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                     U.S. SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                                    FORM 10-K

                                   ----------

(Mark One)

|X|         ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
            EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998

|_|         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

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        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 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-K 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-K or any
amendment to this Form 10-K. |_|

                                   ----------

The number of shares outstanding of the Registrant's common stock is 6,171,120
(as of 3/22/99). The aggregate market value of the voting stock held by
nonaffiliates of the Registrant was approximately $50,421,483 as of March 22,
1999, based upon a closing price on such date of $10.50, as listed on the Nasdaq
SmallCap Market.

DOCUMENTS INCORPORATED BY REFERENCE - None

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                           ORTEC INTERNATIONAL, INC.
                       INDEX TO ANNUAL REPORT ON FORM 10-K
                FILED WITH THE SECURITIES AND EXCHANGE COMMISSION
                          YEAR ENDED DECEMBER 31, 1998

                               ITEMS IN FORM 10-K

                                                                            Page
                                                                            ----

Facing page

Part I

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


Item 2.     Properties.....................................................  12

Item 3.     Legal Proceedings ............................................  None

Item 4.     Submission of Matters to
            a Vote of Security Holders ..................................   None

Part II

Item 5.     Market for the Registrant's Common Equity
            and Related Stockholder Matters.................................  12

Item 6.     Selected Financial Data.........................................  15

Item 7.     Management's Discussion and Analysis of
            Financial Condition and Results of Operations...................  15

Item 7a.    Quantitative and Qualitative Disclosures About
            Market Risk...................................................  None

Item 8.     Financial Statements and Supplementary Data.....................  21

Item 9.     Changes in and Disagreements with Accountants
            on Accounting and Financial Disclosure........................  None

Part III

Item 10.    Directors and Executive Officers of the Registrant..............  21

Item 11.    Executive Compensation..........................................  26

Item 12.    Security Ownership of Certain Beneficial
            Owners and Management...........................................  29

Item 13.    Certain Relationships and Related Transactions..................  31

Part IV

Item 14.    Exhibits, Financial Statement Schedules
            and Reports on Form 8-K.........................................  34

Signatures..................................................................  36

Financial Statements.......................................................  F-1


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                                     PART I

Item 1. BUSINESS

General

      Ortec International, Inc. (the "Company") is a development stage
biomaterial and cell culture biotechnology company that has developed a patented
technology, Composite Cultured Skin ("CCS"), that acts as a biologically active
dressing that stimulates the repair, replacement and regeneration of human skin.
The Company's product is intended to be utilized for the treatment of numerous
skin wounds, including partial thickness burns, venous statis ulcers and
diabetic ulcers, damage from Epidermolysis Bullosa disease, as well as the
treatment of autograft donor sites (which are areas of a patient's body from
which the patient's skin is taken to cover a wound at another part of such
patient's body).

      CCS's permeable, bi-layer structure utilizing a collagen-based scaffolding
(framework) containing immature dermal and epidermal cells (which comprise the
two major layers that form the human skin) stimulates rapid regeneration and
remodeling of human skin. When CCS is applied to the wound site, it produces a
mix of growth factors that stimulate wound closure.

      The Company has received approval from the Food and Drug Administration
("FDA") to conduct human clinical trials for the application of its Composite
Cultured Skin in the treatment of the following indications: (i) partial
thickness burns (also known as "second degree burns"), which are burns that do
not extend through the entire dermis; (ii) donor sites, which are those areas of
the patient's body from which healthy skin is taken ("autograft") and
transplanted onto a wound site, thereby creating an additional wound at the
donor site which then has to be covered; (iii) Epidermolysis Bullosa ("EB"),
which is a rare congenital disease resulting in skin fragility and sloughing;
and (iv) venous ulcers, which are non-healing skin wounds on the lower legs
resulting from stagnant circulation from ineffective leg veins. In addition, in
the second quarter of 1999 the Company also expects, subject to FDA approval, to
initiate patient enrollment for a human clinical trial using CCS in the
treatment of diabetic foot ulcers, which are wounds on the bottom of the feet of
diabetic patients. See "Forward Looking Information."

      In the third quarter of 1999, the Company expects to file an
application with the FDA for a Humanitarian Device Exemption ("HDE"), which,
if approved, would allow the Company to begin marketing CCS for the
treatment of EB patients by the end of 1999.  See "Forward Looking
Information."

      Another application on which the Company has focused is the treatment
of donor site wounds. The Company conducted a donor site pilot study which
was completed in the fourth quarter of 1998.  During the second quarter of
1999, the Company plans to initiate patient enrollment for a pivotal donor
site trial.  See "Forward Looking Information."


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      The human clinical trial program for the treatment of partial thickness
burn patients was conducted on 29 patients at a number of hospitals, after which
patient enrollment was closed. The Company expects to evaluate the results of
such operations after the 12 month follow-up period for the last of those 29
patients in June 1999. See "Forward Looking Information."

      The Company's technology was developed by Dr. Mark Eisenberg, a physician
in Sydney, Australia. Dr. Eisenberg, an officer and director of the Company and
one of its largest shareholders, 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 rare disease called
Epidermolysis Bullosa ("EB"). 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 (a transplant other than with the patient's
own skin) on an EB patient. Dr. Eisenberg continued his research which
eventually led to the development of the Company's CCS -- a biologically active
dressing which consists of both the dermal and epidermal layers.

      Dr. Eisenberg received a U.S. patent for the Company's CCS in February
1994, which was reissued in December 1996, as a composite living skin comprising
an epidermal layer and a layer of non-porous collagen and a dermal layer in a
porous cross-linked collagen sponge matrix. Dr. Eisenberg assigned his patent
for the CCS technology to the Company in April 1998. The Company has also been
granted foreign patents in Europe, as well as in Australia and New Zealand,
Israel, Japan, Thailand, Russia and South Africa. The Company is prosecuting
patent claims in China and Canada. One of the Company's competitors recently
filed an Opposition with the European Patent Office challenging the validity of
the Company's patent in Europe. The Company's patent counsel is now preparing
the Company's response. The Opposition in Europe is not expected to be resolved
for at least two years. While the result in Europe will not affect the validity
of the Companys patent in the United States, there can be no assurance that the
United States patent will not be successfully challenged in court or in further
U.S. Patent Office proceedings. Nor can there be any assurance that any United
States or foreign patents will provide any commercial benefits to the Company.

      The Company's immediate focus is targeted at products to treat skin wounds
and diseases; however, the Company believes that there is an opportunity to
apply its core technologies to repair selected structural tissues such as
tendon, ligament, cartilage, bone and blood vessels. In order to achieve its
objectives, the Company has identified five strategic initiatives: (i)
developing a commercial manufacturing operation; (ii) seeking a corporate sales
and distribution partner; (iii) implementing a plan to operate in a managed
care/reimbursement environment; (iv) continuing its human clinical trials
based on its regulatory strategy; and (v) continuing its research and
development. See "Forward Looking Information."


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      The Company is currently engaged in the process of exploring the viability
of establishing a strategic alliance to enhance its competitive position in the
marketplace and to provide the Company with substantially greater economic
resources and production and distribution capabilities than those currently
available. There can be no assurance, however, as to if or when such strategic
alliance will be formed, or that if the Company succeeds in forming an alliance,
that such alliance will result in the production and/or commercial sale of the
Company's product on a profitable basis.

      To date, the Company -- as a development stage company -- has not sold any
products. Its activities have been limited to human clinical tests of its
product and research and development. From its inception in March 1991 through
December 31, 1998, the Company spent an aggregate of $6,467,129 for human
clinical trials and research and development, which figure does not include
employee salaries.

      The Company was organized in 1991 under the laws of the State of Delaware
for the purpose of acquiring the Company's skin replacement product from Dr.
Eisenberg and in order to develop, test and market it.

Background

      Human skin is composed of cells and matrix proteins that are tough yet
flexible and protect the body against abrasion, water loss, and infection. For
cells to function normally within tissues, the cells must interact with the
proteins that surround them. When certain tissues become damaged, normal healthy
cells attempt to repair the deficient site by moving into the damaged area,
dividing, and depositing new matrix proteins that very often result in scars,
which do not function like normal tissue since the area is surrounded by
excessive amounts of matrix proteins.

      In the case of burns, wounds and other skin diseases, where the human body
cannot repair the tissue by spontaneous healing, there are several medical
treatments that are available, but no treatment that provides completely
satisfactory results. For EB, the conventional approach is cleaning and
disinfecting the site, and then moisturizing; while for skin ulcers, the
conventional treatment after cleaning and disinfecting is compression therapy.
Another alternative is the use of biomaterials (such as metals, ceramics and
plastics) as permanent implantable devices; however, these devices degrade after
years in the body, potentially compromising long-term performance. Another
alternative is the transplantation of tissues taken from human donors; such an
approach, however, is restricted by the shortage of such tissues, the difficulty
and expense of transportation, the risk of rejection, the danger of disease
transmission and the requirement, in certain cases, for life-long use of
immuno-suppressant drugs.

      Another approach is grafting of a patient's own tissue ("autograft
transplant"). 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 approach causes

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damage to the site where the healthy tissue is harvested and is of limited use
for severely wounded patients who have a minimal amount of healthy tissue for
grafting. Burn wound clinicians have sought to replace autograft transplants
with substitute synthetic or natural materials ("allografts") which would
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. Another approach that has been developed
in recent years is the replication of 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 the rejection
of the artificial skin by the patient's immune system and significant
contraction of the transplant after healing, causing cosmetically undesirable
scarring.

The Company's CCS Process

      Description of the Production Process. Utilizing the approach of using
human skin components, the Company has developed its CCS product for the repair
and regeneration of human skin. CCS is an engineered human skin-like dressing
composed of a bi-layered collagen sponge seeded with the same cells that
comprise human skin. CCS cells are derived from infant foreskin obtained during
routine circumcisions. The immature, neonatal cells are highly reproductive and
allow for enhanced proliferation and rapid remodeling of the human skin. The
epidermis is separated from the dermis and each of these layers is treated to
release individual keratinocyte (epidermal) and fibroblast (dermal) cells, which
are the primary cellular components of human skin. The fibroblast and
keratinocyte cells are grown in culture then frozen and stored as a cell bank,
ready for use. Prior to the use of each cell bank, extensive testing and
screening in accordance with the FDA guidelines are conducted on the cells to
ensure that the cells are free of presence of bacterial contaminants, viruses
and pathogens, tumorgenicity or other transmittable diseases. Both the dermal
fibroblast and epidermal keratinocytes cells are separately cultured to
reproduce a large number of individual, identical cells. The dermal fibroblast
cells are then applied to a proprietary, cross-linked bovine collagen sponge to
form the dermal layer matrix and the epidermal keratinocytes cells are grown on
a separate non-porous layer of collagen. This composite matrix is then incubated
and supplied with the proper nutrients to allow the cells to multiply and for
the fibroblasts to permeate inside and anchor to the porous collagen sponge. The
top layer of keratinocyte cells and bottom layer of fibroblast cells, together,
constitute the proprietary CCS, which is then delivered to customers in a
"fresh" state.

       Although the Company's CCS has a shelf life of three days, the Company is
also conducting research in order to provide its customers with a frozen CCS
product that will have an extended shelf life. The Company is developing a
cryopreservation process which it expects to provide a shelf-life of
approximately six months and which will provide a "user-friendly" method for
preparing CCS for application on the patient's wound. To date, the Company has
conducted more than 30 in vitro tests of its cryopreservation process which have
demonstrated that the cryopreserved product provides equal or better cell
viability as compared to the fresh CCS product. In November 1998, the Company
started a progressive


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stability study and a series of pre-clinical trials using cryopreserved CCS. The
initial trials demonstrated the appearance of regenerated epidermis and wound
healing rate consistent or better than that of the Company's fresh CCS. The
Company plans to submit an application to the FDA for an IDE in the second
quarter of 1999 to demonstrate equivalency between the fresh and the
cryopreserved CCS. However, there can be no assurance that the Company will be
successful in developing or manufacturing a commercially-viable cryopreservable
product or that such product will receive regulatory approval. See "Forward
Looking Information."

      Application. The Company's CCS is not a skin transplant but rather a
biologically active dressing which, the Company believes, provides an optimal
environment for stimulating accelerated skin regeneration and wound healing by
utilizing a replica of human skin to encourage the migration of the patient's
own skin cells into the wound. The possibility of rejection of CCS is mitigated
because certain cell types are enzymatically removed and the entire allograft
CCS lasts only approximately two weeks before it is absorbed by the body.

      The Company believes that its bi-layered structure using a porous collagen
matrix is a key product differentiation and one which the Company believes
provides a superior vehicle for skin regeneration and wound healing. The Company
believes that CCS, as a biologically active dressing, optimizes the delivery of
a mixture of growth factors from the CCS's immature cells that stimulate the
patient's own natural healing system. The open collagen structure allows the
immature, highly proliferative donor cells to divide and migrate into the wound
site, as well as to hasten re-vascularization. Over the course of approximately
7-14 days, CCS is absorbed by the body and is replaced by the patient's own
skin, at which time additional CCS patches could be applied if necessary. The
Company believes CCS induces faster wound healing and reduces pain and
complications generally associated with open wounds. Furthermore, the Company
believes donor sites treated with CCS tend to be ready for recropping earlier
than sites treated with the current standard of care. The Company believes that
CCS constitutes a cost effective alternative to conventional standards of wound
care. The conventional treatment for acute wounds, burns and donor sites can be
expensive and requires multiple doctor visits and potentially lengthy
hospitalization. Because of the more rapid healing process expected from
treatment using CCS, the Company believes length of hospital stays and the
number of follow up visits to doctors may be reduced substantially. See "Forward
Looking Information."

Regulatory Process and Clinical Trials

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


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      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 CCS is subject
to regulation as a medical device. Prior to commercial release of the Company's
product, issuance of pre-market approval ("("PMA") ") by the FDA will be
required. A PMA entails proof of non-toxicity, safety and efficacy in human
clinical trials. Pre-market approval is a lengthy and expensive process and
there can be no assurance that such PMA will be obtained by the Company.

      To obtain pre-market 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. Many 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. The human clinical trials may consist
of two stages: the first is a pilot trial, in which a small group of patients is
tested in order to establish safety; the second, a pivotal trial, requires
testing of a larger population to establish non-toxicity, safety and efficacy.

      The Company has developed rigorous internal standards for testing and
compiling data necessary for FDA filings. The Company conducts pilot tests for
all the indications prior to filing applications with the FDA for pivotal
trials. The Company assumes that this process will allow it to submit more
clearly defined protocols to the FDA, thereby clearly defining the clinical
objectives the Company wishes to support in the pivotal trial phase. In
addition, the Company is engaged in an ongoing dialogue with the FDA in an
effort to manage the approval process both effectively and efficiently.

      Regulatory Strategy. In April 1998, the FDA designated CCS as a
Humanitarian Use Device ("HUD") for the use of CCS in the treatment of EB
patients. The Company plans to apply in the third quarter of 1999 for a
Humanitarian Device Exemption ("HDE"), and, if granted, the Company will be able
to begin commercially marketing CCS for the treatment of EB patients in a
shorter time period than is normally required for the full PMA process. The
Company elected to pursue the EB market first in order to receive priority
approval from the FDA and accelerate CCS' market introduction. In addition, the
Company believes that the timing of its market entry for other applications may
also be assisted by recently introduced FDA guidelines, which have expedited the
approval process for medical devices. However, the Company has not factored
these new guidelines in calculating the time


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it expects to commence any commercial sale of its products. See "Forward Looking
Information."

      Clinical Trials. Prior to beginning clinical trials in the U.S., from 1988
through 1994, 37 operations were conducted in Sydney, Australia, using CCS. Five
of those operations were performed on burn patients and four operations were
performed to remove tattoos. The remaining 28 operations were performed to treat
the symptoms of EB. In December 1998, the results of these 28 operations were
described in an article by Dr. Mark Eisenberg and the surgeon who performed all
the operations, Dr. Don Llelwyn, which was accepted for publication in the
British Journal of Plastic Surgery. Thirteen of these operations on EB patients
used CCS as a total or partial substitute for autografts in donor site wounds,
and the remaining 15 used CCS as replacement for skin removed during hand
reconstruction surgery. The results, as reported, concluded that the performance
of CCS was equal or superior to autografts in those twenty eight EB patients.
Notwithstanding the foregoing, none of the operations conducted in Australia
were performed in accordance with FDA approved protocols, and the Company does
not intend to use these results as part of the FDA required human clinical
trials. However, these results were used as safety data in support of the
granting of the Company's original IDE for the treatment of partial thickness
burn patients.

      The Company has received approval from the FDA to conduct human clinical
trials for the application of CCS in the treatment of the following indications:
partial thickness burns, donor sites, EB and venous ulcers. The Company intends
to request approval from the FDA to begin clinical trials using CCS for diabetic
foot ulcers in the second quarter of 1999. See "Forward Looking Information."

      EB. In October 1996, the Company submitted to the FDA a physician IDE to
evaluate the effect of CCS for the treatment of chronic ulcers on patients with
EB. In November 1996, the Company initiated patient enrollment in this trial.
The Company was granted a Humanitarian Use Device designation for this clinical
trial in April 1998, and completed the pilot study enrollment and patient
follow-up in July 1998. The Company is using the results from the application of
CCS for 12 patients who participated in this trial to support its HDE
application which it expects to file with the FDA during the third quarter of
1999. These trials were conducted at the Rockefeller University Hospital in New
York, pursuant to the hospital's protocol approved by the FDA. The Company
anticipates, subject to FDA approval, having CCS commercially available for
treatment of EB patients by the end of 1999. See "Forward Looking Information."

      Autograft Donor Sites. In June 1998, the Company submitted an application
to the FDA for an IDE for a pilot clinical trial for the treatment of autograft
donor site wounds with CCS. An enrollment of patients for the pilot clinical
trial commenced in August 1998 and was completed in October 1998. To date, eight
patients have been treated in the pilot study. The Company has submitted an
application to the FDA for a pivotal clinical trial for the treatment of donor
site wounds. Enrollment for such pivotal trial is expected to


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commence in the second quarter of 1999. This pivotal study is planned to be
conducted at approximately 12 hospitals and involve approximately 75 patients
with six months of follow up. See "Forward Looking Information."

      Venous Ulcers. In November 1998, the Company submitted to the FDA an
application for an IDE for a pilot clinical trial for the treatment of patients
with venous ulcers. After having received FDA clearance for this study in
November 1998, the Company initiated the pilot study enrollment. The pilot study
is anticipated to include 40 patients at eight clinical sites with 12 months of
follow-up. The Company anticipates completing patient enrollment for the pilot
trial in the second quarter of 1999 and submitting an application to the FDA for
a pivotal trial 12 months thereafter. See "Forward Looking Information."

      Diabetic Ulcers. The Company plans to submit to the FDA an application for
an IDE for a pilot clinical trial for the treatment of diabetic ulcers, and to
initiate the patient enrollment therefor, subject to FDA approval, during the
second quarter of 1999. The pilot study is anticipated to include up to 30
patients with 12 months of follow-up. The Company anticipates completing
enrollment during the fourth quarter of 1999, and to submitting an application
to the FDA in the second quarter of 2000 for a pivotal clinical trial. See
"Forward Looking Information."

      Partial Thickness Burns. In March 1992, the Company submitted an
application for an IDE for a clinical trial for partial thickness burns. In
March 1994, the Company commenced a human clinical trial in the United States,
under protocols approved by the FDA, to evaluate the effectiveness of the
Company's CCS on burn patients. To date, the Company tested 29 patients in the
study, employing four active burn centers, primarily Columbia Augusta Medical
Center in Augusta, GA. The Company closed patient trial enrollment in June 1998,
and plans to complete the 12 month follow-up of the 29 treated patients by the
end of the second quarter of 1999. See "Forward Looking Information."

FDA Consultants

      The Company has retained The PHOENIX Clinical Research Management Co.,
Inc. ("The Phoenix") as its Contract Research Organization ("CRO"). The Phoenix,
with offices in New Jersey and California, has significant experience in
managing wound care products. Its responsibilities will include assisting in
clinical trial management, designing protocols and case report forms, clinical
site selection and initiation, monitoring of patient enrollment, data review and
collection. On behalf of its other clients, The Phoenix has conducted
multi-center clinical trials in all phases across a broad spectrum of
therapeutic areas involving over 30,000 patients for both major pharmaceutical
and biotechnology companies, as well as small development stage companies.

      In addition to The Phoenix, the Company has retained Robert J. McCormack,
Ph.D., Vice President, Regulatory Affairs of Target Research Associates, a full
service CRO. Dr.


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McCormack has fifteen years of extensive experience in regulatory affairs, both
in industry and CROs, and has been advising the Company on regulatory matters
for the past five years. Dr. McCormack's primary responsibilities include
advising on and implementing the Company's FDA and regulatory strategy,
interacting directly with the FDA, arranging and conducting meetings with the
FDA and the preparing and reviewing of all regulatory documents and submissions.

Research

      Most of the research and development for the Company's proprietary
technology is performed at the Company's laboratory in New York City and at its
laboratory in Sydney, Australia. In January 1997, the Company 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 collaborate
on research focusing on the development of collagen-based biomaterials for soft
tissue repair, specifically targeting further development of a second generation
collagen matrix to be used for the production of CCS. 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. Under the current terms of the contract, the Company is
required to contribute $60,000 of the research project costs with the remainder
of the costs borne by the New Jersey Commission of Science and Technology.

Patents and Proprietary Rights

      In April 1998, Dr. Eisenberg, the original developer of CCS, assigned his
patent for the technology to the Company. Dr. Eisenberg received a U.S. patent
for the Company's CCS in February 1994, which was reissued in December 1996
after an unsuccessful challenge by Organogenesis, Inc. The Company's patent
expires in 2011 and describes a "composite living skin comprising an epidermal
layer and a layer of non-porous collagen and a dermal layer in a porous
cross-linked collagen sponge matrix." The Company has also been granted foreign
patents in Europe, as well as in Australia and New Zealand, Israel, Japan,
Thailand, Russia and South Africa. The Company is prosecuting patent claims in
Canada and China. One of the Company's competitors recently filed an Opposition
with the European Patent Office challenging the validity of the Company's patent
in Europe. The Company's patent counsel is now preparing the Company's response.
The Opposition in Europe is not expected to be resolved for at least two years.
While the result in Europe will not affect the validity of the Company's patent
in the United States, there can be no assurance that such patents 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


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Corporation, have been granted patents relating to their particular artificial
skin technologies. See "Competition".

Competition

      The Company is aware of several companies that are actively engaged in the
research and development of products for the replacement and regeneration of
skin. There are currently three primary and distinct approaches to the
replacement and regeneration of the skin: the acellular (no cell) approach, the
cell-based unilayered approach, and the cell based bi-layered approach. The
acellular approach uses a non-living substitute for the skin, particularly
cadaver skin, collagen or silicone, that is applied to the treated site. The
cell-based approaches employ living cells in order to closely replicate human
skin cells and stimulate wound repair and tissue regeneration. The unilayered
approach, although a cell-based approach, utilizes living cells of either
epidermal or dermal cells, but not both. The approach considered by the Company
to be the most advanced is the bi-layered, dermal and epidermal approach, which
the Company believes more closely replicates human skin and provides the most
optimal environment through which to encourage the body's natural healing
process.

      Some of the Company's competitors have developed products that are
commercially available. The Company believes that many of these companies may
have greater financial and other resources than the Company and most of them
have conducted and continue to conduct human clinical trials, some of which are
at more advanced stages than the Company's human clinical trials.

      The Company's primary competitors include Organogenesis, Inc., of
Cambridge, Massachusetts ("Organogenesis"), and Advanced Tissue Sciences, Inc.
of La Jolla, California ("Advanced Tissue"), as well as others, all of which
have been granted patents relating to their particular skin replacement
technologies. The FDA approved Organogenesis' product, which employs the
bi-layered approach, in May 1998, and Organogenesis commenced sales of its
product through a joint venture with Novartis Pharmaceuticals Corporation in
June 1998. Advanced Tissue, through a joint venture agreement with Smith &
Nephew PLC, markets Transcyte, a unilayer, non-absorbable biosynthetic matrix,
seeded with dermal fibroblast cells, which act as a temporary wound covering for
severe burns and as a covering for partial thickness burns. Advanced Tissue's
Dermograft product for the treatment of diabetic foot ulcers was rejected by the
FDA in June 1998 and additional trials were mandated by the FDA to prove
efficacy.

      In addition, in the area of chronic wound healing many well known
biotechnology companies are developing products to treat wounds based on the
acellular approach. In December 1997, the FDA approved the commercial sale of
Johnson & Johnson's Regranex, which is used for the treatment of diabetic skin
ulcers.


                                       10
<PAGE>   13

      Although the Company is not aware of any skin replacement product that has
received PMA approval from the FDA, except as set forth above, 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 CCS, or that may make the
Company's CCS obsolete.

Production and Supply

      The Company believes that production capacity at the Company's facility in
the Audubon Biomedical Science and Technology Park should be sufficient to meet
demands for CCS for the initial volume required to supply the EB market. Based
on the Company's timetable for CCS' introduction for other indications and
projected volumes, the Company plans to construct two new production facilities.
The first facility is expected to be validated and approved in the year 2001 to
coincide with the Company's expected launch of CCS for the treatment of donor
site wounds. This facility will be approximately 50,000 sq. ft. and include a
primary processing area with steam sterilization capability, 20,000 sq. ft. of
clean, environmentally-controlled manufacturing space, quality assurance and
microbiology laboratories, distribution space and offices. Due to the
state-of-the-art technology and automated computer-controlled systems
anticipated for this facility, this plant is expected to be capable of operating
24 hours per day, 7 days per week, with a production capacity of approximately
400,000-450,000 CCS units per year. The second facility, which is planned to be
operational by 2003, would provide adequate capacity for projected domestic and
international growth. This additional facility is anticipated to be
approximately the same size and of similar design and layout to the initial
facility. It is expected to be located strategically to facilitate distribution
worldwide. See "Forward Looking Information."

      Any manufacturing, whether by the Company or by a third party
manufacturer, for any future commercial scale production of the Company's CCS,
will have to be in compliance with the Good Manufacturing Practices as mandated
by the FDA.

Employees

      The Company presently employs 47 people on a full-time basis including
four executive officers. In addition to its executive officers, the Company
employs 40 other persons in New York City and three people at its laboratory
in Sydney, Australia, including Dr. Eisenberg.  The Company also has four
part-time employees, three in New York and one in Australia.  The Company
anticipates adding additional employees in the area of quality assurance,
manufacturing and research and development during 1999.  See "Forward
Looking Information."


                                       11
<PAGE>   14

Item 2. PROPERTIES

      The Company occupies 15,000 sq. ft. of new laboratories and offices in
Columbia University's Audubon Biomedical Science and Technology Park
("Audubon") in New York City.  Construction of  the Company's laboratory and
office facility occupying 11,000 sq. ft. was completed in July 1996 and
became fully operational in November 1996.  The Company completed
construction of 4,000 sq. ft. of additional laboratory and office space in
1998.  The laboratory is utilized for assay development, wound healing
research, biomaterial development, bioprocess development, histology and
quality assurance testing. Eighteen hundred square feet of the space
contains two clean rooms where tissue processing, cell culturing and CCS
production is performed.

      The Company pays rent of $28,058 per month for use of all its space at the
Audubon facility. The lease provides for increases in the years 2000 and 2001.
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.

      The Company leases approximately 5,000 square feet of space at 147-155
Queen Street, Beaconsfield, Sydney, Australia, on a month to month basis, in
which the Company operates a 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. The Company pays rent in
Australian dollars, which at the current rate of exchange, amounts to
approximately US$33,000 per year. This space is rented from Dr. Mark Eisenberg's
father on terms that the Company believes are not less favorable to it than for
rental of similar space in Sydney, Australia, from non-related third parties.

                                     PART II

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

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 sales
prices of the Common Stock as reported by NASDAQ for each full quarterly period
from January 1996 through December 31, 1998.


                                       12
<PAGE>   15

<TABLE>
<CAPTION>

                                             High            Low
<S>                                          <C>           <C> 
1998

Common Stock

      First Quarter                          $ 19 3/4      $ 10 1/4
      Second Quarter                           23            17 1/2
      Third Quarter                            18 1/2         5 3/4
      Fourth Quarter                           17 1/2         8

1997

Common Stock

      First Quarter                          $ 10 3/4      $  6
      Second Quarter                            9             6 3/4
      Third Quarter                            14             8 3/8
      Fourth Quarter                           15            10 7/8

1996

Units

      First Quarter (from date of
       inception, January 19, 1996)          $  7 1/2      $  5 3/4
      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>

Security Holders

      To the best knowledge of the Company, at March 10, 1999, there were 164
record holders of the Company's Common Stock. The Company believes that as of
March 10, 1999, there were also 1,053 beneficial owners of the Company's Common
Stock, most of whose shares are held in "street name."


                                       13
<PAGE>   16


Dividends

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

Recent Sales of Unregistered Securities

      During the fourth quarter of 1998 the Company sold to an affiliated group
of three mutual funds 200,000 shares of its Common Stock and three year warrants
entitling the holders to purchase an aggregate of 50,000 additional shares of
the Company's Common Stock at an exercise price of $12.00 per share. The Company
received $2,000,000 in aggregate from such sale. There were no underwriters in
such sale and no underwriting commission or discount paid or given. The price
for the Company's Common Stock on the Nasdaq SmallCap Market at the time that
the purchase price for such shares and warrants was agreed to by the Company and
by the purchasers was approximately $11.75 per share.

      During the fourth quarter of 1998 the Company granted to twelve employees
seven year options under its Employee Stock Option Plan to purchase an aggregate
of 29,000 shares of Common Stock, at an exercise price of $9.00 per share with
respect to 18,000 shares and an exercise price of $12.75 per share with respect
to 11,000 shares. Such grants were in consideration for services rendered to the
Company.

      During the fourth quarter of 1998 the Company granted to two non-employee
directors five year options under its Employee Stock Option Plan to purchase an
aggregate of 15,000 shares of Common Stock, at an exercise price of $12.4375 per
share. Such grants were in consideration for services rendered and to be
rendered to the Company.

      During the fourth quarter of 1998 the Company granted to one person five
year warrants to purchase an aggregate of 25,000 shares of Common Stock, at an
exercise price of $14.00 per share. Such warrants were granted in consideration
for consulting services rendered to the Company.

      During the fourth quarter of 1998 the Company granted to three of its
executive officers five year options under its Employee Stock Option Plan to
purchase an aggregate of 520,750 shares of Common Stock, at an exercise price of
$12.125 per share with respect to 230,750 shares and at an exercise price of
$12.4375 per share with respect to 290,000 shares. Such options were granted in
consideration for services rendered to the Company. Although the exercise of
such options was originally contingent upon the occurrence of certain events,
all such options became vested on December 29, 1998.

      During the fourth quarter of 1998 the Company granted a seven year option
to another one of its executive officers to purchase an aggregate of 82,500
shares of Common Stock, at an exercise price of $9.50 per share. Such option was
granted in consideration for services rendered to the Company. The exercise of
such option to purchase 77,500 shares was 


                                       14
<PAGE>   17

contingent upon the occurrence of certain events none of which has yet occurred.
As of March 1, 1999 the portion of such option to purchase 13,750 shares has
expired and the events that would cause the option to vest as to 63,750 shares
have not yet occurred.

      The grant, offer and sale of all of the securities listed above were sold
without registration under the Securities Act of 1933, as amended (the "Act"),
as they did not involve any public offering, pursuant to the provisions of
Section 4(2) of the Act.

Item 6. SELECTED FINANCIAL DATA

The following selected  financial data are derived from the Company's  financial
statements  and should be read in  conjunction  with, and are qualified in their
entirety  by,  the  related  notes  and  other  financial  information  included
elsewhere in this report:

<TABLE>
<CAPTION>
                                                                                                                        Cumulative
                                                                                                                           from
                                                                                                                         March 12,
                                                                                                                           1991
                                                                                                                      (inception) to
                                                                                                                       December 31,
Statement of operations data                   1994            1995           1996           1997           1998           1998
                                           ------------    ------------   ------------   ------------   ------------  --------------
<S>                                        <C>             <C>            <C>            <C>            <C>           <C>
Revenues - interest income                 $     28,874    $      2,685   $    171,057   $    291,602   $    572,549   $  1,102,366
                                           ------------    ------------   ------------   ------------   ------------   ------------

Expenses
   Research and development                     796,547         573,392        964,864      1,178,836      1,933,877      6,467,129
   Rent                                          21,732          21,732         85,076        166,498        252,397        581,844
   Consulting                                   141,973          34,606        261,633        474,908        908,495      2,140,799
   Personnel                                    333,224         229,183        730,357      1,901,409      4,060,629      7,837,436
   General and administrative                   317,666         161,686        727,192      1,320,488      1,725,201      4,880,061
   Interest and other expense                    92,819           4,809         51,703         75,126       104,,605        294,202
                                           ------------    ------------   ------------   ------------   ------------   ------------

                                              1,703,961       1,025,408      2,820,825      5,117,265      8,985,204     22,201,471
                                           ------------    ------------   ------------   ------------   ------------   ------------

Net loss                                   $ (1,675,087)   $ (1,022,723)  $ (2,649,768)  $ (4,825,663)  $ (8,412,655)  $(21,099,105)
                                           ============    ============   ============   ============   ============   ============

Net loss per share of common stock
   Basic and diluted                       $       (.71)   $       (.42)  $       (.64)  $      (1.01)  $      (1.43)  $      (6.51)

Weighted average common stock outstanding
   Basic and diluted                          2,364,353       2,509,078      4,110,507      4,782,239      5,878,971      3,242,893
                                           ============    ============   ============   ============   ============   ============


Balance sheet data

Working capital                             $     82,431    $ (1,303,948) $ (6,848,650)  $ 12,982,711   $  9,368,901
Total assets                                     845,843         848,470     8,791,925     14,998,414     12,391,039
Long-term debt                                     9,592           1,327       460,774        722,704      1,152,180
Stockholders' equity (deficit)                   522,757        (459,226)    7,716,998     13,716,618     10,390,759
</TABLE>


Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
        RESULTS OF OPERATIONS

      The following discussion should be read in conjunction with the financial
statements and notes thereto. This discussion may be deemed to include forward
looking statements within the meaning of Section 27A of the Securities Act of
1933 and Section 21E of the Securities Exchange Act of 1934 that involve risk
and uncertainty, including financial, clinical, business environment and trend
projections. Although Ortec International, Inc. believes that its expectations
are based on reasonable assumptions, it can give no assurance that its goals
will be achieved. The important factors that could cause actual results to
differ materially from those in the forward looking statements herein include,
without limitation, the early stage of development of both the Company and its
product, the timing and uncertainty of results of both research and regulatory
processes, the extensive government regulation applicable to the Company's
business, the unproven safety and efficacy of the Company's product, the
Company's significant additional financing requirements, the uncertainty of
future capital funding, the existence and future development of competing
technologies, the presence of a number of competitors with significantly greater
financial, technical and other resources and extensive operating histories, the
Company's potential exposure to product liability, uncertainties relating to
patents and other intellectual property, including whether the Company will
obtain sufficient protection or competitive advantage therefrom, and other
factors detailed in this Annual Report on Form 10-K for the year ended December
31, 1998.

General

      Since its inception the Company has been principally engaged in the
research and development of its skin regeneration product for use in the
treatment of chronic and acute wounds, such as venous and diabetic skin ulcers,
burns, donor site wounds and chronic skin ulcers in Epidermolysis Bullosa ("EB")
patients. The Company has not had any revenues


                                       15
<PAGE>   18

from operations since its founding in 1991 since the Company cannot make any
sales of its product until it receives approval from the Food and Drug
Administration ("FDA") to do so. The Company has incurred a cumulative net loss
of approximately $21.1 million as of December 31, 1998. The Company expects to
continue to incur substantial and increasing losses for the next several years
due to continued and increased spending on research and development programs,
the funding of preclinical and clinical testing and trials and regulatory
activities and the costs of manufacturing, marketing, sales, distribution and
administrative activities.

      The Company's revenues consist only of interest income. To date, the
Company has received no revenue from the sale of its product, and the Company is
not permitted to engage in commercial sales of its product until such time, if
ever, as the Company receives requisite FDA and/or other foreign regulatory
approvals. As a result, the Company does not expect to record significant
product sales until such approvals are received.

      The Company anticipates that future revenues and results of operations may
continue to fluctuate significantly depending on, among other factors, the
timing and outcome of applications for regulatory approvals, the Company's
ability to successfully manufacture, market and distribute its product and/or
the establishment of collaborative arrangements for the manufacturing, marketing
and distribution of its product. The Company anticipates its operating
activities will result in substantial net losses for several years more.

      The Company is currently conducting clinical trials of its product in the
treatment of autograft donor site wounds, chronic ulcers in patients with EB,
venous stasis ulcers and partial thickness burns, and is proceeding to secure
FDA approval to conduct a clinical trial to use its product in the treatment of
diabetic ulcers.

Year 2000

      The Year 2000 issue is the result of computer programs being written using
two digits rather than four to define the applicable year. The Company's
computer equipment and software and devices with embedded technology that are
time-sensitive, may recognize a date using "00" as the year 1900 rather than the
year 2000. This could result in a system failure or miscalculations causing
disruptions of operations, including, among other things, a temporary inability
to process accounting, payroll, database, network, and software transactions,
possible disruption of environmental, lighting, and security controls, possible
disruption of copier and fax capabilities, and loss of telephone voicemail
messages, in addition to other similar normal business activities.

      The Company plans to install a new network computer system that will be
Year 2000 compliant. Utilizing both internal and external resources to identify
and assess needed Year 2000 remediation, the Company currently anticipates that
its Year 2000 identification, assessment, remediation and testing efforts will
be completed in 1999.


                                       16
<PAGE>   19

Results of Operations

Year Ended December 31, 1998 to Year ended December 31, 1997

      Revenues. The Company has had no revenues from operations other than
interest income from its inception in 1991 to date. Interest income increased by
approximately $282,000 from approximately $291,000 in 1997 to approximately
$573,000 in 1998 because of larger cash and marketable securities balances in
1998 that resulted from sale of common stock

      Research and Development. The Company's research and development expenses
for the year ended December 31, 1998 increased to $1.9 million from $1.2 million
for the year ended December 31, 1997, which amounts do not include consulting
expenses, a significant portion of which was paid for the Company's research and
development. Such consulting expenses for research and development amounted to
approximately $684,000 in 1998 as opposed to approximately $355,000 in 1997. The
increase in research and development expenses relates primarily to the costs
associated with the increase in clinical trial activity, cryopreservation
research and for enhancement and other applications of the Company's product. In
addition, research and development expenses continue to increase in conjunction
with the Company's progression through the various stages of preclinical and
clinical trials and the increased costs associated with the purchase of raw
materials and supplies for the production of the Company's product used in those
trials. Future research and development expenses may increase depending on the
continued expenses incurred in clinical trials and the costs associated with the
Company's manufacturing scale-up and the expansion of its research and
development programs, which includes the increased hiring of personnel and
continued expansion of preclinical and clinical testing.

      General and Administrative. The Company's general and administrative
expenses for the year ended December 31, 1998 increased to $1.7 million from
$1.3 million for the year ended December 31, 1997. The increase in general and
administrative expenses for the year ended December 31, 1998 as compared to the
same period in 1997 are a result of (i) the increase in costs associated with
professional services received from financial consultants, attorneys and
accountants and (ii) the increased overhead costs resulting from the increase in
personnel. Future general and administrative expenses may increase as additional
personnel are employed, there are increases in corporate development, use of
professional services, compensation expense associated with stock options, use
of financial consultants and other general corporate matters.

      Personnel. The Company's personnel expenses for the year ended December
31, 1998 increased to $4.1 million from $1.9 million for the year ended December
31, 1997. This increase resulted from the larger number of persons employed by
the Company because of its increased research and development, including the
conducting of and preparation for clinical trials, and for which additional
personnel were also required in administrative positions. Approximately $1.3
million of that increase was attributable to the non cash


                                       17
<PAGE>   20

expense consisting of grants of stock options and warrants. Future personnel
costs are expected to increase since the Company intends to expand its clinical
trial program for the use of its product in treating different medical
indications, possible increase in its other research and development activities,
compensation expense associated with the grant of stock options and for
corporate administrative personnel.

      Rent. The Company's expenses for rent for the year ended December 31, 1998
increased to $252,000 from $166,000 for the year ended December 31, 1997. The
increase in rent expense in 1998 as compared to 1997 is the result of the
Company increasing the amount of space occupied by it at Columbia University's
Audubon Biomedical Science and Technology Park in New York City for additional
laboratories built for the Company's research and development, and to
accommodate the additional personnel employed by the Company in 1998. Future
rent expense is expected to increase since the rent expense figure for 1998
reflects rent paid for the Company's additional space for only a portion of that
year.

Year ended December 31, 1997 to Year Ended December 31, 1996

      Revenues. As noted above, the Company has no revenues from operations
other than interest income. Interest income increased approximately $120,000
from approximately $170,000 in 1996 to approximately $290,000 in 1997 because of
larger average cash and marketable securities balances in 1997 that resulted
from the sale of common stock.

      Research and Development. The Company's research and development expenses
for the year ended December 31, 1997 increased to approximately $1.2 million
from approximately $1.0 million for the year ended December 31, 1996, which
amounts do not include consulting expenses, a significant portion of which was
paid for the Company's research and development. Such consulting expenses for
research and development amounted to approximately $355,000 in 1997 as opposed
to approximately $262,000 in 1996. The increase in research and development
expenses related primarily to the costs associated with the increase in clinical
trial activity, cryopreservation research and validating that the Company's new
laboratory facilities meet FDA guidelines so that such laboratories could be
used to produce the Company's product for use in clinical trials.

      General and Administrative. The Company's general and administrative
expenses for the year ended December 31, 1997 increased to approximately $1.3
million from approximately $0.7 million for the year ended December 31, 1996.
The increase in general and administrative expenses for the year ended December
31, 1997 as compared to the same period in 1996 was the result of (i) the
increase in costs associated with professional services received from financial
consultants, attorneys and accountants and (ii) the increased overhead costs
resulting from the increase in personnel.

      Personnel. The Company's personnel expenses for the year ended December
31, 1997 increased to approximately $1.9 million from approximately $0.7 million
for the year


                                       18
<PAGE>   21

ended December 31, 1996. This increase resulted from the larger number of
persons employed by the Company because of its increased research and
development, including the conducting and preparation for clinical trials, and
for which additional personnel were required in administrative positions.
Approximately $0.5 million of that increase was attributable to the non cash
expense consisting of grants of stock options and warrants.

      Rent. The Company's expenses for rent for the year ended December 31, 1997
increased to $166,000 from $85,000 for the year ended December 31, 1996. The
increase in rent expense in 1997 as compared to 1996 was the result of the
Company occupying its office and laboratory facility at Columbia University's
Audubon Biomedical Science and Technology Park in New York City for a full year
in 1997 and for only part of the year in 1996.

Liquidity and Capital Resources

Since inception (March 12, 1991) through December 31, 1998, the Company has
accumulated a deficit of approximately $21.1 million and expects to continue to
incur substantial and increasing operating losses for the next several years.
The Company has financed its operations primarily through private placements of
its Common Stock, its initial public offering and the exercise of its publicly
traded Class A warrants at the end of 1997. As of December 31, 1998 the Company
had received proceeds from the sale of equity securities of approximately $31.4
million. For the year ended December 31, 1998 the Company used net cash for
operating activities of approximately $5.0 million compared to approximately
$5.5 million for the same period in 1997. The decrease in cash used in operating
activities resulted primarily from (i) a net cash outlay in 1997 of
approximately $1.5 million which the Company used to purchase marketable
securities with cash it had on hand, as opposed to net cash received of
approximately $0.8 million from the sale of marketable securities in 1998 (ii)
an increase of approximately $1.3 million attributable to non cash expense
consisting of grants of stock options and warrants ($1.9 million in 1998 and
$0.6 million in 1997) and (iii) increases in accounts payable and accrued
liabilities and depreciation and amortization. In the year ended December 31,
1996, the Company used net cash for operating activities of $2.2 million. The
increase in net cash used in operating activities in 1997 as opposed to 1996
resulted primarily from a net loss in 1997 that was approximately $2.2 million
greater than the net loss in 1996. In the future the amount of cash needed for
operating activities is expected to increase primarily due to an increase in
operating activities associated with the continued expansion of preclinical
testing and clinical trials, the increase in research and development programs
and personnel and the increase in general corporate activities.

      In the year ended December 31, 1998 the Company realized cash provided by
its financing activities of approximately $6.1 million as compared to cash
provided by its financing activities of $8.0 million in 1997. The lesser amount
of cash received from financing activities is accounted for by the larger amount
of net proceeds received by the Company from issuance of Common Stock in 1997
($7.8 million) than in 1998 ($5.7 million;


                                       19
<PAGE>   22
of which $2.4 million were proceeds from the sale of shares of common stock at
the end of 1997 which were received by the Company at the beginning of 1998) and
modest increases of amounts in the repayment of capital lease obligations,
repayment of notes payable and for the purchase by the Company of its own Common
Stock, offset by an increase in proceeds from loans of $600,000 in 1998 compared
to $325,850 in 1997. In the year ended December 31, 1996 the Company realized
net cash from its financing activities of approximately $10.6 million, much of
which was the proceeds from the initial public offering of its securities and
the remainder from sales of its common stock in a private placement offering.

      The Company invested a total of approximately $1.1 million in property,
plant and equipment during 1998 compared to approximately $300,000 during 1997.
The increase is directly related to costs incurred for the expansion of the
Company's laboratory and office space as well as the purchase of equipment for
this space. In the year ended December 31, 1996 the Company invested $884,093 in
building its then new laboratory and office at the Audubon Biomedical Science
and Technology Park in New York City and an aggregate of $63,000 for patent
applications and a deposit. The Company expects to continue to purchase property
and equipment in the future as it expands its preclinical, clinical and research
and development activities. Since inception, the Company has entered into
capital lease agreements for approximately $118,900 of equipment, consisting
primarily of laboratory equipment. The Company expects to continue to lease
equipment from time to time as needed, when and if financing resources become
available at acceptable terms to the Company.

      The Company's capital funding requirements will depend on numerous
factors, including the progress and magnitude of the Company's research and
development programs and preclinical testing and clinical trials, the time
involved in obtaining regulatory approvals, the cost involved in filing and
maintaining patent claims, technological advances, competitor and market
conditions, the ability of the Company to establish and maintain collaborative
arrangements, the cost of manufacturing scale-up and the cost and effectiveness
of commercialization activities and arrangements.

      The Company is likely to require substantial funding to continue its
research and development activities, preclinical testing and clinical trials and
manufacturing scale up, marketing, sales, distribution, and administrative
activities. The Company has raised funds in the past through the public or
private sale of securities, and may raise funds in the future through public or
private financings, collaborative arrangements or from other sources. The
success of such efforts will depend in large part upon continuing developments
in the Company's clinical trials. The Company continues to explore and, as
appropriate, enter into discussions with other companies regarding the potential
for equity investment, collaborative arrangements, license agreements or
development or other funding programs with the Company in exchange for
manufacturing, marketing, distribution or other rights to the Company's product.
However, there can be no assurance that discussions with other companies will
result in any investments, collaborative arrangements, agreements or funding, or
that the necessary additional financing through debt or equity financing will be
available


                                       20
<PAGE>   23

to the Company on acceptable terms, if at all. Further, there can be no
assurance that any arrangements resulting from these discussions will
successfully reduce the Company's funding requirements. If additional funding is
not available to the Company when needed, the Company will be required to scale
back its research and development programs, preclinical testing and clinical
trials and administrative activities and the Company's business and financial
results and condition would be materially adversely affected.

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

      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 February 19, 1999.

                                    PART III

Item 10. DIRECTORS AND  EXECUTIVE OFFICERS OF THE REGISTRANT.

Directors and Executive Officers

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

<TABLE>
<CAPTION>

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

<S>                         <C>    <C>                                      
Steven Katz, Ph.D.          54     President, Chief Executive Officer and
                                   Chairman of the Board of Directors

Dr. Mark Eisenberg          61     Senior Vice President, Research and
                                   Development and Director

Ron Lipstein                43     Secretary, Treasurer, Chief Financial
                                   Officer and Director

Alain M. Klapholz           42     Vice President, Operations and Director

William Schaeffer           51     Chief Operating Officer

Joseph Stechler             47     Director

Steven Lilien, Ph.D.        51     Director

</TABLE>

      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 1994. He has been employed by the Company since 1991. Dr. Katz has
also been a professor of Economics and Finance at Bernard M. Baruch College in
New York City since 1972. He


                                       21
<PAGE>   24

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 Dystrophic
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 by
the Company since 1991. Mr. Lipstein is a certified public accountant.

      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 by the
Company since September, 1991.  Mr. Klapholz has an MBA from New York
University.

      William Schaeffer has been employed by the Company since May 1998 as its
Chief Operating Officer. Prior to joining the Company, Mr. Schaeffer was
employed by Johnson & Johnson for more than 25 years. His last position was Vice
President, Quality Assurance Worldwide for Johnson & Johnson's Cordis, Inc.,
where he was also a member of its Management Board. Mr. Schaeffer has also held
senior management positions at Johnson & Johnson's Ethicon, Inc., Johnson &
Johnson Cardiovascular and Ortho Diagnostics, Inc. His responsibilities have
included process development, manufacturing and quality assurance for a broad
range of medical devices developed, produced and distributed by Johnson &
Johnson.

      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 JD degree from Columbia
University and an LLM degree in corporate law from New York University.

      Steven Lilien was elected a director of the Company in February 1998. He
has been chairman of the accounting department of Bernard M. Baruch College in
New York City for the past eleven years and is currently the Weinstein Professor
of Accounting there. He is a certified public accountant and has a Ph.D. in
accounting and finance and an M.S., both from New York University.

      All directors hold office until the next annual meeting of stockholders
and the election and qualification of their successors. Directors receive no
cash compensation for serving on the Board of Directors. Non-employee Directors
of the Company are compensated for their services and attendance at meetings
through the grant of options pursuant to the Company's Employee Stock Option
Plan.


                                       22
<PAGE>   25

The Committees

      The Board has an Audit Committee and a Stock Option Committee. The Board
of Directors does not have a Compensation Committee or a Nominating Committee,
and the usual functions of such committees are performed by the entire Board of
Directors.

      Audit Committee. The functions of the Audit Committee include
recommendations to the Board of Directors with respect to the engagement of the
Company's independent certified public accountants and the review of the scope
and effect of the audit engagement. The current members of the Audit Committee
are Messrs. Lilien, Stechler and Lipstein, with Dr. Lilien serving as Chairman
of the Audit Committee.

      Stock Option Committee. The Stock Option Committee determines the persons
to whom options are granted under the Company's Stock Option Plan and the number
of options to be granted to each person, except that the Committee has no
authority to grant options to employees who are also directors, such authority
being reserved to the entire Board of Directors. The current members of the
Stock Option Committee are Messrs. Stechler, Katz and Lipstein.

Attendance at Meetings

      In 1998 the Board of Directors, the Stock Option Committee and the Audit
Committee each met or acted without a meeting pursuant to unanimous written
consent, nine times, eleven times and one time, respectively.

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 is required to devote 20
hours per week to the Company.  The Company pays Dr. Eisenberg an annual fee
at the rate of $73,000.  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.


                                       23
<PAGE>   26

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. Robert L. McCauley - Chairman of the Company's Scientific Advisory
Board.  Dr. McCauley is Chief of Plastic and Reconstructive Surgery at
Shriners Burn Hospital in Galveston, Texas.  Dr. McCauley is a consultant to
the FDA's General and Plastic Surgery Device Panel, having previously served
as a member of the FDA's General Plastic Surgery Device Panel Advisory
Committee.  Dr. McCauley is Professor of Surgery in the Division of Plastic
Surgery and Professor in the Department of Pediatrics at the University of
Texas Medical Branch (in Galveston, Texas) and Medical Director of its
tissue bank.  Dr. McCauley has extensive experience in the treatment of
burns and skin wounds and has lectured and published widely on those
subjects.

      Dr. Richard Kronenthal - The Company retains Dr. Kronenthal as a
consultant at a minimum annual fee of $60,000. 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., a division of Johnson and Johnson, for more than 30
years, the 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.

      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.

      Dr. McCauley serves as the Chairman of the Company's Scientific Advisory
Board without compensation. The Company compensates the other two 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 1999
to purchase 2,660 shares, (ii) to Dr. McGuire, warrants expiring in April 2000
to purchase 2,000 shares and (iii) to Dr. Kronenthal, warrants expiring in March
2000 to purchase 2,000 shares. In addition, on April 1, 1996, the 


                                       24
<PAGE>   27

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.

Medical Advisory Board

      The Company has established a Medical Advisory Board to monitor the
efficacy of the Company's programs and procedures for the screening and testing
of potential pathogens and transmittable viruses in the Company's product. The
following persons are serving on the Company's Medical Advisory Board:

      Dr. Aaron Glatt - Chief of Infectious Diseases at Catholic
      Medical Center in Flushing, New York.

      Dr. Andrew Salzberg - of the Westchester Medical Center and
      Co-Director of its burn unit and a plastic surgeon with extensive
      experience in skin grafting.  Dr. Salzberg is also a member of
      the Company's Scientific Advisory Board.

      Dr. Alan Greenspan - a dermatologist in private practice in New
      York City.

      Dr. Suzanne Schwartz - employed by the Company as its medical
      director.

      Melvin Silberklang, Ph.D.- employed by the Company as Vice
      President of Research and Development.

      Nitya Ray, Ph.D. - employed by the Company as Director of Process
      Development.

      The Company compensates the three non-employee members of its Medical
Advisory Board in the amount of $5,000 per annum.

Section 16(a)  Beneficial Ownership Reporting Compliance

      To the best of the Company's knowledge, (i) Dr. Steven Katz and Messrs.
Ron Lipstein and William Schaeffer each failed to file on a timely basis with
the Securities and Exchange Commission during the fiscal year ended December 31,
1998, one report on Form 4, Mr. Schaeffer having been late in reporting one
transaction, and Dr. Katz and Mr. Lipstein having each been late in reporting
two transactions, and (ii) Mr. Schaeffer and Dr. Steven Lilien each failed to
file on a timely basis with the Securities and Exchange Commission during the
fiscal year ended December 31, 1998, one report on Form 3, reporting one late
transaction each. Each of such individuals are executive officers and/or
directors of the Company. 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, 1998
were timely filed.


                                       25
<PAGE>   28

Item 11.    EXECUTIVE COMPENSATION

Compensation of Executive Officers

      The following table sets forth the compensation paid by the Company during
the three fiscal years ended December 31, 1998, 1997 and 1996 to the Chief
Executive Officer and the Company's other executive officers whose cash
compensation exceeded $100,000 (the "Named Officers").

                           Summary Compensation Table

<TABLE>
<CAPTION>
                                                                                     Long Term Compensation

                                   Annual Compensation                          Awards                     Payouts
                                   -------------------                          ------                     -------

Name &                                          Bonus       Other     Restricted       Stock           All           Other
Principal Position        Year   Salary ($)      ($)         ($)      Stock Awards  Option Plan(#)  Payouts($)   Compensation
------------------        ----   ----------      ---         ---      ------------  --------------  ----------   ------------
<S>                       <C>    <C>           <C>         <C>        <C>              <C>           <C>          <C> 
Steven Katz               1998   200,000                   9,000*                      230,750         --             --
Chairman, CEO and
 President                1997   130,000       45,000      8,400*        --            155,000          --            --

                          1996   162,451(1)        --      8,100*        --             50,000          --            --

Ron Lipstein              1998   165,000                   9,000         --            220,000          --            --
Secretary, Treasurer,
 CFO and Director         1997   115,000       30,000      8,400*        --             80,000          --            --

                          1996   135,861(1)        --      8,100*        --             25,000         --             --

Alain Klapholz            1998   150,000           --         --         --             70,000          --            --
Vice President &
 Director                 1997   115,000       20,000         --         --             40,000         --             --

                          1996   112,249(1)        --       3,500*                      10,000         --             --
</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 in 1995.



                                       26
<PAGE>   29
Board Compensation

      In November 1998, for services to be rendered by Messrs. Joseph Stechler
and Steven Lilien as directors of the Company in 1999, Mr. Stechler and Dr.
Lilien were each granted options under the Company's Employee Stock Option Plan
to purchase 5,000 shares of the Company's Common Stock. At the same time, for
services rendered by him in 1998 as a member of the Stock Option Committee of
the Board of Directors, Mr. Stechler was granted an additional five-year option
to purchase an additional 5,000 shares of the Company's Common Stock. All such
options are exercisable at $12.4375 per share. On February 10, 1998, upon his
becoming a director of the Company and for his services as a director in 1998,
Dr. Lilien was granted a five-year option under the Company's Employee Stock
Option Plan to purchase 3,000 shares of the Company's Common Stock at an
exercise price of $12.00 per share.

Option Grants in Last Fiscal Year

      The following table sets forth certain information regarding options
granted during the fiscal year ended December 31, 1998 by the Company to the
Named Officers:

                        Option Grants in Last Fiscal Year
<TABLE>
<CAPTION>

------------------------------------------------------------------------------------------------------------------
                                                                                    Potential Realizable Value
                                                                                     at Assumed Annual Rates
                             Individual Grants                                      of Stock Price Appreciation
                                                                                        for Option Term
----------------------------------------------------------------------------------------------------------------------
 (a)              (b)              (c)              (d)                 (e)             (f)           (g)

                Number of         % of Total             
                Securities       Options/SARs
                Underlying        Granted to        Exercise 
               Options/SARs        Employees in    or Base Price     Expiration
   Name         Granted(#)       Fiscal Year(1)     ($/Share)          Date             5%($)         10%($)
   ----         ----------       --------------     ---------          ----             -----         ------
<S>                <C>              <C>              <C>             <C>              <C>           <C>      
Steven Katz        230,750          35%              $12.13           11/26/03         772,992      1,708,111

Ron Lipstein       220,000          33                12.44           11/24/03         755,975      1,670,508

Alain Klapholz      70,000          11                12.44           11/24/03         240,538        531,535

</TABLE>

----------

(1)   Options to purchase a total of 673,250 shares of Common Stock were granted
      to the Company's employees, including the Named Officers, during the
      fiscal year ended December 31, 1998.


                                       27
<PAGE>   30

Aggregated Options Exercised in Last Fiscal Year and Fiscal Year End Option
Value

      The following table sets forth certain information regarding options
(which include warrants) exercisable during 1998 and the value of the options
held as of December 31, 1998 by the Named Officers. None of the Named Officers
exercised any options in 1998 nor did they hold any options which were not
exercisable at December 31, 1998.

<TABLE>
<CAPTION>

                     Number of Unexercised     Value of Unexercised In-the-Money
                          Options at                        Options
                     Fiscal Year End (All          at Fiscal Year End (All
  Name                   Exercisable)                   Exercisable)(1)
  ----                   ------------                   ---------------

<S>                         <C>                            <C>     
  Steven Katz               420,750                        $690,700

  Ron Lipstein              320,000                        $401,250

  Alain Klapholz            120,000                        $166,875

</TABLE>

----------

(1)   The difference between (x) the product of the unexercised options and the
      closing price of the Company's Common Stock on December 31, 1998, as
      listed on The Nasdaq SmallCap Market, less (y) the product of the
      unexercised options and the exercise price of such options.

Compensation Committee Interlock and Insider Participation

      The Company does not have a Compensation Committee. The compensation of
the Company's executive officers is set by the Board of Directors. Drs. Steven
Katz and Mark Eisenberg and Messrs. Ron Lipstein and Alain Klapholz, all of whom
are employed by the Company and three of whom are executive officers of the
Company, are four of the Company's six directors and participated in the
deliberations of the Company's Board of Directors concerning executive officers
compensation.

      None of the Company's executive officers serves as a member of the
compensation committee or on the board of directors of another entity, one of
whose executive officers serves on the Company's Board of Directors.


                                       28
<PAGE>   31


Item 12. 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 February 28, 1999 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                Beneficial                Outstanding
Of Beneficial Owner            Ownership**               Shares Owned**
-------------------            -----------               --------------
<S>                              <C>                          <C> 
Steven Katz*                     628,362(1)                   9.5%

Mark Eisenberg*                  596,000                      9.7%

Ron Lipstein*                    589,855 (2)                  9.2%

Alain Klapholz*                   415,607 (3)                  6.6%

William Schaeffer*                16,000 (4)                   ***

Joseph Stechler                  950,366 (5)                 14.9%
  15 Engle Street
  Englewood, NJ 07631

Steven Lilien                      8,000 (6)                   ***
  19 Larchmont Street
  Ardsley, NY 10502

Soros Fund Management, LLC       847,500 (7)                 13.7%
  888 Seventh Avenue
  33rd Floor
  New York, NY 10106

Lupa Family Partners             467,400 (8)                  7.6%
  888 Seventh Avenue
  33rd Floor
  New York, NY 10106

Pequot Capital                   824,679 (9)                 13.2%
  Management, Inc.
  354 Pequot Avenue
  Southport, CT 06490

</TABLE>


                                       29
<PAGE>   32

All officers and directors as
  a group (seven persons)      3,204,190 (1-6)               44.1%

*     The address of these persons is 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 Securities and
      Exchange 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 22, 1999.  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.

***   Less than 1%, based upon information available to the company.

(1)   Does not include shares owned by Dr. Katz's children, their spouses and
      his grandchildren. Dr. Katz disclaims any beneficial interest in such
      shares. Includes 420,750 shares issuable to Dr. Katz upon his exercise of
      outstanding options and warrants.

(2)   Includes 18,941 shares owned by Dollspart Supply Co., Inc. (a corporation
      of which Mr. Lipstein is the sole shareholder). Also includes 33,600
      shares owned by Mr. Lipstein's minor children. Mr. Lipstein disclaims any
      beneficial interest in such 33,600 shares. Also includes 305,000 shares
      issuable to Mr. Lipstein and 15,000 to his minor children upon his and
      their exercise of outstanding options and warrants.

(3)   Includes 33,000 shares owned by Mr. Klapholz' minor children. Mr. Klapholz
      disclaims any beneficial interest in such 33,000 shares. Also includes
      120,000 shares issuable to Mr. Klapholz upon his exercise of outstanding
      options.

(4)   Includes 15,000 shares issuable to Mr. Schaeffer upon his exercise of
      outstanding options.

(5)   Includes shares owned by Stechler & Company and 30,000 shares owned by a
      charitable foundation of which Mr. Stechler and another member of his
      family are the trustees. Also includes 210,500 shares to be issued by the
      Company to Mr. Stechler or Stechler & Company upon their exercise of
      outstanding options or warrants. Does not include 1,314,900 shares held in
      investment accounts for clients of Stechler & Company. Stechler & Co.'s
      investment power over such investment accounts may be terminated at any
      time by such clients.


                                       30
<PAGE>   33

(6)   Consists of shares underlying options granted under the Company's 1996
      Stock Option Plan.

(7)   823,800 of the shares of Common Stock are held directly for the account of
      Quasar International Partners, C.V. ("Quasar"). Soros Fund Management LLC
      ("SFM LLC") serves as principal investment manager to Quasar and, as such,
      has been granted investment discretion over the 823,800 shares of Common
      Stock held for the account of Quasar pursuant to an investment advisory
      contract entered into with SFM LC, which is terminable within sixty days.
      The remaining 23,700 shares of Common Stock are held for the account of
      Quasar Rabbico N.V., a Netherlands Antilles corporation ("Quasar
      Rabbico"). Quasar Rabbico is a wholly-owned subsidiary of Quasar.
      Investment discretion granted to SFM LLC by Quasar does not extend to
      portfolio investments of Quasar Rabbico. Stechler & Company currently
      exercises investment discretion over the 23,700 shares of Common Stock
      held for the account of Quasar Rabbico, pursuant to an investment advisory
      contract which is terminable within sixty days.

(8)   Lupa Family Partners ("Lupa") is a New York limited partnership. In his
      capacity as one of two general partners, Mr. George Soros exercises voting
      and dispositive power with respect to securities held for the account of
      Lupa. Stechler & Company currently exercises investment discretion over
      the shares of Common Stock held for the account of Lupa, pursuant to an
      investment advisory contract which is terminable within sixty days.

(9)   Shares held by three investment funds. The Company believes that Pequot
      Capital Management, Inc. has sole or shared investment and/or voting power
      for these shares. Includes 81,153 shares issuable upon exercise of
      outstanding warrants.

Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Consulting Agreement

      See "Eisenberg Consulting Agreement" for a description of the
consulting agreement between Dr. Mark Eisenberg and the Company.

Extension of Expiration Date of Class B Warrants

      On December 3, 1998, the Company's Board of Directors extended the
expiration date of the Company's publicly traded Class B Warrants from January
19, 1999 to May 28, 1999. Mr. Joseph Stechler, a director of the Company, is an
owner of Class B Warrants.

Change of Control Agreements

      The Company's Board of Directors has authorized agreements between the
Company and its four executive officers in the event of a "change of control"
of the Company. In the


                                       31
<PAGE>   34

agreements with Dr. Katz and Messrs. Lipstein and Klapholz "change of control"
is defined as a change in the ownership or effective control of the Company or
in the ownership of a substantial portion of the assets of the Company, but in
any event if Messrs. Katz, Lipstein and Klapholz and Dr. Mark Eisenberg no
longer constitute a majority of the Company's Board of Directors. The payments
to be made to such three executive officers in the event of a change of control
of the Company range from 2 to 2.99 times the compensation paid by the Company
to such executive in the twelve-month period prior to the change of control. Of
the 78,750 options granted to Mr. Schaeffer under the Company's 1996 Stock
Option Plan which are still outstanding, options to purchase 63,750 shares at
$9.50 per share are exercisable in different amounts only as the Company
achieves certain milestones and even after a milestone is achieved, the vesting
of the portion of the options exercisable as a result of such milestone being
achieved will be deferred for periods ranging from one to four years. The change
of control agreement with Mr. Schaeffer will provide that such options which
have not already lapsed because the time to achieve the milestone has passed,
will vest immediately upon the change of control of the Company. The agreement
with Mr. Schaffer will define "change of control" as a merger or consolidation
of the Company with another Company or the sale by the Company of all or
substantially all of its assets. The change of control agreements with Messrs.
Katz, Lipstein and Klapholz will provide that in the event that such change of
control occurs, the expiration dates of all options and warrants which have been
granted to such executive and which expire less than three years after such
change of control, will be extended so that such options and warrants expire
three years after such change of control, and that at Messrs. Katz, Lipstein or
Klapholz' election, the Company will lend such executive officer upon his
exercise of any of his warrants or options, interest free and repayable after
three years, the funds needed by such executive officer to pay the exercise
price.

      The Company believes that such payments to most, if not all, of these four
executive officers will, if they are made, constitute "golden parachute"
payments under the Internal Revenue Code and to the extent the change of control
payments made to an individual executive officer exceeds the average annual
compensation paid by the Company to such executive officer in the five year
period prior to such change of control (a) such excess will not be able to be
deducted by the Company in calculating its income for income tax purposes and
(b) a special excise tax equal to 20% of such excess will have to be paid by the
executive officer receiving such excess payments. The change of control
agreements will provide that the Company will pay such excise tax payable by
such executive officer.

                           FORWARD LOOKING INFORMATION

      This Annual Report includes statements that are "forward-looking
statements" within the meaning of Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities Exchange Act of 1934, as amended,
including statements regarding the Company's expectations, hopes, beliefs,
intentions or strategies regarding the future, that are


                                       32
<PAGE>   35

based on the beliefs of Management, 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 such forward-looking
statements. Such statements reflect the current views of Management with respect
to future events and are subject to certain risks, uncertainties and
assumptions, including those described in this Annual Report. 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.

                            AVAILABILITY OF FORM 10-K

      The Company will provide a copy of its annual report on Form 10-K for the
year ended December 31, 1998, filed with the Securities and Exchange Commission,
including the Company's financial statements and the financial statement
schedules, to any stockholder of the Company and to any person holding warrants
or options to purchase shares of the Company's Common Stock, upon written
request and without charge. Such written request should be directed to Mr. Ron
Lipstein, Secretary, at Ortec International, Inc., 3960 Broadway, New York, NY
10032.


                                       33
<PAGE>   36

                                     PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

      (a)   Financial Statements and Financial Statement Schedules.

            (i)   Financial Statements:

            See Index to Financial Statements.

            (ii)  Financial Statement Schedules

            All financial statement schedules have been omitted since either (i)
the schedule or condition requiring a schedule is not applicable or (ii) the
information required by such schedule is contained in the Financial Statements
and Notes thereto or in Management's Discussion and Analysis of Financial
Condition and Results of Operation.

      (b)   Reports on Form 8-K.

            One report on Form 8-K was filed by the Company in the fourth
quarter of 1998 reporting the action taken by the Company's Board of Directors
extending the expiration date of the Company's publicly traded Class B Warrants
from January 20, 1999 to May 28, 1999. No financial statements were included in
that report.

      (c)   Exhibits.

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)

            Form of Warrant Agreement for the publicly held Class B Common
 4.3        Stock Purchase Warrants(1)

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


                                       34
<PAGE>   37

Exhibit No. Description
----------- -----------

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

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

27*         Financial Data Schedule

----------
*     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-K, and
      incorporated herein by reference.


                                       35
<PAGE>   38

                                   SIGNATURES

      In accordance with Section 13 or 15(d) of the Exchange Act, the registrant
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 29, 1999

      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 29, 1999
------------------------      Officer and Director (Principal
Steven Katz, Ph.D.            Executive Officer)


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


/s/ Ron Lipstein              Chief Financial Officer,            March 29, 1999
------------------------      Secretary, Treasurer and Director
Ron Lipstein                  (Principal Financial and 
                              Accounting Officer)


/s/ Alain M. Klapholz         Vice President, Operations          March 29, 1999
----------------------        and Director
Alain M. Klapholz       


/s/ Joseph Stechler           Director                            March 29, 1999
-----------------------
Joseph Stechler


/s/ Steven Lilien             Director                            March 29, 1999
-----------------------       
Steven Lilien


                                       36
<PAGE>   39

                                 Exhibit Index.

[TO BE REVISED]

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)

              Form of Warrant Agreement for the publicly held Class B Common
 4.3          Stock Purchase Warrants(1)

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

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

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

27*           Financial Data Schedule

----------

*     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-K, and
      incorporated herein by reference.


                                       37
<PAGE>   40
                            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, 1998 and 1997               F-3

       Statements of Operations for the years ended
          December 31, 1998,  1997 and 1996, and for the cumulative
          period from March 12, 1991 (inception) to
          December 31, 1998                                          F-5

       Statement of Shareholders' Equity for the cumulative
          period from March 12, 1991 (inception) to
          December 31, 1998                                          F-6

       Statements of Cash Flows for the years ended
          December 31, 1998, 1997 and, 1996 and for the cumulative
          period from March 12, 1991 (inception) to
          December 31, 1998                                          F-9

       Notes to Financial Statements                                 F-11 - F-34


                                      F-1
<PAGE>   41
               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, 1998 and 1997,
and the related  statements of operations,  shareholders'  equity and cash flows
for each of the years in the three-year  period ended December 31, 1998, and for
the period from March 12, 1991 (inception) to December 31, 1998. These financial
statements   are  the   responsibility   of  the   Company's   management.   Our
responsibility  is to express an opinion on these financial  statements based on
our audits.

We  conducted  our  audits  in  accordance  with  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 provide a reasonable basis for our opinion.

In our opinion,  the financial  statements  referred to above present fairly, in
all material respects,  the financial position of Ortec  International,  Inc. at
December 31, 1998 and 1997, and the results of its operations and its cash flows
for each of the years in the three-year  period ended December 31, 1998, and for
the period from March 12, 1991  (inception)  to December 31, 1998, in conformity
with generally accepted accounting principles.





GRANT THORNTON LLP

New York, New York
February 19, 1999


                                      F-2
<PAGE>   42
                            Ortec International, Inc.
                        (a development stage enterprise)

                                 BALANCE SHEETS

                                  December 31,


<TABLE>
<CAPTION>
                                    ASSETS               1998            1997
                                                     ------------    ------------
<S>                                                  <C>             <C>
CURRENT ASSETS
    Cash and cash equivalents                        $  9,449,679    $  9,532,257
    Cash held at transfer agent                              --         2,418,436
    Marketable securities                                 765,660       1,584,035
    Other current assets                                    1,662           7,075
                                                     ------------    ------------

           Total current assets                        10,217,001      13,541,803




PROPERTY AND EQUIPMENT, AT COST
    Laboratory equipment                                  891,109         602,697
    Office furniture and equipment                        611,624         323,871
    Leasehold improvements                              1,199,407         675,906
                                                     ------------    ------------

                                                        2,702,140       1,602,474
    Less accumulated depreciation and amortization     (1,011,713)       (606,243)
                                                     ------------    ------------

                                                        1,690,427         996,231



OTHER ASSETS
    Patent application costs, net of accumulated
       amortization of $64,355 in 1998 and
       $31,047 in 1997                                    451,914         406,166
    Deposits and other assets                              31,697          54,214
                                                     ------------    ------------

                                                     $ 12,391,039    $ 14,998,414
                                                     ============    ============
</TABLE>


                                      F-3
<PAGE>   43
                            Ortec International, Inc.
                        (a development stage enterprise)

                           BALANCE SHEETS (CONTINUED)

                                  December 31,


<TABLE>
<CAPTION>
         LIABILITIES AND
       SHAREHOLDERS' EQUITY                                    1998            1997
                                                           ------------    ------------
<S>                                                        <C>             <C>
CURRENT LIABILITIES
    Accounts payable and accrued expenses                  $    387,401    $    183,270
    Accrued compensation                                         40,765         101,553
    Accrued professional fees                                   269,173         109,717
    Accrued interest                                              8,831          57,903
    Capital lease obligation - current                           30,341          43,102
    Loan payable - current                                      111,589          63,547
                                                           ------------    ------------

           Total current liabilities                            848,100         559,092


LONG-TERM LIABILITIES
    Capital lease obligation - noncurrent                         5,516          34,608
    Loan payable - noncurrent                                 1,146,664         688,096
                                                           ------------    ------------

           Total long-term liabilities                        1,152,180         722,704



COMMITMENTS AND CONTINGENCIES



SHAREHOLDERS' EQUITY
    Common stock, $.001 par value; authorized,
       10,000,000 shares; 6,182,220 shares issued,
        6,175,620 shares outstanding, at December 31,
        1998 and 5,760,734 shares issued and outstanding
        at December 31, 1997                                      6,182           5,761
    Additional paid-in capital                               31,550,954      26,397,307
    Deficit accumulated during the development
       stage                                                (21,099,105)    (12,686,450)
    Treasury stock, at cost (6,600 shares at December
       31, 1998)                                                (67,272)           --
                                                           ------------    ------------

                                                             10,390,759      13,716,618
                                                           ------------    ------------

                                                           $ 12,391,039    $ 14,998,414
                                                           ============    ============
</TABLE>


The accompanying notes are an integral part of these statements.


                                      F-4
<PAGE>   44
                            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,
                                                  1998                1997               1996               1998
                                               ------------       ------------       ------------      --------------
<S>                                            <C>                <C>                <C>               <C>
Revenue
    Interest income                            $    572,549       $    291,602       $    171,057       $  1,102,366
                                               ------------       ------------       ------------       ------------

Expenses
    Research and development                      1,933,877          1,178,836            964,864          6,467,129
    Rent                                            252,397            166,498             85,076            581,844
    Consulting                                      908,495            474,908            261,633          2,140,799
    Personnel                                     4,060,629          1,901,409            730,357          7,837,436
    General and administrative                    1,725,201          1,320,488            727,192          4,880,061
    Interest and other expense                      104,605             75,126             51,703            294,202
                                               ------------       ------------       ------------       ------------

                                                  8,985,204          5,117,265          2,820,825         22,201,471
                                               ------------       ------------       ------------       ------------

       Net loss                                $ (8,412,655)      $ (4,825,663)      $ (2,649,768)      $(21,099,105)
                                               ============       ============       ============       ============

Net loss per share of common stock
    Basic and diluted                          $      (1.43)      $      (1.01)      $       (.64)      $      (6.51)
                                               ============       ============       ============       ============

Weighted average common stock outstanding
    Basic and diluted                             5,878,971          4,782,239          4,110,507          3,242,893
                                               ============       ============       ============       ============
</TABLE>


The accompanying notes are an integral part of these statements.


                                      F-5
<PAGE>   45
                            Ortec International, Inc.
                        (a development stage enterprise)

                        STATEMENT OF SHAREHOLDERS' EQUITY


<TABLE>
<CAPTION>
                                                                                             Deficit
                                                                                           accumulated
                                                          Common stock        Additional    during the                     Total
                                                      --------------------      paid-in     development   Treasury     shareholders'
                                                        Shares      Amount      capital        stage        stock          equity
                                                      ----------    ------    ----------    -----------   --------     -------------
<S>                                                   <C>           <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>   46
                            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    Treasury    shareholders'
                                                     Shares      Amount    capital         stage         stock        equity
                                                     ------      ------  -----------    -----------    --------    -------------
<S>                                                  <C>         <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>   47
                            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     Treasury     shareholders'
                                                 Shares      Amount       capital         stage          stock          equity
                                                 ------      ------    ------------    ------------    -------      -------------
<S>                                             <C>          <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)
Stock options issued for services                                           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

Exercise of warrants                            1,158,771     1,159      10,821,632                                    10,822,791
Share issuance costs                                                       (657,508)                                     (657,508)
Stock options and warrants issued for services                              660,000                                       660,000
Net loss                                                                                 (4,825,663)                   (4,825,663)
                                                ---------    ------     -----------    ------------                  ------------

Balance at December 31, 1997                    5,760,734     5,761      26,397,307     (12,686,450)                   13,716,618

Exercise of warrants                              221,486       221       1,281,736                                     1,281,957
Stock options and warrants issued for services                            1,920,111                                     1,920,111
Sixth private placement                           200,000       200       1,788,498                                     1,788,698
Warrants issued in Sixth private placement                                  211,302                                       211,302
Share issuance costs                                                        (48,000)                                      (48,000)
Purchase of treasury stock (at cost)                                                                   $(67,272)          (67,272)
Net loss                                                                                 (8,412,655)                   (8,412,655)
                                                ---------    ------     -----------    ------------    --------       -----------

Balance at December 31, 1998                    6,182,220    $6,182     $31,550,954    $(21,099,105)   $(67,272)      $10,390,759
                                                =========    ======     ===========    ============    ========       ===========
</TABLE>

The accompanying notes are an integral part of this statement.


                                      F-8
<PAGE>   48
                            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,
                                                         1998                1997               1996                 1998
                                                    -------------         -----------         -----------       --------------
<S>                                                 <C>                   <C>                 <C>               <C>
Cash flows from operating activities
   Net loss                                         $  (8,412,655)        $(4,825,663)        $(2,649,768)       $(21,099,105)
   Adjustments to reconcile net loss to net cash
     used in operating activities
       Deferred occupancy costs                                                                    (1,327)
       Depreciation and amortization                      438,778             314,433             152,290           1,086,305
       Unrealized (gain) loss on marketable
         securities                                                           (55,800)                                 11,404
       Realized loss on marketable securities                                                                           5,250
       Non-cash stock compensation and interest         1,920,111             660,000             152,000           2,732,111
       Purchases of marketable securities             (17,540,589)         (1,528,235)                            (19,068,824)
       Sales of marketable securities                  18,358,964                                                  18,358,964
       (Increase) decrease in assets
         Prepaid expenses                                    (588)              7,616              (7,616)               (588)
         Other current assets                               6,001              (5,117)             (1,901)             (1,074)
       Increase (decrease) in liabilities
         Accounts payable and accrued liabilities         253,727            (110,356)            133,715             793,997
                                                    -------------         -----------         -----------        ------------

       Net cash used in operating activities           (4,976,251)         (5,543,122)         (2,222,607)        (17,181,560)
                                                    -------------         -----------         -----------        ------------

Cash flows from investing activities
   Purchases of property and equipment, excluding
       capital leases                                  (1,099,666)           (303,053)           (884,093)         (2,615,074)
   Payments for patent applications                       (79,056)            (26,856)            (40,757)           (516,269)
   Organization costs                                                                                                 (10,238)
   Deposits                                                22,517             (22,965)            (25,210)            (29,714)
   Purchases of marketable securities                                                                                (594,986)
   Sale of marketable securities                                                                                      522,532
                                                    -------------         -----------         -----------        ------------

       Net cash used in investing activities           (1,156,205)           (352,874)           (950,060)         (3,243,749)
                                                    -------------         -----------         -----------        ------------
</TABLE>


                                      F-9
<PAGE>   49
                            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,
                                                         1998                1997               1996                  1998
                                                     ------------         -----------        -----------         --------------
<S>                                                  <C>                  <C>                <C>                 <C>
Cash flows from financing activities
    Proceeds from issuance of notes payable                                                                       $     515,500
    Proceeds from issuance of common stock           $  5,700,393         $ 8,404,355        $12,254,682             31,359,983
    Share issuance expenses                               (48,000)           (657,508)        (1,580,690)            (2,575,697)
    Purchase of treasury stock                            (67,272)                                                      (67,272)
    Proceeds from issuance of loans payable               600,000             325,850            500,000              1,425,850
    Repayment of capital lease obligations                (41,853)            (24,940)            (4,554)               (71,347)
    Repayment of loan payable                             (93,390)            (72,733)           (30,406)              (196,529)
    Repayment of notes payable                                                                  (515,500)              (515,500)
                                                     ------------         -----------        -----------          -------------

       Net cash provided by financing activities        6,049,878           7,975,024         10,623,532             29,874,988
                                                     ------------         -----------        -----------          -------------

       NET INCREASE (DECREASE)  IN
          CASH AND CASH EQUIVALENTS                       (82,578)          2,079,028          7,450,865              9,449,679

Cash and cash equivalents at beginning of period        9,532,257           7,453,229              2,364              -
                                                     ------------         -----------        -----------          -------------

Cash and cash equivalents at end of period           $  9,449,679         $ 9,532,257        $ 7,453,229          $   9,449,679
                                                     ============         ===========        ===========          =============


Supplemental disclosures of cash flow information:
   Noncash financing activities
     Capital lease obligations                       $          -         $   100,367        $    18,536          $     118,903
     Deferred offering costs included in
       accrued professional fees                                -                   -                  -                314,697
     Forgiveness of rent payable                                -                   -                  -                 40,740

   Cash paid for interest                                 153,677              47,884             14,792                216,353
   Cash paid for income taxes                              38,442              20,529              1,120                 60,091
</TABLE>


The accompanying notes are an integral part of these statements.


                                      F-10
<PAGE>   50
                            Ortec International, Inc.
                        (a development stage enterprise)

                          NOTES TO FINANCIAL STATEMENTS

                           December 31, 1998 and 1997



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 had granted Ortec a
     license for a term of ten years,  with automatic  renewals by Ortec for two
     additional ten-year periods, to commercially use and exploit the Technology
     for the development of products.  In April 1998, Dr. Eisenberg assigned his
     patent for the Technology to Ortec for no consideration.

     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.

     Initial Public Offering

     On January 19,  1996,  the Company  completed  an initial  public  offering
     ("IPO")  of  1,200,000  units.  Each  unit  consisted  of one  share of the
     Company's common stock, one Class A warrant to purchase one share of common
     stock at $10, of which  1,083,780  were  exercised  and the balance was not
     exercised and has expired as of December 31, 1998,  and one Class B warrant
     to  purchase  one  share of  common  stock at $15,  of  which  11,400  were
     exercised as of December 31, 1998. The Class B warrants were originally set
     to expire in January 1999. The Company has extended the expiration  date to
     May 28, 1999. The Class B warrants are subject to redemption by the Company
     at $.01 per warrant.


                                      F-11
<PAGE>   51
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1998 and 1997



NOTE A (CONTINUED)

     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.


NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

     1.  Research and Development Costs

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

     2.  Depreciation and Amortization

         Property and  equipment are carried at cost,  less any grants  received
         for construction. In 1996, the Company received a $400,000 grant toward
         the  construction  of its new laboratory  and office  facilities and it
         received an additional grant of $130,000 in 1998. (see Note I).


         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.

     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.


                                      F-12
<PAGE>   52
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1998 and 1997



NOTE B (CONTINUED)

     4.  Foreign Currency Translation

         The  Company  conducts  some of its  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  are translated
         at historical rates.

     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.

     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 and Cash Equivalents

         For purposes of the statement of cash flows, the Company  considers all
         highly liquid debt  instruments  purchased with original  maturities of
         three months or less to be cash equivalents.  Cash equivalents  consist
         principally of money market funds and U.S. Government Agency Bonds. The
         market value of the cash equivalents approximates cost.


                                      F-13
<PAGE>   53
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1998 and 1997



NOTE B (CONTINUED)

     8.  Certain Reclassifications

         Certain  reclassifications  have been made to prior  year's  financial
         statements in order to conform to the December 31, 1998 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.

         Basic earnings per share exclude  dilution and are computed by dividing
         income (loss) available to common shareholders by the  weighted-average
         common shares  outstanding for the period.  Diluted  earnings per share
         reflect  the  weighted-average   common  shares  outstanding  plus  the
         potential   dilutive  effect  of  securities  or  contracts  which  are
         convertible  to  common  shares,   such  as  options,   warrants,   and
         convertible preferred stock.

         Options and warrants to purchase  shares of common stock of 944,500 and
         678,609,  respectively,  remain  outstanding  at December 31, 1998, but
         were not  included in the  computation  of diluted EPS because to do so
         would have been  antidilutive for the periods  presented.  (See Notes G
         and H.)

    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, 1998.


                                      F-14
<PAGE>   54
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1998 and 1997



NOTE B (CONTINUED)

    11.  Marketable Securities

         Pursuant  to  Statement  of  Financial  Accounting  Standards  No. 115,
         "Accounting  for Certain  Investments  in Debt and Equity  Securities,"
         investments  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. At December 31, 1998,  marketable  securities  consist
         primarily  of an  investment  in a Federal  Home Loan Bank Note that is
         classified as "trading."


NOTE C - CONCENTRATION OF CREDIT RISK

     The Company  maintains  cash and cash  equivalent  balances and  marketable
     securities at three  financial  institutions  located in New York City. The
     accounts are insured by the Securities Investors Protection  Corporation up
     to $500,000 and the FDIC up to $100,000.  Uninsured  balances  aggregate to
     approximately  $9,288,000  and  $12,406,000  at December 31, 1998 and 1997,
     respectively.  The Company has not  experienced any losses in such accounts
     and believes it is not exposed to any significant credit risk.


NOTE D - PATENTS

     Patent  application costs are stated at cost less amortization  computed by
     the  straight-line  method  principally  over 14 years.  The Company's U.S.
     patent was issued in 1994 and expires in 2011.

     There can be no assurance that any patent will provide commercial  benefits
     to the Company.


NOTE E - CAPITAL LEASE OBLIGATION

     The Company has entered into several capital lease agreements with terms of
     two to three  years at  effective  interest  rates  ranging  from  4.81% to
     15.88%.  The future minimum lease payments and the present value of the net
     minimum lease payments as of December 31, 1998 are as follows:


                                      F-15
<PAGE>   55
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1998 and 1997



NOTE E (CONTINUED)

<TABLE>
<S>                                                     <C>
      Year ending December 31,
        1999                                            $32,527
        2000                                              5,678
                                                        -------

      Total minimum lease payments                       38,205
      Less amount representing interest                   2,348
                                                        -------
      Present value of net minimum lease payments       $35,857
                                                        =======

      Current portion                                   $30,341
      Noncurrent portion                                  5,516
                                                        -------
                                                        $35,857
                                                        =======
</TABLE>

     As of December 31, 1998 and 1997, the Company has recorded $118,903 in
     equipment purchased under capital leases and $85,026 and $35,792 in
     accumulated amortization, respectively.


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.
     During 1997, the Company modified the terms of the loan as a result of
     increased build-out costs incurred in the construction of the facility. An
     adjustment has been made in 1997 to record additional interest and
     principal. The adjusted loan payments are due in monthly installments of
     $10,103, including interest at an effective rate of 7.98%, through July
     2006.

     During 1998, the Company obtained an additional loan from the landlord for
     improvements to the leased facility. This new loan is payable in monthly
     installments of $7,375, including interest at an effective rate of 8.6%,
     through March 2008.


                                      F-16
<PAGE>   56
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1998 and 1997



NOTE F (CONTINUED)

     Minimum payments to be made under the terms of the loans are as follows:

<TABLE>
<S>                                                         <C>
            Year ending December 31,
                1999                                        $  209,738
                2000                                           209,738
                2001                                           209,738
                2002                                           209,738
                2003                                           209,738
                2004 and thereafter                            689,334
                                                            ----------

                                                             1,738,024
            Less amount representing interest                  479,771
                                                            ----------

            Net present value of future loan payments       $1,258,253
                                                            ==========

            Current portion                                 $  111,589
            Noncurrent portion                               1,146,664
                                                            ----------

                                                            $1,258,253
                                                            ==========
      </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>   57
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1998 and 1997



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 (including 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, such
     warrants were exercised on December 29, 1998. 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.

     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 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.

     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.



                                      F-18
<PAGE>   58
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1998 and 1997



NOTE G (CONTINUED)

     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 had exercised options and purchased 5,000
     shares under such agreement at $10 per share. The remaining balance of such
     options has expired.

     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, 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, which expired on July 21, 1997.

     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
     consisted of one share of the Company's common stock, one Class A warrant
     to purchase one share of common stock at $10 and one Class B warrant to
     purchase one share of common stock at $15. As of December 31, 1998,
     1,083,780 Class A warrants were exercised and the balance was not exercised
     and has expired. The Class B warrants were originally set to expire in
     January 1999. The Company has extended the expiration date to May 28, 1999.
     The Class B warrants are subject to redemption by the Company at $.01 per
     warrant. The Company received gross proceeds of approximately $1,282,000
     and $10,823,000 and net proceeds of approximately $1,262,000 and
     $10,165,000 as a result of the exercise of warrants in 1998 and 1997,
     respectively.


                                      F-19
<PAGE>   59
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1998 and 1997



NOTE G (CONTINUED)

     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
     agents, exercisable at prices equal to 120% of the prices paid for such
     shares. Pursuant to the purchasers' request, the Company registered all
     959,106 shares.

     During 1992 and 1993, 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. During 1996 and 1997, 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. At different
     times during the third quarter of 1997, eight persons exercised such
     warrants and purchased an aggregate of 21,210 shares of common stock at the
     $1.00 per share exercise price. During 1998, nine persons exercised such
     warrants and purchased on aggregate of 96,077 shares of common stock at the
     $1.00 per share exercise price. There were no underwriting discounts or
     commissions given or paid in connection with any of the foregoing warrant
     exercises.

     During the third quarter of 1997, the Company granted to one person and its
     seven designees four-year warrants to purchase an aggregate of 37,500
     shares of common stock, at an exercise price of $12.00 per share. Such
     warrants are not exercisable until July 18, 1998 and were granted in
     consideration for consulting services rendered to the Company.


                                      F-20
<PAGE>   60
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1998 and 1997



NOTE G (CONTINUED)

     During the fourth quarter of 1997, the Company granted to one person and
     its six designees four-year warrants to purchase an aggregate of 37,500
     shares of common stock, at an exercise price of $12.00 per share. Such
     warrants are not exercisable until July 18, 1998 and were granted in
     consideration for consulting services rendered to the Company.

     During 1998, warrants for 18,700 shares, mentioned in the two previous
     paragraphs, were exercised utilizing the cashless exercise option of the
     warrant agreement. The Company issued 6,204 shares under this exercise.

     During the third quarter of 1997, the Company granted to one person a
     one-year warrant to purchase an aggregate of 625 shares of common stock, at
     an exercise price of $12.00 per share. Such warrants were granted in
     consideration for consulting services rendered to the Company. The warrant
     was exercised during 1998.

     The Company recorded consulting expense of approximately $64,000 and
     $120,000 as a result of these grants during the year ended December 31,
     1998 and 1997, respectively.

     During the fourth quarter of 1997, the Company granted five-year warrants
     to its three executive officers to purchase an aggregate of 240,000 shares
     of common stock, at an exercise price of $12.00 per share. Such warrants
     were granted in consideration for services rendered to the Company. The
     exercise of such warrants is contingent upon the occurrence of certain
     events, which were considered probable at December 31, 1997. As of December
     31, 1998, five of the six events have occurred so that 185,000 of those
     warrants are now vested. As a result, the Company recorded compensation
     expense of approximately $80,000 in December 1997 and $1,185,000 for the
     year ended December 31, 1998. The balance of the warrants became vested
     upon the exercise of warrants owned by a director in December 1998 in
     accordance with the terms of certain compensation provisions as approved by
     the Company's Board of Directors.

     In consideration for services rendered by him as a director of the Company
     in the five-year period from 1992 to 1996 for which he never received
     compensation, the Company extended by one year to December 31, 1998 the
     expiration date of warrants owned by a director to purchase an aggregate of
     86,930 shares, exercisable at $9.425 per share. As a result, the Company
     recorded compensation expense of approximately $420,000, during the fourth
     quarter of 1997. All of these warrants were exercised on December 29, 1998.



                                      F-21
<PAGE>   61
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1998 and 1997



NOTE G (CONTINUED)

     During the fourth quarter of 1998, the Company granted five-year options to
     its three executive officers to purchase an aggregate of 520,750 shares of
     common stock, at exercise prices ranging from $12.13 to $12.44 per share.
     The exercise of such options was contingent upon the occurrence of certain
     events. All of these options became vested upon the exercise of warrants
     owned by a director in December 1998 in accordance with the terms of
     certain compensation provisions as approved by the Company's Board of
     Directors. As a result, the Company recorded compensation expense of
     approximately $495,000 in December 1998.

     In December 1998, the Company completed a private placement of its
     securities from which it received proceeds of $2,000,000. In addition, the
     Company granted three-year warrants to the Purchaser to purchase 50,000
     shares at $12 per share. The Company sold 200,000 shares of common stock in
     such private placement. The Company assigned value to the common stock and
     warrants issued of $1,788,698 and $211,302 based upon the relative fair
     market value of the stock at the date of issuance and the estimated fair
     value of the warrants using the Black-Scholes option pricing model.



                                      F-22
<PAGE>   62
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1998 and 1997



NOTE G (CONTINUED)

     The following table summarizes warrant activity during the period from
     March 12, 1991 (inception) through December 31, 1998 (excluding the Class A
     and B warrants which were issued during the IPO):

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

       Balance, December 31, 1991                                       9.425                   7,360
           Granted                                                      9.425                  55,080
                                                                                             --------

       Balance, December 31, 1992                                       9.425                  62,440
           Granted                                                9.425 - 12.00                48,230
                                                                                             --------

       Balance, December 31, 1993                                 9.425 - 12.00               110,670
           Granted                                                     12.00                   10,000
                                                                                             --------

       Balance, December 31, 1994                                 9.425 - 12.00               120,670
           Granted                                                     10.00                    4,000
           Expired                                                      9.425                  (2,680)
                                                                                            ---------

       Balance, December 31, 1995                                 9.425 - 12.00               121,990
           Granted                                                 1.00 - 10.00               511,606
           Exercised                                                    1.00                  (33,885)
           Expired                                                     12.00                   (2,450)
                                                                                            ---------

       Balance, December 31, 1996                                   1.00 - 12.00              597,261
           Granted                                                12.00 - 14.25               330,625
           Expired                                                     12.00                  (10,000)
                                                                                             --------

       Balance, December 31, 1997                                  1.00 - 14.25               917,886
           Granted                                                12.00 - 14.00                75,000
           Exercised                                                1.00 - 12.00             (205,852)
           Expired                                                    12.00                  (108,425)
                                                                                             --------

       BALANCE, DECEMBER 31, 1998                                  $1.00 - 14.25              678,609
                                                                                             ========
</TABLE>


                                      F-23
<PAGE>   63
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1998 and 1997



NOTE H - STOCK OPTIONS AND 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.

     In August 1998, the stockholders and Board of Directors ratified and
     approved an amended and restated 1996 Stock Option Plan increasing the
     maximum number of shares of the Company's common stock for which stock
     options may be granted from 350,000 to 1,550,000 shares.

     The following table summarizes the stock option activity for the years
     ended December 31, 1998 and 1997:

<TABLE>
<CAPTION>
                                                                  Weighted
                                                                   average
                                                                   exercise
                                                     Number         price
                                                     -------        ------
<S>                                                  <C>            <C>
      Granted - adoption of stock option plan        156,000        $ 7.08
                                                     -------

      Balance, December 31, 1996                     156,000          7.08

      Granted                                        123,000         11.94
      Forfeited, expired                              (3,000)         6.63
                                                     -------

      Balance, December 31, 1997                     276,000          9.25

      Granted                                        689,750         12.10
      Exercised                                       (6,750)         7.42
      Forfeited, expired                             (14,500)        11.19
                                                     -------

      BALANCE, DECEMBER 31, 1998                     944,500        $11.17
                                                     =======
</TABLE>


                                      F-24
<PAGE>   64
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1998 and 1997



NOTE H (CONTINUED)

     As of December 31, 1998, options outstanding for 793,700 shares were
     exercisable at the weighted-average exercise price of $11.19, and the
     weighted remaining contractual life was approximately 4.7 years. The
     exercise price for all stock options awarded has been determined by the
     Board of Directors of the Company.

     The following table summarizes option data as of December 31, 1998:

<TABLE>
<CAPTION>
                                                             Weighted
                                                              average          Weighted                          Weighted
                                                             remaining          average                           average
           Range of                          Number         contractual        exercise          Number          exercise
      exercise prices                      outstanding         life              price         exercisable         price
      ---------------                      -----------         ----              -----         -----------         -----
<S>                                         <C>                <C>            <C>              <C>             <C>
      $6.25 to $  7.38                      111,000            2.30           $  6.43            111,000         $  6.43
      $8.50 to $10.00                       205,250            5.60              9.17            111,500            8.98
      $12.00 to $14.25                      612,750            4.84             12.46            561,250           12.39
      $18.50 to $21.38                       15,500            4.36             20.72             10,000           20.94
                                            -------                                              -------

                                            944,500            4.70             11.17            793,700           11.19
                                            =======                                              =======
</TABLE>


     In October 1995, the Financial Accounting Standards No. 123 ("SFAS No.
     123"), "Accounting for Stock-Based Compensation," 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 reflect 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 had been recorded.


                                      F-25
<PAGE>   65
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1998 and 1997



NOTE H (CONTINUED)

     The Company follows Accounting Principles Board Opinion No. 25 and its
     related interpretations in accounting for its stock-based compensation
     plans.

     The Company recognized approximately $1,696,000 and $480,000 of
     compensation expense for options and warrants issued to officers and
     directors of the Company in 1998 and 1997, respectively. Such options and
     warrants were accounted for as variable option grants. Such options and
     warrants had vested prematurely in December 1998, upon the exercise of
     warrants owned by a director of the Company, in accordance with the terms
     of certain compensation provisions provided for and approved by the
     Company's Board of Directors.

     The Company utilized the Black-Scholes option-pricing model to quantify the
     expense of options and warrants granted to nonemployees and the pro forma
     effects on net loss and net loss per share of the fair value of the options
     and warrants granted to employees during 1998. The following assumptions
     were made in estimating fair value.

<TABLE>
<S>                                                                 <C>
       Risk-free interest rate                                      5%
       Expected option life                                         3 years
       Expected volatility                                          60%
</TABLE>

     Had compensation cost been determined under SFAS No. 123 for the year ended
     December 31, 1998, net loss and loss per share would have been increased as
     follows:

<TABLE>
<S>                                                              <C>
       Net loss
           As reported                                           $ (8,412,655)
           Pro forma for stock options and warrants               (11,609,531)

       Net loss per share
           As reported                                                $(1.43)
           Pro forma for stock options and warrants                    (1.97)
</TABLE>

     In addition, the Company recognized approximately $160,000 and $180,000 in
     consulting expenses in 1998 and 1997, respectively, for options and
     warrants granted to independent consultants and investment bankers for
     services rendered to the Company.


                                      F-26
<PAGE>   66
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1998 and 1997



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. As of December 31, 1998 and for the cumulative period
     since inception, no bonuses have been earned by Dr. Eisenberg. For each of
     the years ended December 31, 1998, 1997 and 1996, Dr. Eisenberg earned
     approximately $78,000 for consulting services and approximately $537,000
     for the period from inception to December 31, 1998, which is included in
     research and development expense. Included in accrued professional fees at
     December 31, 1998 and 1997 are $31,411 and $37,494, 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. Fees earned by Cornell amounted to approximately $1,145,000 for the
     period from inception to December 31, 1996. The Cornell arrangement was
     terminated as of December 31, 1996.


                                      F-27
<PAGE>   67
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1998 and 1997



NOTE I (CONTINUED)

     In January 1997, the Company 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 contributed $40,000 of the $100,000 cost of such research in
     1998. In June 1998, the Company agreed to pay an additional $60,000 in
     total, in quarterly payments of $15,000 each. The Company has paid $15,000
     of such quarterly payments in 1998.

     Occupancy Arrangements

     The Company leases approximately 5,000 square feet of space in Sydney,
     Australia, on a month-to-month basis, in which the Company operates a
     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. The Company pays rent in Australian dollars, which
     at the current rate of exchange, amounts to approximately US$33,000 per
     year. This space is rented from Dr. Mark Eisenberg's father on terms that
     the Company believes are not less favorable to it than for rental of
     similar space in Sydney, Australia, from nonrelated third parties.

     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.

     Total rent expense under the lease for the years ended December 31, 1998,
     1997 and 1996, was approximately $32,000, $37,000 and $31,000,
     respectively.

     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 1996, the
     Company also granted Columbia a warrant expiring March 2001 to purchase
     5,000 shares of common stock at an


                                      F-28
<PAGE>   68
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1998 and 1997



NOTE I (CONTINUED)

     exercise price of $10 per share. In addition, Columbia had 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. During
     1998, the Company received the $600,000 loan and an additional grant of
     $130,000 and entered into two leases with Columbia for additional space in
     the building. The Company utilizes its laboratory facilities 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 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 for the original lease is five years,
     expiring in June 2001 and one year for the two new leases. The minimum
     rental payments due over the term of the lease at December 31, 1998 are as
     follows:

<TABLE>
<S>                                                                   <C>
            Year ending December 31,
                1999                                                  $318,364
                2000                                                   254,700
                2001                                                   127,350
                                                                       -------

                                                                      $700,414
                                                                      ========
</TABLE>

     Total rent expense under the lease for the years ended December 31, 1998,
     1997 and 1996 was approximately $241,800, $129,700 and $70,300,
     respectively.


                                      F-29
<PAGE>   69
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1998 and 1997



NOTE I (CONTINUED)

     Contingencies

     A competitor had 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.
     Management does not believe that the resolution of such matter 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 - RELATED PARTY TRANSACTIONS

     Prior to December 31, 1998, the "Other Founders" were paid fees for
     services rendered of approximately $980,000 in the aggregate, for the
     period from inception to December 31, 1998. In addition, in 1996, $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).

     In December 1997, the Company extended the expiration date on warrants to
     the director to purchase 86,930 shares, exercisable at $9.425 per share,
     resulting in compensation expense of approximately $420,000 (see Note G).


                                      F-30
<PAGE>   70
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1998 and 1997



NOTE J (CONTINUED)

     The Company paid approximately $35,000 and $25,000 for the years ended
     December 31, 1997 and 1996, respectively, as fees for accounting services,
     to a stockholder (approximately $100,000 for the period from inception to
     December 31, 1997). 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.

     Prior to June 1996, the Company's executive offices were located in office
     space leased by a company owned by an officer, founder and director of the
     Company on a rent-free basis.

     Change of Control

     In December 1998, the Company's Board of Directors authorized agreements
     between the Company and its four executive officers which state that in the
     event of a "change of control" certain "special compensation arrangements"
     will occur. A "change of control" is defined as a change in the ownership
     or effective control of the Company or in the ownership of a substantial
     portion of the assets of the Company, but in any event if certain members
     of the Company's Board of Directors no longer constitute a majority of the
     Board of Directors. In the event that such change of control occurs, the
     agreements will provide three of its officers additional compensation,
     interest-free loans to exercise their stock options and warrants, and
     extensions of the expiration dates of all of their then outstanding options
     and warrants. In addition, for all four of the officers, in the event of a
     change of control, all unvested options and warrants will vest immediately
     upon such change of control.


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, 1998, the Company had net operating loss carryforwards of
     approximately $4,537,000 for income tax purposes expiring through 2013. 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.


                                      F-31
<PAGE>   71
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1998 and 1997



NOTE K (CONTINUED)

     For financial statement purposes, a valuation allowance of approximately
     $8,372,000 and $5,907,000 at December 31, 1998 and 1997, 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.

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

<TABLE>
<CAPTION>
                                                      December 31,
                                             ------------------------------
                                                1998               1997
                                             -----------        -----------
<S>                                          <C>                <C>
      Net operating loss carryforwards       $ 2,087,000        $ 1,570,000
      Deferral of start-up costs               6,285,000          4,337,000
                                             -----------        -----------

                                               8,372,000          5,907,000

      Valuation allowance                     (8,372,000)        (5,907,000)
                                             -----------        -----------

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


NOTE L - FOREIGN OPERATIONS

     The Company has a laboratory in Sydney, Australia. Summary financial
     information for the years ended December 31, 1998, 1997 and 1996 are as
     follows:

<TABLE>
<CAPTION>
                          1998            1997           1996
                         -------        -------        -------
<S>                     <C>            <C>            <C>
      Assets            $ 25,000       $ 23,000       $ 53,000
      Liabilities           --            7,000          3,000
      Expenses           247,000        232,000        180,000
</TABLE>


     Expenses are net of foreign exchange losses of approximately $1,684, $5,698
     and $2,050 for the years ended December 31, 1998, 1997 and 1996,
     respectively.


                                      F-32
<PAGE>   72
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1998 and 1997



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 restated on Form 10-Q/A.


NOTE N - FAIR VALUE OF FINANCIAL INSTRUMENTS

     Statement of Financial Accounting Standards No. 107 ("SFAS No. 107"),
     "Fair Value of Financial Instruments," requires disclosure of the
     estimated fair value of an entity's financial instrument assets and
     liabilities. For the Company, financial instruments consist principally of
     cash and cash equivalents, marketable securities and loan payable.

     The following methods and assumptions were used to estimate the fair value
     of each class of financial instrument for which it is practicable to
     estimate that value.

     Cash and Cash Equivalents

     The carrying value reasonably approximates fair value because of the short
     maturity of those instruments.

     Marketable Securities

     Marketable securities consist principally of an investment in a Federal
     Home Loan Bank Note. The fair values of these securities are based on
     quoted market prices.

     Loan Payable

     Based on borrowing rates currently available to the Company for bank loans
     with similar terms and maturities, the carrying value of the Company's loan
     payable approximates the fair value.


                                      F-33
<PAGE>   73
                            Ortec International, Inc.
                        (a development stage enterprise)

                    NOTES TO FINANCIAL STATEMENTS (CONTINUED)

                           December 31, 1998 and 1997



NOTE O - NEW ACCOUNTING STANDARDS

     Statement of Position ("SOP") 98-5, "Reporting on the Costs of Start-Up
     Activities," provides guidance on accounting for start-up costs and
     organization costs, which must be expensed as incurred. The SOP, which is
     consistent with the Company's previous accounting policy, is effective for
     financial statements beginning January 1, 1999.


                                      F-34