issued
            
            
            14,714
            
            
            13,191
            
            
            15,860Exercise
                price of warrants per share
            
            $
            2.50
            
            $
            2.29
            
            $
            1.90Fair
                value of warrants
            
            $
            23,257
            
            $
            19,106
            
            $
            19,067




The
      fair
      value of the warrants granted under the draws is estimated using the
      Black-Scholes option-pricing model with the following weighted average
      assumptions applicable to the warrants granted:




Warrants
                granted under:Draw
                4
            
            Draw
                5
            
            Draw
                6Risk-free
                interest rate
            
            
            3.76
            %
            
            4.11
            %
            
            4.30
            %Volatility
            
            
            94.6
            %
            
            93.75
            %
            
            91.09
            %Expected
                dividend yield
            
            
            0
            %
            
            0
            %
            
            0
            %Expected
                warrant life
            
            
            5
                years
            
            
            5
                years
            
            
            5
                years




For
      reporting purposes, the carrying value of the liability is reduced at the time
      of each draw by the value ascribed to the warrants. This reduction will be
      amortized at the effective interest rate to interest expense over the term
      of
      the draw.




As
      of
      December 31, 2005 the Company had available $2,057,490 from the second tranche
      of the line of credit with GE from which to draw on in the future.




Future
      minimum payments for draws under the lease credit facility are as
      follows:




Year
                Ending December 31,2006
            
            $
            1,830,6502007
            
            
            1,517,1332008
            
            
            799,046Total
                minimum lease obligation
            
            
            4,146,829Less:
                interest
            
            
            (420,699
            )Present
                value of total minimum lease obligation
            
            $
            3,726,130




Concurrent
      with the SLT acquisition, the Company assumed a $3,000,000 credit facility
      from
      a bank. The credit facility had a commitment term of four years, which expired
      May 31, 2004, permitted deferment of principal payments until the end of the
      commitment term, and was secured by SLT’s business assets, including
      collateralization (until May 13, 2003) of $2,000,000 of SLT’s cash and cash
      equivalents and short-term investments. The bank agreed to allow the Company
      to
      apply the cash collateral to pay down of the facility in 2003. The credit
      facility had an interest rate of the 30-day LIBOR plus 2.25%. The credit
      facility was subject to certain restrictive covenants at the SLT level and
      at
      the group level and borrowing base limitations. The group did not meet the
      covenants set by the bank at December 31, 2003. On March 10, 2004, the bank
      waived the non-compliance with the covenants as of December 31,
      2003.




*Capital
      Leases*


The
      obligations under capital leases are at fixed interest rates of 7.06% to 10.68%
      and are collateralized by the related property and equipment (see *Note
      4* ).




Future
      minimum payments for property under capital leases are as follows:




Year
                Ending December 31,2006
            
            $
            197,8212007
            
            
            89,7422008
            
            
            40,952Total
                minimum lease obligation
            
            
            328,515Less:
                interest
            
            
            (25,805
            )Present
                value of total minimum lease obligation
            
            $
            302,710




F-23


*Note
      11*


**Warrant
      Exercises:**




In
      the
      year ended December 31, 2005, the Company received $147,060 from the exercise
      of
      73,530 warrants. The warrants were issued in connection with a private placement
      of securities in June 2002 and bore an exercise price of $2.00.




In
      the
      year ended December 31, 2004, 2,104,147 warrants on the common stock of the
      Company were exercised, resulting in an increase to the Company’s shares
      outstanding as of the end of the period by the same amount. The Company received
      $3,086,468 in cash proceeds from the exercises. Of these proceeds, $803,456
      was
      from the exercise of warrants that were exercisable at $1.77 per share and
      were
      set to expire on March 31, 2004 and $1,226,112 was from the exercise of warrants
      that were exercisable at $1.16 per share and were set to expire on
      September 30, 2004. See also ***Common
      Stock Warrants*** in *Note
      13* .




*Note
      12*


**Commitments
      and Contingencies:**




***Leases***


The
      Company has entered into various non-cancelable operating leases for personal
      property that expire at various dates through 2008. Rent expense was $558,683,
      $456,077 and $517,662 for the years ended December 31, 2005, 2004 and 2003,
      respectively. The future annual minimum payments under these non-cancelable
      operating leases are as follows:




Year
                Ending December 31,2006
            
            $
            599,1632007
            
            
            220,9012008
            
            
            107,5022009
            
            
            79,680Thereafter
            
            
            105,408Total
            
            $
            1,112,654




***Litigation***


In
      the
      action which the Company brought against Edwards LifeSciences Corporation and
      Baxter Healthcare Corporation in January 2004, the parties reached a settlement
      in December 2005, terminating all prior dealings between themselves with respect
      to transmyocardial revascularization, and providing for payment to the Company
      of an amount that may not be disclosed in accordance with the confidentiality
      restrictions of the settlement. Such settlement, net of directly attributable
      legal expense, is included in other income in the year ended December 31,
      2005.




In
      the
      matter brought against the Company by City National Bank of Florida, the
      Company's former landlord in Orlando, Florida, the Company’s motion for
      summary judgment was heard in limine and denied. Judgment was awarded to the
      landlord in the amount of $77,023. Offsetting the judgment are proceeds,
      approximating $45,000, which are held by the landlord from the sale of assets
      left on the leased premises by the party that bought the assets from the
      Company. The Company has paid the net judgment amount pursuant to a settlement
      that was reached with the landlord which embodies terms which the Company deems
      favorable and which have mooted post-trial motions and appeals.




In
      the
      matter brought by the Company against RA Medical Systems, Inc. and Dean Stewart
      Irwin in the United States District Court for the Southern District of
      California, a new magistrate judge appointed in 2005 to the case has ruled
      that
      discovery will continue to be stayed until the trial judge rules on the
      defendants’ motion for summary judgment, based on a theory of res judicata.
      Notwithstanding the abeyance of the case, the Company has brought in March
      2006
      a motion for partial summary judgment, based on a theory that defendants have
      not had, until January 2006, a license from the State of California to
      manufacture or market their medical devices, and therefore have unfairly
      competed against the Company by unlawfully manufacturing, marketing and selling
      medical devices that were misbranded.




In
      the
      matter brought by the Company against RA Medical Systems, Inc. and Dean Stewart
      Irwin in the Superior Court for San Diego County, California, the
      Company elected in February 2006 to discontinue its motions and appeals in
      the matter, and thus bring closure to this action.




F-24


On
      January 25, 2005, RA Medical Systems, Inc. and Dean Stewart Irwin brought an
      action against PhotoMedex, Inc., Jeffrey Levatter Ph.D. (the
      Company's Chief Technology Officer), Jenkens & Gilchrist, LLP (the
      Company's outside counsel) and Michael R. Matthias, Esq. (litigation
      partner at the Company's outside counsel). The action was brought in
      the Superior Court for San Diego County, California and based on allegations
      that the Company and the other defendants had engaged in malicious prosecution
      in bringing and maintaining the action brought by PhotoMedex in April 2003.
      The
      Company and the other defendants filed a motion to strike the actions, based
      on
      California Code of Civil Procedure section 425.16, the so-called SLAPP statute.
      The motion to strike was denied; the Company appealed the denial. The appellate
      court heard oral argument on the matter on March 14, 2006, taking the matter
      under advisement. We are being defended by our insurance carrier.




On
      May
      13, 2005, Vida Brown brought suit in the Circuit Court, 20 th Judicial
      Circuit for Charlotte County, Florida, for injuries sustained during a surgical
      laser procedure on her lower back. Ms. Brown has sued, among others, the
      surgeon, the anesthesiologist, the supplier of the laser delivery system (viz.
      Clarus Medical LLC), a person holding himself out as a representative of Clarus,
      and the supplier of the holmium laser system and technician (viz. the Company’s
      former subsidiary, Surgical Innovations & Services, Inc. or “SIS”). The
      laser delivery system supplied by Clarus proved defective in the course of
      the
      procedure, notwithstanding which the surgeon continued to perform the procedure.
      The holmium laser provided by SIS did not perform deficiently. Ms. Brown has
      alleged that SIS failed to provide a properly trained operator for the holmium
      laser and that SIS’s operator failed to warn the surgeon of the danger of
      continuing to use a defective laser delivery system. The Company’s insurance
      carrier is providing a defense for SIS in this matter.




The
      Company is involved in certain other legal actions and claims arising in the
      ordinary course of business. Management believes, based on discussions with
      legal counsel, that such litigation and claims will be resolved without a
      material effect on the Company's consolidated financial position, results of
      operations or liquidity.




***Employment
      Agreements***


The
      Company has severance agreements with certain key executives and employees
      that
      create certain liabilities in the event of their termination of employment
      without cause, or following a change in control of the Company. The aggregate
      commitment under these executive severance agreements, should all covered
      executives and employees be terminated other than for cause, was approximately
      $2,459,653 as of December 31, 2005. Should all covered executives be terminated
      following a change in control of the Company, the aggregate commitment under
      these executive severance agreements at December 31, 2005 was approximately
      $2,549,061.




*Note
      13*


**Stockholders’
      Equity:**




***Common
      Stock***


As
      of
      December 31, 2005, the Company had issued 488,854 shares of its restricted
      common stock in connection with the Asset Purchase agreement with Stern Laser
      Srl, or Stern, of which 113,877 shares had been issued in September 2004 and
      248,395 in June 2005 and 126,582 in December 2005.




On
      March
      18, 2005, the Company completed the acquisition of ProCyte Corporation, paid
      through the issuance of 10,540,579 shares of common stock valued at $2.29 per
      share. The merger consideration resulted in the equivalent of a fixed ratio
      of
      0.6622 shares of PhotoMedex common stock for each share of ProCyte common
      stock.




On
      May
      28, 2003, the Company closed on a private placement for 5,982,352 shares of
      common stock at $1.70 per share resulting in gross proceeds of $10,170,000.
      The
      closing price of the Company’s common stock on May 28, 2003 was $2.07 per share.
      In connection with this private placement, the Company paid commissions and
      other expenses of $692,454, resulting in net proceeds of $9,477,546. In
      addition, the investors received warrants to purchase 1,495,588 shares of common
      stock at an exercise price of $2.00 per share. The warrants have a five-year
      term and became exercisable on November 29, 2003 (see ***Common
      Stock Warrants*** below).
      The Company has used the proceeds of this financing to pay for working capital
      and other general corporate purposes. The shares sold in the private placement,
      including the shares underlying the warrants, have been registered with the
      Securities and Exchange Commission.




***Common
      Stock Options***


In
      January 1996, the Company adopted the 1995 Non-Qualified Option Plan (the “1995
      Plan”) for key employees, officers, directors, and consultants, and initially
      provided for up to 500,000 options to be issued thereunder. The exercise price
      of each option granted under the 1995 Plan could not be less than the fair
      market value on the date granted. Options under the Plan generally vested 40%
      upon grant, 30% on the first anniversary of the grant and the remaining 30%
      on
      the second anniversary. No options could be exercised more than 10 years after
      the grant date. Options are not transferable (other than at death), and in
      the
      event of termination for cause (other than death or disability) or voluntary
      termination, all unvested options automatically terminate. The plan is inactive
      at December 31, 2005 and had 39,000 options outstanding.




F-25


On
      April
      10, 1998, the Company created a stock option plan for outside/non-employee
      members of the Board of Directors. Pursuant to the stock plan, each
      outside/non-employee director was to receive an annual grant of options, in
      addition to any other consideration he or she may receive, to purchase up to
      20,000 shares of common stock as compensation, at an exercise price equal to
      the
      market price of the common stock on the last trading day of the preceding year.
      The options granted pursuant to this plan vested at the rate of 5,000 options
      per quarter during each quarter in which such person had served as a member
      of
      the Board of Directors. Since the date of adoption of the Non-Employee Director
      Stock Option Plan (discussed below), the Company no longer grants options to
      members of the Board of Directors under this plan. At December 31, 2005, the
      plan had 15,000 options outstanding.




In
      May
      2000, the Company adopted the 2000 Stock Option Plan (the “2000 Plan”). The 2000
      Plan initially reserved for issuance up to 1,000,000 shares of the Company’s
      common stock, which was increased to 2,000,000 shares pursuant to the
      affirmative vote of the stockholders on June 10, 2002 and to 3,350,000 shares
      on
      December 16, 2003. The reserved shares are to be used for granting of incentive
      stock options (“ISOs”) to employees of the Company and for granting of
      non-qualified stock options (“NSOs”) and other stock-based awards to employees
      and consultants. The option exercise price for ISOs shall not be less than
      the
      fair market value of the Company’s stock on the date of grant. All ISOs granted
      to less than ten-percent stockholders may have a term of up to 10 years, while
      ISOs granted to greater than ten-percent stockholders shall have a term of
      up to
      five years. The option exercise price for NSOs shall not be less than 85% of
      the
      fair market value of the Company’s stock on the date of grant. No NSOs shall be
      exercisable for more than 10 years after the date of the respective grant.
      The
      plan became inactive on December 28, 2005, and had 2,651,304 options outstanding
      at December 31, 2005.




In
      May
      2000, the Company also adopted the Non-Employee Director Stock Option Plan
      (the
“Non-Employee Director Plan”). The Non-Employee Director Plan reserved for
      issuance up to 250,000 shares of the Company’s common stock for the granting of
      non-qualified options to members of the Company’s Board of Directors. In
      consideration for services rendered, each director received on each of January
      1, 2001 and 2002 an option to purchase 20,000 shares of the Company’s common
      stock. The Company’s stockholders voted on June 10, 2002 to increase the number
      of reserved shares to 650,000 and also to increase the annual grant to each
      director from 20,000 to 35,000. On December 16, 2003, the stockholders voted
      to
      increase the number of reserved shares to 1,000,000 and on December 28, 2005,
      they voted to increase the number of reserved shares to 1,400,000. The plan
      is
      active and had 711,250 options outstanding at December 31, 2005.




In
      March
      2005, the Company assumed four option plans from ProCyte: the 2004 Stock Option
      Plan, the 1996 Stock Option Plan, the 1991 Restated Stock Option Plan for
      Non-Employee Directors and the 1989 Restated Stock Option Plan.




On
      December 28, 2005, the stockholders approved the 2005 Equity Compensation Plan,
      authorizing 3,160,000 shares thereto, and approved the 2005 Investment Plan,
      authorizing 400,000 shares thereto. On January 15, 2006, the Company awarded
      860,000 restricted shares of our common stock to two of the Company’s executive
      officers, and 200,000 stock options to one of the two executive officers. On
      January 10, 2006, February 14, 2006 and February 28, 2006, the
      Company granted, in the aggregate, 882,000 stock options to various
      employees and consultants. The stockholders also approved the increase of shares
      authorized to the 2000 Non-Employee Director Stock Option Plan to 1,400,000
      shares.




In
      January 2005, the Company issued 210,000 options to purchase common stock to
      non-employee directors, in accordance with the terms of the Non-Employee
      Director Plan.




Also,
      during the course of 2005, the Company granted an aggregate of 1,182,000 options
      to purchase common stock to a number of employees at the market value at the
      date of grant. The options vest over four years and expire five years from
      the
      date of grant.




In
      February 2005, the Company granted 18,000 options to purchase common stock
      to
      the various members of the Company’s Scientific Advisory Board for services
      rendered at the market value at the date of grant. The options have an exercise
      price of $2.35 per share. The options vest over three years and will expire
      five
      years from the date of the grant. The Company recorded $31,859 of expense
      relating to these options for the year ended December 31, 2005.




F-26


On
      March
      18, 2005, the Company agreed to assume up to 2,063,000 common stock options
      associated with the acquisition of ProCyte Corporation valued at $2,033,132.
      These ProCyte common stock options were converted into 1,366,131 common stock
      options for PhotoMedex common stock.




In
      July
      and October 2005, the Company granted 25,000 options, each, to purchase common
      stock to consultants for services rendered. The options have an exercise price
      of $2.66 and $2.30 per share, respectively. The options vest over four years
      and
      will expire five years from the date of the grant. The Company recorded $49,120
      and $42,278, respectively, of expense relating to these options for the year
      ended December 31, 2005.




In
      January 2004, the Company agreed to extend the life, by one year, of 525,000
      options granted to Mr. O’Donnell in November 1999 as part of a bloc of 650,000
      options, bearing an exercise price of $4.65 per share. In January 2004, the
      Company also agreed to extend the life, by one year, of 350,000 options granted
      to Mr. McGrath in November 1999, bearing an exercise price of $5.50 per share.
      Neither extension had any impact on the consolidated financial
      statements.




In
      January 2004, the Company issued 210,000 options to purchase common stock to
      non-employee directors, in accordance with the terms of the Non-Employee
      Director Plan. In September 2004, 17,500 options were issued to a new
      non-employee director in accordance with the terms of the Non-Employee Director
      Plan.




Also
      in
      January, July, September and December 2004, the Company granted an aggregate
      of
      776,000 options to purchase common stock to a number of employees pursuant
      to
      the 2000 Plan at the market value at the date of grant. The options vest over
      four years and expire five years from the date of grant. Also in 2004, the
      Company issued 66,666 options from the 2000 Stock Option Plan with an extended
      exercise period in replacement of options that had been granted outside of
      a
      plan in 1999, and those replacement options expired unexercised in
      2004.




In
      January 2004, the Company granted 30,000 options to purchase common stock to
      the
      various members of the Company’s Scientific Advisory Board for services rendered
      pursuant to the 2000 Plan at the market value at the date of grant. The options
      have an exercise price of $2.14 per share. The options vested on grant and
      will
      expire five years from the date of the grant. The Company recorded $48,192
      of
      expense relating to these options for the year ended December 31,
      2004.




In
      December 2004, the Company granted 27,000 options to purchase common stock
      to
      the various consultants and members of the Company’s Scientific Advisory Board
      for services rendered pursuant to the 2000 Plan at the market value at the
      date
      of grant. The options have an exercise price of $2.46 per share. The options
      vested immediately and will expire 5 years from the date of the grant. The
      Company recorded $50,243 of expense relating to these options for the year
      ended
      December 31, 2004.




In
      January 2003, the Company issued 175,000 options to purchase common stock to
      non-employee directors, in accordance with the terms of the Non-Employee
      Director Plan. In October 2003, 8,750 options were issued to a new non-employee
      director in accordance with the terms of the Non-Employee Director
      Plan.




Also
      in
      January and April 2003, the Company granted an aggregate of 614,000 options
      to
      purchase common stock to several employees pursuant to the 2000 Plan at the
      market value at the date of grant. The options vest over four years and expire
      five years from the date of grant.




In
      April
      2003, the Company granted 30,000 options to purchase common stock to the various
      members of the Company’s Scientific Advisory Board for services rendered
      pursuant to the 2000 Plan at the market value at the date of grant. The options
      have an exercise price of $1.53 per share. The options vested immediately and
      will expire 10 years from the date of the grant. The Company recorded $38,164
      of
      expense relating to these options for the year ended December 31,
      2003.




F-27


A
      summary
      of option transactions for all of the Company’s options during the years ended
      December 31, 2005, 2004 and 2003 is as follows:




Number
                of Shares
            
            Weighted
              Average
              Exercise
                PriceOutstanding
                at January 1, 2003
            
            
            3,877,045
            
            $
            4.65Granted
            
            
            827,750
            
            
            1.73Exercised
            
            
            (61,458
            )
            
            1.05Expired/cancelled
            
            
            (513,141
            )
            
            5.77Outstanding
                at December 31, 2003
            
            
            4,130,196
            
            
            3.87Granted
            
            
            1,127,166
            
            
            2.50Exercised
            
            
            (120,865
            )
            
            1.75Expired/cancelled
            
            
            (925,957
            )
            
            6.39Outstanding
                at December 31, 2004
            
            
            4,210,540
            
            
            3.48Granted
            
            
            1,460,000
            
            
            2.57Assumed
                from acquisition
            
            
            1,366,131
            
            
            1.73Exercised
            
            
            (350,189
            )
            
            1.80Expired/cancelled
            
            
            (1,608,837
            )
            
            5.83Outstanding
                at December 31, 2005
            
            
            5,077,646
            
            $
            2.11




As
      of
      December 31, 2005, 3,108,379 options to purchase common stock were vested and
      exercisable at prices ranging from $0.95 to $9.50 per share. As of December
      31,
      2004, 2,905,108 options to purchase common stock were vested and exercisable
      at
      prices ranging from $0.95 to $9.50 per share. Options are issued with exercise
      prices equal to the market price on the date of issue, so the weighted-average
      exercise price equals the weighted-average fair value price.




The
      outstanding options, including options exercisable at December 31, 2005, have
      a
      range of exercise prices and associated weighted remaining contractual life
      and
      weighted average exercise price as follows:


OptionsRangeof
                ExercisePrices
            
            Outstanding
              Number
              of
                Shares
            
            Weighted
              Average
              Remaining
              Contractual
                Life (years)
            
            Weighted
              Average
              Exercise
                Price
            
            Exercisable
              Number
              of
                Shares
            
            Exercisable
              Weighted
                Avg. Exercise Price$0
                - $2.50
            
            
            4,264,271
            
            
            3.96
            
            $
            
            1.89
            
            
            2,820,379
            
            $
            
            1.75$2.51
                - $5.00
            
            
            699,375
            
            
            4.51
            
            $
            
            2.78
            
            
            174,000
            
            $
            
            2.84$5.01
                - $7.50
            
            
            97,000
            
            
            4.15
            
            $
            
            5.79
            
            
            97,000
            
            $
            
            5.79$7.51
                - up
            
            
            17,000
            
            
            3.83
            
            $
            
            9.32
            
            
            17,000
            
            $
            
            9.32Total
            
            
            5,077,646
            
            
            4.03
            
            $
            
            2.11
            
            
            3,108,379
            
            $
            
            1.98




The
      outstanding options will expire as follows:


Year
                Ending
            
            Number
                of Shares
            
            Weighted
                Average
              Exercise
                Price
            
            Exercise
                Price2006
            
            
            429,199
            
            $
            
            1.56
            
            
            
            $0.95
                  - $8.002007
            
            
            379,530
            
            
            
            1.72
            
            
            
            $1.26
                - $1.892008
            
            
            613,132
            
            
            
            1.72
            
            
            
            $0.74
                - $2.172009
            
            
            1,006,348
            
            
            
            1.97
            
            
            
            $0.99
                - $2.702010
                and later
            
            
            2,649,437
            
            
            
            2.41
            
            
            
            $1.07
                - $9.505,077,646
            
            $
            
            2.11
            
            
            
            $0.95
                - $9.50






F-28


***Common
      Stock Warrants***


In
      2005,
      the Company issued warrants to purchase common stock to GE Capital Corporation
      related to the leasing credit facility in the following manner: on June 28,
      2005, 14,714 shares at an exercise price of $2.50 per share; on September 26,
      2005, 13,921 shares at an exercise price of $2.29 per share; and on December
      27,
      2005, 15,830 at an exercise price of $1.90 per share. The warrants have a
      five-year term.




In
      2004,
      the Company issued warrants to purchase common stock to GE Capital Corporation
      related to the leasing credit facility in the following manner: on June 30,
      2004, 23,903 shares at an exercise price of $3.54 per share; on September 24,
      2004, 6,656 shares at an exercise price of $2.64 per share; on December 30,
      2004, 3,102 at an exercise price of $2.73 per share. The warrants have a
      five-year term.




In
      May
      2003, in addition to receiving common stock in the Company’s private placement,
      the investors received warrants to purchase 1,495,588 shares of common stock
      at
      an exercise price of $2.00 per share. The warrants have a five-year term,
      expiring in November 2008.




A
      summary
      of warrant transactions for the years ended December 31, 2005, 2004 and 2003
      is
      as follows:




Number
                of Warrants
            
            Weighted
              Average
              Exercise
                PriceOutstanding
                at January 1, 2003
            
            
            2,960,804
            
            $
            1.62Issued
            
            
            1,551,302
            
            
            1.93Exercised
            
            
            (253,271
            )
            
            1.85Expired
            
            
            (7,752
            )
            
            2.00Outstanding
                at December 31, 2003
            
            
            4,251,083
            
            
            1.90Issued
            
            
            33,661
            
            
            3.29Exercised
            
            
            (2,104,147
            )
            
            1.47Expired/cancelled
            
            
            (11,998
            )
            
            2.08Outstanding
                at December 31, 2004
            
            
            2,168,599
            
            
            2.34Issued
            
            
            43,765
            
            
            2.22Exercised
            
            
            (73,530
            )
            
            2.00Expired/cancelled
            
            
            (38,525
            )
            
            13.43Outstanding
                at December 31, 2005
            
            
            2,100,309
            
            $
            1.98




At
      December 31, 2005, all outstanding warrants were exercisable at prices ranging
      from $1.40 to $3.54 per share.




If
      not
      previously exercised, the outstanding warrants will expire as
      follows:




Year
                Ending December 31,
            
            Number
                of Warrants
            
            Weighted
                Average
              Exercise
                Price2007
            
            
            888,350
            
            
            1.892008
            
            
            1,134,533
            
            
            2.002009
            
            
            33,661
            
            
            3.292010
            
            
            43,765
            
            
            2.222,100,309
            
            $
            1.98




*Note
      14*


**Income
      Taxes:**




The
      Company accounts for income taxes pursuant to Statement of Financial Accounting
      Standards No. 109 "Accounting for Income Taxes" ("SFAS No. 109"). SFAS No.
      109
      is an asset-and-liability approach that requires the recognition of deferred
      tax
      assets and liabilities for the expected tax consequences of events that have
      been recognized in the Company's financial statements or tax
      returns.




F-29


The
      Company recorded no provisions in 2005, 2004 and 2003 due to losses incurred.
      Any other provisions, including accrual adjustments for prior periods, were
      completely offset by changes in the deferred tax valuation
      allowance.




Income
      tax expense (benefit) consists of the following. Because the Company acquired
      ProCyte Corporation on March 18, 2005, the effect of ProCyte’s deferred tax
      asset is included for only a part of 2005 and not at all in 2004 and 2003.




Year
                Ended December 31,2005
            
            2004
            
            2003Federal,
                including AMT tax:Current
            
            $
            —
            
            $
            —
            
            $
            —Deferred
            
            
            8,887,000
            
            
            (2,114,000
            )
            
            1,536,000State:Current
            
            
            —
            
            
            —
            
            
            —Deferred
            
            
            68,000
            
            
            (174,000
            )
            
            179,0008,955,000
            
            
            (2,288,000
            )
            
            1,715,000Change
                in valuation allowance
            
            
            8,955,000
            
            
            (2,288,000
            )
            
            1,715,000Income
                tax expense
            
            $
            —
            
            $
            —
            
            $
            —




A
      reconciliation of the effective tax rate with the Federal statutory tax rate
      of
      34% follows:




Year
                Ended December 31,2005
            
            2004
            
            2003Expected
                Federal tax benefit at statutory rate
            
            $
            1,338,000
            
            $
            1,701,000
            
            $
            2,512,000Gross
                change in valuation allowance
            
            
            (8,955,000
            )
            
            2,288,000
            
            
            (1,715,000
            )Adjustments
                of temporary differences and net
              operating
                loss expirations and limitations
            
            
            7,652,000
            
            
            (3,792,000
            )
            
            (950,000
            )State
                income taxes
            
            
            68,000
            
            
            (174,000
            )
            
            178,000Other
            
            
            (103,000
            )
            
            (23,000
            )
            
            (25,000
            )Income
                tax expense
            
            $
            —
            
            $
            —
            
            $
            —




As
      of
      December 31, 2005, the Company had approximately $180 million of federal net
      operating loss carryforwards. Included in the aggregate net operating loss
      carryforward are approximately $23 million of losses sustained by SLT prior
      to
      the tax-free acquisition on December 27, 2002 and approximately $69 million
      of
      losses sustained by ProCyte prior to the tax-free acquisition on March 18,
      2005.
      As of December 31, 2005, the Company has estimated that only $5 million of
      the
      loss from SLT and $25 million of the loss from ProCyte can be realized upon,
      based on Federal limitations on the useabililty of such losses. There have
      been
      no other changes of ownership identified by management that materially constrain
      the Company’s utilization of loss carryforwards. If the Company undergoes a
      change or ownership in the future, the utilization of the Company’s loss
      carryforwards may be materially constrained.




In
      addition, the Company had approximately $2.8 million of Federal tax credit
      carryforwards as of December 31, 2005. The credit carryforwards have begun,
      and
      continue, to expire over the ensuing 20 years. Under Federal rules applicable
      to
      the acquisition of SLT and ProCyte, the research credit carryforwards from
      these
      companies which are from years prior to their respective acquisitions and which
      approximate $2.2 million, are subject to severe utilization constraints and
      accordingly have been ascribed no value in the deferred tax asset.




Net
      deductible, or favorable, temporary differences were approximately $13,857,000
      at December 31, 2005.




F-30


The
      changes in the deferred tax asset are as follows.




December
                31,2005
            
            2004Beginning
                balance, gross
            
            $
            41,095,000
            
            $
            43,383,000Net
                changes due to:Operating
                loss carryforwards
            
            
            9,688,000
            
            
            (1,521,000
            )Temporary
                differences
            
            
            (630,000
            )
            
            (128,000
            )Carryforward
                and AMT credits
            
            
            (102,000
            )
            
            (639,000
            )Ending
                balance, gross
            
            
            50,051,000
            
            
            41,095,000Less:
                valuation allowance
            
            
            50,051,000
            
            
            41,095,000Ending
                balance, net
            
            $
            —
            
            $
            —




The
      ending balances of the deferred tax asset have been fully reserved, reflecting
      the uncertainties as to realizability evidenced by the Company’s historical
      results and restrictions on the usage of the net operating loss carryforwards.




Deferred
      tax assets (liabilities) are comprised of the following. The deferred tax asset
      from the SLT acquisition is reflected in the activity in each of the years,
      but
      only in 2005 for ProCyte.




December
                31,2005
            
            2004Loss
                carryforwards
            
            $
            44,143,000
            
            $
            34,455,000Carryforward
                and AMT credits
            
            
            642,000
            
            
            745,000Accrued
                employment expenses
            
            
            176,000
            
            
            202,000Amortization
            
            
            (808,000
            )
            
            30,000Bad
                debts
            
            
            390,000
            
            
            378,000Deferred
                R&D costs
            
            
            2,607,000
            
            
            2,368,000Deferred
                revenues
            
            
            177,000
            
            
            242,000Depreciation
            
            
            1,152,000
            
            
            1,064,000Inventoriable
                costs
            
            
            58,000
            
            
            118,000Inventory
                reserves
            
            
            140,000
            
            
            302,000License
                write-off
            
            
            701,000
            
            
            802,000Other
                accruals and reserves
            
            
            335,000
            
            
            399,000Gross
                deferred tax asset
            
            
            50,051,000
            
            
            41,095,000Less:
                Valuation allowance
            
            
            (50,051,000
            )
            
            (41,095,000
            )Net
                deferred tax asset
            
            $
            —
            
            $
            —




Benefits
      that may be realized from components in the deferred tax asset that were
      contributed by Acculase from periods prior to the buy-out of the minority
      interest in August 2000 and that approximate $3.6 million in benefit, or that
      were contributed by ProCyte from periods prior to the acquisition in March
      2005
      and that approximate $8.4 million in benefit will first be taken to reduce
      the
      carrying value of goodwill and other intangibles that were recorded in the
      respective transactions. Only after such values have been fully reduced will
      any
      remaining benefit be reflected in the Company’s Statement of Operations. It is
      not expected that any of the benefit from ProCyte net operating loss
      carryforwards will be reflected in the Statement of Operations.




Within
      the net operating loss carryforward as of December 31, 2005 are approximately
      $17.4 million of tax deductions from the exercise of Company stock options.
      The
      preponderance of these options were to employees and therefore under APB No.
      25,
      no book expense was recognized on their grant. Benefits that may be realized
      from such deductions will not benefit the Statement of Operations but will
      directly benefit Stockholders’ Equity.




F-31


*Note
      15*


**Significant
      Alliances/Agreements:**




On
      March
      31, 2005, the Company entered into a Sales and Marketing Agreement with
      GlobalMed (Asia) Technologies Co., Inc. (“GlobalMed”). Under this Agreement,
      GlobalMed will act as master distributor in the Pacific Rim for the Company’s
      XTRAC excimer laser, (including the UltraTM excimer laser), and for the Company’s
      LaserPro® diode surgical laser system. The Company’s diode laser will be
      marketed for, among other things, use in a gynecological procedure pioneered
      by
      David Matlock, MD. The
      Company has engaged Dr. Matlock as consultant to explore further business
      opportunities for the Company. In connection with this engagement, the
      consultant has received options to purchase up to 25,000 shares of the common
      stock of the Company, granted with an exercise price based on fair market
      value.





On
      July
      27, 2005, the Company entered a four-year Marketing Agreement with KDS
      Marketing, Inc. (“KDS”). Using money invested by each party, KDS will research
      market opportunities for the Company’s diode laser and related delivery systems,
      and KDS will then market the diode laser, primarily through a website on which
      physicians may access for information about the lasers and which they may use
      to
      purchase the lasers. KDS’s return on its investment will be based primarily on
      commissions earned on diode lasers that are sold under the program.




***Edwards
      Agreement***


In
      August 1997, the Company entered into an agreement with Edwards
      LifeSciences Corporation, or Edwards. Under the terms of this agreement, the
      Company granted Edwards exclusive worldwide rights to sell our modified excimer
      laser and associated disposable products, for the treatment of cardiovascular
      and vascular disease using the surgical procedure known as transmyocardial
      revascularization, or TMR.




The
      Company’s strategic relationship with Edwards was terminated in early 2001. The
      termination was the subject of certain disputes and litigation between Edwards
      and the Company. All disputes and litigation have been resolved in December
      2005. See *Litigation* in
      Note
      11.




*Note
      16*


**Significant
      Customer Concentration:**




No
      one
      customer represented 10% or more of total revenues for the year ended December
      31, 2005, 2004 and 2003.




*Note
      17*


**Business
      Segment and Geographic Data:**




Segments
      are distinguished by the Company’s management structure, products and services
      offered, markets served and types of customers. The Domestic XTRAC business
      derives revenues from procedures performed by dermatologists in the United
      States. The International XTRAC segment, in comparison, generates revenues
      from
      the sale of equipment to dermatologists outside the United States through a
      network of distributors. The Skin Care (ProCyte) segment generates revenues
      by
      selling skincare products and by earning royalties on licenses for the Company’s
      patented copper peptide compound. The Surgical Services segment generates
      revenues by providing fee-based procedures typically using the Company’s mobile
      surgical laser equipment delivered and operated by a technician at hospitals
      and
      surgery centers in the United States. The Surgical Products segment generates
      revenues by selling laser products and disposables to hospitals and surgery
      centers on both a domestic and international basis.




Unallocated
      operating expenses include costs incurred for administrative and accounting
      staff, general liability and other insurance, professional fees and other
      similar corporate expenses. Unallocated assets include cash, prepaid expenses
      and deposits. Goodwill that is carried at $2,944,423 at December 31, 2005
      and 2004 has been allocated to the domestic and international XTRAC segments
      based upon its fair value as of the date of the Acculase buy-out in the amounts
      of $2,061,096 and $883,327, respectively. Goodwill of $13,430,961 at December
      31, 2005 from the ProCyte acquisition has been entirely allocated to the Skin
      Care (ProCyte) segment.




F-32





Year
                Ended December 31, 2005DOMESTIC
              XTRAC
            
            INTERN’L
              XTRAC
            
            SKIN
              CARE
            
            SURGICAL
                SERVICES
            
            SURGICAL
                PRODUCTS
              AND
                OTHER
            
            TOTALRevenues
            
            $
            3,498,235
            
            $
            1,404,096
            
            $
            10,042,133
            
            $
            7,719,529
            
            $
            5,720,513
            
            $
            28,384,506Costs
                of revenues
            
            
            2,691,506
            
            
            930,574
            
            
            3,132,532
            
            
            5,675,787
            
            
            3,245,106
            
            
            15,675,505Gross
                profit
            
            
            806,729
            
            
            473,522
            
            
            6,909,601
            
            
            2,043,742
            
            
            2,475,407
            
            
            12,709,001Allocated
                operating expenses:Selling,
                general and administrative
            
            
            2,692,388
            
            
            313,713
            
            
            5,331,764
            
            
            1,192,911
            
            
            582,366
            
            
            10,113,142Engineering
                and product development
            
            
            —
            
            
            —
            
            
            442,367
            
            
            —
            
            
            685,594
            
            
            1,127,961Unallocated
                operating expenses
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            6,364,1802,692,388
            
            
            313,713
            
            
            5,774,131
            
            
            1,192,911
            
            
            1,267,960
            
            
            17,605,283Loss
                from operations
            
            
            (1,885,659
            )
            
            159,809
            
            
            1,135,470
            
            
            850,831
            
            
            1,207,448
            
            
            (4,896,282
            )Other
                Income
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            1,302,537Interest
                expense, net
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            (342,299
            )Net
                loss
            
            
            ($1,885,659
            )
            $
            159,809
            
            $
            1,135,470
            
            $
            850,831
            
            $
            1,207,448
            
            
            ($3,936,044
            )Segment
                assets
            
            $
            8,936,793
            
            $
            2,523,953
            
            $
            22,585,592
            
            $
            4,118,909
            
            $
            4,176,741
            
            $
            42,341,988Capital
                expenditures
            
            $
            3,391,376
            
            $
            14,327
            
            $
            —
            
            $
            216,633
            
            $
            80,552
            
            $
            3,702,888











Year
                Ended December 31, 2004DOMESTIC
              XTRAC
            
            INTERN’L
              XTRAC
            
            SKIN
              CARE
            
            SURGICAL
                SERVICES
            
            SURGICAL
                PRODUCTS
              AND
                OTHER
            
            TOTALRevenues
            
            $
            3,256,164
            
            $
            1,626,646
            
            
            —
            
            $
            7,826,519
            
            $
            5,035,852
            
            $
            17,745,181Costs
                of revenues
            
            
            1,890,446
            
            
            1,177,371
            
            
            —
            
            
            5,000,226
            
            
            2,295,226
            
            
            10,363,269Gross
                profit
            
            
            1,365,718
            
            
            449,275
            
            
            —
            
            
            2,826,293
            
            
            2,740,626
            
            
            7,381,912Allocated
                operating expenses:Selling,
                general and administrative
            
            
            1,836,165
            
            
            314,849
            
            
            —
            
            
            1,364,684
            
            
            642,751
            
            
            4,158,449Engineering
                and product development
            
            
            711,384
            
            
            445,338
            
            
            —
            
            
            —
            
            
            644,716
            
            
            1,801,438Unallocated
                operating expenses
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            6,267,8072,547,549
            
            
            760,187
            
            
            —
            
            
            1,364,684
            
            
            1,287,467
            
            
            12,227,694Loss
                from operations
            
            
            (1,181,831
            )
            
            (310,912
            )
            
            —
            
            
            1,461,609
            
            
            1,453,159
            
            
            (4,845,782
            )Interest
                expense, net
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            (138,414
            )Net
                loss
            
            
            ($1,181,831
            )
            
            ($310,912
            )
            
            —
            
            $
            1,461,609
            
            $
            1,453,159
            
            
            ($4,984,196
            )Segment
                assets
            
            $
            6,160,831
            
            $
            2,934,306
            
            
            —
            
            $
            5,012,728
            
            $
            4,440,260
            
            $
            18,547,510Capital
                expenditures
            
            $
            873,723
            
            $
            4,090
            
            
            —
            
            $
            826,242
            
            $
            90,793
            
            $
            1,794,848











F-33







Year
                Ended December 31, 2003DOMESTIC
              XTRAC
            
            INTERN’L
              XTRAC
            
            SKIN
              CARE
            
            SURGICAL
                SERVICES
            
            SURGICAL
                PRODUCTS
              AND
                OTHER
            
            TOTALRevenues
            
            $
            1,325,024
            
            $
            1,166,520
            
            
            —
            
            $
            5,953,462
            
            $
            5,873,787
            
            $
            14,318,793Costs
                of revenues
            
            
            2,795,785
            
            
            817,075
            
            
            —
            
            
            3,899,714
            
            
            2,975,034
            
            
            10,487,608Gross
                profit
            
            
            (1,470,761
            )
            
            349,445
            
            
            —
            
            
            2,053,748
            
            
            2,898,753
            
            
            3,831,185Allocated
                operating expenses:Selling,
                general and administrative
            
            
            1,668,819
            
            
            666,131
            
            
            —
            
            
            1,108,878
            
            
            659,812
            
            
            4,103,640Engineering
                and product development
            
            
            893,277
            
            
            347,386
            
            
            —
            
            
            —
            
            
            535,817
            
            
            1,776,480Unallocated
                operating expenses
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            5,347,5842,562,096
            
            
            1,013,517
            
            
            —
            
            
            1,108,878
            
            
            1,195,629
            
            
            11,227,704Loss
                from operations
            
            
            (4,032,857
            )
            
            (664,072
            )
            
            —
            
            
            944,870
            
            
            1,703,124
            
            
            (7,396,519
            )Interest
                expense, net
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            46,330Net
                loss
            
            
            ($4,032,857
            )
            
            ($664,072
            )
            
            —
            
            $
            944,870
            
            $
            1,703,124
            
            
            ($7,442,849
            )Segment
                assets
            
            $
            5,758,496
            
            $
            2,924,131
            
            
            —
            
            $
            3,493,914
            
            $
            3,704,781
            
            $
            15,881,322Capital
                expenditures
            
            $
            1,436,109
            
            $
            5,417
            
            
            —
            
            $
            121,451
            
            $
            44,780
            
            $
            1,607,757








December
                31,Assets:
            
            2005
            
            2004Total
                assets for reportable segments
            
            $
            42,341,988
            
            $
            18,547,510Other
                unallocated assets
            
            
            6,333,618
            
            
            4,414,416Consolidated
                total
            
            $
            48,675,606
            
            $
            22,961,926




For
      the
      years ended December 31, 2005, 2004 and 2003, there were no material net
      revenues attributed to an individual foreign country. Net revenues by geographic
      area were as follows:




Year
                Ended December 31,2005
            
            2004
            
            2003Domestic
            
            $
            24,667,314
            
            $
            15,460,793
            
            $
            12,011,280Foreign
            
            
            3,717,192
            
            
            2,284,388
            
            
            2,307,513$
            28,384,506
            
            $
            17,745,181
            
            $
            14,318,793






F-34


*Note
      18*


**Quarterly
      Financial Data (Unaudited):**




*For
                the Quarter Ended***2005**
            
            Mar.
                31
            
            Jun.
                30
            
            Sep.
                30
            
            Dec.
                31Revenues
            
            $
            4,983,000
            
            $
            8,055,000
            
            $
            7,624,000
            
            $
            7,722,000Gross
                profit
            
            
            2,351,000
            
            
            3,833,000
            
            
            3,320,000
            
            
            3,205,000Net
                loss
            
            
            (1,128,000
            )
            
            (661,000
            )
            
            (1,350,000
            )
            
            (797,000
            )Basic
                and diluted net loss per share
            
            
            ($0.03
            )
            
            ($0.01
            )
            
            ($0.03
            )
            
            ($0.01
            )Shares
                used in computing basic and
              diluted
                net loss per share
            
            
            41,755,950
            
            
            50,859,562
            
            
            51,198,095
            
            
            51,322,000**2004**
            
            
            Mar.
                31
            
            
            Jun.
                30
            
            
            Sep.
                30
            
            
            Dec.
                31Revenues
            
            $
            4,025,000
            
            $
            4,323,000
            
            $
            4,455,000
            
            $
            4,942,000Gross
                profit
            
            
            1,531,000
            
            
            1,692,000
            
            
            1,954,000
            
            
            2,205,000Net
                loss
            
            
            (1,363,000
            )
            
            (1,207,000
            )
            
            (1,156,000
            )
            
            (1,258,000
            )Basic
                and diluted net loss per share
            
            
            ($0.04
            )
            
            ($0.03
            )
            
            ($0.03
            )
            
            ($0.03
            )Shares
                used in computing basic and
              diluted
                net loss per share
            
            
            37,773,301
            
            
            38,546,338
            
            
            38,960,250
            
            
            40,059,503**2003**
            
            
            Mar.
                31
            
            
            Jun.
                30
            
            
            Sep.
                30
            
            
            Dec.
                31Revenues
            
            $
            3,473,000
            
            $
            3,843,000
            
            $
            3,299,000
            
            $
            3,704,000Gross
                profit
            
            
            1,063,000
            
            
            1,176,000
            
            
            812,000
            
            
            780,000Net
                loss
            
            
            (1,674,000
            )
            
            (1,686,000
            )
            
            (1,913,000
            )
            
            (2,170,000
            )Basic
                and diluted net loss per share
            
            
            ($0.05
            )
            
            ($0.05
            )
            
            ($0.05
            )
            
            ($0.06
            )Shares
                used in computing basic and
              diluted
                net loss per share
            
            
            31,439,058
            
            
            33,644,326
            
            
            37,622,358
            
            
            37,735,242




*Note
      19*


**Valuation
      and Qualifying Accounts:**




Additions
                Charged ToDescription
            
            Balance
                at
              Beginning
              of
                Period
            
            Cost
                and
              Expenses
            
            Other
              Accounts
                (1)
            
            Deductions
                (2)
            
            Balance
                at End
              of
                PeriodFOR
                THE YEAR ENDED DECEMBER 31, 2005:Reserve
                for Doubtful Accounts
            
            $
            736,505
            
            $
            373,964
            
            $
            121,633
            
            $
            466,662
            
            $
            765,440FOR
                THE YEAR ENDED DECEMBER 31, 2004:Reserve
                for Doubtful Accounts
            
            $
            698,044
            
            $
            459,861
            
            $
            —
            
            $
            421,400
            
            $
            736,505FOR
                THE YEAR ENDED DECEMBER 31, 2003:Reserve
                for Doubtful Accounts
            
            $
            1,169,486
            
            $
            254,429
            
            $
            —
            
            $
            725,871
            
            $
            698,044





(1)
            Represents
                allowance for doubtful accounts related to the acquisition of
                ProCyte.


(2)
            Represents
                write-offs of specific accounts
                receivable.







F-35