<PAGE>   1
                     U.S. SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                                   FORM 10-KSB
                                  -------------
(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, 1996

[ ]         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 0-27368

                          ORTEC INTERNATIONAL, INC.
        (EXACT NAME OF SMALL BUSINESS ISSUER AS SPECIFIED IN ITS CHARTER)

              DELAWARE                             11-3068704
   (STATE OR OTHER JURISDICTION OF              (I.R.S. EMPLOYER
    INCORPORATION OR ORGANIZATION)              IDENTIFICATION NO.)

            3960 BROADWAY
            NEW YORK, NY                              10032
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)            (ZIP CODE)

       REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (212) 740-6999
                                ----------------

           SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
                                      None
           SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
                          Common Stock, $.001 par value
      Class A Warrants to Purchase Shares of Common Stock at $10 per share
      Class B Warrants to Purchase Shares of Common Stock at $15 per share

Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Securities Exchange Act during the past 12 months (or for
such shorter period that the Registrant was required to file such reports), and
(2) has been subject to such filing requirements for the past 90 days.
Yes  x   No
   ----     ----
Check if there is no disclosure of delinquent filers in response to Item 405 of
Regulation S-B contained in this form, and no disclosure will 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-KSB or any
amendment to this Form 10-KSB. [ ]

State issuer's revenues for its most recent fiscal year: None from operations.

                   ---------------------------------------

The number of shares outstanding of the Registrant's common stock is 4,603,946
(as of 3/20/97). The aggregate market value of the voting stock held by
nonaffiliates of the Registrant was approximately $21,677,568 as of 3/20/97.

DOCUMENTS INCORPORATED BY REFERENCE - None
<PAGE>   2
                            ORTEC INTERNATIONAL, INC.
                      INDEX TO ANNUAL REPORT ON FORM 10-KSB
                FILED WITH THE SECURITIES AND EXCHANGE COMMISSION
                          YEAR ENDED DECEMBER 31, 1996

                              ITEMS IN FORM 10-KSB

Facing page                                                                Page
                                                                           ----
Part I
------
Item 1.  Business                                                            1

Item 2.  Properties                                                         10

Item 3.  Legal Proceedings                                                  10

Item 4.  Submission of Matters to
         a Vote of Security Holders                                         10

Part II
-------
Item 5.  Market for the Registrant's Common Equity
         and Related Stockholder Matters                                    11

Item 6.  Plan of Operation                                                  14

Item 7.  Financial Statements                                               16

Item 8.  Changes in and Disagreements with
         Accountants on Accounting and
         Financial Disclosure                                               16

Part III
--------
Item 9   Directors, Executive Officers, Promoters
         and Control Persons; Compliance with
         Section 16(a) of the Exchange Act                                  16

Item 10. Executive Compensation                                             21

Item 11. Security Ownership of Certain Beneficial
         Owners and Management                                              23

Item 12. Certain Relationships and Related Transactions.                    25


Part IV
-------
Item 13. Exhibits and Reports on Form 8-K                                   27

Signatures                                                                  29

Financial Statements                                                       F-1
<PAGE>   3
                                     PART I

ITEM 1.     BUSINESS

INTRODUCTION

      The Company has developed a proprietary technology which consists of a
biologically active dressing to stimulate the repair and regeneration of human
skin. The Company's product is intended to be utilized for the treatment of
severe burn patients as well as for other types of wound healing and for
reconstructive and cosmetic surgery. The Company believes that the successful
regeneration of human skin creates the potential for wide commercial
application.

      The Company is a development stage company and to date has not sold any
products. Its activities have been limited to human clinical tests of its
product and research and development under an exclusive license relating to the
Company's biological dressing. From March 12, 1991 (inception) to December 31,
1996, the Company has spent an aggregate of $3,354,416 for research and
development, of which $964,864, $573,392 and $796,547 were spent in 1996, 1995
and 1994, respectively.

      In March 1994, the Company commenced human clinical trials on burn
patients under protocols approved by the Food and Drug Administration ("FDA"),
which require testing of 120 patients. As of March 20, 1997, eight patients have
been treated under this program. More trials will be necessary to test the
safety and efficacy of the Company's product. From 1988 to 1996, the Company's
product was used in skin replacement operations on 29 patients (of which 5
operations were skin replacement for burn patients) in Sydney, Australia. None
of the Australian procedures were performed in accordance with the FDA approved
protocols.

      The Company and The Skin Group, Ltd. (a predecessor of the Company) were
organized in 1991 for the purpose of acquiring the Company's skin product from
Dr. Mark Eisenberg and to develop, test and market such product. In 1992, The
Skin Group, Ltd. was merged into the Company. The Company declared a
twenty-for-one stock split in January 1993. All information contained in this
Annual Report on Form 10-KSB, unless otherwise noted, gives effect to that
merger and stock split.

BACKGROUND

      Physicians have for years been using skin transplanted from one site of a
patient's body onto a wound site that no longer has the capacity to heal
spontaneously. This procedure is called an autograft transplant. Burn wound
clinicians have sought to replace autograft transplants with substitute
synthetic or natural materials ("allografts") which would

                                        1
<PAGE>   4
eliminate the medically undesirable problems that accompany autograft
transplants, such as creation of additional wound sites at the areas of the body
from which the healthy skin is taken.

      Scientists have tried to replicate human skin in a laboratory setting in
order to create an artificial skin that can be transplanted onto diseased or
injured patients. Major problems encountered by scientists include failure of
the artificial skin to heal and significant contraction of the transplant after
healing, causing cosmetically undesirable scarring.

TECHNOLOGY

      In order to create a clinically useful biological dressing, the Company
has duplicated the two major layers that form the human skin, the epidermis and
the dermis. Dr. Mark Eisenberg, of Sydney, Australia, an officer and director
of the Company and its largest shareholder, has been involved in biochemical and
clinical research at the University of New South Wales in Australia for over
twenty years, focusing primarily in treating the symptoms of a unique disease
called Epidermolysis Bullosa ("EB"). The wounds resulting from EB are very
similar to those caused by burns and require similar treatment. In 1987, through
his work on EB, Dr. Eisenberg first succeeded in growing epidermal layers of
human skin, which were successfully applied as an allograft on an EB patient.
Dr. Eisenberg has since developed a biologically active dressing known as
"Composite Cultured Skin", consisting of both the dermal and epidermal layers.

DESCRIPTION OF THE PROCESS

      Specialized cells that are the primary components of human skin are
derived from infant foreskins obtained during routine circumcisions. The
epidermis is separated from the dermis and each of these layers is treated to
release individual cells. These cells in turn are separately cultured to
reproduce a large number of identical cells. The dermal fibroblast cells derived
from the dermis are applied to a cross linked bovine collagen sponge to form the
dermal layer matrix. The epidermal cells are grown on another layer of collagen,
which, together with the dermal layer, constitute the Composite Cultured Skin.
The Composite Cultured Skin requires neither the patient's own cells nor cadaver
skin and is available for allograft replacement of damaged human skin. All
tissue obtained by the Company for producing the Composite Cultured Skin is
extensively screened and tested by independent laboratories for the presence of
potential pathogens and transmittable diseases.

      Although there can be no assurance that the Composite Cultured Skin will
become successful, or reach the commercial stage, the Company believes that its
skin regeneration technology is superior to autograft transplants because, based
on the limited number of medical procedures using the Composite Cultured Skin
conducted to

                                        2
<PAGE>   5
date, the Composite Cultured Skin appears to avoid creating additional wound
sites, to produce a smoother skin surface resulting in less scarring,
postoperative pain and contraction, and is available in case of extensive burns
on a patient's body, where no or limited healthy skin is available for an
autograft transplant. The Company's management believes that use of its
Composite Cultured Skin may shorten the period of required hospitalization,
reduce the number of additional reconstructive surgeries and limit the need for
both physical and psychological rehabilitation. See "Forward Looking
Information May Prove Inaccurate".

CLINICAL TESTS

      In March 1994, the Company commenced human clinical trials in the United
States, under protocols approved by the FDA, to evaluate the effectiveness of
the Composite Cultured Skin on burn patients. Since then eight burn patients
were treated as part of such human clinical trials, one at Cornell Medical
Center in New York City and the other seven at the Westchester Medical Center
in Valhalla, New York. It is too early to draw conclusions about the safety and
efficacy of the Company's product because of the limited number of such
operations to date and because more time is needed, under the clinical trial
protocol filed with the FDA, to assess the results of these and future
operations.

      From 1988 through March 20, 1997, 29 operations were conducted in Sydney,
Australia, using the Company's Composite Cultured Skin. Five of those operations
were performed on burn patients. Four operations were performed to remove
tattoos. The remaining operations were conducted for treating the symptoms of
EB. None of the operations in Australia were performed in accordance with the
FDA approved protocols. The Company does not intend to use the results of any of
its Australian operations as part of the 120 FDA required human clinical trials.

      Under the FDA approved clinical trial protocol, 120 patients are required
to be enrolled in at least five clinical sites located in various burn centers
in the United States. Each patient's progress must be followed for one year
following the procedure. The patients for the FDA mandated human clinical trials
are persons treated at the hospitals at which such clinical trials are
performed.

      The Company has been relying almost exclusively on the burn unit in
Westchester Medical Center for patients for its FDA mandated human clinical
trials. Since its protocols filed with the FDA limit the burn patients that can
be treated in the human clinical trials (based on age, the parts of the body to
be treated, the patient's other medical problems and the availability of skin
for simultaneous autograft transplants for comparison purposes), as well as by
the requirement for informed consent, the Company believes that it must
establish working relationships with burn units in other hospitals to increase
the number of patients available for its clinical trials. Jacobi Hospital in New
York City has agreed to use the

                                        3
<PAGE>   6
Company's Composite Cultured Skin at that hospital's burn center as part of the
Company's human clinical trials. To date, Jacobi Hospital has not conducted any
human clinical trials.

      In 1996, the FDA approved the protocols of Rockefeller University Hospital
in New York City for the use of the Composite Cultured Skin for the treatment of
non-healing skin ulcers of patients with EB. Under this FDA approved clinical
trial protocol, ten to fifteen patients are required to be enrolled at a
clinical site. Rockefeller University Hospital is currently recruiting EB
patients for these trials. None of these trials have yet been performed.

POTENTIAL APPLICATIONS OF TECHNOLOGY AND MARKETS

      The Company believes that its Composite Cultured Skin, if successfully
developed, will have wide commercial application for treatment of severe burn
patients, patients who suffer severe ulcerations and various skin diseases (such
as EB), as well as for reconstructive and cosmetic surgery. There can be no
assurance that the Company's Composite Cultured Skin will be successfully tested
in future human clinical trials or that it can be marketed profitably. See
"Forward Looking Information May Prove Inaccurate".

PRODUCTION AND SUPPLY

      In March 1996, the Company entered into a five-year lease with Columbia
University ("Columbia") for the Company's new laboratory and offices in
Columbia's new Audubon Biomedical Science and Technology Park in New York City
("Audubon"). Construction of the new laboratory and office facility was
completed in July 1996 and became fully operational in November 1996. As of
March 20, 1997, Columbia provided a $400,000 grant and has loaned and advanced
to the Company approximately $619,000 for the Company's construction and
architectural and engineering costs in building its new laboratory and office,
and for equipment installed in the new laboratory. The Company has spent
approximately $210,000 of its own funds, in addition to the loan from Columbia.
The Company anticipates that the construction already completed and the
equipment to be installed in the new laboratory will cost, in the aggregate,
approximately an additional $285,000.

      The Company uses its new laboratory to produce its Composite Cultured Skin
for use in the remaining FDA approved human clinical trials and for further
research to develop the Company's proprietary technology for treatment of other
wounds. The Company intends to further equip its new laboratory as a pilot
production facility for its Composite Cultured Skin. The new Audubon facility is
a dedicated biomedical research facility and the Company, as a tenant, is
entitled to utilize the resources of Columbia's Health Sciences Research
facility at the Audubon facility as well as those at Columbia University-
Presbyterian Medical Center across the street from the facility.

                                        4
<PAGE>   7
      The Company also has its own laboratory facility in Sydney, Australia,
where it conducts additional research and produces its Composite Cultured Skin
used for operations in Australia.

      If the Company is successful in securing FDA approval to market and sell
its Composite Cultured Skin, the Company's ability to operate profitably will
depend on its ability to produce, or have produced for it by third party
producers, its Composite Cultured Skin in large quantities at a competitive
cost. There can be no assurance that the Company will be able to construct and
equip a volume production facility to produce its Composite Cultured Skin at a
commercially viable cost, or that the Company will be able to enter into an
agreement with a third party to produce such product on terms acceptable to the
Company, if at all. Any manufacturing, whether by the Company or a third party
manufacturer, for any future commercial scale production of the Company's
Composite Cultured Skin, will have to be in compliance with the Good
Manufacturing Practices, as mandated by the FDA. See "Forward Looking
Information May Prove Inaccurate."

RESEARCH

      Most of the research and development for the Company's proprietary
technology is done at the Company's laboratory at the Audubon facility and its
laboratory in Sydney, Australia. The Company recently entered into an agreement
with the New Jersey Center for Biomaterials and Medical Devices (the "New Jersey
Center"), whereby the Company and the New Jersey Center will collaborate on
research focusing on the development of collagen-based biomaterials for soft
tissue repair, specifically targeting the development of a second generation
collagen matrix to be used for the production of the Company's Composite
Cultured Skin. The New Jersey Center is a cooperative research initiative
sponsored by the University of Medicine and Dentistry of New Jersey, Rutgers
University and the New Jersey Institute of Technology, and receives financial
support from the New Jersey Commission of Science and Technology. The Company
has agreed to contribute $40,000 of the $100,000 cost of such research. The
Company will pay such $40,000 in quarterly payments of $10,000 each. The $10,000
payment for the first quarter has already been paid by the Company.

FDA CONSULTANT

      The Company retains Oxford Research International Corp. ("Oxford") to
assist it in the FDA approval process, including the preparation of applications
and related documentation and monitoring all phases of the clinical trials. The
agreement has a term of one year and is automatically renewable for additional
one year periods subject to termination at will. Fees payable to Oxford are
based on Oxford's per diem charges. The amount of fees for Oxford's services for
the fiscal year ended December 31, 1996 aggregated $61,430.

                                        5
<PAGE>   8
PATENTS AND PROPRIETARY RIGHTS

      The Company has an exclusive worldwide license to use the proprietary
technology on which its Composite Cultured Skin is based and to market any
products developed from it, except for the treatment of EB patients in
Australia.

Eisenberg License Agreement

      Pursuant to a license agreement (the "License Agreement") dated June 7,
1991, by and between the Company and Dr. Eisenberg, as modified in August,
1995, Dr. Eisenberg has granted the Company an exclusive worldwide license to
use the technology subject to certain limitations. The agreement has a term of
ten years, which may be automatically renewed by the Company for two additional
ten year periods.

      Dr. Eisenberg has retained the exclusive right to use the technology in
Australia solely for nonprofit applications that are not competitive with the
Company's business. The Company has agreed to make its Composite Cultured Skin
available for treatment of EB patients in Australia on a cost basis.

      Upon the expiration or earlier termination of the License Agreement, Dr.
Eisenberg will be entitled to the exclusive rights to the technology licensed
under the License Agreement. However, the Company will retain the exclusive
rights to all improvements to the technology developed during the license
period. If the License Agreement is terminated due to a breach by the Company,
Dr. Eisenberg will also be entitled to the rights to such improvements.

Patents

      Dr. Eisenberg has been granted patents for the Company's Composite
Cultured Skin in the United States and in several foreign countries and is
prosecuting patent claims for it in others. The United States Patent was
initially granted to Dr. Eisenberg on February 1, 1994 and bears U.S. Patent
5,282,589. On December 10, 1996, after an unsuccessful challenge by a competitor
of the Company, the U.S. Patent Office re-issued the Company's Composite
Cultured Skin patent (No. RE-35399).

      There can be no assurance that such patent may not be successfully
challenged in court proceedings. Nor can there be any assurance that any United
States or foreign patents will provide any commercial benefits to the Company.

      Several of the Company's competitors, including Organogenesis, Inc.,
Advanced Tissue Sciences, Inc., Genzyme Tissue Repair Inc., Integra Life
Sciences and LifeCell Corporation, have been granted patents relating to their
particular artificial skin technologies.

                                        6
<PAGE>   9
GOVERNMENT REGULATION

      The Company is subject to extensive government regulations. Products for
human treatment are subject to rigorous preclinical and clinical testing
procedures as a condition for approval by the FDA and by similar authorities in
foreign countries prior to commercial sale.


      Pursuant to the Federal Food Drug and Cosmetic Act and regulations
promulgated thereunder, the FDA regulates the manufacture, distribution and
promotion of medical devices in the United States. The Company's Composite
Cultured Skin is subject to regulation as a medical device. Prior to commercial
release of the Company's product, premarket approval ("PMA") by the FDA will be
required. PMA entails proof of nontoxic, safety and efficacy in human
clinical trials. Premarket approval is a lengthy and expensive process and
there can be no assurance that FDA approval will be obtained.

      To obtain premarket approval, the Company must submit a PMA application,
supported by extensive data, including human clinical trial data, and
documentation to prove the safety and efficacy of the device. Pursuant to
applicable regulations, the FDA has 180 days to review a PMA application during
which time an advisory committee usually evaluates the application and makes
recommendations to the FDA. While the FDA has responded to PMA applications
within that time period, reviews usually occur over a significantly protracted
period of twelve to twenty-four months. A number of devices are never cleared
for marketing.

      If human clinical trials of a proposed device are required and the device
presents significant risk, the manufacturer or distributor of the device will
have to file an Investigative Device Exemption ("IDE") application with the FDA
prior to commencing such trials. The IDE application must be supported by data,
including the results of animal and other testing. If the IDE application is
approved, human clinical trials may begin. In February 1994, the FDA approved
the Company's IDE application for clinical investigation of its product for
burn injuries, allowing the Company to commence human clinical trials on a total
of 120 burn patients. As a result of such approval by the FDA, in March 1994,
the Company commenced human clinical trials. In January 1997, the FDA approved a
physician submitted IDE application for clinical investigation of the Company's
product for the treatment of the symptoms of EB, submitted by Rockefeller
University Hospital in New York City, allowing for the commencement of human
clinical trials on ten to fifteen EB patients. Rockefeller University Hospital
has begun recruiting EB patients for such trials.

      Reports containing results from the human clinical trials will be
submitted to the FDA in support of any PMA application. At this stage, it is not
possible to determine whether the results achieved from the clinical trials will
be sufficient to obtain FDA approval.

                                        7
<PAGE>   10
      Any manufacturing, whether by the Company or by a third party
manufacturer, for any future commercial scale production of the Company's
Composite Cultured Skin, will have to be in compliance with the Good
Manufacturing Practices, as mandated by the FDA.

COMPETITION

      The Company is aware of several companies engaged in the research and
development of replacement skin products, including Organogenesis, Inc.
("Organogenesis") and Genzyme Tissue Repair, Inc. ("Genzyme"), both of
Cambridge, Massachusetts, Advanced Tissue Sciences, Inc. ("Advanced Tissue") of
La Jolla, California, LifeCell  Corporation ("LifeCell") of Woodland,  Texas,
and Integra Life Sciences ("Integra") of Plainsboro, New Jersey.

      Organogenesis, like the Company, has developed a product that is composed
of donor epidermal cells, fibroblast cells and a bovine collagen matrix. The
Company's Composite Cultured Skin differs from Organogenesis' product in its
collagen matrices and the methods used to culture the cells onto the collagen
matrices. In 1995, Organogenesis filed for premarket approval by the FDA for
use of its cultured skin product for treatment of venous stasis ulcers.

      Advanced Tissue has initiated several clinical trials to test a
"dermal equivalent" composed of bio-absorbable material in which donor
fibroblast cells have been seeded to secrete a dermal-like protein matrix. In
the latter part of 1996, Advanced Tissue filed for premarket approval
by the FDA for use of its "dermal equivalent" in the treatment of diabetic skin
ulcers.

      Advanced Tissue has also conducted clinical trials to test a
non-absorbable biosynthetic matrix, seeded with dermal fibroblast cells to act
as a temporary wound covering for severe burns before skin from an autograft
procedure becomes available. This product was approved for marketing by the FDA
on March 18, 1997.

      Genzyme has developed a product that consists of culturing epidermal
cells obtained from the patient through a biopsy to recreate an epidermis
like layer. This product is not regulated by the FDA and is available
commercially. The Company believes that its uses are limited due to the two to
three weeks delay in supplying the product to the patient.

      LifeCell has developed a method to freeze-dry cadaver skin to be used
as an artificial dermis, which must then be covered with an autograft or
cultured epidermal cells. This product does not require FDA approval and has
been sold commercially since 1993.

                                        8
<PAGE>   11
      In 1991, Integra developed a product that consists of a bovine collagen
matrix covered with a layer of silicone. This product is intended to act as an
artificial dermis and requires an autograft several days after treatment. In
March 1996, the FDA approved for marketing INTEGRA(TM) Artificial Skin,
Dermal Regeneration Template(TM).

      All of these companies have greater financial and other resources than the
Company and most of them have conducted and continue to conduct human clinical
trials, many of which are at more advanced stages than the Company's human
clinical trials.

      Except as set forth above, the Company is not aware of any skin
replacement product that has received PMA approval from the FDA.

      In the area of chronic wound healing, many well known biotechnology
companies are developing products to treat wounds. These forms of therapies are
classified as biologics and therefore must meet more extensive regulatory
requirements than skin grafts, which are classified as devices. To date, and to
the best of the Company's knowledge, none of the trials performed to treat
chronic wounds has had any significant success. The Company feels that part of
the efficacy of its technology is based on its ability to deliver to the wound
site a complete skin system that includes epidermal cells and dermal cells.
These delivered cells may produce and deliver a myriad of growth factors that
may be secreted in the proper concentrations and could act as the growth factor
delivery system needed to treat chronic wounds as well as wounds from burns.

      No assurance can be given that other companies having greater financial
resources than the Company will not develop other skin regeneration or wound
healing technology that may be more effective than the Company's Composite
Cultured Skin, or that may make the Company's Composite Cultured Skin obsolete.
See "Forward Looking Information May Prove Inaccurate".

EMPLOYEES

      The Company presently employs sixteen people in the United States,
including three executive officers. Only one executive officer is employed on a
full time basis. In addition to its executive officers, the Company employs nine
other persons in New York City. The Company employs four persons, one part-time,
to work in its laboratory in Sydney, Australia. Dr. Eisenberg also is employed
part-time in Sydney, Australia. The Company's United States and Australian
staffs include six employees possessing either Ph.D. or M.D. degrees. The
Company anticipates that it will employ additional persons in 1997 other than
those referred to above, as its needs require.

                                        9
<PAGE>   12
ITEM 2.     PROPERTIES

      In March 1996, the Company entered into a five-year lease with Columbia
University ("Columbia") for 5,765 square feet of space at 3960 Broadway, New
York City, New York, in Columbia's new Audubon Biomedical Science and
Technology Park ("Audubon"). The Company relocated its executive offices to its
new laboratory facility in July 1996 and commenced operation of its laboratory
in such facility in November 1996.

        The Company initially pays rent of $10,809 per month, with increases in
the fourth and fifth years of the lease. The Company also granted Columbia a
warrant expiring March 10, 2001 to purchase 5,000 shares of Common Stock at an
exercise price of $10 per share. The Company has the option to renew the lease
for an additional five year term at a modest increase in base rent. As of March
20, 1997, Columbia provided a $400,000 grant and has loaned and advanced to the
Company approximately $619,000 for the Company's construction and architectural
and engineering costs in building its new laboratory and office, and for
equipment installed in the new laboratory. The Company has spent approximately
$210,000 of its own funds, in addition to the loan from Columbia. The Company
anticipates that the construction already completed and the equipment to be
installed in the new laboratory, will cost, in the aggregate, approximately an
additional $285,000. Monthly payments of principal and interest to repay the
loan have been calculated on a ten year pay out.

      In 1992, the Company signed a five-year lease for approximately 5,000
square feet of space at 147-155 Queen Street, Beaconsfield, Sydney, Australia,
in which the Company constructed a new research laboratory to conduct its
research and development activities in Australia and to produce the Composite
Cultured Skin used in the operations conducted in Australia. This space is
rented from Dr. Mark Eisenberg's father on terms that the Company believes are
not more favorable to it than for rental of similar space in Sydney, Australia,
from non-related third parties. The Company has an option to extend such lease
for an additional three years after its termination on May 27, 1997, at the then
prevailing market rent for similar properties. From 1992 through December 31,
1996, the Company paid an aggregate of approximately $32,000 in rental payments
to Dr. Eisenberg's father for the use of such space by the Company. Dr.
Eisenberg's father has waived unpaid rent owed by the Company for such space in
the amount of $40,740 through December 31, 1995.

ITEM 3.     LEGAL PROCEEDINGS

      None.

ITEM 4.     SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS

      None.

                                       10
<PAGE>   13
                                     PART II

Item 5.     MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED
            STOCKHOLDER MATTERS

MARKET PRICE OF AND DIVIDENDS ON THE COMPANY'S
COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

      (a)   Market Information.

      From January 20, 1996 to May 28, 1996, the Company's publicly-traded
securities were traded as units, each unit consisting of one share of Common
Stock, one Class A Warrant and one Class B Warrant (the "Units"), and were
listed on the NASDAQ SmallCap Market under the symbol "ORTCU". On May 17, 1996,
the components of the Units each became separately tradeable securities. The
Common Stock of the Company is currently trading on the NASDAQ SmallCap Market
under the symbol "ORTC". The following table sets forth the high and low bid
information of the Common Stock as reported by NASDAQ for each full quarterly
period since January 1996 (and for any subsequent interim period for which
financial statements are included herein).

<TABLE>
<CAPTION>
                                              Closing Prices
                                              --------------
                                          High              Low
                                          ----              ---
Fiscal Year Ended
December 31, 1996
<S>                                       <C>               <C>
Units
-----
      First Quarter (from
        date of inception,
        January 19, 1996)                 $ 7 1/2            $5 6/8

      Second Quarter (to
        May 28, 1996)                       7 1/4             6

Common Stock
------------
      Second Quarter (from
        May 17, 1996)                       6 5/8             4 3/4

      Third Quarter                         7 9/16            5 7/8

      Fourth Quarter                       10 1/2             7 1/2
</TABLE>

                                       11
<PAGE>   14
      (b)   Security Holders.

      To the best knowledge of the Company, at March 20, 1997, there were 144
record holders of the Company's Common Stock. The Company believes there are
numerous beneficial owners of the Company's Common Stock whose shares are held
in "street name." To the best knowledge of the Company, the number of beneficial
owners as of March 20, 1997 was approximately 1,080.

      (c)   Dividends.

      The Company has not paid, and has no current plans to pay, dividends on
its Common Stock.

RECENT SALES OF UNREGISTERED SECURITIES


      1996 PRIVATE PLACEMENT

      In November 1996, the Company completed a private placement of its
securities (the "1996 Private Placement") from which it received gross proceeds
of $6,220,222, and net proceeds of approximately $5,733,000 (after deducting
approximately $487,000 in placement agent fees and other expenses of such
private placement). The Company sold 959,106 shares of Common Stock in such
private placement at an average price of $6.49 per share.

      The offer and sale of the shares in the 1996 Private Placement were made
by the Company, acting through its officers and directors, and three placement
agents, Ms. Teena Lerner and Messrs. Joseph Stechler and Menachem Genack (the
"Placement Agents"). Mr. Stechler is a director of the Company. The Company paid
each Placement Agent cash commissions of 7% of the purchase price for each share
sold in the 1996 Private Placement by such person and, in addition to such cash
commissions, granted five-year warrants to each Placement Agent to purchase such
number of shares of Common Stock equal to 10% of the number of shares of Common
Stock sold by such Placement Agent, exercisable at prices equal to 120% of the
prices paid for such shares (the "1996 Private Placement Warrants"). As
compensation for their services as Placement Agents in connection with the 1996
Private Placement, Ms. Lerner and Messrs. Stechler and Genack received
approximately $280,000, $140,000 and $11,900 as cash compensation and 61,922,
30,500 and 2,639 1996 Private Placement Warrants, respectively. Other than Mr.
Stechler, none of the Company's other directors received any compensation.
Except for their services as Placement Agents in the 1996 Private Placement,
Teena Lerner and Menachem Genack  are not affiliated with the Company, although
Mr. Genack has been a stockholder of the Company since its inception in 1991.

                                       12
<PAGE>   15
      The securities included in the 1996 Private Placement were offered and
sold only to accredited investors, as that term is defined under Regulation D of
the Securities Act of 1933, as amended (the "Act"), in reliance on the
availability of an exemption from the registration provisions of the Act, by
virtue of the Company's compliance with the provisions of Section 4(2) thereof
and Rule 506 of Regulation D. The purchasers in the 1996 Private Placement have
demanded that the Company register all such 959,106 shares of Common Stock
purchased in the 1996 Private Placement under the Act. The Company is presently
preparing a registration statement covering such shares for filing with the
Securities and Exchange Commission (the "Commission").

OTHER GRANTS AND ISSUANCES OF SECURITIES

      During 1996, the Company granted the following options under its Employee
Stock Option Plan:

<TABLE>
<CAPTION>
                              No. of Shares
Class of Persons                Subject to         Date of    Exercise     Expiration
To Whom Granted                  Options            Grant       Price         Date
----------------              -------------        -------    --------     -----------
<S>                              <C>               <C>         <C>          <C>
One employee, consultants
  and advisers                   63,500             4/1/96     $6.00          4/1/01

Two executive officers
  and one employee               42,500             4/1/96     $7.00          4/1/01

Three executive officers         50,000            11/21/96    $8.50        11/21/01
</TABLE>

The foregoing grants of securities were in consideration for services rendered
to the Company.

      On January 20, 1996, the Company granted "lock-up warrants" to 63 persons,
entitling them to purchase an aggregate of 389,045 shares of the Company's
Common Stock at a price of $1.00 per share. All such warrants expire on January
18, 2000. At different times during 1996, seven persons exercised such warrants
and purchased 33,885 shares of Common Stock at the $1.00 per share exercise
price. The issuance of such lock-up warrants was in consideration for such 63
persons' signing lock-up agreements agreeing not to sell or transfer shares of
the Company's Common Stock purchased at prices of $9.00 or more per share until
January 20, 1997.

      On March 11, 1996, the Company granted the Trustees of Columbia University
warrants to purchase up to 5,000 shares of the Company's Common Stock at an
exercise price of $10.00 per share. Such warrants expire on March 11, 2001 and
were granted as

                                       13
<PAGE>   16
partial consideration to Columbia University for leasing office and laboratory
space to the Company at its Audubon facility. See Part I, Item 2, "Properties."

      On June 20, 1996, the Company granted warrants to Mr. Judah Wernick to
purchase up to 12,500 shares of the Company's Common Stock at an exercise price
of $6.00 per share. Such warrant expires on June 19, 1999 and was granted in
consideration for Mr. Wernick's loan of $73,000 to the Company prior to the
Company's initial public offering of its securities in December 1995 and January
1996. Mr. Wernick  is affiliated with Patterson Travis, Inc., the underwriter of
the Company's initial public offering.

      The grant, offer and sale of all of the securities listed above were sold
without registration under the Act, as they did not involve any public offering,
pursuant to the provisions of Section 4(2) of the Act.


ITEM 6.     PLAN OF OPERATION


OPERATIONS FOR THE NEXT TWELVE MONTHS

      For the next twelve months the Company will continue to conduct human
clinical trials. To that end, the Company intends to continue to recruit
hospital burn centers which will provide the necessary patients.

      The Company estimates that the cost to it of each human clinical trial for
burn patients and EB patients will be approximately $8,000. Such amounts
include testing for pathogens and payments to the hospital, but do not include
any allocation to the cost of such trials of salaries, rent or other overhead
expenses of the Company.

CASH REQUIREMENTS

      The Company estimates that it has sufficient funds necessary to operate
through approximately January 1999. The Company may have to secure additional
funds prior thereto or thereafter to complete its human clinical trials, if not
then already completed, to secure FDA premarket approval for commercial sales
and thereafter to produce and market its Composite Cultured Skin in commercial
quantities. See "Forward Looking Information May Prove Inaccurate."

CLINICAL TRIALS AND PRODUCT RESEARCH AND DEVELOPMENT

      The Company has spent an aggregate of approximately $3,354,416 from its
inception through December 31, 1996 for the human clinical trials and for
research and

                                       14
<PAGE>   17
development. That amount includes the salaries of its employees involved in
producing the Composite Cultured Skin, performing quality control, securing
hospital burn centers to participate in the human clinical trials, monitoring
the progress of the patients thereafter and the preparation of reports to be
filed with the FDA.

NEW LABORATORY

      In March 1996, the Company entered into a five-year lease with Columbia
University for 5,765 square feet of space at 3960 Broadway, New York City, New
York, in Columbia's new Audubon Biomedical Science and Technology Park. The
Company relocated its executive offices to its new laboratory facility in July
1996 and commenced operation of its laboratory in such facility in November
1996.

      The Company initially pays rent of $10,809 per month, with increases in
the fourth and fifth years of the lease. The Company also granted Columbia a
warrant expiring March 10, 2001 to purchase 5,000 shares of Common Stock at an
exercise price of $10 per share. The Company has the option to renew the lease
for an additional five year term at a modest increase in base rent. As of March
20, 1997, Columbia provided a $400,000 grant and has loaned and advanced to the
Company approximately $619,000 for the Company's construction and architectural
and engineering costs in building its new laboratory and office, and for
equipment installed in the new laboratory. The Company has spent approximately
$210,000 of its own funds, in addition to the loan from Columbia. The Company
anticipates that the construction already completed and the equipment to be
installed in the new laboratory will cost, in the aggregate, approximately an
additional $285,000. Monthly payments of principal and interest to repay the
loan have been calculated on a ten year pay out.

NUMBER OF EMPLOYEES

      The Company presently employs sixteen people, including three executive
officers. Only one executive officer is employed on a full time basis. In
addition to its executive officers, the Company employs nine other persons in
New York City. The Company employs four persons, one part-time, to work in its
laboratory in Sydney, Australia. Dr. Eisenberg also is employed part-time in
Sydney, Australia. The Company's United States and Australian staffs include six
employees possessing either Ph.D. or M.D. degrees. The Company anticipates that
it will employ additional persons in 1997 other than those referred to above, as
its needs require.


                                       15
<PAGE>   18
ITEM 7.     FINANCIAL STATEMENTS

      Reference is made to the Financial Statements referred to in the
accompanying Index, setting forth the financial statements of the Company,
together with the report of Grant Thornton LLP dated March 18, 1997.

ITEM 8.     CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
            ACCOUNTING AND FINANCIAL DISCLOSURE

      None.



                                    PART III

ITEM 9.     DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL
            PERSONS; COMPLIANCE WITH SECTION 16(A) OF THE
            EXCHANGE ACT.

DIRECTORS AND EXECUTIVE OFFICERS

      The directors and executive officers of the Company are as follows:

Name                   Age       Position
----                   ---       --------

Dr. Steven Katz        52        President, Chief Executive Officer and Chairman
                                 of the Board of Directors

Dr. Mark Eisenberg     59        Senior Vice President, Research and Development
                                 and Director

Ron Lipstein           41        Secretary, Treasurer, Chief Financial Officer
                                 and Director

Alain M. Klapholz      40        Vice President, Operations and Director

Mr. Joseph Stechler    45        Director


      Dr. Steven Katz, a founder of the Company, has been a director of the
Company since its inception in 1991 and was elected chairman of its Board of
Directors in September,

                                       16
<PAGE>   19
1994. He has been employed part time by the Company and a predecessor since
1991. Dr. Katz has also been a professor of Economics and Finance at Bernard
Baruch College in New York City since 1972. Dr. Katz devotes approximately 75%
of his time to the Company. He has a Ph.D. in Finance and Statistics as well as
an MBA and MS in Operations Research, both from New York University.

      Dr. Mark Eisenberg, a founder of the Company, has been a director and
senior vice president of the Company since 1991. Dr. Eisenberg has also been a
consultant to the Company since June 1991. See "Eisenberg Consulting
Agreement". He has been a physician in private practice in Sydney, Australia,
since 1967. He is a member and co- founder of the Dystrophy Epidermolysis
Bullosa clinic at the Prince of Wales Hospital for children in Sydney,
Australia. He has done extensive research on EB disease and has published
widely on this subject in medical journals.

      Ron Lipstein, a founder of the Company, has been the secretary and
treasurer and a director of the Company since 1991. He has been employed part
time by the Company and a predecessor since 1991. Mr. Lipstein has been
president and chief executive officer of Dollspart Supply Co., Inc., a mail
order supply company, since 1987. He devotes approximately 75% of his time to
the Company. Mr. Lipstein, who is a certified public accountant, was employed
as an accountant by Touche Ross & Company, a national public accounting firm,
from 1979 to 1987.

      Alain M. Klapholz, a founder of the Company, has been a vice president
and a director of the Company since 1991. He has been employed full time by the
Company since September, 1991. From 1989 to 1990 Mr. Klapholz was the president
of Klapholz & Associates, a consulting firm that serviced and assisted medical
device and biotechnology firms in developing business plans and raising capital.
In 1990, and until August 1991, he was chief financial officer of Applied DNA
Systems, a publicly held biotechnology company. Mr. Klapholz has an M.B.A. from
New York University. Until December 14, 1998, Patterson Travis, Inc. ("Patterson
Travis"), the underwriter of the initial public offering of the Company's
securities, has the right to designate a director who will replace Mr. Klapholz.
Patterson Travis has not yet made such designation.

      Joseph Stechler has been a director of the Company since 1992. He has been
president and CEO of Stechler & Company, an investment management firm, since
1986, and from 1990 to January 1997, he was the general partner of Old Ironsides
Capital, L.P., an investment fund. Prior to 1986 he was a securities analyst
with several investment firms. Mr. Stechler has a J.D. degree from Columbia
University and an LLM degree in corporate law from New York University.

      If the number of directors is increased to more than five, any person
selected to fill any such additionally created position in the period ending
December 14, 1997 is subject to

                                       17
<PAGE>   20
the prior written approval of Patterson Travis to serve in such position, which
approval may not be unreasonably withheld. The Company's management has no
present intention to increase the number of directors to more than five.

      Although Dr. Katz and Mr. Lipstein are employed by the Company part
time, in the past four years they have devoted most of their time to the
Company's affairs.

SIGNIFICANT EMPLOYEES

      Dr. Melvin Silberklang supervises the Company's laboratory at the
Audubon facility. From 1993 to 1995, Dr. Silberklang was employed by Enzon,
Inc. of Piscataway, New Jersey, as Senior Director of Process Research and
Development, supervising a multi-disciplinary staff of 18. From 1981 to 1993,
Dr. Silberklang was employed by Merck Research Laboratories of Rahway, New
Jersey, where from 1988 to 1993 he was Associate Director of Cellular and
Molecular Biology. In that capacity, Dr. Silberklang directed research and
development for five major protein products and managed transfers of research
results to large scale production. From 1985 to 1988, Dr. Silberklang was a
research fellow in Merck's Department of Cellular and Molecular Biology where
he developed and executed a capital expenditure plan to fully equip both
molecular biology and production facility laboratories.

      Dr. Suzanne Schwartz has been employed full-time by the Company since July
1, 1996, as its medical director. She is responsible for the Company's
relationships with hospitals at which operations using the Company's Composite
Cultured Skin as part of the human clinical trials have been and are to be
performed, with respect to such operations and other matters and securing
additional hospitals to perform such operations. She will also participate in
directing the Company's research and development for possible use of its
technology for other medical applications. Dr. Schwartz received her M.D. degree
from Albert Einstein College of Medicine in New York City in 1988 and trained as
a resident in general surgery at Montefiore Hospital and Medical Center in New
York City from July 1988 to June 1991. From July 1991 to June 1996, she held
various positions for advanced study at the Cornell University Medical College,
including a fellowship in its Burn Center, advanced study in the Wound Healing
Laboratory in the Department of Surgery, and in the Graduate Program in Cell
Biology and Genetics.

CONSULTANTS

      The Company retains Dr. Richard L. Kronenthal, the Chairman of its
Scientific Advisory Board, as a consultant at a minimum annual fee of $36,000.
As part of his consulting services, Dr. Kronenthal has taken the major
responsibility in directing the Company's research and development efforts.
Prior to 1989, Dr. Kronenthal was employed by Ethicon, Inc. ("Ethicon"), a
division of Johnson and Johnson, for more than 30 years, the

                                       18
<PAGE>   21
last four years as Ethicon's director of research and development. Prior to his
retirement in 1989, Dr. Kronenthal was responsible for Ethicon's development of
a variety of successful surgical products. During his more than thirty years
with Ethicon, Dr. Kronenthal held increasingly responsible positions involving
the worldwide commercialization of products derived from collagen, as well as
synthetic absorbable and other materials. Since 1989, Dr. Kronenthal has been
president of Kronenthal Associates, Inc., which provides technical and business
consulting services for investors and companies in the health care field.

      The Company also retains Dr. Lisa Staiano-Coico, Associate Dean of Cornell
University Medical School, as a consultant, to assist and advise in the further
development and production of the Company's Composite Cultured Skin. In addition
to the compensation of $4,166 per month paid by the Company to Dr.
Staiano-Coico, the Company has granted to Dr. Staiano-Coico warrants to purchase
up to 6,700 shares of the Company's Common Stock, at an exercise price of $12
per share. The warrants granted Dr. Staiano-Coico expire May 31, 1998.

EISENBERG CONSULTING AGREEMENT

      Pursuant to a consulting agreement (the "Consulting Agreement") dated June
7, 1991, as amended on September 1, 1992, between the Company and Dr.
Eisenberg, the Company has retained the services of Dr. Eisenberg as a
consultant until August 31, 2005.

      Under the Consulting Agreement, Dr. Eisenberg devotes 20 hours per week
to the Company. The Company pays Dr. Eisenberg an annual fee at the rate of
$73,000 and $58 per hour for each hour in excess of twenty hours per week spent
by Dr. Eisenberg on the Company's affairs. Dr. Eisenberg's fee is subject to
annual increases based on certain formulas.

      In addition, Dr. Eisenberg will receive a bonus in the event that the
Company files for the registration of any patent based on a significant advance
that has been developed under his supervision or direction and which the
Company's Board of Directors determines to have significant commercial
application. The amount of any such bonus shall be determined by the Board of
Directors of the Company, but shall not be less than $30,000 per patent
registration, provided that bonuses may not aggregate more than $60,000 during
any twelve-month period.

      Dr. Eisenberg has agreed not to compete with the Company until one year
after termination of the Consulting Agreement.

                                       19
<PAGE>   22
SCIENTIFIC ADVISORY BOARD

      The Company has secured medical doctors expert in dermatology and surgery
and an expert in the field of development of biomedical and other health care
products, to serve on the Company's Scientific Advisory Board to advise the
Company in the further development of its technology and to provide guidance for
the Company's research strategy. The following persons are serving on the
Company's Scientific Advisory Board:

      Dr. Richard L. Kronenthal -  Chairman of the Company's Scientific Advisory
      Board.  See "Consultants".

      Dr. Eugene Bauer - Chairman of Dermatology at, and Dean of the Stanford
      University School of Medicine.

      Dr. Joseph McGuire - Professor of Dermatology and Pediatrics at Stanford
      University School of Medicine.

      Dr. Andrew Salzberg - of the Westchester Medical Center and Co-Director of
      its burn unit.  Dr. Salzberg is a plastic surgeon with extensive
      experience in skin grafts.

      The Company compensates the members of its Scientific Advisory Board other
than Dr. Kronenthal for their time and expenses only, with minimum payments of
$5,000 per year to each member. The Company has granted to the following members
of its Scientific Advisory Board warrants to purchase shares of the Company's
Common Stock at exercise prices ranging from $9.425 to $10 per share: (i) to Dr.
Salzberg, warrants expiring in August 1997 to purchase 2,660 shares, (ii) to Dr.
Bauer, warrants expiring in September 1997 to purchase 2,000 shares, (iii) to
Dr. McGuire, warrants expiring in April 1998 to purchase 2,000 shares and (iv)
to Dr. Kronenthal, warrants expiring in March 2000 to purchase 2,000 shares. The
Company also has agreed to grant to an academic, charitable, or research
institution designated by a former Scientific Advisory Board member warrants
which expire in April 1998 to purchase 2,000 shares of Common Stock at $9.425
per share. In addition, on April 1, 1996, the Company granted non-incentive
stock options to Dr. Salzberg to purchase 10,000 shares, and to Dr. Kronenthal
to purchase 7,500 shares at an exercise price of $6.00 per share. Such options
expire on April 1, 2001 and were granted for consulting services rendered by
Drs. Salzberg and Kronenthal to the Company.


SECTION 16(A)  BENEFICIAL OWNERSHIP REPORTING COMPLIANCE

      To the best of the Company's knowledge, Joseph Stechler, a director of the
Company, untimely filed two reports on Form 4 during the fiscal year ended
December 31,

                                       20
<PAGE>   23
1996, reporting ten late transactions. To the best of the Company's knowledge,
all other Forms 3, 4 and 5 required to be filed in the fiscal year ended
December 31, 1996 were timely filed.


ITEM 10.    EXECUTIVE COMPENSATION

      The following table sets forth the Company's executive compensation paid
during the three fiscal years ended December 31, 1996, 1995 and 1994 for the
Chief Executive Officer and the Company's most highly compensated executive
officers of the Company (other than the Chief Executive Officer) whose cash
compensation exceeded $100,000 (the "Named Officers").


                          SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
                                                         Long Term Compensation
                                                         ----------------------
                               Annual Compensation          Awards      Payouts
                             -----------------------        --------   ---------
  (a)            (b)      (c)       (d)      (e)          (f)      (g)      (h)       (i)
                                                           Re-
                                               Other       stricted           Plan     All
                                               Annual      Stock              Pay-     Other
Name and Prin-              Salary      Bonus  Compensa-     Awards  Options  outs   Compensa-
cipal Position    Year      ($)         ($)    tion($)        ($)       (#)     ($)    tion($)
--------------    ----     ------      -----   ---------   --------  -------  ----     ---------
<S>               <C>    <C>                     <C>                  <C>
Dr. Steven Katz   1996   $162,451(1)             $8,100*              50,000
 Chief Executive  1995     74,000(2)              6,000*                 --
 Officer and      1994     75,980                 6,000*                 --
 President

Ron Lipstein      1996   $135,861(1)             $8,100*              25,000
 Secretary,       1995     53,848(2)              6,000*                 --
 Treasurer and    1994     71,684(3)              6,000*                 --
 CFO

Alain Klapholz    1996   $112,249(1)             $3,500*              10,000
 Vice President   1995     86,871(2)              6,000*                 --
                  1994     56,959(3)              8,500*                 --
</TABLE>

-----------------

*     In lieu of health insurance.

(1)   Includes $37,986, $26,923 and $16,265, paid to Dr. Katz and Messrs.
      Lipstein and Klapholz, respectively, in 1996 for compensation payable to
      such persons in 1995, but deferred for lack of funds at the Company's
      disposal at such time.

(2)   Includes amounts for compensation payable to such persons in 1995, but
      deferred to 1996 for lack of funds at the Company's disposal at such time.
      See Note (1), above. Also includes $16,154 and $3,113, paid to Messrs.
      Lipstein and Klapholz,

                                       21
<PAGE>   24
      respectively, in 1995 for compensation payable to such persons in 1994,
      but deferred for lack of funds at the Company's disposal at such time.

(3)   Includes amounts for compensation payable to such persons in 1994, but
      deferred to 1995 for lack of funds at the Company's disposal at such time.
      See Note (2), above.


BOARD COMPENSATION

      Although Mr. Klapholz is employed on a full-time basis by the Company, and
Dr. Eisenberg and Mr. Lipstein on a part-time basis, in 1996, no compensation
was paid by the Company to any director for services rendered by him as a
director or for committee participation or for special assignments as a
director.



                        OPTION GRANTS IN LAST FISCAL YEAR

      The following table sets forth certain information regarding options
granted during the fiscal year ended December 31, 1996 by the Company to the
Named Officers:

<TABLE>
<CAPTION>
                                    Individual Grants
                                 ------------------------
                                    Percent of
                    Securities      Total Options
                    Underlying      Granted to      Exercise
                     Options        Employees in    or Base     Expiration
     Name            Granted        Fiscal Year      Price      Date
     ----            -------        -------------   --------    -------
<S>                  <C>                <C>          <C>       <C>
Dr. Steven Katz      30,000             30.4%        $8.50     11/21/2001
                     20,000             20.3%        $7.00     4/1/2001
Ron Lipstein         10,000             10.1%        $8.50     11/21/2001
                     15,000             15.2%        $7.00     4/1/2001
Alain Klapholz       10,000             10.1%        $8.50     11/21/2001
</TABLE>

                                       22
<PAGE>   25
ITEM 11.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
          MANAGEMENT


      The following table sets forth certain information regarding beneficial
ownership of the Company's Common Stock as of March 20, 1997 by (i) each person
(or group of affiliated persons) who is known by the Company to own beneficially
more than 5% of the outstanding shares of its Common Stock, (ii) each director
of the Company, and (iii) all executive officers and directors of the Company as
a group. Except as indicated in the footnotes to this table, the persons named
in this table have sole voting and investment power with respect to all shares
of Common Stock shown as beneficially owned by them.
<TABLE>
<CAPTION>
                                       Amount and
                                       Nature of             Percentage of
Name and Address of                    Beneficial            Outstanding Shares
Beneficial Owner *                     Ownership**           Owned
-------------------                    -----------           ------------------
<S>                                   <C>                    <C>
Steven Katz                           348,507(1)             7.5%

Mark Eisenberg                        598,000               13.0

Ron Lipstein                          323,606(2)             7.0

Alain Klapholz                        308,607(3)             6.7

Joseph Stechler                       697,066(4)            14.2

Home Insurance Company                298,818(5)             6.3
  59 Maiden Lane
  New York, NY 10038

Strong Capital Management, Inc.       305,000(6)             6.6
  One Hundred Heritage Reserve
  P.O. Box 2936
  Milwaukee, WI 53201

Dawson-Samberg                        342,679(7)             7.4
  354 Pequot Avenue
  Southport, CT 06490

The Travelers Indemnity Company       307,692                6.7
  One Tower Square
  Hartford, CT 06183

All officers and
  directors as a
  group (five persons)                2,248,786              45.6%
                                      (1)(2)(3)(4)
</TABLE>
-----------

                                       23
<PAGE>   26
*     The addresses of all of the persons in the foregoing table, unless
      otherwise indicated, are at the Company's offices, 3960 Broadway, New
      York, NY 10032.

**    The number of Shares of Common Stock beneficially owned by each person or
      entity is determined under rules promulgated by the Commission. Under such
      rules, beneficial ownership includes any shares as to which the person or
      entity has sole or shared voting power or investment power. Included among
      the shares owned by such person are any shares which such person or entity
      has the right to acquire within 60 days after March 20, 1997. Unless
      otherwise indicated, each person or entity referred to above has sole
      voting and investment power with respect to the shares listed. The
      inclusion herein of any shares deemed beneficially owned does not
      constitute an admission of beneficial ownership of such shares.

1     Includes 59,000 shares owned by Dr. Katz's children, their spouses and his
      grandchildren. Dr. Katz disclaims any beneficial interest in such 59,000
      shares. Also includes 50,000 shares issuable to Dr. Katz upon his exercise
      of outstanding options.

2     Includes 30,000 shares owned by Mr. Lipstein's children. Mr. Lipstein
      disclaims any beneficial interest in such 30,000 shares. Also includes
      25,000 shares issuable to Mr. Lipstein upon his exercise of outstanding
      options.

3     Includes 36,000 shares owned by Mr. Klapholz' children.  Mr. Klapholz
      disclaims any beneficial interest in such 36,000 shares. Also includes
      10,000 shares issuable to Mr. Klapholz upon his exercise of outstanding
      options.

4     Includes shares owned by Stechler & Company. Also includes 269,536 shares
      to be issued by the Company to Mr. Stechler or Stechler & Company upon
      their exercise of outstanding warrants, 79,206 of which are exercisable at
      $1.00 per share and expire January 19, 2000, 86,930 of which are
      exercisable at $9.425 per share and expire on December 31, 1997, 36,450 of
      which are the publicly held Class A Warrants exercisable at $10.00 per
      share and expire July 19, 1997, 36,450 of which are the publicly held
      Class B Warrants exercisable at $15.00 per share and expire January 19,
      1999, and 30,500 of which are exercisable at $7.87 per share and expire on
      October 17, 2001. Also includes an aggregate of 27,000 shares which Mr.
      Stechler has an option to purchase from Drs. Eisenberg and Katz and
      Messrs. Lipstein and Klaphoz at $10.00 per share. Such option expires
      July 15, 1997.

5     Includes 137,707 shares to be issued by the Company to Home Insurance
      Company upon Home Insurance Company's exercise of outstanding warrants,
      127,707 of which are exercisable at $1.00 per share and expire January 19,
      2000, and 10,000 of which are exercisable at $12.00 per share and expire
      July 21, 1997.

                                       24
<PAGE>   27
6     Shares held by four investment funds.  The Company believes that Strong
      Capital Management, Inc. has sole or shared investment and/or voting power
      for these shares.

7     Shares held by two investment funds. The Company believes that
      Dawson-Samberg has sole or shared investment and/or voting power for these
      shares. Includes 31,153 shares issuable upon exercise of outstanding
      warrants.


ITEM 12.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS


PLACEMENT AGENTS

      See Part II, Item 5, "1996 Private Placement" for commissions paid and
warrants granted by the Company to Mr. Joseph Stechler, a director of the
Company, for his services as a placement agent in the sale of 305,000 shares of
the 959,106 shares sold in the 1996 Private Placement.

LICENSE AND CONSULTING AGREEMENTS

      See Part I, Item 1, "Business - Patents and Proprietary Rights" for a
description of the license agreement between Dr. Mark Eisenberg and the Company
for use of the technology used to produce the Company's Composite Cultured Skin.
See also Part III, Item 9, "Eisenberg Consulting Agreement."


LOAN REPAYMENT

      In January 1996, from the net proceeds received by the Company from the
initial public offering of its securities, $246,500 was used to repay
non-interest bearing loans made to the Company from June through November 1,
1995 by Dr. Steven Katz ($196,500) and by Dollsport Supply Co., Inc., which is
wholly owned by Mr. Ron Lipstein ($50,000).

                           FORWARD LOOKING INFORMATION
                              MAY PROVE INACCURATE

      This Annual Report on Form 10-KSB contains certain forward-looking
statements and information relating to the Company that are based on the
beliefs of management of the Company, as well as assumptions made by and
information currently available to the Company. When used in this document, the
words "anticipate," "believe," "estimate," and "expect" and similar
expressions, as they relate to the Company, are intended to identify
forward-looking statements. Such statements reflect the current views of the
Company with respect to future events and are subject to certain risks,
uncertainties and assumptions, including those

                                       25
<PAGE>   28
described in this Annual Report on Form 10-KSB. Should one or more of these
risks or uncertainties materialize, or should underlying assumptions prove
incorrect, actual results may vary materially from those described herein as
anticipated, believed, estimated or expected. The Company does not intend to
update these forward-looking statements.

                                       26
<PAGE>   29
ITEM 13.    EXHIBITS AND REPORTS ON FORM 8-K

Exhibit No.             Description
-----------             -----------
 3.1        Agreement of Merger of the Skin Group, Ltd. and the Company dated
            July 9, 1992 (1)

 3.2        Original Certificate of Incorporation (1)

 3.3        By-Laws (1)

 4.1        Form of Certificate evidencing shares of Common Stock (1)

 4.2        Form of Underwriter's Option (1)

 4.3        Form of Warrant Agreement for the public Class A and Class B Common
            Stock Purchase Warrants (1)

 4.4        Form of Certificate for the public Class A Common Stock Purchase
            Warrants filed as Exhibit A to Exhibit 4.3 (1)

 4.6        Form of Certificate for public Class B Warrants filed as Exhibit B
            to Exhibit 4.3 (1)

10.1        License Agreement dated as of June 7, 1991, by and between the
            Company and Dr. Mark Eisenberg (1)

10.2        Agreement for Consulting Services dated as of June 7, 1991 by and
            between the Company and Dr. Mark Eisenberg (1)

10.3        Modification of Exhibit 10.1 (1)

10.4        Lease dated May 28, 1992 by and between the Company as lessee and
            Isaac Eisenberg as lessor for 147-155 Queen Street, Alexandria,
            Australia (1)

10.4.1      Waiver by Isaac Eisenberg of certain rental payments required to be
            paid by the Company under such lease (1)

                                       27
<PAGE>   30
Exhibit
Number                  Description
-------                 -----------
10.5        Stock Purchase Agreement dated June 19, 1992, by and among the
            Company, Joseph Stechler, Dr. Steven Katz, Alain Klapholz, and Ron
            Lipstein, plus modifications thereto dated November 30, 1992 and
            August 5, 1993 (1)

10.6        Stock Option Agreement dated August 5, 1993, by and among Drs.
            Eisenberg and Katz and Messrs. Klapholz and Lipstein with Mr.
            Stechler (1)

10.7        Further modification, dated as of July 15, 1994, of agreements
            listed as Exhibits numbered 10.5 and 10.6 (1)

10.8        Agreement with Oxford Research International Corp. (1)

10.9        Lease with Columbia University dated March 14, 1996, for space in
            3960 Broadway, New York, New York(2)

27*         Financial Data Schedule

99          FDA approval for human clinical trials (1)

--------------
*     Filed herewith

(1)   Filed as an Exhibit to the Company's Registration Statement on Form SB-2
      (File No. 33-96090), or Amendment 1 thereto, and incorporated herein by
      reference.

(2)   Filed as an Exhibit to the Company's 1995 Annual Report on Form 10-KSB,
      and incorporated herein by reference.

B.    REPORTS ON FORM 8-K

      No reports on Form 8-K were filed during the last quarter of 1996.


                                       28
<PAGE>   31
                                   SIGNATURES

      In accordance with Section 13 or 15(d) of the Securities Exchange Act
of 1934, as amended (the "Exchange Act") has caused this report to be
signed on its behalf by the undersigned, thereto duly authorized.

                              Registrant:

                              ORTEC INTERNATIONAL, INC.



                              By:   /s/ Steven Katz
                                  -----------------------
                                    Steven Katz, Ph.D.
                                    President and Chief
                                    Executive Officer
Dated:  March 31, 1997


      In accordance with the Exchange Act, 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            TITLE                                        DATE
   ---------            -----                                        ----

/s/ Steven Katz         President, Chief Executive              March 31, 1997
----------------------  Officer and Director (Principal
Steven Katz, Ph.D.      Executive Officer)



/s/ Mark Eisenberg      Senior Vice President, Research         March 31, 1997
----------------------  and Development and Director
Dr. Mark Eisenberg


/s/ Ron Lipstein        Chief Financial Officer, Secretary,     March 31, 1997
----------------------  Treasurer and Director (Principal
Ron Lipstein            Financial and Accounting Officer)


/s/ Joseph Stechler     Director                                March 31, 1997
----------------------
Joseph Stechler



/s/ Alain M. Klapholz   Vice President, Operations              March 31, 1997
----------------------  and Director
Alain M. Klapholz

                                       29
<PAGE>   32
                            Ortec International, Inc.
                        (a development stage enterprise)



                          INDEX TO FINANCIAL STATEMENTS


                                                                           Page
                                                                           ----


Report of Independent Certified Public Accountants                         F-2


Financial Statements

    Balance Sheets as of December 31, 1996 and 1995                        F-3

    Statements of Operations for the years ended
       December 31, 1996 and 1995, and for the cumulative
       period from March 12, 1991 (inception) to
       December 31, 1996                                                   F-5

    Statement of Shareholders' Equity for the cumulative
       period from March 12, 1991 (inception) to
       December 31, 1996                                                   F-6

    Statements of Cash Flows for the years ended
       December 31, 1996 and 1995, and for the cumulative
       period from March 12, 1991 (inception) to
       December 31, 1996                                                   F-9

    Notes to Financial Statements                                          F-11

                                      F-1
<PAGE>   33
                         REPORT OF INDEPENDENT CERTIFIED
                               PUBLIC ACCOUNTANTS



Board of Directors and Stockholders
    ORTEC INTERNATIONAL, INC.


We have audited the accompanying balance sheets of Ortec International, Inc. (a
development stage enterprise) (the "Company") as of December 31, 1996 and 1995,
and the related statements of operations, shareholders' equity and cash flows
for the years then ended and for the period from March 12, 1991 (inception) to
December 31, 1996. 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. The Company's financial statements as
of December 31, 1992 and 1993 and for the period from March 12, 1991 (inception)
to December 31, 1993 were audited by other auditors whose report, dated March 8,
1994, included an explanatory paragraph regarding a substantial doubt about the
ability of the Company to continue as a going concern. The financial statements
for the period from March 12, 1991 (inception) to December 31, 1993 reflect
cumulative revenues and cumulative net losses of $35,599 and $2,513,209,
respectively, of the cumulative totals. The other auditors' report has been
furnished to us, and our opinion expressed herein, insofar as it relates to
the amounts for such prior periods, is based solely on the report of the
other auditors.

We conducted our audits in accordance with generally accepted auditing
standards. 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 and the report of the other auditors provide a
reasonable basis for our opinion.

In our opinion, based on our audits and the report of the other auditors, the
financial statements referred to above present fairly, in all material respects,
the financial position of Ortec International, Inc. at December 31, 1996 and
1995, and the results of its operations and its cash flows for the years then
ended and for the period from March 12, 1991 (inception) to December 31, 1996,
in conformity with generally accepted accounting principles.





GRANT THORNTON LLP

New York, New York
March 18, 1997

                                      F-2
<PAGE>   34
                            Ortec International, Inc.
                        (a development stage enterprise)

                                 BALANCE SHEETS

                                  December 31,





<TABLE>
<CAPTION>
                      ASSETS                                    1996            1995
                                                            -----------      ---------
<S>                                                         <C>              <C>
CURRENT ASSETS
    Cash and cash equivalents                               $ 7,453,229      $   2,364
    Prepaid expenses                                              7,616
    Other current assets                                          1,958             57
                                                            -----------      ---------

           Total current assets                               7,462,803          2,421



PROPERTY AND EQUIPMENT, AT COST
    Laboratory equipment                                        578,530        223,888
    Office furniture and equipment                              170,830         54,527
    Leasehold improvements                                      462,995         49,847
                                                            -----------      ---------

                                                              1,212,355        328,262
    Less accumulated depreciation and amortization             (321,646)      (171,075)
                                                            -----------      ---------

                                                                890,709        157,187


OTHER ASSETS
    Patent application costs, net of accumulated
       amortization of $1,210 in 1996 and $0 in 1995            409,147        369,600
    Deferred offering costs                                                    314,697
    Organization costs, net of accumulated amortization
       of $10,238 in 1996 and $9,729 in 1995                                       509
    Deposits                                                     29,266          4,056
                                                            -----------      ---------

                                                            $ 8,791,925      $ 848,470
                                                            ===========      =========
</TABLE>

                                      F-3
<PAGE>   35
                            Ortec International, Inc.
                        (a development stage enterprise)

                           BALANCE SHEETS (CONTINUED)

                                  December 31,



<TABLE>
<CAPTION>
                LIABILITIES AND
              SHAREHOLDERS' EQUITY                        1996              1995
                                                      ------------      -----------
<S>                                                   <C>               <C>
CURRENT LIABILITIES
    Accounts payable                                  $    466,077      $   347,843
    Accrued compensation                                    39,658           36,492
    Accrued professional fees                               64,662          406,534
    Capital lease obligation - current                       5,738
    Loan payable - current                                  38,018
    Notes payable                                                           515,500
                                                      ------------      -----------

           Total current liabilities                       614,153        1,306,369


LONG-TERM LIABILITIES
    Capital lease obligation - noncurrent                    9,846
    Loan payable - noncurrent                              450,928
                                                      ------------
           Total long-term liabilities                     460,774


DEFERRED OCCUPANCY COSTS                                                      1,327


COMMITMENTS AND CONTINGENCIES


SHAREHOLDERS' EQUITY
    Common stock, $.001 par value; authorized,
       10,000,000 shares; issued and outstanding,
       4,601,963 shares at December 31, 1996 and
       2,408,972 shares at December 31, 1995                 4,602            2,409
    Additional paid-in capital                          15,573,183        4,749,384
    Deficit accumulated during the development
       stage                                            (7,860,787)      (5,211,019)
                                                      ------------      -----------

                                                         7,716,998         (459,226)
                                                      ------------      -----------

                                                      $  8,791,925      $   848,470
                                                      ============      ===========
</TABLE>

The accompanying notes are an integral part of these statements.

                                      F-4
<PAGE>   36
                            Ortec International, Inc.
                        (a development stage enterprise)

                            STATEMENTS OF OPERATIONS


<TABLE>
<CAPTION>
                                                                          CUMULATIVE
                                                                             FROM
                                                                           MARCH 12,
                                                                             1991
                                          Year ended December 31,       (INCEPTION) TO
                                       ----------------------------      DECEMBER 31,
                                           1996            1995              1996
                                       -----------      -----------     --------------
<S>                                    <C>              <C>              <C>
Revenue
    Interest income                    $   171,057      $     2,685      $   238,215
                                       -----------      -----------      -----------

Expenses
    Research and development               964,864          573,392        3,354,416
    Rent                                    85,076           21,732          162,949
    Consulting                             261,633           34,606          757,396
    Personnel                              730,357          229,183        1,875,398
    General and administrative             727,192          161,686        1,834,372
    Other expense, net                      51,703            4,809          114,471
                                       -----------      -----------      -----------

                                         2,820,825        1,025,408        8,099,002
                                       -----------      -----------      -----------

       Net loss                        $(2,649,768)     $(1,022,723)     $(7,860,787)
                                       ===========      ===========      ===========

       Net loss per share              $      (.60)     $      (.38)     $     (2.77)
                                       ===========      ===========      ===========

Weighted average common and common
    equivalent shares outstanding        4,421,637        2,720,208        2,838,265
                                       ===========      ===========      ===========
</TABLE>


The accompanying notes are an integral part of these statements.

                                      F-5
<PAGE>   37
                            Ortec International, Inc.
                        (a development stage enterprise)

                        STATEMENT OF SHAREHOLDERS' EQUITY

<TABLE>
<CAPTION>
                                                                                                      Deficit
                                                                                                    accumulated
                                                                  Common stock        Additional    during the        Total
                                                          ------------------------     paid-in      development    shareholders'
                                                             Shares        Amount      capital         stage          equity
                                                          -----------    ---------   -----------    -----------    -------------
<S>                                                       <C>            <C>         <C>            <C>            <C>
March 12, 1991 (inception) to December 31, 1991

Issuance of stock
   Founders                                                 1,553,820    $   1,554   $      (684)                   $      870
   First private placement ($.30 cash per share)              217,440          217        64,783                        65,000
   The Director ($1.15 and $5.30 cash per share)              149,020          149       249,851                       250,000
   Second private placement ($9.425 cash per share)            53,020           53       499,947                       500,000
   Share issuance expenses                                                               (21,118)                      (21,118)
   Net loss                                                                                         $  (281,644)      (281,644)
                                                          -----------    ---------   -----------    -----------     ----------

Balance at December 31, 1991                                1,973,300        1,973       792,779       (281,644)       513,108

Issuance of stock
   Second private placement ($9.425 cash per share)            49,320           49       465,424                       465,473
   Stock purchase agreement with the Director ($9.425
     cash per share)                                           31,820           32       299,966                       299,998
   Share issuance expenses                                                               (35,477)                      (35,477)
   Net loss                                                                                            (785,941)      (785,941)
                                                          -----------    ---------   -----------    -----------     ----------

Balance at December 31, 1992 (carried forward)              2,054,440        2,054     1,522,692     (1,067,585)       457,161
</TABLE>

                                      F-6
<PAGE>   38
                            Ortec International, Inc.
                        (a development stage enterprise)

                  STATEMENT OF SHAREHOLDERS' EQUITY (CONTINUED)


<TABLE>
<CAPTION>
                                                                                                   Deficit
                                                                                                 accumulated
                                                             Common stock          Additional    during the       Total
                                                      -------------------------      paid-in     development   shareholders'
                                                        Shares         Amount        capital        stage         equity
                                                      ----------    -----------    ----------   ------------   -------------
<S>                                                   <C>           <C>            <C>          <C>            <C>
       (brought forward)                               2,054,440    $     2,054    $1,522,692   $(1,067,585)    $   457,161

Issuance of stock
   Third private placement($10.00 cash per share)        132,150            132     1,321,368                     1,321,500
   Stock purchase agreement with Home
     Insurance Company ($9.00 cash per share)            111,111            111       999,888                       999,999
   Stock purchase agreement with the Director
     ($9.425 cash per share)                              21,220             21       199,979                       200,000
   Shares issued in exchange for commission
     ($10.00 value per share)                                600              1         5,999                         6,000
   Share issuance expenses                                                           (230,207)                     (230,207)
   Net loss                                                                                      (1,445,624)     (1,445,624)
                                                      ----------    -----------    ----------   -----------     -----------

Balance at December 31, 1993                           2,319,521          2,319     3,819,719    (2,513,209)      1,308,829

Issuance of stock
   Fourth private placement ($10.00 cash per share)       39,451             40       397,672                       397,712
   Stock purchase agreement with Home
     Insurance Company ($10.00 cash per share)            50,000             50       499,950                       500,000
   Share issuance expenses                                                             (8,697)                       (8,697)
   Net loss                                                                                      (1,675,087)     (1,675,087)
                                                      ----------    -----------    ----------   -----------     -----------

Balance at December 31, 1994                           2,408,972          2,409     4,708,644    (4,188,296)        522,757

Rent forgiveness                                                                       40,740                        40,740

Net loss                                                                                         (1,022,723)     (1,022,723)
                                                      ----------    -----------    ----------   -----------     -----------

Balance at December 31, 1995 (carried forward)         2,408,972          2,409     4,749,384    (5,211,019)       (459,226)
</TABLE>

                                      F-7
<PAGE>   39
                            Ortec International, Inc.
                        (a development stage enterprise)

                  STATEMENT OF SHAREHOLDERS' EQUITY (CONTINUED)



<TABLE>
<CAPTION>
                                                                                               Deficit
                                                                                             accumulated
                                                        Common stock           Additional    during the       Total
                                                 -------------------------      paid-in      development   shareholders'
                                                    Shares        Amount        capital         stage         equity
                                                 ----------    -----------    -----------   ------------   -------------
<S>                                              <C>           <C>            <C>           <C>            <C>
          (brought forward)                       2,408,972    $     2,409    $ 4,749,384   $(5,211,019)    $ (459,226)

Initial public offering                           1,200,000          1,200      5,998,800                    6,000,000
Exercise of warrants                                 33,885             34         33,851                       33,885
Fifth private placement ($6.49 cash per share)      959,106            959      6,219,838                    6,220,797
Share issuance costs                                                           (1,580,690)                  (1,580,690)
Non-cash stock compensation and interest                                          152,000                      152,000
Net loss                                                                                     (2,649,768)    (2,649,768)
                                                 ----------    -----------    -----------   -----------     ----------

Balance at December 31, 1996                      4,601,963    $     4,602    $15,573,183   $(7,860,787)    $7,716,998
                                                 ==========    ===========    ===========   ===========     ==========
</TABLE>

The accompanying notes are an integral part of this statement.

                                      F-8
<PAGE>   40
                            Ortec International, Inc.
                        (a development stage enterprise)

                            STATEMENTS OF CASH FLOWS


<TABLE>
<CAPTION>
                                                                                     CUMULATIVE
                                                                                        FROM
                                                                                      MARCH 12,
                                                                                        1991
                                                      Year ended December 31,      (INCEPTION) TO
                                                    --------------------------      DECEMBER 31,
                                                        1996           1995             1996
                                                    -----------    -----------     --------------
<S>                                                 <C>            <C>              <C>
Cash flows from operating activities
   Net loss                                         $(2,649,768)   $(1,022,723)     $(7,860,787)
   Adjustments to reconcile net loss to net cash
     used in operating activities
       Deferred occupancy costs                          (1,327)        (8,265)
       Depreciation and amortization                    152,290         57,731          333,094
       Unrealized loss on marketable securities                                          67,204
       Realized loss on marketable securities                            5,250            5,250
       Non-cash stock compensation and interest         152,000                         152,000
       (Increase) decrease in assets
         Prepaid expenses                                (7,616)                         (7,616)
         Other current assets                            (1,901)        11,301           (1,958)
       Increase (decrease) in liabilities
         Accounts payable and accrued liabilities       133,715        203,418          650,626
                                                    -----------    -----------      -----------

       Net cash used in operating activities         (2,222,607)      (753,288)      (6,662,187)
                                                    -----------    -----------      -----------

Cash flows from investing activities
   Purchases of property and equipment                 (884,093)       (49,847)      (1,212,355)
   Payments for patent applications                     (40,757)       (90,365)        (410,357)
   Organization costs                                                                   (10,238)
   Deposits                                             (25,210)         1,047          (29,266)
   Purchases of marketable securities                                                  (594,986)
   Sale of marketable securities                                       153,163          522,532
                                                    -----------    -----------      -----------

       Net cash (used in) provided by
         investing activities                          (950,060)        13,998       (1,734,670)
                                                    -----------    -----------      -----------
</TABLE>

                                      F-9
<PAGE>   41
                            Ortec International, Inc.
                        (a development stage enterprise)

                      STATEMENTS OF CASH FLOWS (CONTINUED)


<TABLE>
<CAPTION>
                                                                                         CUMULATIVE
                                                                                            FROM
                                                                                          MARCH 12,
                                                                                            1991
                                                         Year ended December 31,       (INCEPTION) TO
                                                      -----------------------------     DECEMBER 31,
                                                          1996             1995             1996
                                                      ------------     ------------    --------------
<S>                                                   <C>              <C>              <C>
Cash flows from financing activities
    Proceeds from issuance of notes payable                            $    515,500     $   515,500
    Proceeds from issuance of common stock            $ 12,254,682                       17,255,235
    Share issuance expenses                             (1,580,690)                      (1,870,189)
    Proceeds from loan payable                             500,000                          500,000
    Repayment of capital lease obligations                  (4,554)                          (4,554)
    Repayment of loan payable                              (30,406)                         (30,406)
    Repayment of notes payable                            (515,500)                        (515,500)
                                                      ------------     ------------     -----------

       Net cash provided by financing activities        10,623,532          515,500      15,850,086
                                                      ------------     ------------     -----------

       NET INCREASE (DECREASE) IN CASH
          AND CASH EQUIVALENTS                           7,450,865         (223,790)      7,453,229

Cash and cash equivalents at beginning of period             2,364          226,154
                                                      ------------     ------------     -----------

Cash and cash equivalents at end of period            $  7,453,229     $      2,364     $ 7,453,229
                                                      ============     ============     ===========


Supplemental disclosures of cash flow information:
   Noncash financing activities
     Deferred offering costs included in
       accrued professional fees                                       $    314,697     $   314,697
     Forgiveness of rent payable                                             40,740          40,740

   Cash paid for interest                             $     14,792                           14,792
   Cash paid for taxes                                       1,120
</TABLE>

The accompanying notes are an integral part of these statements.

                                      F-10
<PAGE>   42
                            Ortec International, Inc.
                        (a development stage enterprise)

                          NOTES TO FINANCIAL STATEMENTS

                           December 31, 1996 and 1995



NOTE A - FORMATION OF THE COMPANY AND BASIS OF PRESENTATION

     Formation of the Company

     Ortec International, Inc. ("Ortec" or the "Company") was incorporated in
     March 1991 as a Delaware corporation to secure and provide funds for the
     further development of the technology developed by Dr. Mark Eisenberg of
     Sydney, Australia, to replicate in the laboratory, composite cultured skin
     for use in skin transplant procedures (the "Technology"). Pursuant to a
     license agreement dated June 7, 1991, Dr. Eisenberg has granted Ortec a
     license for a term of ten years, which may be automatically renewed by
     Ortec for two additional ten-year periods, to commercially use and exploit
     the Technology for the development of products, subject to certain
     limitations. At the expiration or earlier termination of the agreement, Dr.
     Eisenberg is entitled to the exclusive rights in the Technology, and Ortec
     is entitled to the exclusive rights to all improvements to the Technology
     developed during the license period.

     The Skin Group, Ltd. (the "Skin Group") also was formed as a Delaware
     corporation, in March 1991, to raise funds for development of the
     Technology. On July 27, 1992, the Skin Group was merged with and into
     Ortec. Owners of Skin Group shares were given .83672 of an Ortec share for
     each Skin Group share. The merger was accounted for as if it were a pooling
     of interests and, accordingly, the accompanying financial statements
     include the accounts of the Skin Group for all periods presented.

     Basis of Presentation

     The Company is a development stage enterprise, and has neither realized any
     operating revenue nor has any assurance of realizing any future operating
     revenue. Successful future operations depend upon the successful
     development and marketing of the Composite Cultured Skin to be used in skin
     replacement procedures.

                                      F-11
<PAGE>   43
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1996 and 1995



NOTE A (CONTINUED)

     Initial Public Offering

     On January 19, 1996, the Company completed an initial public offering
     ("IPO") of 1,200,000 units. Each unit consists of one share of the
     Company's common stock, one Class A warrant to purchase one share of common
     stock at $10, expiring July 1997 and one Class B warrant to purchase one
     share of common stock at $15, expiring January 1999. The Class A and B
     warrants will be redeemable by the Company at $.01 per warrant, if the
     market price of the Company's common stock equals or exceeds $10 for 10
     consecutive trading days during a specified period, as defined.

     The IPO raised gross proceeds of approximately $6,000,000, of which
     $800,000, $537,500 and approximately $315,000 were used to pay underwriting
     commissions, notes payable and deferred offering costs, respectively,
     thereby providing the Company with net proceeds of approximately
     $4,347,500. The Company intends to use the proceeds for continued research
     and development of composite cultured skin transplants, performing human
     clinical trials and general corporate purposes.


NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

     1.  Research and Development Costs

         All research and development costs, including payments related to
         licensing agreements on products under development and research
         consulting agreements are expensed when incurred.

     2.  Depreciation and Amortization

         Office furniture and equipment and laboratory equipment are depreciated
         on the straight-line basis over the estimated lives of the assets (5
         years). Leasehold improvements are amortized over the shorter of the
         term of the related lease or life of the asset.

                                      F-12
<PAGE>   44
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1996 and 1995



NOTE B (CONTINUED)

     3.  Patent Application Costs

         Patent application costs relate primarily to the Company's U.S. patent
         application and consist of legal fees and other direct fees incurred
         therefor. The recoverability of the patent application costs is
         dependent upon, among other matters, obtaining FDA approval for use on
         the underlying technology as a medical device, and such approval is
         both costly and lengthy. On December 10, 1996, the U.S. Patent Office
         reissued the Company's composite cultured skin patent.

     4.  Foreign Currency Translation

         The Company conducts research and development at its laboratory in
         Sydney, Australia. However, because all Australian expenditures are
         funded from the United States, the Company has determined that the
         functional currency of its Australian office is the U.S. dollar.
         Accordingly, current assets and current liabilities are translated
         using the exchange rate in effect at the balance sheet date, and income
         and expense accounts are translated at the average rate in effect
         during the year. Unrealized gains and losses arising from the
         translation of foreign currency are included in the results of
         operations for all periods presented. Noncurrent assets and liabilities
         are translated at historical rates, because the effect is not material
         to the financial statements.

     5.  Use of Estimates

         In preparing financial statements in conformity with generally accepted
         accounting principles, management is required to make estimates and
         assumptions that affect the reported amounts of assets and liabilities
         and disclosure of contingent assets and liabilities at the date of the
         financial statements, as well as the reported amounts of revenues and
         expenses during the reporting period. Actual results could differ from
         those estimates.

                                      F-13
<PAGE>   45
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1996 and 1995



NOTE B (CONTINUED)

     6.  Income Taxes

         Deferred tax assets and liabilities are recognized for the estimated
         future tax consequences attributable to differences between the
         financial statement carrying amounts of existing assets and liabilities
         and their respective tax bases. Deferred tax assets and liabilities are
         measured using enacted tax rates in effect for the years in which those
         temporary differences are expected to be recovered or settled. The
         effect on deferred tax assets and liabilities of a change in tax rates
         is recognized in income in the period that includes the enactment date.

     7.  Cash Equivalents

         The Company considers all highly liquid securities with an original
         maturity of three months or less to be cash equivalents.

     8.  Certain Reclassifications

         Certain reclassifications have been made to conform to the December 31,
         1996 presentation.

     9.  Net Loss Per Share

         Net loss per common share is based on the weighted average number of
         common shares outstanding during the periods. The Company granted, on
         the closing date of its initial public offering, four-year warrants to
         purchase an aggregate of 389,045 shares at $1.00 per share to certain
         shareholders who participated in previous private placements of the
         Company's common stock. Such warrants have been granted to existing
         stockholders who purchased their shares at prices of $9.00 or more per
         share in such private placements and who had entered into lock-up
         agreements agreeing not to sell or otherwise transfer their shares
         without the underwriter's written consent for a period of one year
         after the closing date. Pursuant to Securities and Exchange Commission
         Staff Accounting Bulletin No. 83, such warrants to be granted by the
         Company (using the treasury stock method and the initial public
         offering price of $5.00 per share) have been included in the
         calculation of common and common equivalent shares outstanding as if
         they were outstanding for all periods presented. All other options and
         warrants granted by the Company

                                      F-14
<PAGE>   46
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1996 and 1995



NOTE B (CONTINUED)

         have not been included in the calculation of common and common
         equivalent shares outstanding because such options and warrants were
         antidilutive. Earnings per share are computed by dividing net income by
         the weighted average number of common shares outstanding.

    10.  Impairment of Long-Lived Assets

         The Company reviews long-lived assets and certain identifiable
         intangibles held and used for possible impairment whenever events or
         changes in circumstances indicate that the carrying amount of an asset
         may not be recoverable. The Company has determined that no provision is
         necessary for the impairment of long-lived assets at December 31, 1996.

    11.  Marketable Securities

         The Company adopted Statement of Financial Accounting Standards No.
         115, "Accounting for Certain Investments in Debt and Equity Securities"
         ("SFAS No. 115"), on January 1, 1994. Investments pursuant to SFAS No.
         115 are classified in three categories. Those securities classified as
         "trading" or "available for sale" are reported at fair value. Debt
         securities classified as "held to maturity" are reported at amortized
         cost. Cost for all investments is determined using the specific cost
         method. Unrealized gains and temporary losses from securities
         classified as "available for sale" are reported as a separate component
         of stockholders' equity, net of related tax effects.


NOTE C - CONCENTRATION OF CREDIT RISK

    The Company maintains cash balances at two financial institutions located in
    New York City. Accounts at each institution are insured by the Securities
    Investors Protection Corporation up to $500,000. Uninsured balances
    aggregate to approximately $6,500,000 at December 31, 1996. The Company has
    not experienced any losses in such accounts and believes it is not exposed
    to any significant credit risk on cash and cash equivalents.

                                      F-15
<PAGE>   47
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1996 and 1995



NOTE D - PATENTS

    The patent is stated at cost less amortization computed by the straight-line
    method principally over 14 years. Accumulated amortization related to the
    patent was approximately $1,200 at December 31, 1996.

    There can be no assurance that such patent reissued may not be successfully
    challenged in court proceedings. Nor can there be any assurance that any
    patent will provide commercial benefits to the Company.


NOTE E - CAPITAL LEASE OBLIGATION

    During 1996, the Company entered into a three-year capital lease agreement
    for the phone system at its New York City location. The lease calls for
    payments to be made monthly at an effective interest rate of 15.88%. The
    future minimum lease payments and the present value of the net minimum lease
    payments as of December 31, 1996 are as follows:

<TABLE>
<S>                                                                      <C>
        Year ending December 31,
          1997                                                           $ 7,807
          1998                                                             7,807
          1999                                                             3,253
                                                                         -------

        Total minimum lease payments                                      18,867
        Less amount representing interest                                  3,284
                                                                         -------

        Present value of net minimum lease payments                      $15,583
                                                                         =======

        Current portion                                                  $ 5,738
        Noncurrent portion                                                 9,846
                                                                         -------

                                                                         $15,584
                                                                         =======
</TABLE>

    As of December 31, 1996, the Company has recorded $3,604 in accumulated
    amortization on the property purchased under the capital lease.

                                      F-16
<PAGE>   48
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1996 and 1995



NOTE F - LOAN PAYABLE

    During 1996, the Company obtained a loan from the landlord of its new
    laboratory for the construction of, and equipment for, the leased facility.
    The loan is payable in monthly installments of $6,000 through July 1, 2006,
    with interest payable monthly at the effective rate of 7.98%.

    Minimum payments to be made under the terms of the loan for the five years
    following December 31, 1996 are as follows:

<TABLE>
<S>                                                                     <C>
        Year ending December 31,
            1997                                                        $ 78,795
            1998                                                          72,733
            1999                                                          72,733
            2000                                                          72,733
            2001                                                          72,733
            2002 and thereafter                                          333,360
                                                                        --------

                                                                         703,087
        Less amount representing interest                                214,141
                                                                        --------

        Net present value of future loan payments at 7.98%              $488,946
                                                                        ========
</TABLE>


NOTE G - EQUITY TRANSACTIONS

    In January 1993, Ortec effected a stock split and granted twenty new shares
    of common stock of $.001 par value for each outstanding share of common
    stock. This stock split is retroactively reflected in the accompanying
    financial statements and all references to shares are to the new shares with
    per share amounts appropriately adjusted.

    Pursuant to an agreement between Dr. Eisenberg and the other founders (the
    "Other Founders"), a business relationship was formed by the founders for
    the manufacture and sale of products derived from the Technology (the
    "Business Agreement"). Under the terms of the Business Agreement, Dr.
    Eisenberg, who was the owner of all the capital stock of Ortec (600,000
    shares) agreed to license the Technology to Ortec and sell 70% of Ortec's
    shares for a purchase price of $1,000,000 to the Skin Group. Dr. Eisenberg
    was paid $85,000 in connection with this agreement as reimbursement for his
    expenses ($35,000 during the period from inception (March 12, 1991) to
    December 31, 1991 and $50,000 during the year ended December 31, 1992).

                                      F-17
<PAGE>   49
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1996 and 1995



NOTE G (CONTINUED)

    The "Other Founders" initially owned all of the stock of the Skin Group
    (953,820 shares). In March 1991, the Skin Group issued, in a private
    placement, 217,440 shares for $65,000. In June and October 1991, the Skin
    Group issued 130,160 and 18,860 shares, to a director of the Company (the
    "Director") for $150,000 and $100,000, respectively. Commencing in November
    1991, the Skin Group issued 79,480 shares under a second private placement
    for $750,006 (26,460 shares during the year ended December 31, 1992). On
    July 27, 1992, the Skin Group was merged with and into Ortec.

    Also under the second private placement 22,860 shares of Ortec were issued
    for $215,467. In addition, the Director was granted warrants to purchase
    7,360 shares of Ortec at $9.425 per share.

    Pursuant to a stock purchase agreement entered into with the Director in
    June 1992, 53,040 shares of Ortec were sold to the Director for a total
    purchase price of $499,998. In addition, the Director was granted warrants
    to purchase 79,570 shares at an exercise price of $9.425 per share. The
    purchase price was payable in installments and shares and warrants were
    issued in installments pro rata with the payment of the purchase price.
    During the years ended December 31, 1993 and 1992, the Director paid
    $200,000 and $299,998, respectively, and was issued 21,220 and 31,820
    shares, respectively. The agreement also provided that, if at any time
    within two years of the agreement, the Director introduced other persons or
    entities who purchased shares in the Company in a private placement, he was
    entitled to receive warrants to purchase ten percent of the number of shares
    purchased by such persons or entities, at an exercise price equal to the
    price paid by such persons or entities. No such warrants have been issued to
    the Director.

    Further, in connection with the Director's purchase of the 53,040 shares, in
    1993, the Other Founders granted to the Director options to purchase from
    them an aggregate of 74,000 Ortec shares, at a price of $5 per share. In
    1993, the Director has exercised such option in part, and purchased 49,000
    shares from the Other Founders at the option price of $5 per share. The
    remaining balance of such options expired April 15, 1994. Since the Director
    provides no services to the Company, the fair value ascribed to such
    options, approximately $327,000, is not reflected as a transaction in the
    accompanying financial statements.

                                      F-18
<PAGE>   50
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1996 and 1995



NOTE G (CONTINUED)

    Pursuant to a third private placement that commenced in January 13, 1993,
    and concluded on March 31, 1993, Ortec sold an aggregate of 109,650 shares
    at $10 per share ($1,096,500). Subsequent to such offering, in 1993, the
    Company sold an additional 22,500 shares at $10 per share ($225,000). In
    connection with such purchases, all purchasers received certain registration
    rights.

    Pursuant to a Stock Purchase Agreement dated July 19, 1993, by and between
    Ortec and the Home Insurance Company ("Home Insurance"), the Company sold to
    Home Insurance 111,111 shares of common stock for an aggregate purchase
    price of $999,999, or $9 per share. In connection with such purchase, Home
    Insurance received certain registration rights.

    In addition, in 1993, the Company issued 600 shares to an individual as
    compensation for commissions in connection with the sale of the Company's
    shares. Such commissions are included in share issuance expenses. The stock
    issued was valued at $10 per share.

    In August 1993, the Director entered into a stock option agreement with Dr.
    Eisenberg and the Other Founders, pursuant to which he received the right to
    purchase an aggregate of 100,000 shares owned by such persons in various
    amounts and at various times, at a purchase price of $10 per share. As of
    December 31, 1993, the Director has exercised options and purchased 5,000
    shares under such agreement at $10 per share. As of December 31, 1996
    options expiring July 15, 1997 to purchase 27,000 shares remain outstanding
    under this agreement.

    Pursuant to a fourth private placement consummated in July 1994, Ortec sold
    an aggregate of 39,451 shares at between $10 and $10.25 per share for
    aggregate proceeds of $397,712.

    Pursuant to a Stock Purchase Agreement dated July 22, 1994, by and between
    Ortec and Home Insurance, the Company sold to Home Insurance 50,000 shares
    of common stock for an aggregate purchase price of $500,000, or $10 per
    share. In connection with such purchase, Home Insurance received certain
    registration rights and warrants to purchase 10,000 shares of common stock
    at $12 per share, expiring July 21, 1997.

                                      F-19
<PAGE>   51
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1996 and 1995



NOTE G (CONTINUED)

    On January 19, 1996, the Company completed an initial public offering
    ("IPO") of 1,200,000 units for aggregate proceeds of $6,000,000. Each unit
    consists of one share of the Company's common stock, one Class A warrant to
    purchase one share of common stock at $10, expiring July 1997, and one Class
    B warrant to purchase one share of common stock at $15, expiring January
    1999. The Class A and B warrants will be redeemable by the Company at $.01
    per warrant, if the market price of the Company's common stock equals or
    exceeds $10 for 10 consecutive trading days during a specified period, as
    defined.

    In November 1996, the Company completed a private placement of its
    securities from which it received gross proceeds of $6,220,797 and net
    proceeds of approximately $5,733,000 (after deducting approximately $487,000
    in placement fees and other expenses of such private placement). The Company
    sold 959,106 shares of common stock in such private placement at average
    prices of $6.49 per share. In addition, the Company granted five-year
    warrants to placement agents to purchase such number of shares equal to 10%
    of the number of shares of common stock sold by such placement, exercisable
    at prices equal to 120% of the prices paid for such shares. The purchasers
    have demanded that the Company register all such 959,106 shares.

    During 1992, the Company issued warrants to purchase 6,660 shares at $9.425
    per share, and during 1995 the Company issued warrants to purchase 2,000
    shares at $10 per share to members of the Scientific Advisory Board of the
    Company and certain others. During 1996, the Company issued warrants to
    purchase 242,101 shares at $6 to $12 per share to the director and certain
    others. These warrants expire at various dates through November 2001.

    On January 20, 1996, the Company granted "lock-up warrants" entitling
    shareholders to purchase an aggregate of 389,045 shares of the Company's
    common stock at a price of $1.00 per share. All such warrants expire on
    January 18, 2000. At different times during 1996, seven persons exercised
    such warrants and purchased 33,885 shares of common stock at the $1.00 per
    share exercise price. The issuance of such lock-up warrants was in
    consideration for such shareholders signing lock-up agreements agreeing not
    to sell or transfer shares of the Company's common stock purchased at prices
    of $9.00 or more per share until January 20, 1997.

                                      F-20
<PAGE>   52
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1996 and 1995



NOTE G (CONTINUED)

    Outstanding warrants granted as of December 31, 1996 are summarized as
    follows:

<TABLE>
<CAPTION>
                                                                Price
                                                                range                 Shares
                                                              --------               -------
<S>                                                           <C>                    <C>
         March 12, 1991 (inception) to December 31, 1991
             The Director                                     $  9.425                 7,360
                                                              --------               -------

         Balance, December 31, 1991                              9.425                 7,360

             Scientific Advisory Board                           9.425                 4,660
             Second private placement                            9.425                 2,680
             The Director                                        9.425                47,740
                                                              --------               -------

         Balance, December 31, 1992                              9.425                62,440

             The Director                                        9.425                31,830
             Third private placement                            12.00                 14,400
             Scientific Advisory Board                           9.425                 2,000
                                                              --------               -------

         Balance, December 31, 1993                              9.425 - 12.00       110,670

             Home Insurance Company                             12.00                 10,000
                                                              --------               -------

         Balance, December 31, 1994                              9.425 - 12.00       120,670

             Scientific Advisory Board                          10.00                  4,000
             Expired                                             9.425                (2,680)
                                                              --------               -------

         Balance, December 31, 1995                           $  9.425 - 12.00       121,990

             Columbia University                                10.00                  5,000
             The Director                                        7.87                 30,500
             Fifth Private Placement                             6.00 - 8.00          87,061
             Lock-up warrants                                    1.00                389,045
             Exercised                                           1.00                (33,885)
             Expired                                            12.00                 (2,450)
                                                              --------               -------

         BALANCE, DECEMBER 31, 1996                           $  1.00 - 12.00        597,261
                                                              ===============        =======
</TABLE>

                                      F-21
<PAGE>   53
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1996 and 1995



NOTE H - STOCK OPTIONS AND STOCK PURCHASE WARRANTS

    In April 1996, the Board of Directors and stockholders approved the adoption
    of a stock option plan (the "Plan"). The Plan provides for the grant of
    options to purchase up to 350,000 shares of the Company's common stock.
    These options may be granted to employees, officers of the Company,
    nonemployee directors of the Company and consultants to the Company. The
    Plan provides for granting of options to purchase the Company's common stock
    at not less than the fair value of such shares on the date of the grant.

    The following table summarizes option activity for the year ended December
    31, 1996:

<TABLE>
<CAPTION>
                                                                        Weighted
                                                                         average
                                                                        exercise
                                                     Number               price
                                                     -------            --------
<S>                                                  <C>                <C>
Granted                                              156,000            $   7.08
</TABLE>

    As of December 31, 1996, options outstanding for 156,000 shares were
    exercisable at prices ranging from $6.00 to $8.50, and the weighted
    remaining contractual life was 2.5 years. The exercise price for all stock
    options awarded has been determined by the Board of Directors of the
    Company. All options awarded in 1996 become exercisable immediately
    following the grant date.

    The following table summarizes option data as of December 31, 1996:

<TABLE>
<CAPTION>
                                 Number          Weighted                            Number
                               outstanding        average          Weighted        exercisable       Weighted
                                  as of          remaining          average           as of           average
             Range of         December 31,      contractual        exercise       December 31,       exercise
        exercise prices           1996             life              price           1996              price
        ---------------       ------------      -----------        --------       ------------       --------
<S>                           <C>               <C>                <C>            <C>                <C>
        $6.00 to $8.50          156,000          2.5 years           $7.08           156,000          $7.08
</TABLE>

                                      F-22
<PAGE>   54
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1996 and 1995



NOTE H (CONTINUED)

    In October 1995, the Financial Accounting Standards Board issued SFAS No.
    123, "Accounting for Stock-Based Compensation" ("SFAS No. 123"). SFAS No.
    123 established financial accounting and reporting standards for stock-based
    employee compensation plans. The financial accounting standards of SFAS No.
    123 permit companies to either continue accounting for stock-based
    compensation under existing rules or adopt SFAS No. 123 and begin reflecting
    the fair value of stock options and other forms of stock-based compensation
    in the results of operations as additional expense. The disclosure
    requirements of SFAS No. 123 require companies which elect not to record the
    fair value in the statement of operations to provide pro forma disclosures
    of net income and earnings per share in the notes to the financial
    statements as if the fair value of stock-based compensation has been
    recorded.

    The Company will continue to follow Accounting Principles Board Opinion No.
    25 and its related interpretations in accounting for its stock-based
    compensation plans. Accordingly, no compensation cost has been recognized in
    the statement of operations for its employee stock option plan.

    The Company utilized the Black-Scholes option-pricing model to quantify the
    pro forma effects on net income and earnings per common share of the fair
    value of the options granted during 1996. The following assumptions were
    made in estimating fair value.

<TABLE>
<S>                                                                  <C>
         Dividend yield                                               0.00%
         Risk-free interest rate                                      5.64%
         Expected option life
             Directors and officers                                   2.5 years
             Others                                                   2.5 years
         Expected volatility                                         27.62%
</TABLE>

    Had compensation cost been determined under SFAS No. 123 for the year ended
    December 31, 1996, net loss and loss per share would have been increased
    as follows:

<TABLE>
<S>                                                                 <C>
         Net earnings (loss)
             As reported                                            $(2,649,768)
             Pro forma for stock options                             (2,831,413)

         Pro forma earnings (loss) per share
             As reported                                            $      (.60)
             Pro forma for stock options                                   (.64)
</TABLE>

                                      F-23
<PAGE>   55
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1996 and 1995



NOTE H (CONTINUED)

    During the initial phase-in period of SFAS No. 123, such compensation
    expense may not be representative of the future effect of applying this
    statement.


NOTE I - COMMITMENTS AND CONTINGENCIES

    Agreement With Dr. Eisenberg

    Pursuant to an amended agreement, the Company has engaged the services of
    Dr. Eisenberg as a consultant through August 31, 2005. The consulting
    agreement may be renewed for an additional two years unless terminated by
    either party prior to such renewal period. Under the agreement, Dr.
    Eisenberg is obligated to devote twenty hours per week to Company business
    and is entitled to an annual compensation for such services with annual
    increases, as defined, of not less than $3,000. In addition, Dr. Eisenberg
    is paid $58 per hour for services in excess of twenty hours per week. The
    agreement also provides for a bonus in the event the Company files for the
    registration of any patent. The bonus, which shall be determined by the
    Board of Directors of the Company, shall not be less than $30,000 per patent
    registration, but may not aggregate more than $60,000 during any
    twelve-month period. To date, no bonuses have been earned by Dr. Eisenberg.
    For each of the years ended December 31, 1996 and 1995, Dr. Eisenberg earned
    approximately $73,000 for consulting services and approximately $381,000 for
    the period from inception to December 31, 1996, which is included in
    research and development expense. Included in accrued professional fees at
    December 31, 1996 and 1995 are $45,328 and $95,000, respectively,
    representing unpaid consulting fees to Dr. Eisenberg.

    Manufacturing Agreements

    In October 1991, the Company entered into an agreement with Cornell
    University Medical College ("Cornell"), a medical institution in New York
    City, for Cornell to produce and supply the Company, on an exclusive basis
    and using Dr. Eisenberg's technology, all of the cultured skin equivalent
    necessary for the Company's use in human clinical tests in the United
    States. For each of the years ended December 31, 1996 and 1995, fees earned
    by Cornell amounted to approximately

                                      F-24
<PAGE>   56
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1996 and 1995



NOTE I (CONTINUED)

    $258,000 and approximately $1,145,000 for the period from inception to
    December 31, 1996. Presently, the Company anticipates it will continue to
    operate under its agreement with Cornell until such time as the Company
    completes its new laboratory, discussed above. The annual amount payable to
    Cornell for subsequent years is subject to annual increases for personnel
    and supply costs, as defined. The Cornell arrangement was terminated by
    December 31, 1996.

    The cultured skin equivalent to be used in human clinical tests in Australia
    is produced in the Company's laboratory in Sydney, Australia.

    The Company recently entered into an agreement with the New Jersey Center
    for Biomaterials and Medical Devices (the "New Jersey Center"), whereby the
    Company and the New Jersey Center will collaborate on research focusing on
    the development of collagen-based biomaterials for soft tissue repair,
    specifically targeting the development of a second generation collagen
    matrix to be used for the production of the Company's Composite Cultured
    Skin. The New Jersey Center is a cooperative research initiative sponsored
    by the University of Medicine and Dentistry of New Jersey, Rutgers
    University and the New Jersey Institute of Technology, and receives
    financial support from the New Jersey Commission of Science and Technology.
    The Company has agreed to contribute $40,000 of the $100,000 cost of such
    research. The Company will pay such $40,000 in quarterly payments of
    $10,000 each. The $10,000 payment for the first quarter has already been
    paid by the Company.

    FDA Consultant

    The Company retains Oxford Research International Corp. ("Oxford") to assist
    it in the FDA approval process, including the preparation of applications
    and related documentation and monitoring of all phases of the clinical
    trials. The agreement has a term of one year and is automatically renewable
    for additional one-year periods subject to termination at will. Fees payable
    to Oxford are based on Oxford's per diem charge. For the year ended
    December 31, 1996, the Company has paid Oxford $61,000.

    Occupancy Arrangements

    In May 1992, the Company entered into a noncancellable operating lease for
    its research laboratory in Sydney, Australia with Dr. Eisenberg's father.
    The lease may be renewed for an additional three years after May 1997 at the
    then prevailing market rent for similar properties. Rental expense is
    recognized on a straight-line basis, rather than in accordance with base
    payment schedules for purposes of recognizing a constant annual rental
    expense. In addition, the lease provides for the review of the rental
    commitment with provision to increase the rent by a percentage fixed by the
    agreement. Also, the Company is liable for operating expenses as defined.
    The future minimum rental commitments under this lease are as follows:

<TABLE>
<S>                                                                     <C>
      Year ending December 31,
          1997                                                          $12,667
                                                                        =======
</TABLE>

                                      F-25
<PAGE>   57
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1996 and 1995



NOTE I (CONTINUED)

    During the year ended December 31, 1995, Dr. Eisenberg's father waived the
    rights to $40,740 of unpaid rent which was accounted for as additional
    paid-in capital.

    In March 1996, the Company entered into a five-year lease with Columbia
    University for the Company's new laboratory and offices in Columbia's new
    Audubon Biomedical Science and Technology Park in New York City.
    Construction of the new laboratory and office facility was completed in July
    1996 and became fully operational in November 1996. In addition, Columbia
    has agreed to provide the Company with a grant of $400,000 and a ten-year
    self-amortizing loan with interest at the rate charged by Columbia's bank
    for up to an additional $600,000, to build and equip the Company's
    laboratory. Annual aggregate lease payments will approximate $130,000. The
    Company also granted Columbia a warrant expiring March 2001 to purchase
    5,000 shares of common stock at an exercise price of $10 per share. The
    Company will use its new laboratory to produce its Composite Cultured Skin
    for use in the remaining FDA-approved human clinical trials and for further
    research to develop the Company's proprietary technology for treatment of
    other wounds. The Company expects at a later date to further equip its new
    laboratory for use as a pilot production facility for its Composite Cultured
    Skin.

    The Company conducts a major portion of its operations at a leased facility
    in New York, New York. The lease term is five years, expiring in June 2001.
    The minimum rental payments due over the term of the lease at December 31,
    1996 are as follows:

<TABLE>
<S>                                                                    <C>
        Year ending December 31,
            1997                                                       $129,713
            1998                                                        129,713
            1999                                                        132,955
            2000                                                        139,603
            2001                                                         71,503
                                                                       --------

                                                                       $603,487
                                                                       ========
</TABLE>

    Total rent expense under the lease for the year ended December 31, 1996
    amounted to approximately $70,300.

                                      F-26
<PAGE>   58
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1996 and 1995



NOTE I (CONTINUED)

    Contingencies

    A competitor has advised the Company of a potential patent infringement on
    at least one of its United States patents. Management believes, based on the
    advice of patent counsel, the Company has not infringed such patents.

    Approximately two years ago, the University of Minnesota advised the Company
    that it has a claim against the Company for $82,970 allegedly owed pursuant
    to a contract requiring the University of Minnesota to perform research for
    cryopreservation of the Company's product. The Company has denied any
    liability and, accordingly, no amounts relating to this matter have been
    provided for by the Company.

    Management does not believe that the resolution of the above matters will
    have a material adverse effect on the financial condition or results of
    operations of the Company.

    Government Regulation

    The Company is subject to extensive government regulation. Products for
    human treatment are subject to rigorous preclinical and clinical testing
    procedures as a condition for approval by the Food and Drug Administration
    ("FDA") and by similar authorities in foreign countries prior to commercial
    sale. Presently, the Company is continuing to submit the results of its
    human clinical trials to the FDA; however, it is not possible for the
    Company to determine whether the results achieved from the human clinical
    trials will be sufficient to obtain FDA approval.


NOTE J - OTHER RELATED PARTY TRANSACTIONS

    During the years ended December 31, 1996 and 1995, the "Other Founders" were
    paid fees for services rendered of approximately $378,000 and $207,000,
    respectively (in the aggregate, approximately $1,358,000 for the period from
    inception to December 31, 1996). In addition, $140,000 was paid to a
    director as cash compensation for services as placement agent in connection
    with the November 1996 private placement. Also, the director received 30,500
    warrants (see Note G).

                                      F-27
<PAGE>   59
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1996 and 1995



NOTE J (CONTINUED)

    Also, the Company paid approximately $25,000 and $15,000 for the years ended
    December 31, 1996 and 1995, respectively, as fees for accounting services,
    to a stockholder (approximately $65,000 for the period from inception to
    December 31, 1996). Also during the year ended December 31, 1996, the
    Company repaid loans of approximately $247,000 from the net proceeds of the
    "IPO" to officers.

    Further, the Company's executive offices are located in office space leased
    by a company owned by an officer, founder and director of the Company on a
    rent-free basis.


NOTE K - INCOME TAXES

    The Company has deferred start-up costs for income tax purposes and intends
    to elect to amortize such costs over a period of 60 months, under Section
    195(b) of the Internal Revenue Code, when the Company commences operations.

    At December 31, 1996, the Company had net operating loss carryforwards of
    approximately $2,932,000 for income tax purposes expiring through 2011. Due
    to the merger of Skin Group with and into Ortec in July 1992, the net
    operating losses and other built-in deductions existing at that time are
    subject to annual limitations pursuant to Internal Revenue Code Section 382.
    The Company's ability to utilize net operating losses and other built-in
    deductions generated after that date may be limited in the future due to
    additional issuances of the Company's common stock or other changes in
    control, as defined in the Internal Revenue Code and related regulations.

    For financial statement purposes, a valuation allowance of approximately
    $3,623,000 and $2,473,000 at December 31, 1996 and 1995, respectively, has
    been recognized to offset entirely the deferred tax assets related to the
    Company's operating loss carryforwards and other temporary differences
    related to the deferral of start-up expenses for tax purposes, as the
    realization of such deferred tax assets is uncertain.

                                      F-28
<PAGE>   60
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1996 and 1995



NOTE K (CONTINUED)

    Components of the Company's deferred tax asset are as follows:

<TABLE>
<CAPTION>
                                                           December 31,
                                                 ------------------------------
                                                     1996               1995
                                                 -----------        -----------
<S>                                              <C>                <C>
Net operating loss carryforwards                 $ 1,378,000        $   955,000
Deferral of start-up costs                         2,245,000          1,518,000
                                                 -----------        -----------

                                                   3,623,000          2,473,000

Valuation allowance                               (3,623,000)        (2,473,000)
                                                 -----------        -----------

Net deferred tax asset                           $      --          $      --
                                                 ===========        ===========
</TABLE>


NOTE L - FOREIGN OPERATIONS

     The Company has a laboratory in Sydney, Australia. Summary financial
     information for assets and liabilities at December 31, 1996 and 1995, and
     expenses for the years ended December 31, 1996 and 1995 are as follows:

<TABLE>
<CAPTION>
                                                    1996                  1995
                                                  --------              --------
<S>                                               <C>                   <C>
Assets                                            $ 53,000              $ 95,000
Liabilities                                          3,000                22,000
Expenses                                           180,000               115,000
</TABLE>

    Expenses are net of foreign exchange losses of approximately $2,050 and
    $2,590 for the years ended December 31, 1996 and 1995, respectively.


NOTE M - FOURTH QUARTER ADJUSTMENTS

    During the fourth quarter of 1996, the Company recorded certain equity
    transactions that resulted in consulting ($125,000) and interest ($27,000)
    expenses being recorded in the amount of $152,000. These adjustments, or
    $.03 per share, related to previously issued quarterly data for the second
    quarter of 1996, which the Company is restating on Form 10-Q/A.

                                      F-29